When I wrote yesterday’s post I realized there is a fundamental flaw in the FIRE model. Yesterdays post had to do with changing the AA and moving the portfolio onto the efficient frontier, and it’s effect on portfolio success. By eliminating a class of stocks (global) and putting that money into bonds we saw an amazing change in the risk of the two portfolios, defined as % success. Why did this happen? How can selling stocks and buying bonds improve things so dramatically in terms of success?
You read the FIRE literature and all you read is the “magic of compounding”. Compounding has a specific mechanism. You take some “interest” add it to some principal, wait a year take some slightly larger “interest” add that to last years portfolio and the thing grows!
Here is $1000 over 10 years @ 7% interest. It nearly doubles to $2000 and every time you plunk $1000 into a 7% money machine for 10 years it will grow to $1976.15. There is a specific investment called a zero coupon bond that works exactly like this. If you buy a $1000 10 year 7% zero coup in 10 years you will get $1967.15 for your trouble. A bond is a contract that pays out in money and a low risk of failure. This is the magic of compounding! A mortgage works like this. You borrow $200K on a 15 year mortgage for a house and at the end of 15 years you have a piece of property you paid $360,000 for, (excluding tax write off etc.) The property may be worth more or less or equal to $360K, but that is independent of the loan. If you’re the mortgage lender you’re the recipient of the magic of compounding! A bond’s value can be directly calculated at any time and is fixed. There is a market in bonds, but if you just hold to maturity it is what it is. You’re bond at maturity becomes promised cash. Income on bonds are taxed as ordinary income unless the bond is a special deal like a Muni bond. The bond aspect of your portfolio uses the magic of compounding to inflate it’s value.
A stock is a piece of property. It’s like the house. You pays some money and gets some property and you owns he property. You don’t own money. What sets the value of your property is the market, so the value floats up and down on the market, but that value is not money unless you sell it. If the asset appreciates it’s called capital gain and if depreciates capital loss so it’s taxed in a completely different way indicating it is not using the magic of compounding to inflate it’s value. It’s using the market to set it’s price. Like the value of your house, you hope a stock goes up in value but there is no contract assuring that like with a bond. Stocks offer return based on profits. Basically you take a raw material or service add some value and sell it at a higher price, but that profitability rides on the waves of the economy. Generally economy good, profit good, economy bad, profit bad, but also stock price is based on management’s ability to execute and creative destruction, inflation, the cost of money, the cost of labor, the cost of logistics, aka the cost of commerce. So stocks are risky. There are a lot of variables and variables vary.
When you own a portfolio and you are not adding or extracting you basically own a fixed amount of property. This is an important concept. Regardless of the “value” of a share which is set by the market, if you own 1000 shares you own 1000 shares, same as if you own a house you own a house. This is why in a down market if you don’t sell there is a chance to recovery because the property stays constant. This is why I see little difference in Real Estate and stock investing. Real Estate throws off cash flow, stocks throw off dividends. Real estate can be leveraged so can stocks. Real estate can be depreciated stocks can be tax loss harvested. Real estate can be used as collateral for a loan so can stocks in several forms for example covered calls. The value of real estate is market and economy driven, same with stocks. Some difference like liquidity and carrying charges and efficiency and correlation but more alike than different from my perspective. There are some tax breaks in the law for real estate but without the breaks profits would/will get taxed as capital gains.
When you open a portfolio and start deflating it, now value is being drained from the portfolio. It is no longer a bobber floating on the economic waves but starts to loose value. If the economy is good the value is high and you can slice off a little and sell high. If the economy sucks you sell low, but sell you must because you need some hamburgers to eat. High or low the portfolio has converted some of its property into money. You may say dividends! dividends! When the portfolio was closed those dividends were being reinvested into more property, when open that value is coming out and dividends are still floating on the economy. They may last a while but eventually will falter in a down economy. This is not the magic of compounding. Let’s look at a couple graphs:
The magic of compounding!
You go SEE SEE the market goes up!! Except when it doesn’t You had to buy hamburgers in the years surrounding 1995 and 2003 and 2009 so sell low. Sell low = bad SOR. What’s the mean?
Not much magic here. Good old fashioned commerce with it’s concomitant risk and FED manipulation and money printing but no magic of compounding. The magic of this chart is you and your neighbor getting up every day and being productive. That’s the magic in stocks. American productivity and capitalism. So that’s why the 80/20 portfolio failed so much more than the 50/50 portfolio. It’s all been “magic” since 2009 but that trend line is calling for it’s pound of revision. In a balanced risk adjusted 50/50 portfolio half the assets are exposed to the compounding magic, in a 80/20 only 20% is exposed to the compounding magic. If you’re 80/20 you best be about protecting policies that encourage the magic of capitalism and productivity.