Is the Market Overpriced?

Should you make changes to your wealth management strategy based on current market conditions and predictions?

I received this question from a friend recently:

“I am getting very nervous with the current market. I feel like the record highs don’t make any sense with the turmoil and uncertainty in politics, the pandemic and the economy. Does it make sense to adjust to a more conservative allocation for the first half of the year until some of the current events play out? I am thinking any upside to the market is limited while potential downside would be significant.”

Short Answer: Market timing is not a strategy for wealth management

You know the moral of the story with the tortoise and the hare: slow and steady wins the race. You could sprint and make some gains, given you have the endurance and resources to finish the marathon at that pace. Market timing is a difficult strategy for any one investor. It wreaks havoc on your psyche to be constantly questioning “in or out” with an ever changing market. Further,  you won’t know if it was a successful or optimal strategy for many years.

So, does that mean you should ignore valuations, stick your head in your shell and keep your current allocation and pace? Quite possibly, yes. I’ve met great success with buy-and-hold accumulators that invest from paychecks each month, year over year. Steadily saving into a diversified portfolio over a long period of time is absolutely one ideal way to grow wealth.

Perhaps you have amassed a large portfolio and are now retired or close to it, living off of the wealth you steadily gained with your investment strategy. A 30% decline to your wealth in a short period of time is a scary prospect. What should you do? Get out of the market?

Short Answer: Buying in and out of the market is not strategy, it is guesswork

I never advocate selling your investments and exiting the market all together. Why? No one has a crystal ball. What if you sell now and the market continues to go up? How long can you hold steady, waiting for it to fall? What if it doesn’t fall in 2021? And keeps going up in 2022?  

Or, perhaps the opposite holds true and the market crashes because the COVID vaccines don’t work, political unrest disrupts our society, or any number of other unforeseen events occur? When will you buy back in? Did it occur to you, in the midst of a developing pandemic, to buy stocks in March last year? When the unemployment rate soared to record heights, were you focused on your portfolio? It was difficult enough to stay-at-home, mask-up and not let the political turmoil overtake my social and emotional well-being. The point is: don’t play guessing games with your wealth management.

Short Answer: Defense is the best offense when it comes to wealth management strategy

Now is a great time to set up defenses within your portfolio. Hopefully you made some gains from the bull market in 2020. If you invest in a well diversified, index-fund portfolio then now is a great time to shore up your personal balance sheet. Take those gains and pay down some debt. Rebalance your holdings back to your normal allocation or even to a slightly less aggressive portfolio.  

We are in the “sell high” phase of the old adage “buy low, sell high.” Enjoy some gains and get ready for the inevitable stumbles the market will make over the next few years.  

Short Answer: Planning is the only strategy to guarantee success

“My portfolio is usually 80% stocks, 20% bonds – but I’m going to rebalance to 75% stocks and 25% bonds until there’s a 20% decline from an all-time high in the market. At that point I’ll rebalance back to 80/20.”  That’s a plan that you can write down and follow.*

Don’t rely on your emotions to know when to buy and sell: make a plan. As we’ve all learned in this past year, our carefully built house of cards can fall at any time. When that happens, making decisions intellectually can be difficult. You feel like “sell” is the right move, when in actuality, according to your written plan, you should “buy.” Trust in your plan to keep you on track when the proverbial poop hits the fan.

Practice what you preach: Here’s what I’m doing

In the vein of “Don’t tell me, show me,” I am planning to be more defensive in my own wealth management strategy. Nothing drastic, just some tweaks to be ready. Here are a few of my priorities:

  1. Pay off some debt. I’m paying down my HELOC, which has a very low interest rate but still costs me more than the return on any cash in the bank!
  2. Rebalance my portfolio. I’m a pretty aggressive investor, so I am pulling back and changing my investment to 80% stocks / 20% bonds. Once I pay down some debt, my investments will be over 80% in stocks and therefore I need to sell some to rebalance.
  3. Watch the market and stick to my plan. If the market rises, I’ll continue to sell whatever gains the most. I’m very comfortable staying at 80/20 for a long time. If the market falls 20%, 30% or 40% from all-time highs, I will not only rebalance back to 80% equities but also up that to 85%, 90% or 95%. If the market falls drastically, I will also utilize my line-of-credit to fund any lifestyle needs, rather than hold cash in reserve for potential purchases.

So, what’s your plan for 2021?

*If the market goes up 45% from there and then falls 20%, you may buy back in above where you sold. That’s OK: you had a plan and executed it.****And in fact, during that 45% rise hopefully you again rebalanced and “sold high”!

Photo by Lucas Clara on Unsplash

Understanding Employee Stock Options

My company has granted me several stock options. What are stock options, and what do I need to know about them?

First, you need to know that stock options are a form of compensation so congratulations on earning additional rewards from your employer beyond your base salary. Stock options provide you with the right to purchase a company’s stock. Once you buy the stock, then you own it – just like any other stock that you purchase in your brokerage account. However, with options there are a number of key terms and considerations to familiarize yourself with:

Key Terminology to Understanding Stock Options

  • Stock option grant : Grants are akin to bonuses; companies offer grants to employees as an incentive to keep them within the organization. A single grant is a right to purchase a certain number of shares of company stock at a stated price within a specific period of time. Employees who remain with a company for a long time may have multiple stock option grants.
  • Vesting : In order to incentivize employees to remain with the company, stock option grants are often not yours for the taking immediately.  The company is investing in you, and therefore you must wait until your options are vested before you can exercise them. If you leave your organization before the options are vested, you forfeit them.
  • Stock option exercise : Once your options are vested, you can exercise your right to purchase.  Stock option exercise is the decision to purchase your granted shares of a particular stock option.
  • Strike price : As the name suggests, the strike price (also referred to as the exercise price) is the cost, per share, that you pay to buy the stock.
  • Spread or bargain element : Here is where the bonus comes into play: The strike price of your stock option is likely less than the market value of the stock on the date you exercise your option. Therefore, the spread, or bargain element, is the amount of money you earn on your purchase if you, in turn, sold your stocks.  

There are two popular types of employee stock options available: Non-qualified Stock Options (NQSO) and Incentive Stock Options (ISO).

Non-qualified Stock Options (NQSO) – NQSO, or NSO

Non-qualified Stock Options (NQSON or NSO), are pretty straightforward once you understand the key terms above. When these options vest, you have the right to exercise them, which means you purchase the stock at the given strike price. Once you own the stock, you must decide if you will keep it in your brokerage account with the belief that it will increase in value, or you may sell it and take the cash.  Non-qualified stock options are frequently preferred by employers because the company is allowed to take a tax deduction equal to the amount you are required to include in your incom

Tax Consequences of Exercising and Selling NQSOs

When you decide to exercise the NQSO, the bargain element is additional taxable income.  Put simply, the difference between what you paid and the full market value is treated the same as  a cash bonus.

Case in Point

Jack was granted 1,000 NQSO from his company on January 1, 2019, with a strike price of $20 per share.  One year later, in January 2020, 250 of those options vest.  On March 1, 2020, the shares are trading at $25 per share, so Jack decides to exercise his 250 stock options: he pays $5,000 (250x$20), and now owns 250 shares.  Since the share price is $25 each, his 250 shares are worth $6,250 or $1,250 more than he paid, which is the bargain element.  Jack has to report $1,250 in additional income in 2020.  Jack must now decide if he wants to hold onto the stock or sell it:

  • If he immediately sells the stock, Jack gets $6,250 (having paid $5,000). There is no tax consequence because the $1,250 is already reported as income.
  • Instead, Jack decides to hold the stock for 2 years and then sells all 250 shares for $40 per share, or $10,000.  Jack reports a long-term capital gain of $3,750: the difference between the $6,250 (the market value when he purchased the stock in 2020) and $10,000

Tax Consequences of Exercising and Selling ISOs

Incentive Stock Options (ISOs) provide more tax incentive to employees.  As such, they are more complicated and require the following:

  1. The option must be granted to an employee, meaning independent contractors and non-employee directors are not eligible.  An employee who leaves the company while holding active stock options must exercise them within three months.
  2. The grant period is ten years, so an ISO granted on September 15, 2019, must be exercised by September 15, 2029.
  3. The strike price must be equal to or higher than the fair market value of the underlying stock on the date of the grant.
  4. The employee cannot own more than 10 percent of the company at the time of the grant.
  5. The ISO grant is not transferable, with an exception in the case of death of the option holder.
  6. The value of all grants (strike price of shares) in a single year cannot exceed $100,000.

Tax Consequences of Exercising and Selling ISOs

It pays to know the difference between the types of sale of your stock.  Ideally, you want your bargain element to be taxed at the long-term capital gains rate (typically 15%) by performing a qualifying disposition versus a non-qualifying disposition. 

  1. A qualifying disposition occurs when you sell the stock at least:
    1. Two years after it was granted and
    2. One year after you exercise the option
  2. Otherwise, it’s a non-qualifying disposition and the bargain element is taxed at ordinary income rates which are generally much higher than the capital gains rate.

Another tax consideration is a potential increase in your AMT (Alternate Minimum Tax) calculation.  If you exercise your ISO’s (purchase the stock) but do not sell them in the same calendar year, the bargain element is included as income for calculating your AMT.  If your bargain element is high (excellent bonus for you), your AMT could be higher than the normal tax rate and you’ll owe more to Uncle Sam.  Fear not, you may receive an AMT credit in the future which will help balance the scales.

CASE IN POINT

Jane was granted 1,000 ISO from her company on January 1, 2019, with a strike price of $40 per share.  One year later, in January 2020, 250 of those options vest.  On March 1, 2020, the shares are trading at $50 per share, so Jane decides to exercise her 250 stock options: she pays $10,000 (250x$40), and now owns 250 shares.  Since the share price is $50 each, her 250 shares are worth $12,500 or $2,500 more than she paid, which is the bargain element.  Jane adds $2,500 as income for her AMT, but no tax consequences for her ordinary tax calculation.  After considering the numbers below, Jane decides to hold the stock.  Here’s why:

  • The stock goes to $65 per share 6 months later (Aug 1, 2020).  If Jane sells her 250 shares for $16,250, she makes a total of $6,250 of which she will report $2,500 as ordinary income and $2,750 as short-term capital gains. It would be a non-qualifying disposition.  She pays $2,000 in taxes: since she’s in the 32% tax bracket; (32% x 2,500) + (32% x $2,750) = $2,000
  • Instead, Jane decides to hold the stock for 2 more years and then sells all 250 shares for $65 per share, or $16,250.  Jane reports a long-term capital gain of $6,250 as a qualifying disposition.  She has a total tax bill of 15% x $6,250 = $937.50 – or $1,062.50 MORE in her pocket vs. the IRS.

When it comes to stock options, it pays to understand the details. 

How to stay rich: Protect your money by diversifying

Do you dream of getting rich? For many of us, the pursuit of becoming financially independent is our overall life aim. Yet while striking it rich is undoubtedly a challenge, a far bigger challenge is learning how to stay rich. 

A 2016 study by Cornell University found that over half of all Americans will find themselves in the top 10% of earners at least once in their life, while 11% will find themselves in the top 1%. However, very few can remain there, and the turnover in these categories is huge, with 72% of the top 400 earners retaining their position for just one year between 1992 and 2013. 

So why are so many people struggling to stay wealthy? It’s because getting rich, and staying rich, are two very different skills which require a completely different way of thinking. 

How to get rich

There are many different methods that people use to get rich. The traditional way of working hard in your career, saving your money, and enjoying a comfortable retirement is a clear goal for many Americans. However, it is not always the most effective method for building wealth quickly. That is why there are many different ways to strike it rich, with some of the most common including:

  • Be an Entrepreneur / Start your own business: Working hard, building a successful business, and selling it (or going public) is a fantastic way to make yourself a lot of money. 
  • Investing: Whether you are looking to build an impressive portfolio of stocks and shares or purchasing and developing property, investing is a great way to get your money working for you. 
  • Work hard and save harder: Focusing on your job and working your way up the career ladder, coupled with frugal living and high savings rate, can help you build up a significant pot of money.
  • Real Estate: Start small with a rental property, rehab it, put in some sweat equity and slowly build to another property and bigger properties. Build your fortune with a real estate empire!

How to stay rich

Earning your riches requires some big risks; however, once you have achieved it, staying rich is a different type of challenge. It is only natural that as we become successful at something, the more convinced we are that it is the route to success, meaning we double down on following that same path. 

However, this is not the best solution in this case because the narrowing of focus and doubling-down to build wealth is exactly the opposite approach to keeping that wealth. It becomes easy to get complacent when we are successful, which can have devastating consequences when something unexpected sideswipes your business. The COVID-19 pandemic is a prime example; however, throughout history, there have been many downturns that have seen countless people lose their wealth. 

That is why in order to stay rich, you need to adopt an almost opposite approach to your business decisions. Instead of the high-risk strategy, you need to start taking fewer risks, and the most important thing to do is to start diversifying your portfolio across a variety of types of assets so that no one “thing” can bring you down.

By spreading your wealth, you will be able to insure yourself against any downturn that might come in sideways and wipe your wealth out. Diversifying does not mean you should stop focusing on your skillset and expert domain, instead, it means taking a portion of your wealth off the table and investing it into a different area. 

This could be anything, from investing public and private companies to entering the real estate market. Helping to diversify will spread your savings and ensure that you will not lose your lifestyle no matter what happens. 

If the current global crisis has shown us anything, it is the need to recognize that whatever “got you here” is not necessarily what will “keep you here”, so now is the time to take a different approach and retain your hard-earned wealth.

What I’m doing with my Investment Portfolio

First: I hope that you are well, safe and implementing healthy habits during this unprecedented time. While of course our attention is on the coronavirus, I will focus the remaining of this article on the financial markets. With all that is going on nationally and here in MA, I want to provide you an update on what I’m personally doing with my investment portfolio.

Asset Allocation

Assets are simply things you own that have value: your house, cars, jewelry, business ownership, cash and investments (stocks, bonds, etc). When I use the term Asset Allocation in this article, I’m specifically referring to investments which include cash, stocks and bonds. Within each of those high-level asset classes there are further subdivisions. In Cash you could hold actual dollars (stuffed in your mattress!), savings accounts, checking accounts, and money market accounts. Bonds are “I owe you” loans that can be issued by the government (treasuries, bills, etc), municipalities or corporations. And finally Stocks (or Equities) can be investments in US companies, International companies, in large companies or small companies. There is a whole range of ways to break down the different asset classes into subclasses.

My investment philosophy is to use asset classes and allocate my entire investment portfolio into them on a percentage basis. The idea is similar to the pie chart shown here (though my actual ownership is quite different than this simple example).

Rebalance

When the market goes up or down, the percentages in the overall pie chart change because asset classes (typically) don’t move the same amount in the same direction. Usually this out-of-balance change happens slowly, but over the last month it has come about quite quickly. Say if my bond investments stays the same but my stock investments drop by 20%, then in order to bring my portfolio back to my target percentages, I will need to sell some bonds and purchase some stocks. This is automatically selling high (bonds did not drop in value) and buying low (stocks have lost value). This is exactly what I want to do as an investor.

Therefore, I am taking this market decline as an opportunity to rebalance my own portfolio. Obviously my stock investments are down as are everyone’s and so my portfolio allocation between stocks and bonds has skewed far enough that I can sell some bonds and purchase some stocks at these discounted prices. This is exactly why I recommend owning both stocks and bonds.  By rebalancing I am automatically selling high and buying low: exactly what I want to do.

Adjust Risk

In addition to a rebalancing back to my target portfolio, I am also looking to adjust my goal allocation slightly towards stocks as they continue to become cheaper. The market is putting equities on sale, so this is the time to consider purchasing more.

Although I am personally considering this strategy as stocks continue to fall, two caveats:

  1. Stocks are still not particularly “cheap” by historical standards. They are just no longer very overpriced.
  2. I must be mentally and emotionally prepared for further declines: there is no way to predict the future.

It’s important to have a plan. My plan has always been “when the market declines, I will add to my stock allocation”. Although not set in stone, it roughly looks like this:

  1. If the market pulls back 20%+, add 5-7% to my stock allocation (from say 70% to 76%)
  2. If the market pulls back 30%+, add another 5-7%
  3. If the market pulls back 40%+, add another 5-7%

It is absolutely worth noting that I am a risk-taker as you might know from my background founding two startup companies and starting my own financial planning business. You have to understand your own ability to take on the risk of further market drops.

Have a Plan

Like you, my emotions are telling me that this market has nowhere to go but down: the coronavirus fallout will continue to hit us personally and the businesses that we invest in. The news will get worse each day. With a solid plan, I have a way forward that will buy low, so I can eventually sell high.

If you are worried about your finances, retirement portfolio or the markets, please get in touch. I want to make sure that you are comfortable with your plan and a have a good path forward.

Photo by Carlos Muza on Unsplash unsplash-logoCarlos Muza