Aggregates

I woke up this morning thinking about activity.  Activity is the thermodynamic concept of non standard behavior in a chemical solution.  As solutions become concentrated the A + B =AB relationship become x*A + y*B = z*AB  where xyz are a kind of fudge factor which describes real behavior instead pristine theoretical behavior in chemical solutions.  The variability is due to how charge, solubility and entropy changes local environments for molecules instead of just viewing their behavior in a dilute solution.  The local matters in the real world.  

Blood is an aggregate of hemoglobin contained in corpuscles and a kind of dirty proteinacious water called plasma.  The hemoglobin is highly soluble to O2.  You can stuff a whole lot of O2 into hemoglobin especially hemoglobin contained in corpuscles, but not so much in plasma or free hemoglobin in solution.  Your cells crave ATP and the ONLY way to efficiently make ATP is to deliver enough O2 to the cell mitochondria.  Not enough O2 = RIP.  So life itself depends on this method of hemoglobin aggregation.  Dis-aggregate the hemoglobin, and even though the amount remains the same the effective O2 delivery is so poor you will die. 

I was reviewing the nature of VTI.  VTI is a total stock market tracking ETF.  People own VTI as a proxy for owning all the stocks in the US market.  It is commonly published there is some comfort that “all the stocks” are “more diversified” and therefore “safer”.  Actually the majority of diversity is achieved in as little as 20 stocks.  1000 stocks only provides 5% more diversity.   VTI as a tracking vehicle has as its portfolio 1560 stocks.  The total us market has a bit over 3800 stocks, so VTI is only 41% of “total stock market”. 

Ya Ya blablabla so what?  Well the point of activity was to account for the non standard behavior of solution with high concentration.  Index funds make up 29% of the market.  That’s called an aggregate and I would call that a high concentration.  The behavior IMHO is not random but actually quite concentrated, and the measuring tool is just an estimate.  The “tracking fund” just estimates the actual total market.  In normal times it estimates beyond good enough.  But what about abnormal times?   The point of owning index funds is the so called safety of diversity.  If you sell VTI and Vanguard doesn’t have cash on hand it will have to sell 1560 stocks to raise the cash to pay you.  This causes a distortion in the tracking.  There is now downward momentum on those 1560 stocks in excess of normal market swing.  Remember you actually own VTI not the total market, so the value of your portfolio is the actual price of VTI not the price of the total market.  Now what if half of the 29% who owns the “index stocks” sell.  What happens to balance of the the index?  What happens to the value of your portfolio?  My impression is xyz kicks in and all of the “formula” which rely on say “8% long term market gain” goes out the window as momentum forces dynamic distortion onto the system, and the distortion will be worst in those 1560 stocks you own since those are the ones being most sold at fire sale prices.  The robots don’t care.  You give them a sell order, they sell sell sell, damn the torpedoes.

The point, the point?  Jack Bogel worries about this.  I’ve read it over and over in his writings but I don’t see it anywhere in the usual Bogglehead boilerplate.  Is your “diversity” really diverse or merely an illusion because your diversity is actually a part of an aggregate and therefore captured in that aggregate and not free to oscillate independently?  This is why some real bond mix like 60/40 IMHO saves you, because bonds are truly independent with a correlation of 0, and not captured as part of an aggregate.   Lemme see all ya gotta do is 4 x 25 in low cost index funds…  

The Other Motor

I wrote a post ‘on Creative Destruction  as the Motor that propels the American economy, and so it is.  There is another Motor that propels the individual’s financial reality and that’s work.   In my recent post on journaling your family financial history, you might also journal your own history.   If you’re honest with yourself, it will reveal your own relationship with money and work.  That analysis can be invaluable.  

I grew up on the south side of Chicago in the 50’s, a neighborhood kid, Catholic school and all of that.  Down the block was a little park where we played baseball and football.  One one end of the field they had scooped out a little area a few inches deep, when they graded the park, next to the fire hydrant.  In the winter once the ground froze they would turn on the hydrant and we had instant Hockey!   I thought what a cool concept, just add water!  In the spring the field would dry out and it was time for baseball again, hey batta hey batta hey batta SWING!  I moved from Chi to a tiny town in southern Indiana when I was about 10 or 11.  It was a totally different smoke than Chi had been.  The kids had been there for generations and somewhat clicky and the Ethos had more in common with Alabama than Chi.  There was a kid in my new neighborhood that had a paper route and he was moving, so I got the paper route, and at age 11 I was in business for myself.  It was real business.  The paper charged 35 cents a week which I had to go collect.  The papers were delivered to a small market 1 mile away.  On Thursday the paper was double in weight because of flyers.  On Sunday it was a regular Sunday paper with half a dozen sections adds etc.  The paper and I split 20 cents/15 cents BUT if I didn’t collect because some prick wouldn’t pay I lost 35 cents because I still had to pay for the paper.  I collected on Friday and it was funny how people were home every other day, in fact tapping their watches if I showed up 15 minutes late, but on Friday their place was a mausoleum.

This “job” was gold as a learning experience regarding commerce.  I was making about 15 bucks a week (+- deadbeats) cash at my own hand.  60 bucks a month for an 11 year old in 1963 wasn’t chump change.  After that I always had a job except for 2 years of medical school.  I worked in a stone mill and quarry running a jack hammer, drove a wrecker, worked a gas station, drove a delivery truck in High School.  I couldn’t wait for ice storms so I could get in the wrecker and go give people jumps and pull them out of the ditch, like a true Lincoln Park Pirate

In college I usually had 2 jobs.  I was a janitor, a chemistry research asst., I had a pizza delivery gig on Sat and Sun complete with a free pizza so papa ate good on Sat and Sun!  The pizza gig was for cash.  I also tutored physics math and chemistry on the side.  Eventually I went to grad school and became a teaching asst and had a rock and roll band on the side.  I left academia and became an engineer and got a gig teaching electronics at a community college on the side.   I also had a consulting business and was eat up with learning commodities trading.  Circumstance had it I ended up getting accepted to med school.  My first 2 years I had a gig teaching MCAT review to pre-meds and eventually ran out of tuition money so I joined the Navy as interest rates on loans were 18% immediate accrual.  Homey don’t play that.  Went in the Navy after residency and did moonlighting on the side, and paid off my commitment.  My first gig post Navy was Locums, traveling around so I could figure out how practices worked and the pathology involved.  I found a model I liked, Fee for Service Private Practice Solo and found a hospital in an area with a great payer mix and went to work passing gas, saving lives and winning valuable prizes!  I also started a pain practice on the side.  I learned how to do pain in the Navy.  Later we formed a group at that hospital and even later we started a SDSC.  By then I was old so I retired.  I stuffed money in some market since age 25.  I never had debt except for a mortgage which is proper use of leverage, instead I had work and lived within my means.  I worked hard but never bled my eyes out and my work made me wealthy and wise.  Healthy?  Like Joe Walsh says: Some say I’m crazy but I have a good time, I’m just lookin’ for clues at the scene of the crime.  Life’s been good to me so far..  

That’s my motor story.  None of it is about money.  It’s about taking advantage of the opportunity that presented.  

Journal Your Family’s Financial History.

My colleague Doc G has written about his financial pedigree.  He claims 3rd gen FI!  Your attitude toward money comes out of your family at a very basic level, like at a breathing air kind of basic.  There is probably a lot that is sorta known in the broader family about Finance, like Alcoholism or Robbery is sorta known.  It’s not something really dwelt upon and kind of ignored if it’s not in your face or kicking your patootie. 

His bravery at posting got me to thinking about my own financial family history.  So I sat down and journeled me up a far reaching family financial history going back 4 generations as far as I knew, about back to great grand parents who lived in the late 1800’s.  There was a family farm back then for some aspect of the family,  and all the uncles and aunts would gather at the farm for reunion! and the women would bake pie and Blatz beer and Pabst Blue Ribbon drinkin men would get out the 10Ga shotgun and laugh as we pip squeak kids would set off a blast toward the sky and get kicked like hell in the shoulder.  That 10G was no joke!  Rite of passage.  The farm smelled of manure.  I’m not exactly sure where it was located, somewhere south of Gary IN.   

My grandparents were born at the turn of the 20th century.   If you trace it, their jobs, their education, their success at raising a family in the face of things like WW1 and WW2, Korea, Viet Nam (reached into my generation) and the great depression, and various layoffs, unions. rotten offspring, successful cousins etc you have lain before you an understanding of the American economy for a century or more and how your personal family dealt with making it in America.  You understand the constraints of retirement.  Did Grandpa have a retirement?  If so what was he invested in? (a way to understand risk).  Did he advance at work?  Was he a Union man?  How did he survive the great depression?  What did his kids (your aunts and uncles) wind up doing?  What was their retirement like?  Did they save?  What about cousins?  What about cousins’ kids?  All of these people somehow survived with a real story, not just a blogosphere projection.  A real story that is the life you lived the financial air you breathed as a youngster. 

From that you can also look at your relationship with money under that light and see what insight that provides.  It’s actually fascinating.   A quick example: My Dad was an engineer.  A professional engineer which means he was like board certified and could stamp jobs as sound design from an engineering perspective.  A valuable credential.  It means a project can get financed and insured. Prior to certification he was subject to getting laid off.  Engineers are in high demand in the good times but dead weight in the recession.  So that was my story, living in the house of an engineer with 4 kids who got laid off every so often and required a job change and possibly a move.  My Dad lived through 6 moves in his career.  The 7th was his retirement move to my town where he could be near me and watch his grand kids grow along with my Mom, who is still alive.  He knew  I would take care of Mom if anything happened, the ultimate in risk management, so I’m familiar with the finances and have seen how my Dad handled those.  He was a star.  My Dad handled my Nana’s finances once gramps died and he also handled my Aunt (gramps sis) who had no kids but was married to an entrepreneur back in the 40’s and semi retired to FL in the 50’s.  The guy was hell on wheels on the organ.  I was very familiar with those financial histories and their successes and relative failures.  (Word to the wise a CD ladder is a poor investment strategy in a 1973 stagflation, and 1980 raging inflation environment). 

I discovered much more, likely too personal to relate, but the point is the point.  You are sitting on a treasure trove of personal insight and righteous systems analysis if you bother to look.  If you bother to look, Suze O won’t have anything on you.  You will have personal history of success and failure far beyond some 4 x25 blog snot.

What’s the Motor?

Have you ever wondered where the advancement of your wealth comes from in an equity?  In a bond it comes from the coupon rate. In a $1000 bond with a 5% coupon, your wealth advances $50/yr.  This is actual interest and can be reinvested for compounding or used for spending.  A Bond therefore is a kind of legal contract offering you a money motor called cash flow. 

A stock OTOH is a piece of property.  It’s ownership and it’s value is indeterminate.  For example more stock can be created or some can be bought back.   It’s only worth what someone will pay you for it.  If you own 1000 shares of BRK.B you own a percentage of BRK.B.  You can trade your BRK.B for money but until you do that you just own some property, same as a house or a farm or a car.  So what makes a stock valuable?  We glibly buy stocks and quack about the “magic of compounding”, but on it’s own property does not compound.  On any given day it can be worth more or worth less or even become worthless.  What’s the motor for a stock?

Henry Bessemer patented a process for making steel in 1856.  The process made steel purer stronger and easier.  The process existed in other parts of the world (cold blast) since the 11th century.  The story is an intriguing look into creativity and mythology and perhaps a dollop of theft, but none the less the blast furnace method of steel production ensued.  This new steel compared to cast iron lasted 10 times longer, was malleable and could be produced in vast quantities.  Bessemer’s process brought down the price and improved the quality.   Because of Bessemer’s process Minnesota’s Mesabi range of Iron Ore went from a 6% of need output to 51% and steel workers went to work making steel (imagine all those jobs and lives changed).  Cheaper steel allowed rail roads to prosper.  A rail was cheaper to make and lasted 10x longer.  At one point Chicago was the cross road for 14% of the nations railways.  My Grandfather  had a second grade education and worked the steel mills in south Chicago his whole life.  He raised 6 kids.  They were poor but Henry Bessemer’s innovation fed them.  My other Grandfather had an 8th grade education.  He became a meat buyer for A&P foods.  Eventually he worked his way to the C suite as VP.  I used to tag along to the Chicago stock yards where gramps would inspect and cull meat to send to the butchers, the meat my other grandfather would feed to his kids.  The meat got to Chicago as cattle on the trains, which road the rails so much improved by Bessemer’s process.  My uncle (grampa #1’s son) was a butcher who cut up the meat, and the abundance of meat brought down prices and grew strong people with good solid brains. God bless Henry Bessemer where ever you are!  The Chicago stock yards are what peaked my interest in commodities trading.  There’s gold in them there pens!  

What this is, is a description of creative destruction.  Creative destruction is the motor that drives stock price.  It’s productivity and innovation and a relentless improvement in efficiency.  It destroys the inefficient and creates the efficient.  It’s a concept born of economist Joseph Schumpterer of the Austrian school which uses Marx’s dialectic as the motor.  In Marx’s theory production was static and money flowed from have not’s to haves causing what he thought would be social unrest to the extent the proletariat would rise up and smote their bourgeoisie overlords and usher in utopia.  Marx lived in the fossilized society of London and his  mistake was misunderstanding human ingenuity and creativity.  The sucker was stuck in the mud without the creativity to understand he was in the belly of a fossil not something alive and growing.  Unfortunately tens of millions died and lived in abject poverty over his stupidity.  Not creative destruction but pure destruction and quenching of the human spirit.

Production is not static so the pie can grow!  Not only can the pie grow but you can bake a bigger better pie or a dozen bigger pies!   What Schumpterer saw was the real dialectic is between creation and stagnation.  The creative dynamo would rise up and pulverize the fossil.   The creative dynamo would rise up, eat the fossils lunch and multiply the loaves and fishes (increasing value).  The real dialectic was Bessemer’s efficiency of the new steel v the inefficiency of cast iron.  The pie expanded and trillions were created out of thin air, and the opportunity flowed to my Grandfathers who each in their own way were able to feed their children, and their children had children.  Creative destruction of course predated Schumptlerer he just normalized an understanding.  It’s creative destruction,  improving efficiency and productivity that is the motor in stocks.  That’s were the excess value comes from.  Unlike a bond which is pretty much a fixed legal contract creative is a living thing where something is made from nothing. 

There are tons of examples of this dynamo.   Cyrus McCormick developed a thrashing machine (also developed in Europe).  In pre-machine days 1 man could harvest 1 acre of wheat a day with a scythe.  Post machine 2 men could harvest 20 acres a day.   Henry Ford and his innovation, the recent fracking technology etc etc.  Examples enough to prove the path forward.   Anything that places a boot on creative destruction is deadly, and as investors you best know which side of your bread has the butter.  Creative destruction is the motor impelling us into the future, not the “magic of compounding”

Granularity of Roth Conversion

I’ve decided on a Roth conversion schedule.  

$250,000, $250,000, $250,000, $250,000 for a total of 1M over 4 years.  I’m in process now and I have till Dec 31 to get the first conversion done.  This process has turned out to be more complicated than I thought but once understood very do-able.  This schedule does not eliminate some of the cliffs of conversion like excess medicare costs but minimizes them over 4 years.  

The considerations are 

  1. Volatility of tax law.  Since the present tax law expires and the politicos seem hell bent on changing the law again it’s time to make hay while the sun shines.  This is why the first conversion are $250K.  No matter what that much will be converted and likely no matter what $750K will be converted before anything could legislatively be done to ruin the plan.  What could ruin the plan you ask?  They could eliminate the ability to convert.  Hopefully gridlock will protect me on all 4 conversions.  By sticking to $250K, as a couple we avoid the extra 3.8% medicare surcharge, but still get 1M converted in 4 years.  
  2. My wife and I both own IRA’s which were funded with post tax dollars.  It turns out the government only expects you to pay once, so a % of the Roth conversion will be tax free and the rest will be taxed as ordinary income.  I’ve dutifully saved the 8606 IRS forms each year so I have an accurate legal basis.  Something to consider is each spouses IRA gets treated separately since Roth conversions are per spouse.  My IRA is large.  My earliest IRA contributions were only 2000/yr which was the  max contribution till about the year 2000.  The IRS has a formula by which you determine a percentage of already tax paid money which you can subtract from the gross conversion to give you net taxable money.  The formula (from investopedia) : 

“John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2018, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.

Here’s how it works:

Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000 ÷ ($200,000 + $100,000) = $100,000 ÷ $300,000

Tax-Free amount of Conversion = 33.3% (or $33,333)Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate”

That percentage is set each year based on contribution amount, total IRA size and total amount of non deductible assets in the IRA, for each spouse,  once IRA conversion commences.  Because my early IRA contribution was small when I started my percentage is small, about 2%.  When I started the IRS only allowed 2K per year per spouse.  So I will have to pay on 98%.  2% off works for me!  My wife however worked a shorter time and raised our kids as a SAHM so her IRA is much smaller so her % tax relief is much larger, about 9% meaning on every dollar converted she pays, only 91 cents are taxed.  Such a deal!  The 1M conversion is not just my conversion it is OUR conversion but the IRA belong to each of us separately so sequencing the conversions into each spouses Roth accounts matters.  It turns out by converting her entire IRA and by back-filling the remaining from my IRA to reach $250K total we save an additional $4000 in taxes.   So my sequence becomes: convert all of hers then begin to convert mine for a $4000 maximized savings on this years conversion.   I will recalculate next year on a conversion based on my IRA alone.

3. What you convert matters.  You want to convert your highest risk assets first and of those high risk assets convert the ones that are down first.  My TIRA’s are at Fido and Vanguard as are my wife’s and our Roth’s are there as well.  Fido and Vanguard will transfer assets from a IRA to a Roth without a conversion to cash step as long as both IRA and Roth are at their brokerage.  So the funds are transferred and a tax bill generated, slick!  This year Emerging markets and Foreign are down 11% and 9% so these are my first equity’s to convert.  Stocks are property and by transferring the least appreciated highest risk property first you can transfer the most property for the least tax bite.  My conversion order will then be remaining stock, then alternatives, then REIT, then commodities, and finally bonds.  My goal is to end up with most of my bonds still in the TIRA and not in the Roth.  This minimizes the tax bill.  A Roth’s greatest advantage is sheltering capital appreciation as in stocks.  It’s less effective in sheltering assets that don’t appreciate much as in bonds.  The trade off is pay the government now or pay the government later.  Assets with large appreciation potential should be in the Roth ASAP so they can compound over years tax free.  Something like bonds which don’t appreciate much can be RMD’d as an interest bearing annuity, and pay those taxes over time.  BIG NOTE the RMD is still subject to whatever percentage you determine yearly from the non deductible portion when you started conversion so in my case if I RMD $30K I pay on only $29,400 since my percentage is reduced by 2% or so (variable each year).  I’ll take $600 tax free, so it gives me a little Roth like relief even while being a TIRA.  By splitting my assets into TIRA and Roth based on capital appreciation I split my tax bill between paying some now on the aggressive earners with no further tax consequence, and paying some in the future on smaller less aggressive earners as opposed to paying it all at once.  This reduces sequence of return risk early in retirement to some extent.  I am paying my taxes from my post tax account so by having a smaller tax bill for conversion that extra tax money I would pay by converting everything continues to grow in the post tax account.  My goal at RMD is to live on SS + a small RMD which gives me room to grow for quite a while before a jump to a new tax bracket, supplement my income as needed from small donations from my taxable account and let the Roth grow unmolested forever.   

4. By cleaning appreciation out of the IRA you have the ability to control tax brackets for a longer time.  My SS will be about $43K and my wife’s will be about $10K for a total of $53K.  Taxes are paid on 85% of the $53K or  $45K.  The top of the 12% bracket including deductions for age 65+ is 104,000 (26,600 deduction plus 77,400 (top end 12% bracket), so I have $59K of RMD money I can use to fill to the top of the 12% bracket.  If I RMD say $25K my taxable is 45K + 25K or 70K and I have $34K of growth before I hit the next tax bracket.  That probably is 12-15 years of retirement.  Because of the .85% break on SS my spendable income will be 53K+25K or $78K.  I’ll fill in my remaining needs from selling post tax stock or from post tax dividends.  Since I’m in the 12% bracket cap gains are 0%.  A masterpiece in optimization!  (I think).  I’ve run it by my professional adviser and he thinks so also.

Just a snapshot of what post retirement granularity including Roth conversion looks like.  So much for 4% x25, get drunk on the beach.

Granularity

You can’t control the future but you can control the likely shape of the future. In fact the whole 4 x25 rule is based on this, that somehow the future will look like the past. You only need a subset of the future to look like the past. You need the future to look like the past long enough for your plan to work until you become a carbon donor. Ever notice Curling? In Curling some joker throws a stone down a path of ice towards a bulls eye. Two other jokers have brooms and they slide along with the stone and sweep the way so the stone hits it’s mark. Victory has some component of luck but mostly application of doing what you can do to realize the result, aka risk control. The path of how this ballet plays out is not just accepting chance, but it’s encased in constantly changing the odds. I’m sure much drinking is involved as well perhaps changing the odds in another direction.

Poker is the same. In black jack the house has an 8% advantage. The advantage is due to the fact the house bets last so the player goes bust first. By correctly playing the player can reduce the houses odds to 0.2%, still a loser for the player but barely. The odds change because as cards are played, what’s left in the deck determines new odds with each hand and the fact the house has to live by betting rules. By understanding those changing odds and by judicious betting 0.2% negative goes positive and the player takes the advantage. If you get too good the house won’t play with you.

So retirement is not just abandoning yourself to chance but careful adherence to sweeping the path and correctly playing your cards and correctly betting, EVERY SINGLE THROW OR EVERY SINGLE HAND. The future plays out minute by minute not as an aggregate. Minute by minute is called accounting for sequence of return risk, aggregate is a future value calculator. People have trouble pulling the trigger because they are extremely risk averse. Their brains are wired that way. Your employer takes on the cost of your risk when he hires you. He pays for insurance, half your SS, makes sure all the government forms are filed on time, provides some retirement incentive etc. When you quit, all that risk cost comes back on you. If you have a plan that has dealt with the risk your pretty golden, if you have a plan that is based on some dumb assed formula you read on the internet.. ”At some point, we just have to decide that everything will be alright.” There is truth in that, but the truth is not inevitable and maybe not even probable.

I was playing with this the other day and I decided the formula should be a payout say 100K per year + a risk premium say 20K per year, for 120K per year and save x25 of that number. 3M instead of 2.5M. That would give you living expense plus risk premium expense. This is why people like 3 x33 because that just about equals living plus risk premium. You also have to include taxes based on yearly payouts and filing status etc. Sweep the ice!

Who gets to FIRE?

I’ve read story after story about how to FIRE.  The formula always starts with “SAVE HALF”  or some similar bromide.   What does save half really mean beyond the obvious application of third grade math?  I was reading an article stating:  “Whopping 62 percent of jobs don’t support middle-class life after accounting for cost of living”  I’ve seen it proclaimed by some FIRE bloggers as if anyone can do this FIRE thing, with a bit of a sneer implying “and if you don’t you’re a dope”.  To save half, means you have to make twice!  Middle class is defined in the article as wages between $44K and $79K.  Professional class is $79K or more.  This means to save half and remain even in the low end of middle class ($44K) you have to be professional class ($88K).  On the high end of the range to save half you must make nearly $160K per year.   An entry level engineer makes $84K in NYC, $59K in Chicago.  Save half kind of implies you have no debt after say 5.5 years of engineering school.

But wait it’s even worse!  It turns out depending on where you live you may be under water even on $44K.  Honolulu has a starting middle class wage of $66K and if you apply the same middle class spread the upper limit would be $118K meaning save half would require remuneration between $132K and $236K per year.  You might say OK Mr. Smarty Pants, we’ll save 1/4 and work longer!  Yes precisely, you will work 9 years longer.  Saving half of $88K @5% for 15 years gets you $1M.  Saving 1/4 of 88K for 24 years gets you the same 1M.  A common scheme I have read espoused by some bloggers is all you need is 15% savings yearly.   15% of $88K is $13K.  That pays you 1M in 32 years.  I guess if you can land a $88K/yr job at 22 you can retire on almost $44K/yr at age 54 assuming you never get fired or laid off, and live in a cheap place.  Does the parlance of a 32 year career fit the fantasy definition of RE?  What is the true longevity of $1M at a 4% withdrawal?  At 54 you have 11 years to Medicare.   At 4% withdrawal ($40K/yr) would put your retirement 10% less than middle class ($44k).  You officially get to retire poor.   OK Mr Smarty Pants, we’ll work longer!  Why yes, yes you will.

What’s Your Strategy?

In the past decade we have had unusual market stability, artificially induced by the FED and the regime of stress testing of banks.  In my opinion we narrowly avoided a depression in 2008.  We are off the gold standard since largely since the great depression and that allows the government to print money.  Also the FED bought toxic debt and returned treasuries which allowed banks to not go out of business.  The problem is if the debt had been called in 2008, banks would have imploded.  By moving the toxic debt to the FED balance sheet, it was allowed to mature and as it matured it became at least somewhat profitable.  Like healing a wound add protein vitamin C, zinc, and time.  By forcing bond returns low people moved out the risk curve and bought stocks, a lot of stocks.  The forced stability of the FED on the market gave the illusion of safety.  The economy is strong enough for the FED to unwind it’s balance sheet.  Both bonds and stocks have have moved far off their historic mean trend lines.  With the termination of FED interference both stocks and bonds will tend toward the mean, and the name of that game is increased volatility.   Bonds are starting to yield enough return that their inherent safety plus a little dab of yield starts to look attractive in the face of turmoil.    Stocks are inherently risky.  You think something like SPY is pretty safe but did you know SPY tracks only a little over 300 stocks not 500 and it has a large cap tilt.  VTI is even worse.  It’s not 3000+ stocks but about 1500.

I always wondered what would happen in a crash.  If you own SPY and they are forced to sell, SPY would likely no longer track the S&P because the momentum of the selling pressure on the 300 SPY stocks would overshooting would overwhelm the tracking of the instrument.  So your 15% volatility might be greater and increased vol means bigger losses compared to the real S&P or total market index.  Who knows?  A LOT of people own SPY and VTI and a huge heard of sellers is an enormous pressure on price.

Controlling volatility is important in a portfolio, as important as return IMHO.  High return is your friend in expansion but low vol is your friend in a crash.  Lets say you own SPY.  It’s projected return is 9.23% and it’s risk is 14.8%.  Lets say you own a million bucks worth.  Let’s say the market drops in half and my concern about increased vol doesn’t happen.  So your 1M turns into 500K, a 50% loss.  This means to recover to zero you need to make 100% before you reach your pre-loss level.  When you reach your pre-loss level you start compounding again and making money.  Till then you’re merely recovering.  That recoup can take a long time.

Here is a chart of SPY you can see the local max was on 10/8/2007.  It closed at $155.85  That number was not seen again till 3/11/2013.  That means for almost 6 years your money was sitting there under water.  After 3/11 you started accumulating and compounding again.  It’s Halloween, you want even scarier?  

This is the same SPY dating back to 8/28/2000.  Notice it takes till 2007 to recover from 2000 and almost immediately another crash.  This means nearly 13 years of living under water.  If you’re going to make your million bucks with this sequence you’re going to have a tough time.

This is what you made over those 13 years with a SPY account, 2.246%/yr and that was from reinvested dividends.  Say you retired in Dec 1999, with the intention of living off the dividend.  Your net growth/yr over the first 13 years of your retirement is 0.343%/yr.  Freaky eh!  

Imagine you had some bonds say 60/40 SPY VBMFX.   Your return is 7.41% and your risk is 8.93%.  Lets say SPY drops in half.  since your not 14.8% risked but only 8.93% risked (60% of SPY’s risk) your S&P will go down only 30% (1/2 of 60%) instead of 50%.  Your 1M would only drop to 700K not 500k.  That means you only have to get 60% back not 100% as in the first example.   You would get your 60% back about 2 years sooner and start compounding again,  while portfolio #1 is still under water.  If you did that twice say in the 2000-2013 case that would be an extra 4 years of compounding portfolio #1 misses out on.  For sure once portfolio #1 starts to grow again  it will grow faster but the return rate on #1 is 9.23% while the return on #2 is 7.41%  only 1.8% more.  Eventually #1 will overtake unless there is a bad SOR as in the 2000-2013 sequence.  What happens if yet another crash?.  The sequence repeats.    

Let’s look at the 40/60 case.  40/60 has an expected return of 6.53% and a risk of 6.24% (only 42% of SPY’s risk).  Now when SPY goes down 50% 40/60 goes down only 21% (1/2 of 42%).  Your million becomes 790K.  Your recovery to compounding again only needs to go up 42% as opposed to 100%.  This portfolio has the shortest recovery time of all.  Your portfolio is still compounding at 6.53% only 2.7% less return than the riskier portfolio.

Just because you pulled some asset allocation out of thin air does not mean you are wedded to that forever.  It’s not all or none.  You don’t have to go completely flat, you merely have to reduce your risk for a while by using a less aggressive allocation.  You can turn down the volume a bit, you don’t have to shut things off. In addition you can use that 60% bond money when stocks are cheap to buy a passel and be “loaded for bull” on the way back up.  Investing is like playing poker.  The house is slated to win by 8% but by playing correctly you can reduce those odds to almost parity to -0.2%(aka change asset allocation in a down turn).  You can further change the odds by buying low so you can sell high and let compounding work its magic.   How to know when to hold em and when to fold em is problematic.  I use a financial adviser and quant analysis and I’m happy to pay for that.  That’s my strategy.  If the guy gives me an extra 5 years of compounding during accumulation… you do the math.

This article is  an outline of a concept, a different way of looking at a portfolio from a perspective of capital preservation.  It is not a plan.  I do have a specific plan for my situation, but it’s more involved than this article would pretend.  If our interested it gives you a starting vantage point to begin your study.  The bogglehead approach is to simply stand there and take it with the refrain “I’m young I can recover!!” Problem is the young get old and the time to recover vanishes into the mist of mistakes made.  Compounding takes time.  If it’s a good sequence it pays off.  But another way to look at compounding is mistakes take just as much time to compound into failure.

This also points out a problem with FIRE.  Compounding relies on time.  You can wet start your portfolio by over funding.  HUH? Over funding?  It means you save half for 10 years instead of say 15% for 20 years.  Nothing wrong with that right?  What about mistake compounding?  That mistake is merrily compounding but is overshadowed by your exuberant saving profile.  It will manifest in it’s allotted 30 year time frame because it may take a long time for a mistake to become significant,  (Example national debt.  We ignore it continues to grow).  Let’s say you overfund save a lot of money but make a mistake (say running a portolio at 90/10 AA) that mistake manifests in 30 years but you retire in 15 years.  It means 15 years into retirement an over exuberant asset allocation takes its toll.  

Big ERN wrote a series here and here , looking at oscillating your risk profile risk and what he uses as red flags to know when to pull the trigger.  A second point of reference.

Efficient Frontier

It’s no secret I’m a big fan of efficient investing.  Efficient investing means you pay for your return with no more risk than necessary.  If your in a cup game where a ball is hidden under a cup, you want the least number of cups in the game.  3 cups 1/3 odds.  8 cups 1/8 odds.  The bet (return) is the same so what is varying is risk.  Less cups means risk optimization and a greater chance of success.  I play a lotto game every week.  I don’t play power ball or mega million, I play lucky money.  Power ball has a 300M:1 chance, lucky money is 3M:1 so my 1 dollar ticket is equal to 100 bux worth of tickets on the other game.  Lucky Money caps at a 2M payout.  If the cap is reached the excess trickles down to lesser prizes so the $10 dollar payout with much better odds may grow to $15.  I don’t win a lot but I do win sometimes.  I win enough to buy myself a more expensive ticket on another game when that game hits 1.6 billion and the cost of playing for the 1.6 billion ticket is free because it’s from the free money out of winnings from the less risky bet.  Over the years I’ve hit $800-$1000 a couple times so at one buck a week the whole shootin’ match is free.  Playing for free is good risk management.   I could cash out and buy hamburgers, but I already have a source of hamburgers so I’ll risk a little free money.  You never know, plus it’s a hoot optimizing my risk.   Risk management is the driver for my play, not return.  

This is no different with portfolios.  IMHO that is all about risk management as well.  The beloved Harry Markowitz published a paper, the year I was born, on optimal portfolio selection which included risk, asset correlation, return, variance and co-variance.  The zero point or origin is called a risk free asset.  It is an asset where you can park your wealth and be virtually assured of your return.  The risk free asset is typically short term govenment paper called T-Bills.  Your risk and return on any other asset is therefore judged against the Risk free asset. 

Here is a pic of a Bogglehead 50/50 2 fund efficient frontier.  You see the curve sits on a plane.  Every point on the plane represents a risk (SD) on the horizontal axis and a reward (% return) on the vertical.  0.0, 0.0 is the risk free asset (T-Bill).  Every this else is related to this.  You see VBMFX which has a 4.79% return and a 3.4% risk compared to a T-Bill.  You see VTSMX which has a 9.9% return and a 15.19% risk.  Remember when you own stocks and bonds you own property.  What those numbers tell you is when the value of the bond property drops say 50% the value of the stock property drops 4.6 times more, mucho risk. (there is a correlation factor in there yet to be addressed I just want to let the risk nature of two assets to sink in.  To own bonds you can expect to get 4.79% back on your money.  To own stocks 9.9%.  Owning stocks gives you only 2 x the return that owning bonds yields, but at 4.6 times the risk.  You are paying for your return with a hell of a lot of risk.  Note these values are averaged values for each asset from 1997 to 2018.  The calculations are quadratic which means they are not linear but curved, and id you have a curve you can define a maximum point.  The maximum point on this curve is called the tangent portfolio.  It is the ratio of these assets that pays the most return for the least risk.  Those values are 16% VTSMX and 84% VBMFX and you can expect 5.55% return for only 3.58% risk.  Best bang for the buck.  The risk goes up a measly .18% (3.58-3.4) and the return goes up 0.76%.  How many boggleheads kvetch over saving 3 bp on the cost of a fund?  This is a whole 76 bp increased return!  

Notice the provided 50/50 portfolio.  It still lives on the efficient frontier.  You still pay an optimum amount of risk for your reward, it’s just that you choose to own a more risky portfolio in hopes of greater return.  The R/R of a 50/50 is 7.69 risk 7.32 return.  You pay 46% more risk for 31% more return.  The curve is curved because Bonds and Stocks have almost zero correlation so when the value of one is oscillating the value of the other is pretty much static.  The efficient frontier calculator likes non correlated assets because of this because it further reduces risk.  In fact some assets tend to grow in the face of a stock down turn.  Gold is such an asset.

Here is a picture of gold v S&P 500 during the 2008 down turn.  If you owned some gold and S&P, and you needed some money in 2009 what would you sell?  Buy low sell high of course, sell the gold!  This is why I own some gold.  It’s not investing it’s insurance,  it also points out the value of non-correlation.  

The bogglehead 3!:

Boggle heads love their 3 fund.  The rap is all about “diversity”  If you own more piled higher and deeper you are more diverse (right?) so let’s own US International, AND Bonds by golly.  Lets look at that on the frontier:

Remember every point on the plane represents a risk and a reward and the above is the R/R of 50% VTSMX, 30% VGSTX and 20% VBMFX, the vaunted 3 fund.  The return is 7.84% and the risk a whopping 12.27%!  Recall the 50/50 2 fund was 7.32 return and 7.69 risk.  All I can say is DUH owning a 3 fund is stupid stupid stupid.  You pay 63 cents more risk for 7 cents more return.  BUT BUT BUT how can that be Mr Natural?  

The R/R for VGTSX is 6.5% and 17.10, super risky, shitty return.  The correlation between VGSTX and VTSMX is 0.85 an high correlation means the 2 assets act nearly identically as far as response to a crash.  So you own a shitty asset compared to VTSMX (6.5% return v 9.9% return) but your risk is greater (17.1% v 15.19%)  Note these are averages.   Any one year a given class can out perform but on the average… (complete this sentence).  

So there you have it, lesson 1 in efficient frontier.  I may write a follow up about market diversity.

You can play with the calculator yourself 

Assess Yourself

I recently did a psychometric personality self assessment.  It’s created and published by noted Canadian psychologist Jordan B, Peterson and his university group.  I went to a Peterson lecture concert up in Jax last month with my wife and enjoyed the presentation.  I’m keenly interested in neuropsychology and functional imaging and how that affects lives and especially in the investing arena.  It’s 10 bux for the test so I decided to see what Jordan’s assessment has to tell me.

Peterson is a big brain and is also interested in neuropsychology and I find him quite credible and proliferative.  The study of personality over the years has evolved into what is called the “Big Five”.  These include:

  • Agreeableness: Compassion and Politeness
  • Conscientiousness: Industriousness and Orderliness
  • Extraversion: Enthusiasm and Assertiveness
  • Neuroticism: Withdrawal and Volatility
  • Openness to Experience: Openness and Intellect

Each of the big five are further refined into 2 more dimensions giving a greater granularity.   Each trait can be viewed non judgmentally as each trait conveys it’s own power and support structure upon society (family, work, friendships, Church etc.) and melds it’s utility into the matrix of life.  As you discover the traits you come to know better “How you are” not just who you are.  My interest especially is with an eye on investment.  What type is a risk taker, what type procrastinates.  What type has a high barrier to investing and what manner of investing suits whom.  Investing at some level is competition and understanding the game and it’s players is useful.  Eventually we will be investing against AI and a comparative analysis of how you think and how an AI thinks will be mandatory.    It also gives some insight into choice of mate and understanding how your traits might mesh with theirs.  Information is power and nothing ventured nothing gained (the test tells me that’s one of my off the scale traits).  The test is available at Understanding Myself.  You are compared to men and women of all ages and strata so if you imagine a 10 dimensional heat map of society you get some idea of where you fit in 10 space.  Peterson’s goal is to give the assessment and then conjoin this knowledge with a self authoring program where you can write your story, and in the act of writing your story you gain significant insight into yourself.  Enough insight that you can start to iteratively make changes for the good.  He has a lot of good ideas to help people empower themselves for successful lives instead of just living in the stew.

I’m open to releasing my results but I won’t because I’m not sure how a preview would affect reliability for someone else taking the test.  Especially for physicians who are very testing savvy.  Some innocence I’m sure improves validity.    You take it only once, as repeated testing adds noise and unreliability to the result.  You can probably take it again 4 or 5 years down the road as personality changes as we mature in our life’s roles.  It’s kind of the basis of for at 20 you’re a liberal because you have a heart and at 40 you’re conservative because you gained in wisdom.   The scores in each dimension is read out numerically and a narrative provided regarding what people along that dimension are like.  I will say many of my scores were extreme, but then I kind of do live on the perimeter, stoned immaculate.  It’s my feature.  I wasn’t sure what to expect but I felt it interesting and the insight useful.  So for the price of a couple flights of craft beer you can get your head shrunk, gain some insight and have a hoot all at once and not wake up with a headache, having to pee like a race horse.