Q&A: You Made a Money Mistake. Now What?

28:09That was when I got on Gusto and I'm still there today. Try Gusto today at gusto.com slash paula and get three months free when you run your first payroll. That's three months of free payroll at gusto.com slash paula. One more time, gusto.com slash paula, G-U-S-T-O dot com slash P-A-U-L-A.

28:39Our next question comes from June. Hi Paula. With tax season coming up this year, I realized that in selling some of my taxable brokerage account, I realized some short-term capital gains and some wash sales. Primarily, I had long-term capital gains, but I was wondering if you had any advice for how to avoid and notice that you're doing a short-term capital gain or a wash sale, particularly using the Vanguard interface, which I'm sure many of your listeners also use. Thanks for all you do. June, thank you for the question. So in terms of short-term capital gains, if you have held assets for less than a year, those are generally going to be taxed to short-term capital gains.

29:34If you rebalance annually, what I like to do is I like to go for one year plus one day. So just to be on the safe side, give it 366 days in order to make sure that you have held the stock for over a year. The extra day is probably unnecessary, but I like to just give it that little margin of error just out of an abundance of paranoia. So that's my approach to locking in long-term capital gains and avoiding short-term. Well, and I also just think, Paula, whenever I sell anything, if it's outside of a tax shelter, I just want to go back and do a quick look at when I bought it. I want to look at what I paid for it so I can do a calculation before I sell about approximately what my tax cost is going to be.

30:22And so because that's going to give me the date of purchase as well, then I can work backwards. onto what the cost of this transaction is going to be. Right. And if you have an account with a lot of different assets that have all been purchased at different times, you want to check to see if it's FIFO or LIFO. FIFO means first in, first out. LIFO is last in, first out. So basically think of it this way. With FIFO, let's say you've got Alvin, Simon, and Theodore, right? You've got three different assets. We'll call them Alvin, Simon, and Theodore. You buy Alvin in October. So Alvin is the first in.

30:58you buy Simon in November and then you buy Theodore in December. Wait a minute. We're buying chipmunks? Yeah, yeah. We're buying chipmunks. Gotcha. Okay. Yeah. We're buying chipmunks. We're chipmunks commodity traders. Big money. I use this analogy because Alvin, Simon, and Theodore always go in that order. Nobody ever says Simon, Theodore, and Alvin. It's never ordered like that. We know that the order of the chipmunks is always first Alvin, then Simon, then Theodore in that order. Theodore gets it every time. Right. And so Alvin is always the first. Theodore is always the last. So imagine that you bought Alvin in October, you bought Simon in November, you bought Theodore in December, right?

31:49Alvin is always the first one that you buy. Theodore is always the last. So if it's FIFO, you're selling Alvin first. And if it's LIFO, you're selling Theodore first. And when you're looking at the way the assets are sold out of an account, check to see if it's FIFO or LIFO so that you know, based on date of purchase, is this account, when you make that trade, are you going to be selling Alvin or are you going to be selling Theodore? That's what you want to find out. Well, I may think that way in my head. I would not explain that to the help people at Vanguard. I'm trying to sell Theodore. Really?

32:28You want to sell Alvin? You want to sell Alvin. Right. You totally want to sell Alvin because Alvin is the one that you will have held for the longest period of time. And therefore that's going to be most likely to be the long-term capital gain. Theodore is way more likely to be the short term. But using our lingo, June, find yourself on the Vanguard blacklist. People who they won't talk to. She gets a call from like wildlife rescue.

32:59PETA's on the phone. I will say this June is that all brokerage accounts have upsides and downsides. Vanguard is known for two things. The first one is they're incredible low pricing. And it's partly because of the way that that company is owned. When you're a shareholder, you actually own a piece of the company. The bad thing about that, though, Vanguard is also known for maybe, Paula, the clunkiest interface of all the major brokerage houses. And it's the thing that everybody bemoans. So if you don't have an account at Vanguard, just be ready. And I'm not saying don't have it at Vanguard. It is clearly something that you can use, you can navigate around, but it's also not the most user-friendly thing.

33:42But I think also you shop at Aldi, you have to pay for the shopping cart. I think there's an analogy there. Well, technically they give you the quarter back when you return the card at the end. I don't know about you. I always pay it forward at Aldi though. I always hand my card to the next person. Ah. Choon, you asked about two things. You asked about both short-term capital gains as well as wash sale rules. With the wash sale rule, you pretty much just don't want to buy the same thing within 30 days. So if you're planning on selling out of something and then buying back into it again, wait for 31 days.

34:18And that's on a tactical nature that we want to wait 31 days. My question is, when somebody's dealing with wash sale rules, what you're trying to do, I think far too often, Paula, is bet on something. You're betting something's going to go down. So you sell it. And then the thing either doesn't happen or it does happen, right? It goes down and you avoid the pain so that you go to buy it back. And then you end up with this wash sale. I'm just not a fan of that. The only time for me that from a strategic standpoint, wash sale rule actually comes into play is if it's the end of the year and you're walking through your portfolio, aka my analogy I'm about to use, your garden, right?

35:03And you're weeding your garden, meaning you're looking at some of these ETFs that you bought and they're headed down. So I want to make lemons for my lemonade. so what i do is i go and i sell those things and then after the beginning of the next year i go buy them back it's just so that i can create this taxable event now if i do that within 30 days i didn't do that because the wash sale rule applies and the government goes no you really didn't sell that you really still hold it so in that case i get it but in these other cases where I see wash sale rule apply. It drives me crazy. I actually know a professional that got caught up in this, Paula.

35:42They sold back early on in the pandemic. If you remember, the market took a sharp drop. And a lot of people thought, especially some pros, that this is the beginning of a doomsday scenario of a black swan. So it got to what ended up being the bottom and they sold. And I know a story of one young professional who will remain nameless because I don't want to shame anybody that realized that for their clients, they sold it. They had what was called discretion in the client's accounts, meaning they could do whatever they thought was right. And then if you remember that sharp drop at the beginning of the pandemic in March, the market literally came right back and realizing this wasn't the end of the world, they bought everything back.

36:32All they did was they locked in a loss. And because it was a wash sale, the client couldn't even take advantage of that loss and of costing their clients just tons and tons and tons of money. There's a story. See, John, you don't have a bad. That's bad. That's one I might ruminate over. Yeah. Especially doing that with somebody else's money. Professionally. Ooh. Yes. Not a professional move at all. A, panicking when you're telling your clients not to panic. You panicked. And then you don't understand the wash sale rule. Yeah. Pretty amateur across the board. Joe, have you seen people accidentally trigger the wash sale rule because they think that they're rebalancing, but they, in an attempt to rebalance, end up buying a security that, unbeknownst to them, is so similar to what they thought they were doing.

37:26buying, selling out of that they end up really just trading one's security for a different security. Yeah. They think that they're diversifying, not realizing that the two securities are so similar that it triggers the wash sale rule because they've just traded an apple for another apple rather than an apple for an orange. So I'm going to tell you first that I am not a tax advisor. I'm not an accountant. I don't even play one on TV, not a CPA. So get tax advice from people that are in that area. But what you're talking about, Paula, is I sell SPY, which is the S &P 500, and I buy IVV. Yeah, exactly.

38:08Which is the iShares version of the S &P 500. Yeah. I've seen people do that, and I have seen that not trigger the wash sale rule. And frankly, I think it should. And I think you probably think it should too. Yeah. But I've seen people do that. And I think it's because the IRS truly hasn't paid attention that much. And again, I am not your tax advisor. This is not tax advice. I even said out loud, I think it probably should, but I've seen people do it and it didn't. So yeah, I haven't seen it. I know exactly what you're talking about and I have not seen that happen. Wow. And maybe somebody else, maybe somebody in the afford anything community has seen it happen.

38:54I'd love to hear that story as well. Well, June, there are your answers. Don't try to time the market by selling in and out of the same security. If you are going to do so, wait for at least 31 days. And when you are annually rebalancing, wait for one year plus one day. Wait, and there's one more, Paula. Ooh. Try to sell Alvin. Alvin, exactly. Sell Alvin, hold Theodore. Elvin's like, damn it.

39:51more examples where something unexpected led to innovation that changed the world. In the 1940s, Percy Spencer was an engineer working at Raytheon. He was building magnetrons, which are high-powered vacuum tubes used in radar technology. And this one day, while he was standing near an active radar set, he noticed that the candy bar in his pocket had melted. So he was like, huh, wonder what else would happen if I brought some more food around here. So he just started bringing food around. He brought in popcorn kernels, which popped. He brought an egg, which exploded. After seeing all of this, he built a metal box that could contain and direct the microwaves, which allowed for controlled cooking.

40:35And he patented the idea in 1945 and two years later released the first commercial microwave oven. It cost$5 ,000, which adjusted for inflation is about$70 ,000 today. So he built a$70 ,000 microwave. But the whole discovery was an accident. He noticed something totally unexpected and then got curious about it. And I think it speaks to, this is a theme we've been talking about on the podcast, follow your curiosity. Okay, moving on. Velcro. So in 1941, a Swiss engineer named George de Mastro Trial, went on a hunting trip and he noticed that these burrs from burdock plants were stuck to his pants and stuck to his dog's fur.

41:23You know when you go out in the woods and get covered in burrs? Most of us just pick the burrs off and forget about it. Well, he decided to look at one under a microscope and what he saw was a series of really tiny hooks that latch onto any fiber that has loops like dog fur or fabric, pants fabric. And so he realized that he could replicate this mechanism and use it as a fastening system. So then he went to all these fabric manufacturers and they all told him it's not going to work. They're like, look, making loops is simple, but creating really tiny durable hooks that could hold securely but still separate when needed, that's going to be tough, right?

42:05So he tried for years and finally found a manufacturer in France that was working with nylon blended with cotton. And he was able to use this material to handcraft these microscopic little hooks and attach it to a separate piece of cloth that had loops. And so he patented it in 1955 and named it Velcro, which is a combination of the word velvet and the word crochet, which is French for hook. And so that, again, began as an accident, began sort of as an everyday annoyance that just sparked some curiosity. It sparked a peek under a microscope and a question of, hmm, how could this be useful? Third and final story of an accident are Toll House cookies.

42:54The funny thing about Toll House cookies is that they're widely believed to be accidental, but that might not be the full story. So the widely told version of the story is that in 1938, Ruth Wakefield, who was the owner of the Toll House Inn, was making cookies and she ran out of Baker's chocolate. And so supposedly she chopped up this Nestle semi-sweet chocolate bar and added it to the dough and she was expecting it to melt, but it didn't melt and the chocolate held its shape and that created the chocolate chip cookie. But her biographer, Carolyn Wyman, disputes this telling. She says that's not what actually happened.

43:29So Wakefield was a very experienced and very meticulous baker. And she wasn't, according to Wyman, she wasn't actually out of ingredients. She was intentionally experimenting to try to create a cookie with a different texture. And so she wanted pieces of chocolate embedded into the dough rather than uniform chocolate. So whichever version of the story that you believe, what ultimately happened was that she chopped up a semi-sweet chocolate bar that was gifted to her by Andrew Nestle. That turned into the Toll House cookie. The lesson is that often what looks like a mistake or what may be widely interpreted as a mistake is actually just a well-executed experiment.

44:19So, in keeping with the theme of happy little accidents, mistakes that turn into these unexpected wins, those are three stories with a bit of wisdom embedded in. All right, we're going to take a break, and when we return, we'll hear from Zerai, who's figuring out how to get small and mid-cap exposure in his 457 plan. Stay tuned.

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45:46We'll see you next time.

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46:25our final question today comes from zarai hey paulo and joe this is zarai from seattle thank you very much for all you do and i've been listening to your podcast for i think three four years and i found you through paul merriman's website and uh i have been a very referring people to your podcast and appreciating your teaching and analysis of different questions. So I have a question for you here today. My question is I have a 457 with my job, and we have limited mutual funds. And I am currently at 65 % S &P and 35 % international, but they have two mid-cap funds that they have on there that is available to us.

47:06And I was not sure which ones would be better. So the first one is the Fidelity Extended Market Index Fund, F-S-M-A-X and the other one is the Wellington CIF2S MidCap Research Fund, which you can't really find a lot of information on the Wellington one, but the fee is a little bit higher for that versus the Fidelity Extended Market Index Fund. And I was just trying to add the mid-cap or small cap to my portfolio and I wanted to know to get your feedback on which one would be a better product. And any help you can provide, it would be greatly appreciated. And this is a ride from Seattle. Joe, I met you on the Stacking Benjamins meetup in Bellevue and appreciate all your assistance and looking forward to your answers.

47:51We had so much fun, Paula. I shared a few beers with Zerai and great to hear your voice again, my friend. Oh, that sounds like a lot of fun. It was a dangerous place we held our meetup at. It was a place called Tapster, Paula, in downtown Bellevue, right across the lake from Seattle. It was pour your own beer. Oh, that sounds great. I know. I have to trust my own ability to say no, which I have to say is not as strong when my hotel is Kitty Corner from Tapster was not that strong. Yeah. This from the guy who literally took his arm and grabbed everything in the mini fridge, everything from that, put it all in his suitcase.

48:36It turned out those beers weren't for either. Who knew? Actually, I did know that time. But Zerai has an interesting question here, Paula, on a couple different fronts. So I, Zerai, then went and looked up these two funds. The number one place that I believe, Paula, you go to first is the same place I go to, Morningstar.com, when I'm looking up any 401k, 403b, 457 funds. Zerai, you're right on. The Fidelity Extended Market Index Fund is in Morningstar. your Wellington CIP2 fund is not. I was able to find it. It turns out, Paula, that fund, not surprising to me, is actually a fund that Wellington has made for annuities.

49:21And a lot of small to medium-sized companies, 401k, 403b, 457 plans are annuity-based. Also, a lot of the time when a company, if it is a hospital or a municipality, they don't have a big budget to run those things. So unfortunately, they pass the cost on to the participants. So these annuity companies will run the fund for a very low cost for the provider and instead pass the fees on. So I will confirm that, yes, Zerai, the Wellington Fund's fee structure is more expensive just by the type of beast that it is. It's not a true mutual fund. It's what's called a separate account. Another thing I don't like about the Paula is because it's not a Morningstar, I can't track it.

50:15And you and I know you don't want to track your stuff all the time, but I want to have the freedom to, whenever I want, be able to find up-to-the-minute data. And there's so many funds out there like the Fidelity Extended Market that do that, that I don't want to choose a fund if I've got two choices that doesn't. So for that reason, I like the Fidelity Extended Market. But I'm going to question this even more, Paula, which is, so Zerai right now has large companies and has international stocks, 70-30. If I am broadening that out, what I would push back on is why am I going mid-cap next? Why am I going mid-sized company?

50:57Because when I think about the points of diversification, mid-size squeezes up next to large cap. And in fact, it's funny when you look at a lot of data, mid-cap and small-cap, while the companies don't overlap, how they react in similar markets tend to overlap much more than small and large would. If I'm doing a third point on my triangle, I think I'd think long and hard about small-cap versus mid-cap. Yeah, most of Paul Merriman's research really points to the value in having a mix of large cap blend and small cap value. Yeah, those two really work well together over long periods of time. Yeah.

51:44I question that. But looking at the Fidelity Extended Market Index, Paula, do we want to take a second? Yeah. Dive into Morningstar on this? Yeah, absolutely. Yeah. Let's see it for people watching on YouTube if I can share my screen. Ooh. And even for people listening, I'll try to make sure that this is interactive. Now, when I go to this fund on Morningstar, the first thing people look at, Paula, is the fact that this is a three-star fund. On a scale of one to five, it's a three-star fund. This is what everybody looks at first, but I'm not going to evaluate that yet. Having a growth mentality means not how am I right, but what don't I know?

52:20I want to know why this is a three-star fund. Why does Morningstar call this three stars on a scale of one to five? That gives me kind of a research goal of why it's there. So the first thing Zerai talked about was the expense ratio. And that's right on the front page. Take a look at this, Paula. 0.03%. Very, very, very low cost fund. So that makes me happy. Again, not the first thing that I look at, but definitely, definitely there. Now, what's funny is the category is mid-cap blend, but look at the investment style. The investment style says small blend. Well, that's really interesting. So I'm going to come back to that.

53:04But the next thing is I go through the tabs. There's tabs across the top of each Morningstar page for the fun that you're looking at. And as I go across these tabs, the tab that I click on first is performance. And this shows me over long periods of time, over a 10-year period specifically, how this fund compared with other investments in its class and how it compared versus the index. And the index for people watching is in red. The category is in yellow. This fund is in blue. So you'll find that the index outperformed everything over 10 years. This fund finished second. The average fund in its category finished behind it.

53:45I also look at then quartile rank. Quartile rank is how did this fund perform versus its competitors? So we'll see in 2015, it was in the second quartile. So top 50%, top 50%, top 50, top 50, top 50, top 25, top 75%. So not a great year in 2021. 2022, top 50, then top 25, top 25. So far this year, it's in the bottom. Well, that's interesting because what it shows me as I look at the chart, we'll notice that from 2019 until through 2020, it really did really, really well. But then it did much worse. So it actually outperformed the index. And then it did much worse than the index in 2021. And then it's kind of come back during these good years in 2023 and 2024.

54:40but it still trails the index. So what that kind of tells me is I'm expecting this. It's almost like I'm a wine connoisseur looking at wines by smelling it, looking at the color. I'm expecting the taste of this investment to be taking more risk than the investments in its category take. And I also see that when it said small blends. So next I'm going to go over to risk. So I'm going back up to the tabs and I tab over to risk. And when I look at risk, I'm going to look first at this chart. It looks very much like the charts that we look at when we look at the Efficient Frontier, right? We've got total return on the left.

55:20We've got standard deviation, aka risk on the right. And look at what's interesting. The red dot, Paula, is the index and blue is this particular fund. Very similar returns over a three-year period. And I can click up here at the top, I can click on five years. Very similar returns over five. Very similar returns over 10, but look at where it is risk-wise. So, Zerai, what this leads me to is this. I would think about small companies first, but what's funny is this takes so much more risk like a small company fund does that this fund is closer to being on the small company meets mid-company line than mid-company meets large company line.

56:13So if you don't have a small company fund available, this might be a decent substitute because it's going to have more of those characteristics than it will the large company fund. But it's also, if you're looking for a mid-company fund, this is going to bounce around more, which is why, Paula, I believe they named this three stars. If you're looking for a mid-company fund, five-star is going to be low cost and act like a mid-company fund. This is going to be low cost and act like a fund that's a small company fund. Mm-hmm. So that volatility is the reason that it's three stars. Yeah, 100%. Because you can get there.

56:50If you're looking for a midsize company fund, what this shows is, heck, let's not take the volatility of this fund. Let's buy the mid-cap index, which is going to be a lot less volatile. Well, you make a great case for the fund. Just the fact that I can do that research, just the fact that I could look at that versus the Wellington fund, my choice of the two. Beautiful. Well, thank you, Joe. And I guess, are we supposed to give a disclaimer here of this is not investment advice? It's purely educational? Well, it's 100 % educational. But you can see, and my goal is just education to show you what my funnel is.

57:22When I look at it, what I look at and how I look at it. And notice, by the way, fee people, how little the fees were a part of my analysis. I just want to pour a little more salt in that. Attention to fees is necessary but not sufficient. It is. And there are many more things that we should be also considering. It's on the list, but it's not nearly as high on the list as a lot of people that I roll over make it. Right. Well, thank you, Zerai, for the question. And thank you, Joe, for that walkthrough. That was incredible. Joe, where can people find you if they would like to hear more of you? You will find me and the Paula Pant among other amazing characters at the Stacky Benjamin show every Monday, Wednesday, Friday.

58:11If you want to watch us and how we make the show live and watch Paula as she says amazing things for most of the episode and then crashes and burns on our trivia question. Yep. You can also find us live every week. If you just subscribe to the channel and hit the button, it'll notify you when we're going live. Usually it's Wednesday afternoons, but you can watch us make the show, which is also pretty fun. Yeah, I constantly come in last place in that trivia contest. It actually defies a statistical probability. Totally does. Right? Because, I mean, if we were randomly guessing, I would get it right one third of the time.

58:51But no, I consistently get it wrong three out of three times. It is incredible how consistent you are. Yeah, there is no reversion to the mean. None. Someday, Paula. We can all dream. Well, thanks to all of you for tuning in. If you enjoyed today's episode, please share it with your friends, your family, your co-workers, your neighbors. Share it with the people in your life. Also, subscribe to our newsletter at affordanything.com slash newsletter. And if you want to talk to the community about how to make melons out of melanade, you can do so at affordanything.com slash community. Thanks again for being an Afforder.

59:35This is the Afford Anything Podcast. I'm Paula Pantz. I'm Joe Salcihai. And we'll meet you in the next episode.