Diversification & Beneficiary Planning

Hey, I think I just wanted to start off by way of introduction for our clients who might be watching this. It's a bit of a new format, we've never done before, but just so they know, really, I think the whole idea behind what we're doing here is just to give people a sense of what we're discussing at the office, pull back the curtain a little bit on different topics that we're discussing amongst ourselves. You know, things that may not even be implemented, but things that we're looking at week in and week out, whether it be, you know, investment news for the last quarter, any popular items in the news, or an upcoming election such as this year.

I think equally as important, any financial planning topics that might be relevant that don't even pertain to the investments. And so hopefully this will be helpful to them and we'll get some good discussions out of it, and hopefully this is the first of many videos to come. But I thought, Will, today I think you're going to kick us off with some investment information that you found relevant recently in the past few weeks.

Yeah, that's right. So, you know, we talk a lot about diversification with our clients, and I think it's sometimes a buzzword in finance and people don't really know what it means. Like, oh yeah, my portfolio is diversified. But what is that? What does that mean in your IRA or your brokerage account? And I have a visual that I'm going to share with you guys that I think does a really good job of explaining diversification. Can you see my screen here?

Yeah, you're also... yeah, we can see it.

All right. So this is just a table of different asset class returns, and how to read it is each column is a year. So this one goes back to 2009 all the way through 2023, and then year to date, so January 1st '24 through end of the quarter, March 31st. And the bar, or the row on top, is the highest returning asset class that year. So in 2011, REITs did the best, and emerging markets equity lost 18.2%, did the worst. So going from left to right, you know, 2009 to date, you can see what the highest returning asset classes were and the lowest returning asset classes.

In the middle you'll see a black line that says asset allocation, and that's an example of a diversified portfolio that holds a certain amount of money, or a certain allocation, towards each of these different asset classes. And you have emerging markets equity, high yield bonds, developed markets equity, REITs, small caps, small stocks, large cap stocks, commodities, fixed income and cash.

And the idea is that each year, you know, no one knows what the best returning asset class is going to be in any given year, but by holding a diversified portfolio of, you know, all of these or some of them, your personal return of your diversified portfolio will be somewhere in the middle. And I just think that's a really important thing, because the truth is, you know, markets are random in the short term, but they are more consistent in the long term.

And if you look at this leftmost column, this average returns from 2009 to 2023, this is the annualized return, and this is the annualized volatility, which is a measure of risk. And risk and return, another thing that kind of goes hand in hand: typically the higher risk investment will have a higher return. Lower risk investments like cash and fixed income will have lower returns. That's, you know, another common idea in finance. So I guess I'll open up to you guys. Any comments on this chart or anything that you'd want to add?

Yeah, I've got a couple things, I think. One thing is pointed to me, people talk about, like, performance of, you know, oh, the market's up, the market's down. In my mind, like, the market is many different markets. Like, what do you mean by the market? Like, there's the S&P 500, is like the index that we use to track the US equity large cap stocks, and like, that's one of, I don't know, a hundred different indexes out there that track different things. And like, that's such a small part of the overall market, but it is really important. That's like the largest of the equity markets in existence.

But I think, as Will kind of shows out here, like, we don't want to be just in the US large cap, which is those green boxes, because you could see, you know, 2022 it was down 18%. If your portfolio is down 18%, like, that's really going to hurt, especially if you're somebody in retirement who's living off of their portfolio. That'd be a pretty traumatic experience, I would think. So we want to be diversified across all the different markets. So we'll have some US exposure, some international exposure. You know, we want a healthy amount of bonds, also some what we call, like, diversifiers, things that are supposed to, you know, keep the portfolio up in times of volatility. So we want to be diversified across all those other things.

I think something I just noticed about this chart too is kind of like your point of reference, your lens that you're looking at, matters a whole lot. So if you look at, like, the farthest left box, the large cap annualized return of 14% from 2009 to 2023, it's a 10-year average return. But also 2008 falls off this chart, because that's not part of the 10-year. So if you go to, like, the 11-year return, I'd be curious to see what that number is, because in 2008 the S&P 500 was down 37% during the great financial crisis. So I think, like, it's important to think about your frame of that return.

I agree, Zach, and I think this period of time that's represented here is really interesting, because you see a lot of green up at the top over the last 15 years, you know, US large cap, which coincidentally, when you're reading about or hearing in the news, you know, the Magnificent 7, the S&P 500. For people that live in the United States, the S&P and how it's performing is basically the benchmark for how people can consider the market's doing in general, even though there's all these different asset classes listed here.

And so especially over the last 5 years, it seems like it's just been obvious of what companies to invest in, because, you know, the seven biggest best performing companies that make up the largest percentage of the S&P 500 have just continued to outperform all these other benchmarks. And so it seems like, oh, it's really obvious, I read or I see in the media every day that US large cap is the only choice. But to your point, I would be interested to see this same chart from 2000 to 2009 and where that green would end up there.

And I think you might see what you see at the bottom of this chart, you know, commodities. And I think that really drives home the overall point of not getting allocated to one asset class, because taking a stance like putting, you know, a bulk of your money in commodities over the last 15 years would have just been the worst thing you could have done for your portfolio. And I've got a feeling each of these colors represented on this chart, throughout some period of history, would end up being, you know, at the bottom of this chart for a significant period of time.

And so, you know, by taking that diversified approach, you know, you're probably not going to end up at the top of this chart an awful lot, which can be frustrating, but you can see you're hitting singles, you know, every rolling 10-year period, which I think is encouraging. It can be comforting to know that it's pretty consistent where you're going to end up, particularly for retirees.

Yeah, and I think that actually really kind of leads into what I was planning on showing today and talking about today. So, Will, you got anything else to add on that one, or I'll get going on it?

No, go ahead.

Can you guys see my screen here?

Yeah, you're good.

So this kind of is something really similar to what Will was talking about. So this chart is something that BlackRock puts out from time to time, and I think it does a really good job of talking about diversification versus owning, like, just the S&P 500. So this chart shows, this column here is just the S&P 500 returns for different periods of time. So from 2000 to 2002 is what they, was the tech bubble. So before 2000, all the technology stocks were going crazy, but for these two years, you know, S&P 500 was down 40%. And then from 2003 to 2007, the S&P 500 did really well. Once again, S&P 500 is just that US large cap index.

And then we have 2008 here, S&P 500 was down 37%. And then from 2009 to '19 was, you know, pretty much straight up to the right. S&P 500 went up 351% over that period. And then we have the pandemic here, down 30%, but the quick recovery of 2020, or second quarter of 2020 through 2021, up 119%, that V-shape recovery that we've talked about. And then 2022 was a really difficult year as the Fed was raising interest rates to slow inflation. S&P 500 was down 18%. And then last year recovered really well, up 26%.

Which, all of that, if, you know, all of your money is in the S&P 500, I got to imagine that's really scary to live through some of these significant drawdowns. But if you put in, I think it was $100,000 in 2000, it would have grown to be $490,000 if you were able to sit through all of that and not panic and not sell, which I think would be really tough to do.

But this column over here, I think, does a really good job of explaining diversification and why it's worthwhile. So this is a diversified portfolio of about 60% equities, 40% bonds, and it's made up of a little bit of a different mix of equities. So there's some US large cap, there's some US mid cap, some international, some US small cap and a little bit of emerging markets. Which, our portfolios generally have global diversification. We do overweight US relative to international, but we don't want to be all in US, because being diversified over a long period of time, you know, I'll get to it at the bottom here, you end up with kind of a smoother investor experience.

You're never going to be, you know, really happy, but you're never going to be, you know, down 40%. Guess I shouldn't say never, but it's very, very, very unlikely that you're ever going to be down as much as you would with the S&P 500. But so, as I talked about earlier, like, during the tech bubble, you're not happy, you're unhappy because you lost money, but you didn't lose the 40%. During 2003 to 2007, you actually came out ahead of the US equity market, because during this period emerging markets and international equities did really, really well.

During 2008, you're, you know, unhappy because you lost money, but you didn't lose as much as you would if you were fully in the US equity index. You know, you're unhappy during 2009 to 2019 because you didn't make as much as the S&P. It's just kind of a reoccurring thing where you're not making as much on the upside, but you're not losing as much on the downside. And there's a guy from BlackRock who actually has a saying that I really like, that you make more by losing less. So, like, protecting the downside, even if you don't get all the upside, you end up coming out on top.

And I know it's, what is that, a 1.5% better return over 20 years, 23 years. But you end up with more money being in a diversified portfolio. But just, I got to imagine living and sticking with this portfolio is a whole lot easier than if you were just fully in the US equity index. Yeah, so that's kind of another case for being diversified.

Yeah, and I think a couple of things stand out to me about this chart here, Zach. And like you mentioned, you know, only coming out ahead at 1.5%. However, you know, if you look at all those different colors on the right, seven out of eight of those periods you're, quote unquote, unhappy. You know, only one out of eight times were you actually happy that you were diversified. So basically 85%, 90% of the time you're unhappy, and yet you still ended up coming out ahead. So yeah, it can feel frustrating, but the math works out, you know, over the long term.

I remember reading somewhere once as well that, you know, you mentioned the losses and going through those periods of losses, and the thing about being diversified is that people, I think, are two times more concerned about losing their money than they are gaining on the upside. And so I think, you know, basically almost every one of these periods, seeing that you lose almost less than half what the S&P did during some of the struggling periods of this country, it can be very encouraging and can give you a lot of confidence that, you know, what's most important to people, which is avoiding losses, can usually be better avoided by being diversified.

But I think the third thing is that, you know, even when you're diversified, 2022 was an example of, you know, taking on less risk and being diversified, you know, doesn't always completely protect you from losses versus the S&P. I mean, that was a period where basically everything was down for the year. So it's not always easy, even when you know it's going to work out over the long term, being diversified. And there are periods, you know, that happen rarely, where, you know, being diversified, you know, you would have done just as poorly as if you were in a 100% stock portfolio. But I think, you know, this shows the averages in those periods where things got tough, that it really does work out, you know, well for you in terms of protecting your wealth.

Yeah, I think you're exactly right. It's kind of crazy when you see the dollars of it all at the end of 23 years of returns. Will, anything from you on this?

No, I think you guys hit most of it right on the head. Diversification is not a perfect investment strategy. There is no such thing as a perfect investment strategy, but what the research will show us, and what we see on a daily basis with our clients, is that it does a good job. And if it's something that helps most people stay the course and stay invested to reach their goals, then, you know, it's a good strategy.

Okay, Zach, if that's it for you, I'm just gonna hop to...

Yeah, I think you're gonna cover some financial planning and stuff.

Yeah, yeah. And I actually just wrote a blog on this last month, so this may be repetitive for any clients that had read that. But I think it's becoming particularly relevant with an aging population, you know, and even COVID, with what, you know, this country and what every country went through worldwide with the pandemic, loss of life. The importance of estate planning and, you know, putting beneficiaries on your accounts.

And we deal with this a lot when it comes to IRAs, but, you know, there's all these different types of accounts you can have and should have beneficiaries on, whether it be 401(k)s, bank accounts, insurance policies. When you add it up, there's a lot of different accounts that people may have out there where they should have beneficiaries, but maybe they don't, or they haven't checked them in a while.

And so I think there were two really important things that I've been reading about recently that are common mistakes that people can make, and things that they should review. And they're common mistakes because they're small things that, you know, if you don't examine them closely, it's easy to make a misstep, and it really can cost you big time in terms of not only dollars from a tax perspective, but more importantly, where you want your assets to go if something happens to you.

And so the first thing that I just want to cover briefly just has to do with the idea of naming a trust as a beneficiary of, you know, most notably your IRA or 401(k). And I think, first off, to cover why people do that in the first place, it is an attractive proposition to name your trust as the beneficiary of your IRA or 401(k). Number one, for simplicity. A lot of people will just say, listen, I've created this trust and I want all of my assets that I own when I died to go into this trust, and it's got it perfectly laid out of where I want my assets to go, when I want them to go, and how much of them I want to go to different individuals.

And so I think the best thing that comes out of having a trust as a beneficiary is that you get that additional control, particularly for parents if they have younger children, or children in college, where they say, listen, if something happens to me and I have substantial net worth, I want to be able to say exactly when my kids will get access to funds that I leave for them. And even when they get access, maybe I only give them the income from the investments and not the principal, you know, unless there's some sort of event where they really need it and the trustee can approve of them dipping into that.

But I think that gets covered a lot by attorneys who are promoting this to clients. But what I think doesn't get covered sometimes can be, there's an adverse tax effect to doing that. And essentially what can occur is, if you make the trust the beneficiary of a 401(k) or an IRA, assets that go into a trust when you pass, number one, you get a shorter time period to move assets out of your IRA after you pass, and you have to move them into a trust.

Even though the laws have changed, and really for everybody you get a shorter period of time to move assets out of your IRA to an individual or to a trust, typically if the trust isn't written in a certain way, you have to move all of your assets out of your IRA into a trust within 5 years. And so for somebody who's got a $1 million IRA, you know, that could cause $200,000 each year to be taken out of an IRA and put into the trust.

The reason why that's a problem is because trust tax rates are a lot higher than individual tax rates, and so after $15,000 of income is put into a trust from an IRA, you're already in the top tax bracket. And so in that example, if someone's got a $1 million IRA, they pass away and they've got the assets going into the trust, basically you're going to have $200,000 that's being taxed at the highest tax rate every single year until the account's emptied in five years. But what you could do is, if you name different individuals directly, you know, each of them not only typically will get 10 years to take the money out, it's going to be at lower tax rates. It's going to be at their individual tax rates.

And so I just think it's something that's really important for people to consider, or to double check with their attorney or their advisor, to make sure that a trust is what they want as the beneficiary of their IRA. And trusts can be written in such a way where you can avoid that tax problem, but it's something that should be analyzed closely, because particularly for people that have large balances in their 401(k) or IRA, it can cost them a lot, and their family a lot, in a short span of time. So I think that's super important. But any questions on that before, while I pull up my next quick thing on beneficiaries?

One thing, I think, in addition to just, like, accelerating taking it and paying the taxes in a condensed amount of time, like, you're also not getting the benefit of the tax deferral of, you know, continued growth in the portfolio. So I think there's more aspects than just the tax aspect of it.

Yeah, absolutely. Second thing, I'm just going to share my screen here real quick. It's something that I think can be the most missed. And as I mentioned in this blog I wrote, part of the reason why it gets missed so often is because this designation that I'm going to cover, which is called per capita versus per stirpes, is usually a tiny box that's on a beneficiary form that people don't even notice as they're writing down their beneficiaries.

And this is something that's really important, I think, for anybody who is the sole remaining spouse of a family who has multiple children, and really anyone that has sizable dollars that they're looking to leave to multiple children. And the specific situation where this may come up, and why it's important to take a look at either designating beneficiaries as per capita or per stirpes, is if you unfortunately have a child that predeceases you, and then you pass away shortly thereafter.

Essentially, most custodians, which is wherever you have your investment account, will default your beneficiaries on your account as what they call per capita, which basically means if you have three children and one of them passes away before you, and then you pass away, any assets that you had will be passed along to the remaining two children. It won't be passed along to the deceased child's family. The way to set up, you know, that, which is what most people want, is called per stirpes, which means that, hey, if my child happens to pass before I do and I pass, any assets that I had set aside for them, you know, as part of my account, will pass to their family.

And so I think it can be something that comes up rarely, but can be really important, particularly if you want to make sure not only your family's taken care of, but their families are taken care of. Because for people that don't choose that per stirpes designation, which is usually the box you have to check, it's a choice you have to make on the beneficiary form, you run the risk of, you know, assets moving over to two remaining children. And really there's no way for them to take those assets that are now meant for them and pass them along to your grandchildren. And so I think it's something that is really important to take a look at and review, and that way you make sure that, you know, everyone is taken care of in the way that you want.

And the last thing I'll mention about this: people think it's really one or the other in terms of a choice of per capita versus per stirpes. You may have children that don't have any children of their own, and so in that instance you may say, hey, for child A, I'm going to make them a per capita beneficiary, but for my other two children that have children of their own, they're going to be per stirpes. And so you can mix and match, you know, in a way that you think is appropriate. But that's something that's a little more in the weeds, but again, I think is good for people to look at.

Yeah, I think that's great. Definitely just another added bonus that many people don't think about.

So I think that's it for today. Just a couple different topics that we wanted to cover. So, as I said at the beginning, hopefully more of these videos to come, and appreciate both your thoughts, Zach and Will, and look forward to covering some more ground with both of you next time.

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