Quiz!

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment.
  2. Rising bond interest rates.
  3. Expectation for inflation.
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks.
  6. Economic recovery from the pandemic.
  7. The best option out there.

Tipping Point for Value?

Last year will go into the history books given the pandemic. But another, less noticed, rare thing happened. Growth stocks, those with a high price relative to the company’s book value (P/B), or intrinsic value, went from very expensive to extremely expensive – a level barely second to the late 1990’s. While they’ve become more expensive for a while, there was a big spike in unprofitable small growth stocks. Last time we had a spike even close to this magnitude was around 1999. This is very reassuring for Value stocks, because often a long-lasting trend ends in a big spike in the direction of the trend, followed by a sharp reversal. For value stocks in the US, last time the reversal meant a 50% outperformance in a mere 2 years.

There are a number of logical reasons to see a reversal at this point:

  1. A change in sentiment: The reversal already started a few months ago, long enough for people to take note, and start treating it more like a new trend than noise.
  2. Expectation for inflation: Two forces are leading to an expectation for higher inflation: (1) Dramatic government stimulus; (2) The Fed planning to hold interest rates low until after inflation overshoots the typical target. Bond prices already started declining reflecting this expectation.
  3. Very low valuations relative to growth (high Price/Book) stocks: With the valuations of growth stocks going so much higher relative to value stocks, growth stocks became much more dangerous. People took note and started shifting towards value stocks.
  4. Economic recovery from the pandemic: Value stocks tend to outperform at times of economic recovery.

Note that value stocks outside the US have much lower valuations than US stocks – near record difference, making them even more appealing. As always, there could be surprises, and it is important to structure your financial picture to account for them.

Quiz Answer:

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment. [Correct Answer]
  2. Rising bond interest rates. [Correct Answer]
  3. Expectation for inflation. [Correct Answer]
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks. [Correct Answer]
  6. Economic recovery from the pandemic. [Correct Answer]
  7. The best option out there. [Correct Answer]

Explanations: #4 is only partly correct. In the US value stocks are not low relative to their historic average, though they are very low relative to growth stocks. Outside the US, valuations are clearly low.

See article for more explanations about the correct answers.

Disclosures Including Backtested Performance Data

Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

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

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data

Quiz!

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter.
  3. It was scarier.
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual.

The Surprises & The Expected of 2020

The pandemic of 2020 was shocking to investors and humans in general. It involved substantial uncertainty, leading people to predict years of pain for stock investments. While the split between surprises & the expected will vary depending on the reader, below is my split.

Surprises:

  1. While the key actions to contain the pandemic were known early on (looking at some Asian countries), the magnitude of unwillingness to take these actions seriously in other countries was greater than I expected, leading to a much worse result than possible otherwise. While stocks recovered rapidly, they could have bottomed higher, with fewer lives lost on the way.

Expected:

  1. The decline was shorter than typical, because it didn’t come from a position of economic leverage and euphoria.
  2. When panic took hold in March, the Fed repeated its 2008 announcement, being prepared to do whatever it would take to support the economy. Other countries operated similarly.
  3. The turnaround came as soon as the level of uncertainty diminished, far before the economy improved, as typical.
  4. While the economy is still hurting badly, it started the turnaround much earlier than in prior declines, thanks to the cause being a shock and not leverage.
  5. Many people said about this decline that it’s different, and will last much longer than past declines. Fortunately, this prediction failed, as typical when made at past times of uncertainty.

The specifics of every market decline are different, creating a need to prepare for declines of varying lengths & depths, worse than we experienced before. While the specifics vary, there are some truths that follow through the cycles, especially some level of correlation between starting valuations (e.g. Price/Book) of risky assets and the severity of the decline. With the right planning, whether cash set aside or low spending relative to liquid assets, there is no need to label any case as “this time is different”. The more prepared you are, the stronger you can be going through scary times, with discipline to avoid panic selling at the depth of the decline.

Quiz Answer:

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter. [Correct Answer]
  3. It was scarier. [Correct Answer]
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual. [Correct Answer]

Explanations:

  1. This decline was shallower than the other two declines.
  2. This decline was dramatically shorter than the other two declines.
  3. While every decline is scary, this was scarier, because we haven’t seen such a widespread pandemic in our lifetimes.
  4. This decline was dramatically shorter than the other two declines.
  5. In most declines, the turnaround comes far ahead of the economic turnaround. It comes from a combination of government & central banks (e.g. the Fed) support along with an expectation for a future turnaround.
  6. Both 2008 and 2020 saw very big government & central bank support, but this year’s support was even bigger.

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news.
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Testing Emerging Markets Value Investments in a Simple Graph

Value stocks are priced low relative to their intrinsic value (low Price/Book, or P/B). Value investing makes logical sense: when buying cheap stocks, you can expect to enjoy higher returns. It is not only logical, but also supported by nearly 100 years of evidence. This is all nice, until you look at the past 10 years and see that value underperformed growth (high Price/Book) for the whole period. This raises the suspicion of a new normal. Maybe the entire group of companies with low prices has something wrong with them, and their value will go down over time, to justify the low price?

There is an easy test to differentiate between bad companies and cheap investments:

  1. Bad companies: The underperformance is explained by underperformance of their book values relative to the rest of the market. This is why Warren Buffett tracks the book values of his companies more than prices.
  2. Cheap investment: A lot of the underperformance of value stocks is explained by a change in their valuations (P/B) relative to the rest of the market.

As an example, here is a comparison of DFA funds, one representing overall Emerging Markets (EM), and the other representing EM Value. The graph divides the valuations (P/B) of EM by EM Value. A high value represents an increase in the price paid for all of EM relative to the price paid for EM Value stocks.

clip_image002

For the year (2020), EM Value underperformed EM by about 11%, while the valuations difference increased by 15%. This means that the value companies, as measured by their book value, did 4% better than the overall market. This supports the thesis that these investments are simply cheaper, and you may reap the benefit as the valuations continue their cycle.

Quiz Answer:

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news. [Correct Answer]
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Explanations:

  1. You cannot conclude anything positive or negative from a 1 year period.
  2. See #1 above.
  3. The combination of averaging many 10-year stretches with a focus on pricing (valuations) similar to today, gives useful information.
  4. See #3 above.
  5. After a decade of unusually good returns, the risk of a weaker decade goes up, so it is not necessarily a good sign.
  6. After a decade of unusually good returns, the risk of a weaker decade goes up, but it is also not a guarantee for a bad next decade.
Disclosures Including Backtested Performance Data

Quiz!

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

A Hidden Measure of Investment Risk, Beyond Volatility

This article debunks a conventional wisdom that equates volatility with risk, and ignores all other factors. The following example demonstrates a problem with this narrow focus. Compare the following two situations:

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

By focusing on volatility alone, you would conclude that the first investment is less risky. This conclusion is wrong. The lowest balance that the stable investment can reach is 1M, since it never declines. The lowest balance that the volatile investment can reach is 1.2M, since it starts with 3M and can go down by up to 60% of the peak. The first investment is riskier for two reasons: (1) it grows more slowly on average, and (2) it has a lower worst-case balance. Your risk of running out of money with this investment is greater.

Since the starting investment amounts are different in the two cases, how can this apply to the real world? An example could help:

  1. Say you have 1M invested in a stable investment.
  2. The investments grow to 1.1M through a combination of investment growth and new savings. This allows you to shift your investments towards higher expected growth along with higher volatility. Specifically, the investments can potentially decline by another 100k (10%) during declines, to get you to the prior risk during declines.
  3. You repeat the step above, leading to higher and higher expected growth, while keeping the risk level the same.
  4. Your investments reach 2.5M, and you reached an allocation for maximum potential growth, along with potential declines of up to 60%. Your risk level is still the same with the lowest balance being: 2.5M x (1 – 60%) = 1M.
  5. Your investments reach 3M, and you keep the allocation the same, since you already enjoy the maximum potential growth. But now the lowest your investments can reach is up to 3M x (1 – 60%) = 1.2M, giving you higher security, despite the much higher volatility.

Notes:

  1. Risk is determined by spending/investments, not investments alone. To account for expenses going up or down, you should track spending/investments, not just the investment balance.
  2. Another risk factor is the valuations (P/B = Price/Book, or price relative to intrinsic value or liquidation value). In diversified portfolios, high valuations lead to higher risk (greater potential decline), and lower valuations lead to lower risk (lower potential decline).
  3. Some stable investments are exposed to inflation risk, making them riskier than seems.  On the other hand, there is no guaranteed maximum decline for any investment.  It is all a matter of odds.
  4. If higher volatility leads you to panic and sell low, that is another risk factor that can take away the financial benefits described above.
  5. While income from work can be lost at any point, some jobs are much more secure than typical (e.g. doctors), and can help your risk profile.

Implications:

  1. A plan that may be risky for someone else, may be conservative for you (and vice-versa), depending on your respective ratios of expenses/investments & valuations.
  2. A plan that would have been risky for you a few years ago, may be conservative for you today (and the reverse is potentially true if your expenses grow faster than your investments).

Quiz Answer:

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines. [Correct Answer]
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

Explanation: See article for explanations.

Disclosures Including Backtested Performance Data

Quiz!

Which of the following are expected results of protectionism (e.g. taxes on imports, quotas to limit imports)?

  1. Saving jobs.
  2. Lowering costs of products.
  3. Better products.

Long-Term Protectionism is Unnatural and Not Likely

Protectionism (e.g. tariffs = taxes on imports, quotas to limit imports) is done for two reasons:

  1. Temporary: negotiations between countries on different topics, alternatives to wars.
  2. Long-term: protect local producers from competition from foreign producers.

There is a concern about long-term protectionism (#2 above), that can affect stock prices. Long-term protectionism is unlikely for the following reasons:

  1. Unintended consequences: While higher prices save jobs in one industry, it costs jobs in other industries. It does so in two ways:
    1. Consumers have to pay a higher price for products, leaving them with less money to spend on products and services of other industries.
    2. When the consumer is a company, it has to raise its own prices to make up for the higher input cost. This makes the company less competitive with foreign producers that have lower input costs.
  2. Net loss: The higher cost to the consumers goes to benefactors beyond retaining jobs in the protected industry, including company profits (investors), manager bonuses, and higher pay to employees. For example, it cost consumers $826,000 per year for every saved job in the sugar industry in 2002 (Federal Reserve Bank of Dallas).
  3. Online Shopping promotes globalization: The coronavirus accelerated the transition to online shopping, where comparing prices is much easier than going to multiple physical stores. This gives a boost to cheaper products that are imported from countries with cheaper labor.
  4. Improved Quality: There was a time where buying from China involved a tradeoff – lower quality for lower price. The quality of products improved significantly and is no longer a concern, improving their exports.
  5. Economies of scale: Protectionism limits trade and reduces the number of buyers from each company. This hurts the scale of companies, leading to lower efficiencies.
  6. Specialization: Protectionism limits the market for each company, and reduces the opportunities to specialize.

Quiz Answer:

Which of the following are expected results of protectionism (e.g. taxes on imports, quotas to limit imports)?

  1. Saving jobs.
  2. Lowering costs of products.
  3. Better products.

None of the answers is correct. Specifically:

  1. Protectionism saves jobs in the protected industry, but takes away jobs from other industries. The overall effect is lost jobs.
  2. Protectionism artificially inflates the prices of the product coming from abroad, leading to a higher price.
  3. Protectionism limits the market of companies, leading to lower specialization and lesser economies of scale. At best, the quality of products stays the same, and at worst it is hurt.
Disclosures Including Backtested Performance Data

Quiz!

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy.
  3. When stock valuations are high, and uncertainty is high.

Investing in the Midst of a Pandemic

The coronavirus pandemic brings substantial uncertainties. While the instinct is to wait for clarity before investing, the biggest returns tend to come starting at times of greatest uncertainty. This was true in past declines, and the current one is no different. On 3/23/2020, stocks hit a bottom with no clarity on the timeline for the world stopping the spread of the virus, and no clarity on how the world economy would survive social distancing. A moderate reduction of uncertainties led to phenomenal gains in stocks. As additional uncertainties get resolved, there is a chance for additional gains. This article refers to the coronavirus – as always, additional negative and positive surprises may appear, leading for ups and downs, beyond the uncertainties listed below. In addition, investors expect economic pain from the social distancing, and this may be reflected in stock prices too little or too much. Here is the timeline so far and potentially looking forward.

Past:

  1. Around the bottom, central banks and governments announced substantial support for economies, including the Federal Reserve using the term “unlimited support”.
  2. Over time, we saw the number of daily new cases in many countries level off, and in some cases, revert. This gave some comfort that with social distancing, the virus could be contained in a reasonable timeline.

Future:

  1. Additional central bank & government support until the end of the pandemic’s economic impact.
  2. Increased testing, to allow quick isolation of infected people. A lot already happened, but more is needed.
  3. Increased contact tracing, both automated and manual, to isolate people who got in contact with infected people. Automated solutions are being developed. There is currently substantial hiring for contact tracers. My understanding is that a lot more progress is needed on this item. This is a good example of creating reemployment to help with the effort to end the pandemic.
  4. Transition from level and fewer daily new cases, to a worldwide reduction in total cases, so fewer people will be able to spread the disease.
  5. A potential die-off or weakening of the virus, as eventually happens with some viruses.
  6. Treatments to reduce the severity of the disease.
  7. Widespread vaccines.

Key Point: The intuition of many investors is to wait to invest in stocks until uncertainties are removed. This leads them to invest at times with much higher risk of long-lasting declines. If you have enough resources to weather substantial declines that are always a possibility with stock investing, you may be lucky enough to invest at a time that can both help your returns as well as prepare you for future cycles.

Quiz Answer:

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy. [Correct Answer]
  3. When stock valuations are high, and uncertainty is high.

Explanation:

  1. A strong economy with positive sentiment can lead to gains for a long while, but is also reflective of peaks in stocks.
  2. When the economy is in poor shape, and valuations already reached low levels, people already sold a lot. The declines may continue for some time, but eventually a turnaround comes, and some of the strongest stock returns may begin.
  3. High uncertainty along with high stock valuations could sometimes lead to gains and sometimes losses. The high valuations sometimes mean that not enough selling was done to reflect the uncertainty.

See article above for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.Disclosures Including Backtested Performance Data

Quiz!

What is a way to minimize taxes under the new SECURE Act that limits inherited IRA distributions to 10 years?

  1. Distribute the inherited balance in equal amounts over 10 years.
  2. Each year, distribute the remaining balance divided by the remaining years.
  3. Convert the IRA to a Roth IRA during your lifetime, while your heirs distribute the entire Roth IRA on the end of the 10th year.
  4. Distribute larger amounts early on, to account for the growing balance with investment growth.

Optimizing the Stretch IRA under the new SECURE Act

On December 20 we got a new law: the SECURE Act (Setting Every Community Up for Retirement Enhancement). One of its provisions eliminated the distributions of inherited IRAs over the heir’s lifetime (often referred to as Stretch IRA) for most people. Instead, these IRAs typically have to be distributed within 10 years. The distribution can happen at any point in the 10 years. Spreading the distributions evenly can minimize income taxes for your heirs, but in some cases there is a strategy that can significantly improve this solution:

  1. Convert the IRA to a Roth IRA during your lifetime at a schedule that is designed to minimize your income taxes. See ideas in my article: Planning for Unlimited Roth IRA Conversions.
  2. Your heirs distribute the entire Roth IRA near the end of the 10th year of inheriting it.

This can maximize the IRA benefit, by paying no dividend and capital gains taxes on the investments for your lifespan + a full 10 additional years for your heirs.

Important Considerations:

  1. This works as long as the account is left untouched (or mostly untouched) until 10 years after the inheritance. Otherwise, a more careful analysis is needed.
  2. There is no way to access Traditional IRA money without paying income tax on it, so it is worth analyzing carefully weather a Roth Conversion is beneficial in your lifetime, regardless of planning for your heirs.
  3. When thinking about your heirs, note that the new rule adds at least 10% of your future IRA balance to their income (in case of even withdrawals over the maximum 10 years). So, even if they are in a low income tax bracket, a large enough IRA can push them to one of the top income tax brackets, making a Roth Conversion in your lifetime beneficial to them.
  4. If the beneficiary of your IRA is your Trust, and the trust limits IRA distributions to the minimum required distributions, the new law will lead your heirs to not see a dime from your IRA until 10 years after inheriting it, and then getting a potentially huge tax bill at high tax rates all at once. If this is not in line with your wishes, it is worth reviewing your trust document.

Quiz Answer:

What is a way to minimize taxes under the new SECURE Act that limits inherited IRA distributions to 10 years?

  1. Distribute the inherited balance in equal amounts over 10 years.
  2. Each year, distribute the remaining balance divided by the remaining years.
  3. Convert the IRA to a Roth IRA during your lifetime, while your heirs distribute the entire Roth IRA on the end of the 10th year. [Correct Answer]
  4. Distribute larger amounts early on, to account for the growing balance with investment growth.

Explanation: In cases where a Roth Conversion during your lifetime could make sense, this plan allows your heirs to enjoy a full 10 years of tax-free investing (dividend & capital gains tax) with your IRA, while you enjoy paying income taxes on IRAs at the optimal time. This works if you and your heirs don’t need most of your IRA until 10 years after they inherit it.Disclosures Including Backtested Performance Data

Quiz!

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -8M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left.

8 Principles for Happiness in the FIRE Movement

FIRE stands for: “Financial Independence, Retire Early”. People aiming for FIRE save aggressively, as much as 50%-75% of their income, aiming to retire at a young age. They typically retire once they reach enough savings to support 3%-4% annual spending.

While the result may sound very appealing, the plan can result in an unhappy life or be abandoned, if not done right. Here are 8 principles that helped me in my process, and may help you:

  1. Spend for happiness: Drop all expenses that won’t make you much happier in life today or in the future, but keep and emphasize the expenses that are important to the core of your happiness, or to build a good future.
  2. Experiment and adapt: Keep dropping additional expenses, even if everyone tells you that the expense is as important as drinking water. Question every conventional wisdom, and you are bound to enjoy some pleasant surprises. When needed, reintroduce expenses.
  3. Keep low-frequency & lower-scale expenses: Eating out once a week (or month) instead of never can add to your happiness far more than the 5th weekly meal out. Going on a road-trip to a national park off season, and sleeping outside the park costs a small fraction of a flight to another continent with a stay in a nice hotel. Such a trip still gives you time away, with family or friends, nature, and relaxation – providing the bulk of the happiness.
  4. Save most when your spending/investment ratio is high: You will save more (1) early, compounding every dollar saved exponentially for longer – giving you free extra money, and (2) when your investments are low, and expected returns are higher.
  5. Invest for high growth: High growth helps reach independence earlier. In addition, high growth investments tend to be more volatile, providing excess gains to a consistent saver (read https://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/ to understand). Two caveats: (1) Stay highly diversified across sectors and countries; (2) Be prepared to stay consistent through multi-year declines – something that comes with all high-growth investments.
  6. Aim for a conservative outcome: Aim for a 3% annual spending rate, to support a potential of many decades in retirement. Spending includes non-recurring and surprise expenses, including car upgrades, major home repairs, and healthcare costs, to name a few.
  7. Keep working at what you love: Once you reached financial independence, keep working at something you love. It can be your current job, a new lower- or higher-paying job, or a new business.
  8. Maintain 3% spending: As your investments reach higher peaks, you can raise your spending proportionately to enjoy the fruit of the optimizations leading to that point. You can call this modification the FIRES movement = Financial Independence, Retire Early, then Spend, Save or whatever makes you happiest. Whatever you choose, the compounded growth of investments is expected to grow the benefit exponentially over time.

There are several benefits to these principles:

  1. Maximum happiness gained from every dollar spent.
  2. Enjoying work in retirement from a position of power with no pressure.
  3. Decades of financial independence + growing spending. You are likely to enjoy far greater lifelong spending than the typical person.

Quiz Answer:

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -2M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left. [Correct Answer]

Explanation:

The frontloading of spending created a disadvantage that was impossible to recover from, despite doubling the number of working years. Details:

  1. The extra spending in the first 20 years of scenario #1, led to a balance of 460k relative to 2.3M in scenario #2.
  2. 7 years later, with 13 years of work remaining for scenario #1, the annual spending of 90k was lower than the spending level of the person who retired already 7 years earlier.
  3. By the end of the working career, the 90k spending compares to 173k for the person retiring 20 years earlier. The investment balance grew nicely to 2.6M, but short of the 6.1M of the early retiree.
  4. By the end of retirement, the spending jumped to 196k relative to 460k for the early retiree. The investment balance reached nearly 7M vs. 16M for the early retiree.

Disclosures Including Backtested Performance Data