Should you front load my 401k contributions?

Should you front load your 401k/ IRA contributions? Most certainly yes, given a few caveats.

In general, there is little doubt that you should front load your 401k contributions as soon as possible in the year rather than distribute it over the 12 month period.

Note: Although this post is about 401k, most of it is equally applicable to IRA contributions as well.

Most of this post will assume that you have the money to contribute (for many the money left after their living expenses might not be sufficient to contribute what this post might suggest. Please make changes accordignly.

Now coming to the two main reasons why you should front load your 401k contributions:

  1. Tax Reasons
    All the retirement accounts offer some kind of tax advantage, either they are tax deferred or tax exempt. You can read more about them in my earlier post Big difference between death and taxes.
  2. Reasons relating to job uncertainty
    What if you lose your job (or quit)? You can contribute to a 401k only while you are employed.

Tax Reasons

Contributions to 401k are tax deductible. This means – when you contribute $12,000 to your 401k in 2017; the $12,000 will be reduced from your taxable income for 2017.

The tax-deductibility of this $12,000 does not change whether you  contribute $500 every paycheck OR you contribute $2,000 per paycheck from Jan to Mar.

Here is what changes: The taxes you pay on the earnings. One fundamental thing to keep in mind here is – if you do not contribute to the 401k, you (hopefully) are investing the money elsewhere (in a taxable account).

Assuming you save $24,000 per year ($2,000 per month). Here are two possible scenarios: In one scenario, you contribute uniformly $1,000 each month to your 401k and the rest to your regular investment account. In the other scenario, you contribute $2,000 to your 401k for the first 6 months (and nothing to the regular investment account).

End of the year – you have contributed $12,000 to 401k and $12,000 to your regular trading account in both the scenarios. BUT the earnings in 401k are not taxed until withdrawal but earnings in regular trading account are taxed when they occur. Assuming 12% earnings and 25% tax rate, here is what it looks like:

So you save $95 in additional taxes just by contributing to the 401k more during the first half of the year rather than uniformly throughout the year.

Reasons related to job uncertainty

This is specifically applicable to 401k (and not to IRA). You can contribute to your 401k only through your paycheck. That implies that you cannot contribute to your 401k as soon as your paychecks stop.

Now this job termination can be voluntary or involuntary. There is always a possibility that you might get terminated or you might choose to switch jobs (and your new employer might not offer a 401k plan).

In either scenario, you lose your ability to contribute to 401k.

In certain special scenarios of job change, it is possible that you maxed out your 401k at the first employer BUT the 401k at the new employer is even better. In that case, you work with your first 401k plan administrator to withdraw your contributions (and earnings) in the first plan so that you can contribute to the second plan.

OneMoreDime Special – There is only caveat to the 401k front loading logic: if you start a new job and your employer matches your 401k after a certain period of time, then this might backfire. Below is an example.

For example: You start a new job on 5/1/2015 and your employer will match your contributions AFTER 1 YEAR up to 50% of 5% of your base salary (this is the industry standard now days). That means for someone with a base salary of $100,000, the employer will match up to $2,500 of the contributions.

Since the employer’s 401k match will start after 1 year, they will match contributions only after 5/12016. If you make the entire $18,000 contribution in January – April time frame, you will not get a match. And remember – employer’s match is free money.

Front loading retirement account contributions

My ex-employer’s 401k match policy

I can count on finger tips the number of financial mistakes I have made in my life, this is one of them – I lost money, I contributed too soon and did not get the employer match. On the right, you will see an actual screen shot of my employer’s 401k match policy (I have just replaced the actual employer name by the word ’employer’).

Another version of this ‘problem’ is – some employers contribute on a per pay check basis, so they contribute 50% of 5% of PER PAY PERIOD base salary. They contribute only when you contribute (even though they might deposit the match only once a year, they calculate it per pay check).

Talk to your HR about the employer’s match, once that issue is resolved, go for it !

Real-life Case Study

Situation: One of my blog readers (we will call him Aaraon) asked the following: I started a new job on 1/2/2017 with an annual base salary of $120,000. My employer matches dollar on dollar per paycheck for the first 1% contribution and then 40 cents to a dollar for the next 5%. Assuming I want to max out my 401k contributions, what is the best plan (timing wise)?

Analysis:

  1. In order to get the maximum tax deduction in 2017, Aaron has to contribute $18,000 during 2017.
  2. Company PER PAYCHECK matches upto 6% of salary if the employee contributes.
  3.  Although Aaron did not mention it in his first message, follow up discussions revealed that his employer permits 0% to 50% (of income) contributions to 401k per paycheck.

Company match is free money, in order to get the company match Aaron necessarily has to contribute 6% of salary each paycheck. Per paycheck salary is $5,000 ($120,000 divided into 24 paychecks).

6% of $5,000 is $300. So Aaron necessarilyhas to contribute $300 each paycheck. That will amount to $7,200 for 2017.

IRS limit for 401k currently is $18,000. That implies, he can contribute $10,800 more.

He should contribute this $10,800 as early as possible in the year. Here is where the 50% employer cap comes in.

He can contribute only a maximum of 50% of salary per paycheck. So 50% of $5,000 = $2,500 per paycheck.

Solution

Here is what an ideal situation looks like: He contributes $2,500 for the first 4 paychecks (Jan and Feb). That is a total contribution of $10,000.

The remaining $8,000 can be contributed over the remaining 20 paychecks – $400 per paycheck.

Consumer Financial Protection Bureau (CFPB)

Have you ever felt like suing a bank but did not want to spend the time and money in doing so? A complaint to CFPB is the closest you can get (for free).

I will use ‘bank’ as an exmaple but CFPB (and most of this post) is equally applicable to credit unions, credit reporting agencies, money transfer agencies, payday lenders, mortgage servicing firms, and debt collection agencies.

So you can reach out to CFPB for help if you have an issue for example with Citibank, Wells Fargo, Chase, Transunion, Equifax, or Western Union.

CFPB is your friend

CFPB is not an attorney acting on your behalf BUT some of the ‘effects’ are similar – you will get a response on time and many a times it will have the details of what you were looking for.

Often enough, the matter will be resolved in your favor if the bank realizes that they were at fault.

Going to CFPB does not stop you from taking any other action that you might be entitled to (for example – suing the bank).

Why does the CFPB model work?

It works in your favor because of the following reasons:

  1. Banks do not have a choice, they have to respond
  2. Banks have to be careful about what they respond – their response is going to a regulatory body
  3. It is no longer your job to find who the concerned person/ department is within the bank to answer your query
  4. It all happens online

Banks do not have a choice

It has happened to me multiple times that the bank just did not get back to me on my issue. They cannot do that with CFPB. With CFPB, they have to respond and that too in a timely manner.

Banks have to be careful

I have often enough encountered under-trained customer service professionals at banks who really do not know what they are talking about.For example, I was told that a second add-on card will be free while they later charged me a $14.99 fee for it.The chances that your CFPB complaint is answered by someone under-trained are very less. These complaints usually are answered by responsible knowledgeable people.

These people are aware that all the responses are being monitored by CFPB and too many issues can lead to regulatory action (disciplinary actions like fines).

Concerned person/ department

One of the most common problems incurred by customers in talking to customer service representatives (CSR) of the bank is “I am not from that department”. See if the below sounds familiar:Bobby goes and finds the 1-800 number online (or on the back of the credit card)
Bobby finds a quiet place to make that phone call
Bobby dials 1-800-000-0000 and goes through the entire menu, press 7 for accounts, press 3 for credit cards
Bobby enters his account number so that the process goes quickly
Bobby is asked for more identification information
Now Bobby listens to music
Bobby listens to more music
Your call is important to us, please wait for the next available agent
Some more music
An agent comes online and asks for more information to identify my account
Bobby explains the problem
CSR: Sure, I will help you today, may I please place you on a brief 2 to 3 min hold?
After 2-3 min, I cannot find any notes on your account
Bobby: I spoke to ‘Mike’ last week
CSR: I am sorry Sir but there is nothing on the account
Bobby: Ok, can you please tell me about ‘that charge’?
CSR: Sir you would have to talk to ‘the other’ department’. May I give you their direct number?
Bobby: Yes please
CSR: 1-800…..

So after 30 – 40 minutes, I have a new 1-800 number.

CFPB eliminates this problem, and rightly so. I mean, I am not making a sales call here that navigating through a bank’s hierarchy and internal organizational structure is my responsibility. If I have an issue with the bank, the bank should take ownership and get me an answer.

When you make a complaint at CFPB, you just provide basic information about the bank / product/ complaint. You leave the rest for the bank to figure out.

Online

All of the CFPB process happens online. You go to their website and make a complaint online. You instantly get an email confirmation. Usually within 5 minutes, you will also see another email that says “your complaint has been forwarded to the company for a response”.

The company responds within a few days (usually somewhere between one and 2 weeks). You can read the response online. Most will also send you the same response by paper mail.

At this point, you can either do nothing or dispute the response. If you dispute the response, CFPB and the bank both know that you disputed. The bank is not liable to respond again but CFPB makes a note of it and acts if there are too many disputes of a similar nature.

Personal experience

The screenshot below shows 10 of the complaints I have filed so far. You can see that I  disputed a couple of the company responses. For a couple (the top 2), I am still within the 60 day period to dispute the company response. For the rest, the status is ‘response not disputed’ – this means company provided information that was satisfactory.

In some cases, I was able to get a faster and more accurate response through CFPB rather than talking to customer service (of the bank).

CFPB – real example

I was helping a friend obtain a copy of her credit report. Here is a screenshot of the complaint from the CFPB website:

Here is the screenshot of the company’s response from the CFPB website:

To summarize: this friend of mine was trying to get a copy of her credit report for more than 6 months from Equifax. She was unable to do it online, she requested it by mail, they asked for additional documentation, and then silence for several weeks. So on and so forth.

When she filed a complaint with CFPB – she had a copy of her credit report in her hand within 10 days. It frankly can’t get better than this.

Helpful tip

Keep emotions away – Of course things have been wrong to a certain extent therefore you are at the CFPB site but keep the emotions away. I have learned it by experience.

Look at the following two descriptions of the same situation, tell me which one is better?

  1. They charged me $50 for xyz – this is unfair because xyz. I expect the fee to be refunded
  2. They charged me $50 for xyz. Other banks in the industry do not charge this fee. It looks like they do not care about customers. I am thinking about taking my business to another bank. When I called up the customer service, the bank representative said there is not much she can do. I asked her if I can speak with a supervisor, she took down my contact details and said the supervisor will call me back but the supervisor never did. The bank has very poor customer service. I am fed up with the bank.

The first one is better – both the descriptions will likely lead to the same end result, but the first one is crisp and precise. You are being very clear in what happened and the remedy you are requesting. It does not leave any room for confusion/ misinterpretation.

Top 6 year-end tax tips

Year end is just around the corner. Make sure that you do not forget to check the following before we get into 2017. Some of these items are fairly straight forward and provide huge value for money.

401k contributions

401k contributions are payroll contributions and hence cannot wait till Jan 2017 (for the year 2016). If you have not maxed out your 401k contributions for 2016 and have the funds to do so, then now is the time.

It is a now or never situation. 401k contributions are tax deductible. If you are in the 25% tax bracket, then you save $250 on taxes right away for every $1,000 you contribute to your 401k.

In addition to the tax benefits, 401k plan offers other advantages too – for example, bankruptcy protection. 401k is protected by Bankruptcy laws. Attorneys cannot seize your 401k account to repay creditors.

Tax loss harvesting

You can deduct up to $3,000 capital losses from your other income. Check your stocks and sell the losers.

It is $3,000 in NET capital losses. Here is how the calculation works:

Example-1: Capital gains $2,000, Capital losses $3,000, net capital losses deducted form ordinary income $1,000

Example-2: Capital gains $2,000, Capital losses $5,000, net capital losses deducted form ordinary income $3,000

Example-3: Capital gains $2,000, Capital losses $6,000 -> net capital losses $4,000. Deduct $3,000 from form ordinary income in 2016 taxes and deduct $1,000 from the ordinary income in 2017 (carry forward $1,000 capital losses in excess of the $3,000 allowed limit per year).

Keep in mind the Wash Sale Rule though – you cannot buy the same or ‘substantially identical’ stock within the 30 days before or after the sale. So if you sell the losses on Dec 31st 2016, then you cannot buy a substantially identical stock in all of Dec 2016 and Jan 2017.

FSA account (insurance)

Some employers offer one of the two grace options: “grace period” of up to 2 ½ extra months to use the money in your FSA OR carry over up to $500 to use in the following year.

If your employer does not offer any of these options, then you will lose the money you have in there at year end. So you have to spend it soon.

You can buy things online up to midnight on Dec 31st. Eligible items include contact lens, sunscreens, and even condoms.

IRA/ Roth IRA

In general, sooner you make your IRA contributions the better it is. You can make IRA contributions for 2016 till the tax filing deadline (Apr 15, 2017… or Oct 15, 2017 with extensions).

But here is the catch: the IRA account should have been opened before Dec 31, 2016.

Yes, let me repeat: You can make IRA contributions for 2016 till the tax filing deadline well into 2017 BUT the IRA account should have been opened by Dec 31, 2017.

So make sure that you have an IRA account open – even if you are not able to contribute later, you do not lose anything.

IRA distributions

One of the extremely harsh penalties that exist in the Internal Revenue Code (IRC/ IRS code) is the failure to take Required Minimum Distributions (or RMDs).

You must start making regular minimum distributions from your traditional IRA after the age of 70 ½.

If you do not, then IRS charges you a penalty of 50% based on the amount that should have been withdrawn.

So if applicable to your situation, make that RMD distribution now. I would suggest not to wait till Dec 31st – sometimes the distribution itself might take a few days.

Property taxes

This is applicable to all property taxes but most significant in case of home owners.

In my county, you get a 4% discount on the annual property taxes if you pay them by November (3% if you pay by Dec, 2% by Jan, 1% by Feb, 0% by March, and you are delinquent if the taxes are not paid till April).

I just paid my property taxes last week and received a 4% discount.

In addition, I will be able to itemize these taxes on the Schedule A when I file my taxes.

Time value of money

$1 tomorrow is worth less than $1 today. $1 today = $1 tomorrow + time value of money. This time value of money is represented by interest in savings account and earnings in investment accounts.

Time Value of Money

Time Value of Money

People in general would prefer to consume $1 today than wait till tomorrow. Now, there are two categories of people – those would would postpone their consumption in return of interest/ earnings. And there are those who would prepone their consumption by paying interest.

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How does a well diversified portfolio look?

A simple yet highly scientific explanation of what is diversification, why is it important, and how should you achieve it?

What is diversification?

As the old saying goes “You should not keep all your eggs in the same basket”. Diversification is keeping your eggs in different baskets.

Diversification lowers risk. Risk can be measured by ‘variance’. Therefore, diversification reduces variance.

The below write up about variance looks a little mathematical to begin with, but trust me – it is not complex mathematics. If you read it a few times, you will understand it well. Even if you do not understand the math, continue to read and you will get the gist of this post.

What is Variance?

In most simple terms, variance is nothing but a measure of how far individual values are from the average value.

Look at two portfolios below – both have the same average return (as we will soon confirm) but Portfolio-1 has a higher variance: the returns in individual years are ‘spread’ further from the average (mean) of 5%.

Diversification

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Are you financially smart?

I live with someone who is incredibly smart (ivy-league doctor). Read the 7 examples that lead me to believe that she is not financially smart.

1. If she has money, she will invest. If I see a good investment opportunity, I will think about how to ‘fund’ it. Like other financially smart people I have learned to say How?

2. She does not understand the time value of money – she always lends me money interest-free when we play Monopoly. And then she wonders why I always win – because I will buy every property that I can on the board by taking money from her (or the bank) interest free. Financially smart people are always on the lookout for interest free money.

Keep in mind the following though:

a. High interest debt like credit cards is a suicide but interest free debt is a blessing if invested properly. Read a related post here.

b. Do not over – spend because the seller is offering you an interest free loan. Interest rate should not dictate your purchase size in this case.

3. We own a house that we are in the market for refinancing right now. We got the original mortgage in 2014 (0% down payment). When we talk about refinancing at 100% LTV or pay down 20%, she often talks about ‘But the house might be worth much more in 5 years?’

She seems to think that the house appreciation will benefit us more if we make a down payment. While I know that the house appreciation will benefit us exactly the same amount whether we put nothing down, or 20% down, or even 100% down (pay off the mortgage).

We own the house, irrespective of whether there is mortgage on the house or not. Our equity in the house depends on how much mortgage do we owe to the lender, but our exposure to real estate is the entire value of the house (irrespective of the mortgage amount).

You will see other variations of this problem too – and sometimes even financially smart experts get confused. Here is a good example:

Here a couple would like to plan for an early retirement and the Number 1 personal finance magazine in the country advises them:

The equity in the rental property does not matter (as far as the impact on net worth is concerned). Let us say two examples assuming the rentals are worth $200,000

  1. Equity of $78,000 and debt (mortgage) of $122,000
  2. Equity of $50,000 (and the rest $150,000 is mortgage)

When/ if the real estate market crashes and the value of property falls to say $160,000 – the couple has lost $40,000 from what they own today (irrespective of the debt/ equity ratio).

In case 1, the equity falls to $38,000 and the mortgage is still $122,000 -> so net, they ‘owe’ $84,000. Actually look at it this way -> you owe the bank $121,000 and your property value is $38,000. So now you owe net $84,000.

Earlier you owed $122,000 – $78,000 = $44,000. You have lost $40,000

In case 2, you owe $150,000 to the bank and the equity falls to $10,000 -> so the net you owe is $140,000. Earlier net owed was $150,000 – 50,000 = $100,000. So you lost $40,000.

To summarize this point – the couple owns rental property worth $200,000 -> and they will gain/ lose the entire amount by which the property increases or decreases in value. The amount of equity does not matter.

The other problem with the above expert advise is “sell rentals when you have difficulty finding tenants” – I would say NO, that will be too late. Selling the rental now when it is a turnkey investment might give you a good selling price rather than waiting for the real estate market to go bad before selling it.

4. She was unhappy that she did not get any refund while her colleagues got tends of thousands of dollars back.

She does not explicitly realize the fact that she was getting less taxes withheld during the year so essentially what her colleagues are getting back now, she has been getting all along with every paycheck.

Hopefully she will appreciate taxes due vs tax liability difference some day soon (else I will start to consider myself a failure lol, just kidding).

5. She hated debt and was paying off her student loans as fast as she can – this works great in 2 situations: if you have money then you will end up spending it rather than investing it and if the debt is high interest rate.

She was paying down her loans that had an interest rate of 2% while I take as much loan as possible as I can get at 2%.

The reason – I am confident that I will make much more through my investments. How much more? I am hoping that I will make about 8% over long term.

But debt is risky and since 8% is uncertain, I will not take debt at say more than 4% to speculate. If someone is loaning me money at 2%, then I will surely take it. If someone is giving it to be at 5%, then I will definitely not take it.

For things like 3-4%, I will have to run specific numbers (using my Excel).

6. She was not claiming her mother as a dependent, I made her file amended returns for three years, got back $3,000 in refund each year. This money is not all that much given what she earns today but this was a hell lot of money when she was doing her residency and earning $50,000 a year.Exemption section on 1040 Tax Form

Her CPA never asked her and she never mentioned it. I wish she would have met me sooner. One of the main reasons I urge people to understand taxes is for situations like these: a CPA will only know what you are telling them, sometimes they will not ask you the right things because they do not know your situations.

7. She was about to buy a car for $42,000.  I asked her ‘Will you wait 10 days if I get it for $5,000 less’? She said – yes. 10 days later, we bought the exact same car for $36,000. We saved $6,000.

financially smart

More on car buying negotiation techniques some other time, but essentially I negotiated the price of the car down to $36,000 from $42,000. I was able to do so because I was not in a hurry – I got multiple quotes from multiple dealers and essentially made them bid against each other.

How I saved $6,000 on a car purchase?

My girlfriend selected a car that she wanted to buy for $42,000. I asked her if she can wait for a few days, 1 week later I bought the same car at $36,000.

All I did was follow a few simple steps of negotiation. Listed below are the steps you can also follow to save huge amounts of money when you buy a car (I saved $6,000 on a car purchase using these simple steps).

Step 1: Document your requirements exactly 

I documented exactly what I needed – Make, model, color, accessories. I listed everything so that there is no discussion required with any car dealer.

This is very important. Time is of essence – visiting any dealership will take a couple of hours, and however determined you are you will not be able to do more than 2-3 in an entire day.

While on the internet you can easily reach out to 15 – 20 within an hour.

Step 2: Find all the dealers in your area

Again, internet is your friend here. Go online and search all dealers in your neighborhood.

I suggest to think of neighborhood as something really broad – would you not drive 300 miles if you can save $2,000? If yes, then search for dealers in your city and neighboring cities.

Caste your net wide – you do not have to drive 300 miles later but it does not harm to know what the price difference is. May be the price difference will be enough to warrant a drive.

The only thing to keep in mind is: stay within your state. Handling out of state registrations might be something you would like to avoid.

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Should you afford what you can afford?

I live (and want to live) a comfortable life but I do not want to maximize my consumption just because I have money to do it.

In 2014, I was in the looking for a house to buy (primary residence). Like most rational people, I wanted to start with a budget. I wanted to find out answer to the following question:

“Given my income, what is the least amount I should spend on housing?” I searched for days and weeks, but did not find an answer.

Let me first elaborate on my question. I have good income. I tend to be frugal (simple living). But I did not want to be frugal to the extreme, I did not want to end up below the ‘suggested bottom’. I had often heard people talk about “You should not spend more than x% of your salary on housing”. I wanted to hear something like “You should spend at least y% of your salary on housing”.

I did not find my answer, here is what I found – I found hundreds and hundreds of websites and blogs telling me ‘the upper limit of how much should I spend’. Here are some examples:
1. Your monthly total debt should not be more than 43% of your take home pay
2. Your house should not cost more than 2.5 times your gross annual base pay

This related to my car buying experience too – the salesman always kept on coming back to monthly payments saying “It is only $391 a month, you can afford that”. And I was thinking in my mind “Should I afford it just because I can?”.

Coming back to my housing question – I do not have an answer today on how much is the minimum you should spend. Frankly, I did not start to write the post looking for an answer.

Affordability calculator

Affordability calculator

All I would like to discuss today is – should you afford what you can? Since no website was able to tell me the ‘suggested minimum’, I believe most people are not thinking along those lines.

Per the affordability calculator present on www.zillow.com, someone earning $100,000 a year without any other debt can afford a house worth $489,216. They make the calculations using some assumptions and those assumptions are not our focus today.

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Rent vs Buy a house

12 factors that go in the decision Rent vs Buy a house – you can also download the Excel with a real example, change the numbers per your situation.

36 million people move every year, assuming these 36 million people represent 20 million households, 20 million households face the following question every year: Rent or Buy?

In most cases, people say ‘Let us start by renting and then see if we like the place enough to buy’. Although that is a very valid way to think about things, read on to find a holistic scientific method of determining what makes more sense financially?

12 Facts to consider

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Importance of Asset Allocation

What is an Asset Class? What is Asset Allocation? How should you determine your Target Asset Allocation?

If you read my blog often enough, and have started to think I qualify everything I write about as ‘most important’ – then you are mistaken (and partly it is my fault). I might be saying those things in a different context.

For example, when I say compounding is your biggest friend, I mean it, but keep in mind that compounding happens over a period of time. When I say Asset Allocation is the most important factor in determining long term returns, I do not mean to say asset allocation is more important than compounding.

Things apart from Asset Allocation are important too, specially how much you save and how soon you start to save, how much expenses do you have etc; but once you have started to save/ invest, Asset Allocation is what will be a primary driver of your long-term returns.

What is Asset Allocation?

Asset Allocation is simply how your portfolio (money) is divided into various Asset Classes.

If you do not understand big jargon like Asset Allocation and Asset Class (and some others) we are talking about today, please do not be discouraged, read till the end. I am introducing these terms so that you can interpret and understand host of information that is available on the internet on this topic.

I could have explained the basics even without using any jargon but I want you to be able to read that Wall Street Journal article with confidence the next time you see it, so getting familiar with the jargon is essential.

What is an Asset Class?

An asset class is a group of ‘investments’ that share riskiness and return. Three main asset classes in stock market are stocks, bonds, and cash. Let us focus on stocks and bonds for now. Stocks are more risky but provide higher returns long term.

By risky, I mean the returns on stocks are more volatile – they might return 25% in a single year but might lose 25% of the value also in a given year. But over a long period of time, their annualized returns are most likely going to be higher than bonds.
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