Take More Risk in Tax Advantage Accounts

The Bond King Bill Gross likes to philosophize about profound emotions such as joy and melancholy in his investment rants, and this post is driven in part by the emotion of regret seeing Bitcoin hit all time highs, and even surpassing the price of gold.

Such is the case for many in my field. When I was finishing my last year at Berkeley, I came upon news reports of the fancy new cryptocurrency idea called Bitcoin. Independently at the same time, so did my fiancee’s brother, childhood friend, and cousin-in law (all techies). We didn’t think much of it, and as risk averse as I was, I didn’t even bother putting $50 or so of play money into there. If I did, it would be worth almost a million! Similarly, my fiancee’s aunt regrets not buying Apple stock when it was down in the dumpster right before Jobs took over (seriously, most smart money was on the company going bankrupt, not staging a phoenix-like revival).

While we can all regret not doing the most “optimal” thing (life doesn’t have a save/reload button) in hindsight, we can also never with certainty predict what the future will hold. What we can do, and it will sound boring, is to make sure we have the right types of investments in the right places, and to stay allocated to assets in a way that allows us to sleep well at night. If we do dedicate a small (e.g. 5%) portion of our portfolio to lottery ticket bets on small cap stocks, that’s fine. Just make sure to do it in the tax advantaged section of the portfolio.

Standard portfolio theory suggests that we should make sure that our money is invested in the way that takes advantage of legal tax shelters to our benefit, as much as possible. Just to recap, there are in general three big categories of holdings: taxable, pre-tax 401k/IRA, and Roth 401k/IRA. Here’s what we should put in each:

  • Taxable: The goal here is to hold for as long as possible and to minimize the number of transactions and income generated, since each sale can generate a huge tax bill for capital gains. The best choice is a low fee total stock market index fund (Vanguard, iShares, and Schwab are all good choices) that is held and not sold until death. Then we can take advantage of the tax free basis step up when we bequeath to heirs. The small amount of dividends generated is taxable, yes, but at a much lower rate than the marginal rate. Bond holdings should be in tax-free municipal bonds as much as possible, doubly so if you’re in a high tax bracket.
  • Pre-Tax: We have to pay tax on the whole thing anyway but not until we cash the money out from the account. That quirk makes pre-tax accounts ideal for traders, stock pickers, and market timers who move in and out of positions with regularity. It’s also a good place to stash taxable bond funds and high dividend funds that throw out a lot of periodic income.
  • Roth: This is where you should make your highest risk “lottery” type bets. Let’s say you could (and want to) invest in bitcoin, startups in their infancy, micro cap stocks, penny/value stocks, turnaround stories, Greek bonds on the verge of default, and foreclosed homes. You would do so here. The bigger the potential gains, the better it will be. Whether you stumble upon a 10-bagger or 100-bagger doesn’t matter. You won’t pay any tax on it at the end.

So in summary, you want to use the right tool for the job. A balanced portfolio should consist of stock funds, bond funds, and maybe a dash of play money. Instead of making each tax category holding the same, we should concentrate our investments in the type of account that is best-suited from a tax perspective. Big gainers should be in the Roth, slow steady accumulator broad market funds should be in taxable, and income spewing investments in the pre-tax account.

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Passive Clearly Beating Active

These past few years have not been good to actively managed funds, or their managers. As this Morningstar article shows, funds are continuing to lose investor money and as a result, they have to lay off their fund directors. Shed no tears for them though, as they’ve had several years of high six figure+ income without providing a corresponding return to their investors.

Let Uncle Warren and Jack Bogle light the way. It’s no secret why the biggest indexer, Vanguard, is growing more than everyone else combined!

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The Few Proud Stock Winners

Remember my exhortation against stock picking, due to the few winners driving gains and the majority of stocks being meh or losers? This Morningstar article posted an insightful finding based on a recent study:

Half of U.S. stock-market wealth creation has come from 0.33% of listed companies.

Please note, that figure is not 33%. It is one third of 1%—one security out of 300.
Of the 26,000 stocks that appear in CRSP’s database, 86 provided half the aggregate wealth creation, 282 are required to reach the 75% figure, and 983 account for the full 100%. That is, after the 983 highest wealth creators, the remaining 25,000-plus securities are net neutral. Some made money for their investors, and some lost, but overall they were a wash.
Let’s re-emphasize. 86 stocks drove half of the gains of the market as a whole. If you were to randomly pick a stock to place your bets on, you would only have a 0.33% chance of picking a major winner. What’s the lesson, Morningstar?
In other words, do as your columnist prescribes, not as he does: Diversify. Widely and broadly.
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Startup Philosophy – Cater to the Whims of the Rich

Warren Buffett has always published insightful yearly shareholder letters. This year’s is no different. The key passage that stood out to me was his critique of the hedge fund industry. With the exorbitant fee model, and given the fact that even their own managers don’t invest in their own product (what’s the opposite of dogfood?), why do they still survive?

Uncle Warren explains the answer:

I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.

That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.

The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.

In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is –on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.

Emphasis mine. That there is the key to understanding that there is money to be made in catering to the whims of the rich. I’ve always thought but never said out loud that the keys to a successful startup are one (or more) of the following:

  1. Get paid
  2. Get laid
  3. Feel special

This sets apart the *great* startup ideas from the merely good ones. Take for example Airbnb, Uber, and Coffee Meets Bagel. For the end user they offer convenience, but they also offer other incentives – matchmaking or earning money – to the participants. Contrast that to any sort of home food delivery service (which were hot startups not that long ago). Sure, they were nice incremental convenient improvements on the status quo, but they weren’t life changing. I could just as easily call up the restaurant myself for not that much difference in value.

The special sauce comes with #3. Basically the user must think there’s something mystical or unique about the service’s secret sauce that’s an improvement over everything else. Airbnb and Uber are great ways to monetize (for a decent amount of money) assets that you already have. Nothing else out there is comparable. CMB gives you the right amount of control over matches and simplifies the overwhelming dating world.

The last category can be a stand alone business idea all by itself. Just think to all the hostess cafes in Tokyo where a cute young woman caters to your every whim (except sex). That’s a huge boost to a shy nerd’s self esteem. Great niche to be in, as these guys tend to be high earning engineers! A hedge fund can basically be thought of as a hostess cafe for the wealthy. Here come all these experts to fawn over you and make you feel special. I bet that at some level the rich know that they’re going to lose money compared to an index fund, but nothing beats the thrill of having access to Ivy League educated experts at the tip of their finger. That fulfillment, and not any actual investing expertise, is essentially the business model of a hedge fund.

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The Superstar Effect

From this:

the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.

It’s stating nothing more than what we know. If only a few “superstar” stocks drive the majority of earning (and some like ADP and Altria spin off many other successful companies), it’s all the more reason to diversify. If we just pick a few stocks, what are the chances we’ll have a proportional amount of those mega winner 4% stocks? Not good, despite how great a stock picker you think you are. Just look at my thought experiment for details. After all, if Harvard’s endowment could hire the best and brightest and still underperform the market, despite their pedigree and venture into “alternative investments”, how well can you as an individual do?

In other news, there is a similar superstar effect in the labour market.

The recent fall of labor’s share of GDP in numerous countries is well-documented, but its causes are poorly understood. We sketch a “superstar firm” model where industries are increasingly characterized by “winner take most” competition, leading a small number of highly profitable (and low labor share) firms to command growing market share.

The winners are disruptive because they are more efficient, able to do more with fewer workers. This is not much solace to those displaced as a result of old firms going under.

To survive in this world, we need to learn the skills of superstars. Stay in the few remaining jobs that remain, save and invest like crazy, and start our own businesses. That’s the key to success. My book is your guide to this.

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Another One Bites The Dust

Another hedge fund, that is. Despite the market being up more than 200% since the depths of the financial crisis, some hedge fund managers have somehow managed their billions of investments into the ground.

Richard Perry will shutter his hedge-fund firm after billions of dollars in investment losses and client defections.

The longtime hedge-fund manager told clients in a letter Monday “the industry and market headwinds against us have been strong, and the timing for success in our positions too unpredictable.”

Perry’s eponymous firm has lost more than 60% of its assets under management since November 2014, when it managed $10.4 billion. Its main fund lost more than 12% last year, much of it from a bad bet on Fannie Mae and Freddie Mac, and was down 1.3% this year through August, said a person familiar with the matter.

Perry won’t give back all of the remaining money immediately. He committed in the letter only to returning “a substantial amount of the fund’s capital” starting next month. Some of the remainder won’t be cashed out for more than a year, the letter said. Bloomberg News earlier reported Perry’s shutdown plans.

Ahem, notice how he excuses his own poor actions by claiming that headwinds arrayed against him were too strong, even though the overall market was up. Also note that he doesn’t have plans to return all the investors’ money. Why would anyone pay these guys in the first place, given this kind of performance?

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How the Wealthy Became Rich

The answer? It’s mostly through slow and steady investment.

The article defined wealthy as those with at least $3 million in investable assets, which is easily within reach.

According to the survey, more than three-quarters of the wealthy investors surveyed came from middle-class or lower backgrounds, and earned their wealth mostly through income from work and investing.

They took one of three basic paths to wealth: earning it; investing to get it, or becoming an entrepreneur. Only 10% attributed their wealth mostly to an inheritance. In short, the wealthy have worked their way to their enviable portfolios, and took a long time getting there.

Regardless of the asset (preferably stocks or real estate), diligent saving and investing over time will let anyone achieve great wealth.

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There’s a Reason They Promote Active Management

Just saw this ad on Morningstar:

marketwatch ad

Investors have started to wake up to the high fees and poor performance seen with active management, and as a result, big financial service firms are trying to stem the flow of money away from active funds to passive funds. As a result, they’ve ramped up advertising trying to sell potential customers with fear. “Now is a turbulent time,” they say. “In an uncertain world, it’s not good to be passive.” “Have an expert guide you.”

But really, if they have to work that hard to sell you on something, it’s probably a bad investment. Just remember: they’re worried about profit, not about working in your best interest. They (apart from Vanguard) have little incentive to sell you on low-margin passive products.

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Why Boring is Best in Investing

Are you a solo investor trying to imitate the big boys? It may not be such a good idea. You may have seen hedge funds, institutional investors, and big university endowments delve into “alternative” investments, meaning esoteric low-liquidity products that ordinary people wouldn’t have access to. Financial service providers, hoping to capitalize on a trend, created mutual funds and ETFs allowing ordinary people to buy into these supposed hot new strategies. Warning: they just want to charge high fees.

The performance has been dismal. As the chart on the link shows, a boring tried and true approach with stocks and bonds has outperformed all of these newfangled products.

The article goes on to explain the reason for the discrepancy:

Ben Johnson, Morningstar’s director of global ETF research, says many alternative ETFs have serious flaws. “Those guru-type portfolios are just equity strategies taking the long side of some well-known hedge-fund managers’ positions and following them on a lagged basis,” he told me.

“Oftentimes what you see in these ‘mimicking’ strategies is the derivative of the underlying asset that is many times watered down or is otherwise not directly connected to the…real asset.”

In other words, the ETFs are very poor substitutes for the real thing. Institutions like Yale get to pick the best private equity and hedge funds, and can buy, say, actual timberland rather than the WOOD ETF.

So yeah, if you can buy and operate an acre of farmland and know how to run it profitably, you may do ok. But for the rest of us, just stick with a diversified collection of stocks and bonds.

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Are ETFs Too Risky?

There’s a lot of news out there about ETFs lately, focusing on their negatives. They’re an untested instrument. The bid-ask spreads are too wide. They tempt people into trading when they should be holding on to their investments.

My book on wealth recommends using ETFs as the instrument with which to build a diversified mix of stocks and bonds, a time tested approach to accumulating wealth over the long haul. Just in time to discredit the rash of negative reports is a great Schwab article on the facts of ETFs.

Like anything, ETFs are an instrument, and can be used for good or evil. Like any instrument, the ETF in question can be sharp or blunt. Here’s the lowdown on why they’re still useful and things to look out for:

  • You don’t have to worry about the wide bid-ask spread at times. If you’re using ETFs as a mutual fund substitute, you shouldn’t be looking at daily prices and being tempted to trade in and out. Broad market stock or bond ETFs are meant as vehicles for investing. Even though they offer you the ability to trade in or out at any time as easily as individual stocks doesn’t mean we should. Moving too much incurs frictional trading expenses and incurs taxes.
  • For the same reason, you shouldn’t worry about temporary fluctuations in value versus the underlying asset. 99.9% of the time the two will be correlated. When things are derailed, it will be temporary (usually minutes at most), so hold on to your investment through the panic. Chances are you won’t even notice that anything happened unless you obsessively follow the market every day, which you shouldn’t be doing.
  • Stick to the tried and true (broad market funds). Don’t get suckered in by fancy ETFs such as triple inverse or super sector specific funds. Those exotic instruments usually have much higher expenses (you can see how much on Morningstar) and offer no benefit for long-term investors.

As you can see, ETFs are not to be feared, but rather something that the wise ones can control. Use ETFs like this and stay on the slow but steady well-trod path to wealth. Tune out the noise and you will prosper.

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