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

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