No one portfolio is suitable for all investors and no lifestyle or target date fund has a portfolio that is appropriate for all investors of the same age or projected retirement date. Building a portfolio that is tailored specifically to you is a better way to go.

Some Key Issues to Understand About Yourself:

When designing your own portfolio, you need to take into consideration at least these issues:

1. Your level of need for current income from your portfolio
2. Your tolerance for volatility based on requirements for capital withdrawals to pay for lifestyle or particular capital needs, such as college tuition
3. Your level of emotional tolerance for portfolio value fluctuation
4. Your ability to replace potential capital losses with earnings from work
5. Your other assets and sources or income, such as rents or pensions
6. Your ability, willingness, available time and self-discipline to research and manage your portfolio’s assets
7. The level of total return you seek and your time horizon for achievement of expected returns.

Lifecycle / Target Date Funds:

The lifecycle / target date funds concept is based on a simple principle that has some merit, but that must be tweaked for each specific investor. The principle is similar to Ibbotson’s ratio of “human capital” versus “financial capital” to describe the investor’s condition.

Human capital represents future earnings potential, whereas financial capital represents realized asset accumulation. Your total capital is the sum of the two.

When you are young and beginning your investments, you have 100% human capital and 0% financial capital. After you retire and reach the point that re-employment or operating your own business is no longer a reasonable option, you have 0% human capital and 100% financial capital.

The problem with lifecycle / target date funds is that different people do not reach the same points on the human capital - to - financial capital scale” (“HC-FC scale”) at the same ages or upon retirement from a career or upon selling a business.

Lifetime Capital Sufficiency:

We think it’s important to add another scale perpendicular to the HC-FC scale. Let’s call it the lifetime capital sufficiency scale (“LCS” scale). It is indexed to that point in life (whatever the chronologic age) that the amount of accumulated financial capital is just sufficient to supply all of the money you need for the rest of your life to maintain your lifestyle, and to fund any capital payments that are in addition to life style. That lifetime capital sufficiency would be rated 100%.

The two scales together on a chart make for an interesting plot of your condition as shown here.

You can see on the chart that the LCS scale goes from 0% when you have no financial capital to 100% when you have just enough to live all your remaining life on your assets without working again. The scale continues to amounts in excess of lifetime capital sufficiency.

Notice that chronologic age does not appear anywhere on the chart.

You could think of your “financial age as 0 to 100 on the “% Total Capital as Financial Capital” scale (the inverse of “% Total Capital as Human Capital”), but your chronologic age is only important in estimating the number of probable years of remaining life. Even then other factors come into play. Someone 80 years old could live for 20 years or more, while someone with a terminal disease at age 45 may have less than 3 years to live.

Problem With a Popular Maxim:

For those reasons, we find the old maxim, “Hold you age in bonds” (e.g. 50% bonds at 50 years of age) to be overly general and inconsistent with the diversity of conditions that one may be in, as suggested by the chart. Maxims may be born in wisdom, but cannot be applied blindly across the board to every person and situation. Lifecycle and target date funds are flawed in the same kind of way. They are overly general and do not recognize the myriad of conditions (including financial age and lifetime capital sufficiency) of specific investors.

If you reach 100% lifetime capital sufficiency at any age (G, F, H, C and D on the chart), you could retire then and there.

If you reach 0% human capital and do not have 100% lifetime capital sufficiency (E on the chart), you are in trouble.

If you reach the 0% human capital / 100% financial capital / 100% lifetime capital sufficiency condition (C on the chart), you are OK, but you have little room for mistakes. You may need to give capital preservation priority over capital appreciation to minimize the risk of outliving your assets due to the combination of regular withdrawals and portfolio volatility.

If you reach 100% financial capital (0% human capital remaining) and your lifetime capital sufficiency is well beyond 100% (D on the chart), you can reasonably choose between a capital conservation, low volatility, income biased portfolio; or a more aggressive pursuit of capital appreciation with attendant higher volatility and possibly less income bias.

Similarly, if you reach 100% lifetime capital sufficiency level, but have not yet reached 100% financial capital stage — more human capital remaining — (F on the chart), you do not need to be as conservative or income oriented as if you had no remaining human capital.

As you plan your portfolio, evaluate the seven issues listed above and try to place yourself in the chart of financial capital, human capital and lifetime capital sufficiency to orient yourself before you make your investment decisions.

Richard Shaw
QVM Group LLC

Summary:

In the words of Tony Soprano: “Fogetaboutit”.

Expanded Summary:

In the words of the IRS: “Section 1091“, “Section 267” and “Rev Ruling 2008-5”

Purpose:

All investors and their investment advisors, should have an understanding of the Wash Sale Rule and related rules before making investment decisions, instead of learning about them painfully from their accountants at tax filing time.

This article is about where we stand as investment advisors on the important Wash Sale Rule with respect to schemes to circumvent the 30-day exclusionary period with alternate investment accounts such as:

• IRA accounts
• 401-k accounts
• other self directed tax qualified accounts
• sole owner limited liability companies
• sole owner S or C corporations
• revocable living trusts
• marital joint taxable accounts
• spouse’s individual taxable accounts
• children’s accounts

Disclaimer:

This article is for discussion purposes only and is not personal or specific “tax advice”. We are investment advisors, not tax accountants, tax lawyers or tax advisors, but we are able to read, and the reading seems clear. You should read the IRS materials and draw your own conclusions, or rely on the guidance of your personal tax advisor.

Discussion:

The Wash Sale Rule contained in IRC Section 1091 says that an investor (who is not a dealer) cannot deduct the realized loss on investment if the investor made a “substantially identical” investment within the 30-day period before or after the date of the realized loss.

We wrote about whether or not substitute investment funds are “substantially identical” in two prior articles (August 11, 2007 and May 20, 2008).

“Substantially identical” is not defined in the regulations, but general consensus could probably be found with something like:

Substantially identical means the same in all important respects, particularly economic position and risk exposure, but not correlation of return, except for the case of two companies undergoing merger or the case of one security convertible to another.

This article discusses the use of multiple accounts of different types in relation to the Wash Sale Rule.

Rev Ruling 208-05: The most common alternate account scheme involves harvesting a loss in a regular taxable account, immediately buying the same security in an IRA (and perhaps then 31 days later closing the IRA position followed by re-opening the position in the regular account).  

Blogs and forums have many references to this approach. The general responses to questioners are essentially “maybe that would work, and probably the IRS wouldn’t find it” or “it probably doesn’t work”.  

The IRS dealt with that scheme in January of 2008 with Revenue Ruling 2008-05, which flatly closes the door on the approach.  

Key language from that ruling is as follows:

“ISSUE
If an individual sells stock or securities for a loss and causes his or her individual retirement account or Roth IRA to purchase substantially identical stock or securities within 30 days before or after the sale, is the loss on the sale of the stock or securities disallowed?”

“HOLDING
The loss on the sale of stock is disallowed under § 1091.”

There are no current reporting requirements in place for taxpayers, brokers or fund companies to assist the IRS in finding Wash Sales involving an IRA, but we do not recommend tempting fate. We’ve all been put on notice by the Revenue Ruling. Someday, we may find one more new form to complete at tax time to deal with that issue.

One might argue that the IRA (or any other tax qualified account) changes the economic position and risk exposure of the investor by converting all gains and dividends to ordinary income, and by making capital losses within the IRA non-deductible. However, we’ve got better things to do than to argue with the IRS about that, and probably so do you.  

Bottom line, you cannot use an IRA of any kind to circumvent the Wash Sale Rule.  

The ruling does not say, but surely an IRS auditor would likely take the position, that use of a 401-k or other self-directed retirement plan to substitute a substantially identical holding is also not an acceptable way around the Wash Sale Rule.

Side Note: An interesting question might arise if an employee was making regular monthly purchases of employer stock in a 401-k, while also holding shares in the employer’s company in a taxable personal account, and selling some of those taxable account shares at a loss. It seems that it would be disallowed by the logic of the ruling, but it also seems to be a quite different set of facts and circumstances.  Perhaps there may be a ruling on that someday too.

Section 267: Related Party Transactions: Other wash sale avoidance schemes might involve harvesting a loss in a regular account and immediately buying the same security in a trust for which you are the beneficiary, or in a solely owned LLC or an S or C corporation, or in a joint marital account, a spouse’s individual account or a child’s account.  Well – ”Fogetaboutit”.

Section 267 says,

“You cannot deduct your loss on the sale of stock through your broker if, under a prearranged plan, a related party buys the same stock you had owned.”   

We’re not exactly sure what the larger term “pre-arranged means”, but we are comfortable that it includes intentionally selling security “A” in controlled account XYZ and purchase of security “A” in controlled account ABC within the 30-day exclusionary period before and after the sale of security “A” in account XYZ, where you or your family benefit by both accounts.

There may or may not be some alternate structure that you can identify that the Related Party Rule of Section 267 does not specifically list, but the intent of the IRS is clear – If you control both accounts and benefit from both accounts, or the nature of the transaction is intra-family, they are related parties and you can’t use them to avoid the Wash Sale Rule.

Conclusion:

Unless you find good sport in baiting the IRS and spending your time and money arguing points with them or the tax court, be satisfied that there is no way around the Wash Sale Rule with alternate accounts.

Perhaps someone with a mega-loss and mega-wealth will find good occasion to challenge some aspect of these rules, but if you lose hundreds, thousands or even tens of thousands of dollars, your time and money is better spent seeking similar, but not substantially identical, substitute investments in the same account where you incurred the loss.  We discuss working rules for viable substitutions in another article.

Richard Shaw
QVM Group LLC

Large banks are way down in the past 12 months, and as a consequence their trailing yields are well above normal.  That potentially creates substantial long-term equity income opportunity, but the big question is whether the dividends that make those yields will hold or be cut. 

If you subscribe to the “buy it when it’s cheap” philosophy, then you really need to evaluate any sector when it sinks the way large banks have done.

If you conclude that taking a position (partial or full) in large banks is the right thing to do, we believe that you should buy the sector, not individual banks (unless you have high research-based conviction about the individual company).

If you buy the sector, you are exposed to systematic risk for banks (general market risk and industry specific risk, such as more mortgage market trouble).  You would probably hold some stinkers in the group, but you would also hold the winners.  That means that a few banks with negative surprises will not destroy the income advantage of the sector.

If you buy inidividual banks, you take on systematic market and systematic sector risk, but also non-systematic (individual company) risk.  With individual banks, you have greater risk of permanent capital loss (some banks could fail), greater price volatility risk, and greater risk of yield reduction through dividend cuts.

Two good ETFs to participate in large banks are XLF (S&P 500 financials sector, which also includes insurance and investment banking) and KBE (KBW large bank index).

Richard Shaw
QVM Group LLC