Your Friendly Neighborhood July Mailbag

Welcome back to the mailbag! In this installment, we will explore your personal finance questions. Grab a beverage and a snack, if you like, and off we go.

Why do I feel inflation more than what the numbers reflect?

Because the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) price index aren’t cost-of-living measures. Their purpose is to measure trends across the entire spectrum of goods and services for sale in the US. This usually results in outlying categories averaging one another out. Ditto for local trends.

One fun way of seeing this is to compare your typical monthly expenses to each item’s weight in the CPI basket. Groceries are only 8.2% of it.^[i] Does that match your food-buying patterns? Prescription drugs, a budgetary sore spot for many, are just 0.9% of CPI.^[ii] Do they loom larger in your personal budget? Medical services are 6.5%, with nursing homes and at-home elderly care only 0.4% combined.^[iii] But for people who actually consume these services on a regular basis, they are a much larger chunk. (More on this shortly.) Ditto on tuition, just 1.3% of CPI, and childcare (0.7%).^[iv]

Meanwhile, there are a lot of things in the CPI basket that people just don’t buy each month. Think furniture, electronics, appliances, tools, clothes, airplane tickets and the like.

If you were to square the inflation rates for each item in your personal budget to the changes in your expenses, they would probably look more similar than a simple comparison of your budget with headline inflation rates would imply. It wouldn’t be perfect, given local variance and personal shopping preferences, but it would be in the neighborhood. Oh, and remember: Inflation rates measure the percentage change in prices … not the level. So, as we noted in our prior installment, improved inflation doesn’t mean a decline in the prices you see. Just a slower rate of increase.

How do you plan for longevity when health care costs are accelerating far faster than CPI and other inflation rates?

Factor them in! Past inflation rates don’t predict future inflation rates, of course. But looking at the average inflation rate for each segment of your household budget can help you anticipate the level of portfolio growth you will need over time to reduce inflation’s impact on your finances.

When doing this, don’t just focus on your current expenses, especially if you are still in your prime working years. Spend some time thinking about what your life will look like at age 80, 90 and beyond, and don’t wear rose-colored glasses when you do. Be realistic about the possibility of stroke, dementia or other maladies requiring you to consume round-the-clock care, and include that in your future cash flow projections. Then look at the current price, apply the relevant inflation rates (which you can find at the St. Louis Fed’s economic data portal), and start mapping out how much you will need at that point in your life to avoid running out of money too soon.

We imagine that is a lot to digest. So may we offer a shameless plug? Fisher Investments Founder and Executive Chairman Ken Fisher wrote a great book called Plan Your Prosperity that includes this very exercise and even has sample worksheets you can use. 

What do you think of Roth IRAs and Roth IRA conversions? Should I consider converting some of my IRA funds into Roth with tax rates potentially increasing?

We like both traditional and Roth IRAs, and which one is right for you at any given time will probably depend on your taxable income, what you anticipate it being post-retirement and, therefore, what your current and expected effective tax rates are.

Traditional IRAs are tax-deferred. The money you contribute is pre-tax, so you can deduct it from your income and pay less in taxes now. It also grows tax-free, so you don’t pay taxes on accrued interest and dividends or capital gains within the account. But withdrawals are taxable at ordinary income tax rates. And they are required once you reach a certain age so that Uncle Sam gets his cut.

Roth IRAs are post-tax. You contribute money you have already paid income taxes on. But it, too, grows tax-free, and withdrawals are also tax-free.

So the choice generally depends on whether you expect to pay a higher or lower effective tax rate in retirement than you do today.

But with conversions, it is a little more complicated, because you have to pay income taxes on the amount you convert. This adds to your taxable income and can incur a higher rate than you would normally pay as a result. Hence, why our reader wonders if now is the time to bite the bullet, before the 2017 tax changes sunset.

The right move for you will depend on your specific situation. We would simply encourage you to consider two key points as you weigh the decision. One, your long-term goals and needs over your entire investment time horizon—meaning, the entire length of time your money must be working for you—should be the basis of any key financial decision. Taxes are but one factor here. And two, we don’t have clarity on how Congress will handle the sunsetting tax cuts. We have seen a bipartisan push to extend most of them, which is typical when this situation arises (see: Congress and the Obama administration making permanent most of George W. Bush’s tax cuts). What happens from here will depend in large part how this November’s elections shake out. Rushing to a conclusion now could unnecessarily incur taxes better spaced out over time—or not converted at all.

There are a lot of possibilities on the tax front, but right now, we don’t see a strong basis for estimating probabilities. And we think probabilities are a far more solid foundation for financial decision making.

Is borrowing on margin a good or bad idea?

In our opinion, a bad one. If you are buying stocks with borrowed money, you risk losing more than your initial investment. You also run the risk of getting hit with a margin call if your portfolio is down with the market during a bear market, forcing you to liquidate positions and reduce your stock exposure while stocks are down. This can be financially and emotionally devastating.

We don’t think borrowing on margin for other purposes is wise, either. You might not be investing with borrowed money, but you will still face the risk of margin calls and all this entails. So we can see a basis for using it over ultra-short windows of time (a week or two) if you have a short-term cash pinch set to abate. But carrying the loan is, in our view, a no-no.

Lastly, if you are considering investing on margin, search yourself and ask, why. What is motivating you? Fear of missing out? Discontentment with market-like returns? Greed is a mirror of fear. Letting either emotion drive you can lead to short-term decisions that jeopardize your long-term goals. Those goals, not your feelings in the heat of the moment—whether those feelings amount to greed or fear—should be your first consideration.