Banking on Dollar Decline

The bulk of my assets is invested in low cost index funds, as all the experts recommend. That should be good enough for most people out there, but if you want to gain an extra edge over the market, there are a few options. I discourage trying to time the market or to bet on individual securities. Rather, if you must deviate from indexing, the safest is to practice strategic reallocation.

What this means is to skew the composition of your index funds towards a mix that fits with your investment thesis. For instance, an aggressive investor may stick with Warren Buffett’s recommended mix of 90% S&P 500 index tracker, and 10% short term US treasury bonds, implemented like this using iShares ETF tickers:

  • 90% IVV
  • 10% SHY

Whereas a more conservative posture with a higher allocation towards bonds may look like this:

  • 40% IVV
  • 20% SHY
  • 40% AGG

There are of course a myriad of other strategies in allocation that can be done. Some popular ones include splitting between growth vs value stocks, international vs domestic, and mixes of various types of bonds (domestic, international, short-term, long-term, TIPS, municipal, business, high-yield). Generally speaking, you get the most diversification when choosing between major categories such as stocks vs bonds rather than within a category.

My own inclination is not to mess around too much with these sub-categories, as they generally have higher fees without adding to extra return. I stick with the tried and true basics to minimize the temptation of tinkering with the portfolio.

However, if you were to force me to make a bet on the future and to structure my portfolio against a macro trend, I would bet against the US dollar. If there’s one thing we can all do to prepare it’s for a slow drop in the value of the US dollar relative to the rest of the world. With soaring deficits and entitlement obligations, declining prestige, tariffs/trade wars, I don’t see how the dollar can rise in the next few decades. At best it will tread water. The implications for quality of life in the US are profound. We can anticipate more costly imports, especially electronics. For food we should be self-sufficient, but overall prices will rise as food is now sold on the world market, and farmers would have incentive to export their hogs and corn instead of keeping them for domestic consumption. While there may be more low-end jobs such as manufacturing and textiles, the country will also be beset by wealthy foreigners 

How can we best position our portfolios to benefit from this trend? I would diversify outside of the dollar with a splash of international equities and bonds (especially in Asia). However, note that with the S&P 500 companies already having significant international operations, even if you invest purely in “domestic” companies you’ll automatically have some international exposure. This is also why when the dollar falls, the earnings (measured in dollar terms) of S&P 500 companies generally rise. No wonder foreign personal finance bloggers look on with envy at the cheap, mature, and diversified American stock market.

This would look something like:

  • 50% IVV
  • 40% IXUS
  • 10% SHY

Which actually is close to my own allocation.

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Turbocharge Wealth Accumulation with Naked Puts

Post written per special request from a new reader

I’ve been playing with options for almost a decade now. Some trades have made money, and some have lost money. It’s the nature of the beast. However, I eventually honed in on one strategy that was a sure win-win: selling naked puts. It’s less daunting than it sounds and can be a real moneymaker if you know how to use it right and compensate for its limitations. Let’s first explain the nature of option contracts.

The Basics of Options

An option is a promise or a bet on a security. You can be either the buyer or seller (also known as writer) of options. As the seller, you get to choose the security, the date the option expires, and the strike price. Then there’s the type of option. The big two categories are calls and puts. You can remember them with the mnemonic call me up and put me down. In other words, a call is a bet that a the subject of the bet will rise, while a put is a bet that it will fall.

The main permutations of the above controllable aspects of options thus becomes translated as such. A seller of a call option sells the promise of “I will sell you ___ security on ___ date at ___ price.” Correspondingly, a buyer of the same call option has the option (that’s where the terminology comes from) of “buying ___ security on ___ date at ___ price.” At the scheduled date, the buyer can decide if it’s worthwhile to exercise the option. Obviously, that will depend on if the price of the security is above or below the strike price. If the buyer chooses not to exercise the option at the date, it expires worthless. In return for owning this flexibility, the buyer pays the seller a certain amount of money called the premium.

Our strategy focuses on put options, so let’s explore that side of things. Using the same terminology, the seller of a put option sells the promise of “I will buy ___ security from you on ___ date at ___ price.” This is selling downside protection, or insurance against a market crash. As you can imagine, there would be a lot of people interested in this type of insurance, namely those sitting on big gains who fear losing it all in a market crash. It’s here where we can exploit a psychological inefficiency. People feel a lot more pain losing money than they gain in pleasure from making the same amount of money. Thus, premiums on put options are quite high. If only there were a way to pocket that for ourselves.

Creating a Win-Win

Here’s another reason that put options are win win for the seller (the one exploiting the fears of buyers). Let’s imagine the two possible outcomes, based on what I actually do each year. Every year in January I check to see what level the S&P 500 index fund (SPY) is at. Let’s say it’s selling right at $200 per share. I then sell/write a put option for a year out (next January) for the SPY security at $180 (my preferred 10% margin of error). In return for doing so, I pocket about $7 per share upfront as the premium. Fast forward a year later. If the stock market stays the same or rises, the option expires worthless and I make money. If the market has dropped, I would be forced to buy in at $180. The only way I would lose money from this is if the price of SPY is less than $180 – premium, which comes out to a break even price of $173. Although it looks like in this situation I would have lost money, I choose to see it in a different light psychologically. I’m a young person with a long time horizon, and stock indexes over the long run have done well. If I would have been comfortable buying in at $200, I should be ecstatic to be able to buy in at an even lower price. Even if I’ve lost money in the short run, I’m in the accumulation phase of my investing life where dollar cost averaging and staying disciplined buying at regular intervals will pay off.

In other words, think of put options as being paid to hold a limit order at the strike price you want.

You can also tweak the margin of error to suit your personality. If you are more conservative or are worried about imminent market drops, set a larger margin of error (known as selling options far out of the money) and sell fewer options. Keep in mind that each option is equal to 100 shares of the underlying security.

I would never sell options like this on individual stocks. That’s far too risky and exposes you to company specific random tail risk events (like Deepwater Horizon). Instead, the SPY security is widely traded, incredibly liquid, and a low cost investing vehicle that I would love to own at any time and at almost any price.

I also like to set my options for a year out. YMMV, but I’ve found that this gives me a reasonable time window to avoid being hit by flash crashes. My options tend to get exercised less the longer out I write them for. This makes sense because over longer time horizons, the more likely it is that the stock market will go up.

Swimming Naked

The astute investors among you may notice a problem. In selling an option, you need to place on hold the underlying security (for call options) or money (for put options) as a kind of escrow. Using the above strategy, this can easily tie up hundreds of thousands of dollars each year. That’s huge opportunity cost due to not being fully invested. This is why my strategy really only took off once my brokerage approved higher level options trading – naked options. Selling naked options means that I don’t put down the escrow. Rather, due to a large portfolio size, the brokerage has calculations that estimate how much margin they can extend you. Mind you, this is different from margin trading, which actually uses margin. Having margin on hand allows us to sell the above put options and use our margin buffer as escrow. An added benefit is that since the margin is not being used unless the option is exercised, we don’t get charged interest.

This also raises the importance of risk management when using margin. Again, I’m a conservative investor who likes having enough buffer to survive unexpected market situations like a big crash. This means that I never write more options than is the value of half of my margin. I also try to keep the total dollar value of all options to be less than my yearly salary. This way I can start planning to save up the cash in case it looks like the market is dropping and there is a chance that the option may be exercised by whoever bought it.

The Perfect Setup

Now for the kicker. While my dad likes to invest in real estate, I’m much more of a stock person. However, from talking to him I’ve discovered the perfect complement to the above naked put writing on margin strategy – home equity lines. Think about it this way. We all need a place to live, and real estate is generally a good investment, as long as you’re in a growing rather than dying area. Most people have a substantial amount of their net worth locked up as equity in a house. That to me is idle cash sitting around not doing any work! Why not use that to act as the “cover” for naked put options?

Let’s say you have a $750,000 house that’s fully paid off. You can easily get a $500,000 home equity line of credit on it. Now let’s assume a $1 million stock portfolio. By my above buffer estimates, this is safe enough to write $500,000 worth of options each year on margin and still have all but the most apocalyptic scenario covered. Using the above guide, I write $500k of naked put options on the S&P 500 index in January, for the January of next year. I pocket $17,500 in premiums that I get to keep no matter what (I normally just plow it back into the market). In most years the market goes up or stays steady, so I get to pocket the premium year after year without ever activating my credit line. Once in a decade or so there’s a big enough crash that my options are exercised. Great! That’s the time that I should be buying in anyway (what did I way earlier about market discipline?). Even when that happens all I have to do is withdraw the cash from my home equity line and buy into the market at a bargain bin price. Then I slow down my option writing, keeping it very conservative in the next few years as I diligently pay off my home equity loan with my income and dividends from my portfolio. As it gets paid off, I start writing larger options and the process begins anew.

This setup is infinitely scalable. The more houses and lines of equity you have, the more put options  you can write. I would even add bonds to the mix. With a healthy 10% portfolio allocation to bonds, that’s also kind of like money sitting idle. I mentally add that to my total of liquid cash equivalent instruments that I can tap to cover my options.

So there you have it, this strategy can guarantee you a 1-3% boost in total returns over the market, with very little risk. By mostly holding low cost index funds tracking the market, we can juice our returns and guarantee a beat every year.

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Another Reason to Tune Out Market Gurus

If the examples in my book didn’t already convince you of this, the latest flip flop on Marketwatch should convince you that the so-called experts don’t know what they’re talking about.

On Jan 24, the head of the world’s largest hedge fund said, “if you’re holding cash, you’re going to feel pretty stupid.” That’s the gist of it, but if you click through you’ll hear some blah blah justification about how the market is rising, valuations are reasonable (even though by CAPE they’re expensive), and that there’s still room to run.

Then we had the 10% market swoon in the beginning of February.

The next time we hear from the same guy, he’s singing a different tune: “I think we are in a pre-bubble stage that could go into a bubble stage.” He goes on to say that the chance of a recession are 70%.

Luckily, though Marketwatch doesn’t call him out on the rapid change in tone, it does provide helpful links to his prior comments. Any discerning reader with even a modicum of financial knowledge would think that this guy is utter crap and going along with the prevailing tone, fanning the flames in a bull market and turning on a dime at the slightest whiff of panic. Why would you entrust your money to someone who doesn’t know what he’s talking about?

It amuses me to have recently received mass emails from both Fidelity and Schwab advising clients to stay calm in the recent market turbulence. It seems that with each boom-bust cycle, we attract new speculators without any inkling of what it means to truly invest. What am I doing? Tuning out the noise, rebalancing, and overall staying invested in a stock:bond ratio that matches my risk tolerance and time horizon. The market’s short term gyrations don’t matter a whit.

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Should I Contribute to an IRA with a 401k?

If you don’t have a 401k offered by your workplace, then an IRA is a no-brainer. You may even be eligible, if you have your own business, to contribute $55,000 (in 2018) to a SEP-IRA. But what if your workplace gives you a 401k? Should you contribute to an IRA on top of that? If so, what type should you choose – traditional or Roth?

First, you should understand that your limit is $5,000 ($6,000 if age >= 50). Since you have a 401k plan already, the limits and rules for an IRA on top of that are less generous. Now let’s first look at the IRS’s rules for contributions:

The key here is tax deductibility. If you stay below certain income limits, your traditional IRA contributions are deductible from your taxes, which is 90% of the benefit from these plans. However, tight income limits of $63,000 for singles and $101,000 for married filers makes this a difficult proposition. The worth of tax deductibility is based on your marginal tax bracket. The higher the bracket is, the more you save on taxes for the year with an IRA contribution. Based on 2018 tax brackets, at those incomes limits, the corresponding tax bracket is 24%. That’s quite low by historic standards. The general rule about Roth vs traditional 401k is that if your tax bracket is low now, you should choose Roth, for which you pay taxes now and everything accumulates tax free within the account. However, if your tax bracket is high now, you may benefit from deferring taxes, taking the savings up front, and withdrawing in retirement at a lower bracket. That’s the traditional IRA plan.

So basically, the conclusion is that if your income is such that you qualify for an IRA while you already have a 401k, your bracket is by default so low that you should only consider the Roth option. Now a wrench in this general guideline is state income tax. If you are in a high state income tax state such as Hawaii, California, Oregon, and Minnesota, be aware that Roth contributions mean paying all taxes up front, including state income taxes. These are the only corner cases where a traditional IRA is still worth considering even with a low federal tax bracket.

Regardless of what you do with the IRA, make sure you maximize the company sponsored 401k first, and put away enough in savings to meet emergency needs.

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Can Locums Doctors Qualify for a 20% Tax Deduction?

The new tax bill has become law and accountants are eagerly poring over the details, dissecting it for loopholes. One of the biggest giveaways is to small businesses, allowing a 20% deduction for income that is passed through (called “pass-thru” in the law) to the individual. It’s called Section 199A, and I expect that this will become a household name as famous as the 401k. The intent of the addition is to benefit small businesses (larger ones tend to go for C-corp style taxation) that employ the bulk of Americans but would otherwise be penalized at higher individual tax rates versus C-corps. To avoid incentivizing too many of these entities to be forced to convert to C-corps, it was decided to offer some token tax cut to pass through businesses. Ron Johnson largely pushed this addition through by himself, given slim margins for Republicans in the Senate.

Remember, this website isn’t interested in debating the ethics of the law or the politics behind its passage or ramifications. Rather, we want to be more practical (or nakedly capitalist if you will) – can I exploit this loophole for my own gain? This will be a more fine tuned analysis geared towards medical professionals, due to my own expertise in this area, but the principles are largely applicable to other professional service businesses as well.

To qualify, first you must be taxed as a pass through business. This includes:

  • Sole proprietors. If you’re taxed by filling out Schedule C reports of your 1099 independent contractor income, you count in this category. It’s the default if you haven’t gone out of your way to form a more advanced business structure.
  • Partnership. Basically a few sole proprietors working together on the project, each owning a portion of the firm. Each passes through income proportionally. Note that a married couple can be counted as a sole proprietor because they file together.
  • S-corp. This is where things get fun. This business model can scale as big as you want. You have all the responsibilities of a big corporation in terms of payroll, offering 401k, health benefits, getting a corporate board, and filing quarterly tax payments. It’s a big setup and reporting hassle and can be expensive to maintain. Luckily there are software packages out there that can make it easy for you to create one.
  • LLC status is a legal distinction that doesn’t matter to the IRS.

Contracted physicians (this includes the locums category) tend to be either sole proprietors or S-corp. Many have opted for the latter because you can choose to structure some income as wage income (W-2) and the rest as a pass through business distribution that is not subject to payroll tax. The IRS closely scrutinizes the proportion that is in each category to prevent people underpaying themselves and taking almost everything as a distribution. The generally accepted principle is that your income should be close to the national average for your profession and the type of work you do. Given the high incomes of physicians, this won’t save you anything in Social Security (unless you work part time) once you pass the income limit, but it will only save you the 2.9% Medicare portion of payroll tax that is applied to all earned income. It’s up to you to determine whether the tax savings outweigh the setup and maintenance costs as well as tax reporting hassles.

When crafting this carve out, politicians were careful to limit its benefits to favoured categories of individuals. They like businesses that own real estate, employ people, and invest in capital equipment. They most definitely did not want this loophole to benefit high income professionals who don’t employ others. Politically that would be depicted as overly favouring the rich, who presumably don’t need this loophole. Thus the law featured two “tests” – the income test and the profession test.

The Income Test

If you’re single and your total taxable income (this includes all other investment, side job, and interest income) is less than $157,500, great! You can take this deduction no questions asked. If you’re married, the same limit is $315,000. Mind you, if your income is higher than this threshold, it doesn’t mean you can’t take it. Rather, there’s a phase out period up to $207,500 for singles and $415,000 for married individuals. The phase out is essentially linear. What it means is if your income is above the phase out thresholds, you can’t use *any* of this 20% deduction. It doesn’t mean that you can still deduct the portion that’s under $315,000.

Ironically, this creates significantly negative incentives around the phase out line where one’s marginal tax rate goes up temporarily to ~50-60% because of rising brackets and losing benefits. Greg Mankiw may chime in in five years and say that it’s a “upper middle class” income trap with bad incentives.

Don’t fret if your income is above either threshold (lucky you!). Remember this test just wants to check your total taxable income. Anything that reduces this number can make you thin enough to squeeze under the bar and claim the deduction. This includes SEP-IRA, 401k, and business expenses, all of which reduce what’s visible as taxable income.

The Profession Test

If you make more than the income cutoffs, you can benefit from the law if your business fits into one of these categories:

  1. Anyone who is in the business of being an employee (yes, being an employee is considered being in a business), and
  2. Any “specified service trade or business.” 

The IRS will spend several years filing lawsuits and refining this broad definition, but for now you can consider that if your business features your skills and services as opposed to owning property and selling goods, you’re one of the undesirable types. You will fail the profession test. Law, medicine, “consultant” and accounting are some of the professions that are explicitly mentioned as failing this test.

Somehow there are exceptions for architects and engineers. No one knows why but presumably their professional societies lobbied hard.

The Recap

So for our locums physician to take advantage of this benefit, he or she needs to satisfy the income test, because we know that medicine will surely fail the profession test. This is easier to do if you work in one of the lower paying specialties, work part-time, and are married. For our friends with S-corp setups, since the income test evaluates you on your overall income, it doesn’t matter if you slice your earnings as salary or a business distribution, they both will be counted for purposes of the limit. This obviates a big advantage of S-corps relative to sole proprietors.

Some of the more astute readers will note that there is another test called the W-2 test, which is supposed to limit abuse by preventing really high income people from quitting their jobs and becoming a consultant working the same job. Forbes explains better than I can:

I’m a partner at a BIG, PRESTIGIOUS ACCOUNTING FIRM. I am also, however, an employee; one who collects a wage. Now, let’s just assume that my annual wage is $800,000 (it is not). With the new rules coming down and offering a 20% deduction against my income, what would prevent me from quitting my current gig, and then having my firm engage the services of “Tony Nitti, Inc.” a brand new S corporation I’ve set up specifically to facilitate my tax shenanigans? Now, my firm pays that same $800,000 to my S corporation, and my S corporation simply allows that income to flow through to be as QBI. I, in turn, take a 20% deduction against that income, reducing my income to $640,000. See the problem?

My role at my firm hasn’t changed. I provided accounting services before, I provide accounting services now. But before, I was receiving wages taxed at ordinary rates as high as 37%. Now, by converting to an S corporation and foregoing wages in favor of QBI, I am now paying an effective rate on that income of only 29.6% (37% * 80%). That’s not fair, is it? Compensation for services should be taxed at the same rate, whether it’s coming to me as a salary or flow-through income.

To prevent these abuses, Congress enacted the W-2 limitations. Because, in my example, Tony Nitti, Inc. does not pay any wages, in both scenarios my limitation would be a big fat ZERO, meaning I get no deduction. Like so:

My deduction is the LESSER OF:

  1. 20% of $800,000, or $160,000, or
  2. The GREATER OF:
    1. 50% of W-2 wages, or $0, or
    2. 25% of W-2 wages, or $0, plus 2.5% of the unadjusted basis of the LLC’s assets, or $0, for a total of $0..

It’s a lot of calculation and looks complicated, but we can actually disregard it all as this limitation will only come into play if you fail the income test. Since we’ve already determined that a physician who fails the income test will automatically fail the profession test and be prohibited from taking the deduction, we shouldn’t even worry about this section.

As Forbes explains:

Section 199A(b)(3)(A) provides that if your TAXABLE INCOME for the year — not adjusted gross income, not QBI, but TAXABLE INCOME — is less than the “threshold amount” for the year, then you can simply ignore the two W-2-based limitations. The “threshold amounts” for 2018 are $315,000 if you are married, and $157,500 for all other taxpayers. These amounts will be indexed for inflation starting in 2019. And quite obviously, you determine taxable income WITHOUT factoring in any potential 20% deduction that we’re discussing here.

The Payoff

Phew. You’ve waded through all of the above because you’re eagerly salivating over seeing how much you can save on your taxes, right?! Let’s crunch some numbers.

Our example physician is married, works as a contractor (paid as 1099), and is set up as a sole practitioner (in the end, S-corp calculations won’t be too different from this) for simplicity’s sake. Assume no kids. This person is based in Texas and to avoid troublesome state income tax calculations performs contract work in Washington, Nevada, Texas, and Florida only. Yearly income starting in 2018, the first year the new law will apply, is estimated to be $400,000.

To fit under the threshold, we maximize our SEP-IRA contributions, which are $54,000. We accumulate $22,000 in deductible business expenses. Then we also take the standard deduction of $24,000 for a married couple. That leaves us with $300,000 exact in visible taxable income. All of it is eligible for the 20% deduction.

Let’s use Marketwatch’s calculator to calculate our total tax under the new bracket system for 2018:

  • $40,179 for federal income tax
  • $0 state income tax
  • $15,958.8 Social Security (double because of 1099)
  • $12,114 Medicare (including surtax)
  • Total of $68,251.8

For comparison, if we earn that $300,000 as W-2 income (employed physician), our total tax will be:

  • $60,578 for federal income tax
  • $0 state income tax
  • $7,979.4 Social Security
  • $6,633 Medicare (including surtax)
  • Total of $75,190.4

There is a net savings of $6,938.6 with business income as opposed to wage income. The numbers are close but not exact, since the business owner will be able to deduct business expenses and half of the payroll tax that the W-2 earner can’t itemize.

I haven’t included calculations for S-corp owners because there are complex rules depending on how much you take as W-2 salary and how much is a distribution. The same thresholds apply, and you are only allowed the 20% deduction on the portion that is a distribution.

 

(Much of the details are from the source text, as well as Forbes Tax Geek and Evergreen Small Business)

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Don’t Do Something, Just Stand There

Another week, another all time in the stock market. North Korea’s saber rattling and the devastation wrought by the hurricanes don’t seem to have put a dent in the market’s relentless ascent. Furthermore, with this being the “most hated” bull market in history (or so they all say), things don’t seem primed for a major collapse. A mild pullback on the order of 5-10%? Sure, perhaps it will happen within the next year, but a major recession doesn’t seem to be in the cards.

What’s the best mentality for an average investor to have? The same as always – don’t change your long-term strategy due to short-term circumstances. Ignore the noise going on around you and robotically invest what you won’t touch in the next 5-10 years. The mantra that my mentor in medicine told me, which brings “do no harm” into the modern world, is encapsulated by the title of the post. Sometimes it’s simply better to do nothing than to react like a jumpy cat to every slight movement.

Take this advice of this article for instance:

“If you don’t want to invest in equities because you fear a market crash, then you should never be in equities, because equities always crash,” Ritholtz said, speaking at Morningstar’s annual ETF conference.

He noted that there was a bear market in equities—defined as a 20% drop from a peak—every five years, on average, although the recent market environment has been bereft of even much smaller declines. Current valuations have led to concerns that such a crash could be imminent, but “If you’re under [the age of] 50, you should be rooting for a market crash, because it would be nice to have a 20% discount and then 20 years to compound that discount.”

He added, “there’s no escaping this: markets go up and down, that’s what they do. But if you’re still worried, you should significantly lower your expectations for future returns” by buying safer—but lower growth—alternatives. He noted that over the past century, U.S. stocks have returned about 10 times what Treasurys have, although they also experienced numerous massive selloffs over that time, something the government bonds hadn’t.

“The risk you assume when you buy equities is that there will be a significant drawdown in the 20 to 30 years you own them. But you get rewarded for that risk. Treasurys don’t have the same kind of drawdowns, but don’t deliver the same kind of returns.”

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To Buy or Not to Buy at Market Highs

There is always a bit of fear when evaluating buying in at all time highs. The sentiment is understandable. Everyone is afraid of buying in at a market peak and eating the recession that follows. After all, after almost a decade of uninterrupted growth, aren’t we due for a downturn?

However, the data analysis (done by someone else!) and existing scholars such as Tobias Moskowitz supports momentum investing. In other words, when the market or an individual stock is rising, it’s more likely than not to keep rising than to suddenly reverse.

Applied to current market highs, I would still encourage ordinary people to invest their new capital in accordance with prior allocation ratios, to achieve a healthy rebalance despite stock market highs. More likely than not, the market will be even higher (even after adjusting for inflation) in the next decade. If prior trends hold, we may be on the cusp of a 1-2 decade run of sustained all time highs.

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Secrets to Successful Investing

It feels like we’re always hammering the same points on investing over and over again. Don’t watch your portfolio. Stop tracking the market’s daily gyrations. Focus on the long term. Stay diversified. Don’t try to stock pick or market time. Stick with the asset allocation determined earlier and rebalance. Stick to these tried and true principles based on solid research and you’ll be fine.

Sometimes, we feel that we can be exceptional or lucky and we try for the moon. Humans are poor learners from others’ failures, and rather learn best from a strongly emotional personal experience (like a major loss in the market due to a self-inflicted error). I believe everyone should learn that by starting out playing single stocks with small amounts of play money, ideally earlier in life rather than later, so we can quickly return to the right path having learned our lesson in a way that sicks.

In other words, use the “the martyr system” to your advantage, letting the hippocampus impart the long-term financial scars from personal failures that will leave lasting memories of what not to do.

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No Regrets

My last post touched briefly on the nature of regret in missing out (selling too soon, buying in too late). However, this is not a healthy mindset to have. As Marketwatch pointed out today, very few people have the intestinal fortitude to ride out the market’s gyrations and hold for the 10+ years needed for wealth to compound exponentially. How many of us would have sold out during one of the times when bitcoin or Netflix crashed >50%?

This Morningstar article serves as a reminder that we are our own worst enemies:

Well, it’s really about the target-date funds because they are sort of the confluence of good behavior. In other words, they are boring funds. You’ve got tremendous diversification. They don’t cause fear or greed. They are just boring. But then the other part of it is, in 401(k)s where you see nearly all the target-date money, people are investing every paycheck very steadily. So, they are also kind of shielded from the ups and downs of the market. So, if you go back to ’08, ’09, 2010, people just kept steadily investing, people generally did not panic in their 401(k)s, and so that meant you are really buying low and then staying with it to see those benefits. So, if you think about it, target-date is kind of the intersection of good funds and good investor behavior and it kind of suggests where we might want to go as an investing group as a whole because this is where things really work well.

The best returns actually came from disciplined boring investing. As Monevator likes to say, keep investing as boring as watching paint dry, so you won’t be tempted to buy and sell all the time. As another former mentor once told me, “Don’t just do something, stand there!” That is really the approach to take when investing.

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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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