When Will the Fed Start to Raise Interest Rates?

Fed Interest Rates

The US economy has perked up recently: an average of almost 250,000 jobs have been added per month so far this year, a substantially faster pace than any other year in the past decade. As a result, the Federal Reserve has shifted its focus away from trying to stimulate the economy and toward potentially raising interest rates. Raising rates would have some impact on essentially every investment, affecting bond prices, stock valuations, the general economic outlook, and even the how much interest your bank pays on savings accounts.

So when will the Fed end its policy of close to 0% interest rates that’s been in place for the past 6 years? The Fed’s most recent statement on its interest rate policy said it can be “patient,” suggesting that it won’t start raising rates until the middle of 2015. Financial markets seem to agree with this outlook: futures prices, which can be used to calculate when investors think interest rates will rise, indicate that the Fed isn’t likely to start raising rates until the summer.

Even when interest rates start to rise, however, they’re likely to rise slowly. History suggests that the Fed prefers to make small, incremental changes rather than sudden, large shifts (the financial crisis in 2008, when the Fed dramatically slashed interest rates, was a notable exception). Most Fed policymakers think that rates won’t return to a more “normal” 3% to 4% level until 2017.

There’s also the possibility that interest-rate rises won’t get very far before the economy starts to lose steam. The euro zone, Sweden, Norway, and Australia have all suffered that fate in recent years. The US could face a similar situation if the Fed overestimates the strength of the economy and raises rates too soon.

How a Strong US Dollar Can Hurt Emerging Markets

Strong Dollar

The US Dollar has surged in 2014, increasing in value since the start of the year versus every other major currency. A strong US dollar has big implications for the global economy and affects almost every investment in your portfolio. Not all of these effects are the same, however, and the most substantial impact may be on investments in emerging markets.

The most straightforward effect from a stronger US dollar is a decline in the value of international holdings for US investors. This is simply math: when the values of the investments in foreign currencies are converted back to US dollars, they’re worth less than they previously had been.

For some foreign companies part of this decline may be offset because a stronger dollar means that their exports become more affordable. But overall these direct effects of a stronger dollar tend to hurt emerging market investments. Both emerging market stocks and local-currency emerging market bonds have returned about -5% so far this year.

A stronger dollar has other effects as well. It tends to be associated with lower prices for commodities such as oil (there are a number of reasons for this association, with both a stronger dollar contributing to a lower oil price and a lower oil price contributing to a stronger dollar). The oil price has indeed plunged this year, particularly hurting oil-producing countries such as Russia, Venezuela, and a number of countries in the Middle East. With declining oil revenues and a tanking currency, Russia appears to be on the verge of a financial crisis that could wreak havoc on its economy.

There could be additional emerging market victims if the US dollar continues to gain strength. Many emerging markets have debts denominated in dollars, and a stronger dollar makes these debts harder to repay. Given their external debts and their proximity (both geographically and economically) to Russia, a number of other Eastern European countries may be vulnerable.

Reducing Your Capital Gains Tax Bill

Calculator

The end of the calendar year can be a good time to try to reduce the amount you have to pay in taxes. You have to pay capital gains taxes on your investments that have been sold for a profit during the year (at least in standard investment accounts; you don’t have to worry about this in tax-advantaged accounts such as 401k, IRA, and 529 accounts). But if you also have investments that have declined in value, you could potentially sell some of these before the year ends to create “capital losses” to offset the capital gains. This tactic, called “tax-loss harvesting,” can lower the amount you pay in taxes and therefore boost the size of your portfolio over time.

Unfortunately there are a few nuances that can make successful tax-loss harvesting more difficult. The first is that you can’t sell an investment to lock in the loss and then immediately buy it back. The IRS calls this maneuver a “wash sale” and prevents you from getting any tax benefit from it. Instead you have to wait more than 30 days before re-purchasing the same investment (or any investment that the IRS considers to be essentially the same). Capturing the tax benefit from capital losses without creating a distorted portfolio while you wait for the 30-day period to end can be difficult.

A further complication is that the tax rate on capital gains can be different for different people, or even for different investments held by the same person. For example, the tax rate on gains from investments held more than a year (“long-term capital gains”) is lower than the tax rate on gains from investments held less than a year (“short-term capital gains”). That means that figuring out how much you can actually save through tax-loss harvesting can be tricky.

The bottom line is that tax-loss harvesting can potentially be an effective way to reduce the hit to your portfolio from taxes. But with so many subtleties involved in successfully implementing it, having a professional financial advisor guide you through the process may be a good idea.

Avoiding Confirmation Bias

Newspapers

Managing your wealth involves a plethora of decisions, from choosing how much money to save to selecting an appropriate asset allocation to picking individual investments. Every one of these decisions requires your brain to gather and process large amounts of information, which means that there are plenty of ways for it to make mistakes. One of the most common mistakes is “confirmation bias,” the (very natural) tendency for people to seek out and interpret information in ways that support beliefs they already hold.

Confirmation bias can occur in all aspects of life. In politics, for example, people tend to get information from the same news sources as other people who have similar ideological views. And they’re more likely to sympathetically interpret statements by politicians from a party they support, and to critically interpret statements by politicians from a party they oppose.

When it comes to investing, confirmation bias can affect almost every decision you make. If you’ve just increased your allocation to stocks, for example, you may (even subconsciously) be more likely to read news articles where the headlines suggest optimism about the economy. Or you may tune out anyone who suggests the stock market is going to do poorly. Over time confirmation bias can hurt your investment performance by making it more difficult to realize when you’ve made a mistake and potentially leading to additional bad decisions.

So how can you avoid these problems? The simplest way is simply to be aware of them. Realizing that it’s natural to seek out information that supports your existing views and actively pushing back against this tendency can go a long way. You can also come up with ways to objectively measure whether your decisions are panning out. Specifying your financial goals, monitoring your progress toward those goals, tracking your investment performance, and comparing yourself to appropriate benchmarks can all help mitigate the effects of confirmation bias.

Apple Stock Reaches a Milestone

Apple Stock

Apple stock reached a symbolic milestone last week as the total value of all the company’s stock—its “market capitalization”—surpassed $700 billion for the first time. Some analysts are now speculating that the company could grow to become worth over $1 trillion. These numbers are gaudy, and they reflect the fact that Apple’s business has been booming. But they may distract from what Apple shareholders should really focus on, which is the stock’s total return.

“Total return” refers to the combination of the change in the price of an investment and other payments made to investors, such as dividends. This concept reflects how an investment actually affects the value of an investor’s portfolio.

A bigger market capitalization can be associated with a higher total return, but that’s not always the case. When a company pays a dividend to its shareholders, for example, the company’s market capitalization decreases (because the company now has less cash), but the total return does not (because investors have received the cash).

Since it reintroduced its quarterly dividend in 2012, Apple has been paying its shareholders more than $10 billion a year in dividends (it’s spent an even greater amount buying back its own stock, another way of returning money to shareholders). Each dividend payment lowers the total value of the company’s stock, making it slightly harder for the company to reach a new market capitalization record.

But the dividends are arguably very good for shareholders. Even after the tens of billions of dollars in dividends and buybacks, Apple still has more than $150 billion in cash and other assets that it could easily convert to cash. This large amount of cash suggests that Apple may be having trouble finding profitable ways to deploy its money, and that more dividends and buybacks may be better for Apple’s shareholders than simply watching the cash pile continue to grow. Investors cheering for Apple stock to achieve new market capitalization milestones should keep that in mind.