It’s hard to beat the market, especially if you aren’t doing it full-time. Good investing should be boring. However, there are techniques, tips, and tools that professionals use in order to improve their odds of success. Let’s go through some of them.
In this post, we’ll dive into more advanced investing topics like taxes, inflation, debt, and strategies for becoming a successful investor. If you haven't already read All About Investing Part 1, I recommend you do so because it covers some of the fundamental considerations that will add value to the conversation.
🏆 Make sure you compete against the market
When we talk about investment return, you have to look at the performance of your investments relative to the overall market. And take it from me; it's a bit of a mental playground. It's entirely possible to have your portfolio go up 36% in one year, and you feel amazing, only to realize that the entire market went up by 52%... and your portfolio actually underperformed. A common benchmark that people use is the S&P 500, but if you have a globally diverse portfolio of stocks, it might make more sense to use something like VT (Vanguard’s Total World Stock ETF) or if your portfolio has a mix of stocks and bonds, one of Vanguard’s Target Date Funds with a similar stock/bond ratio might make more sense.
💸 Minimize taxes with tax-advantaged accounts
There is more to be gained by saving on taxes than almost anything else. However, just remember that for many tax benefits, there will be a tradeoff with liquidity – meaning that while you may save on taxes, you may not have easy access to the funds.
The most common tax-advantaged accounts are Individual Retirement Accounts (IRAs), 401(k) plans, and 529 college savings plans. They all offer advantages of deferring tax (paying tax later) or growing tax-free (paying tax now, no tax later). The tax advantages will help accelerate growth, but for IRAs and 401(k)’s, you don't have access to these funds until 59 ½ years old without penalty. And for 529 plans, you can maintain tax advantages only if the funds are used on allowable education expenses.
IRAs
IRAs include two different types. The first is a Roth IRA, where you can invest after-tax money and never pay tax on the growth or withdrawals in the future. The second is a traditional IRA, where you can invest pre-tax money and skip paying taxes on gains until you make future withdrawals. Both IRAs allow you to contribute $6,000 per year (or $7,000 if you are 50 or older), but if your income is high enough or you’re eligible for a retirement plan at work, you may not be eligible for either unless you take advantage through the backdoor Roth IRA process (below).
If you are eligible for both, it's up to you to choose which one is better for you. Here’s how I would think about it: my wife and I are in our peak earning years and we live in a state with some of the highest income taxes in the country. While I don’t know what the future holds, I think it’s more likely we’ll have lower tax rates in retirement, so I would opt for the traditional path if I were eligible.
The backdoor Roth IRA process is tricky (so I suggest talking to your CPA), but it’s also one of my favorite tricks and I’ve been using it for most of the past decade. In general, this is how it works. First, you make non-deductible contributions to a traditional IRA (after-tax money). Then, you roll the funds over to a Roth IRA (and don't pay taxes since you already used the after-tax one in the first step). Then you can invest in whatever your account allows and the account will grow tax-free into the future. The most important consideration is if you already have funds in a traditional IRA, you’ll need to do pro-rated rollovers, which will likely incur taxes, so if that’s your circumstance, I would strongly encourage talking to an accountant.
I personally hold my Roth IRAs at Wealthfront, but I was originally hesitant to put my IRAs there, because you don’t get the amazing value of tax-loss harvesting in a tax-advantaged account. However, I love my passive investments to be hands off and I’m happy to pay for convenience and automation… but even more importantly, Wealthfront will coordinate trades between all your accounts (including IRAs) to avoid triggering any wash-sale rules (see below), which could result in an extra tax bill.
401(k)s
A 401(k) is similar to an IRA but is tied to your employer. The default option is a pre-tax / traditional contribution, but many plans offer a Roth 401(k) option for after-tax contributions that functions similarly to a Roth IRA. For both, you can elect to contribute a portion of your paycheck directly into the plan, up to $20,500 per year. And in some cases, employers even match a portion of your contribution amount, which acts as free contributions.
While that number is the employee tax-advantaged limit, you can actually contribute up to $61,000, and if your employer allows it (sadly it’s not that common), there is a process called the mega-backdoor Roth 401(k) that can be used with 401(k) plans and would allow you to make significant Roth contributions each year. I talk about the backdoor and mega backdoor Roth IRAs in episode 65, so you should go check it out.
529s
A 529 plan is not a retirement account but has similar tax advantages. It's designed to help pay for education costs. Like a Roth IRA, you make after-tax contributions but grow the account tax-free and make tax-free withdrawals so long as you use them on qualifying educational-related expenses for you or your kids. There is an exception for scholarships, so if your child receives one, you can withdraw that amount penalty free. However, if you end up with more money than need for educational expenses, you’ll have to pay a penalty to withdraw it or it can be retitled in anyone else’s name, so it could be given to a grandchild or other family member. Contribution limits match the IRS gifting limit of $16,000/year (in 2022), but you can actually superfund your 529 with up to 5 years of contributions at once.
I personally hold my 529 plans at Wealthfront, and while I was originally hesitant to pay the fee for the same reason I was about my Roth IRAs (see above), I couldn’t find another 529 plan that offered as globally diverse a set of ETFs and I think the value of that diversification is greater than the 0.25% fee. On top of that, I love the automation of everything and having all my investments in one place.
Wealthfront
If you’re interested in any Wealthfront accounts, I’d appreciate you using my referral link, which will get us both $5k managed for free.
Note for anyone self-employed: I didn’t cover SEP IRAs or Solo 401(k)s above, but I’m hoping to include them more in a future newsletter (and by then I will have set my own up, so I’ll have some firsthand experience to share).
🧑🌾 Capture losses with tax loss harvesting
In any year, the IRS will let you deduct capital losses from your income (up to $3,000 per year) or against any other capital gains you have. If you have more losses than you can use, you can even carry them over to future years. It's a huge tax advantage to pay attention to. But there is an important rule to consider. It’s called the wash sale rule. The IRS will not allow you to take a loss if you buy back the same investment (or a substantially identical one) within 30 days before or after the sale.
For example, let’s say you had originally bought $10,000 of VTI (Vanguard’s Total Stock Market ETF) and it's now down 25%. If you sold it, you’d have a $2,500 loss that you can use to reduce your taxes this year. Now ideally, you’d want to buy back the $7,500 of VTI so you’re not out of the market when it (likely) recovers. However, the wash sale would prohibit you from realizing that loss if you rebought VTI.
But the trick is that you can buy a similar investment that’s very correlated to your original investment. So, for the example above, you could buy SCHB (Schwab’s US Broad Market ETF), which is so correlated to VTI that you can barely see that there’s two lines in this chart comparing their performance over the last 5 years:
So how much does this matter? Well, Derek Horstmeyer reported in the Wall Street Journal that tax loss harvesting can, on average, boost an equity portfolio’s annual return by 1.10% - 1.42% percentage points, meaning if you had an expected return of 5%, tax loss harvesting could increase it to 6.1 to 6.42%. However, you should be careful because there are many ways that wash sale mistakes could revert the benefits, so you need to make sure that you know what you are doing. Software handles this much better than most humans, so I urge you to automate this process.
🤔 Think twice about funding retirement accounts
The above conversation may lead you to believe it's a no-brainer to take every tax advantage, but maybe you shouldn't.
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Yes, you invest right from your paycheck, making it easy and pain-free.
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Yes, you can grow the money without paying taxes each year
However, many of my past guests agree that it may not be the best thing to do, because you are locking up your money for a long time and you may not know when you’ll need that money. In episode 19, Andy Rachleff points out that using every retirement contribution opportunity to minimize taxes might lock up all your money when you might need it most, like for a down payment, advanced degree or other emergency. To use the funds for any of those, you’d likely be penalized for early withdrawal and lose the advantage of accelerated compounding growth.
However, there’s one thing everyone I know will agree on: if your employer matches any portion of your retirement contributions, invest as much as you need to get that free money, because there aren’t many places in life that you get free money like that.
🔥 Inflation is hard to beat short-term
Inflation is front and center today, and we are all feeling its impact. And for anyone under 40, we have never experienced this type of environment before. So, what can we do about it? One option is to invest in I-Bonds with current rates at 9.6% (listen to episode 64 or read this past newsletter for a full rundown on them). Another option you might consider is trying to hedge against inflation, but in episode 42, Ben Carlson said putting on a short-term hedge can be tempting, but also is really hard to do successfully. Gold is a perfect example. Historically, gold is said to be the best hedge against inflation and the past few years provided a great opportunity for gold to explode. But spoiler alert: that didn't happen. So I say ignore trying to solve for the short-term and focus on the long-term, where I think the stock market is your best inflation hedge.
🏦 Debt will magnify gains and losses
If you need money, but want to avoid selling and realizing gains, you can always just borrow against your portfolio, but things can also go very badly. In theory, when expected returns are greater than the interest rates, it's a good bet, but it's a very risky proposition. When thinking about it, I am often challenged by the question, 'Why is it okay to take on debt in my house but not in my portfolio?' I actually had a great conversation with Joe Saul-Sehy in episode 35 about this exact topic.
There are two specific risks when using debt in your portfolio: margin calls and variable rates. If you take out a loan on your house and the value goes down, the bank does not come knocking to take your house (as long as you keep paying your mortgage). But if the value goes too low in your portfolio, the brokerage firm will request you to add more funds to the portfolio to meet the debt requirements (margin call) or even sell your positions if the balance gets too low or you don’t make your deposit in time. The second risk catches more people off guard. If you locked in a fixed rate mortgage, your rates (and payments) don’t rise when interest rates rise. But your portfolio loan usually has a variable rate, and in today's environment, the federal reserve is keen on raising those rates. So please consider those risks before borrowing.
My two rules of thumb when borrowing against your portfolio are 1) borrow a small enough amount that if we experience a major market crash, you likely won’t get a margin call (for me that means borrowing <30% of the value of the account) and 2) make sure you have a plan to pay back the loan. And for those of you thinking about home equity lines of credit (HELOC), many are subject to the same variable risk as a portfolio loan. So you need to pay close attention, or you could be paying way more interest on your debt than you expected.
🎰 Get comfortable making many bets
I talk a lot about passive investing because it makes up the vast majority of portfolio. But the numbers don't lie; there is a rise in active investing. And the truth is, whether you are a passive or active investor, you will be wrong a lot. In episode 6 with Morgan Housel, we talk about how normal it is that the majority of your gains will come from a small number of investments. You don't need to be right always; you just need to be right sometimes. Good investing is about putting the odds of success in your favor. And this is staying in the game and making many bets.
📄 Summary
Let's take stock of some actions from the newsletter and podcasts. And for those who skipped to the end, think of this as your TL;DR.
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Be a boring investor.
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Determine what risk you are willing to endure.
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Balance tax advantages with liquidity.
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Think long-term.
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Consider a dollar cost averaging strategy.
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Build an investor policy statement to guide your decision-making (see episode 48 with Brian Feroldi).
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Create an investment checklist and filter with your criteria.
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Hire a financial advisor, if needed.
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Keep an investment journal to track your decision process.
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Automate the investing process with tools and software.
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Compare your returns against the market.
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Leverage tax advantages accounts and tax-loss harvesting.
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Fight inflation with long-term investing (or I-Bonds).
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Be careful with debt.
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Stay in the game and make enough bets over time.
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Read and listen to intelligent people (so go back and listen to all the money and investing episodes of the podcast 😃)
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Editor’s Note: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, hotel, airline, or other entity. This content has not been reviewed, approved or otherwise endorsed by any of the entities included within the post.
