At Wealthfront we try to make it very clear that our investment approach is only appropriate for the long term. This often raises the question: How long is “long term”?
To us long-term investing implies at least five years. With this post we will explain why we chose that number, as well as what you might consider doing with cash you need in less than five years.
Invest In Something Safe If You Really Need It
Before you commit to long-term investing it’s important to understand the tradeoffs of an investment portfolio relative to risk and timing. The table below reports the probability of loss over time for a hypothetical diversified portfolio*. You can see that there is almost a 37% chance of loss after the first year. The number drops to just over 22% after five years, then down to only 14% after 10 years.
The probability of loss essentially declines with the investment horizon. This is driven by the positive expected rate of return on even a risky portfolio, which captures the compensation an investor earns for the passage of time (the risk free rate) and for bearing risk (the risk premium). Similarly, the positive rate of return on the portfolio generates a progressively longer tail of upside outcomes.
But even a well-diversified portfolio is at high risk for a sharp decline in the very short term. However, it becomes far more tolerable after five years. Therefore, taking some risk to get some extra return could prove worthwhile if you’re not going to make a major expenditure until a number of years in the future, and you opt for a diversified portfolio.
Consider Other Options For Big Purchases in the Short Term
The primary reasons for a major withdrawal from an investment account should be major expenditures like paying for your kids’ education or the purchase of a car or house. When it comes to these major purchases you can’t afford to take any risk as the commitment date approaches. In other words, if you have already saved enough to make a down payment on a condo then the opportunity to earn an extra 10% while you wait is not worth the risk, as your account value might decline by 10%. Our advice: Nothing should get in the way of making that down payment.
So if you need to make a big purchase in the short term and can’t afford to take a loss, we recommend investing your money in a very low-risk option like a money market account, savings account or certificate of deposit. (Bankrate.com is a helpful resource to find the best CD rates.)
We also don’t think a diversified portfolio of index funds is the proper vehicle for your emergency fund. As we explained in Build the Emergency Fund That’s Right for You, we think you should stash away at least three-to-six months of your living expenses in a low-risk account before you even begin to think about investing.
We are often asked if CDs or money market accounts make sense in a very low-interest-rate environment, such as the one we’re in today. The question comes up because many people wonder why they should keep their money in an account that generates a return below the rate of inflation. But over the short term the lost purchasing power due to earning less than the rate of inflation will not hurt you nearly as much as the volatility associated with an equity-oriented diversified portfolio potentially killing your ability to make your big purchase.
Diversify, Contribute Regularly and Minimize Taxes to Generate The Best Long Term Returns
However — and even accounting for risk — you are far better off investing in a low-cost diversified portfolio like what we offer if you are willing to let it compound over the long-term. You should also steadily add to your long-term portfolio as you save money no matter how the financial markets perform. As we pointed out in Invest Despite Volatility, you’ll likely be far better off in the long run if you add to your investment account when the financial markets decline. Also Tax-Loss Harvesting and Direct Indexing could dampen the blow of a down market in the form of a harvested loss that reduces the taxes you pay. The benefits of a diversified portfolio with strategies like Tax-Loss harvesting and Direct Indexing could be huge, but only if you have a long-term perspective.
*For the purposes of the computations, the expected return of the portfolio was set equal to 5.8%, and its annualized volatility to 14% (a level of risk comparable to that of a Wealthfront portfolio with a risk level of 7).
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.
For the chart above, we calculated the hypothetical probability of loss for a hypothetical portfolio. We assumed a Gaussian probability distribution, an expected return of 5.76% and an annualized volatility of 14%. The Gaussian probability distribution is generally thought to understate the true probability of loss.
This information is based on hypothetical performance calculations, which are not an indicator of any investor’s actual current or future experience and is provided for illustrative purposes only.
Hypothetical results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.
Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Hypothetical performance is developed with the benefit of hindsight and has inherent limitations. Specifically, hypothetical results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from hypothetical performance. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.
This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.
Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.
Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.
The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth below, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.
A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at 844-995-8437. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.