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Excess Risk Just as most people would like to earn excess returns, few people want to incur excess risk. Excess risk is risk that you take that is greater than the amount of risk you would have if you owned “the market.” In the case of the U.S., the S&P 500 is considered representative of “the market.” Financial theory measures risk in a variety of ways. One of the most common ways is called the standard deviation of return. The standard deviation of return is a mathematical measurement of volatility, or how much returns bounce around. The following chart illustrates two assets that have approximately the same long run return, but different volatilities.

The value of the stock index bounces around much less than that of the single stock. While not every stock carries excess volatility, most do. Using the math of finance theory, it can be proven that a concentrated position results in a portfolio that carries excess risk. Excess risk, in financial theory terms, is risk that you could diversify away. For example, instead of owning one stock that constitutes 20% of your portfolio, if you adjusted your portfolio so that no stock constituted more than, say, 2% of your portfolio, you’d eliminate excess risk without giving up much expected return.   If concentrated positions generate excess risk, why do people hold them? Let’s look at some reasons.   Why Do People Hold Concentrated Positions? While there are probably as many reasons for holding concentrated positions as there are investors who hold them, we have identified four main reasons people hold concentrated positions. These are: -         Expectation of Outsize Gains -         Control -         Aversion to Taxes -         Status Quo Bias In this article, we’ll look at the first two reasons: Expectation of Outsized Gains, and Control. Outsized Gains Many of the great fortunes of history have been made by people who owned concentrated positions, usually in a single stock. Examples range from famous 19th century industrialists like John D. Rockefeller and Andrew Carnegie, to 20th century entrepreneurs like Henry Ford and Bill Gates, to 21st century tech founders like Mark Zuckerberg and Elon Musk. These owners, and many others like them, may have felt more comfortable keeping large positions because they had, as CEO, controlling shareholders, and/or Chairman, a significant amount of influence on the business. Nevertheless, many or most of them choose at some time to take a large amount of money off the table. That is, they reduce the size of their concentrated position, exactly so that they can diversify their portfolios. In 2021, for example, Zuckerberg sold about $4.5 billion of stock in Facebook; Jeff Bezos sold over $9 billion of his Amazon stock; Elon Musk sold an estimated $11 billion. The hope of earning further above-market gains is one important financial reason people hold concentrated positions. Control Control, and the desire to maintain control, is another reason people may hold concentrated positions, even if doing so potentially exposes them to excess risk. Control investors who wish to reduce their positions may have alternatives that are beyond the scope of this discussion. In a future article, we’ll examine two additional reasons people fail to diversify their portfolios: aversion to taxes and status quo bias. If you’d like to understand specifics of finance theory for excess risk, apply for an early copy of The Intelligent Layman’s Guide to Personal Investing, forthcoming from Wiley. Click here to be added to the list. You might win a prepublication review copy. Or call 703 437 9720 and ask for Connor or Dave.

5/22/23

When a client sells, or prepares to sell, a small business such as a dental, medical, veterinary or similar practice, stakes are high for the advisor, as well as the client.

You, as the advisor, have a unique opportunity to cement both your relationship with the client and your position as a high-value-added advisor.

Mostly, you have the opportunity – if you plan in advance – to capture assets under management. You can do this while enabling your client to keep much more of his or her hard-earned wealth, as compared to how much the typical dentist, doctor or vet keeps when the practice is sold.

What to Look For

Many dental, medical or veterinary practices are organized as S-corporations. S-corporations have some tax benefits while the dentist is in practice (such as avoidance of corporate tax), but can present tax problems or obstacles when the practice is sold.

In most cases, the best outcome upon the sale of a dental practice is long term capital gain tax treatment. In high-tax states, long term capital gain tax can easily result in a tax of 1/3rd or more of the gain. Most clients find it extremely painful to find that 1/3rd of their life’s work disappears. As an advisor, if you can show the seller how he or she can avoid the tax pain, you’ll be in a good position to keep that client forever.

Analyze the Assets

A typical dental, medical or veterinary practice will own (and sell) one or more of the following assets:

1.                 Equipment

2.                 Real estate and/or a lease

3.                 Client list

4.                 Goodwill

If the entire enterprise (such as S-corporation stock) is sold, the seller will typically be taxed on capital gain income.

However, few buyers will want to purchase S-corporation stock. Instead, they will prefer to purchase assets. Thus, the seller will typically still own the S-corporation, and the S-corporation itself will sell the assets.

Each of these assets may be taxed differently, both to the seller and the buyer.

Recapture

The sale of assets creates the potential for tax surprises in the form of depreciation recapture. For example, while a dentist was in practice, the practice will probably have purchased equipment (chairs, dental equipment, x-ray machinery, computer systems, and the like).

Almost certainly, those assets will have been depreciated. The catch is that when those assets are sold, the full amounts that were depreciated must be “recaptured” and taxed. The rate of recapture tax on most assets that are not real estate is the ordinary-income tax rate. This tax on recapture can come as a nasty surprise, and drive the total tax rate for the seller above even the already high capital gains tax rates.

In addition, if the practice owns real estate (if you are planning going forward, it will almost always make sense for the real estate to be owned outside of the practice), and that real estate is part of the sale, the accumulated depreciation will be subject to recapture tax. The rate on recapture tax is currently 25% on real estate, as compared to the 20% top federal tax rate on capital gains.

A Better Tax Outcome

If the practice is an S-corporation, and both the situation and your client’s goals line up, it may be possible to entirely avoid tax on the S-corporation’s sale of assets. The solution is to have the corporation use a tax-exempt Business Owner Trust inside the corporation.

If the corporation contributes less than “all or substantially all” of its assets to the tax-exempt Business Owner Trust, the trust can sell the assets tax-free. The trust, properly structured, will then be able to distribute income, or accumulate it tax deferred, for decades into the future.

If the practice, or certain assets, are owned individually, there is also the opportunity for the seller to take advantage of the tax-free nature of a Business Owner Trust.

Personal Goodwill

Many dental practices have a significant aspect of goodwill associated with the primary dentist’s name. In these cases, there may exist personal goodwill, which if owned outside of the S-corporation may present additional important planning opportunities. This will be the subject of another post.

To Learn More

Cases involving assets owned inside closely held corporations – such as dental practices -- often present significant planning opportunities. The solutions will typically involve more than one facet. See here to learn more about tax-exempt Business Owner Trusts, or call 703 437 9720 and ask for Connor or Dave.

5/31/23

If you have clients who own and run businesses in which they, as individuals, play an important role, they may have personal goodwill.

Identifying personal goodwill can open up valuable planning opportunities, especially for businesses that might be hard to plan for otherwise.

Goodwill is an accounting concept, as well as a real world phenomenon. Goodwill – in an accounting sense – arises when a company or business is worth more than the value of the sum of the other tangible and intangible assets. Tangible assets are assets such as property, plant and equipment. Intangible assets include intellectual property, brand names and customer lists.

Goodwill can belong to a company, such as a C-corporation, or to an individual. In either case, the goodwill can be “real world” goodwill, such as the positive feeling many people have toward companies like Coke or Apple.

Individual goodwill frequently arises in contexts of small companies where a founder has many personal relationships, and/or develops a good reputation in the community and the market.

Planning Opportunities

C-corporations typically involve double-taxation, once at the corporate level because C-corporations pay tax, and again at the shareholder level when dividends are received. Double-taxation can also arise in the context of S-corporations with “earnings and profits” or built-in gains.

This double-taxation can make it quite expensive for owners of some closely held companies to sell or otherwise take profits off the table.

Double tax on the sale of a C-corporation (or an S-corporation with earnings and profits or built-in gains) can be avoided by selling the stock. But such a sale is not always possible.

Buyers often prefer to purchase assets rather than stock. Buying assets gives the buyer a basis equal to the price paid. This basis in the assets allows the buyer to depreciate the depreciable assets, usually resulting in better after-tax results for the buyer as compared with a purchase of the stock. Purchasing assets also allows a buyer to pick and choose which assets to purchase.

Another reason buyers may prefer to buy assets rather than stock is to avoid picking up any hidden liabilities that may lurk on or off the company’s balance sheet.

If a buyer will not purchase stock, some sellers try to reduce the tax impact through alternatives including long term employment contracts, non-compete agreements, or consulting agreements. However, these are generally taxable as ordinary income, which while only one level of tax, is imposed at significantly higher rates than is capital gains tax.

When the facts permit, overall tax in a sale of assets can be reduced (and some taxes may be eliminated) if part of the sale of the business involves personal goodwill.

Case Study

We worked on a case involving the sale of a corporate business. The business assets were specialized manufacturing equipment, several parcels of real estate, and customer lists. In addition, the founder had built up a great deal of personal goodwill. His advisors were astute enough to sell the personal goodwill separately from the other business assets, though as part of the same transaction.

The total value of the assets sold was $15 million. Of that, $6 million was allocated to the seller’s personal goodwill, $7 million to the real estate, and $2 million to the equipment and customer lists.

The fact that he was able to allocate $6 million to his personal goodwill, outside of the C-corporation, enabled him to avoid an effective double tax on the personal goodwill portion, saving him approximately 20%, or $1.2 million.

Additional Planning Opportunity

Personal goodwill, as a personally owned capital asset, provides a great deal of planning flexibility. One such opportunity is to contribute, before the sale, some or all of the personal goodwill to a tax-exempt Business Owner Trust. To learn more about business owner trusts, please request our Business Owner Trust Advisor Guide. Or call 703 437 9720 and ask for Connor or Dave.

In a case decided last year, the Tax Court denied Martha Albrecht a $463,676 income tax deduction for about 120 items jewelry she donated to the Wheelwright Museum of the American Indian in Santa Fe, New Mexico.

The case, Martha L. Albrecht v. Commissioner, makes for painful reading. The court did not deny that Albrecht had made the gift, nor did the court challenge the valuation.

Instead, in the words of the Court:

The issue for decision is whether petitioner satisfied the requirements of section 170(f)(8)(B) for a charitable contribution she made during 2014 (year at issue). 

The section in question, 170(f), deals with the “Disallowance of deduction in certain cases.”

Section (8)(B) reads:

Content of acknowledgement. An acknowledgement meets the requirements of this subparagraph if it includes the following information: (i) The amount of cash and a description (but not value) of any property other than cash contributed; (ii) Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property described in clause (i). (iii)A description and good faith estimate of the value of any goods or services referred to in clause (ii) or, if such goods or services consist solely of intangible religious benefits, a statement to that effect. For purposes of this subparagraph, the term "intangible religious benefit" means any intangible religious benefit which is provided by an organization organized exclusively for religious purposes and which generally is not sold in a commercial transaction outside the donative context.

The rules required Albrecht to obtain a “contemporaneous written acknowledgement” and she did. But the Court didn’t like the way the acknowledgement was written. It said the acknowledgement:

“Does not comply with section 170(f)(8)(B) on the grounds that it did not specify whether the Wheelwright Museum provided any goods or services in return for the donation or state that it represented the entire agreement between the museum and petitioner. Specifically, respondent points out the reference in the deed to the “Gift Agreement” as creating ambiguity as to whether additional terms, including donee provision of goods or services, were part of the donation.”

It seems that the museum’s acknowledgement “does not state whether the Wheelwright Museum provided any goods or services with respect to the donation.” There was no allegation or claim that Albrecht did receive any goods or services. The problem, according to the court, was that although the donation to the museum was “unconditional and irrevocable”, there was also a “Gift Agreement” referred to. And the gift was of “all rights, titles and interests held by the donor in the property are included in the donation unless otherwise stated in the Gift Agreement.” And the Gift Agreement was not included in the original filing, so the court found the absence “leaves open a significant question about whether the parties had entered into a side agreement that included additional, superseding terms.”

Perhaps the most painful part for Albrecht was that the was no allegation that she had not made the contribution in good faith; there was no claim that she had in fact had a “side agreement”; and there was no challenge to the valuation.

The Court seems to have hung its decision to deny the entire deduction on the technicality. The Court admitted that Albrecht had “substantially complied”:

“We appreciate what appears to have been a good faith attempt by petitioner to substantially comply with the Code by executing the deed with the Wheelwright Museum. Substantial compliance, unfortunately for petitioner, does not satisfy the strict requirements of section 170(f)(8)(B).”

The court threw the book at her, apparently as a lesson to others.    

That lesson is to make sure that all the i’s are dotted, and t’s crossed when substantiating a charitable deduction.

If you’d like, please request a very brief synopsis of 107 charitable deduction court cases.

5/3/23

If you’ve ever done gift or estate planning, you are no doubt familiar with the valuation discounts for lack of control and/or lack of marketability.

You’re probably also familiar with the concepts of inside and outside basis, especially low inside basis and low outside basis.

Low outside basis is, for example, where the client owns an entity, such as an s-corp, and the client has a low basis in the shares of the s-corp.

Low inside basis would be when the s-corp itself owns assets that have low basis.

You know that when the s-corp sells assets, or the client sells (or gifts) shares in the s-corp, one of those low bases is going to bite.

For example, suppose that the total pre-capital gains tax value of the s-corp shares to your client were $10 million, (the actual numbers don’t matter much – they pretty much scale except at the very low end), and the potential tax is $3 million.

You might think that because there’s a $3 million tax that will be due, the actual, pre-discount value (i.e. ignoring lack of marketability and lack of control) of the s-corp to your client is really only $7 million, because to get cash the client will have to incur the tax.

Can your client get gift or estate taxes reduced by the amount of the tax?

 To learn more, click here or call 703 437 9720 and ask for Connor or Dave.

Sales of existing homes have fallen every month this year since February.
 
And now, there is growing evidence that prices have peaked too.

While some “experts” see falling real estate prices as a good thing – supposedly falling prices ease the “affordability crisis” - real estate owners are not likely to agree.
 
We’re hearing from many advisors that more and more real estate owners are looking to sell their real estate. The main reasons, not in order, are:

1. lock in gains
2. reduce the amount of risk
3. diversify out of an overweight position, either in a specific property, or real estate in general
4. get away from the hassle of managing real estate

The biggest factor holding these people back from selling is the reluctance to pay a huge chunk of their gains in taxes.
 
The two most common solutions for these owners are:

1. 1031 tax-free exchange into other real estate
2. 664 Real Estate Shelter Trust, allowing full diversification 

You almost certainly have clients or prospects with appreciated real estate, and some of these probably should be diversifying out of real estate.
 
We don’t do 1031s, but we do 664 Trusts. A 664 Real Estate Shelter Trust can allow your clients to sell their real estate, without paying tax. You’d then invest the proceeds.
 
If you’d like discuss whether a 664 Trust , please contact Connor Barth ([email protected]) or Ryan Whiting ([email protected]), or call (703) 437-9720 and ask for Ryan or Connor.
 
And please feel free to call, or email us, to discuss any situation or ask questions. If you have a client situation where you think we can be of help, you can schedule a meeting with Sterling Advisor Solutions using a form on our website.
 
P.S. If you’d like a chart of real estate values for your area, please fill out the form on our website.

 

March 27, 2023

Treasury Inflation-Protected Securities are widely advertised as an effective hedge against inflation.

But are they?

There are a number of reasons the answer may be “no.”

CPI may not reflect the inflation you face

The principal of TIPS bonds is adjusted by the CPI. For example, if you buy a TIPS with $100 principal, and the CPI is 4% for the year, the principal of your TIPS will be adjusted by $4 (4% of 100) to become $104.

It might seem like this is a good deal, but the CPI may actually be irrelevant to the price inflation you personally face. In fact, there is no single, “correct”, measure of inflation. The particular price inflation that you face may be more in line with prices as reflected by the PCE, or some other measure of inflation.

Inflation-adjustment isn’t paid out until maturity

Another issue with the above scenario is that TIPS don’t actually pay out the additional amount until the security reaches maturity. So you wouldn’t actually receive cash from the adjusted principal value of the TIPS, the $104, until the security reaches maturity.

Phantom Income Risk

There’s another problem with the inflation-adjusted value of the principal: it hits TIPS holders with an additional tax, even if they receive zero cash.

Consider the example from above: the TIPS with a principal value of $100 and inflation of 4%. The Treasury will adjust your principal value to $104. But the extra $4 counts as taxable income to you in the year it is recorded, even though you don’t get cash then.

Furthermore, you may be taxed even if you never receive a cent of income.

The more money you invest in TIPS, the more you stand to lose to phantom income tax. For example, if you invested $10,000 in TIPS and inflation reached 9% (as it did last year), you stand to be taxed on an additional $9,000 of income which you never received. The additional taxation incurred could wipe out a large fraction, or even all, of the interest that you earn on TIPS, depending on the rate of interest you receive from the securities.

TIPS are complex

TIPS are financially complex instruments, and it can be difficult to understand all the intricacies. We’ve highlighted some of the hesitations with TIPS above, but there are others we haven’t mentioned.

How can you protect yourself?

Given that TIPS are, in many cases, not an effective hedge against inflation, how can you protect yourself from inflation?

You might consider diversifying your assets.

If you or your clients have with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

 

March 20, 2021

What Happened?

SVB, like all banks, was highly leveraged. Before the collapse, SVB had only 8% capital, which in the world of banking, is considered well-capitalized.

When a bank is highly leveraged, even a relatively routine loss in on the asset side of the balance sheet can wipe out its equity. That’s what happened to SVB.

SVB’s management invested too much of their portfolio in “safe” mortgage-backed securities.

Although these assets are usually considered “safe” from the point of view of credit risk, the “safe” ignores the important factor of interest-rate risk.

Interest rate risk is measured by a number called “duration.” The duration of a bond is, approximately, the amount that the bond will fall in market value if the interest rate rises by 1%.  When interest rates increase, the value of fixed-income assets such as bonds or mortgage-backed securities decreases. (That is a fact of finance.) Mortgages typically have a duration of over ten years. They also have a nasty characteristic called “negative convexity” which means that their duration gets longer (everything else equal) as interest rates rise.

These financial characteristics of mortgages are well known to anyone with any degree of fixed-income experience.  The duration mismatch on SVB’s balance sheet would have been obvious to a first year finance student. It remains to be determined who at SVB made and approved these high-risk investments.

When the Fed hiked interest rates, the value of SVB’s portfolio declined. At the end of 2022, SVB had lost 15.9 billion dollars on a mark-to-market basis. This means that if they tried to liquidate their entire bond portfolio by selling it at market prices, they would’ve lost 15.9 billion dollars.

Simultaneously, startups were having trouble raising money, so they had to withdraw deposits from SVB.

Higher interest rates, therefore, hit SVB with a double-whammy: the value of their mortgage-backed investment portfolio declined, and depositors wanted to withdraw money. To pay all the depositors, SVB sold $21 billion of bonds at a $1.8 billion loss. Then SVB’s management announced that SVB would raise capital to cover the loss. Depositors freaked out and began withdrawing their money, and SVB could not pay all the depositors. The FDIC seized SVB.

If Silicon Valley Bank had exposed itself to less interest-rate risk by keeping its investment assets with a much shorter duration, it would not have lost as much money when interest rates increased.

The Fed and FDIC policies suggest inflation will continue

In addition to SVB, two other banks failed in the past week. Multiple bank failures led the former chair of the FDIC to advocate for the Fed to stop hiking interest rates.

Fed chairman Powell has been increasing interest rates because he believes (though why is not clear) that raising interest rates is the way to fight inflation. (Paul Volcker, the Fed Chairman who brought down the inflation of the 1970s, explicitly said in his memoir Keeping At It that he never targeted interest rates to bring down inflation. Inflation is proven by thousands of years of history, and by economic theory, to be the result of rapid increases in the money supply. See our book HERE.) Powell seems to view interest rates as his only tool for fighting inflation. If he is right, and if he stops increasing interest rates, inflation might accelerate.

Inflation is primarily a function of the too-rapid increase in the money supply. In the banking system today, bank deposits are a huge part of the money supply.

That’s another reason why inflation is likely to continue: the FDIC is going to bail out SVB’s (and other banks’) depositors.

If the FDIC did nothing, many depositors would lose a large fraction of their deposits. This would reduce the money supply, and everything else equal would tend to bring inflation down.

Instead, the FDIC is going to compensate depositors for everything that the bank was supposed to pay.  This will prevent the contraction of the money supply that would otherwise occur.

The FDIC claims this won’t cost taxpayers, but where else is the money going to come from? If it doesn’t come from taxes, the money must be printed. So, rather than allow this natural consequence of increasing interest rates to reduce the money supply, the FDIC, no doubt with the approval of the White House, has decided to create new money. The creation of new money causes inflation.

How can you protect yourself?

You can protect yourself in a variety of ways, including diversifying your assets so they’re not subjected to one risk (such as interest rate risk).

If you have clients with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

March 13, 2022
 
Although the terms hedging and diversification are sometimes used interchangeably, the two terms actually refer to different areas along a spectrum. That spectrum is the correlation of returns.
 
Hedging
In plain English, hedging refers to the process of holding one asset (such as a stock), and then also buying another asset (such as a put option) that offsets the risk of holding the first asset. The hedging asset should have a strong negative correlation with the asset you are hedging.
 
A “perfect” hedge will remove all risk, and all return. Financial hedging in the modern world traces its history back to the 1840s. The Great Plains were being settled and farmed. Grain was being grown for the Eastern markets. Farming is a very risky business, and the price of grain is, and always has been, very volatile.[1]
 
Farmers had enough risk, associated with weather and the growing of crops, that they didn’t also want price risk.
 
Grain buyers (for example, bakers, millers, and grain merchants) also ran businesses that had enough of their own risks that they didn’t want to bear the risk of grain prices rising.
 
Being “long” a commodity means owning the commodity and bearing the risk of the price of the commodity falling.
 
Being “short” a commodity means having sold (or sold forward) a commodity that you don’t own, and bearing the risk of the price of the commodity rising.  Farmers were (and are) naturally long grain. Grain buyers were (and are) naturally short grain.
 
In the 1840s, farmers and grain buyers got together and founded the Chicago Board of Trade and developed first futures markets in the western world.[2]
 
A “perfect” hedge, then, for a long holding would be to hold a contract to sell exactly that amount, at some future date, at a fixed price. (For example, the grain farmers would want a contract to sell an exact certain amount of grain at a fixed price.) Producers and users of commodities often want their hedges to be as close to perfect as possible. Commodity producers and users, for the most part, seek to earn profits from factors other than the price change in the commodity they produce or use. So, they are happy with perfect or near-perfect hedges that remove that price risk.
 
Hedging Against Inflation
On the other hand, few investors desire a perfect hedge. Investors care about generating returns, and perfect hedges remove returns. Unlike farmers and grain buyers, investors don’t mind taking risk if that means getting returns. A perfect hedge would mean that return, in addition to risk, was given up.
 
Instead, most investors want a properly diversified portfolio that provides the highest expected return consistent with the amount of risk taken. In financial theory terms, investors want an efficient portfolio.
 
Nevertheless, people, including investors, continue to talk about “hedging” against inflation.
 
Inflation is the fall in the purchasing power of money. To qualify as a perfect hedge against inflation, an asset would have to increase in market value by the same amount that money loses purchasing power.
 
There is an investment that is sold as a hedge against inflation, and that is believed by many people to be a nearly perfect such hedge. That investment is TIPS. How useful are TIPS? We’ll look at that question next week. The answer may surprise you.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

March 6, 2023

Pop quiz: What was the world’s first recorded hyperinflation?

We have described that politicians, including the Roman Emperor Diocletian, use inflation as intentional policy.

Sometimes politicians get so carried away that they cause hyperinflation. The term hyperinflation is often thrown about carelessly. To economists, Hyperinflation is defined as inflation of over 50% per month.

You probably wouldn’t associate hyperinflation with cries for  ”Liberty, Equality, and Fraternity”, but  you should. The first recorded hyperinflation occurred in the wake of the French Revolution.

In 1789, revolutionaries violently seized control of the French government. They cancelled all taxes, but didn’t reduce government spending. Nor did they default on government debt.

The new government, called the National Assembly, seized the Church’s land, then worth perhaps 2 billion French livres (pounds).

But most of this land was not liquid. The government couldn’t spend it.

The Assembly issued paper claims called assignats, supposedly, though not legally, backed by the Church lands. Assignats, like bonds, were supposed to pay interest to the holder. Despite the talk about land backing, these assignats were unsecured debt, that is, debt not backed by any collateral.

The government used assignats to purchase real goods.

In 1790, the National Assembly issued 400 livres’ worth of assignats. A few months later, they increased that number to 800 livres. And then they eliminated the interest rate.

The assembly found that it didn’t have to tax or borrow if it could instead create, and spend, assignats.

Assignats were now basically fiat money; the Assembly could print them in whatever quantities they liked, whenever they liked.  And they did.

The Assembly printed so many assignats that their purchasing power fell by half over the following two years. From 1790 to 1793, inflation averaged about 1.3% per month, or about 17% per year (taking compounding into account). In 1794, inflation averaged about 7.5% per month. Prices more than doubled. What could once be bought for 1 livre now cost about 2.38 livres. By 1796, the assignat was basically worthless, and the French productive class – farmers and peasants – had been ruined. They were ripe for recruitment by a would-be savior. One soon appointed himself, and Napoleon waged war on all the areas of the world he could reach.   

 

 

The assignat inflation ruined the French economy, and ultimately caused tens of thousands of deaths. As more and more assignats were printed, they were worth less and less. . In the 1790s, most of the French economy was farmers. But as inflation rose, farmers realized that they’d be better off holding onto their grain, which holds its value, instead of trading it for paper that was rapidly losing its value.

Farmers acting rationally withheld grain from the market. In the modern politico-speak, this would be called a “supply chain crisis.”

The average Frenchman in 1790 got about 75% of his calories from grain. So rising prices was an existential crisis. Assignat printing caused the price of grain to skyrocket, and the supply to sharply shrink.

In 1793, the government acted as demagogues often do: they enacted price control laws purportedly to decrease the price of grain. They declared a maximum price on grain, and made it illegal not to accept assignats at face value. But farmers rebelled. Many of them were arrested or killed. As always happens, the price controls made the problem much worse.

All that interference in the markets had a cost. Imprisoning and killing farmers for selling wheat at market prices decreased the supply of wheat, and France suffered a famine in 1974. Thousands of innocent people died.

The French hyperinflation was the predictable (French economist Turgot had been in government and his understanding of the importance of real money was well known) result of deliberate government policy. And its counter-productive destructive results were also predictable.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation, Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.

 

February 27th, 2023

To answer the question, let’s start with this basic fact: the federal government benefits from inflation. In 2022, the government “made” at least $2,000,000,000,000 (that’s $2 trillion!) from inflation.[1]

That $2 trillion had to come from somewhere, because “printing” money creates no value.

As Warren Buffet says about the poker game, if you don’t know who the patsy is, it’s you.

That $2 trillion came from all of us who produce or own assets.

Politicians won’t admit this, but the government benefits hugely from inflation. That fact is not unique to our government now.  Governments across the world and across history have deliberately inflated the money supply to accomplish their goals. We’ll start our quick review of historical inflation by going all the way back to the Roman empire.

Today’s post will examine how the Emperor Diocletian pursued deliberate inflation to accomplish his goals.

Broadly speaking, governments have 3 ways to raise revenue: 1) taxation, 2) borrowing, 3) and printing money (inflation). And when governments spend large amounts of money, they need to raise revenue.

So when Diocletian wanted to finance expensive wars, he decided to use a combination of taxation and inflation.

Inflation in the Roman Empire

When Diocletian became Emperor of the Roman Empire in 284 CE, he embarked on a spending spree that would put all the world’s drunken sailors to shame. He spent money on expanding the size of the army. He spent money expanding the bureaucracy. He spent money building  buildings. He spent money building a capitol. All that spending had to be financed somehow.

So he enacted three highly destructive policies: crushingly-high taxation, intentional debasement of the currency, and eventually price controls.

When Diocletian found that tax revenues were not sufficient, he augmented his coffers by debasing the silver denarius (the standard Roman coin). In those pre-paper money days, workers would gather in silver coins (from taxes and other sources). For example, they might take 1000 coins, melt them all, add some copper (much less valuable than silver), and remint 1100 coins. This process of adding a base metal to a precious metal was the original form of currency debasement. 

Diocletian increased the money supply increased so much that prices rose out of control. During Diocletian’s rule and prior to his price controls, the price of wheat, for example, was 35 times higher than it had been the previous century, according to historian Richard Duncan-Jones.

Instead of fixing the problem by stopping increases in the money supply, Diocletian decided to shoot the messenger. He believed he could stop prices from rising by legally fixing prices. He resorted to price-fixing because he didn’t want prices to keep rising, but he was unwilling to stop creating new money.

He issued the famous Edict of Diocletian, which imposed price controls on commodities, labor, transportation, and animals. The edict was enforced on pain of death.

But price controls don’t work. They never have, and never will.[2] By holding prices below the market-clearing price (the price at which demand equals supply), price controls increase demand because consumers perceive that they can pay less than the market-clearing price for products. And by holding prices below the market-clearing price, price controls reduce supply because sellers can’t earn the market-clearing price in revenue. This mismatch between supply and demand inevitably creates shortages.

In Rome, the market price of commodities such as wheat was increasing because the money supply was increasing, and price controls merely incentivized sellers to sell on the black market (where they could charge market prices, prices that reflected the true cost of producing commodities) or flee Rome to escape Diocletian’s oversight. Shops closed. Supply fell. Goods disappeared. The price controls had the exact opposite effect of those hoped for by Diocletian.

Yet Diocletian doubled down on state control. To prevent peasants from fleeing their land and seeking refuge elsewhere, Diocletian issued a law tying all citizens to their land. In other words, it became illegal to leave. Farmers became bound to land as serfs.

So not only did reckless government spending create sustained inflation, it directly caused serfdom – an institution akin to slavery that wasn’t abolished in the west until the mid-19th century.

We’re uniquely qualified to offer you insight on inflation. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation: Politicians Spend, We Pay, available here.

We’re celebrating Presidents’ Day instead of Lincoln’s birthday. But Lincoln’s birthday isn’t the only part of his history we’ve forgotten.

We all know Lincoln as the president who saved the Union and ended slavery.

But did you know that Lincoln also instituted the nation’s first income tax and created the IRS?

Lincoln also pursued a deliberate policy of inflation to finance the Civil War.

That’s today’s topic. We welcome your feedback!

The Civil War cost about $6.65 BILLION dollars total – more than an entire year’s Gross National Product, measured in 1860 dollars. (This measures only the direct monetary cost of the war, not the cost of the 750,000 American lives, or the opportunity cost of goods/services that were never produced.) The devastating war had to be financed somehow – and Lincoln chose not only to institute an income tax, but to print paper money. And print it. And print it.

The Legal Tender Act of 1862 authorized the federal government to literally print paper money, called “greenbacks.” Lincoln suspended the gold standard, and the government forced citizens to accept these greenbacks as legal tender. Congress issued about $450 million total in greenbacks by the end of the war.

Prior to the printing of the greenbacks, the gold standard meant that pieces of paper traded for goods had to be backed by gold. The pieces of paper were not themselves money. They were certificates that represented money – gold. The government would redeem paper notes for gold upon demand.

But with the printing of the greenbacks, greenbacks and other paper currency was no longer redeemable for gold.

Of course, merely printing money didn’t create any real value. But printing did create purchasing power. Spending the new money without increasing the supply of real goods/services caused a huge price increase, and transferred value from the people who created the goods and services, to the government.

Prices doubled between 1861 and 1865, as can be seen in the graph below.   As bad as it was in the North, the South fared much worse. The South also decided to issue its own currency, unbacked by gold. That currency rapidly depreciated. According to the Lerner Price Index, commodity prices in confederate dollars increased 90 times (by 9,000%) over the four years of the Civil War.

By the end of the Civil War, Southern currency wasn’t worth anything at all. Thousands who had, in good faith, accepted this paper in exchange for their goods and service were left penniless.

Both the North and the South suffered great economic ruin. But after Lincoln and his successor General US Grant left office, the US government, under pressure from Congress, restored the gold standard. In 1875, the Specie Resumption Act was passed, stating that the government would begin redeeming greenbacks for gold at face value in 1879.

President Rutherford B. Hayes realized that the government would have to increase its reserves of gold if it were to make good on its promise. Through careful financial management, Hayes and his administration managed to run a budget surplus (yes, apparently it’s possible for the US government to run a budget surplus!) and accumulated gold with which to redeem the greenbacks.

The intentional policy of inflation operated as a hidden, unlegislated tax on everyone who (many had no choice) accepted the depreciating paper money.

The inflation stopped and was reversed, because the government stopped its excess spending, and eventually restored the gold standard. During the roughly 30 years following the restoration of the gold standard, the US (and the developed world, which was also on a gold standard) experienced one of the greatest periods of economic growth in the entire history of the world.

In fact, most of the technologies that define modern life were developed and commercialized during this “golden age.” Among these are electricity, air travel, the automobile, trucks, the telephone, radio, and even plastics.

The Civil War was devastating. But the country recovered. A large contributor to that recovery was severe shrinkage of federal spending, and restoration of a non-inflationary dollar.

We’re uniquely qualified to offer you insight on inflation. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation: Politicians Spend, We Pay, available here.

Does Apple’s board know something? Apple has just announced that it cut CEO Tim Cook’s pay by over 50%

Here are five reasons for clients to consider diversifying any Apple holding greater than about 1% of the portfolio.

“Return-Free Risk”: This is the opposite of the risk-free return we hear about. As you know, having a large percentage of a portfolio invested in a single stock increases risk. It adds risk, but doesn’t add expected return. (In fact, it reduces expected return. Ask about our webinar for a full explanation.)

Economic Cycles: Apple, like many technology companies, is exposed to the business cycle. In a recession, technology companies tend to underperform the broader market.

Valuation: Apple has reached a high valuation and its growth rate is slowing down. The P/E ratio is considered high, which means that the stock is overvalued, and it might be a good time to sell.

Regular Portfolio Review: Many advisors approach the issue as part of a portfolio review. If Apple, or any other stock, is significantly overweight, it makes sense to sell the Apple, or other company, and diversify.

Historical performance of other huge companies: As history has shown, even the most successful companies can experience significant stock drops. Recent examples include:

Boeing (stock drop of 52% in 2019, and worse in 2020)

General Electric (stock drop of 58% in 2018, and worse in 2020)

Intel (stock drop of 57% in 2000)

Cisco Systems (stock drop of 78% in 2000-2002)

Microsoft (stock drop of 78% in 2000-2003)

Enron (stock drop of 85% in 2001, and then to zero)

Lehman Brothers (stock drop of 95% in 2008, and then to zero)

How to Avoid Tax on the Sale

Most large gains would result in large taxes if the stock were sold. If you have clients with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

You may also be interested in an upcoming webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. To learn when the next webinar is, and register for it, use this form on our website.

Apple may be dangerous to your financial health.

A month ago, we discussed the dangers of holding concentrated positions in large, “reliable” companies like Apple.

Since then, Apple has lost nearly $400 billion of market value.

Now, we see four reasons to diversify any large holding Apple.

They are:

1. China exposure

2. Recession risk

3. Earnings risk

4. Multiple compression

 

China

Apple is heavily dependent on China.

Covid and growing criticism of China have made that position extremely precarious. And according to CNN, “reducing [Apple’s] significant dependency on China could take years, if it ever happens at all.”

 

Recession

According to The Wall Street Journal top economists now expect a recession, with 2023 forecasts “increasingly gloomy.”

When the economy is in recession, consumer spending falls. Apple’s products are sensitive to consumer spending, and the company could see demand drop sharply.

 

Earnings Risk

Earnings are what is left after expenses are subtracted from revenues. Apple earnings could get squeezed from both sides, as China problems raise costs, and potential recession cuts revenues.

 

Multiple compression

In bear markets, the price to earnings ratio of stocks often falls. That can create a double whammy for stocks like Apple. If earnings fall, and the multiple decreases, the result could be a significant fall in the price of the stock.

 

Diversification Without Tax

If you have clients with a large holding in Apple, chances are they have big gains. And chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

 

664 Stock Diversification Trust

Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our weekly webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. You can register for, or request a recording of, that webinar using this form on our website.

Happy New Year, everyone! 

This post is part three in our decision-making series, "Are Your Clients Really Irrational?"

Sometimes, even an “easy” decision can be emotionally difficult if the stakes are high enough.
 
And if the decision seems easy, but the stakes are high enough, a good decision maker might well pause and wonder whether he is missing something.
 
For example, each year many people have the opportunity to decide what state to live in. For most people, the decision of where to live depends on more than one factor. But for some, state income taxes can be an “elephant in the room.”
 
Consider, for example, a married couple who like the Pacific Northwest, and earn a combined $500,000. If they decide to live in Oregon, they would pay about $44,000 in state income taxes.
 
Everything else equal, if they live in Washington, they’ll pay zero state income taxes.
 
Over a twenty year period, the difference in state income taxes could easily amount to $1 million dollars. That’s high stakes for most people.
 
One reaction to that difference might be something like “what’s the catch?” A million dollars is a lot of money. Consider someone who has no other reason to prefer one state over another, and for whom saving a million dollars is a no-brainer. That person might still pause, because the amount is so large, and take a second look to be sure he’s not missing something obvious.
 
These kinds of “no-brainer” high stakes decisions can arise in many different areas. However, taxes seem to bring them up often. One reason is that there are so many taxes, the tax laws can be complicated, and some tax laws seem designed specifically to tax people who don’t stop to consider that they might not have to pay as much tax if they choose “A” instead of “B.”
 
“High Stakes Paralysis”
“High stakes paralysis” is the condition of indecision that some people face when they must make a decision which is clear and easy, except for the fact that the stakes are high.
 
Most people who encounter “high stakes paralysis”, almost by definition, only encounter it a small number of times. This is either because they rarely face high stakes decisions, or because if they face many high stakes decisions, they become comfortable making high stakes decisions.
 
Hidden Insecurity?
Some clients will not admit to you that they are afraid to make a big decision, or that they believe they are not really competent to make a big decision. Instead, sometimes these clients will avoid making a decision, or they will offer supposed reasons that are in fact merely excuses. If you take those reasons at face value, you are probably wasting your time, because those reasons are excuses, and as soon as one is answered the client will generate another. All because the client cannot, or will not, admit that he is just stumped.
 
Dealing With High Stakes Paralysis
In dealing with high stakes paralysis, the first step is to clarify that it is in fact the high stakes, and not some other aspect of the decision, that is giving the decision maker a hard time.
 
As noted in the first part of this series, there are typically five factors that can make it hard for people to decide. In addition to high stakes, the others are:
 
Conflicting Goals
Complexity
Uncertainty about outcomes
Small differences between outcomes
 
To help a client dealing with “big decision” paralysis, who is privately afraid of making “the wrong” decision, walk through his issues with him. While all decisions are likely to have several factors making them hard, if you can identify the key difficulty your client is facing, you are in a better position to help him get past that difficulty.
 
Once you identify high stakes as the key issue, the next task is to get the client to discuss what he’s afraid of.
 
Is he afraid that there’s a hidden “gotcha?”
 
For example, someone who moves from California to Texas, looking forward to eliminating his state income tax, might not believe that it is so easy. In addition to consulting with a state tax expert, you might note that the US census bureau reported that between April 2020 and July 2021, over 300,000 people left California for lower tax states. There are costs – such as the cost of missing friends, the cost of moving, of making new friends, and so on. But your client probably already understands those. But he might still be worried that he’s missing something crucial.
 
If neither you nor the client can identify the “hidden gotcha” but the client is still afraid, try to help the client understand that not making a decision is not free. Every year the client lives in California, instead of Texas, he pays a ton of extra taxes; taxes that are in effect optional. Of course it’s your client’s choice to pay extra taxes. But just make sure that the client owns his decision to pay more taxes.
                                                                                                               
Non-Decisions Are Usually Costly Decisions
The above example of someone not moving because he won’t make the decision is typical of non-decisions.
 
Non-decisions are in fact decisions, and often lousy ones. You cannot make your client make a decision. But you can at least try to make sure the client knows that a non-decision is still a decision, and one that he’s responsible for.
 
As a result, the client is likely to get relatively lousy outcome, compared to what is possible with even basic planning. He’ll pay a ton of tax, he’ll accomplish zero estate planning (meaning he’s teeing up another big tax when he dies), and, ironically, he’ll have less flexibility (because he’ll have less) cash if he does choose to enter a new business.
 
Key Decision Skill #2 – Identify and Overcome Fear of a Big Decision
Any decision that is both hard and important is likely to have high stakes. If the stakes weren’t high, you as and advisor probably wouldn’t be involved.
 
Sometimes a client’s real difficulty is simply fear. If so, your client is not alone.
 
Alice Boyes, writing in the Harvard Business Review, advises
 
“Don’t be ashamed or afraid of your fear of making mistakes and don’t interpret it as evidence that you’re indecisive…”[1]
 
Boyes also advises not to try to eliminate fear. Most people cannot, and don’t have to. They have to act in spite of their fear, or anxiety.
 
Part of the advisor’s role is to stand with his client, and help the client make a fear-inducing decision.

We will continue to discuss key decision skills in the remainder of this series on decision making. Stay tuned to our blog for more updates.

We’ve all faced conflicting goals, and it can seem like it happens all the time.
 
For example, when was the last time you worked, when in an ideal world you’d have been doing something else?
 
Maybe you decided to go to work because you really wanted to close a sale, even though part of you really wanted to golf instead.
 
Conflicting goals are part of life. Most of us have figured out relatively effective methods for making decisions even when there are two (or more) goals that conflict.
 
When goals really conflict, it means we cannot achieve both, at least not in the same way at the same time.
 
And sometimes clients are in denial about that fact.
 
Business Example
I’m pretty sure you could come up with dozens of examples on your own.
 
Here’s one that I ran into today. An advisor had a client selling a business. The client is in his sixties, married, with kids. The business has been very successful, and the client is selling out to a much larger firm in the same industry.
 
The pre-tax proceeds will be about $11 million. The gain is largely capital gain, but there’s also recapture on various assets that have been depreciated, as well as some real estate recapture. Overall, the estimated tax bill, between state and federal and the above recapture, will be around $3,500,000.
 
This client was all over the map in terms of his conflicting goals. He tells his advisor that he is horrified at the tax bite. But he also wants to take his chips off the table while the opportunity exists. He doesn’t want to work anymore. But he might want to reinvest in some new business. And he doesn’t want to make any estate planning decisions, even though with the sale his estate is likely to exceed the estate tax exemption.
 
Is this starting to sound familiar? [click here for “sounds familiar”] A client who wants everything, and isn’t willing (or says he’s unwilling) to make any tradeoffs?
 
Non-Decisions Are Usually Costly Decisions
The above mentioned business sale looks like it will close, and the client has made no decisions. He says that he doesn’t want to decide. Instead, by “not” deciding, he is deciding in favor of the default plan – actually no plan – that just happened to be in place by historical accident.
 
As a result, the client is likely to get relatively lousy outcome, compared to what is possible with even basic planning. He’ll pay a ton of tax, he’ll accomplish zero estate planning (meaning he’s teeing up another big tax when he dies), and, ironically, he’ll have less flexibility (because he’ll have less) cash if he does choose to enter a new business.
 
You Can’t Have it All
At least as there are death and taxes, you (or your clients), can’t have it all.
 
We can’t be in two places at once. We can’t have our cake and eat it too. We can’t take our gains off the table, and still have all the upside potential.
 
You know that. And your clients know it too, deep down.
 
But too often, clients somehow refuse to make what seems to the advisor like an obvious decision.
 
How to Help Clients Choose Between Conflicting Goals
Often the best way to help a client choose between conflicting goals is to simplify.
 
Most real world choices have multiple aspects. Almost any planning will involve some complexity, at least in the details.
 
In 1939, Albert Einstein (along with Enrico Fermi and Leo Szilard), persuaded Franklin Roosevelt to allocate an enormous sum of money to the theory that an atom bomb could be built.
 
How did they convince Roosevelt? Did they attempt to explain nuclear physics to the president? No.
 
Did they try to explain to Roosevelt why they believed that such a bomb was possible?
 
No.
 
Did they discuss the engineering challenges? Or the probable side-benefits even if a bomb were not possible?
 
None of the above
 
Instead, they focused one key decision factor: if it turned out the bomb were possible, what would the world look like if Hitler had it and the US didn’t?
 
They got Roosevelt to focus on the most crucial issue for Roosevelt, and they ignored everything else.
 
Simplify to the Key Choice
A client wants to liquidate, but doesn’t want to pay tax. You have a method that he can sell without paying tax, but it comes at the price of (say) not having liquidity.
 
If the client wants both liquidity and to avoid tax, that choice, to the exclusion of everything else, needs to be made clear to the client.
 
For example, in the above $11 million business sale, the advisor might frame the decision as something like “is it worth $3.5 million of taxes to you, Mr. Client, to avoid having to make a decision about the proposed plan?” (The advisor was proposing a trust that would shelter the gain.)
 
Conflicting Goals
Try to get the client to be clear about all his, her or their (in the case of couples, families or partnerships) goals.
 
You know how to do this by asking questions.
 
Then try to get them to rank their goals.
 
Many clients will claim that all their goals are “top priorities.” But that is not reality. Your client knows this. But sometimes they are paying you to make them behave like adults.
 
Making difficult choices, saying “I’m not willing to pay $3.5 million in taxes; I’d rather have less liquidity” is an adult decision. Refusing to decide (which, as we said, is actually still a decision, though a bad way to make one) is not an adult behavior and is not, in all likelihood, how your client became successful in the first place.
 
Key Decision Skill #1 – Focus on the MOST IMPORTANT Tradeoff
Any decision that is hard likely involves tradeoffs. If there are no tradeoffs in a situation, there is no decision to be made.
 
But when there are multiple conflicting goals, and the client is having a hard time deciding, there is significant evidence that helping the client focus only on the most important tradeoff, then decide on that basis, results is better decisions than other approaches.[1]

We will continue to discuss key decision skills in the remainder of this series on decision making. Stay tuned to our blog for more updates.

Over the past thirty years, oceans of ink have been spilled promoting the idea that, in effect, your clients are stupid. Or if not stupid, “irrational.” The academics will have us believe that people, clients, are hopelessly “biased” in their decision making.

I was at Stanford when I first encountered the claim that people are systematically biased decision makers. It was 1982. In the bookstore there I found a collection of academic papers titled Judgment Under Uncertainty: Heuristics and Biases, edited by Daniel Kahneman and Amos Tversky. Tversky was then at Stanford. Academia loves certain ideas, and this one caught on like wildfire. Kahneman won the Nobel Prize for it.

But the idea has gone way overboard.

I don’t know your clients (at least I don’t know most of them personally), but I know people like your clients, and they are not stupid (not most of them, anyway.)

But it is not fair, or helpful, to claim that merely because clients don’t make decisions exactly the way that academic theory says they should, your clients are “irrational.”

How the Academics Say Your Clients “Should” Decide

Please don’t feel like you need to understand the following. I’m including it here so you have an idea of what Nobel Prize-type academicians have in mind when they talk about “rational” decision making. The following is a long quotation from the Stanford Encyclopedia of Philosophy:[1]

 

Here is a different representation of how a rational person “should” decide:

I do not say the above is wrong. In fact, when I was at Stanford, I had the privilege of studying decision science with one of the giants in the field, a wonderful professor named Ron Howard. Professor Howard actually coined the term Decision Analysis. I have tremendous respect for him.

However, for most people, it is not realistic to expect that they will make the significant effort required to learn the technical tools required to make “rational” decisions according that

Only that it is quite a bit to expect. Most people, even very smart, very rational people, do not use such procedures.

Your clients are not stupid, and they are probably not really irrational. But, they can probably also (at least sometimes) use some help in making decisions.

What Makes Real World Decisions Hard

In our experience over the years, working with hundreds or thousands of people, including advisors and their clients, we have learned that it is not ignorance of the technical theories that make decisions hard.

Instead, there are about five distinct factors that can make decision hard for real people. These are:

We will look at each of these in the remainder of this series on decision making. Stay tuned to our blog for more.

 

Are your clients paying more than their fair share of taxes?
 
The chances are high that they feel they are.
 
And the statistics suggest they might be right.


What Level of Taxation is Fair?
The US Government claims that “taxes are the price we pay for a civilized society.” That claim is based, more or less, on the idea that taxes are to used to pay for goods and services that benefit everyone. A classic example is police, and another is national defense.
 
But today, such expenditures for the common good account for a small fraction of US government spending. By some estimates, 80% or more of the US federal government expenditures are “transfer” payments. A “transfer” payment is money that is taken by taxes from one person and paid to another.
 
The US defense budget, as large as it is, as a percentage of federal spending is smaller than it has been at any time since before WWII.
 
Top 10% of Earners Pay 71% of the Income Taxes
To be in the top 10% of income earners in the US requires income of about $132,000 a year. That includes two income couples. So, for example, two people, who each earn just over the national average, will together be in the top 10%.
 
Chances are that many of your clients are in this top 10%, and for that are among those  paying the 71% of income taxes paid.
 
So if your clients believe they pay too much in taxes, chances are, they are right.
 
What Can You Do About It?
For the taxpayers in the highest tax brackets, tax rates can easily exceed 50% in many states.
 
But there are steps you, and your clients, can take that can reduce the severity of the tax bite. Four tools that you should be familiar with are:

• Section 642 Income Trusts
• Section 664 Tax Exempt Trusts
• Donor Advised Funds (Deferred Actual “F”ilantrophy funds)
• Private Foundations

To learn more, you may check out our page on year-end tax savings. If you are interested, you may also schedule a meeting with Sterling Advisor Solutions.

We all know how successful Apple has been historically.
Or do we?
We’ve heard from a number of people, including some advisors, who say that Apple will always grow.
At worst, these people say, “Apple will maintain its position as the world’s most valuable company.”
The unspoken assumption is that the stock is a “forever” hold, even if the position held is a large, concentrated one.

China Syndrome?
Recent criticism of Apple, even from left-leaning outlets like the NY Times, increases the risk for Apple. The Times says, in a 2021 article, “Apple has largely ceded control to the Chinese government.” China could be the trigger that causes Apple to lose its polish.

History of the Top Dog
But concentrated positions are dangerous, even in stocks as “stable” as Apple.
The historical data shows that even market leading companies like Apple can, and do, plummet.
Here is a short list of once-great American companies that have fallen on hard times. Most of these went bankrupt and disappeared:

• ATT
• Bell Labs (Lucent – went to zero)
• GE
• GM (Bankrupt)
• Sears (Bankrupt)
• TWA (Bankrupt)
• Pan Am (Bankrupt)
• Texaco (Bankrupt)
• Chrysler (Bankrupt)
• AIG
• Washington Mutual (Bankrupt)

Utilities Are Not Exempt
Even public utilities, once considered the ultimate “widows and orphans” stocks, are not exempt. Here’s a short list of some of the more prominent utilities that have gone bankrupt

• Pacific Gas and Electric (twice!)
• Portland Genera (Enron)
• Griddy
• Brazos Electric

Here are a few charts that show GM and GE, former industry giants, crashing to zero around 2009/2010:

Tech Stocks are Not Immune
Many advisors and clients have already felt the hit that big tech stocks have taken in the past year or so.
Netflix had a dramatic nosedive earlier this year. Facebook and Google have experienced similar plunges.
Google lost 44% of its value in 2022, and Facebook lost nearly 77% of its value in the same time period.

Even forward-thinking big tech companies are prone to periods of significant loss.

Could Apple Be Next?
While Apple has been good to its investors recently, that wasn’t always the case.
From 1998 to 2003, Apple stock price soared, just as it is doing today; then it fell just as rapidly.

And current data shows that Apple may be headed towards falling again.
Below is a graph of Apple, Facebook, and Google since 2012, when Facebook/Meta opened.

Notice that Apple, in orange, has largely followed Facebook (or META, in blue) and Google (in green) on the upward trend in 2020 and 2021.
It’s not hard to see how Apple may be just as susceptible to dropping as its contemporaries did.
Many clients feel as if Apple is “too big to fail.” But as we’ve seen with companies like GM, GE, and even recent powerhouses like Netflix, there is no such thing.

How To Get Out Before It’s Too Late
If your clients (or you!) have concentrated Apple stock positions, the safest and smartest thing to do is to diversify.
But stockholders are often reluctant to sell such positions, as they would face a huge tax hit in the event of a sale.
Luckily, there is a solution.

Sec. 664 Stock Diversification Trust
A good solution for many is a tax-exempt Sec. 664 Stock Diversification Trust.
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our weekly webinar on concentrated holdings, where we discuss the best ways to advise clients with highly concentrated stock positions. You can register for, or request a recording of, that webinar using this form on our website.

Bitcoin, along with the rest of the “crypto” universe of assets is down roughly 75% from recent highs.
 
Many of your clients who own Bitcoin or similar assets will have losses.
 
However, those who have been invested for a longer time may still have huge gains.
 
Fundamental Value
There is a strong case that the fundamental value of issues like Bitcoin is zero. Here is a short argument for that case.
 
The bullish case for crypto “currencies” is that they, or one of them, will become the commonly used medium of exchange. That is, they will become money.
 
Money, by definition, is that asset in an economy which is the most liquid and is the most widely accepted asset in exchange. In the US, the dollar is money, and nothing else is money. For example, credit cards, checks, ACH, bank wires, and PayPal are all methods of payment. But what is paid is dollars.
 
Historically, going back to the at least to the time of Alexander the Great (he died 2500 years ago), money has always had a relatively stable value. When money ceases to have a stable enough value, it ceases to be used as money. (We wrote a book on inflation, available here, if you want to read over 100 pages on the history of money).
 
Demand for Crypto
People demand money because they want to use it for transactions, in the present or in the future. (See, e.g. chapter 17 of Human Action, by the 20^th century economist Ludwig von Mises.) To serve this role, and therefore to be demanded, the exchange value of money must be relatively stable.
 
People demand crypto, so it seems, for precisely the opposite reason. They demand crypto as a speculative asset. Most people (possibly excluding a small number of aficionados, and some unknown number of criminals) buy and hold crypto because they believe (or hope) that it will go up in exchange value. That is, they buy (if they buy) say Bitcoin at $16,000 because they believe (or hope) that it will go up to (say) $30,000 in a short period of time.
 
We believe that “crypto”, at least in the form of issues like Bitcoin, is not a currency, and is unlikely to be a currency. When people stop holding Bitcoin and similar cryptos because they believe the exchange value (i.e. the price in money) will rise, we believe the demand for such cryptos will virtually disappear. In that event, the value could go toward zero.
 
US Taxation
Bitcoin (and presumably other similar cryptos) are in the US taxed as capital assets. That means, for example, that if a client owns a Bitcoin with a basis of $1000, and uses it to buy a car for $16,000 (to use a current market price of a Bitcoin), that client will have a taxable capital gain when he “purchases” the car with the Bitcoin.
 
That’s the downside of capital treatment.
 
The upside is that it is possible to avoid taxation on the sale of crypto held for long term gains by using one of several appropriate techniques.
 
Section 664
One such technique is to contribute the appreciated crypto to a trust that qualifies as tax exempt under section 664 of the code.
 
Capture AUM
For clients who have appreciated crypto, a 664 trust can be a great opportunity to take profits without incurring tax. And for advisors, such a trust can be a great opportunity to gather AUM, while helping a client take profits, avoid tax, and diversify out of a highly risky asset.
 
If you think a Sec. 664 Tax Exempt Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

Commercial real estate, as an asset class, is very sensitive to the availability, and pricing, of loans.
 
The graph below shows the history – the black line – of the prices of US commercial real estate going back almost 30 years.
 
Also on the graph are loan demand – blue – and lending standards, shown in red.
 
As makes sense, when loans are easy to get, that tends to boost the demand for commercial real estate.
 
And when loans are hard to get, demand, and therefore prices, tend to suffer.
 
The sharp fall in the red and the blue lines suggest that a credit crunch has begun.
 
Prices have begun falling, but if the last go-around is any indication, they could fall much farther.

Your Clients
Some of your clients own investment properties – which are considered commercial real estate. Apartments, shopping centers, strip malls, office buildings, self-storage, medical buildings, parking lots, industrial property, even raw buildable land will all likely be affected by a credit crunch.
 
If you have clients with such property, now might be a good time for them to lock in profits.

Taxes
Many clients will not want to sell because they don’t want to pay taxes on gains.
 
There are two main sections of the tax code that such clients might be able to use to sell and not pay tax. These are sections 1031, and 664.
 
Section 1031 provides for tax-free exchange of one real estate property for another. The limitation, of course, is that if the client wants out of real estate, 1031 won’t do that.
 
Section 664 allows for the tax-free transfer to trust, and the tax-free sale by the trust, of qualifying real estate.

Sec. 664 Real Estate Shelter Trust
A good solution for many is a tax-exempt Sec. 664 Real Estate Shelter Trust.
 
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Real Estate Shelter Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

There have been two extended bear markets in the last thirty years. One followed the dot.com collapse in 2000, and the other was associated with the financial crisis.

The chart below shows the weekly S&P 500, in blue, along with its 50 week moving average (green) and its 100 week moving average (red).

The 50 week moving average crossed the 100 week moving average on the way down twice. Each time, it signaled a several-years long bear market.

The first time, in 2000, the market declined until 2003. The second time, in 2008, the market declined much faster, and more steeply. The circle labeled “3” shows that the 50 week is poised to plunge through the 100 week.

Is this signaling a bear market?

Locking In Gains

Some advisors are urging clients to lock in gains, on entire portfolios, and especially on large positions.

Other advisors are advising taking profits on all positions, large and small, that have big percentage gains.

The problem, of course, is taxes.

Taxes

Capital gains taxes on sales of appreciated positions are a return killer. For most significant gains, the capital gain tax plus state income tax ranges from 23.8% all the way up to 37.1% for those unfortunate enough to be subject to California tax.

But there are some ways to avoid tax on sale.

664 Trust

Many owners have large gains, and would face a large tax if they sold. The desire to avoid paying tax is often a primary reason stockholders that should sell, don’t sell.

A good solution for many is a Sec. 664 Stock Diversification Trust.

A Sec. 664 Stock Diversification Trust is a tax-exempt trust that allows stockholders to contribute their stock to the trust so that the trust can sell their stock, tax-free. The proceeds of the sale can be reinvested by the stockholder's financial advisor, allowing the assets to grow tax-free. The client does not have access to these assets, but does gain the right to an annual income stream of up to 5% of the assets; this can be deferred to allow the assets to continue growing inside the trust, tax-free.

A Sec. 664 Stock Diversification Trust is often a great solution for clients who want to remove the excess risk they face from their concentrated holdings but are resistant to pay the heavy taxes on such a sale.

If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

Greed is back. And that might be a great opportunity for investors holding concentrated positions in a stock who didn’t get out earlier.
 
As we all know, after a terrible first three quarters, the stock markets have bounced sharply.
 
But is it a new bull market?
 
The Greed Index suggests not.
 
CNN Money compiles their Fear and Greed index.
 
It has made huge jump toward Greed. Here’s a picture.
 

 
Why It Matters
If you have clients who have a concentrated stock position, the markets’ mood swing might offer a second chance for them to get out.
 
And you should know about a way for them to get out without taking the tax hit.
 
Taxes
Many investors with concentrated positions don’t want to sell because they don’t want to incur pay steep capital gains taxes.
 
A good solution for many is a tax-exempt Sec. 664 Stock Diversification Trust.
 
Here’s how it works. A stock owner contributes stock to the trust. The trust then sells the stock, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

You may also be interested in our next Stock Webinar. You can register using this form on our website.

Home prices have been crashing in English-speaking countries including Canada, New Zealand and Australia.
 
Now, the most recent data show that house prices have peaked in the US, and are trending down.
 
It’s in the headlines too.
 
Bloomberg Headline:

Australia House Prices Record Steepest Drop in Four Decades

• Sydney again led declines, falling 2.3%; Brisbane dropped 1.8%
• Housing market seen remaining under pressure from rate hikes

 Hong Kong’s South China Morning Post:

Home prices poised to fall in Hong Kong, Australia, Canada, France and the US as global central banks raise interest rates

The most recent data show that prices have now peaked in the US too.
 


After the last peak in 2006, house prices gently turned down almost two years before the crash. Over about six year, the Case Shiller index dropped 28% from its peak. So far this time, prices are down only a couple of percent.
 
The house price bear market last time lasted about six years. If the pattern repeats, owners should have time to get out well above the bottom, even if prices are down from their highs.
 
Taxes
Many owners have large gains and would face a large tax if they sold. The desire to avoid paying tax is often a primary reason property owners that should sell, don’t sell.
 
A good solution for many is a tax-exempt Sec. 664 Real Estate Shelter Trust.
 
A property owner contributes property to the trust. The trust then sells the property, tax-free. The proceeds become AUM, and the advisor invests the trust assets.
 
If you think a Sec. 664 Real Estate Shelter Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor or Ryan.

So far this year, multi-unit building (i.e. apartment) starts, are up 17.6%.  Huge numbers of housing units are at various stages of completion, with the number of homes under construction at the highest level on record back to the 1970s.
 
In fact, the data show that multi-family deliveries are at their highest level since 1986!



At the same time, household growth and population growth are at their lowest levels since the Civil War. See the below graph from the Pew Foundation.



Economics 101
Basic economic theory, and tons of experience, both tell us that, everything else equal, if supply increases, price (in the case of apartments, rents, as well as building prices) will fall.
 
Economic theory, and experience, also tell us that, everything else equal, as demand falls, so will prices.
 
It appears that apartments are about to be hit with a double whammy – record high supply, along with record low demand growth.
 
Action
If you have clients with apartments who might want to sell, either to diversify, or to get out before the market falls more, or for any other reason, there are several alternatives that can save your client taxes. One of these is the Sec. 664 Real Estate Shelter Trust. We can also provide you with a twenty-page Advisor’s Guide to Appreciated Real Estate, for free.

Click here to request your copy of your complimentary advisor guide.
 
We’re also happy to discuss any individual client situations with you. Please contact Connor Barth ([email protected]) or Ryan Whiting ([email protected]), or call (703) 437-9720 and ask for Ryan or Connor.