Quiz!

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your savings nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year.

Should Higher Earners have Higher or Lower Saving Rates?

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. Should you keep your saving rate of 10%, increasing your savings to $16k/year? Should you increase your savings by less than that or even more? For many reasons, you should increase your saving rate, leading to new savings greater than $16k/year. Here are a few reasons:

  1. Usually, the higher your income, the lower your job security. Many more people compete for CEO or VP roles, than a fast food restaurant employee. You need to build security through savings faster to make up for your declining job security.
  2. If you lose your job, there are fewer jobs to choose from, the higher the income.
  3. The excess happiness obtained by increased spending goes down quickly as the amount goes up. Reducing financial stress typically brings much greater happiness.
  4. Social security covers a smaller portion of high incomes. If you earn $30,000 per year, social security will give you a retirement greater than half of your earnings. But, at $300,000 per year, social security income covers a small portion of the income you got used to. It is up to you to make up the difference. To get income of $300,000 from a portfolio that can generate 3% per year, you would need to build savings of $10,000,000. If you want to enjoy anywhere near the standard of living you got used to, you need a very high saving rate combined with investing for high growth compounded over many years.

The good news is that even at 20% = $32k saving rate, your income available to spending grows by a substantial: (160k – 32k) – (100k – 10k) = 38k minus income taxes. You get the double benefit of higher spending along with a big increase in your saving rate.

Quiz Answer:

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your saving nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year. [The Correct Answer]

Explanations: Read this months’ article for an explanation.

Disclosures Including Backtested Performance Data

Quiz!

Which rule of thumb for spending can be useful for all personality types?

  1. Save 10% of your income and spend the rest.
  2. Save 10% of your income for incomes up to $200k, and 20% for incomes above that. You can spend the rest.
  3. Keep your spending as low as needed to avoid chronic financial stress.
  4. Save as much as needed to allow you to retire by a reasonable age such as 65 or 70. You can spend the rest.

How Much Should You Spend? A Rule of Thumb for All!

This article offers a rule of thumb for a healthy spending level for all personality types.

Full sustainability: No matter your preferences, you can feel comfortable to spend an amount that is likely to be sustainable for as long as you live, whether you work or not. This is: your current social security payments, pensions and other guaranteed income, plus a sustainable withdrawal from your investments (e.g. 3%-4% for many globally diversified stock portfolios, reduced enough to account for surprise expenses).

Rule of thumb for all: Early in your career, full sustainability is rarely possible. A rule of thumb is to keep your spending as low as needed to avoid chronic financial stress. The benefit of this rule is that it can apply equally to different personalities. Here are a few examples:

  1. Risk averse: If you are risk averse, you may become stressed by any income instability or large surprise expenses. It may be worth keeping your spending as close as you can to 3%-4% of your portfolio. It may involve a large initial adjustment, but in return you will get many rewards. You will take the fastest road out of financial stress. You will enjoy the extra savings, plus the compounded growth of the extra savings. This will lead to a positive snowball effect of fast growing sustainable income along with relaxation.
  2. Time-sensitive spending: Some expenses lead to benefits that may not be available if delayed. Examples include children’s education & healthy eating. If you are risk averse, a compromise may be delaying most expenses, but still retaining your time-sensitive expenses.
  3. Instant gratification: If you are averse to delaying gratification, and don’t get too stressed without much of a safety net, you may choose to spend the bulk of your income, no matter how limited your investments are. Any loss of job, and many surprise expenses will require quick adjustments and potential stress. With low total savings to enjoy compounded growth, you will likely have a lot less money to spend in your lifetime, and your dependency on work will stay consistently high. But if immediate gratification is your top desire, and the consequences don’t stress you, it may be worth the tradeoff.

Important notes:

  1. Be realistic about upcoming expenses. Many types of non-recurring expenses are bound to happen. Examples include medical costs, house repairs, car repairs, new cars, loss of job and business downturns. I’ve heard people refer to these as bad luck. Switching your mindset, and seeing them as expected non-recurring expenses, can significantly increase your happiness and success in life.
  2. The benefit: The rule of thumb of avoiding chronic financial stress can be helpful regardless of your priorities. If your spending creates ongoing stress, you are probably not living an authentic life, and the price could be greater than any benefit you are getting by the spending. This is true whether you think you are spending very little or a lot.
  3. Stable jobs with guaranteed pensions. Because most jobs are far from guaranteed, the ultimate way to avoid chronic financial stress is to depend on sustainable withdrawals from actual money in the bank (investments). If you are lucky enough to have a very stable job that has a guaranteed pension, the pressure to reduce the dependency on work is lower. Please remember, though, that such jobs are rare, and pensions may not be as guaranteed as they used to be.
  4. If you are married, it is worth discussing spending, with a clear goal of resolving and preventing chronic financial stress. To motivate the talks, realize that one person’s stress typically hurts both members of the couple – even the person who is less risk averse and eager to spend more.
  5. Perspective: You can maximize your happiness by comparing yourself to people living in a basic structure with no running water and no electricity, and realize how fortunate you are. No matter how much you lower your spending, you are very fortunate in life.

Quiz Answer:

Which rule of thumb for spending can be useful for all personality types?

  1. Save 10% of your income and spend the rest.
  2. Save 10% of your income for incomes up to $200k, and 20% for incomes above that. You can spend the rest.
  3. Keep your spending as low as needed to avoid chronic financial stress. [The Correct Answer]
  4. Save as much as needed to allow you to retire by a reasonable age such as 65 or 70. You can spend the rest.

Explanations:

  1. Your saving rate depends on how much you have saved, how soon you desire to retire, your spending rate, your income level, your job stability, and a number of other factors. There isn’t one percentage that applies to everyone.
  2. All else being equal, you should save a greater percentage of your income, the higher it is, since it is tougher to replace higher incomes, and your basics are more likely to be covered already. But, spending and saving rates depend on many other factors, some of which are mentioned in #1 above.
  3. Stress is a protection mechanism that tells you that you are not acting in an authentic way. If you are chronically financially stressed, you are acting against your internal beliefs. This rule of thumb can help everyone.
  4. There are many problems with this advice. A few of them: You cannot count on a specific growth rate on your investments to know when you can retire, you cannot anticipate health problems, loss of job, volatile business income, and the list goes on.
Disclosures Including Backtested Performance Data

Quiz!

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that.
  2. He is wealthy.
  3. He lives in a fancy house.

Your Neighbor’s Grass is Brown!

Have you ever seen a friend’s or neighbor’s fancy car, or heard about her fancy trip, and thought how lucky she is? After nearly 1.5 decades in this business, I’ve heard many people’s stories, and learned that things are rarely what they seem. Specifically:

  1. Each person emphasizes certain expenses, while often keeping other expenses much lower. A person can fly business class, while living an otherwise modest life. Another may lease a fancy car, while renting a modest home. A third may live a simple life in a fancy home. A fourth may pay for a very expensive private school for her children while living a modest life. These are all examples based on people I personally know. I believe that only a small fraction of people who spend big in a few categories, can afford to spend big in all categories. It makes sense to choose the most important things in your life and focus your spending on them, rather than spending evenly across all categories, whether important to you or not, leaving less money to your top priorities.
  2. Many big spenders are chronically stressed. It fits with a recent study showing that income above $105,000 in North America paradoxically leads to diminished happiness. Anyone with high income faces the temptation to spend a big portion of their income. Say you gross $1M and net $600k per year. You save what feels like a respectable 20% of your net income: $120k, and spend $480k. After a number of years, you built a nice investment portfolio of $1M. You are still highly dependent on your income, and replacing such high income can be a big challenge. This can lead to unusually big stress. In addition, high income often comes with big responsibilities (CEO, business owner), putting extra pressure. To sustain $480k of spending from a stock portfolio that can handle sustainable 3% withdrawals, you would need to reach savings of $16M. Such a level of savings is not common, and probably a lot less common than spending of $480k per year.

If you are able to satisfy your basic needs (food, a place to sleep, basic clothes, etc.), and spend modestly relative to your savings, you are under a fraction of the financial pressures of many big spenders. You may think that their grass is greener, but it is brown compared to yours. Peace of mind, lesser dependency on work, and appreciation for the little things in life are worth a lot more than what big expenses can buy along with the stress involved. You are the source of envy of some very big spenders who realize that your grass is greener. Next time you see a big spender, you may replace feelings of envy with some compassion.

Quiz Answer:

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that. [The Correct Answer]
  2. He is wealthy.
  3. He lives in a fancy house.

Explanations:

  1. People often spend money on things they value.
  2. People usually spend money based on their income, even if their total wealth (savings/investments) is low.
  3. People usually spend big money on several categories, but not all.
Disclosures Including Backtested Performance Data

Quiz!

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up.
  2. Down.

Do Rising U.S. Interest Rates Hurt Emerging Markets?

There is a widely held belief that when the US Fed (Federal Reserve) raises interest rates, emerging markets investments should decline.

Why do people expect emerging markets to get hurt when US rates go up?

  1. Stronger dollar: When US rates go up relative to rates in other countries, people can earn a higher rate on savings in the US. This would lead to money flowing from other countries to the US, which would strengthen the dollar.
  2. Higher borrowing costs for emerging markets: Many emerging markets companies borrow in dollars. If a Chinese company earns money in yuans and borrows in dollars, a stronger dollar would make the loan more expensive in yuans, hurting the company.

Reality is the opposite!

While the logic seems sound, reality in the past 20 years has been the opposite. The table below tracks the returns of ET (Extended-Term Component), a portfolio focused on emerging markets, in periods of rising and declining rates in the US:

Period Start

Period End

Change in US rates

ET Returns

12/31/1998

5/16/2000

+1.75%

+58%

5/16/2000

6/25/2003

-5.50%

-11%

6/25/2003

6/29/2006

+4.25%

+169%

6/29/2006

12/15/2015

-5.25%

+20%

12/15/2015

9/28/2018

+2.00%

+50%

Observations & notes:

  1. In all rising-rate periods, ET gained substantially.
  2. In declining-rate periods, ET had much worse results, with negative to low-positive returns.
  3. Market tops and bottoms didn’t coincide perfectly with the borders between the periods. Measured from the turning points in the portfolio, the results are substantially stronger.

Why do emerging markets go up when US interest rates go up, and vice versa?

The Fed reacts to the world economies when setting the interest rates. It focuses on the US, but considers the rest of the world as well. Specifically:

  1. When the economy shows signs of weakness after a period of expansion, the Fed lowers rates, to support the economy.
  2. When the economy turns around after a period of contraction, the Fed raises rates to moderate the expansion.

While I wouldn’t count on emerging markets to go up perfectly whenever US rates go up, the data is useful in avoiding expecting the opposite.

Quiz Answer:

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up. [The Correct Answer]
  2. Down.

Explanations: Read this month’s article for an explanation.

Disclosures Including Backtested Performance Data

Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50%

How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

Portfolio 1

Portfolio 2

Year 1

0%

-50%

Year 2

0%

100%

Average

0%

0%

If you start with $100, both portfolios will be worth $100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) $100 – 50% = $50. (Year 2) $50 + 100% = $100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add $100 in the beginning of each year:

Portfolio 1

Portfolio 2

Year 1

($100 + 0%) = $100

($100 – 50%) = $50

Year 2

($100 + $100) + 0% = $200

($50 + $100) + 100% = $300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher ($300 vs. $200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up $100 – double the -$50 impact of the decline.

Notes:

  1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
  2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

Quiz Answer:

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50% [The Correct Answer]

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

Quiz!

Who are the winners when a country increases taxes on imports (tariffs) from another country?

  1. The country taxing imports.
  2. The other county (the exporter).
  3. Neither country.
  4. Both countries.

The Winners and Losers of Tariffs

Tariffs hurt specialization across borders, limit global trade, and increase the costs to consumers – it’s a losing proposition for everyone involved. So, why would the US seek to increase tariffs? I believe that it is a negotiation tactic by the US, to try to reduce the trade imbalance with other countries (the US imports more than it exports). If I am correct, this can go on while each country involved figures out the extent of its power. I believe that once all the information is available and the negotiations are complete, any buildup in bilateral tariffs would be removed to everyone’s benefit.

Supporting my opinion is the fact that the world is very interconnected economically. Let’s view two big players in these negotiations: the US and China. I will point out several mutually beneficial connections in the table below.

Action

Benefit to the US

Benefit to China

The US imports from China a lot more than it exports

US consumers get cheaper products, thanks to cheaper labor in China.

China gets more buyers for their products

China loosely pegs the yuan (its currency) to the dollar. They get dollars from exports to the US, and buy US treasuries to keep the dollar’s value high enough relative to the yuan.

The US government gets cheap loans from China, to support its huge budget deficit. China is the largest lender to the US government.

By buying dollars, China keeps its currency low, to make its exports cheaper in dollars, and be more competitive.

Quiz Answer:

Who are the winners when a country increases taxes on imports (tariffs) from another country?

  1. The country taxing imports.
  2. The other county (the exporter).
  3. Neither country. [The Correct Answer]
  4. Both countries.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following are common to Warren Buffett and Quality Asset Management?

  1. Value investing
  2. Home bias
  3. Profitability bias
  4. Reduced volatility

Warren Buffett’s Strategy vs. Quality Asset Management’s

Warren Buffet is one of the greatest investors of all times. Given that his fund, Berkshire Hathaway, holds a small number of stocks, you may think that his strong performance was the result of superior stock selection (a.k.a. alpha). A study that was published in 2013 (https://www.nber.org/papers/w19681) found that the benefit of his stock selection was statistically insignificant, attributing virtually the entire performance to structural decisions. Below I review the sources of his performance that are in common with Quality Asset Management (QAM), and those that are different.

In common:

  1. Value: Both invest in companies with a low price relative to the company’s book value (low P/B).
  2. Quality: Both invest in profitable companies.
  3. Reduced Volatility: Buffett buys low volatility stocks that historically resulted in excess returns. QAM achieves similar results (reduced volatility, excess returns) by excluding extremely small and expensive (high P/B) stocks as well as stocks experiencing negative momentum.

Buffett’s benefits:

  1. Leverage: Buffett employs leverage of 1.4 to 1.6, with very low costs of borrowing thanks to using capital from his insurance business (premiums received until claims where paid), and interest-free loans: differed tax on depreciation, accounts payable and option contract liabilities. QAM helps clients use home mortgages & HELOCs (home equity lines of credit) to generate leverage, when desired, possible (the client can qualify for the loans) & subject to a risk analysis. In addition, it invests deferred obligations, including income taxes until due (e.g. when the client pays 110% of past year’s taxes in estimated taxes, and enjoys faster growing income). QAM uses very low cost margin for loans backed by unused HELOCs, and other sources. While there are some similarities, this strategy is not used for all of QAM’s client’s, and the leverage level declines with the growth of the portfolio relative to the client’s home value. In addition, the interest rate that Buffett gets from his insurance arm is lower than the interest rates that QAM’s clients get. Therefore, this is usually a benefit to Buffett relative to QAM.

QAM’s benefits:

  1. Size: Early on, Buffett focused on small companies. Given the size of his fund, he cannot practically focus on a small number of small companies, and he developed a bias towards large companies. QAM has a bias towards small companies that is likely generate a return premium relative to Buffett. This benefit is likely to be sustainable for a very long time, given QAM’s strong diversification.
  2. Country: Buffett has a bias towards American companies. QAM doesn’t have this bias, and it focuses on companies from less developed countries. This is likely to generate a return premium.

Quiz Answer:

Which of the following are common to Warren Buffett and Quality Asset Management?

  1. Value investing [Correct Answer]
  2. Home bias
  3. Profitability bias [Correct Answer]
  4. Reduced volatility [Correct Answer]

Explanations: Please read the article above for explanations.

Disclosures Including Backtested Performance Data

Quiz!

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

  1. It gained more often than declined.
  2. It declined more often than gained.
  3. It gained consistently in all cases.
  4. It declined consistently in all cases.
  5. As with most things, the results were mixed.

What do Stocks do when Interest Rates Rise?

This article reviews the impact of rising rates from a low point on the high-volatility high-growth stock portfolio Extended-Term Component, both empirically and logically.

 

Empirically: We have 2 cases of rising rates from a low point in the live history since 1998:

Increase Date Starting Rate Trend information Performance since rate increases started Duration Rates before peak portfolio
6/30/2004 1% Gain started 1.5 years earlier +277% 3.3 years Reduced for a month after plateaued for over a year
12/17/2015 0%-0.25% Gain started after a short-lived (35 days) 12% decline +61% so far (including the initial decline) 2.2 years so far Peak not established yet

So far, we enjoyed phenomenal gains in both cases. While this data is not statistically significant, these strong results dispel the myth that you should expect declines when rates go up. So far, all [2] cases go against this theory.

Logically: The Fed acts in reaction to US and non-US economic activity. It lowered rates as a result of poor economic performance, in an attempt to stimulate the economies. Very low rates tend to be a result of big financial shocks, as we have seen in 2000-2002 and 2008. After these big shocks, the Fed was slow to reverse course and raise rates, because the risk of deflation seemed greater than the risk of inflation. By the time it raised rates, there were clear signs of economic improvement around the world. Additional rate increases were done cautiously after the economies continued to improve. The positive effect of economic improvements was greater than the negative effect of rising rates, by design. In addition, with such low starting rates, it took a long while for rates to stop being accommodative to the economy.

More Good News: While stocks did well as rates went up from low levels, you may expect stocks to get hurt when rates reach higher levels. In the history we have since 1998, the 1-year return leading to high peaks, when interest rates reached a cycle-high, was not only positive, but unusually high: The 1-year return was 92% leading to the 2000 peak, and 73% leading to the 2007 peak.

Quiz Answer:

In the past 20 years, how did Extended-Term Component perform in a period of rising rates from low rates?

  1. It gained more often than declined.
  2. It declined more often than gained.
  3. It gained consistently in all cases. [The Correct Answer]
  4. It declined consistently in all cases.
  5. As with most things, the results were mixed.

Explanation: Please read this month’s article for an explanation. Note that while the results were consistent, there were only two instances in total over 20 years, so these results are not statistically significant. A conclusion that is safe to make: we cannot count on high odds of declines as rates go up, because the history so far goes strongly against this theory.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then.
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken.

Mortgage Deduction Strategies Under The Tax Reform

The tax reform that was signed on 12/22/2017 (Tax Cuts and Jobs Act), reduces the mortgage deduction from $1M to $750k and eliminates the home equity debt interest deduction of $100k. This article presents how it can impact you, and strategies for lessening the impact.

  1. Enjoy Grandfathering: While new mortgage debt above $750k does not get a tax deduction, you can continue to enjoy up to $1M deduction on existing mortgages & loan amounts preserved through refinances. Strategy: Refinance with a larger and/or interest-only mortgage, and keep refinancing to keep the mortgage from dipping below $1M (or below your existing balance between $750k and $1M). Examples for the grandfathering:
    1. You took a 1M mortgage in the past and by 2017 the balance was down to 600k. Deductions on future refinances will be limited to interest on 600k, even if you increase the borrowed amount. If the balance goes down to 500k in 2020, deductions through future refinances are limited to interest on 500k.
    2. You took a 1M mortgage in the past and by 2017 the balance was down to 900k. If you refinance to 1.2M, you keep getting a deduction on interest on 900k, as long as the balance is over 900k.
    3. You took a 2M mortgage in the past and by 2017 the balance was down to 1.5M. The balance keeps declining to 1.4M by 2018, and then you refinance with a 2.2M mortgage. At all times, you get to enjoy the full deduction of interest on 1M.
  2. Get Investment Interest Expense Deduction: Whether you have a new mortgage above $750k, an old mortgage above $1M, or a HELOC (Home Equity Line of Credit), you may be able to get a partial or full deduction vs. investments income (interest, dividends or capital gains). This deduction is called “Investment Interest Expense”, and is given because you technically borrow to invest, whether you intended to do so or not. This is evident if you compare your current reality relative to selling from your investments to pay off your home loans. By keeping both the loan and the investments, you are borrowing to invest. A few notes:
    1. The deduction is available regardless of the source of investment income. For example, if you have a $100k HELOC costing you $5k per year in interest, and a $500k investment generating 1% realized annual income = $5k, you can use that.
    2. If you don’t have enough investment income in any given year, you can defer the disallowed interest amount to the next year, and continue to do so indefinitely. If your investment has high average growth and generates income and/or capital gains, you may have a chance of enjoying the disallowed deduction later on.
    3. Taking the deduction vs. investment income that is taxed at your marginal tax rate (i.e. short-term gains & non-qualified dividends) gives you the full benefit, like the mortgage & HELOC deductions.
    4. If you don’t have enough of the ideal investment income mentioned above, you can elect to take deductions vs. long-term gains & qualified dividends. You have to decide whether taking the lesser deduction today is better than the full deduction later on, requiring some analysis. This decision may not apply to state taxes where there is the same tax rate for both types of investment income.

Important notes:

  1. You should only borrow to invest if the investments are likely to provide materially higher growth than the interest on your loans, or you are seeking liquidity as part of your risk plan and willing to accept the interest costs.
  2. Do a very careful risk analysis that prepares you for a great deal of bad luck. Don’t forget what happened to those who skipped this step in 2008.
  3. You need perfect discipline through the market cycles. The best risk analysis won’t protect you if you panic-sell at the bottom of a decline.
  4. Always do a full comparison of the current picture vs. the new one you are considering, to see if the change is beneficial. The most common failure results from considering one or two factors in isolation, without the remaining moving parts. For a refinance, start with risk planning, then include: estimated refinance costs, change in rate, impact of cash flow change (e.g. between interest-only and fully amortized), and any change in tax benefits. Sometimes the decision will be simple, and sometimes it will require a full simulation in a spreadsheet.

Also, remember that I am not a CPA, and I recommend consulting with a CPA on all tax matters.

Quiz Answer:

Which of the following are true?

  1. You cannot deduct interest on any mortgage above 750k.
  2. You can only deduct interest on a mortgage above 750k if the mortgage was established before 12/15/2017.
  3. You can deduct interest on a mortgage above 750k only if its lowest balance before the tax reform was over 750k, and even if you refinanced it since then. [Correct Answer]
  4. You can deduct interest on a mortgage above 750k for any mortgage that was taken before the tax reform.
  5. You may get a deduction on mortgage interest, for mortgages above 750k, regardless of when the mortgage was taken. [Correct Answer]

Explanations:

  1. If the mortgage was taken before the tax reform and was kept or refinanced to a similar/higher balance, you can get a deduction up to 1M.
  2. If you refinance a >750k mortgage and keep the balance higher than 750k, your deduction is grandfathered.
  3. Old borrowed amounts are grandfathered. Specifically, as long as you sustained your mortgage balance above 750k, you get to keep the deduction on interest up to 1M. This holds even through refinances.
  4. Not true if the mortgage balance went below 750k at any point.
  5. A bit tricky, and is true because you can get a partial or full investment interest expenses deduction on disallowed mortgage interest amount, depending on your investment income. The article explains this further.
Disclosures Including Backtested Performance Data

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