Four Questions

Jonathan Clements

AFTER YEARS OF handwringing, you finally concede that it’s all but impossible to beat the market over the long haul, so you shift your portfolio into index funds. Next up: the truly tough decisions.

Almost every writer for—and reader of—HumbleDollar is a fan of indexing, and there’s no doubt that index funds are a wonderful financial tool. But how will you use that tool? Let the bickering begin.

The differences of opinion show up among the articles we run on HumbleDollar. As the site’s editor, I strive to make sure the pieces we publish are well written and well argued. But there’s no official party line. Consider four burning investment questions:

1. Where should you hold your bonds? Conventional wisdom says bonds should be kept in a retirement account, where you don’t have to pay taxes on each year’s interest. Meanwhile, stocks should be held in a regular taxable account, so you benefit from the low tax rate on qualified dividends and long-term capital gains.

But in a recent, feisty article, Dan Danford took issue with this standard advice, arguing that stocks should be held in a retirement account, because you want to defer taxes on what should be your highest-returning asset. He argued that conventional wisdom is “kind of dumb.”

Earlier this month, Dan got partial agreement from Adam Grossman. Adam noted that holding bonds in a taxable account might make sense for younger investors. That way, the money will be available for unexpected expenses, plus the tax hit should be modest, given today’s tiny bond yields.

While I have great respect for both Dan and Adam, I’m sticking with conventional wisdom. The fact is, if you buy and hold broad stock market index funds in a taxable account, you get tax-deferred growth—just like you would with a retirement account—and, should you sell, those sales will benefit from the preferential long-term capital gains rate.

On top of that, if you hold these investments until death, your heirs will get the step-up in cost basis, thus nixing the embedded capital gains tax bill. Indeed, now that the SECURE Act has killed off the stretch IRA for almost all beneficiaries, except spouses, saving your taxable account for your heirs is looking like a much smarter strategy.

2. Should you even own bonds at today’s tiny yields? Back in October, Bill Ehart sang the praises of balanced funds, which typically hold 60% stocks and 40% bonds. Adam Grossman doesn’t believe a 60-40 mix is right for everybody. But in January, he made a strong case for owning U.S. government bonds, even at today’s low yields, because they’ve consistently proved to be a great diversifier for stocks. I’m inclined to agree with Bill and Adam, though I prefer to limit my interest rate risk by favoring shorter-term bond funds.

Last week, however, John Yeigh countered that he has little appetite for bonds at today’s low yields. Instead, he favors substituting cash investments. What if you’re retired? John advocates keeping enough in cash in to cover three-to-five years of portfolio withdrawals, and then stashing the rest in stocks.

3. Is it okay to stray from 100% index funds? My investment portfolio is entirely in index funds, with the exception of an inflation-indexed bond fund. (I know, I know, it’s confusing: The bonds are indexed to inflation, but the fund itself is actively managed.) When I was at The Wall Street Journal and then at Citigroup, I owned a little company stock. But other than that, I haven’t bought anything but mutual funds for two decades.

Other HumbleDollar writers are less dogmatic. John Yeigh has a thing for dividend-paying stocks and writing covered calls. Sanjib Saha has also dabbled in options. Adam Grossman has occasionally offered guidelines for those inclined to take an investment flier and has noted the value of individual stocks in teaching his kids about money.

Indeed, over the years, I’ve met many index-fund aficionados who stray from the straight and narrow. They might have a “fun money” account for trading individual stocks or they might vary their mix of stocks and bonds, depending on market valuations. And, within reason, I think that’s okay. Messing with 5% of your portfolio isn’t so terrible, especially if it satisfies your urge to play market Nostradamus and it means you’re happy to stash the other 95% in index funds.

4. How much should you invest abroad? I suspect that, if you could peek inside the portfolios of your fellow indexing devotees, you’d immediately be struck by two huge variations in their holdings. First, there would be big differences in the stock-bond mix. That, however, is no great surprise: We’re all at different life stages and have different appetites for risk.

More notable would be the second difference: You’d see enormous variations in the stock portfolio’s allocation to foreign shares. I have roughly half my stock portfolio invested abroad. Why? I believe in piggybacking on the collective wisdom of all investors and, today, investors are saying that U.S. and foreign stocks are roughly equal in value.

But I’m clearly an outlier. For instance, Bill Ehart is 38% in foreign stocks, while Adam Grossman recommends just 20%. Who’s right? If you judge by the past decade’s performance, I’ve badly blundered. And, no, I’m not going to puff out my chest and insist that my day will come.

Rather, I’d ask readers to remember that, while we have only one past, we face all kinds of possible futures—and nobody knows which future we’ll get. Faced with that uncertainty, I favor spreading a portfolio’s investment bets widely. Some of those bets will turn out to be duds and, eventually, we’ll know their identity—but only after the fact.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Rule the RoostNobody Told Me and Great to Gone.

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