A worldwide recession. All time market highs. A global contagion. All time market highs. A foreign invasion. Are all time market highs in our future? The stock market is a wild ride. Stocks are a highly volatile asset class. They always has been. They likely always will be. So, how should one invest for volatility? How do you get to financial independence as quickly as possible while minimizing any missteps along the way?
My favorite investing strategy for volatile times (which is all the time) is pretty simple: subtract your age in years from 100. The result is the % of your portfolio you should keep in a total stock market index fund (like VTSAX). The balance (your age) should be in a total bond fund (like VBTLX).
It makes taking action (or remaining inactive) amidst volatility really simple. Is the market at all time highs? Sell some stocks and buy some bonds to rebalance and lock in your gains. Is the market crumbling around you? Sell some bonds and buy some stocks while they’re at a discount. Aim to keep your percentages within about 5% of their targets.
Selling At A Bottom Can Delay Financial Independence
One of the worst things an investor can do is sell at the bottom of a market correction/crash when emotions are high. Doing so can significantly delay the time to financial independence. Making an ill-timed sale turns a paper loss into a real one. Now, you need a correspondingly bigger increase to make up for the loss. Instead, invest for volatility so you never feel the emotional pressure to sell low.
Your Portfolio Adjusts For Risk As You Age
As you age, your portfolio will get more conservative. That’s not a bad thing, especially as you close in on needing to draw from the portfolio. But, the portion in stocks will still grow significantly, helping to ward off the insidious effects of inflation. And, this approach recognizes that human behavior, has a real effect on a portfolio’s performance.
A Variation
For more aggressive or risk tolerant investors, consider subtracting your age from 110 or even 120. You’re still investing for volatility! You’ll simply end up with a higher percentage of the portfolio in stocks (and likely a wilder ride). But, over the long haul, you can expect a higher total portfolio value because more of the portfolio is invested in growth assets (stocks).
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
My girls will have awesome 21st birthday parties if they want them. Or, they will have startup capital, weddings, house down payments, or gap years. How, you ask? Some modest investments, time, and dependent capital gains harvesting.
Investing In Your Child’s Financial Future
When my oldest daughter was born, her uncle Dan gave her a gift of $100 with the following instructions:
New Baby-
Tell your Dad to open an investment account for you (if he hasn’t already) and put this cash into the account. When you turn 21, you can have a big party with all your friends!
Uncle Dan
Any time she received money from other family members, we bought more of Vanguard’s total stock index ETF, VTI. Turns out infants don’t really need much more than diapers and onesies. So, we asked family members for any gifts during her first few years to be cash too. I also split up my 529 contributions so that every paycheck I put a bit more into this account instead of the 529.
Over time, we just kept adding more shares. Once her account crossed $3,000, we converted it to Vanguard’s total stock index fund, VTSAX and set it to auto purchase a little bit each pay check.
It has been a very positive 5 years during her investment career. I looked at my records and plotted the historical growth of her UTMA account. Being a nerd, I also extrapolated 3 scenarios into the future:
At the low end, we’re just contributing $300/yr and the account grows at a rather paltry 3%.
The nominal scenario has us contributing about $850/yr with the account growing at 5%.
In the high scenario, we’re adding $1700/yr and it all grows at 7%.
Three potential growth scenarios for a child investor
It’s a proud papa moment when my almost 6 year old is able to peer into her young adult years and have between 25-95k in capital at her disposal. Thank you, Uncle Dan!
Now for the fun part: Dependent Capital Gains Harvesting
As the market moves up and to the right, I periodically sell VTSAX and buy something similar like Vanguard’s S&P500 index fund, VFIAX. This is a taxable event. We sold shares for a profit, and my daughter, our dependent, owes capital gains taxes on her earnings from the sale. Note: to keep things simple, I’m assuming no other types of income (no dividends, no interest, no earned income).
For minors in 2023, the IRS taxes capital gains on up to $2200 of unearned income per year at 0%. My oldest daughter is almost 6. This is her only source of income. While she is our dependent, as long as she doesn’t profit more than $2200/yr, she owes nothing on the gains for that year.
Once she is no longer our dependent, she will be eligible to pay “filing single” capital gains taxes. Let’s pretend that we’ll flip that switch when she turns 18. That may not reflect reality, but it’s an example. In 2023, for individuals filing singly, the IRS capital gains tax rate on up to $40,400 of taxable income is 0%. Let’s take the low balance scenario and see what her cost basis looks like at 21. Remember, we’re making some assumptions here:
Selling enough shares each year until she turns 18 to lock in $2200 of capital gains with 0$ of taxes owed
After she turns 18, selling enough shares each year until she turns 18 to lock in $40,400 of capital gains with 0$ of taxes owed. OK, this may not be as realistic, but it should illustrate the point
A Deeper Look At The Scenarios
Using capital gains harvesting for a dependent while she has $0 of other income, by the time she reaches 21, the entire balance of her after tax account will already have had the capital gains taxes paid…at 0%!
Low balance scenario where we contribution ~$300/yr & it grows at 3%. See how quickly the basis catches up to the balance (the purple line is right at the orange line by the time she is 7). That’s the power of harvesting capital gains for your dependents.
By making these taxable transactions periodically and harvesting her capital gains, she will incrementally increase the cost basis of her investments. As her new cost basis increases, she has a lower potential tax burden in the future. The next two scenarios are a little more aggressive, but also show the power of this approach. Here’s the nominal scenario (contribute about $850/yr; grow at 7%/yr) resulting in around $50,000 of investments with little to no tax obligation at age 21:
In this scenario, the growth is high enough that she needs one year of filing single to fully catch back up. The net result is that by 21, she has a big asset with little to no tax obligation.
Finally, the high growth scenario is truly exciting. Yes, we’re contributing $1700/yr, which could be a pretty high burden for some folks. And, the funds are growing at 9% year after year. That’s high, but not unreasonable, I hope.
There it is: nearly $100,000 of assets with ~$0 of tax obligations against them. How cool is that?
By age 21, she has nearly $100,000 of investments, again with nearly $0 in tax obligation. Have a crazy cool 21st birthday? OK! Pay off a big chunk of student loans? OK! Down payment for a house? OK! Seed capital for a business? OK! It’s enough that she can do almost anything…but she cannot do nothing.
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
A 50% decline is bigger than a 50% gain if it happens first. Let’s take a quick look at Sequence of Returns risk.
Your investment portfolio is represented by a pie, raspberry if you like.
Yes, that is a full pie.
Pretend that you have worked hard for 15 years, saving 54% of your income and are ready to embrace your financial independence. The day after you step into your new life, the market crashes 50%, wiping out half of your portfolio’s value. Think of your portfolio looking like half a pie now. Ouch.
One half of the pie. It was either “lost” due to declining portfolio value or after eating.
In our simple example, it is a volatile market. The very next day, the market soars 50%!
You’re back to where you started, right?
Nope.
You’re only at 75% of your original balance. A 50% gain after a 50% loss is only a 25% gain on the original amount.
Take away half the pie and then add half back. You don’t get the full pie.
If you needed to buy groceries or pay your mortgage (or make any withdrawal from your portfolio) while the market was down, you have even less left.
This simple example illustrates sequence of return risk where a decline in the portfolio happens shortly after someone starts to draw from it (e.g., in early retirement or FI years).
How to mitigate sequence of return risk:
Manage your asset allocation. Keep some bonds, cash, & stocks in your portfolio, especially if you’re planning to draw from it soon. In this way, you won’t have to sell stocks when they’re down in order to eat.
Continue to generate some income so required portfolio withdrawals can be reduced. If you keep working or pick up some extra work, that income can be used for living expenses instead of selling assets at a loss during an early down turn.
