Interest Rates: High or Low? Which is better? This Remains The Key Question.

We have been hearing about the coming change in policy by the Federal Reserve. It is commonly referred to as The Fed but its official name is The Board of Governors of the Federal Reserve System. Most people think that interest rates will rise as a result of the Fed’s meetings sometime early in 2014. We've seen some rates shoot up 1% very quickly since the chatter escalated last May but subsequently things settled down for a while. The Federal Reserve has been artificially keeps rates down by buying bonds on the open market. The more bonds that are purchased drives up the price of bonds and their respective yields lower. You may have heard the term quantitative easing, or QE, which refers to the Fed’s bond buying program. The question becomes why is the Federal Reserve so intent on keeping rates low?

The theory is that if interest rates are low people will be encouraged to borrow money and spend it. The banks will be encouraged to lend money to people who will spend it. The more people spend, the more the economy grows. The more the economy grows, the higher rates will go because otherwise inflation will spiral out of control. If inflation becomes too rampant, the value of currency will fall. If the value of your currency falls, foreigners won’t want it because it is losing value. Therefore we can see that there is a delicate balance between interest rates, inflation and currency values.

Some people just dismiss the relationship between these factors as the normal result of a cause and effect situation. Let’s use an example of inflation rising. Just because the rate of inflation rises doesn’t automatically mean that rates should suddenly increase. What if the rate of inflation increased due to temporary shortages of certain durable goods or raw materials? This might be a short-term spike which will correct itself over time and the effects should only be limited to the respective industry. If rates were to move up quickly, the entire economy would now be affected instead of limiting it to the particular industry. Sometimes having a lower valued currency encourages outside investment which is a good thing for the economy. Again, just because the currency value goes down doesn't automatically mean that inflation is out of control.

If all these factors are interrelated, it must mean that there is an ideal and delicate balance between interest rates, inflation and currency values. If you earn more on your savings, you’ll pay more to borrow. If you earn less on your savings, you’ll pay less to borrow. Lower rates generally mean lower inflation. Higher rates generally mean higher inflation. It would seem they cancel each other out; if you earn more and pay more and earn less but pay less, they balance each other out. Not so fast! When you borrow don’t you lock in rates for a period of time? If you obtain a 30-year mortgage and choose a fixed rate, your rate will stay the same for the 30-years. This means that the timing of spending or purchases is critical to the “effect” of interest rate changes. Wouldn’t there be a huge difference between locking in a mortgage at 8% versus 4%? Wouldn’t a 4% mortgage buy more house than an 8% mortgage?

People always have an answer or a counter-claim. You were probably just thinking that it would be easy just to refinance when rates went back down. What if rates didn’t go back down for a long period of time? You would think that it would be better to lock in rates for the long term when rates are really low. Rates have been very low for years now yet people are encouraged to lock in rates for 10 or 15 years instead of 30 years. Wouldn't it make more sense to lock in low rates for a longer period of time than a shorter one? Wouldn't it make more sense to lock in high rates for a shorter period of time than a longer one? Don't many people end up buying high and selling low? Why do so many people do the exact opposite of what makes the most common sense?

This brings us right back to the question of which is better, high interest rates or low interest rates? There is no one correct answer. The best scenario lies in the delicate balance in the relationship between interest rates, inflation and the value of money. There is no magic bullet to solve our economic problems. If everyone saved as much money as they could and only bought what was necessary to live, would the economy grow? Isn’t this what people in some countries do now? In our country Americans expect the economy to grow and therefore spend money. If the economy doesn’t grow, should the answer be to stop spending? If Americans stop spending money and start saving as much as they can, won’t the economy slow down even more? If people save more, the demand for borrowing would go down. If fewer people borrow the rates go down. This means that with more savings we might get lower rates again. Didn’t we just go full circle here? There’s your answer!

A Rising Tide Lifts All Boats…(But It Doesn't Mean They Are All Seaworthy!)

We have all heard the saying. There is some truth to the idea that when the economy is doing very well most of the people benefit in some way to some degree. This doesn't mean that all people benefit equally or even proportionately. Even when things are going very well there are bumps in the road or waves on the ocean. We need to remember that if the economy is doing well it indicates that the country as a whole is doing well based on averages. Anytime you average any numbers, you’ll come up with an average for the set but it will also have a median. Averages can be misleading; the median tells you that half the numbers are lower and the other half of the numbers are higher. The median acts as your center point or your balancing point. Why is this important?

It is important because if you only look at averages you will be missing a great deal of the statistical information that is available to you no matter what the subject matter is. You could be researching investments or you could be researching Fantasy Football or Fantasy Baseball players. Let’s say a baseball player had a batting average of .302 the previous season. Most people would say he hit 302 but it is actually .302 which represents the average of all his visits to the plate. If he steps in the batter’s box 1,000 times he’ll get 302 hits. Let’s make this simpler and say for every 10 at-bats he’ll get about 3 hits. Here’s a very important question: Can you deduce from this batting average that this ballplayer will get a hit for each of his next 3-at-bats if he has not had a hit his last 7 trips to the plate? No!

Where are we going with this? If the S&P 500 Index has gone up an average of 14% in the previous 20 years does this mean it will go up about 14% this year or next year? No! We put too much emphasis on the average and we don’t look deeper. There are 500 stocks in the S&P 500 Index. If the Index climbs 14% in one year does this mean that every individual stock in the index climbed exactly 14%? No! One stock might have risen 80%, another 40%, another 10%, and another 1% while several others could have had negative returns yet the index climbed an “average” of 14%. Would you rather invest in the index and take the average of 14% or would you rather invest in the individual stocks that returned 80% and 40%? What about when the index is negative? Does this mean every individual stock had a negative return in that year? No! Would you want to invest in the index knowing it would return a negative average for the year?

The best investments are those which can stand on their own no matter what the overall economy is doing, and no matter if the tide is going in or out. Over time I have slowly shifted my thinking away from indexes and geographical investments. I learned the hard way that just because there were compelling reasons why the Brazilian economy should perform strongly the last few years leading up to the Olympics and World Cup, it doesn’t mean that a Brazilian ETF will realize a great return. China may have a bright future but it doesn’t mean you should invest in an ETF that invests solely in China. It would be wiser to invest in individual solid companies which would benefit from a more successful Chinese economy.

You might believe that a collection might be a wise long-term investment; there are many physical items that you could choose to collect such as cars, coins, stamps, paintings, sculptures, etc. Would a Yugo command the same return over time as a Ferrari? No chance! So you would invest in a “collection” or “index” of cars if you knew they could own Yugos, AMC Pacers and Pontiac Azteks? Research is key to making sound decisions no matter the subject matter. Asking the right questions and seeking the necessary information is critical to success. The next time you hear or read that this is the perfect time to make some investment ask yourself all the prerequisite questions. If investing were so easy we would all own some index funds and there would be no advisers, wealth managers or hedge fund managers.

Have You Started Your Year-End Tax Planning Yet?

One of my favorite holidays is the 4th of July, especially when it comes on a Thursday to create a 4-day weekend. I love the summer and July 4th means that summer is in full-swing. I also dislike when it quickly goes by because before you know it we are into mid-September and we just blew through Labor Day weekend. Thanksgiving Day is almost upon us and Christmas is not far away. This means that the end of the year will come very soon. I’m sure you are thinking about presents right now but you should be thinking about taxes!

Most people only think about taxes when it is absolutely necessary like on April 15th, completing paperwork for a new employer or choosing options for a 401-K plan. You should be thinking about taxes at some point every year as a way to plan to pay the least possible amount going forward. One of the easiest forms of tax planning is tax-loss harvesting. Tax-loss harvesting involves selling your losers before the end of the year to book a capital tax-loss. Some advisors recommend that you sell the security in which you have an unrealized capital loss and buy a similar security or wait 30 days and buy back the same security. I manage my client’s portfolios with taxes in mind all year round, not just at the end of the year.

If you haven't had a discussion about tax planning for this year with your investment adviser by now it can only mean two things. Your adviser is an RIA (Registered Investment Adviser), has discretionary trading authority and has done planning for you and your family in a comprehensive way. This would mean the adviser knows what needs to be done to minimize taxes based on your planning sessions. This is a good thing. Your adviser is not a RIA and/or a CFP (Certified Financial Planner), your adviser does not have discretionary authority and you have not had any comprehensive planning done. This is a bad thing. It means you probably aren't going to be taking advantage of tax losses which might be in your portfolio. Not every investment goes up all the time. There are winners and losers.

I might sell a security in March if I believe it is the right thing to do at that time, regardless of the tax consequences. First and foremost you own any investment because you believe it is a good investment to hold at that time. Buying and selling any investment or asset strictly based on tax considerations is not very sound investment strategy. When you do sell any security that you've held for more than one-year you'll have a long-term capital gain or loss. When you sell any security that you've held for less than one-year you'll have a short-term capital gain or loss.

The key is to effectively offset losses against gains whenever possible: long-term losses against long-term gains and short-term losses against short-term gains. Short-term gains are taxed are your regular income tax rate while long-term gains are taxed at the capital gains tax rate. We're used to the long-term capital gains rate being lower than your regular income tax rate but this is not necessarily true by definition. Congress has the ability to change both rates every year.

Take a look at your unrealized capital losses and gains in your portfolio. Unless you have a specific estate planning function in mind, it’s usually better to spread out your gains over time while maximizing any potential tax-loss harvesting. If you have a specific holding that represents a good percentage of your overall portfolio and it has substantial embedded capital gains, your tax liability will only continue to grow. At some point (unless you die and use the step-up in basis rule) you may need the money or want to reallocate your portfolio and you'll find yourself with a huge tax bill all at once. With proper planning and using the right adviser you'll find that you don't need to worry about taxes come the end of the year. Your tax planning should be an on-going process just like the buying and selling of your securities.