Brandon Renfro, Ph.D.

Retirement - Finance - Investing

Month: November 2016 (page 1 of 2)

Traditional or Roth IRA?

So, you have decided to invest. Great. Presumably, you are investing for a purpose. Even better. If that purpose is for retirement you may have even spent time thinking about whether a Roth IRA or Traditional IRA is best.

For 2017, Roth and Traditional IRA contribution limits both remain at $5,500. The key difference in investing through a Roth IRA or Traditional IRA is the taxation of contributions and deductions.

Contributions to a Traditional IRA are deductible whereas Roth IRA contributions are not. As an example, if you contribute the maximum $5,500 in a Traditional IRA you can deduct that amount from your taxable income. If you are in the 25% federal income tax bracket, that means you would lower your tax bill by $1,375. If that same $5,500 is contributed to a Roth IRA, you still pay income taxes on it.

That may seem like a win for the Traditional IRA but there is a difference on the back end when withdrawals are made that for many, especially younger, investors will far overshadow any upfront tax implications.

That advantage lies with the Roth IRA. Withdrawals from Roth IRA’s are not taxed. Since the money was taxed before it went in, it stands to reason that it should not also be taxed when it is taken out. Of course, this situation is reversed for a traditional IRA. Since the money was not taxed when it went in, it stands to reason that it should be taxed when withdrawn.

Tax Impact

So, what? Each dollar is taxed at some point, right? Why does it matter?

Let’s look at an example I have used previously of an investor that is starting when they are 25 and retiring at 65 and compare the differences that would exist between using a Roth or Traditional IRA.

If one were to put $5,500 per year into a Traditional IRA for 40 years they would save $55,000 (40 x $1,375) in taxes if we continue to assume a 25% marginal bracket. This person would have total investments of $1,424,810.85 if we use 8% as an estimated rate of return. Remember though, this final amount is now taxable when withdrawn.

Of course, it won’t all be withdrawn at the same time. A common measure for determining the amount of money that can be withdrawn from a retirement account in each year is the 4% rule. Essentially, you look at the balance of the account and take 4%. In this case, it would be approximately $57,000.

Given the progressive nature of federal income taxes the average tax rate on each dollar withdrawn will be something less than the marginal rate. There are many things that would affect taxation of the withdrawal. I am not a tax professional nor do I want to divert from the main point of this post, so I’ll simply tell you that I am assuming an average tax rate of 12%.

Roth or Traditional?

$57,000 taxed at an average rate of 12% would leave $50,160 in spendable income.

Now, compare that to the Roth IRA. The same numbers apply giving us a withdrawal amount of $57,000. The big difference here is that the full amount is not taxed. That gives the investor an additional $6,840 (the same 12% that would have otherwise gone to taxes) per year in expendable retirement income.

Do You Research a Company’s Culture Before You Invest?

As you move into your thirties or hit your stride in your career, you likely have student loan debt, and maybe you are thinking about saving for a home. Somewhere along the way, you might also decide to create a family. In the midst of all these decisions, there’s the notion that you will put away money for retirement. That could be decades in the future, but it’s still an important financial goal.

While your employer likely offers investments in various mutual funds through a 401(k), you might decide you want more control over your retirement savings. You may have decided to pursue ethical investing because you feel that there are many things wrong with the business world today. This view is increasingly popular among younger investors from Generations X and Y, namely, millennials. The question becomes: “Do you care about a company’s culture and ethics as a condition of investing in it?”

A recent article from the Deloitte University Press by Kaplan et al noted that: “Culture can determine success or failure during times of change: Mergers, acquisitions, growth, and product cycles can either succeed or fail depending on the alignment of the culture with the business’s direction.” You want your retirement savings invested in companies that will succeed even in times of change. That’s just the world that we live in.

When you think about ethical and socially responsible investing, you are making a personal commitment to learn more about companies in order to determine that the corporate objectives align with your own set of values. You can use the Internet to find facts about a company’s general reputation, especially looking for criticisms of its culture. In the ideal scenario, your search would reveal a company’s triumphs because it has an ethical culture; it is well-recognized in its industry for maintaining socially-responsible operations.

You certainly want to invest responsibly with your own hard-earned money. But, it may mean more to you than that. Follow through with your investigation of each potential company or search for information on mutual funds that only invest in companies that align to your culture and values. There are a lot of investment options out there that actively screen for ethical, social, or environmental concerns. As the popularity of socially responsible, values-based, green, and sustainable investment grows, so will the number of mutual funds and ETF’s that cater to this market.

Market Efficiency

One of the most popular and controversial topics in the entire field of finance is the efficient market hypothesis. This topic fascinates me, and is central to my investment philosophy. The following excerpt from my dissertation gives a brief overview of the hypothesis.

The belief in market efficiency has dominated mainstream academic finance since Eugene Fama, Professor of Finance at Chicago, published his article Efficient Capital Markets: A Review of Theory and Empirical Work in the Journal of Finance in 1970. This was certainly not the first time the idea of market efficiency had been presented (Regnault, 1863; Bachelier, 1900; Cowles, 1933;Mandelbrot, 1963; Samuelson, 1965; Fama, Fisher, Jensen, & Roll, 1969) but at this point the idea that markets are rational became the mainstream view.

The efficient market hypothesis postulates that information regarding the value of securities is quickly and completely imputed into the value of assets, and that investors impute this value in a rational manner. In other words, prices “fully reflect all available information.”(Fama, 1991).

The theory provides for three degrees of market efficiency, dubbed “forms” of the efficient market hypothesis; weak-form, semi-strong form, and strong-form (Fama, 1970).

In a weak-form efficient market, past price movements are the only information about a security on which an investor cannot make an abnormal profit by trading. All other information concerning a securities value can be used to gain an advantage. This is said to be weak efficiency because of the vast amount of information that is not completely imputed into security value (Fama, 1970).

In the semi-strong form, the efficient market hypothesis states that all publicly available information is already incorporated into a securities price, and therefore, cannot be acted upon in order to gain an abnormal profit. This means that only private information, not disclosed to the public, may be used to gain an advantage because it has not been incorporated into a securities value. If an individual has information concerning the value of a security that is private, they may trade securities on this information and gain a profit from their informational advantage. Of course, this is expressly prohibited as “insider trading” (Fama, 1970).

A strong-form efficient market is a market in which all information, to include inside information, is anticipated by the market and incorporated into security prices. This leaves no room for gaining an informational advantage, and no trading strategy that relies on such information can be expected to gain an advantage over the market (Fama, 1970).

In order for markets to be efficient, they must also be rational. There are two possibilities for achieving market rationality. The first is that each individual agent within the market behaves rationally and makes each decision in a rational manner. The second possibility for achieving market rationality involves a market with some individually irrational agents, with two distinct characteristics. The first is that the irrational decisions made by these agents are sufficiently random as to be offsetting and bring the market to rest on a rational equilibrium. This underlies what is referred to as the “Random Walk” in finance literature (Working, 1934; Cowles & Jones, 1937; Mandelbrot, 1963; Fama, 1965). The second characteristic of a rational market containing irrational agents is that the rational agents, seeking to maximize their own utility, will take actions that counteract the irrational agents and thus bring the market to a rational equilibrium in a process known as arbitrage (Friedman, 1953; Shleifer, 2000).

There has been significant interest and research regarding the efficiency of markets (Ang, Goetzmann, & Schaefer, 2011). This study I conducted is related to that body of research and carries implications for the rationality of investors and, by extension, the market.

There is a lot more to talk about, and I’m sure I’ll get to it in future posts. One of my favorite books is The Myth of the Rational Market by Justin Fox. I have owned this book since shortly after it was published and I read it again every few years. I think he does a great job of laying out the development of the theory from a historical perspective. Its a comfortable read, but very informative.




Ang, A., Goetzmann, W., & Schaefer, S. (2011). Review of the Efficient Market Theory and Evidence: Implications for Active Investment Management. Hanover, MA: Now Publishers.

Bachelier, L. (1900). Theorie de la Speculation. Annales Scientifiques de l’Ecole Normale Superieure Ser. 3(17), 21-86.

Cowles, A. (1933). Can Stock Market Forecasters Forecast? Econometrica, 1, 309-324.

Cowles, A., & Jones, H. (1937). Some A Posteriori probabilities in Stock Market Action. Econometrica, 5, 280-294.

Fama, E. (1991). Efficient Capital Markets: II. Journal of Finance, 46(5), 1575-1617.

Fama, E. (1965). Random walks in stock market prices, Financial Analysts Journal 21, 55-59.

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of  Finance 25, 383-417.

Fama, E., Fisher, L., Jenson, M., & Roll, R. (1969). The adjustment of stock prices to new information. International Economic Review, 10(1), 1-21.

Friedman, M. (1953). The case for flexible exchange rates. Essays in positive economics. Chicago, IL: University of Chicago Press.

Mandelbrot, B. (1963). The Variation of Certain Speculative Prices. Journal of Business, 36, 394-419.

Regnault, J. (1863). Calcul des Chances et Philosophie de la Bourse. Paris: Mallet Bachelier and Castel.

Samuelson, P. A. (1965). Proof that Properly Anticipated Prices Fluctuate Randomly. Industrial Management Review, 6, 41-49.

Shleiffer, A. (2000). Inefficient Markets: An Introduction to Behavioral Finance. Oxford: Oxford        University Press.

Working, H., (1934). A random-difference series for use in the analysis of time series. Journal of the American Statistical Association, 2(185), 11-24

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