## 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.

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.

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

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.

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.

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!

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.