An Aggressive Intermediate Term Savings Strategy (Analysis on Balanced Funds)

140px-Assorted_United_States_coinsIn honor of the upcoming Tax Day, I'm going to gripe. The tax code is unfair and broken. (There, I did it. I don't feel any better.) While there are volumes of reasons to complain (literally), I'm going to focus in on a specific aspect: savings

A case in point of the unfairness is savings (plain old, non-retirement accounts). The tax code is structured so there is a huge disincentive to save money, particularly for the short term or intermediate term. 

You might be trying to save money for an emergency fund, save for a big purchase item such as a car or house, save for a big event such as a wedding, or just trying to plan for the future. But if you try saving for these types of things and your time span is less than the long term (say less than 5 years), the tax code works against you.

For a short/intermediate time span, you probably don't want to sink all your money in stocks or real estate. Both are volatile and if there is a crash, it could take 5 years (or more) just to recover as we saw with the S&P 500 in the dot-com crash and other historical crashes.

For a short/intermediate time span, you want something a little more conservative. For short, in particular, you probably don't want to lose any money at all. The obvious vehicles for this are savings accounts, money markets, and certificates of deposits (CDs). But this is where the unfairness of the tax code penalizes those who are trying to be responsible. All of these savings vehicles are taxed on the interest you earn.

Why is this a problem? There are several factors. 

1) The interest you earn on conservative savings vehicles is not very high to begin with. Less risk is going to earn less money.

2) Inflation. Your money just sitting around loses value over time. Simply put, remember when you could buy a gallon of gas for $2? Imagine if you put that $2 under a mattress all those number of years ago. Now go fetch that $2 and see how much gas you can buy today with that $2. 

3) Earned interest is taxed every year. To make matters worse, inflation is not accounted for when you are taxed by the government. And as a final insult, interest is taxed at your income tax bracket. This tax rate is higher than if sold a stock you held for over a year (long term capital gains).

An example of how inflation and taxes cause responsible savers to lose money

So let's put these three things together and see what happens. Imagine you decided to put $100 into a savings account one year ago. Let's assume you actually got a pretty good interest rate for your savings account of 5% per year. So after one year, your initial $100 turns into $105.

So far, so good, but now we need to account for inflation. Let's assume inflation was 4% for the year. That means that you need $104 dollars today to be equivalent to $100 a year ago. So the $5 profit in interest you were looking at is really only $5-$4=$1 profit.

Well, $1 profit is still something. Well, not so fast. The government wants to eat your money too. But they are not taxing just the $1 profit, they are taxing the entire $5 of interest you made. So let's assume you are middle class and in the 25% federal tax bracket. So 25% of $5 is $1.25. This $1.25 goes to the IRS. This means: $105-$4-$1.25=$99.75. You are now in the hole by $0.25. But the fun doesn't stop there. Don't forget state and local taxes too. For California, let's use the 9.30% state income tax rate. So that is another $0.46 in taxes, yielding a final total of $99.29 which is even deeper in the hole. (Note: I'm ignoring possible deductions of state taxes on federal for simplicity and because deductions are not always available depending on your situation.) 

And this is done to you on a yearly basis. If you compare to a capital gain on a stock you hold for several years and then sell, the stock comes out way ahead because you only get taxed once when you sell (and at a lower long term capital gains rate) whereas the yearly repeated taxation snowballs against you. This is compounding working against you instead of for you.

Your Savings Account Before Taxes

(5% interest)

Amount of Money Needed to Break-Even from 4% inflation

Amount taken by Federal Taxes (25%)

Amount taken by State/Local Taxes (9.3%)

Amount Left After Taxes

Effective Loss

Year 0



Year 1







Year 2







Year 3







Notice by year 3 in this scenario, the amount you have before taxes is overtaken by inflation.

So basically put, there is no incentive to save money particularly for the short term. In a sick way, you are encouraged to spend it immediately. Even saving for the long term is kind of murky because stocks and mutual funds sometimes pay dividends and if they are taxed on a yearly basis, not to mention the higher risk involved. Particularly for mutual funds, you need to be aware of a fund's tax efficiency which isn't something that can always be accurately predicted. (It doesn't help either than Congress keeps changing the rules.)

Putting a strategy together: A quick look at some investment vehicles, their risk, and tax implications

Even though I said I was going to gripe at the beginning, my actual purpose was to talk about strategies and solutions. This is not meant to be a political blog so I'm not going to talk about changing policy or voting a specific way. Instead, I want to focus on real strategies that can be used today.

So after watching inflation and taxes eat away at my short and intermediate term, non-tax-sheltered savings for some number of years, I've been trying to get creative about how to save without losing as much. Honestly, I still don't have a good answer, but this is what I've come up with. There is no magic in this. Basically, my solution just puts more risk into the equation which really isn't special or interesting at all. The only trick I have is that I try to use long term capital gains and qualified dividends to my advantage.

For those who don't know, a qualified dividend is a relatively new type of dividend introduced in 2003 that is taxed like a long term capital gains instead of as income. This means the tax rate is lower for qualified dividends compared to regular dividends. To be 'qualified', there are a bunch of rules, but it generally means the company is a U.S. company and you've held the stock for a certain amount of time. Ignoring the fact that dividends are still essentially taxed twice (once on the company, and once on you), qualified dividends are pretty nice all things considered, but sadly, the law that introduced these is set to expire in 2010 unless Congress does something to extend them.

But before I get into that, I should mention I first considered bonds and bond funds. I'm not good at dealing with individual bonds, so I do prefer mutual funds. Bonds can pay higher interest rates, but that reflects the higher risk. And bond funds in particular can lose value. But at the time I started looking at this, bond yields were not so great at the level of risk I was looking at to escape the inflation and tax drag. (In fact, cash was doing better.) Only high yield bonds seemed to be paying enough interest to really offset the inflation and tax drag, but even these weren't paying enough in my opinion compared to the risk. And since then, with the recent housing market crisis, many of these funds have crashed. I theorize that there was too much money in the market at the time so people were taking more risk for less money (and weren't thinking things could crash).

So bonds and bond funds by themselves were not sufficient in my opinion. So this is when I started thinking about long term capital gains and qualified dividends. These are generally associate with stocks though, so the risk is much higher than a savings account. So the real trick is to find something that contains stocks, but has an acceptable level of risk.

The ideal case is just to find a conservative stock that will probably not lose much value and will earn something comparable to a savings account or better. This ideal stock would not pay dividends so you won't get taxed every year. Slightly less ideal is that dividends are paid, but they are at least qualified. If you could get a risk/return similar to a bond, then at least you are paying less in taxes and you are ahead of interest based earning. The problem is I don't know of anything like this. (Please leave feedback if you do.)

Mutual funds can help reduce risk by introducing some diversification. Multiple stocks may help soften the blow if one stock falls dramatically (assuming they don't all fall in unison). So mutual funds get my focus and I started looking for mutual funds that contain stocks that try to not lose value. Unfortunately, I couldn't find any with this focus. The closest thing seemed to value oriented funds, particularly in the large cap arena. But looking at historical numbers, these were also quite capable of losing 40% in a crash and take awhile to recover which is too risky for me. There do seem to be some mutual funds that focus on dividend payouts. While I rather have a fund that tries to minimize distributions and not make many capital gains, I would settle for dividends if the risk level met my needs. These seem to be a subset of the large-cap-value funds. Of the few funds like this I found, the risk seemed slightly reduced, but not by a lot, but most of these funds were fairly new and didn't have a long history.

Balanced Funds the solution?

So I was unable to find the perfect mutual fund. However, I did notice that 'balanced' mutual funds seemed to have the risk profile I was looking for. Balance funds are typically a combination of stocks and bonds. Typically they seem to be 50%-70% equities, and the remaining is held in bonds, cash or other non-equities. While the bond/cash aspect is not ideal for taxes, if at least some of the distributions made are qualified dividends and long term capital gains, it still might be an improvement. 

So I started researching balanced funds. My favorites are:

Vanguard Wellington (VWELX)

T. Rowe Price Capital Appreciation (PRWCX)

Dodge & Cox Balanced (DODBX)

Oakmark Equity & Income (OAKBX)

All of these funds have returns that look more like equities than bonds and their maximum historic loss never has exceeded 10%. For me, 10% loss (compared to 40% loss) is within my risk tolerance for intermediate term savings given the potential upside.

I usually like to look at index funds as well as they often are competitive if not superior due to their low costs. But in this category, I found that the managed funds to be generally superior. I speculate this is due to the fact that managed balanced funds can shift money towards or away from equities while an index may not. Compared to the minutia of picking individual stocks, it may be easier for managers to correctly recognize overall trends of when equities are in fashion or are not.

Quick-take on 4 Balanced Funds

Vanguard Wellington has been around since the early 20th century. Of note, John Bogle used to work at Wellington until he founded Vanguard which acquired Wellington. It is a proven fund with a consistent track record. Vanguard is well known for bringing indexing into fashion and offering no-load, low-expense funds with responsible management. Of this group, this fund has the lowest expense ratio.

Dodge & Cox is another old, well-respected firm for managing funds well with low expenses. Considering how long they have been around, they only have four mutual funds. They have a stellar reputation for shareholder interest. This fund seems to have struggled recently, but this fund has a good long term record.

Oakmark is a company I know very little about, but seems to be popular with investors. In recent years, their Equity & Income fund has done very well and with comparatively good tax efficiency. Of the four funds, this one has the highest expense ratio and is the youngest of the group (meaning shortest history).

T. Rowe Price has been on the rise in recent years. Some have compared them to Vanguard as the low-cost shop for managed funds. Capital Appreciation is the fund I found the most information on (maybe because the management just changed recently so they are putting information out there to keep people calm). But Capital Appreciation is very interesting because it is currently the only equity based fund to not have lost money at the close of a calendar year for 17 straight years. It's last lost was in 1990 with a loss of -1.25%. And this seems to be the only calendar loss since the fund's inception in 1986. In the crash of 2002, they squeaked by with a positive 0.5% (compared to the S&P 500 loss of 22%). 

Granted that the not losing money at the end of a calendar year is an accident of timing, but it's still pretty darn amazing. Their track record of minimizing losses is also very impressive. But the really amazing thing is over the past 17 years, I think they have outperformed the S&P 500 overall by being a steady-eddie. Their motto seems to be "equity-like returns without equity-like risk".

I should mention one other fund: Fairholme (FAIRX). I'm not sure what this fund is. It performs much like a balanced fund with minimal losses, but it seems to hold 80% equity and 20% cash which seems less balanced than the other 'balanced funds'. It holds less than 25 stocks, with a large holding in Berkshire Hathaway and some energy companies. They seem to employ a very selective stock process. The returns have been terrific with very little loss. I think this fund might almost reflect my "ideal" fund (all equities, minimal distributions, low risk), but I wasn't able to convince myself that this fund is actually low risk. I can't tell if this is an accidental coincidence or if this is really by design to have losses similar to lower risk funds. All the other balanced funds seem to have a historic maximum loss of around 10%. This fund seems to have a maximum loss in the same ballpark which surprised me due to the larger percentage of equities and high concentration of the fund. The fund is still less than 10 years old, so there wasn't enough data for me to feel comfortable. This fund also has a higher expense ratio than all of the previous funds at slightly over 1%. Still, this is a fund to watch.

So even though most or all the funds are intended for long term horizons, all of these balanced funds seem to have similar performance and risk characteristics that seem to fall within my tolerance (though it is hard to rule out the possibility of a steep loss). Even though they do produce more distributions than I would like and do contain interest income, at least a non-trivial fraction of the distributions are qualified dividends and long term capital gains, furthermore enhanced by more 'equity-like' returns in good years.

Operational tidbits on T. Rowe Price Capital Appreciation

So far in my research, I have found the most operational information on T. Rowe Price's Capital Appreciation. The fund has undergone recent manager changes so I  suspect that T. Rowe Price was making more information available to calm concerns about the changes. The fund has undergone manager changes before and most of this one seemed to be well planned. Stephen Boesel, who was in charge since 2001 retired in 2006 handing the fund to David Giroux and Jeffrey Arricale. It appears that the retirement was planned and Giroux and Arricale started working with Stephen Boesel on the fund two years before the retirement to ensure a smooth transition. There did seem to be one surprise in 2007 when it was announced Arricale would be moved to lead T. Rowe Price's Financial Services Fund. But I've found the breadth of information T. Rowe Price has put out on this fund to reflect well on them. I only wish I could find comparable detail for other funds.

How Capital Appreciation performance compares to the other funds I mentioned, I will leave as an exercise to the reader, but I will mention some of the operational points of the fund.

They like to buy stocks that have been beaten down so they will hopefully not fall much further but have a much larger potential upside. They plan for the stock to meet their expectations in about 3 years at which time they sell. This means the fund turns over about 1/3 of its holding every year. While the downside is obviously more distributions (i.e. taxes), at least these are mostly going to be long term capital gains.

They are willing to use cash in lieu of bonds if they see an advantage. This makes them a little unusual compared to the other funds. This has paid off for them over the last several years as cash has produced better returns than bonds.

They like to use convertible securities as an additional tool when they think the climate is right. Convertible securities are bonds that can be exchanged for stock. So if the stock price happens to rocket up, you can convert the bond into a stock and cash in on the rise. Again, this is a little unusual compared to the other funds.

Finally, I thought I read somewhere that Giroux invested his entire retirement account in this fund. I am having trouble finding that reference again though so be warned that I cannot verify this. But I like it very much when managers eat their own dog food.

The Analysis

So it's time to crunch some numbers. I will walk through my analysis of T. Rowe Price Capital Appreciation for 2007 so you can see how I computed my numbers (in case there are problems). The remaining funds are displayed in the table further down.

On the day of the distribution, the fund price dropped from 21.30 to 19.76.

I compute (21.30-19.76)/21.30 = 7.23% for the distribution. (Remember that smaller distributions are better because more money stays in the fund which is not taxed until you sell.) This number may not be totally accurate due to actual price fluctuations on the fund itself for that day, but I am unable to find exact numbers so for computational purposes, I ignore this factor.

This percentage as an absolute value is not great, but the premise is that no conservative short/mid-term savings plan is great due to the stupid tax code. Comparatively speaking, If you were earning 5% in a bank account, then this number may not be so bad because not all of the 7.23% is taxed at the income rate unlike a savings account.

So of that distribution, it was broken down as follows:

Dividends:  32.12%
Short Term Capital Gains:  10.30%
Long Term Capital Gains:  57.58%

Remember that long term capital gains are taxed lower. Also remember that qualified dividends are taxed lower.

47.55% of the dividends (32.12%) are qualified.

Regular Dividends: 16.85%
Qualified Dividends:  15.27%
Short Term Capital Gains:  10.30%
Long Term Capital Gains:  57.58%

Rearranging for tax types, we combine qualified+long term and regular+short term:
Taxed as income:  27.15%
Taxed at fixed rate:  72.85%

Of course, this isn't the end of the story. The fund price is also a factor. If the fund price stayed constant for the year, then you beat the savings account since you got a bigger distribution and probably a lower tax bite. But there is higher risk associated with this fund and the price could drop, so on paper, you could have lost out. However, one last thing to keep in mind is that you don't realize the loss from the price drop until you sell. So maybe there is a chance that the fund price comes back by the time you do sell so the loss isn't a complete disaster yet. (But if you do sell and suffer a capital loss, there may be some additional deductions that may offset taxes on your distributions.)

2007 was kind of a rough year for the stock market, particularly the latter half. All these funds claim gains for the year (including distributions) which suggests their risk level is in a range I may consider acceptable for intermediate term savings.

But the rough year also demonstrates the gamble. You can choose a bank account with a guaranteed loss to taxes and inflation, or you can choose something riskier with a chance to win, keep pace, or lose more.


Year before Post-Distribution Price

Post-Distribution Price

Distribution Percentage

Percent of Short Term Capital Gains

Percent of Long Term Capital Gains

Percent of Regular Dividends

Percent of Qualified Dividends

Percent Taxed as Income

Percent Taxed as Fixed Rate

Hypothetical Tax Burden (25%) of $100 invested

T. Rowe Price Capital Appreciation (PRWCX)











Oakmark Equity & Income (OAKBX)











Dodge & Cox Balanced (DODBX) (quarterly distributions)











Vanguard Wellington (VWELX) (quarterly distributions)











Fairholme (FAIRX)











Hypothetical Savings Account (5%)











*Note: Dodge & Cox and Vanguard pay quarterly distributions so I normalized the numbers so they could be easily compared in this table.

* Note: Tax Burden is computed as 25% for income and 15% for capital gains/qualified dividends. State is not computed due to varying rates and not all states tax capital gains at lower rates.

One last thought before I end this. I have not accounted for the AMT (Alternative Minimum Tax). The AMT is complicated, confusing, difficult to plan for, and simply kind of evil. If you are a likely candidate to be subject to the AMT, you will want to be careful here as likely none of these funds deal with AMT-free holdings, and the potentially higher yields from these funds could push you across the AMT threshold, especially if you are already on the cusp. It will be up to you to compute whether you will be better off with 'losing' savings accounts or a strategy like the one laid out here.

Disclaimer: You could end up losing a bunch of money doing this. I don't actually know anything and my facts could be wrong. I'm not advocating the use of this and am not responsible for any actions you may take after reading this article. In fact, you should probably just forget everything you read here.

Update 2008-10-09: Balanced Fund Update & Market Thoughts

Copyright © PlayControl Software, LLC / Eric Wing