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A debt crisis is building in the US, and there is nothing that can be done to stop it. However, there are alternatives for dealing with it. We explain the alternatives, and why we think inflation, over the medium to long run, is almost guaranteed.
 
The Oxford English Dictionary defines crisis as “A situation or period characterized by intense difficulty, insecurity, or danger.”
 
A debt crisis is our future because the US government has made promises that are impossible to keep. Many of those promises are in the form of US Treasury Bonds.[1]
 
US Treasury Bonds represent dollars that the US government has borrowed, and promised to pay back, with interest. The total of these comprise the government debt.[2]
 
The US government never (or almost never) pays down the debt. Instead, when bonds mature, the government sells new bonds to pay off the old ones.
 
But even though the government doesn’t pay off the principal of the debt, the government does pay interest on the debt. And the dollar value of that interest has been skyrocketing in the past year. It has now reached one trillion dollars a year. The graph below shows how the interest on the debt has grown.
 

 
How Much is $1 Trillion?
In 2022, Federal revenue was $4.9 trillion, according to the Federal Reserve bank. But the government will likely collect less this year. Through the first 8 months of 2023, US government revenue is lower than last year by over $400 billion. That projects out to full year revenue falling about $600 billion short of last year, for a projected 2023 total revenue of about $4.3 trillion.
 
Meanwhile, the interest expense continues to rise, as the government refinances low-rate bond maturities at today’s higher interest rates.
 
Simple division shows that interest payments are accounting for almost 25% of Federal revenue right now, and that percentage is likely to grow.
 
The Problem Keeps Growing
As just shown, the US government has a debt problem. Merely paying interest on the existing debt now consumes nearly one of every four dollars the government brings in as revenue.
 
And yet, the government continues to spend vastly more money than it brings in. In 2022, for example, the federal government spent $1.1 trillion more than the all-time record revenue of $4.9 trillion.
 
How is it possible to spend more than your revenue?
 
There are two ways. You can spend down capital – that is money you have saved – or you can borrow.
 
Government Assets Not a Solution
The US government owns assets, mostly in the form of land. The Bureau of Economic Analysis[3] estimates that the US government owns 24% of the land area (about 454 million acres) in the lower 48 states, and that this land is worth about $1.8 trillion, or about $4100 per acre.[4]
 
In addition, the government publishes a balance sheet.[5] This balance sheet shows an additional $4.9 trillion of assets (and $39 trillion of liabilities).
 
Federal government assets, therefore, are less than ¼ of the federal debt. In addition, there has been no political will to reduce debt through selling assets.
 
That leaves three sources of cash: taxation, borrowing, and printing money.
 
Taxes
Tax revenues are not very responsive to changes in government policy. Since 1947, through all kinds of economic environments, the Federal government’s revenues have averaged about 17.5% of GDP. And on average, the higher the top tax rates, the lower the percentage actually collected.
 
While the government may raise tax rates, history shows that it is extremely unlikely that any such increases will have a significant positive effect on revenue. In fact, history teaches that it is more likely that raising tax rates will reduce revenue.
 
Borrowing
The government can borrow as long as it can sell bonds. It can sell bonds as long as buyers will buy them. As noted above, even if the government never pays down the total debt, it must pay interest.
 
And there’s the rub.
 
What happens when the interest on the debt climbs to be too big a percent of the total government revenue?
 
Something must give.
 
That’s where inflation comes in.
 
Inflation
If the government cannot sell enough bonds on the open market at an interest rate that it believes it can afford, the government can sell bonds to the Federal Reserve.
 
When the Fed buys such bonds, the Fed creates the dollars out of thin air. In the modern world, most dollars exist only as entries in a computer somewhere. When the Fed buys bonds from the Treasury, the Fed creates new dollars in the form of computer entries that the government then spends.
 
In the private world, for someone to borrow money, someone else must save it. But when the Treasury borrows from the Fed (i.e. the Treasury sells bonds to the Fed), no one saved the money first. The Fed simply creates the money out of thin air.
 
Inflation is mainly the result of this creation of money. When the Treasury sold trillions of dollars of bonds to the Fed during 2020 and 2021, the result was the highest inflation since the 1970s, because the Fed expanded the money supply so sharply.
 
What Does the Future Hold?
The last 75 years of history that suggests that the Federal government will not be able to generate revenue of more than about 17.5% of GDP. So as long as Federal government spending is more than that, the government will continue to run deficits. Deficits, by definition, add to the debt.
 
As the debt grows, the interest cost grows, and interest consumes more and more of the 17.5% of GDP that is sustainable Federal revenue.
 
Congress has shown no intent to cut other spending as interest costs increase. So it seems likely that the deficits will, on average, continue to grow.
 
If the time comes when the government cannot sell all the bonds it wants to on the open market, the government will have the choice of missing interest or principal payments, cutting spending, or selling bonds to the Fed.
 
History offers few (if any) instances in which a government that had the option of printing money (or in the modern world, access to a central bank that will create the electronic entries out of thin air), chose instead to cut spending enough, or chose to miss interest or principal payments.
 
If the past is prologue, the US government will select the inflationary option.
 
We have over 2000 years of history that says inflation is the likely outcome. We wrote a book that looks in detail at the history of inflation, explains in simple terms the economics of inflation, and expands on the argument presented above. The title is Politicians Spend, We Pay.
 
We are offering a free copy of Politicians Spend, We Pay to the first 25 responders to this email. Ask for your copy here. Or email ConnorBarth@SterlingFoundations.com, or call Connor at (703) 437-9720 to request a copy.
 
And please feel free to share your thoughts on this, or any other, of our writings. Thank you.

9/5/2023

The mistake referenced in the title is a misunderstanding of withdrawal rate.
 
I was recently speaking with a successful entrepreneur about sustainable withdrawal rates from investment funds, particularly retirement funds.
 
He said that he had heard that 4.5% was a “sustainable” withdrawal rate, and that anything higher was too risky.
 
Yet, we recently conducted a simulation of a tax-exempt trust that was invested in the US stock market and paying out 5% every year.
 
We looked at 77 rolling 50 year periods, beginning in 1945 and ending in 2022. We assumed that each trust began with $1,000,000, and distributed 5% of its beginning year value every year for 50 years. We then took the amount of the trust balance in year 50, and put that in our histogram, below.
 

 
In every single 50 year rolling period, the simulated trust ended year 50 with more than the $1 million dollars it started with. That is despite paying out 5% of its beginning value every year.
 
So why do so many authorities state that the top “sustainable” distribution is about 4.5%?

In fact, many good studies have found that the top sustainable distribution is significantly less than 4.5%.[1]
 
Two Major Factors
We believe there are two major reasons that good studies have found that even a 4% withdrawal rate is risky. These two reasons are:

1. The definition of a withdrawal rate
2. The expectation that accounts will be invested in a balanced portfolio

Definition of Withdrawal Rate
The withdrawal rate question usually arises in the context of retirement planning. Suppose a client retires with $1 million in a retirement account. The “sustainable withdrawal” rate question is actually a question of sustainable dollar amount, not percentage rate.
 
When people[2] say that a sustainable withdrawal rate is 4.5%, often (as is the case with the Fidelity example cited) what they really mean is that a fixed dollar amount is to be withdrawn. In the first year, that fixed dollar amount is $45,000 (on a million). That is 4.5% of the initial $1 million, but the withdrawal amount in subsequent years will likely be different from 4.5% of the amount in the retirement account.
 
In fact, in the example Fidelity offers, they suggest[3] that the amount be adjusted by inflation. In the modern world, that means it is very probable that the amount will increase each year.
 
Balanced Portfolios
Balanced portfolios are a second reason that a fixed and growing 4.5% of the initial retirement balance may expose the retiree to an unacceptable risk of running out of money.
 
The reason is that, although balanced portfolios (e.g. 60% equities, 40% bonds) are generally less risky than all equity portfolios (i.e., they have less risk of decreasing sharply in value), they also have significantly lower expected returns.
 
This lower expected return is a mathematical fact, as long as bonds have a lower expected return than equities. Suppose, for example, that we expect the long run rate of return on equities will be 10% compounded annually,[4] and that the long run expected return on bonds is 5%[5].
 
The math is simple. Sixty percent of 10% is 6%, and 40% of 5% is 2%, giving an expected total return on the 60/40 portfolio of 8%.
 
Variability
An 8% long run average return would be pretty good, and would seem to be more than enough to offset annual distributions based on 4.5% of the starting value.
 
But many simulation studies suggest that even at 4.5% of the initial amount, the distribution might not be sustainable.
 
The reason is variability of returns. Some advisors call this “path dependency.”
 
The math is a little involved, but the concept is easy.
 
Suppose a portfolio begins with $1,000,000, and the withdrawal amount is set at $45,000, to be adjusted each year by inflation.
 
Now suppose that we get a year like 2022. In 2022, US stocks returned -18%, and US bonds had an equally dreadful year.[6] And to make matters worse, inflation, as measured by the CPI, was 6.5%.
 
Let’s look at what happens with our hypothetical portfolio. It starts at $1 million. The market knocks 18% off.[7] The portfolio is now down to $820,000. We also have to withdraw the $45,000, leaving an amount remaining of $775,000.
 
If the withdrawal rate really were 4.5%, the withdrawal would be sustainable.
 
But the withdrawal rate is not 4.5%. It is $45,000, and then we increase that by inflation of 6.5%, so the withdrawal in year two is $47,925.
 
That second year withdrawal amount of $47,925 represents 6.2% of the remaining portfolio value of $775,000.
 
A single such year is not likely to be a problem. But two or three bad years near the beginning of a withdrawal plan could easily derail it, particularly if those bad years are accompanied by inflation.
 
True Percentage Withdrawals
One mathematically effective solution is to base withdrawals on a fixed percentage of the account value each year. Done this way, it is mathematically nearly[8] impossible for the account to run out of money.
 
The simulation shown at the beginning of this post offers two important lessons. One is the lesson that there is an important difference between a fixed withdrawal amount often mistakenly considered as a percentage, and a true percentage that is the same percentage every year. The second lesson is that over long periods, such as 50 years, the main effect of a balanced portfolio has been to depress long run returns.
 
Long-Term Tax Exempt Trusts
It is possible to create a tax-exempt trust for clients who have long term investment goals. For more information, click here to request free copy of our Advisor Guide to Stock Diversification Trusts. Or email your request to ConnorBarth@SterlingFoundations.com, or call us at (703) 437-9720 and ask for Connor or Katherine.
 

8/21/2023

I remember a commercial that declared, “An informed customer is our best customer.”
 
The commercial offered no proof, no argument, and no evidence of the claim.
 
However, with respect to financial advisors, there now is proof, argument, and evidence. It is those facts with which I deal in this essay.
 
The facts come from research conducted by Olivia Mitchell of the University of Pennsylvania’s famed Wharton School, and two co-authors.[1]
 
The Claims
Here are the claims:
 

1. The smarter a person is, the more likely the person is to seek help from a professional financial advisor.
2. The more financially literate a person is, the more likely the person is to seek help from a professional financial advisor.
3. These same people are less likely to accept “free” advice that is accompanied by a conflict of interest.

 
However, there is a catch. The study also found that “those with higher cognitive function also tend to distrust financial advisors,” and are therefore less likely to seek the advice they need.
 
Why Cognitive Function is Important
Theoretically complex issues are endemic to financial life, regardless of the level of complexity of a person’s situation. For example, in addition to the complexities inherent in required government programs such as social security and medicare, a “mass affluent” client will likely face challenges such as income tax planning, provision for survivors, tuition finance (for children and/or grandchildren) and risk management. High net worth clients have the added complexities of the estate tax (possibly federal and state), and often income taxes as well.
 
As static problems, each of these issues is complex. (A static problem is one in which all the facts are given, and presumed known.) Static problems are complex enough on their own. But in the real world, most or much of the time we are dealing with a playing field on which the goal posts may move. For example, we all know (or can look up) what the current rules for social security are. But we also know that those rules are likely to change. And it is impossible to predict with precision what those changes will be, or when they will occur. Maybe congress will cut benefits, or restrict benefits, or further tax benefits, or change the eligibility requirements, or the eligibility age, or whatever else legislative aids concoct.
 
It is not hard to recognize that, everything else equal, a smarter person will be better able to grapple with the complexities and uncertainties of financial life.
 
Evidence
Olivia Mitchell and her colleagues measured this effect. Here’s one of the multivariate probit regression models they used:
   
I’m just joking!
 
Not about the model (this really is the model they estimated). I’m joking by putting this equation in here. I don’t expect many of our thousands of readers to recall what a probit model is, or how it works, or why use it, or a dozen other issues implied in here.
 
In fact, this example of complexity is pretty much the point of this essay. Just as your clients rely on you to know about and understand the complexity in their financial lives, we, as practitioners, must rely on other experts (in this case professors who have the luxury of spending their days thinking about things like how to measure the role of intelligence) for much of what we need to know to do our jobs right.
 
Here’s a general explanation of the model. Don’t worry if you don’t follow all of this. There’s a lot of statistics/econometrics behind what they’re doing, and if you haven’t studied those subjects, this might just be a foreign language.
 
The left side is the probability that a person (the “i^th” person – don’t worry if you don’t follow) seeks professional financial advice. By definition, a probability must be between zero and one, inclusive. Because they are estimating a probability, they cannot use a linear regression.[2] Instead, they use a probit regression.
 
In an ideal world (ideal in an academic sense of a world that is easy to model accurately), it would be possible to predict who seeks professional financial advice by looking at certain facts about the person. The researchers hypothesize that those facts would be things like financial sophistication and intelligence.
 
The right hand side of the equation includes those two factors, plus a third term which, perforce, includes everything else. The Φ (the Greek letter phi) is the standard normal cumulative distribution with respect to the model variables. Again, just don’t worry about it if that is Greek to you. (After all, Φ is Greek!)
 
What They Found
Enough of what they did. What did they find?
 
They found that just about 1/3 of the 1168 people who participated in the study sought financial advice.
 
That means, of course, that 2/3s did not. Ironically, it is likely that those 2/3rds who didn’t seek advice need it at least as much as those who did seek it.
 
We want to know why people seek financial advice, why they don’t, and what we can do to help those who need it get it.
 
As mentioned above, the study found that smarter people are more likely to seek financial advice, and people with more financial literacy are also more likely to seek financial advice.
 
So What?
Intelligence
At first, it might seem like we cannot do anything about people’s intelligence. And strictly speaking, that is probably right. However, when it comes to affluent and high net worth prospects and clients, advisors can, and should, “do something.”
 
That “something” is to do everything possible to build client relationships with people who need help, as early as possible.
 
The unfortunate reason for “as early as possible” is that on average, people experience cognitive decline as they age. That’s a harsh statement, and as someone who is not getting any younger, I do not mean to cause any offense or upset. But on average it is true.
 
And it means that, on average, the earlier an advisor can get to a prospect, make the prospect a client, and build a relationship, the better for the client.
 
Financial Literacy
We can do a lot for people’s financial literacy. People can learn. And many advisors we talk to see their primary role as educating their clients.
 
“Do It For Your Future Self”
While none of us wants to believe that we will experience cognitive decline, we know that there is a risk. Forget for a second about prospects and clients. Think about yourself. As we think about ourselves, it is obvious that if we could, we would want to take action now to help protect our future selves.
 
If you knew for a fact that cognitive decline was in your future, you would work hard right now to make sure that you had in place competent, trustworthy people to handle your affairs for you. Or if they don’t fully handle the affairs, to at least advise you to help you handle them well.
 
This idea of what we would do for ourselves is an idea that, if we can communicate it to prospects, may help them to become clients right now.
 
While the prospect/client has 100% of his or her cognitive function, that is the time (i.e. now is the time – it’s never going to get any better) to start forming those trusted relationships. In the best case, the client will keep his or her full cognitive function for life. And in that case, there is still nothing lost, and everything gained, from taking advice from a competent and trustworthy advisor.
 
Offer
We have a number of free resources to help both advisors and clients learn about a variety of areas. For example, if you have clients, or prospects, who own a business, you might want a copy of our Advisor Guide: Selling a Business. We also have advisor guides for retirement plans, real estate, and concentrated stock positions. Please request your free copy here. Or call Connor Barth at 703 437 9720, or email him at ConnorBarth@SterlingFoundations.com.
 
You might also request a free copy of Chapter 14 – about the ways the professional financial advisors add value for clients -- from our forthcoming book.
 
Request
Your feedback helps us provide you with content that is useful and valuable to you. If you have any reactions to this, positive, negative, or other, please feel free to email me directly with your comments at Roger.Silk@SterlingFoundations.com. Or call me at 703 437 9720. I look forward to hearing from you.

8/14/2023

If you’ve ever studied finance in a university setting, or read the academic literature, you’ve almost certainly been exposed to the Efficient Market Hypothesis.
 
And if you believed the Efficient Market Hypothesis, you would have to believe that momentum trading strategies cannot work, at least not consistently or in the long run.
 
But the actual empirical evidence, against all logic, suggests that momentum strategies do work, or at least, that they have worked for very long periods in the past.
 
What is Momentum
Momentum is the name given to the observation (or the hope) that assets that have gone up recently will continue to go up, and that those that have gone down recently will continue to go down.
 
Finding and identifying momentum is not as easy as, for example, “It went up yesterday, therefore it will go up today.”
 
As far back as 1993, in the academic literature, Narasimhan Jegadeesh and Sheridan Titman published Returns to Buying Winners and Selling Losers in the Journal of Finance. They found that, on average, stocks that had done well in the past year were more likely to continue doing well than stocks that had done poorly.
 
But investors have recognized, and profited from, momentum for far longer than that. For example, Dunn Capital Management, operating out of Stuart, Florida, has been investing successfully using momentum strategies since the mid-1970s. (This is not a promotion of any specific investment strategy.)
 
Why Momentum “Shouldn’t Work”
The US stock market is a very competitive environment. Every day, thousands of the brightest minds in the world scrutinize the stock market, looking for opportunities to earn more than the average return in the market.
 
Momentum “should not” work because anyone can see how a stock has been performing. If everyone can see that the stock has gone up, it should only take a relatively small number of people to buy that stock, and push its price up to the point at which it will not continue to go up.
 
Similarly, if a stock has been doing badly, it should take only a relatively small number of people selling that stock, or selling it short, to push the price down to a point at which it will not continue to go down.
 
And yet, across many markets, and across many decades, it appears that momentum has worked, and continues to work.
 
Why Believe that Momentum Works
If you have ever had the personal experience of watching a stock go up, and then bought that stock, only to see it flounder or go down, you might be skeptical of the idea of momentum. From a business point of view, we (Sterling) don’t have a dog in the fight. That is, we’re not in the business of investing, and we don’t promote any particular investment strategy.
 
Nevertheless, momentum is surprising, and there seems to be quite a bit of evidence that it works. Here is some of that evidence, in brief.
 
The above-mentioned paper by Jagadeesh and Titman found that for holding periods of about 6 to 12 months, they (on paper) earned profits of about 12%.
 
Bruce Grundy and Spencer Martin, in a 2001 paper published in Review of Financial Studies, found “momentum profits are remarkably stable across subperiods of the entire post-1926 era.” The paper is titled Understanding the Nature of the Risks and the Sources of the Rewards to Momentum Investing. I studied with Bruce Grundy when he was at the Stanford Graduate School of Business in the 1980s. He’s a very smart guy.
 
Cliff Asness, another super-bright guy, and an extremely successful money manager, along with several colleagues, published a paper titled Value and Momentum Everywhere in 2013 in the Journal of Finance. The paper reported significant momentum effects in a number of markets, including international (i.e. non-US) equities, commodities, government bonds, and currencies.
 
We don’t understand why momentum works, but it sure seems to.
 
Gotcha!
You knew there had to be a gotcha, right?
 
There is.
 
Momentum strategies are mostly effective over periods of less than two years, and often over periods of less than one year. That is, you might be long on an asset for six months, make money, but then have to sell it and buy something else.
 
That kind of strategy produces mostly short-term gain.
 
Short-term gains are taxed at approximately 40% at the federal level, and even higher in most states.
 
Having your investment returns fully taxed at 40% every year puts a real and significant break on compounding.
 
But there is a solution.
 
Solution
One solution is to have your high-turnover momentum strategies in a tax-exempt Active Trading Trust.
 
When appropriate, an Active Trading Trust allows the client – or the advisor – to sell the stock, pay no capital gain tax, and reinvest in a diversified portfolio. It also often allows an advisor to convert a non-AUM asset – the client’s concentrated position – into managed AUM. This solution is very similar to our Stock Diversification Trust for concentrated stock positions.
 
To learn more about how you can use an Active Trading Trust for your clients, please call 703 437 9720 and ask for Connor or Katherine, email ConnorBarth@SterlingFoundations.com, or click here to request a free copy of our Sterling Advisor Guide: Concentrated Stock Positions.

8/7/2023

At the end of July, 2023, the financial rating agency Fitch announced that it was downgrading the sovereign debt of the United States.
 
The stock market tumbled. The bond market tumbled. Talking heads talked.
 
But what does the downgrade really mean?
 
“Sovereign Debt Cannot Default”
In the aftermath of the Fitch announcement, many pundits solemnly intoned their opinion that “the United States will never default on its debt” or something similar.
 
Is this claim true?
 
That depends to some extent on how you interpret the claim. In this email, we will examine three types of default. We will see that it is indeed unlikely that the United States will default in two of the senses. In the third sense, we will see that not only is it likely that that US will default, it’s almost guaranteed. We’ll also see that the United States federal government has, in the past, defaulted on its sovereign debt.
 
Sovereign Debt
Sovereign debt is debt issued by a so-called sovereign entity. Originally, this was a king, and technically in kingdoms like the United Kingdom, government borrowing is borrowing by “the crown,” meaning the king.
 
We don’t have to look deeply into history to find many, and repeated, examples of sovereigns defaulting. For example, Fitch reports 14 separate sovereign defaults since 2020! Among those defaulting have been Ukraine, Argentina and Ecuador. So, the mere fact that the US federal debt is sovereign debt certainly does not tell us that it cannot default.
 
Three Types of Default
What does it mean for a bond to default? In general, the term default means failing to meet a stated obligation. In the context of most non-sovereign bonds, there are two general types of default: money defaults, and non-money defaults.
 
Money Defaults
When most talking heads talk about the US government defaulting on its bonds, they are implicitly referring to a money default. A money default occurs when the obligor (e.g. the US Treasury) fails to make a scheduled payment in full and on time.
 
Money defaults can occur for two basic reasons: inability to pay, or unwillingness to pay.
 
In some contexts, a borrower has the ability to pay, but chooses instead to default. Usually, such a voluntary money default would part of a negotiating strategy, or a strategy to position oneself for bankruptcy.
 
Bankruptcy is the legal process for adjudicating the various conflicting claims on a borrower who cannot pay all the claims in full.
 
For the legal bankruptcy process to work, however, all the parties must submit to the jurisdiction of the court. In the case of private bankruptcies within a single country, this is usually not an issue.
 
However, there is no well established or accepted such process for nations or sovereigns that cannot meet their obligations.
 
As messy, costly and inefficient as the bankruptcy process is, the process, and the associated law, gives at least some idea to the various parties regarding what can be expected if the borrower does default.
 
But an orderly, or semi-orderly, restructuring of the US federal obligations through the bankruptcy process is not a possible outcome.
 
While it might make sense for the US government to voluntarily admit that it has more debt than it can service over the long run, and take appropriate steps, that seems unlikely to happen in the foreseeable future. In other words, voluntary money default seems extremely improbable.
 
Non-Money Default
In most private debt and non-sovereign (e.g. state and local) debt, there is a contract between the borrower and lender. Those contracts, or bond indentures, may contain clauses, called covenants, that require the borrower to meet certain tests from time to time. For example, a corporate borrower may be restricted from allowing total debt to exceed a certain percentage of revenue, or assets, or something like that.
 
When such covenants exist, and a borrower violates a covenant, the borrower can be in default even if the borrower never misses a payment.
 
Such covenants, however, do not apply to US federal debt.
 
Fiat, or Inflation, Default
For borrowers like the US government, and select other governments around the world that borrow mostly in the currency that it can print, including the Japanese, Chinese, and UK governments, there is a third option. We’ll call it Fiat Default.
 
The US government can print dollars. It can, therefore, simply create, out of thin air, essentially any quantity of dollars that it decides to.
 
This ability to print money means that it is unlikely that the US will ever (at least in the foreseeable future) face a situation in which it is unable to meet its obligations to pay interest or principal on the debt.
 
However, that same ability virtually guarantees that such debt will be paid with dollars that are worth less than before. This process of repayment with worth-less dollars is not recognized by most economists as default, though it is hard to classify it as anything else.
 
Inflation Since 2020
Official US government statistics show that cumulative inflation since 2020 has amounted to about 20%. In other words, what cost a dollar in 2020 would now cost about $1.20.
 
So someone who lent the US government $1000 in 2020, and gets that $1000 back now, actually receives money worth only about $833. Yes, they got interest, but that interest was supposed to compensate them for not having the use of the money. And, the interest rate in 2020 was close to zero anyway.
 
If you lend me $1000, and I pay you back only $833, you would be entirely justified in believing that I had defaulted.
 
But that inflation-default is standard operating procedure for the US government. And it has been so ever since 1933. In that year, the government explicitly defaulted by reneging on its commitment to repay loans in gold. Before 1933, the dollar was defined as a certain weight (1/20.67 troy ounces) of gold.
 
The government knowingly and intentionally defaulted on that promise. And since then, the US government has consistently spent more than it takes in from all forms of revenue, making up the difference by borrowing and printing money.
 
That intentional policy of fiat money finance is why we have inflation.
 
Future of Inflation
We believe that in the short to medium term, we have seen the highs for inflation. We believe a recession is likely, and that the government will respond to such a recession with yet more money printing, which, we expect, will cause inflation to revive and return, possibly at even higher levels than were seen in the past two years.
 
We are experts on inflation. To learn more, please call us at 703 437 9720 and ask for Connor or Katherine. Or click here to enter a drawing for a copy of our book on inflation, Politicians Spend, We Pay.

7/31/2023

Congress enacted section 1202 in 1993 with the stated purpose of creating an additional incentive for certain types of small business investment.

The law allows investors in Qualified Small Business Stock (sometimes called QSBS) to avoid tax on up to $10 million in gains.

If you have clients with Qualified Small Business Stock, you probably know this. But you might not be aware that in some circumstances it may be possible to avoid tax on more than $10 million.

Qualifying Rules
To qualify for section 1202 special treatment, a business must be a Qualified Trade or Business (sometimes called a QTB), and for stock investments made after 2010, the stock must be held for at least five years. The stock must be in a C-corporation, and can have been acquired by the owner (which cannot be another corporation) for cash, or in exchange for property or even stock acquired in exchange for services. Though the rules are complex, the corporation generally must not exceed $50 million in aggregate assets.

The rules defining what is, and is not, a Qualified Trade or Business are also complex. Many types of business do not qualify, including accounting, brokerage, architecture, consulting, engineering, farms, financial services, health (possibly excluding medical devices), hospitality, insurance, law, and any business in which the principal or employees primarily provide skilled services.

So what does qualify? High tech, manufacturing, software, and certain types of research and development. The rules are not completely fleshed out.

Tax-Free for more than $10 Million?
In general, the first $10 million of a taxpayer’s gain (or ten times the basis, if that ten times is greater than $10 million) is tax free.

But it may be possible for a single taxpayer to, in effect, avoid tax on at least twice as much. Let us consider a simplified example. To make the numbers easier to follow, we will assume a single taxpayer. Our single taxpayer will be a couple – for these purposes the couple each has the equivalent of $5 million, which is tax-free. The couple’s basis is zero, and they have a Qualified Small Business Stock with a market value of $20 million.

In the standard case, the first $10 million would not be taxed as per section 1202, and the second $10 million would be taxed as capital gain.

Now consider the same facts, but the couple, prior to the sale of the stock, sets up a qualifying tax-exempt Business Owner Trust. The couple contributes $10 million of stock to the tax-exempt trust, and names themselves as income beneficiaries for their remaining joint lives. They keep the other $10 million.

When the stock is sold, the couple receive $10 million of income, but that income is free from tax under section 1202.

At the same time, the trust (which is tax exempt under sec. 664) also receives $10 million. It too is free of tax.

A Business Owner Trust can distribute cash to the income beneficiary each year at a set rate, such as 5%. In the example just given, the trust has $10 million. Ignoring trust earnings or gains, if the trust distributes $500,000 each year to the couple, for the next twenty years that income will be tax-free. It is tax free because the trust is considered a different taxpayer for purposes of section 1202. (Even better, the trust can and will invest the entire $10 million, pre-tax, to generate yet more wealth for the owners.)

Thus, the couple can effectively double the section 1202 exclusion. With a bit of creativity, if they had $30 million, and were willing to make the irrevocable contributions to two trusts, they could effectively avoid tax on the entire $30 million.

These are complex issues, and the goal of this email is only to make you aware of the potential planning opportunities. For more information, click here to request our guide on business sales, or call (703) 437-9720 and ask for Connor. 

7/17/23

In February of this year, I was speaking with an advisor in Utah. We were discussing the use of a Stock Diversification Trust (click here to request an Advisor Guide) for a client who had 80% of her net worth in a single stock.
 
She was reluctant to sell because she felt emotionally attached. The trust would have allowed her to sell, diversify, and not pay capital gains tax. The advisor advised her that she should diversify. But she still didn’t sell.
 
The stock, Zions Bank, cratered when Silicon Valley Bank collapsed.
 
This example is noteworthy primarily because of the timing. The month after the client rejected the advisor’s advice to diversify, Zions Bank stock collapsed.

 
But I talk to advisors almost every week who have a similar story. A client holds an overweight position. The client knows that the “average” investor should diversify. But the client wants to hold onto his or her position because of some hard-to-explain feeling. We believe that feeling, that unexplained emotional attachment, is what psychologists (like Nobel Prize winner Daniel Kahneman) would call a cognitive bias. The cognitive bias is the belief that amounts to “it’s special.”
 
Except, of course, the stock is not special. At least not most of the time.
 
In fact, the risk of any given stock (looking forward, not using hindsight) having long run negative returns, is shockingly high.
 
That is the key finding of a study by Arizona State University’s Hendrik Bessembinder.[1]
 
Here’s the main takeaway: “57.8% of stocks… reduced, rather than increased, shareholder wealth.”
 
Let’s look at that again.
 
More than half of all stocks reduced shareholder wealth.
 
How is that possible?  Hasn’t the stock market generated an average long run compound return of about 10%?
 
Yes. But that emphatically does not mean that the average stock has generated that return.
 
In fact, the key Bessembinder finding is the opposite: the average stock (i.e. 57.8% of all stocks) actually reduced shareholder wealth. In other words, if you randomly choose one stock to invest in, there’s a 57.8% chance that you’ll lose money.
 
Based on the evidence from many advisors who have clients who won’t diversify a massively overweight position, many shareholders either don’t know, don’t understand, or just don’t care.
 
We have a theory, and hopefully a treatment, for this form of financial blindness.
 
Theory: Lake Wobegon Effect
The so-called Lake Wobegon Effect, named after the fictional town in which everyone is above average, has been documented in many areas. Most students think they are more popular than average (Zuckerman & Jost, 2001). Half of American drivers rated themselves in the top 20% of safety (Svenson, 1980). And a full 98% of high school students reported average or above leadership ability (Aronson, Wilson, Akert, 2010).
 
We want to suggest a corollary to the Lake Wobegon Effect. Let’s call it the “Mine is Different” effect.
 
“Congress is Terrible. But My Congressman is Good.”
The Gallup polling organization reports that “Americans overwhelmingly disapprove of the job Congress in general is doing, [yet] voters re-elect most members of Congress in every election. This phenomenon is partly explained by the finding that Americans have significantly more positive views of their own representative than they do of Congress overall.”
 
Mine is Different
Most people have some vague understanding that a concentrated position is riskier than a diversified portfolio.
 
But it seems that many act as though their concentrated position is special.
 
In the great majority of cases, the concentrated position is not special, at least not looking forward. It is, quite simply, extremely risky to keep a large fraction of your portfolio in one stock. Of course, if you knew ahead of time that you’d picked a “winner”, this would be a good strategy, but most people don’t pick the winners.
 
And for stocks that have done very well, it might be even worse precisely because most of the very high rate of return is in the past. Even the genius Warren Buffet has not sustained the high rates of return he earned when his company, Berkshire Hathaway, was small. From 1965 to 1998, the annual compound return to owners of Berkshire was 30%.
 
And while Buffet has continued to perform well, from 1998 to 2022, the annual compound return to owners of Berkshire was just about 8%. Not bad, but just about what the S&P 500 returned. However, the long run volatility (measured as standard deviation of return) of Berkshire Hathaway has averaged over 19% during that period, compared to less than 16% for the S&P 500.
 
In other words, even though Berkshire Hathaway has been one of the most successful companies in history, and even though it is run by the man who is arguably the greatest investor ever, since 1998, Berkshire Hathaway, on a risk adjusted basis, has underperformed the S&P 500.
 
Even, or perhaps especially, if you own a large position in a company that has done very well, diversification is, from a risk management perspective, a “no brainer.”
 
In the words of Adam Farago “most stocks deliver very poor returns while a few deliver exceptionally large returns. Second, this extreme skewness is quickly reduced through diversification (e.g., with 50 stocks in the portfolio).”[2]  
 
Cure: Sell and Diversify Without Taxes
The emotional reasons to hold a concentrated position are not logically valid.
 
But the desire to not pay a large capital gains tax is quite logical.
 
One excellent solution to the problem of capital gains tax is the use of a Stock Diversification Trust. When appropriate, a Stock Diversification Trust allows the client – or the advisor – to sell the stock, pay no capital gain tax, and reinvest in a diversified portfolio. It also often allows an advisor to convert a non-AUM asset – the client’s concentrated position – into managed AUM.
 
To learn more about how you can use a Stock Diversification Trust for your clients, please call 703 437 9720 and ask for Connor or Katherine, or email ConnorBarth@SterlingFoundations.com, or click here to request a free copy of our Advisor Guide: Concentrated Stock Positions.

7/10/23

If Tesla won’t own the world, consider selling your Tesla shares.

In recent trading, the market cap of Tesla reached $869 billion.

If you own Tesla, this high market cap is good news. But if you plan to keep Tesla stock, this astronomical market cap may, in fact, be bad news.

If you, or clients, have big gains, you might not want to sell and incur capital gains tax. If you want to skip the discussion of Tesla, jump right here to request your free copy of our Sterling Advisor Guide: Concentrated Stock Positions.

But if you’re interested in learning more about why Tesla’s $869 billion market may be bad news, read on.

The answer has everything to do with 1) value, and 2) volatility. If the value is not justified, there might be more downside than upside.

Value

The value argument is fairly straightforward. At an $869 billion market cap, the market is valuing Tesla at MORE THAN the sum of all these 12 car companies:

• Toyota
• Porsche
• Mercedes-Benz
• BMW
• Volkswagen
• Ford
• General Motors
• Honda
• Hyundai
• Kia
• Nissan
• Subaru

In the most recent year, Tesla reported earnings of $13 billion. That means Tesla trades at a price/earnings ratio of 66.

But consider that the combined earnings of the 12 other car companies was $145 billion!

Why is the market valuing Tesla’s $13 billion of earnings at more than these 12 other companies’ $145 billion?

The market represents the combined judgments of thousands or millions of investors and potential investors. We cannot pretend to know why the market does what it does. But here are two hypotheses.

The Musk Mystique

One hypothesis is what we’ll call the Musk Mystique. Whatever you might think of Elon Musk, whatever you might think of his politics, his personal life, or his business methods, there is no doubting that he is a genius of rare ability and accomplishment. Few, if any, other businessmen have built such a variety of huge businesses. And none has ever amassed the personal fortune that Musk has.

Given Musk’s track record of, seemingly, spinning straw into gold for shareholders, it seems plausible that there is a “Musk premium” built into the price of Tesla. Perhaps some investors believe that Musk will continue to be able to do the “impossible,” thus justifying the high value the market is placing on Tesla.

The Allure of Artificial Intelligence (AI)

Another hypothesis, perhaps a corollary of the first, is that the market is valuing Tesla as an AI company. For years, the promise of self-driving cars has captured the imagination of investors. And for years, Tesla has been promising that true self-driving cars are on the horizon, if not actually just around the corner.

With the current enthusiasm for AI, it seems plausible that Tesla is benefiting from the hope, belief, or expectation that true self-driving cars will propel Tesla to a market dominance that justifies the current price.

The Volatility Argument

Tesla stock has historically been extremely volatile. Historical annual standard deviation of returns on Tesla stock has been in the neighborhood of 57%.

For comparison, the long run volatility of the S&P 500 has averaged about 17.5%. That makes Tesla over three times as volatile as the market.

You might ask, so what?

Remember that we are trying to explain how the current value of $869 billion is a “fair” or “efficient” value.

The Efficient Market Hypothesis, as readers may recall, is the hypothesis that all available information is already reflected in the price of a stock.

Certainly, all the information that we have adduced above is well known to any investor who cares. That is, we cannot claim or assume that we know more than the market. The market knows about Musk, about the value of Tesla versus other car companies, about AI, and about Tesla’s volatility.

In the world of efficient markets, investors (on average) get paid for bearing risk. Risk is usually measured as standard deviation of returns.

In one version of the Efficient Market Hypothesis, the expected return on a stock is a linear function of the expected standard deviation of returns on that stock. Applying that to Tesla, a volatility of 3.25 times the volatility of the market implies that the expected return is also 3.25 times the expected return of the market.

The long run (compound) return on the S&P 500 has averaged about 10%.

Applying that to the above reasoning implies that the market “expects” Tesla to generate returns of approximately 32.5% annualized.

In other words, if the expected return to a stock is a function of the stock’s volatility, and the market price is the “efficient” price, the expected return to a stock with the volatility of Tesla is about 32.5%.

Are Such Returns Possible?

What would 32.5% annual growth, compounded, mean?

Suppose the growth is expected for six years. Tesla’s market cap would then grow to about $4.7 trillion after five years. That’s more than Apple’s market cap.

It’s not impossible. But it doesn’t seem very likely either.

If You Think It’s a Good Time to Sell Tesla

We don’t know if it’s a good time to sell Tesla. That might depend on how much Tesla you, or your clients, own.

With Tesla’s volatility, most advisors we’ve spoken with suggest that Tesla’s 1.6% of the S&P 500 seems about right as a target for a good portfolio weight to Tesla.

                                                

However, given Tesla’s tremendous long term performance, many investors have a much bigger position.

How to Avoid Capital Gains Tax

Reluctance to pay the capital gains tax on large gains makes some people hold even when they know they should sell.

For people who should sell, and don’t want to pay the capital gains tax, a good alternative is a tax-exempt Stock Diversification Trust.

A tax-exempt Stock Diversification Trust is easy and cost-effective to implement. The client transfers the stock to the trust. The trust then sells the stock, and because the trust is tax-exempt, there is not capital gains tax on the sale. You, the advisor, are then able to invest the entire pre-tax value of the stock into a diversified portfolio. The client, usually the client’s children, and often grandchildren, continue to benefit from the trust. In cases we see, the family will typically end up with over twice as much net, after-tax, spendable money by using a Stock Diversification Trust compared with selling the stock, paying tax, and reinvesting the proceeds.

To learn more, please call us at 703 437 9720 and ask for Connor or Katherine. Or request a copy of our Sterling Advisor Guide: Concentrated Stock Positions. This 31 page guide, available free, will walk you through nine common solutions, how each works, its benefits and limitations, and provides a convenient "Choosing a Solution" flowchart to help you select the best alternative for each client situation.

7/4/23

Happy Independence Day!

Here’s a fun pop quiz for your Fourth of July BBQ: Who was the first American economist to warn about the dangers of inflation?

You may not have heard this name before, but it was Pelatiah Webster, who – in a series of essays, some of which he sent to Ben Franklin[1] -- warned that the nascent American nation was quickly depreciating its currency[2] because they were printing so much money.

That goes to show that the inflationary crisis we’re facing isn’t new. Our nation has grappled with inflation ever since its founding.

All of America’s bloodiest wars, including the Revolutionary War, were financed partly via inflation.

Continental Congress Causes Inflation

During the Revolutionary War, Congress had limited power to tax, and the nascent country had difficulty borrowing money.

So printing money was the easiest option to finance the war.

Congress issued continental dollars. These began as zero-interest bonds that promised to pay the holder back in gold or silver at a later date. However, between 1775 and 1782, Congress issued about $6 million of Continental currency. In 1775, when the Continental Congress began to issue continental dollars, one continental dollar could be redeemed for one silver dollar. By 1779, it took 40 continental dollars to buy one silver dollar. By 1783, so many Continentals were printed that they became almost worthless.

By the winter of 1777, Continental dollars were already losing their value. So Congress decided to impose price controls.[3] Congress imposed a maximum price upon goods, and this led some farmers to refuse to sell their excess produce to Americans. Instead, some of those farmers sold their goods for gold to the British.

Price controls meant that farmers who would have otherwise been able to sell their goods didn’t want to, because they weren’t getting the market value for their goods. The reduced supply of goods on the market was one of the factors that contributed to supply shortages at Valley Forge during the harsh winter of 1777.[4] After Washington’s army nearly starved, the Continental Congress finally concluded that “limitations upon the prices of commodities are … productive of very evil consequences.”[5]

Although Pelatiah Webster issued his warning about depreciating currency in 1780, the Continental Congress kept printing. By the end of the war in 1783, Continental dollars were worth less than 1/40 of their original value. This experience led Thomas Paine, the Founder who had written the influential pamphlet Common Sense, to write in 1786 about the “evils of paper money”.[6]

The evils of paper money, and the irresistible temptation that paper money presents to politicians, were abundantly clear to the writers of the Constitution. Article 1, Section 10 of the US Constitution provides that “no … thing but gold and silver” shall be legal tender. Since that clause was ignored in the 20^th century, the US dollar has lost over 99% of the value that it had held for the whole of the 19^th century.

Although we’ll celebrate our nation’s founding and associated freedom this week, we’re not free from the dangers of inflation.

Our federal government keeps spending. The ability to print money – inflation – allows them to spend way beyond the amount raised through taxes.

America has overcome inflation in the past. If we – as a nation – act prudently, we can do so again. But we must understand what we’re facing, and what consequences our actions as a nation could have.

We’re uniquely qualified to offer insights on inflation. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation: Politicians Spend, We Pay, available here.

You can enter here for a chance to win a free copy. Or call 703 437 9270 and ask for Connor or Katherine.

[1] https://founders.archives.gov/documents/Franklin/01-32-02-0238

[2] https://www.hetwebsite.net/het/profiles/webster.htm

[3] “Forty Centuries of Wage and Price Controls; How Not to Fight Inflation” by Robert Sheuttinger and Eammon Butler, page 48

[4] Ibid.

[5] https://www.govinfo.gov/content/pkg/CREC-1997-10-02/html/CREC-1997-10-02-pt1-PgE1910.htm

[6] https://www.govinfo.gov/content/pkg/CREC-1997-10-02/html/CREC-1997-10-02-pt1-PgE1910.htm

 

6/26/23

If you have clients who own real estate in a C-corporation, you probably already know some of the difficulties that stand in the way of clients getting their hands on “their” money (i.e. the assets inside the C-corporation).

Consider a case we’re currently working on. (The names are changed to protect client and advisor confidentiality.) The advisor has been handling the investment of the client’s non-corporate assets for over ten years.

The client’s primary business is real estate brokerage. In connection with that business, the client’s company, a C-corporation, has acquired a significant portfolio of property. That property has appreciated a great deal. The company’s total basis is about $5 million, and the estimated market value of the property is $40 million.

The client doesn’t want to keep working, neither in the business nor managing the real estate. However, the gain from the appreciated property is trapped inside the C-corporation.

Bad “Solutions”

C-corporations involve double-taxation. The corporation is taxed, and the individual shareholder receiving dividends from the corporation is taxed. There is no simple, straightforward way to get the real estate out of the corporation without generating double tax.

Alternatives that create double tax include having the corporation sell and then pay out a dividend, or directly deeding the real estate out as a dividend. The latter transaction is treated for tax purposes as a “deemed sale” and will generate both corporate level tax and a dividend income (taxable) to the shareholder.

A Better Solution

If the shareholder has time (and control), a better solution than either of the above alternatives may be to convert the C-corporation to an S-corporation.

The actual mechanics of making the conversion are relatively simple. However, there are several important rules and limitations that must be considered. Consider a case in which a corporation owns appreciated real estate. Some of the most important rules are:

1. There is a five year window after the conversion during which the corporation will still be taxed as a C-corporation on the “built-in gains.”
2. If the corporation has “earnings and profits” from the time it was a C-corporation, the new S-corporation may be subject to tax on its net passive income if gross passive income exceeds 25% of gross income.
3. If an S-corporation has “earnings and profits”, and excess passive income (see (2) above), for three years in a row, that can defeat the conversion to an S-corporation, causing the corporation to revert to C-corporation status.

There are solutions to the above issues, and those solutions may be as simple as paying out certain amounts or items to shareholders as dividends.  The preferred course of action will depend on the exact amounts and involved and the desires or preferences of the shareholders.

 

A successful conversion from C-corporation to S-corporation, after 5 years, will allow the corporation to sell the real estate without tax at the corporate level. However, the sale will still result in tax at the shareholder level, because S-corporations are pass-through entities.

In addition, it is necessary to wait five years, during which the real estate must be managed, and the market may change.

The Best Solution?

There may be a better way to avoid the double tax. That way is to combine the conversion from C-corporation to S-Corporation with the use of a tax-exempt Real Estate Shelter Trust inside the corporation.

If the corporation contributes less than “all or substantially all” of its assets to the Real Estate Shelter Trust, the trust can sell the real estate tax-free. The trust, properly structured, will then not distribute any income to the S-Corporation during the 5 year period.

After the 5 years have run, the “built-in gains” issue goes away, and there will no longer be double tax.

To Learn More

Cases involving assets owned inside closely held corporations often present significant complexities. The solutions will typically involve more than one facet. To learn more about tax-exempt Real Estate Shelter Trusts, request an advisor guide here, email ConnorBarth@SterlingFoundations.com, or call 703 437 9720 and ask for Connor or Katherine.

6/15/23

If you have clients who have more than 10% of their net worth in Apple stock, please read on.

You might want to consider how much uncompensated risk your clients are taking. Why? Because trees, even Apple trees, don’t grow to the sky.

At its recent highs, Apple is valued at about $2.9 trillion.

Is Apple is worth $2.9 trillion? Only time will tell. But that’s probably the wrong question.

The right question for owners of large amounts of Apple is: can I expect to be compensated for the risk I take in my Apple?

 

200 Companies, or One?

Do you think there’s more risk in owning a portfolio of 200 companies, or of owning a single company, even a company as good as Apple?

Finance theory, and almost all professionals, would agree that it is less risky to own a diversified portfolio of 200 companies.

At today’s valuation levels, Apple alone, at $2.9 trillion, is worth as much as the bottom 200 companies in the S&P 500!

Or, Apple alone is worth more all the following companies put together:

           Mastercard

+         Home Depot

+         Chevron

+         Merck

+         Coca Cola

+         Costco

+         Walmart

+         McDonalds

+         Bank of America

+         Disney!

There is nothing particularly special about these ten stocks. They are ten of the biggest and most well known (and important) companies in the US.

We all know the expression, “Don’t put all your eggs in one basket.”

If you didn’t already own exposure to the US market, would you put all your eggs in a single basket called Apple? Or would you rather own ten of the biggest and most important companies?

Apple’s Future – Irrational Exuberance?

We have no crystal ball, and no special insight. But we can do math.

Since the year 2000, Apple has returned a compounded annual return of almost 40%.

Mathematics assures us that it is virtually impossible that it will do so over the next 23 years.

Here’s the math.

Apple is worth $2.9 trillion today.

If that $2.9 trillion were to grow by a compounded 40% a year for 23 years, that $2.9 trillion would have to grow to $6.4 quadrillion. Let’s put that in perspective.

According to a recent McKinsey study, total GLOBAL assets today are worth roughly $500 trillion.

Global GDP has grown at about 3% since the 1960s. The total value of global assets can’t grow much faster than the GDP growth rate over the long run.

If we compound $500 trillion at 3% per year for 23 years, we get $986 trillion.

In other words, the entire value of ALL GLOBAL ASSETS in 23 years is likely to be about $986 trillion, or roughly 1 quadrillion.

It is mathematically impossible for Apple, or any company, to be worth more than all the assets in the world. So it is mathematically impossible for Apple to grow at the same rate grown for the past twenty-three years.

Taxes

Aside from an irrational faith that Apple can continue to outperform as it has in the past, the main reason people don’t diversify holdings is taxes.

People who have big gains in Apple, and sell their positions, will pay a lot of tax.

Solutions

Many advisors are familiar with several possible solutions, including exchange funds, and various hedging strategies. But not all are aware of a tax-exempt Stock Diversification Trust.

A qualifying stock diversification trust is a tax-exempt entity that allows the client to sell a stock, keep 100% of the proceeds available for reinvestment, and produce income for the client and the client’s family. When we run the numbers on these trusts, using the trust, instead of selling and paying the tax, the family in most cases can expect to get more than twice as much total net spendable income.

Sterling has published an Advisors Guide to Concentrated Stock Positions. If you would like a free copy, please request it here. Or if you have a current client situation and would like to discuss it with us, please call 703 437 9720 and ask for Connor or Katherine.

6/19/23

Recent IRS actions may create an opportunity for your clients to receive a premium price for their charitable remainder trust interests.
 
On June 1, 2023, the IRS finally adopted “new” mortality tables. We place the word “new” in quotation marks because the tables in question are based on 2010 data.
 
The world has changed drastically since 2010, and so the IRS’s new tables are hopelessly optimistic. Unfortunately, real world life expectancy has plummeted. In other words, these new IRS tables are yesterday’s news. They are also the law.
 
That is good news for some people, and bad news for others.
 
The new tables are great news for people who own income interests in an existing charitable remainder trust.
 
Value of an Income Interest
The income beneficiary of a charitable remainder trust typically owns the right to receive income from the trust for the rest of that beneficiary’s life, and the life of a spouse if there is one.
 
The value of that right therefore depends on how long those lives will last.
 
No human being knows how long those lives will last. That is why we have actuarial science. Scientific inquiry designed to answer the question goes back to at least 1693 when Edmund Halley (who discovered the comet named after him) published the first known mortality table. (Some historians assign credit to John Graunt a few years earlier.)
 
In the United States, the Actuarial Society of America began in 1889, with 38 members. In 2022, the society reported 32,649 members. In case you’re wondering, that works out to about 1 per every 10,000 Americans. (I don’t think you were wondering, but I’m a bit surprised there are that many. For comparison, there are about 330,000 personal financial advisors in the US, according to Bureau of Labor Statistics.)
 
New IRS Tables
On June 1, 2023, the IRS adopted Table 2010CM as the official table to use for calculating the life expectancies associated with charitable remainder trusts.
 
For legal purposes, it does not matter whether the table is accurate. It is the law.
 
The table may have been accurate as of 2010, which is when the data in the table are from. The table is based on data gathered in the 2010 Census.
 
As we all know, a lot has happened since 2010. And on the mortality front, most of it is not good.
 
The IRS is constrained by the rules imposed on it by Congress. That is why the IRS uses 2010 data.
 
But non-government actuaries are not so constrained.
 
Life Expectancy Has Peaked and is Declining
Data recently published by Johns Hopkins University show that US life expectancy peaked in 2014 at 78.9 years.
 
In seven short years, US life expectancy plummeted by 2.8 years, to barely 76 years. That is the sharpest drop in US life expectancy since the time around WWI.
 
The reasons for the drop are not well understood. And there is unfortunately no reason to believe that the trend will reverse.
 
Opportunity to Take Risk Off the Table, Above Fair Value
For most of our lives, we could count on life expectancies remaining at least as long as they were, if not growing.
 
But those happy days are gone.
 
For your clients who own assets, such as income interests in charitable remainder trusts, that depend on the clients’ life expectancies, the new IRS tables may present a golden opportunity.
 
To the extent that a client’s income interest can be sold based on the life expectancies in IRS table 2010CM, and to the extent that those life expectancies are too long (compared to more modern tables) your client may be able to eliminate actuarial risk on an important asset, and get paid at very top dollar.
 
To learn more, call us at 703 437 9720 and ask for Connor or Katherine. Or click here to request an Advisor Guide.

6/12/2023

In the United States, the sale of an appreciated stock holding will trigger capital gains taxes. In addition, 41 states tax capital gains, on top of the federal tax. As of this writing, the effective top federal capital gains tax rate is 23.8%. State income tax rates go as high as 13.3% in California, with San Francisco adding another 0.38% to bring the rate up to almost 13.7%. But the highest rate in the nation is found in New York City, where the combination of state and city income tax exceeds 14.7%.

 

Thus, people who live in New York, California or other high tax states can face capital gains taxes approaching 40%. The average state income tax rate is about 6%, meaning that the average top capital gains rate in the US is 30%.

 

The desire to not pay 20%, 30% or more of your gain is a powerful reason for people to hold onto concentrated positions, even though they know they lack control, and even though they know they incur excess risk by holding the concentrated position.

 

Breakeven Takes "Forever”

Suppose you are in the fortunate position to have a large gain in a concentrated position. For the sake of discussion, suppose that the overall value of your portfolio is $10 million, and you have a single position that is worth $2 million.

 

Using portfolio theory, and some basic assumptions about the volatilities of the average stock, we can calculate that the concentrated position is adding about 1.5% per year of risk (standard deviation) to the portfolio. Or, looking at it the other way, diversifying the concentrated position would reduce the risk of the portfolio by about 1.5% per year.

 

That might not sound like much, but the way the math of compound returns works, everything else equal, higher volatility of a portfolio equals lower returns.

 

However, that math is more than we want to go into here (and probably more than you want to read about). For the sake of this discussion, we’ll just say that the reduced risk corresponds to an increase in expected return of about .06% per year.

 

However, the portfolio will shrink, because of the capital gains tax. As Shakespeare said, “Aye, there’s the rub.”

 

Assume you paid $100,000 for the stock that is now worth $2 million. At the average tax rate of 30%, the tax on the capital gain from selling the $2 million position would be about $570,000. Thus, the value of the total portfolio after such a sale, and after taxes, would be $9,430,000. The lower risk portfolio will have a slightly higher return. But it would take over one hundred years for the higher return to make up for the tax hit.

 

Prospect Theory

Nevertheless, people are often willing to pay the tax to reduce the risk. The bigger the concentrated position, the greater the willingness, because the bigger the position, the bigger the downside.

 

If you have $40 million, and it’s mostly in one company, and that company hits the skids, your life will change a great deal for the worse.

 

For most people, a large loss hurts more than a gain of the same amount feels good. For example, if you have a net worth of $10 million, it is likely that you would feel more pain from a $2 million loss than you would feel pleasure from a $2 million gain.

 

Most people feel this way, and the psychologists Amos Tversky and Daniel Kahneman became famous partly for documenting this fact in a number of experiments.

 

But you don’t care how other people feel. You care about how you feel. And if you’d feel more pain from a large loss than you would pleasure from an equal size gain, that’s a strong reason to think about reducing a concentrated position.

 

Status Quo Bias

Almost everyone can recall a situation in which they failed to take advantage of some obvious opportunity, even when the cost of acting was low, the risk was low or zero, and the potential for gain big. All of us, it seems, are sometimes afflicted by the desire to just sit there.

 

You can probably recall at least one such situation.

 

If so, you’re not alone. In fact, researchers even have a name for it. They call it the status quo bias. Most people have a tendency to prefer what they have, whatever that is, over alternatives, simply because they already have whatever it is. For example, in one study, researchers found that test subjects valued a coffee mug much more highly when they already had the mug compared to when they didn’t already have the mug.

 

A variety of carefully conducted studies[1] have found that even highly intelligent people, who are very successful, frequently make this kind of decision. The researchers call such behavior irrational. Here’s a quick example of why. You’ll see that when it’s explained, people usually abandon their irrational behavior in favor of more rational behavior.

 

Consider a study done at Simon Fraser University. Researchers kept everything else the same, except that they gave one set of subjects a mug, asked another set how much they’d be willing to pay for a mug, and a third set got the choice between a mug and cash. The subjects who were given the mug (on average) wouldn’t sell the mug for less than $7.12, while the other two groups valued the mug much lower, at $3.12 and $2.87.

 

Investors also can be subject to status quo bias. For example, you might be unwilling to buy a stock that has already gone up a lot, but if you already own it, you might continue to own it.

 

If you are willing to own a stock that has gone up a lot, but you wouldn’t buy the stock at that price, that could be a case of status quo bias.

 

The good news is that you, when you are aware of status quo bias, can overcome it more easily.

 

To understand how you might be able to overcome status quo bias, click here to apply for a pre-publication copy of our latest book, The Intelligent Layman’s Guide to Personal Investing. Or call 703 437 9720 and ask for Connor or Katherine.

5/22/23

When a client sells, or prepares to sell, a small business such as a dental, medical, veterinary or similar practice, stakes are high for the advisor, as well as the client.

You, as the advisor, have a unique opportunity to cement both your relationship with the client and your position as a high-value-added advisor.

Mostly, you have the opportunity – if you plan in advance – to capture assets under management. You can do this while enabling your client to keep much more of his or her hard-earned wealth, as compared to how much the typical dentist, doctor or vet keeps when the practice is sold.

What to Look For

Many dental, medical or veterinary practices are organized as S-corporations. S-corporations have some tax benefits while the dentist is in practice (such as avoidance of corporate tax), but can present tax problems or obstacles when the practice is sold.

In most cases, the best outcome upon the sale of a dental practice is long term capital gain tax treatment. In high-tax states, long term capital gain tax can easily result in a tax of 1/3rd or more of the gain. Most clients find it extremely painful to find that 1/3rd of their life’s work disappears. As an advisor, if you can show the seller how he or she can avoid the tax pain, you’ll be in a good position to keep that client forever.

Analyze the Assets

A typical dental, medical or veterinary practice will own (and sell) one or more of the following assets:

1.                 Equipment

2.                 Real estate and/or a lease

3.                 Client list

4.                 Goodwill

If the entire enterprise (such as S-corporation stock) is sold, the seller will typically be taxed on capital gain income.

However, few buyers will want to purchase S-corporation stock. Instead, they will prefer to purchase assets. Thus, the seller will typically still own the S-corporation, and the S-corporation itself will sell the assets.

Each of these assets may be taxed differently, both to the seller and the buyer.

Recapture

The sale of assets creates the potential for tax surprises in the form of depreciation recapture. For example, while a dentist was in practice, the practice will probably have purchased equipment (chairs, dental equipment, x-ray machinery, computer systems, and the like).

Almost certainly, those assets will have been depreciated. The catch is that when those assets are sold, the full amounts that were depreciated must be “recaptured” and taxed. The rate of recapture tax on most assets that are not real estate is the ordinary-income tax rate. This tax on recapture can come as a nasty surprise, and drive the total tax rate for the seller above even the already high capital gains tax rates.

In addition, if the practice owns real estate (if you are planning going forward, it will almost always make sense for the real estate to be owned outside of the practice), and that real estate is part of the sale, the accumulated depreciation will be subject to recapture tax. The rate on recapture tax is currently 25% on real estate, as compared to the 20% top federal tax rate on capital gains.

A Better Tax Outcome

If the practice is an S-corporation, and both the situation and your client’s goals line up, it may be possible to entirely avoid tax on the S-corporation’s sale of assets. The solution is to have the corporation use a tax-exempt Business Owner Trust inside the corporation.

If the corporation contributes less than “all or substantially all” of its assets to the tax-exempt Business Owner Trust, the trust can sell the assets tax-free. The trust, properly structured, will then be able to distribute income, or accumulate it tax deferred, for decades into the future.

If the practice, or certain assets, are owned individually, there is also the opportunity for the seller to take advantage of the tax-free nature of a Business Owner Trust.

Personal Goodwill

Many dental practices have a significant aspect of goodwill associated with the primary dentist’s name. In these cases, there may exist personal goodwill, which if owned outside of the S-corporation may present additional important planning opportunities. This will be the subject of another post.

To Learn More

Cases involving assets owned inside closely held corporations – such as dental practices -- often present significant planning opportunities. The solutions will typically involve more than one facet. See here to learn more about tax-exempt Business Owner Trusts, or call 703 437 9720 and ask for Connor or Dave.

6-5-23 Excess Risk Just as most people would like to earn excess returns, few people want to incur excess risk. Excess risk is risk that you take that is greater than the amount of risk you would have if you owned “the market.” In the case of the U.S., the S&P 500 is considered representative of “the market.” Financial theory measures risk in a variety of ways. One of the most common ways is called the standard deviation of return. The standard deviation of return is a mathematical measurement of volatility, or how much returns bounce around. The following chart illustrates two assets that have approximately the same long run return, but different volatilities.

The value of the stock index bounces around much less than that of the single stock. While not every stock carries excess volatility, most do. Using the math of finance theory, it can be proven that a concentrated position results in a portfolio that carries excess risk. Excess risk, in financial theory terms, is risk that you could diversify away. For example, instead of owning one stock that constitutes 20% of your portfolio, if you adjusted your portfolio so that no stock constituted more than, say, 2% of your portfolio, you’d eliminate excess risk without giving up much expected return.   If concentrated positions generate excess risk, why do people hold them? Let’s look at some reasons.   Why Do People Hold Concentrated Positions? While there are probably as many reasons for holding concentrated positions as there are investors who hold them, we have identified four main reasons people hold concentrated positions. These are: -         Expectation of Outsize Gains -         Control -         Aversion to Taxes -         Status Quo Bias In this article, we’ll look at the first two reasons: Expectation of Outsized Gains, and Control. Outsized Gains Many of the great fortunes of history have been made by people who owned concentrated positions, usually in a single stock. Examples range from famous 19th century industrialists like John D. Rockefeller and Andrew Carnegie, to 20th century entrepreneurs like Henry Ford and Bill Gates, to 21st century tech founders like Mark Zuckerberg and Elon Musk. These owners, and many others like them, may have felt more comfortable keeping large positions because they had, as CEO, controlling shareholders, and/or Chairman, a significant amount of influence on the business. Nevertheless, many or most of them choose at some time to take a large amount of money off the table. That is, they reduce the size of their concentrated position, exactly so that they can diversify their portfolios. In 2021, for example, Zuckerberg sold about $4.5 billion of stock in Facebook; Jeff Bezos sold over $9 billion of his Amazon stock; Elon Musk sold an estimated $11 billion. The hope of earning further above-market gains is one important financial reason people hold concentrated positions. Control Control, and the desire to maintain control, is another reason people may hold concentrated positions, even if doing so potentially exposes them to excess risk. Control investors who wish to reduce their positions may have alternatives that are beyond the scope of this discussion. In a future article, we’ll examine two additional reasons people fail to diversify their portfolios: aversion to taxes and status quo bias. If you’d like to understand specifics of finance theory for excess risk, apply for an early copy of The Intelligent Layman’s Guide to Personal Investing, forthcoming from Wiley. Click here to be added to the list. You might win a prepublication review copy. Or call 703 437 9720 and ask for Connor or Dave.

5/31/23

If you have clients who own and run businesses in which they, as individuals, play an important role, they may have personal goodwill.

Identifying personal goodwill can open up valuable planning opportunities, especially for businesses that might be hard to plan for otherwise.

Goodwill is an accounting concept, as well as a real world phenomenon. Goodwill – in an accounting sense – arises when a company or business is worth more than the value of the sum of the other tangible and intangible assets. Tangible assets are assets such as property, plant and equipment. Intangible assets include intellectual property, brand names and customer lists.

Goodwill can belong to a company, such as a C-corporation, or to an individual. In either case, the goodwill can be “real world” goodwill, such as the positive feeling many people have toward companies like Coke or Apple.

Individual goodwill frequently arises in contexts of small companies where a founder has many personal relationships, and/or develops a good reputation in the community and the market.

Planning Opportunities

C-corporations typically involve double-taxation, once at the corporate level because C-corporations pay tax, and again at the shareholder level when dividends are received. Double-taxation can also arise in the context of S-corporations with “earnings and profits” or built-in gains.

This double-taxation can make it quite expensive for owners of some closely held companies to sell or otherwise take profits off the table.

Double tax on the sale of a C-corporation (or an S-corporation with earnings and profits or built-in gains) can be avoided by selling the stock. But such a sale is not always possible.

Buyers often prefer to purchase assets rather than stock. Buying assets gives the buyer a basis equal to the price paid. This basis in the assets allows the buyer to depreciate the depreciable assets, usually resulting in better after-tax results for the buyer as compared with a purchase of the stock. Purchasing assets also allows a buyer to pick and choose which assets to purchase.

Another reason buyers may prefer to buy assets rather than stock is to avoid picking up any hidden liabilities that may lurk on or off the company’s balance sheet.

If a buyer will not purchase stock, some sellers try to reduce the tax impact through alternatives including long term employment contracts, non-compete agreements, or consulting agreements. However, these are generally taxable as ordinary income, which while only one level of tax, is imposed at significantly higher rates than is capital gains tax.

When the facts permit, overall tax in a sale of assets can be reduced (and some taxes may be eliminated) if part of the sale of the business involves personal goodwill.

Case Study

We worked on a case involving the sale of a corporate business. The business assets were specialized manufacturing equipment, several parcels of real estate, and customer lists. In addition, the founder had built up a great deal of personal goodwill. His advisors were astute enough to sell the personal goodwill separately from the other business assets, though as part of the same transaction.

The total value of the assets sold was $15 million. Of that, $6 million was allocated to the seller’s personal goodwill, $7 million to the real estate, and $2 million to the equipment and customer lists.

The fact that he was able to allocate $6 million to his personal goodwill, outside of the C-corporation, enabled him to avoid an effective double tax on the personal goodwill portion, saving him approximately 20%, or $1.2 million.

Additional Planning Opportunity

Personal goodwill, as a personally owned capital asset, provides a great deal of planning flexibility. One such opportunity is to contribute, before the sale, some or all of the personal goodwill to a tax-exempt Business Owner Trust. To learn more about business owner trusts, please request our Business Owner Trust Advisor Guide. Or call 703 437 9720 and ask for Connor or Dave.

5/8/23

In a case decided last year, the Tax Court denied Martha Albrecht a $463,676 income tax deduction for about 120 items jewelry she donated to the Wheelwright Museum of the American Indian in Santa Fe, New Mexico.

The case, Martha L. Albrecht v. Commissioner, makes for painful reading. The court did not deny that Albrecht had made the gift, nor did the court challenge the valuation.

Instead, in the words of the Court:

The issue for decision is whether petitioner satisfied the requirements of section 170(f)(8)(B) for a charitable contribution she made during 2014 (year at issue). 

The section in question, 170(f), deals with the “Disallowance of deduction in certain cases.”

Section (8)(B) reads:

Content of acknowledgement. An acknowledgement meets the requirements of this subparagraph if it includes the following information: (i) The amount of cash and a description (but not value) of any property other than cash contributed; (ii) Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i). (iii)A description and good faith estimate of the value of any goods or services referred to in clause (ii) or, if such goods or services consist solely of intangible religious benefits, a statement to that effect. For purposes of this subparagraph, the term "intangible religious benefit" means any intangible religious benefit which is provided by an organization organized exclusively for religious purposes and which generally is not sold in a commercial transaction outside the donative context.

The rules required Albrecht to obtain a “contemporaneous written acknowledgement” and she did. But the Court didn’t like the way the acknowledgement was written. It said the acknowledgement:

“Does not comply with section 170(f)(8)(B) on the grounds that it did not specify whether the Wheelwright Museum provided any goods or services in return for the donation or state that it represented the entire agreement between the museum and petitioner. Specifically, respondent points out the reference in the deed to the “Gift Agreement” as creating ambiguity as to whether additional terms, including donee provision of goods or services, were part of the donation.”

It seems that the museum’s acknowledgement “does not state whether the Wheelwright Museum provided any goods or services with respect to the donation.” There was no allegation or claim that Albrecht did receive any goods or services. The problem, according to the court, was that although the donation to the museum was “unconditional and irrevocable”, there was also a “Gift Agreement” referred to. And the gift was of “all rights, titles and interests held by the donor in the property are included in the donation unless otherwise stated in the Gift Agreement.” And the Gift Agreement was not included in the original filing, so the court found the absence “leaves open a significant question about whether the parties had entered into a side agreement that included additional, superseding terms.”

Perhaps the most painful part for Albrecht was that the was no allegation that she had not made the contribution in good faith; there was no claim that she had in fact had a “side agreement”; and there was no challenge to the valuation.

The Court seems to have hung its decision to deny the entire deduction on the technicality. The Court admitted that Albrecht had “substantially complied”:

“We appreciate what appears to have been a good faith attempt by petitioner to substantially comply with the Code by executing the deed with the Wheelwright Museum. Substantial compliance, unfortunately for petitioner, does not satisfy the strict requirements of section 170(f)(8)(B).”

The court threw the book at her, apparently as a lesson to others.    

That lesson is to make sure that all the i’s are dotted, and t’s crossed when substantiating a charitable deduction.

If you’d like, please request a very brief synopsis of 107 charitable deduction court cases.

5/3/23

If you’ve ever done gift or estate planning, you are no doubt familiar with the valuation discounts for lack of control and/or lack of marketability.

You’re probably also familiar with the concepts of inside and outside basis, especially low inside basis and low outside basis.

Low outside basis is, for example, where the client owns an entity, such as an s-corp, and the client has a low basis in the shares of the s-corp.

Low inside basis would be when the s-corp itself owns assets that have low basis.

You know that when the s-corp sells assets, or the client sells (or gifts) shares in the s-corp, one of those low bases is going to bite.

For example, suppose that the total pre-capital gains tax value of the s-corp shares to your client were $10 million, (the actual numbers don’t matter much – they pretty much scale except at the very low end), and the potential tax is $3 million.

You might think that because there’s a $3 million tax that will be due, the actual, pre-discount value (i.e. ignoring lack of marketability and lack of control) of the s-corp to your client is really only $7 million, because to get cash the client will have to incur the tax.

Can your client get gift or estate taxes reduced by the amount of the tax?

 To learn more, click here or call 703 437 9720 and ask for Connor or Dave.

 

March 27, 2023

Treasury Inflation-Protected Securities are widely advertised as an effective hedge against inflation.

But are they?

There are a number of reasons the answer may be “no.”

CPI may not reflect the inflation you face

The principal of TIPS bonds is adjusted by the CPI. For example, if you buy a TIPS with $100 principal, and the CPI is 4% for the year, the principal of your TIPS will be adjusted by $4 (4% of 100) to become $104.

It might seem like this is a good deal, but the CPI may actually be irrelevant to the price inflation you personally face. In fact, there is no single, “correct”, measure of inflation. The particular price inflation that you face may be more in line with prices as reflected by the PCE, or some other measure of inflation.

Inflation-adjustment isn’t paid out until maturity

Another issue with the above scenario is that TIPS don’t actually pay out the additional amount until the security reaches maturity. So you wouldn’t actually receive cash from the adjusted principal value of the TIPS, the $104, until the security reaches maturity.

Phantom Income Risk

There’s another problem with the inflation-adjusted value of the principal: it hits TIPS holders with an additional tax, even if they receive zero cash.

Consider the example from above: the TIPS with a principal value of $100 and inflation of 4%. The Treasury will adjust your principal value to $104. But the extra $4 counts as taxable income to you in the year it is recorded, even though you don’t get cash then.

Furthermore, you may be taxed even if you never receive a cent of income.

The more money you invest in TIPS, the more you stand to lose to phantom income tax. For example, if you invested $10,000 in TIPS and inflation reached 9% (as it did last year), you stand to be taxed on an additional $9,000 of income which you never received. The additional taxation incurred could wipe out a large fraction, or even all, of the interest that you earn on TIPS, depending on the rate of interest you receive from the securities.

TIPS are complex

TIPS are financially complex instruments, and it can be difficult to understand all the intricacies. We’ve highlighted some of the hesitations with TIPS above, but there are others we haven’t mentioned.

How can you protect yourself?

Given that TIPS are, in many cases, not an effective hedge against inflation, how can you protect yourself from inflation?

You might consider diversifying your assets.

If you or your clients have with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

 

March 20, 2023

What Happened?

SVB, like all banks, was highly leveraged. Before the collapse, SVB had only 8% capital, which in the world of banking, is considered well-capitalized.

When a bank is highly leveraged, even a relatively routine loss in on the asset side of the balance sheet can wipe out its equity. That’s what happened to SVB.

SVB’s management invested too much of their portfolio in “safe” mortgage-backed securities.

Although these assets are usually considered “safe” from the point of view of credit risk, the “safe” ignores the important factor of interest-rate risk.

Interest rate risk is measured by a number called “duration.” The duration of a bond is, approximately, the amount that the bond will fall in market value if the interest rate rises by 1%.  When interest rates increase, the value of fixed-income assets such as bonds or mortgage-backed securities decreases. (That is a fact of finance.) Mortgages typically have a duration of over ten years. They also have a nasty characteristic called “negative convexity” which means that their duration gets longer (everything else equal) as interest rates rise.

These financial characteristics of mortgages are well known to anyone with any degree of fixed-income experience.  The duration mismatch on SVB’s balance sheet would have been obvious to a first year finance student. It remains to be determined who at SVB made and approved these high-risk investments.

When the Fed hiked interest rates, the value of SVB’s portfolio declined. At the end of 2022, SVB had lost 15.9 billion dollars on a mark-to-market basis. This means that if they tried to liquidate their entire bond portfolio by selling it at market prices, they would’ve lost 15.9 billion dollars.

Simultaneously, startups were having trouble raising money, so they had to withdraw deposits from SVB.

Higher interest rates, therefore, hit SVB with a double-whammy: the value of their mortgage-backed investment portfolio declined, and depositors wanted to withdraw money. To pay all the depositors, SVB sold $21 billion of bonds at a $1.8 billion loss. Then SVB’s management announced that SVB would raise capital to cover the loss. Depositors freaked out and began withdrawing their money, and SVB could not pay all the depositors. The FDIC seized SVB.

If Silicon Valley Bank had exposed itself to less interest-rate risk by keeping its investment assets with a much shorter duration, it would not have lost as much money when interest rates increased.

The Fed and FDIC policies suggest inflation will continue

In addition to SVB, two other banks failed in the past week. Multiple bank failures led the former chair of the FDIC to advocate for the Fed to stop hiking interest rates.

Fed chairman Powell has been increasing interest rates because he believes (though why is not clear) that raising interest rates is the way to fight inflation. (Paul Volcker, the Fed Chairman who brought down the inflation of the 1970s, explicitly said in his memoir Keeping At It that he never targeted interest rates to bring down inflation. Inflation is proven by thousands of years of history, and by economic theory, to be the result of rapid increases in the money supply. See our book HERE.) Powell seems to view interest rates as his only tool for fighting inflation. If he is right, and if he stops increasing interest rates, inflation might accelerate.

Inflation is primarily a function of the too-rapid increase in the money supply. In the banking system today, bank deposits are a huge part of the money supply.

That’s another reason why inflation is likely to continue: the FDIC is going to bail out SVB’s (and other banks’) depositors.

If the FDIC did nothing, many depositors would lose a large fraction of their deposits. This would reduce the money supply, and everything else equal would tend to bring inflation down.

Instead, the FDIC is going to compensate depositors for everything that the bank was supposed to pay.  This will prevent the contraction of the money supply that would otherwise occur.

The FDIC claims this won’t cost taxpayers, but where else is the money going to come from? If it doesn’t come from taxes, the money must be printed. So, rather than allow this natural consequence of increasing interest rates to reduce the money supply, the FDIC, no doubt with the approval of the White House, has decided to create new money. The creation of new money causes inflation.

How can you protect yourself?

You can protect yourself in a variety of ways, including diversifying your assets so they’re not subjected to one risk (such as interest rate risk).

If you have clients with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

March 13, 2022
 
Although the terms hedging and diversification are sometimes used interchangeably, the two terms actually refer to different areas along a spectrum. That spectrum is the correlation of returns.
 
Hedging
In plain English, hedging refers to the process of holding one asset (such as a stock), and then also buying another asset (such as a put option) that offsets the risk of holding the first asset. The hedging asset should have a strong negative correlation with the asset you are hedging.
 
A “perfect” hedge will remove all risk, and all return. Financial hedging in the modern world traces its history back to the 1840s. The Great Plains were being settled and farmed. Grain was being grown for the Eastern markets. Farming is a very risky business, and the price of grain is, and always has been, very volatile.[1]
 
Farmers had enough risk, associated with weather and the growing of crops, that they didn’t also want price risk.
 
Grain buyers (for example, bakers, millers, and grain merchants) also ran businesses that had enough of their own risks that they didn’t want to bear the risk of grain prices rising.
 
Being “long” a commodity means owning the commodity and bearing the risk of the price of the commodity falling.
 
Being “short” a commodity means having sold (or sold forward) a commodity that you don’t own, and bearing the risk of the price of the commodity rising.  Farmers were (and are) naturally long grain. Grain buyers were (and are) naturally short grain.
 
In the 1840s, farmers and grain buyers got together and founded the Chicago Board of Trade and developed first futures markets in the western world.[2]
 
A “perfect” hedge, then, for a long holding would be to hold a contract to sell exactly that amount, at some future date, at a fixed price. (For example, the grain farmers would want a contract to sell an exact certain amount of grain at a fixed price.) Producers and users of commodities often want their hedges to be as close to perfect as possible. Commodity producers and users, for the most part, seek to earn profits from factors other than the price change in the commodity they produce or use. So, they are happy with perfect or near-perfect hedges that remove that price risk.
 
Hedging Against Inflation
On the other hand, few investors desire a perfect hedge. Investors care about generating returns, and perfect hedges remove returns. Unlike farmers and grain buyers, investors don’t mind taking risk if that means getting returns. A perfect hedge would mean that return, in addition to risk, was given up.
 
Instead, most investors want a properly diversified portfolio that provides the highest expected return consistent with the amount of risk taken. In financial theory terms, investors want an efficient portfolio.
 
Nevertheless, people, including investors, continue to talk about “hedging” against inflation.
 
Inflation is the fall in the purchasing power of money. To qualify as a perfect hedge against inflation, an asset would have to increase in market value by the same amount that money loses purchasing power.
 
There is an investment that is sold as a hedge against inflation, and that is believed by many people to be a nearly perfect such hedge. That investment is TIPS. How useful are TIPS? We’ll look at that question next week. The answer may surprise you.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

March 6, 2023

Pop quiz: What was the world’s first recorded hyperinflation?

We have described that politicians, including the Roman Emperor Diocletian, use inflation as intentional policy.

Sometimes politicians get so carried away that they cause hyperinflation. The term hyperinflation is often thrown about carelessly. To economists, Hyperinflation is defined as inflation of over 50% per month.

You probably wouldn’t associate hyperinflation with cries for  ”Liberty, Equality, and Fraternity”, but  you should. The first recorded hyperinflation occurred in the wake of the French Revolution.

In 1789, revolutionaries violently seized control of the French government. They cancelled all taxes, but didn’t reduce government spending. Nor did they default on government debt.

The new government, called the National Assembly, seized the Church’s land, then worth perhaps 2 billion French livres (pounds).

But most of this land was not liquid. The government couldn’t spend it.

The Assembly issued paper claims called assignats, supposedly, though not legally, backed by the Church lands. Assignats, like bonds, were supposed to pay interest to the holder. Despite the talk about land backing, these assignats were unsecured debt, that is, debt not backed by any collateral.

The government used assignats to purchase real goods.

In 1790, the National Assembly issued 400 livres’ worth of assignats. A few months later, they increased that number to 800 livres. And then they eliminated the interest rate.

The assembly found that it didn’t have to tax or borrow if it could instead create, and spend, assignats.

Assignats were now basically fiat money; the Assembly could print them in whatever quantities they liked, whenever they liked.  And they did.

The Assembly printed so many assignats that their purchasing power fell by half over the following two years. From 1790 to 1793, inflation averaged about 1.3% per month, or about 17% per year (taking compounding into account). In 1794, inflation averaged about 7.5% per month. Prices more than doubled. What could once be bought for 1 livre now cost about 2.38 livres. By 1796, the assignat was basically worthless, and the French productive class – farmers and peasants – had been ruined. They were ripe for recruitment by a would-be savior. One soon appointed himself, and Napoleon waged war on all the areas of the world he could reach.   

 

 

The assignat inflation ruined the French economy, and ultimately caused tens of thousands of deaths. As more and more assignats were printed, they were worth less and less. . In the 1790s, most of the French economy was farmers. But as inflation rose, farmers realized that they’d be better off holding onto their grain, which holds its value, instead of trading it for paper that was rapidly losing its value.

Farmers acting rationally withheld grain from the market. In the modern politico-speak, this would be called a “supply chain crisis.”

The average Frenchman in 1790 got about 75% of his calories from grain. So rising prices was an existential crisis. Assignat printing caused the price of grain to skyrocket, and the supply to sharply shrink.

In 1793, the government acted as demagogues often do: they enacted price control laws purportedly to decrease the price of grain. They declared a maximum price on grain, and made it illegal not to accept assignats at face value. But farmers rebelled. Many of them were arrested or killed. As always happens, the price controls made the problem much worse.

All that interference in the markets had a cost. Imprisoning and killing farmers for selling wheat at market prices decreased the supply of wheat, and France suffered a famine in 1974. Thousands of innocent people died.

The French hyperinflation was the predictable (French economist Turgot had been in government and his understanding of the importance of real money was well known) result of deliberate government policy. And its counter-productive destructive results were also predictable.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

 

February 27th, 2023

To answer the question, let’s start with this basic fact: the federal government benefits from inflation. In 2022, the government “made” at least $2,000,000,000,000 (that’s $2 trillion!) from inflation.[1]

That $2 trillion had to come from somewhere, because “printing” money creates no value.

As Warren Buffet says about the poker game, if you don’t know who the patsy is, it’s you.

That $2 trillion came from all of us who produce or own assets.

Politicians won’t admit this, but the government benefits hugely from inflation. That fact is not unique to our government now.  Governments across the world and across history have deliberately inflated the money supply to accomplish their goals. We’ll start our quick review of historical inflation by going all the way back to the Roman empire.

Today’s post will examine how the Emperor Diocletian pursued deliberate inflation to accomplish his goals.

Broadly speaking, governments have 3 ways to raise revenue: 1) taxation, 2) borrowing, 3) and printing money (inflation). And when governments spend large amounts of money, they need to raise revenue.

So when Diocletian wanted to finance expensive wars, he decided to use a combination of taxation and inflation.

Inflation in the Roman Empire

When Diocletian became Emperor of the Roman Empire in 284 CE, he embarked on a spending spree that would put all the world’s drunken sailors to shame. He spent money on expanding the size of the army. He spent money expanding the bureaucracy. He spent money building  buildings. He spent money building a capitol. All that spending had to be financed somehow.

So he enacted three highly destructive policies: crushingly-high taxation, intentional debasement of the currency, and eventually price controls.

When Diocletian found that tax revenues were not sufficient, he augmented his coffers by debasing the silver denarius (the standard Roman coin). In those pre-paper money days, workers would gather in silver coins (from taxes and other sources). For example, they might take 1000 coins, melt them all, add some copper (much less valuable than silver), and remint 1100 coins. This process of adding a base metal to a precious metal was the original form of currency debasement. 

Diocletian increased the money supply increased so much that prices rose out of control. During Diocletian’s rule and prior to his price controls, the price of wheat, for example, was 35 times higher than it had been the previous century, according to historian Richard Duncan-Jones.

Instead of fixing the problem by stopping increases in the money supply, Diocletian decided to shoot the messenger. He believed he could stop prices from rising by legally fixing prices. He resorted to price-fixing because he didn’t want prices to keep rising, but he was unwilling to stop creating new money.

He issued the famous Edict of Diocletian, which imposed price controls on commodities, labor, transportation, and animals. The edict was enforced on pain of death.

But price controls don’t work. They never have, and never will.[2] By holding prices below the market-clearing price (the price at which demand equals supply), price controls increase demand because consumers perceive that they can pay less than the market-clearing price for products. And by holding prices below the market-clearing price, price controls reduce supply because sellers can’t earn the market-clearing price in revenue. This mismatch between supply and demand inevitably creates shortages.

In Rome, the market price of commodities such as wheat was increasing because the money supply was increasing, and price controls merely incentivized sellers to sell on the black market (where they could charge market prices, prices that reflected the true cost of producing commodities) or flee Rome to escape Diocletian’s oversight. Shops closed. Supply fell. Goods disappeared. The price controls had the exact opposite effect of those hoped for by Diocletian.

Yet Diocletian doubled down on state control. To prevent peasants from fleeing their land and seeking refuge elsewhere, Diocletian issued a law tying all citizens to their land. In other words, it became illegal to leave. Farmers became bound to land as serfs.

So not only did reckless government spending create sustained inflation, it directly caused serfdom – an institution akin to slavery that wasn’t abolished in the west until the mid-19th century.

We’re uniquely qualified to offer you insight on inflation. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation: Politicians Spend, We Pay, available here.

We’re celebrating Presidents’ Day instead of Lincoln’s birthday. But Lincoln’s birthday isn’t the only part of his history we’ve forgotten.

We all know Lincoln as the president who saved the Union and ended slavery.

But did you know that Lincoln also instituted the nation’s first income tax and created the IRS?

Lincoln also pursued a deliberate policy of inflation to finance the Civil War.

That’s today’s topic. We welcome your feedback!

The Civil War cost about $6.65 BILLION dollars total – more than an entire year’s Gross National Product, measured in 1860 dollars. (This measures only the direct monetary cost of the war, not the cost of the 750,000 American lives, or the opportunity cost of goods/services that were never produced.) The devastating war had to be financed somehow – and Lincoln chose not only to institute an income tax, but to print paper money. And print it. And print it.

The Legal Tender Act of 1862 authorized the federal government to literally print paper money, called “greenbacks.” Lincoln suspended the gold standard, and the government forced citizens to accept these greenbacks as legal tender. Congress issued about $450 million total in greenbacks by the end of the war.

Prior to the printing of the greenbacks, the gold standard meant that pieces of paper traded for goods had to be backed by gold. The pieces of paper were not themselves money. They were certificates that represented money – gold. The government would redeem paper notes for gold upon demand.

But with the printing of the greenbacks, greenbacks and other paper currency was no longer redeemable for gold.

Of course, merely printing money didn’t create any real value. But printing did create purchasing power. Spending the new money without increasing the supply of real goods/services caused a huge price increase, and transferred value from the people who created the goods and services, to the government.

Prices doubled between 1861 and 1865, as can be seen in the graph below.   As bad as it was in the North, the South fared much worse. The South also decided to issue its own currency, unbacked by gold. That currency rapidly depreciated. According to the Lerner Price Index, commodity prices in confederate dollars increased 90 times (by 9,000%) over the four years of the Civil War.

By the end of the Civil War, Southern currency wasn’t worth anything at all. Thousands who had, in good faith, accepted this paper in exchange for their goods and service were left penniless.

Both the North and the South suffered great economic ruin. But after Lincoln and his successor General US Grant left office, the US government, under pressure from Congress, restored the gold standard. In 1875, the Specie Resumption Act was passed, stating that the government would begin redeeming greenbacks for gold at face value in 1879.

President Rutherford B. Hayes realized that the government would have to increase its reserves of gold if it were to make good on its promise. Through careful financial management, Hayes and his administration managed to run a budget surplus (yes, apparently it’s possible for the US government to run a budget surplus!) and accumulated gold with which to redeem the greenbacks.

The intentional policy of inflation operated as a hidden, unlegislated tax on everyone who (many had no choice) accepted the depreciating paper money.

The inflation stopped and was reversed, because the government stopped its excess spending, and eventually restored the gold standard. During the roughly 30 years following the restoration of the gold standard, the US (and the developed world, which was also on a gold standard) experienced one of the greatest periods of economic growth in the entire history of the world.

In fact, most of the technologies that define modern life were developed and commercialized during this “golden age.” Among these are electricity, air travel, the automobile, trucks, the telephone, radio, and even plastics.

The Civil War was devastating. But the country recovered. A large contributor to that recovery was severe shrinkage of federal spending, and restoration of a non-inflationary dollar.

We’re uniquely qualified to offer you insight on inflation. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation: Politicians Spend, We Pay, available here.

Does Apple’s board know something? Apple has just announced that it cut CEO Tim Cook’s pay by over 50%

Here are five reasons for clients to consider diversifying any Apple holding greater than about 1% of the portfolio.

“Return-Free Risk”: This is the opposite of the risk-free return we hear about. As you know, having a large percentage of a portfolio invested in a single stock increases risk. It adds risk, but doesn’t add expected return. (In fact, it reduces expected return. Ask about our webinar for a full explanation.)

Economic Cycles: Apple, like many technology companies, is exposed to the business cycle. In a recession, technology companies tend to underperform the broader market.

Valuation: Apple has reached a high valuation and its growth rate is slowing down. The P/E ratio is considered high, which means that the stock is overvalued, and it might be a good time to sell.

Regular Portfolio Review: Many advisors approach the issue as part of a portfolio review. If Apple, or any other stock, is significantly overweight, it makes sense to sell the Apple, or other company, and diversify.

Historical performance of other huge companies: As history has shown, even the most successful companies can experience significant stock drops. Recent examples include:

Boeing (stock drop of 52% in 2019, and worse in 2020)

General Electric (stock drop of 58% in 2018, and worse in 2020)

Intel (stock drop of 57% in 2000)

Cisco Systems (stock drop of 78% in 2000-2002)

Microsoft (stock drop of 78% in 2000-2003)

Enron (stock drop of 85% in 2001, and then to zero)

Lehman Brothers (stock drop of 95% in 2008, and then to zero)

How to Avoid Tax on the Sale

Most large gains would result in large taxes if the stock were sold. If you have clients with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

You may also be interested in an upcoming webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. To learn when the next webinar is, and register for it, use this form on our website.

Apple may be dangerous to your financial health.

A month ago, we discussed the dangers of holding concentrated positions in large, “reliable” companies like Apple.

Since then, Apple has lost nearly $400 billion of market value.

Now, we see four reasons to diversify any large holding Apple.

They are:

1. China exposure

2. Recession risk

3. Earnings risk

4. Multiple compression

 

China

Apple is heavily dependent on China.

Covid and growing criticism of China have made that position extremely precarious. And according to CNN, “reducing [Apple’s] significant dependency on China could take years, if it ever happens at all.”

 

Recession

According to The Wall Street Journal top economists now expect a recession, with 2023 forecasts “increasingly gloomy.”

When the economy is in recession, consumer spending falls. Apple’s products are sensitive to consumer spending, and the company could see demand drop sharply.

 

Earnings Risk

Earnings are what is left after expenses are subtracted from revenues. Apple earnings could get squeezed from both sides, as China problems raise costs, and potential recession cuts revenues.

 

Multiple compression

In bear markets, the price to earnings ratio of stocks often falls. That can create a double whammy for stocks like Apple. If earnings fall, and the multiple decreases, the result could be a significant fall in the price of the stock.

 

Diversification Without Tax

If you have clients with a large holding in Apple, chances are they have big gains. And chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

 

664 Stock Diversification Trust

Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our weekly webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. You can register for, or request a recording of, that webinar using this form on our website.

Happy New Year, everyone! 

This post is part three in our decision-making series, "Are Your Clients Really Irrational?"

Sometimes, even an “easy” decision can be emotionally difficult if the stakes are high enough.
 
And if the decision seems easy, but the stakes are high enough, a good decision maker might well pause and wonder whether he is missing something.
 
For example, each year many people have the opportunity to decide what state to live in. For most people, the decision of where to live depends on more than one factor. But for some, state income taxes can be an “elephant in the room.”
 
Consider, for example, a married couple who like the Pacific Northwest, and earn a combined $500,000. If they decide to live in Oregon, they would pay about $44,000 in state income taxes.
 
Everything else equal, if they live in Washington, they’ll pay zero state income taxes.
 
Over a twenty year period, the difference in state income taxes could easily amount to $1 million dollars. That’s high stakes for most people.
 
One reaction to that difference might be something like “what’s the catch?” A million dollars is a lot of money. Consider someone who has no other reason to prefer one state over another, and for whom saving a million dollars is a no-brainer. That person might still pause, because the amount is so large, and take a second look to be sure he’s not missing something obvious.
 
These kinds of “no-brainer” high stakes decisions can arise in many different areas. However, taxes seem to bring them up often. One reason is that there are so many taxes, the tax laws can be complicated, and some tax laws seem designed specifically to tax people who don’t stop to consider that they might not have to pay as much tax if they choose “A” instead of “B.”
 
“High Stakes Paralysis”
“High stakes paralysis” is the condition of indecision that some people face when they must make a decision which is clear and easy, except for the fact that the stakes are high.
 
Most people who encounter “high stakes paralysis”, almost by definition, only encounter it a small number of times. This is either because they rarely face high stakes decisions, or because if they face many high stakes decisions, they become comfortable making high stakes decisions.
 
Hidden Insecurity?
Some clients will not admit to you that they are afraid to make a big decision, or that they believe they are not really competent to make a big decision. Instead, sometimes these clients will avoid making a decision, or they will offer supposed reasons that are in fact merely excuses. If you take those reasons at face value, you are probably wasting your time, because those reasons are excuses, and as soon as one is answered the client will generate another. All because the client cannot, or will not, admit that he is just stumped.
 
Dealing With High Stakes Paralysis
In dealing with high stakes paralysis, the first step is to clarify that it is in fact the high stakes, and not some other aspect of the decision, that is giving the decision maker a hard time.
 
As noted in the first part of this series, there are typically five factors that can make it hard for people to decide. In addition to high stakes, the others are:
 
Conflicting Goals
Complexity
Uncertainty about outcomes
Small differences between outcomes
 
To help a client dealing with “big decision” paralysis, who is privately afraid of making “the wrong” decision, walk through his issues with him. While all decisions are likely to have several factors making them hard, if you can identify the key difficulty your client is facing, you are in a better position to help him get past that difficulty.
 
Once you identify high stakes as the key issue, the next task is to get the client to discuss what he’s afraid of.
 
Is he afraid that there’s a hidden “gotcha?”
 
For example, someone who moves from California to Texas, looking forward to eliminating his state income tax, might not believe that it is so easy. In addition to consulting with a state tax expert, you might note that the US census bureau reported that between April 2020 and July 2021, over 300,000 people left California for lower tax states. There are costs – such as the cost of missing friends, the cost of moving, of making new friends, and so on. But your client probably already understands those. But he might still be worried that he’s missing something crucial.
 
If neither you nor the client can identify the “hidden gotcha” but the client is still afraid, try to help the client understand that not making a decision is not free. Every year the client lives in California, instead of Texas, he pays a ton of extra taxes; taxes that are in effect optional. Of course it’s your client’s choice to pay extra taxes. But just make sure that the client owns his decision to pay more taxes.
                                                                                                               
Non-Decisions Are Usually Costly Decisions
The above example of someone not moving because he won’t make the decision is typical of non-decisions.
 
Non-decisions are in fact decisions, and often lousy ones. You cannot make your client make a decision. But you can at least try to make sure the client knows that a non-decision is still a decision, and one that he’s responsible for.
 
As a result, the client is likely to get relatively lousy outcome, compared to what is possible with even basic planning. He’ll pay a ton of tax, he’ll accomplish zero estate planning (meaning he’s teeing up another big tax when he dies), and, ironically, he’ll have less flexibility (because he’ll have less) cash if he does choose to enter a new business.
 
Key Decision Skill #2 – Identify and Overcome Fear of a Big Decision
Any decision that is both hard and important is likely to have high stakes. If the stakes weren’t high, you as and advisor probably wouldn’t be involved.
 
Sometimes a client’s real difficulty is simply fear. If so, your client is not alone.
 
Alice Boyes, writing in the Harvard Business Review, advises
 
“Don’t be ashamed or afraid of your fear of making mistakes and don’t interpret it as evidence that you’re indecisive…”[1]
 
Boyes also advises not to try to eliminate fear. Most people cannot, and don’t have to. They have to act in spite of their fear, or anxiety.
 
Part of the advisor’s role is to stand with his client, and help the client make a fear-inducing decision.

We will continue to discuss key decision skills in the remainder of this series on decision making. Stay tuned to our blog for more updates.

We’ve all faced conflicting goals, and it can seem like it happens all the time.
 
For example, when was the last time you worked, when in an ideal world you’d have been doing something else?
 
Maybe you decided to go to work because you really wanted to close a sale, even though part of you really wanted to golf instead.
 
Conflicting goals are part of life. Most of us have figured out relatively effective methods for making decisions even when there are two (or more) goals that conflict.
 
When goals really conflict, it means we cannot achieve both, at least not in the same way at the same time.
 
And sometimes clients are in denial about that fact.
 
Business Example
I’m pretty sure you could come up with dozens of examples on your own.
 
Here’s one that I ran into today. An advisor had a client selling a business. The client is in his sixties, married, with kids. The business has been very successful, and the client is selling out to a much larger firm in the same industry.
 
The pre-tax proceeds will be about $11 million. The gain is largely capital gain, but there’s also recapture on various assets that have been depreciated, as well as some real estate recapture. Overall, the estimated tax bill, between state and federal and the above recapture, will be around $3,500,000.
 
This client was all over the map in terms of his conflicting goals. He tells his advisor that he is horrified at the tax bite. But he also wants to take his chips off the table while the opportunity exists. He doesn’t want to work anymore. But he might want to reinvest in some new business. And he doesn’t want to make any estate planning decisions, even though with the sale his estate is likely to exceed the estate tax exemption.
 
Is this starting to sound familiar? [click here for “sounds familiar”] A client who wants everything, and isn’t willing (or says he’s unwilling) to make any tradeoffs?
 
Non-Decisions Are Usually Costly Decisions
The above mentioned business sale looks like it will close, and the client has made no decisions. He says that he doesn’t want to decide. Instead, by “not” deciding, he is deciding in favor of the default plan – actually no plan – that just happened to be in place by historical accident.
 
As a result, the client is likely to get relatively lousy outcome, compared to what is possible with even basic planning. He’ll pay a ton of tax, he’ll accomplish zero estate planning (meaning he’s teeing up another big tax when he dies), and, ironically, he’ll have less flexibility (because he’ll have less) cash if he does choose to enter a new business.
 
You Can’t Have it All
At least as there are death and taxes, you (or your clients), can’t have it all.
 
We can’t be in two places at once. We can’t have our cake and eat it too. We can’t take our gains off the table, and still have all the upside potential.
 
You know that. And your clients know it too, deep down.
 
But too often, clients somehow refuse to make what seems to the advisor like an obvious decision.
 
How to Help Clients Choose Between Conflicting Goals
Often the best way to help a client choose between conflicting goals is to simplify.
 
Most real world choices have multiple aspects. Almost any planning will involve some complexity, at least in the details.
 
In 1939, Albert Einstein (along with Enrico Fermi and Leo Szilard), persuaded Franklin Roosevelt to allocate an enormous sum of money to the theory that an atom bomb could be built.
 
How did they convince Roosevelt? Did they attempt to explain nuclear physics to the president? No.
 
Did they try to explain to Roosevelt why they believed that such a bomb was possible?
 
No.
 
Did they discuss the engineering challenges? Or the probable side-benefits even if a bomb were not possible?
 
None of the above
 
Instead, they focused one key decision factor: if it turned out the bomb were possible, what would the world look like if Hitler had it and the US didn’t?
 
They got Roosevelt to focus on the most crucial issue for Roosevelt, and they ignored everything else.
 
Simplify to the Key Choice
A client wants to liquidate, but doesn’t want to pay tax. You have a method that he can sell without paying tax, but it comes at the price of (say) not having liquidity.
 
If the client wants both liquidity and to avoid tax, that choice, to the exclusion of everything else, needs to be made clear to the client.
 
For example, in the above $11 million business sale, the advisor might frame the decision as something like “is it worth $3.5 million of taxes to you, Mr. Client, to avoid having to make a decision about the proposed plan?” (The advisor was proposing a trust that would shelter the gain.)
 
Conflicting Goals
Try to get the client to be clear about all his, her or their (in the case of couples, families or partnerships) goals.
 
You know how to do this by asking questions.
 
Then try to get them to rank their goals.
 
Many clients will claim that all their goals are “top priorities.” But that is not reality. Your client knows this. But sometimes they are paying you to make them behave like adults.
 
Making difficult choices, saying “I’m not willing to pay $3.5 million in taxes; I’d rather have less liquidity” is an adult decision. Refusing to decide (which, as we said, is actually still a decision, though a bad way to make one) is not an adult behavior and is not, in all likelihood, how your client became successful in the first place.
 
Key Decision Skill #1 – Focus on the MOST IMPORTANT Tradeoff
Any decision that is hard likely involves tradeoffs. If there are no tradeoffs in a situation, there is no decision to be made.
 
But when there are multiple conflicting goals, and the client is having a hard time deciding, there is significant evidence that helping the client focus only on the most important tradeoff, then decide on that basis, results is better decisions than other approaches.[1]

We will continue to discuss key decision skills in the remainder of this series on decision making. Stay tuned to our blog for more updates.

Over the past thirty years, oceans of ink have been spilled promoting the idea that, in effect, your clients are stupid. Or if not stupid, “irrational.” The academics will have us believe that people, clients, are hopelessly “biased” in their decision making.

I was at Stanford when I first encountered the claim that people are systematically biased decision makers. It was 1982. In the bookstore there I found a collection of academic papers titled Judgment Under Uncertainty: Heuristics and Biases, edited by Daniel Kahneman and Amos Tversky. Tversky was then at Stanford. Academia loves certain ideas, and this one caught on like wildfire. Kahneman won the Nobel Prize for it.

But the idea has gone way overboard.

I don’t know your clients (at least I don’t know most of them personally), but I know people like your clients, and they are not stupid (not most of them, anyway.)

But it is not fair, or helpful, to claim that merely because clients don’t make decisions exactly the way that academic theory says they should, your clients are “irrational.”

How the Academics Say Your Clients “Should” Decide

Please don’t feel like you need to understand the following. I’m including it here so you have an idea of what Nobel Prize-type academicians have in mind when they talk about “rational” decision making. The following is a long quotation from the Stanford Encyclopedia of Philosophy:[1]

 

Here is a different representation of how a rational person “should” decide:

I do not say the above is wrong. In fact, when I was at Stanford, I had the privilege of studying decision science with one of the giants in the field, a wonderful professor named Ron Howard. Professor Howard actually coined the term Decision Analysis. I have tremendous respect for him.

However, for most people, it is not realistic to expect that they will make the significant effort required to learn the technical tools required to make “rational” decisions according that

Only that it is quite a bit to expect. Most people, even very smart, very rational people, do not use such procedures.

Your clients are not stupid, and they are probably not really irrational. But, they can probably also (at least sometimes) use some help in making decisions.

What Makes Real World Decisions Hard

In our experience over the years, working with hundreds or thousands of people, including advisors and their clients, we have learned that it is not ignorance of the technical theories that make decisions hard.

Instead, there are about five distinct factors that can make decision hard for real people. These are:

We will look at each of these in the remainder of this series on decision making. Stay tuned to our blog for more.

 

Are your clients paying more than their fair share of taxes?
 
The chances are high that they feel they are.
 
And the statistics suggest they might be right.


What Level of Taxation is Fair?
The US Government claims that “taxes are the price we pay for a civilized society.” That claim is based, more or less, on the idea that taxes are to used to pay for goods and services that benefit everyone. A classic example is police, and another is national defense.
 
But today, such expenditures for the common good account for a small fraction of US government spending. By some estimates, 80% or more of the US federal government expenditures are “transfer” payments. A “transfer” payment is money that is taken by taxes from one person and paid to another.
 
The US defense budget, as large as it is, as a percentage of federal spending is smaller than it has been at any time since before WWII.
 
Top 10% of Earners Pay 71% of the Income Taxes
To be in the top 10% of income earners in the US requires income of about $132,000 a year. That includes two income couples. So, for example, two people, who each earn just over the national average, will together be in the top 10%.
 
Chances are that many of your clients are in this top 10%, and for that are among those  paying the 71% of income taxes paid.
 
So if your clients believe they pay too much in taxes, chances are, they are right.
 
What Can You Do About It?
For the taxpayers in the highest tax brackets, tax rates can easily exceed 50% in many states.
 
But there are steps you, and your clients, can take that can reduce the severity of the tax bite. Four tools that you should be familiar with are:

• Section 642 Income Trusts
• Section 664 Tax Exempt Trusts
• Donor Advised Funds (Deferred Actual “F”ilantrophy funds)
• Private Foundations

To learn more, you may check out our page on year-end tax savings. If you are interested, you may also schedule a meeting with Sterling Advisor Solutions.

We all know how successful Apple has been historically.
Or do we?
We’ve heard from a number of people, including some advisors, who say that Apple will always grow.
At worst, these people say, “Apple will maintain its position as the world’s most valuable company.”
The unspoken assumption is that the stock is a “forever” hold, even if the position held is a large, concentrated one.

China Syndrome?
Recent criticism of Apple, even from left-leaning outlets like the NY Times, increases the risk for Apple. The Times says, in a 2021 article, “Apple has largely ceded control to the Chinese government.” China could be the trigger that causes Apple to lose its polish.

History of the Top Dog
But concentrated positions are dangerous, even in stocks as “stable” as Apple.
The historical data shows that even market leading companies like Apple can, and do, plummet.
Here is a short list of once-great American companies that have fallen on hard times. Most of these went bankrupt and disappeared:

• ATT
• Bell Labs (Lucent – went to zero)
• GE
• GM (Bankrupt)
• Sears (Bankrupt)
• TWA (Bankrupt)
• Pan Am (Bankrupt)
• Texaco (Bankrupt)
• Chrysler (Bankrupt)
• AIG
• Washington Mutual (Bankrupt)

Utilities Are Not Exempt
Even public utilities, once considered the ultimate “widows and orphans” stocks, are not exempt. Here’s a short list of some of the more prominent utilities that have gone bankrupt

• Pacific Gas and Electric (twice!)
• Portland Genera (Enron)
• Griddy
• Brazos Electric

Here are a few charts that show GM and GE, former industry giants, crashing to zero around 2009/2010:

Tech Stocks are Not Immune
Many advisors and clients have already felt the hit that big tech stocks have taken in the past year or so.
Netflix had a dramatic nosedive earlier this year. Facebook and Google have experienced similar plunges.
Google lost 44% of its value in 2022, and Facebook lost nearly 77% of its value in the same time period.

Even forward-thinking big tech companies are prone to periods of significant loss.

Could Apple Be Next?
While Apple has been good to its investors recently, that wasn’t always the case.
From 1998 to 2003, Apple stock price soared, just as it is doing today; then it fell just as rapidly.

And current data shows that Apple may be headed towards falling again.
Below is a graph of Apple, Facebook, and Google since 2012, when Facebook/Meta opened.

Notice that Apple, in orange, has largely followed Facebook (or META, in blue) and Google (in green) on the upward trend in 2020 and 2021.
It’s not hard to see how Apple may be just as susceptible to dropping as its contemporaries did.
Many clients feel as if Apple is “too big to fail.” But as we’ve seen with companies like GM, GE, and even recent powerhouses like Netflix, there is no such thing.

How To Get Out Before It’s Too Late
If your clients (or you!) have concentrated Apple stock positions, the safest and smartest thing to do is to diversify.
But stockholders are often reluctant to sell such positions, as they would face a huge tax hit in the event of a sale.
Luckily, there is a solution.

Sec. 664 Stock Diversification Trust
A good solution for many is a tax-exempt Sec. 664 Stock Diversification Trust.
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our weekly webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. You can register for, or request a recording of, that webinar using this form on our website.

Bitcoin, along with the rest of the “crypto” universe of assets is down roughly 75% from recent highs.
 
Many of your clients who own Bitcoin or similar assets will have losses.
 
However, those who have been invested for a longer time may still have huge gains.
 
Fundamental Value
There is a strong case that the fundamental value of issues like Bitcoin is zero. Here is a short argument for that case.
 
The bullish case for crypto “currencies” is that they, or one of them, will become the commonly used medium of exchange. That is, they will become money.
 
Money, by definition, is that asset in an economy which is the most liquid and is the most widely accepted asset in exchange. In the US, the dollar is money, and nothing else is money. For example, credit cards, checks, ACH, bank wires, and PayPal are all methods of payment. But what is paid is dollars.
 
Historically, going back to the at least to the time of Alexander the Great (he died 2500 years ago), money has always had a relatively stable value. When money ceases to have a stable enough value, it ceases to be used as money. (We wrote a book on inflation, available here, if you want to read over 100 pages on the history of money).
 
Demand for Crypto
People demand money because they want to use it for transactions, in the present or in the future. (See, e.g. chapter 17 of Human Action, by the 20^th century economist Ludwig von Mises.) To serve this role, and therefore to be demanded, the exchange value of money must be relatively stable.
 
People demand crypto, so it seems, for precisely the opposite reason. They demand crypto as a speculative asset. Most people (possibly excluding a small number of aficionados, and some unknown number of criminals) buy and hold crypto because they believe (or hope) that it will go up in exchange value. That is, they buy (if they buy) say Bitcoin at $16,000 because they believe (or hope) that it will go up to (say) $30,000 in a short period of time.
 
We believe that “crypto”, at least in the form of issues like Bitcoin, is not a currency, and is unlikely to be a currency. When people stop holding Bitcoin and similar cryptos because they believe the exchange value (i.e. the price in money) will rise, we believe the demand for such cryptos will virtually disappear. In that event, the value could go toward zero.
 
US Taxation
Bitcoin (and presumably other similar cryptos) are in the US taxed as capital assets. That means, for example, that if a client owns a Bitcoin with a basis of $1000, and uses it to buy a car for $16,000 (to use a current market price of a Bitcoin), that client will have a taxable capital gain when he “purchases” the car with the Bitcoin.
 
That’s the downside of capital treatment.
 
The upside is that it is possible to avoid taxation on the sale of crypto held for long term gains by using one of several appropriate techniques.
 
Section 664
One such technique is to contribute the appreciated crypto to a trust that qualifies as tax exempt under section 664 of the code.
 
Capture AUM
For clients who have appreciated crypto, a 664 trust can be a great opportunity to take profits without incurring tax. And for advisors, such a trust can be a great opportunity to gather AUM, while helping a client take profits, avoid tax, and diversify out of a highly risky asset.
 
If you think a Sec. 664 Tax Exempt Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

Commercial real estate, as an asset class, is very sensitive to the availability, and pricing, of loans.
 
The graph below shows the history – the black line – of the prices of US commercial real estate going back almost 30 years.
 
Also on the graph are loan demand – blue – and lending standards, shown in red.
 
As makes sense, when loans are easy to get, that tends to boost the demand for commercial real estate.
 
And when loans are hard to get, demand, and therefore prices, tend to suffer.
 
The sharp fall in the red and the blue lines suggest that a credit crunch has begun.
 
Prices have begun falling, but if the last go-around is any indication, they could fall much farther.

Your Clients
Some of your clients own investment properties – which are considered commercial real estate. Apartments, shopping centers, strip malls, office buildings, self-storage, medical buildings, parking lots, industrial property, even raw buildable land will all likely be affected by a credit crunch.
 
If you have clients with such property, now might be a good time for them to lock in profits.

Taxes
Many clients will not want to sell because they don’t want to pay taxes on gains.
 
There are two main sections of the tax code that such clients might be able to use to sell and not pay tax. These are sections 1031, and 664.
 
Section 1031 provides for tax-free exchange of one real estate property for another. The limitation, of course, is that if the client wants out of real estate, 1031 won’t do that.
 
Section 664 allows for the tax-free transfer to trust, and the tax-free sale by the trust, of qualifying real estate.

Sec. 664 Real Estate Shelter Trust
A good solution for many is a tax-exempt Sec. 664 Real Estate Shelter Trust.
 
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Real Estate Shelter Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

There have been two extended bear markets in the last thirty years. One followed the dot.com collapse in 2000, and the other was associated with the financial crisis.

The chart below shows the weekly S&P 500, in blue, along with its 50 week moving average (green) and its 100 week moving average (red).

The 50 week moving average crossed the 100 week moving average on the way down twice. Each time, it signaled a several-years long bear market.

The first time, in 2000, the market declined until 2003. The second time, in 2008, the market declined much faster, and more steeply. The circle labeled “3” shows that the 50 week is poised to plunge through the 100 week.

Is this signaling a bear market?

Locking In Gains

Some advisors are urging clients to lock in gains, on entire portfolios, and especially on large positions.

Other advisors are advising taking profits on all positions, large and small, that have big percentage gains.

The problem, of course, is taxes.

Taxes

Capital gains taxes on sales of appreciated positions are a return killer. For most significant gains, the capital gain tax plus state income tax ranges from 23.8% all the way up to 37.1% for those unfortunate enough to be subject to California tax.

But there are some ways to avoid tax on sale.

664 Trust

Many owners have large gains, and would face a large tax if they sold. The desire to avoid paying tax is often a primary reason stockholders that should sell, don’t sell.

A good solution for many is a Sec. 664 Stock Diversification Trust.

A Sec. 664 Stock Diversification Trust is a tax-exempt trust that allows stockholders to contribute their stock to the trust so that the trust can sell their stock, tax-free. The proceeds of the sale can be reinvested by the stockholder's financial advisor, allowing the assets to grow tax-free. The client does not have access to these assets, but does gain the right to an annual income stream of up to 5% of the assets; this can be deferred to allow the assets to continue growing inside the trust, tax-free.

A Sec. 664 Stock Diversification Trust is often a great solution for clients who want to remove the excess risk they face from their concentrated holdings but are resistant to pay the heavy taxes on such a sale.

If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

Greed is back. And that might be a great opportunity for investors holding concentrated positions in a stock who didn’t get out earlier.
 
As we all know, after a terrible first three quarters, the stock markets have bounced sharply.
 
But is it a new bull market?
 
The Greed Index suggests not.
 
CNN Money compiles their Fear and Greed index.
 
It has made huge jump toward Greed. Here’s a picture.
 

 
Why It Matters
If you have clients who have a concentrated stock position, the markets’ mood swing might offer a second chance for them to get out.
 
And you should know about a way for them to get out without taking the tax hit.
 
Taxes
Many investors with concentrated positions don’t want to sell because they don’t want to incur pay steep capital gains taxes.
 
A good solution for many is a tax-exempt Sec. 664 Stock Diversification Trust.
 
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our next Stock Webinar. You can register using this form on our website.

Home prices have been crashing in English-speaking countries including Canada, New Zealand and Australia.
 
Now, the most recent data show that house prices have peaked in the US, and are trending down.
 
It’s in the headlines too.
 
Bloomberg Headline:

Australia House Prices Record Steepest Drop in Four Decades

• Sydney again led declines, falling 2.3%; Brisbane dropped 1.8%
• Housing market seen remaining under pressure from rate hikes

 Hong Kong’s South China Morning Post:

Home prices poised to fall in Hong Kong, Australia, Canada, France and the US as global central banks raise interest rates

The most recent data show that prices have now peaked in the US too.
 


After the last peak in 2006, house prices gently turned down almost two years before the crash. Over about six year, the Case Shiller index dropped 28% from its peak. So far this time, prices are down only a couple of percent.
 
The house price bear market last time lasted about six years. If the pattern repeats, owners should have time to get out well above the bottom, even if prices are down from their highs.
 
Taxes
Many owners have large gains and would face a large tax if they sold. The desire to avoid paying tax is often a primary reason property owners that should sell, don’t sell.
 
A good solution for many is a tax-exempt Sec. 664 Real Estate Shelter Trust.
 
A property owner contributes property to the trust. The trust then sells the property, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Real Estate Shelter Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.