A:   An Employee Stock Purchase Plan (ESPP) is a company-sponsored employee benefit which allows participants to purchase company stock through payroll deferral.  Most ESPPs allow participants to buy shares at a discount from the market price.  The discount is generally applied to the lower of the beginning price or ending price during a designated offering period (a time-frame usually ranging from three to six months, depending on the plan).  This means at the time of purchase, ESPP shares’ built-in profit may be even greater than the stated discount, as participants benefit if the stock price appreciates during the offering period. 

The discount varies from plan to plan, but can be as much as 15%.  Opportunities to earn an immediate return on investment don’t come along very often.  Consequently, we generally recommend anyone who is eligible to participate should consider doing so.

Here are some details to consider: 

Tax Considerations

Although contributions to an ESPP are made through payroll deferral, they are not tax-advantaged like 401(k) plan deferrals.  There is no tax-deduction for contributions to an ESPP.  Furthermore, the discount on stock purchases is considered compensation for tax purposes.  Taxable income is not recognized, however, until the shares are disposed of through a sale or gift to another party.  When shares are sold, this “disposition” of shares is characterized as either “qualified” or “disqualified” depending on how long the shares were held.  Whether a disposition is qualified or disqualified dictates how much of the sale proceeds are considered ordinary income versus capital gain/loss.

Qualified Dispositions

The sale or gift of ESPP shares is considered “qualifying,” if both of the following criteria are met: 

1. The shares must be held for at least twelve months from the date of purchase.
2. The shares must also be held for at least twenty-four months from the grant date (generally defined as the first day of the offering period).

If the disposition is deemed “qualifying,” compensation income is the lesser of two numbers:

1. The difference between the market price and the discount price calculated on the grant date (not necessarily the actual purchase price).
2. The difference between the sales price (or market price when gifted) and the purchase price.

Disqualifying Dispositions

The sale or gift of ESPP shares is considered “disqualifying,” if both the criteria above are not met.  If the disposition is deemed “disqualifying,” compensation income is the difference between the market price on the date of purchase and the actual purchase price.

Capital Gain or Loss

In both qualifying and disqualifying dispositions of ESPP stock, cost basis is calculated by adding the compensation income to the actual purchase.  The difference between the sales price and the cost basis is either a gain or loss.  The gain or loss is considered short-term if the shares were held less than twelve months from the time of purchase and long-term if held longer than twelve months. 

Quirky Transactions

A disqualifying disposition of ESPP shares that have declined sharply since purchase can result in paying taxes on “phantom income.”  Remember, the compensation income in a disqualifying disposition is the difference between what was paid and how much the shares were worth at the time of purchase.  That is true even when a subsequent decline erases that initial profit.  Under this scenario, with only up to $3,000 of capital loss allowed to offset income—an ESPP participant might end up paying taxes on income that no longer exists.  A qualifying disposition in this same scenario results in no compensation income. 

Finally, in an instance in which the share price declines during the offering period, but then appreciates prior to when the ESPP shares are finally sold, a disqualifying disposition can actually result in less tax than a qualifying one. 

Obviously, it pays to be aware of the implications of ESPP dispositions across different holding period and stock price scenarios.

A:  We are reluctant to advise anyone to change their investment portfolio based on the opinion of one expert or at the urging of the media.  Portfolio changes should be made in response to changes in one’s personal situation, not in response to the market or expert sentiment. Interestingly, despite being the only asset class to keep its head above water during the Global Financial Crisis, Treasury bonds are now the proverbial punching bag of the investment community. Concern over whether these safe instruments, too, will lose value as inflation rears its head and/or the dollar depreciates is widespread.  We should state clearly that short-term return is not the reason we favor Treasury bonds.  If all we wanted out of an investment was more return, we’d forgo Treasury bonds entirely and invest only in riskier asset classes (like stocks).  Bonds are a prudent choice simply because they provide safety and capital preservation in the worst of times; no bond provides that protection better than U.S. Treasuries.

A:  There is no denying the rapid ascent in the price of gold over the past few years.

We do not, however, view gold as an investment. Gold does not provide the inherent return stream (like interest income and/or cash flow) which makes core asset classes such as stocks, bonds and real estate attractive for long-term investment.  Returns from gold, rather, are speculative:  they come from the difference in the purchase price and what someone is willing to pay today.  That’s not to say we don’t benefit from increases in the price of gold.  After all, a diversified index fund portfolio holds virtually every publicly-traded company that mines or processes the yellow metal.

A:  A common misconception is that indexing only works in less efficient markets—those in which there are fewer participants and in which information is harder to come by.  In asset classes such as small cap stocks and international stocks, the argument goes, there is more opportunity for active management to add value.  A review of actual results in these markets, however, suggests otherwise:  For the 15 years ended 12/31/2009, roughly 85% of actively-managed small cap mutual funds underperformed their benchmark.   Internationally, 56% of developed-market funds underperformed, while 64% of emerging market funds failed to meet the benchmark return.^[i]

These results should come as no surprise, really, when one considers the simple arithmetic of active management.  In a world without costs—management fees, trading costs, and the impact of taxes—one would expect, by simple chance, for half of active investors to outperform while the other half underperform.  Index investors earn the average.  For active managers to outperform, they must do so at the expense of other active investors.  On average, therefore, they must earn the same return as index investors.  But, this is before costs.  After costs (higher management fees, trading costs, etc.), we would expect the majority of active investors to underperform—regardless of the market’s perceived “efficiency.”

ⁱ Phillips, Christopher. “Debunking some misconceptions about indexing.” Vanguard Research Note, December 2010.

A:  Properly-selected private equity investments have the potential to generate high returns relative to publicly-traded stocks, but offer little in the way of added diversification to a traditional stock and bond portfolio.  A discussion of investing in private equity, therefore, quickly becomes all about portfolio returns.  It should be noted not all private equity investments deliver high returns.  Historically, the average private equity manager has delivered returns only on par with, or even below, those of returns from a traditional stock mutual fund.  Bottom-quartile managers often perform far worse than the poorest-performing mutual funds.   As a result, manager selection is crucial.  Finding the right manager is but one of many risks of private equity investing: illiquidity, use of leverage, and higher management fees are others.  As a result, private equity investing is not appropriate for many investors.  For more about our access to private equity, see our full-length article, “The Role of Private Equity.”

A:  We always get a laugh out of that joke.  The point of it, of course, is that the index investor is such a fervent believer in efficient markets that he cannot possibly entertain the idea that such easy-pickings actually exist.  Our stock-picking colleagues probably like the joke even more, as it suggests active managers routinely spot such opportunities, thus “winning” at the expense of disbelieving index investors.

Ignoring the legitimate question of whether the $20 bill was found due to luck or skill, the simplest response is actually another question:  Is it a worthwhile economic pursuit to comb the streets looking for $20 bills?

A:  These stories likely place too much emphasis on short-term predictions and serve only as a distraction from what is really important.  It is hard to argue against rates going up eventually; they are at or near historic lows currently.  If and when rates do go up, the prices of existing bonds will go down, hurting short-term performance.  For investors who reinvest income and replace bonds as they mature—or for those who own bond funds which do the same—higher interest rates are actually good news.  Higher rates mean new bonds added to a portfolio or fund will provide higher yields.  Over time, the effect of compounding income—earning interest on interest—at increasingly higher yields should more than compensate for the initial price decline.

A:  It is a common misconception that skilled active investors can anticipate bear markets, and take precautionary actions to prevent losses in a market downturn.  Despite the chatter about active investors’ ability to pick superior stocks in a bear market (e.g., favoring larger, defensive companies in a recession), hold more cash, time the market (buy on dips, sell on tops) or sell stocks short (to profit from price declines) active managers, collectively, have not demonstrated an ability to beat index investors during these periods of market stress.

In 2001, analysts at Schwab’s Center for Investment Research compared the performance record of 120 index funds and 2,100 actively-managed mutual funds.^[i] After analyzing these funds’ performance during market declines occurring between December 1986 and March 2001, the researchers concluded:

• Index funds outperformed actively managed funds in 55% of the down markets.
• In the worst downturns, defined as declines of 10% or more, index funds outperformed actively managed funds 75% of the time.
• In the longest downturns, defined as declines of 5 consecutive months or longer, index funds outperformed actively managed funds 100% of the time.

In the recent Global Financial Crisis, results were similar.  According to mutual fund database Morningstar, the Dow Jones U.S. Total Stock Market Index beat more than 60% of actively-managed U.S. stock funds from November 2007 through December 2008.

The implication of this data is clear:  Index funds minimize the risk of having an actively-managed fund turn a bad year into a horrible one.   While it might sound logical and alluring to employ an active manager to “do something” in the face of uncertain markets, the evidence resoundingly supports the efficacy of an index fund approach.

ⁱ Schwab Center for Investment Research. “Index or Actively Managed Equity Mutual Funds: Which Way to Go In A Down Market,” July 2001.