Quiz!

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling your biggest risks (any number of answers may be correct):

  1. Limiting yourself to fast growing investments.
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including stocks, bonds & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales.

Outpacing the Longevity Escape Velocity

Ray Kurzweil, director of engineering at Google & inventor, predicts that in 10-12 years we will reach longevity escape velocity. This is the point when science and technology will add more than a year to our lifespan for every year we remain alive, leading to an infinite life. With an 86% accuracy rate for his prior predictions about the future, there is some chance that this will be true as well. He may be almost completely wrong, with a lifespan of a mere 200 years or 2,000 years, instead of infinity. When planning my investments, I wouldn’t bet with 100% confidence that he is completely wrong, especially when losing the bet would mean spending most of my long life broke.

Unfortunately, many retirement plans do make this bet. A retirement plan with a 95% chance of providing 30 years of retirement income is typically considered appealing. That means a 1-in-20 (5%) chance that if you live for 30 years, you will go broke later in life, just when financial stress is the toughest to handle. If you live longer than 30 years, the odds of failure go up. I have personally known a retired woman that gradually depleted her assets, and faced one of two tough cases: dying soon or going broke. This memory is carved in my mind, and I am not ready to see any of my clients reach the same position.

Accepting some chance of an infinite life, or simply a very long one, requires infinite income. While the word infinite sounds dramatic, it is not impossible to plan for infinite income with very high odds. You simply need to apply a similar principle of escape velocity to your investments, with more growth than spending, in an average year. Stable investments (bonds, money market) grow too slow to support long-lasting withdrawals that accelerate with inflation. So, we need to seek faster growing investments, and handle the volatility, by accounting for withdrawals during downturns. By using investments that grow fast enough, you can make up for the penalty of withdrawals during declines, as long as the investments are diversified, and the withdrawal rate is low enough. Two stock portfolios fit the requirements:

  1. Long-Term Component (LT) is likely to support 4% withdrawals forever.
  2. Extended-Term Component (ET) is likely to support 3% withdrawals forever.

For the disciplined investor with low withdrawal rates, longevity risk turns some common risk-planning principles on their heads: bonds and cash become risky, and diversified stocks become safe! This is because running out of money becomes a greater risk than losing it all during a temporary decline (through small withdrawals).

Once your withdrawal rates from these portfolios go below the stated rates, you would likely reach escape velocity, providing you with income for as long as you live, even infinitely. But instead of just solving the longevity financial risk, you get a big bonus. After reaching a sustainable withdrawal rate, your portfolio is expected to keep growing over full cycles despite your withdrawals. You can choose between higher security or higher income (or some of each) with every new peak.

My clients tend to be conservative, and don’t count on any specific limited lifespan. I tend to reject more aggressive investors.

Quiz Answer

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling the biggest risks you may face (any number of answers may be correct):

  1. Limiting yourself to fast growing investments. [The Correct Answer]
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including bonds, stocks & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales. [The Correct Answer]

Explanations:

  1. If you end up living a long life, you need high enough growth to support annual withdrawals that grow with inflation. With low growth, you can run out of money.
  2. Trying to pick the right stocks introduces the risk of picking the wrong ones – this is a big risk to take when your lifelong income depends on it.
  3. Low-volatility investments are necessary for high withdrawal rates for a short horizon, and for people who panic during stock declines. You have the benefit of discipline and low withdrawal rates, and may face a long horizon.
  4. It is critical to stay disciplined with your plan, and avoid panic sales. A couple of panic sales can negate the entire benefit of the high average gains.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks.
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Insurance vs. Diversified Stocks

The table below presents a basic comparison between diversified stocks and insurance. The first two rows show similar benefits, while the remaining rows show where each approach shines.

Topic Diversified Stocks Insurance Comments
Distribute risk at any point The growth of 1,000 stocks overshadows one company’s bankruptcy. By pooling 1,000 homeowners, the premiums paid cover the cost of one flooded house. Both help diversify risks at a given instant.
Distribute risk over time The growth of stocks over a full cycle overshadows the decline periods within the cycle. The premiums paid by a large group of homeowners over time cover hurricane damages to a large group of homeowners. Both help diversify risks over time.
Devastating risks House burns down without big money saved => bankruptcy. House burns down => covered by insurance. Insurance is critical for covering risks that would devastate you.
Non-devastating risks Can sell from stocks to cover the low risks. Otherwise, the saved insurance premiums that are invested in stocks are likely to grow dramatically over a lifetime. The insurance premiums are lost. Stocks are typically more beneficial for risks that are not devastating.
Availability The money is available for you at all times, without being at the mercy of an insurance company, but the value will be lower during stock declines. Claims can be declined for various reasons. Insurance: Read carefully the exclusions list for insurance, and have money set aside for declined claims.
Stocks: Have plenty more than the self-insured amounts, to account for stock declines.
Negotiated pricing Not applicable This applies for some types of insurance. Health insurers negotiate lower prices. You get negotiated healthcare costs even with high deductible health insurance, in case this item tips the scale for you.
Risk of under-treatment Risk of avoiding treatment that would otherwise be covered by insurance. Having low-deductible health insurance can encourage treating high-risk problems that seem minor at first If choosing self-insurance using stocks (e.g. by having high-deductible health insurance), be careful to not avoid necessary treatments that you would get with low-deductible insurance.
Overhead No overhead Insurance involves administrative costs and profits to the health insurer, that you pay for. Unless you are a high risk person for using the insurance, your overall average cost may be higher with insurance.

Quiz Answer:

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks. [The Correct Answer]
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Explanations: Read the article for explanations.

Disclosures Including Backtested Performance Data

Quiz!

What is the most powerful way to maximize the value of college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years.
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Look for the answer below.

Growing College Savings Fast Despite the Short Horizon

Problem: Saving for college involves a tough combination:

  1. College costs are high and grow fast (over 5% historically), requiring the help of a fast growing investment such as stocks.
  2. The time horizon is limited and fixed at 18 years, making the volatility of a stock allocation problematic in the later years. Imagine a stock allocation in 2008 right as your child reaches college age.

Solution:

  1. Invest 100% in stocks, if you (or your advisor) can stay disciplined through tough market downturns, and as long as you have strong stock-, sector- and country-diversification. Otherwise, include as many bonds & cash as needed for you to be able to stick to your plan through declines such as 2008.
  2. Once you reach college years, if there is no major decline, you can sell from your college savings, and enjoy the high likely average growth.
  3. If there is a major decline during college, you can take a student loan. This stretches the expense and lowers your yearly cash outlay during the decline. Once the investment recovers from the decline plus extra to make up for the loan interest & the limited sales during the decline, you can pay off the loan reducing or eliminating the penalty for the decline.

Additional thoughts:

  1. Currently, college saving accounts (529 & Coverdell Education Savings Account) cannot be used for paying off student loans. To enjoy this strategy, you should limit the amount of savings in these accounts. Notes:
    1. You can still use these accounts to pay for student loans that are used for current-year expenses.
    2. A bill (H.R.529 – 529 and ABLE Account Improvement Act of 2017) was introduced in January 2017 to allow use of the account to pay for student loans, but it is just in the proposal phase.
  2. There are additional reasons to limit the use of college savings accounts, despite the tax benefits. Saving too much can happen for numerous reasons:
    1. High investment growth.
    2. Lower college costs, e.g. through proliferation of online (or partly online) programs.
    3. Getting a large scholarship.
    4. Going for a cheaper university than the parents planned for (e.g. an in-state college).
    5. Skipping college altogether, and starting a business.
  3. You can benefit from maximizing a Coverdell ESA (Coverdell Education Savings Account) before using 529, for several reasons:
    1. Nearly unlimited investment choices, just like IRAs, allowing for more optimal growth, when given to the right hands.
    2. Unlike 529, the money can be used for grade-school expenses. This can help in case of saving too much.
  4. You can benefit from avoiding 529 altogether. The Coverdell ESA account is limited to $2,000 contribution per year, which significantly reduces the risk of overshooting the saving amount, especially if (but not limited to) you end up taking temporary student loans.
  5. This plan does not get in the way of you gifting the college expenses: you can gift the loan payments. If done right, you are likely to end up with a lower cost regardless of your luck with the investments, as long as you hold onto the loans until the investments go through enough of the up years of the cycle.
  6. Another consideration: the more college years you expect, the lower the overall negative impact of declines, even without the help of temporary student loans. For example, if you have 2 children, 2 years apart, and each studies for 4 years, the expense is spread over 6 years.

Quiz Answer:

What is the most powerful way to maximize the value of your college savings?

  1. Include increasing amounts of bonds and cash, reaching 100% as your child reaches 18, to minimize the chance of losses due to stock declines.
  2. Maximize 529 plan contributions – while returns are unknown, tax savings are a guarantee.
  3. Allocate 100% of the savings to stocks, and be prepared to take temporary student loans in case of a stock decline during college years. [The Correct Answer]
  4. Create a balanced allocation of stocks & bonds, while maximizing the tax benefits of college saving plans, including both 529 & Coverdell ESA.

Explanation:

  1. While bonds and cash reduce the downside, they also limit the upside. There is a way to limit the downside without this sacrifice (see the correct answer, #3).
  2. There are two problems with this solution: (1) You can over-save, resulting in a 10% penalty on the excess + income tax on the gains on the excess, if you can’t find a family member that under-saved; (2) 529 plans have limited investment options with a drag on returns that may be greater than the entire tax benefit.
  3. This optimizes the growth combining the following: (1) fast growing stocks; (2) moderating or completely reverting downturns by spreading the withdrawals over many years, in case of a decline in college years.
  4. See #1 & #2 above.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

When Increased Leverage can Improve Your Short-Term Security

Borrowing to invest can let you enjoy excess returns equaling the investment growth minus the loan interest. While you commit to a fixed cost, to enjoy a volatile benefit, there is a case that can increase your overall short-term security, in addition to the typical higher long-term security. An example can demonstrate this point. Please read carefully the assumptions & notes below – most people are better off not borrowing to invest.

  1. Say you have $100k in investments (in Extended-Term Component), a $1M house with no mortgage, and you spend $100k per year. If you lost your job for more than about a year, you can be wiped with no cash to support yourself.
  2. Now, assume that you borrow $800k at 5% interest-only, and add to your investments. Even under tough investment scenarios, you can survive the 2 years out of a job.

The following table summarizes the impact of the borrowing-to-invest:

Impact of different leverage choices, with $100k in investments (in Extended-Term Component), $1M house, and a 2-year job loss, leading to $200k withdrawals

Case No mortgage $800k mortgage @ 5%
Good: Starting at 2003 Out of cash after 1.5 years +$1.74M after 2 years, owe $800k
Bad: Starting at 2008 Out of cash after 0.8 years +$410k after 2 years, owe $800k

The leverage helped you avoid bankruptcy, by turning your illiquid house into a liquid source of cash. Surprisingly, whether your unemployment occurs during a stock surge, or the worst crash of your lifetime, it helps you survive an extended period of unemployment.

Important assumptions & notes:

  1. This article reviews only one aspect of leverage. The topic is complex and requires a thorough risk analysis.
  2. While the short-term security goes up in this case, and the long-term security would typically be higher, there could be a combination of an extreme decline combined with many years of withdrawals, that can negate the long-term benefits, resulting in an overall loss.
  3. The key to the increased short-term security is the improved spending/assets ratio. In the example above, there is a dramatic improvement from 100% ($100k/$100k) to 16% ($140k/$900k). If the interest on the loan is higher than your current spending rate, the loan will hurt your short-term security. This is typical of retirees. For example, if you have $4M and spend $120k/year, your spending rate is a comfortable 3%. Adding the loan, will increase your spending rate to 3.33% ($160k/$4.8M). While your long-term security can still benefit, it is not recommended for retirees, especially if the new withdrawal rate is high enough to lead to problems under severe declines.
  4. The loan cannot be called. This is typical of mortgages in the US, assuming you make all payments on time. This is not true for margin loans that may be called at the worst time – at the depth of a market decline.
  5. You invest the entire loan amount.
  6. Your spending habits stay the same, and you don’t get tempted to increase your spending with the extra $800k in the bank.
  7. You don’t sell in a panic after a decline like 2008, and don’t get a heart-attack. Either can turn the temporary decline into a permanent loss.
  8. As soon as you find another job, you go back to saving regularly. You never withhold investing at low points (after big declines).
  9. You may enjoy some of the short-term benefits above using a HELOC – a home equity line of credit, that is left not borrowed until the need comes up. There are some pitfalls to HELOCs to watch out for: (1) in rare cases it may be frozen to new borrowing, and (2) the interest rate is usually higher than mortgage rates. Also, without the actual borrowing to invest, you can’t get the long-term benefits.
  10. In the example above, you may be able to sell the house, but there are a number of issues with this plan: (1) When selling the house, you turn a temporary problem (job loss) into a longer-term issue – selling a house, moving, maybe later buying another house, and paying realtor fees; (2) You would not want to sell too soon, while hoping to find a job, but if you wait too long, you may need to sell in a rush, leading you to get underpaid for the house.

Quiz Answer:

Which of the following statements are true?

  1. Borrowing to invest can make anyone wealthy.
  2. Borrowing to invest in a volatile fast growing investment, leads to higher long-term security at the price of lower short-term security.
  3. Borrowing to invest is never smart for young people.
  4. Borrowing to invest is never smart for retirees.

None of the statements are true! Explanations:

  1. If you can qualify for large loans, you invest the full proceeds in a fast growing investment, you never panic and sell at a decline, you do a careful risk plan and a host of other conditions, you have a chance to become wealthy. If you mess up any of the conditions, you can go bankrupt, even if you started as a billionaire.
  2. See this month’s article – under certain conditions, you may enjoy higher short-term security along with a typical higher long-term security.
  3. Borrowing to invest may be smart for young people under the right conditions, and after a careful risk analysis.
  4. Borrowing to invest is typically not smart for retirees, but there may be unusual circumstances, where a retiree can maintain a very low withdrawal rate despite the borrowing, and also prefers the higher potential growth despite the higher volatility.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
  2. Buy well established companies that are not going anywhere.
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand.

The Secret to Getting Rich

Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:

Good Action

Bias

Biased Action / Human Nature

Defer spending to invest, and enjoy compounded growth

Present Bias

Emphasize the present over the less tangible future

Invest in fast growing (and volatile) investment classes

Myopic Loss Aversion

Avoid declines, even temporary

Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines)

Recency Bias

Prefer investments that did best in the recent 5-10 years

Diversify across countries

Home Bias

Buy familiar stocks that are close to home

Own small stocks

Familiarity Bias

Buy large stocks that are more familiar

Enjoy momentum

Disposition Effect

Sell too soon, after seeing a gain, and too late after seeing a loss

Buy small & unknown profitable companies

Familiarity Bias

Focus on known profitable companies over less known ones

A couple of notes about the list above:

  1. If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
  2. An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.

If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.

Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:

  1. Think of tangible examples for the tradeoffs. For example, would you give up spending $10,000/year for the next 20 years, in return for $38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of $521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
  2. Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
  3. After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.

Quiz Answer:

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
  2. Buy well established companies that are not going anywhere. [Correct Answer]
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand. [Correct Answer]

Explanations:

  1. Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
  2. Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
  3. As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
  4. Familiarity Bias. See #2.
Disclosures Including Backtested Performance Data

Quiz!

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66%

Can you Guess the Top Performing Country Last Year?

As an Investment Advisor, a fiduciary that is responsible for the life’s savings of entire families, you would expect to count on me to follow the economic news closely and be ready to react to any new developments. Do I do this? I do the exact opposite – I separate my investment decisions from economic news. If I were to depend on the news for investment decisions, I could hurt your life’s savings badly.

A recent example from 2016 can demonstrate this counterintuitive point. Brazil spent the entire year in a devastating recession – the worst on record (over more than 100 years). Unemployment climbed throughout the year from 9% to 11.9%. The president was impeached and there were numerous corruption scandals. Predicting this year could have made you a fortune by shorting (making money when stocks decline) Brazilian stocks in 2016, right? Not so fast. The Brazilian stock market gained +66% in 2016. Not only did it not decline – it was the top performing country for the year.

How is it possible to get stellar returns during the worst economic decline on record? The answer is simple – ignoring prices. The consensus view was for a long and deep economic decline, which would hurt Brazilian companies. In reaction, people sold Brazilian stocks to avoid the declines. The problem was that people kept selling these stocks without regard to prices. Why is this a problem? Say that in normal times a basket of Brazilian stocks is worth $100. Now comes a big recession, and the new realistic value is, say, $80. You would expect rational people to sell until the price reaches $80. But many investors see a struggling economy and sell with disregard to the price. Others cannot imagine a turnaround and sell to reflect a multi-year depression. So, the continued selling brought the basket to a much lower value, say $40. This reflects an unusually bad expectation – far worse than reality. Now comes additional moderately negative news, lowering the realistic value from $80 to $75. With the news being far less negative than expected, people become more positive, and are more likely to accept a value closer to reality. They are ready to correct some of the excess decline, leading to a surge from $40 to, say, $66.40 (a gain of 66%), all while the economy is doing poorly. While the numbers in this example where made up, the mechanism explains what could have led to the surge of Brazilian stocks.

As of 9/30/2016, Brazil represented 6.82% of emerging markets, while the allocation to it in the emerging market portion of QAM’s portfolios was 9.19%. This emphasis reflects the deep value focus (a focus on low priced stocks) of these portfolios, something that often leads to outperformance compared to the general market during recovery years.

Quiz Answer:

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66% [The Correct Answer]
Disclosures Including Backtested Performance Data

Quiz!

If the longest possible decline (peak-to-peak) for ET (Extended-Term Component) were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years
  2. 3 years
  3. 12 years
  4. More than 12 years

Look for the answer below and read this month’s article for a discussion.

Volatility is not the best Measure of Investment Risk

Volatility is the most common measure of investment risk.  There are a number of reasons:

  1. Some investors panic and sell at a low point.  Selling a high-growth high-volatility investment at a low point can negate the entire benefit of the high average growth.
  2. Some investors build concentrated portfolios, where volatility involves the risk of a loss that extends beyond a market cycle.
  3. When the horizon of the entire investment is shorter than a cycle of a volatile investment, volatility can lead to a permanent loss if it is fully sold at a lower point in the cycle.

What if you are a disciplined investor, saving for retirement (or being in retirement, with limited annual withdrawals), and are able to stick with your plan throughout the cycle?  In such a case, seeking low volatility at the price of lower average returns, can lead to higher overall risk, given the risk of outliving your money – the opposite of what is intended.  If you are going to stick with your plan throughout the cycle, a higher-growth diversified investment is less likely to leave you bankrupt as a result of regular retirement withdrawals.

Another factor is the position in the cycle.  While it is impossible to identify the precise peaks and bottoms of the cycle, there are certain factors that are not typical for peaks:

  1. Valuations are lower than usual.  The beginning of the worst declines tend to occur at very high valuations, not low.
  2. The investments are in the midst of a deep and long decline.  For example, if the recent peak was 9 years ago, and you are at a 28% decline, your risk level is much lower today.  And, to continue the example, if the total decline is 12 years long, you get a 39% gain in the remaining 3 years.

Quiz Answer:

If the longest possible decline (peak-to-peak) for ET were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years  [The Correct Answer]
  2. 3 years
  3. 12 years
  4. More than 12 years

Explanation:  Since we are over 9 years into the current decline, if 12 years were the longest decline, the remainder would be at most: 3 years.  With the portfolio currently 28% below the 10/31/2007 peak, not only would you recover any decline within 3 years – you would enjoy an addition gain of 39% (to revert the starting point of -28%).  This means that the longest decline to recovery of an investment made today would be substantially less than 3 years.

Disclosures Including Backtested Performance Data

Quiz!

What are the outcomes of consistently adding to a portfolio during declines of 20% + 20% followed by a 2 year recovery (25% + 25%), instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio.
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

Can You Make Money in a Down Market?

Imagine living through a long decline period. If you are retired and your entire life’s savings are invested in your portfolio according to your plan, you can relax knowing that your low withdrawal rate is likely to sustain your money for as long as you live.

If you are still in saving mode, or have money that was not put to work in your portfolio, you have choices. Let’s review two different options:

  1. You wait for the portfolio to recover to gain more comfort, and after it proved itself, you add more money to it. You don’t add money to a losing portfolio.
  2. You add all money available, whether it is savings from work, money invested elsewhere, equity in your home that you can borrow (subject to a risk assessment), or an inheritance.

Let’s continue with an example: Say you had 1M that declined for 2 years, and then recovered in 2 years. Also, say you had 100k to add per year. During the declining period, you choose between diverting to a portfolio that gained 10% per year and adding to the portfolio that simply declined and recovered with no new gains (as described in 1 & 2 above, respectively). Let’s see the financial impact of the 2 options:

1M Portfolio state Value of

original 1M

Value of new investments
Option #1: Invest at 10% Option #2: Invest in portfolio
20% decline + saved 100k 800k 100k 100k
20% decline + saved 100k 640k 100k + 10% + 100k = 210k 100k – 20% + 100k = 180k
25% gain + saved 100k 800k 210k + 10% + 100k = 331k 180k + 25% + 100k = 325k
25% gain to full recovery 1M 331k + 10% = 364k 325k + 25% + 100k = 506k
Performance of deposits 364k / 300k – 1 = 21% 506k / 300k -1 = 69%

After 4 years, option #1 would result in 364k, while option #2 would result in 506k.

In option #1, your entire mental focus is on the wait for a recovery, to regain comfort with the portfolio. You have no good feelings about the portfolio until you fully regained the lost grounds. In the meantime, you feel good about growing your new savings at 10% per year, and are happy that you did at least one smart thing.

In option #2, you keep adding to the portfolio, ignoring its behavior. At first, you feel good buying low. As the decline continues, you are tempted to feel that you are throwing good money after bad, but you remind yourself that the portfolio is far more attractive the lower it gets, and the new money can enjoy this benefit. After one year of gains, you can already celebrate the impact on your recent deposit. So, instead of focusing on the remaining path to recovery, you can enjoy the hard dollars that you gained during the initial part of the recovery. By the full recovery, you enjoy far better results than 10% per year even though you added to a portfolio that had 0% returns from peak to the new peak.

Quiz Answer:

What are the outcomes of consistently adding to a portfolio during declines of 20% & 20% followed by a 2 year recovery, instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio. [The Correct Answer]
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

The article above provides an explanation.

Disclosures Including Backtested Performance Data

Quiz!

Which are conditions that are all necessary for not thinking about small expenses?

  1. Your income covers your expenses.
  2. You are withdrawing less than 3% or 4% of your portfolio, every year.
  3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
  4. You feel that you are using your money in a way that maximizes your happiness.

Sweat the Small Stuff

You can skip this article if all of the following are true:

  1. Your total annual spending equals less than 3% or 4% of your stock portfolio, depending on its allocation. Make sure to include infrequent items such as car upgrades, roof replacements, uncovered medical expenses, and a long stay in a nursing home. You can deduct amounts covered by guaranteed lifelong income such as social security payments, pensions or inflation-adjusted annuities.
  2. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong.
  3. You feel that you are using your money in a way that maximizes your happiness.

Since I still have your attention, this article may help increase your happiness. You probably know that big financial decisions have a meaningful impact on your finances. Buying a large house, boat or a private jet will have substantial impact given the initial price and high maintenance costs. Having a high paying job, or two sources of income for a household can have a big positive impact.

As you work on getting the big picture right, you may follow the advice “don’t sweat the small stuff”. Indeed, you don’t need to sweat the small annoyances in life, but you may benefit from sweating the small expenses, especially the recurring ones. Here are examples.

  1. Subscriptions that you don’t utilize significantly. This could be cable TV with many channels, various software & apps, credit cards with annual fees and infrequently visited clubs.
  2. Infrequently used appliances that consume energy and require maintenance, including various refrigerators, lights, and computer systems.
  3. More employees than necessary, including nannies for older children, cooks and various maintenance staff.
  4. Eating out in expensive restaurants that you don’t appreciate in line with the cost.

The list above is a random sample of expenses. The list of expenses that can be reduced without a significant impact on your happiness is personal. You have to go through your expenses and find out what doesn’t makes you happy in line with the cost. One person may greatly appreciate a nice restaurant, while another may take great pleasure in having plenty of choices for TV programs.

Quiz Answer

Which are conditions that are all necessary for not thinking about small expenses?

  1. Your income covers your expenses.
  2. You are withdrawing less than 3% or 4% of your portfolio, every year. [Correct Answer, but read below]
  3. You are relaxed about your financial position, and have no concerns with investment volatility or surprise expenses when things go wrong. [Correct Answer]
  4. You feel that you are using your money in a way that maximizes your happiness. [Correct Answer]

Explanations:

  1. Jobs can come and go, bonuses can be reduced, and businesses can have fluctuating revenues. Income from work typically provides only temporary security.
  2. It is true that you need to withdraw less than 3% or 4% of your portfolio annually, but there is a much stronger condition – the 3% or 4% should be your total spending, ignoring income from work. Also, this applies to a stock portfolio. Bonds don’t grow fast enough to support lifelong withdrawals at 3% or 4%, growing with inflation.
  3. Even if you are at a sustainable withdrawal rate from your portfolio, if you are stressed with volatility or surprise expenses, you should build your resources to the point of a relaxed financial life.
  4. If you are sustainable financially (explanation #2) & relaxed about finances, but feel constrained, and are not happy with what money can buy you, you can be careful with your small expenses to free up money for other spending that may improve your happiness.
Disclosures Including Backtested Performance Data

Quiz!

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio.
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Your Financial Health in a Single Number

People use various numbers to measure their financial health. Let’s review some common ones, and see where they fail, through examples:

 

Measure Person 1 Person 2 Person 2 has better financial health
even though… because…
Net worth (total assets minus total liabilities) Net worth: $10M

Annual spending: $1M

Net worth: $1M

Annual spending: $50k

His net worth is x10 smaller His money can support double the years of living expenses
Income Income: $1M per year

Savings: $0 per year

Total saved: $0

Income: $100k per year

Savings: $20k per year

Total saved: $200k

Her income is x10 lower She has some financial security in case she loses her job
Annual savings Income: $1M per year

Income taxes: $400k

Annual spending: $500k Annual savings: $100k

Liquid assets: $200k stocks

Income: $100k per year

Income taxes: $20k

Annual spending: $50k

Annual savings: $30k

Liquid assets: $60k stocks

His annual savings is x3.3 smaller He is building security faster, saving 60% of annual spending vs. only 20%. His savings in stocks are also greater relative to spending.
Withdrawal rate from stock portfolio (annual withdrawals from the stock portfolio divided by its value) Expenses: $1M per year

Stocks: $1M

Annual withdrawals: $0k

Expenses: $40k per year

Stocks: $1M

Annual withdrawals: $20k

Her withdrawal rate is infinitely greater Her total spending (4%) can be sustained with no work, while the other has only 1 year of expenses saved
Spending rate from liquid assets (total annual spending divided by the value of all liquid assets) Liquid assets: $1M cash

Spending: $40k per year

Liquid assets: $1M stocks

Spending: $44k per year

His spending rate is 10% greater Stocks provide growth, and are more likely to sustain a 4.4% withdrawal rate than 4% from cash

Is there a single number that can give some indication of your financial health? Yes! It is the spending rate from your stock portfolio: total annual spending divided by the value of your stock portfolio. This assumes that the stock portfolio is diversified, and held for the long run, with no market timing, and no panic sales during stock declines. Also, you can reduce your spending measure by any amount that is guaranteed for life by an inflation-adjusted source, such as social security.

Why does this measure work?

  1. It shows progress towards financial freedom / financial security / retirement. Once your spending rate is below 3%-4%, depending on the specific portfolio allocation, the portfolio is likely to sustain the spending for as long as you live. If your spending rate is 6%-8%, you know that, between savings and investment growth, 100% increase will make you independent of work.
  2. It is not sensitive to a loss of job. It ignores income from work, that can be lost in various ways. In addition, if you want to ever be independent of the need to work, you want to measure your position assuming no income.
  3. It can withstand high inflation, given the focus on stocks.
  4. It does not suffer from liquidity concerns related to real estate, private equity and small businesses. Exception: If you have a diversified collection of properties, you can consider their income, after accounting for vacancies and repairs, if they are diverse geographically (and ideally enjoy country diversification, same as with stocks).
  5. It focuses on current health instead of potential. Even if you save a large amount every year, the saving can stop completely if you lose your job. What matters is money on hand (prior savings).

What are the implications? How can you improve your financial health?

  1. Maximize your allocation to stocks, but not beyond the point of risking getting into trouble during stock declines, either through large withdrawals, or panic sales. This requires a careful risk analysis.
  2. Keep your spending under control. A 10% reduction in spending provides an instant 10% gain in your financial health – this is powerful.
  3. Maximize your savings, either through lower spending or higher earnings. Note that higher earnings will not have any immediate impact, but the saved money from your increased earnings will build up gradually.

Quiz Answer

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio. [The Correct Answer]
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Explanations: See article above. Note that the last option “withdrawal rate from liquid assets” is not addressed by the article, since it suffers from the combination of flaws of the two options above it (5 & 6).

Disclosures Including Backtested Performance Data