Stimulus Checks, Taxes, and Investments

IRA tax season and the third round of stimulus checks are inspiring recipients to deploy their $1,400 stimulus to reduce their 2020 tax burden. A deposit in a qualified retirement account could minimize 2020 (or 2021) taxes and at the same time enhance retirement – or even help with home purchase options down the road. Getting the most benefit from investing these longer-term assets is dependent on many factors, including the individual’s time horizon. The following advice from a highly credentialled investment analyst may help inform investors’ allocation options.

Robert R. Johnson, Ph.D., CFA, CAIA, is a Professor of Finance at Heider College of Business, Creighton University. He is also a co-author of The Tools and Techniques Of Investment
Planning, Strategic Value Investing, and Investment Banking for Dummies, among others. As if these credentials aren’t enough, he is the former deputy CEO of the CFA Institute and headed the CFA Program, as well as having been the President of the American College of Financial Services. Dr. Johnson is one of the most credentialed individuals in the field of finance and investment, so I asked him a question important to those that use Channelchek for insight on small and microcap investments. The answer is worth knowing for anyone that is more investment than trading-oriented.

Channelchek (PH): “Dr. Johnson, if over a long enough timeline, small-cap indices outperform large-cap. Could it stand to reason that if you’re a young saver for retirement, holding stocks that have demonstrated a greater return over time should have an allocation? Also, could individual stocks be more suitable than an ETF in the small-cap sector? What stipulations would you have for an investor buying small or even microcap stocks in their IRA?

Dr. Robert R. Johnson: You are absolutely correct in that small-cap stocks are most suitable for investors with a long time horizon. According to data by Duff & Phelps [formerly Ibbotson Associates] from 1926 through 2019, an index of small-cap stocks returned 11.9% compounded annually, while large-cap stocks returned 10.2% compounded annually. While that may not sound like much of a difference, one dollar invested in a large-cap index would have grown to $9,243 at year-end 2019. That same dollar invested in a small-cap index would have grown to $39,381 at year-end 2019. Now, those higher long-term returns come at a cost of higher volatility. Over that same time period, the standard deviation of annual returns was 19.8% for the large-cap index and 31.5% for the small-cap index.

“…one dollar invested in a large-cap index would have grown to $9,243 at year-end 2019. That same dollar invested in a small-cap index would have grown to $39,381 at year-end 2019.” – Robert R. Johnson, PhD, CFA, CAIA

Individuals need to be taught to invest for retirement and not to save for retirement. The surest way to build true long-term wealth for retirement is to invest in the stock market. Starting early is the key to successfully building wealth because of the effect of compound interest. Albert Einstein said that “compound interest is the greatest mathematical discovery of all time.” Time is the greatest ally of the investor because of the “magic” of compound interest. An IRA is the perfect investment vehicle for an individual with a long time horizon. They can weather the increased volatility of the small-cap universe.

People in their 20s should begin investing in a low-fee, diversified small-cap equity index fund and continue to invest consistently whether the market is up, down, or sideways. Dollar-cost averaging into an index mutual fund or ETF is a terrific lifelong strategy. Dollar-cost averaging is a simple technique that entails investing a fixed amount of money in the same fund or stock at regular intervals over a long period of time.

Additionally, these investors should be 100% invested in stocks and have no bond exposure. Ironically, one of the biggest mistakes young investors make is taking too little risk, not too much risk.

“…often that is what happens to beginning investors who buy the stock of the company they work for or the stock of a product they like. When they experience failure, they withdraw from the equity markets. Investing in a broadly diversified basket of securities is a prudent strategy.” – Robert R. Johnson, PhD, CFA, CAIA

For the vast majority of investors, the KISS mantra — keep It simple, stupid — should guide their investment philosophy. The idea behind index investing is “if you can’t beat ‘em, join ‘em.” Investors simply can’t afford to make oversized bets on individual securities. And, often that is what happens to beginning investors who buy the stock of the company they work for or the stock of a product they like. When they experience failure, they withdraw from the equity markets. Investing in a broadly diversified basket of securities is a prudent strategy. An interesting study done by University of Arizona professor Hendrick Bessembinder shows that only four percent of common stocks have provided a higher return than Treasury bills. In other words, the returns on the market have been driven by a small percentage of big winners. Trying to pick winners, for most, is a loser’s game. The solution is to invest in diversified funds and you don’t need to pick those winners.”

Take-Away

There is debate whether today’s popular cap-weighted indices represent diversification relative to a well-selected, large diversified basket of a more even weighting. A previous Channechek article is provided below that discusses this concern; it was published before the 2020 explosion of tech stocks. Last year’s uneven growth reduced their diversification even more. Investors should evaluate if the current imbalance of individual index funds is now in fact making an oversized bet.

Professor Robert R. Johnson, Ph.D., CFA, CAIA, certainly feels strongly that there is a difference between savings and investing. Bank accounts, CDs, bonds and notes are not the path for true long-term wealth. IRAs, 401ks and other funds earmarked for retirement should be in equities if you are not soon expected to live off those funds. For those that have a longer time horizon, accepting the higher volatility of small-cap stocks for the higher probable returns could be viewed as most prudent.

Paul Hoffman

Managing Editor, Channelchek

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