Solid Financial News & Retirement Planning Information. Rule Number #1 Turn off the TV

In his book, The Black Swan Nassim Taleb recommends paying less attention to the news of the moment; rather reflect on more digested more journalized information.  I fully agree.  I do not watch or have on ever any television business news shows ever running in my office.  James Cramer gives me a huge headache.

Rather, I read the Wall Street Journal and the British newspaper Financial Times on a daily basis.  My weekends are television news free as well.  Rather I tend to catch up on the week by reading the Economist, which is delivered to my door by Thursday or Friday. I am not a complete Luddite, I bounce around from the print edition, to reading the Economist on my iPad, and listening to articles on the Economist audio edition on my iPhone, as it is blue toothed through my car’s stereo as I drive around on the weekend.

Beyond that, I tend to try to dig deeper into academic research when looking to hone my financial knowledge and skills, an effort I pursue incessantly.

For years, I have relied on the Center for Retirement Research at Boston College for substantive, yet approachable research regarding planning for retirement.  Research driven over profit driven, I recommend that folks looking for answers regarding financial issues surrounding retirement to check out CRR’s website at crr.bc.edu.  There you will find briefs, solid research and condensed pieces on Social Security, health/long-term care insurance, and financing retirement.  For those willing to dig even further, there are working papers on many salient retirement topics.

 

logo

 

So, what I have learned and what would I like to share?  A common question in retirement is, “Do I have enough to live on and how much can I spend?” A reasonable and fair question that can set the heads of even the most intelligent financial professionals and academics incessantly spinning.  There are lots of variables involved, expected return, future inflation, and how long the money will need to last are some of the key issues.  Of course how big the whole pot you are pulling from is a huge issue as well.

Academic research has focused on trying to optimize how much funds can be withdrawn from a portfolio.  Interestingly, the optimal amount comes doggone close to what the IRS recommends for IRA required minimum distributions (RMDs).

RMDs are a function of two variables; (1) the balance of the IRA was at the end of last year and (2) one’s age.  In years when your balance is up, your RMD goes up.  In years when your balance is down, your RMD goes down.  This rule buffers pulling out money during down years a bit, which really helps in the end.  As for the age variable, first of all RMDs do not start until you are 70 ½ so you have deferred withdrawals for quite a while. Beyond that, the IRS RMD rule pretty much works out to be that the older you are, the more money you have to pull out of your IRA.  The IRS what’s you to pay taxes on those withdrawals before your die.  It also works out, that you are pretty safe to pull out more money as you get closer to St. Peter’s gate, which makes sense on a common sense level.

Using this two variables to determine how much money you withdrawal on an annual basis come quite close to the statistical actuarial optimum you will likely be able to withdraw over the remainder of your life.  What you give up in timing you make up for having more money to spend in the end.

On that note, I will close and reiterate that you should check out crr.bc.edu. The Center for Retirement Research at Boston College has a solid Facebook page as well.  Sure you can find it!

Advertisements

My Firm’s Approach to Investing

My firm’s investment policy focuses on using asset allocation and diversification as the primary means of achieving a client’s desired investment goals.  I recognize the preponderance of academic evidence that the capital markets are highly efficient.  Given this, I construct portfolios primarily using securities that are cost-efficient, diversified, and tax efficient.  My strategy seeks to maximize after-tax risk-adjusted total return for the client.

Allocation, Allocation, Allocation
Several academic studies indicate that investment policy and asset allocation explain that from 90% to 100% of a portfolio’s return.  Therefore, our policy focuses on the allocation of several asset classes as the determinant of investment results rather than individual security selection.  Money market funds, fixed income, domestic equities, real estate, and international equities are all integral components of a suitably balanced portfolio.

Stay Indexed & Passive, Avoid Active
Index-based securities and funds are well suited for asset allocation since they are more style specific in terms market capitalization and sector exposure than most actively managed mutual funds which are prone to “style drift”.  For example, a large cap value fund may buy growth stocks in order to improve performance.  Regardless of the correctness fund manager’s judgment call, the risk and return profile of the fund can change substantially from the time the investor initially invested in the fund.  Using indexed-based securities allows the investor to select the appropriate value/growth mix knowing that the underlying securities bought will be more stylistically consistent over the life of the investment.

Follow Academic Research
Based upon considerable academic evidence that value stocks and smaller capitalization stocks outperform over the long term, I seek to add value by judiciously increasing the value bias and smaller company bias in the weighting of the equity portfolio.  The most relevant academic research has been done by Eugene Fama and Kenneth French of the University of Chicago.  Fama received a Nobel prize in 2013 for his research.

I also seek to add value by including international equity investments, real estate investment trust and various alternative assets which offer broader capital market exposure and which have low correlations to the U.S. equity markets.

Municipal Bonds or Municipal Bond Funds? Don’t Ask WWSOD? (What Would Suze Orman Do?)

Municipal Bonds or Municipal Bond Funds?

 We read an article about Suze Orman in Costco’s magazine a while back.  The Costco mag rag has a few articles and lots of Costco products. In a sidebar to the article, Orman advises investors to buy individual bonds rather than bond funds. Orman’s primary argument is that individual bonds can be held to maturity and that interest income of individual bonds is more stable. We disagree with Orman for the most part. We think she is making a quick punchy magazine bullet point that does a disservice to most readers who take her comments at face value.

A Bit of a Drag

In her article, Orman did not differentiate between taxable and tax-free bonds.  We will focus specifically on municipal bonds where we think Orman’s broad brushed advice is particularly doing readers a disservice.  The primary municipal bond mutual fund that we use in client portfolios is the Vanguard California Intermediate Municipal Bond Fund (VCADX). The internal management fee charged by Vanguard is 0.09 percent annually. One would naturally think that if one were to buy individual municipal bonds, after paying the transaction costs of the original bond purchase, one could at least save 0.09 percent a year avoiding the annual expense ratio drag embedded in the bond mutual fund. This does not turn out to be the case.

A Bit of a Spread

The municipal bond market is more fragmented and less efficient than the stock market. Individual bond investors routinely pay from 1 percent to 4 percent more than what a mutual fund manager would pay for the same bond. The mutual fund companies have a scale and a frequency of buying municipal bonds that allow brokers to lower bond prices and still make money. The difference between what one investor can sell a bond for and the price she would pay for that same bond is called the “spread.” The wider spread that smaller municipal bond investors pay is effectively a fee embedded in the price of the bond and not really fully disclosed. Studies indicating simultaneous prices paid by retail investors versus institutional investors confirm these wide spreads.

(Unlike the bond market, the equities markets are pretty much priced the same for smaller investors and large institutional investors. This is due to a combination of free market competition and regulation. As bond trading platforms improve, we do expect smaller investors to eventually have access to more competitive pricing. We expect this process to take several years.)

Assume you pay 2 percent more than what Vanguard paid for the same bond. Roughly speaking, you would have to hold onto that bond about 22 years (2%/0.09% = 22.3 years) before the 2 percent higher price you paid for the bond starts being more attractive than the additional 0.09 percent in annual fees you pay to Vanguard.

Particularly if you are in the asset building mode, individual municipal bond investing is even more expensive, because the individual investor continues to pay a premium every time she buys more bonds to reinvest municipal bond interest income. Municipal bond funds, however, allow savers automatic monthly reinvestment into the bond fund without a transaction fee. Also, depending on the size of coupon interest, the individual investor may not even be able to find a municipal bond issue small enough to buy in order to stay fully invested.

Stability, Income, and Diversification

We think a common investor opinion that the income from individual bonds is more stable than the income from bond funds is incorrect. Let’s say an investor builds a laddered bond strategy and attempts to keep a fairly stable average weighted maturity (or duration, which is a metric used by institutional investors and is a little more complex) by buying longer, such as by buying bonds of rolling maturities. If the investor keeps buying a replacement bond of the longest desired maturity every time a bond matures, she faces the risk that the reinvested coupon interest may be less than the coupon paid by the last maturing bond.

Another common investor sentiment goes something like, “Well, if I hold on to the bond until maturity, I will always get my principal back.” Bond prices fluctuate daily, just like bond mutual funds. Every investment should be evaluated on a total return basis, which incorporates both the change in price from one period to the next and the cash flow earned from the investment. Factoring changes in interest rates, the time value of money, and inflation, a known nominal fixed dollar payment ten to twenty years out really is not much of an assurance of the value of your bond today. More importantly, that fixed dollar amount that will be paid off that far out in the future is not much of an assurance of what your real economic return will be from that investment.

Digging through the actual mechanics and going over the details confirms what we really think: Any comfort that comes from knowing exactly when your individual bonds will mature relative to the constant maturity of a bond fund is really a false sense of security.

Finally two more points on why municipal bond funds may be better for you than individual municipal bonds. The first one is fairly simple. Unless the client has a large dollar amount to be dedicated to municipal bonds, the amount of diversification achievable through a bond fund such as VCADX is difficult to replicate.

The second point is a little more conceptually difficult. Broadly speaking, a portfolio of individual bonds becomes a little shorter in maturity every day. That may lead to your bond allocation moving from its original specified risk tolerance. This can be adjusted when new money is invested in bonds and when a bond matures. Developing strategies using municipal bond funds that target specific maturity ranges (i.e., short-term, intermediate, and long-term) is likely a better way to customize a municipal fixed income allocation tailored specifically for an individual’s interest rate sensitivity and risk tolerance.

Taxes Do Matter

Key points I want you to take away from this post are:

• In a low return and increasing tax rate world, the tax drag is increasingly important

• Tax efficiency starts with initial portfolio design

• An effective tax strategy carries on for the life of the portfolio.

Where We Are At
Many respected experts think long-term returns for several asset classes will be lower going forward than historical norms. Given that so much is unknown regarding the future performance of a particular investment strategy, not taking advantage of what is known, i.e. the tax impact, is leaving valuable information on the table. If future investment returns are lower than historical norms, working on maintaining a tax efficient process will help contribute to a larger portion of the real net return. Compounding this circumstance are the likely increases in tax rates at some point in time in the future which will be necessary to address Federal and State budget and debt needs.

Upon Inception
Tax efficiency starts upon portfolio inception. While it is difficult to predict future tax rates, steps can be taken at the point of starting a portfolio strategy which can help insulate against current and future taxes. For example most equity mutual funds are inherently tax inefficient and should be avoided for the most part in taxable accounts. (We do make an exception for a few tax managed equity funds we use in taxable accounts.) We prefer to use more tax efficient exchange traded funds (ETFs) in taxable accounts. If you have a Roth IRA, we should take advantage of the tax free aspect of that account to stock up on your highest expected return assets or perhaps some inherently tax inefficient assets which can be sheltered by the completely tax free nature of a Roth. We generally prefer to hold a larger portion of income producing bonds and high dividend paying REITs in tax deferred accounts like a traditional IRA or 401k plan. Once an asset allocation is determined, working on “asset location” or which investments go into which type of account, is the next logical step.

Carry On
Keeping a portfolio focused on providing suitable after-tax returns takes ongoing discipline. We work on rebalancing portfolios as tax efficiently as possible, often rebalancing the entire portfolio by trading assets within the tax sheltered accounts to avoid creating taxable capital gains. We are inclined to realize losses in taxable accounts in order use these captured losses at a later time to eliminate the tax burden of realized gains. We use specific tax lot identification in all taxable accounts which allows us to clearly identify the tax impact of any investment security sale in client taxable accounts and to seek the most tax efficient combination of tax lots when we do sell.

While I did start by saying taxes do matter and that they are an integral part of the investment decision making process, I do think there are examples when the tax tail should not wag the investment dog. One clear example is when an investor has a concentrated holding with large embedded unrealized taxable capital gains. While the investment industry has offered some (usually commission laden) strategies, most often selling a reasonable portion of the asset to reduce risk is the logical and prudent choice. Also, if a portfolio’s riskier assets have increased appreciably; taxable capital gains may have to be realized to keep a portfolio within acceptable risk tolerance levels.

bb

Asset Location, Location, Location…

There’s an old joke –

Q. Why is kissing a lot like real estate?

A. Because what matters most is location, location, location.

The same could be said for investing.  Where you plant that investment matters.

Let’s assume that you read my last blog regarding asset allocation and you did some homework on what is the ideal asset allocation for you. How do you proceed from there?

The Bucket List

I view there are essentially 3 kind of buckets for you to invest your money in from a tax perspective, Taxable, Tax Deferred, and Tax Free.

Taxable Buckets – Think your Brokerage Account
Taxable buckets –There are two tax rates one faces in taxable investment account, the higher ordinary income and short-term capital gains tax rates; and the bit lower long-term capital gains and qualified dividend tax rates.  An investor who is taxed at the 35% Federal tax rate for ordinary income and short-term capital gains will be taxed at the 15% Federal tax rate for long-term capital gains and qualified dividends.

What To Emphasize in The Taxable Bucket: Tax Free Municipal Bonds, Domestic Stocks and International stocks.

Tricks: Focus on buy and hold.  Sell investments which have unrealized losses since you will be able to use those losses to lower taxes by lowering your  taxable ordinary income and realized taxable capital gains.  If you must sell, try to wait until you have held the investment for over a year so that you pay the lower long-term capital gains tax rate.

Tax Deferred Buckets – Think your IRA, 403B, and 401K
Tax Deferred Buckets – The good news is you usually get a tax deduction when putting money into the tax deferred bucket.  This way you pay less in taxes and have more money to put in to begin with. Also, no taxes are paid on any interest, dividends, and realized capital gains earned prior to withdrawing funds. The bad news is you pay the higher ordinary income tax rate when you eventually do pull out the money.  You have deferred that tax at least.

What to Emphasize in the Tax Deferred Bucket:  Taxable Bonds, Real Estate Investment Trusts (REITs).  Mutual funds which are tax inefficient by their nature.  Focus on investments which pay a lot of taxable interest, ordinary income and/ore which generate a lot of short-term capital gains.

Tricks:  Unlike common stock dividends REIT dividends are taxed at the higher ordinary income rate so tax deferred accounts are a good parking spot.  When you need to rebalance your overall portfolio, rebalancing in your IRA/403B/401K will allow to rebalance without creating any capital gains taxes.  Consider weighting assets with lots of long-term appreciation potential in your taxable bucket, or better yet, your tax free bucket where you can pay the lower capital gains tax rate or no taxes at all in the case of the tax free bucket.

Tax Free Buckets – Think your Roth IRA, Roth 401K
Tax Free Buckets – After-tax money usually goes into tax-free buckets.  While you have paid taxes on the earnings which funded the tax free bucket, all income and appreciation thereafter are tax free.

What to Emphasize in your Tax Free Bucket:  I call this my shoot for the moon bucket.  I recommend a well-diversified mix of one’s riskiest highest expected return assets.  Shoot for the moon but keep in mind it took a lot of technology, math, and research to get man on the moon, so be aggressive but be diversified and well thought out following the best academic research.

Tricks:  I pretty much just put equities in Roth IRA accounts.  I focus on a well diversified broad market allocation, but then skew the portfolio from there to include small agressive stocks and emerging markets.  I shy away from individual holdings particularly in the Roth since tax losses cannot not be taken in a tax free account.  Finally there is a strategy when one is retired to convert Roth IRA assets to regular IRA assets between retirement and receiving Social Security.  When you get there, talk to me about it and I will walk you through the issue.

Please note I used the word “emphasize” several times above regarding what to include in each bucket type.  You still want each of your buckets to be well diversified and include several asset classes if possible.

OK, I’m LOST…
Hoping not to get too lost in the details, here’s a really simple way of looking at it:

Figure out your target allocation then break it out as such –

Taxable Accounts
More Stocks (Domestic and International)
Less Bonds – Consider Municipal Bonds when you do
Generally no REITs

Tax Deferred Accounts
More Bonds – Corporate and US Government Bonds
Less Stocks (Domestic and International)
Most REITS

Tax Free
Little to No Bonds
Lots of Diversified Equity (Domestic and International) – especially riskier and/or high dividend equity investments
Some REITS perhaps

That’s it for now.

Asset Allocation: A Beginner’s Guide

There are principles in Finance that are rigorously studied at the highest levels of Academia , which often come across as abstract, obtuse, and barely understandable.  Frequently these principles boil down to some basic common sense such as:

  1. You should only take risk you have a reasonable chance of being compensated to take. Higher risk assets should offer higher expected returns.
  2. Take only as much rick as you can afford to take. Don’t bet the farm unless can afford to lose the farm.
  3. Don’t put all your eggs in one basket. Mitigate risk. Diversify. Diversify. Diversify.

All three of the above have one key word in common, ‘Risk.’  Anything you can do to mitigate risk while keeping the opportunity for the same return, or even higher return, you should absolutely jump on.  Let’s dig into each one a bit further…

No. 1 Risk & Return 

While hard for some people to grasp, holding concentrated equity holdings in just a few companies often backfires.  You are just not compensated for the amount of risk each company faces individually since it is so easy to hold a broadly diversified basket of stocks.  The simplest way to avoid getting one bum egg is to buy a couple dozen of them.  Start with buying the Vanguard Total Stock Market ETF (Ticker VTI) and be done with it.

No. 2 How Much Risk Can You Handle?

Nearly all of us likely need to save more. The best strategy is to start as early as possible so that you have the most time to invest and handle any bumps in the road, which will always occur.  The tough-love truth of it all is that as you get older and closer to retirement, time is running out and you need to start investing in more stable, lower return, investments.

In a very simple example, take the above fairly volatile higher expected return  Vanguard Total Stock Market ETF (VTI), and pair it with the more stable, lower expected return iShares Core U.S Aggregate Bond ETF (AGG), increasing how much you invest in the more stable U.S. Aggregate Bond investment over time.  Fine tune the mix to best fit you.  Here’s a pretty generic example to give you the gist of it all-

Age Chart

Risk is a very personal thing.  Here’s a link for a risk profile questionnaire from Vanguard that can help get you going: https://personal.vanguard.com/us/FundsInvQuestionnaire.

No. 3 The Risk Mitigating Mosaic – More. More. More. Plus…

Diversify. Diversify. Diversify.  In the above example, I took two assets classes, U.S. Stocks and U.S. Bonds, and with your judicious pairing of just those two asset classes you have taken a big amount of risk out of your portfolio and you have fine-tuned your investments to fit your specific needs.

However, why stop there?  Dig into it deeper and go from there.  A good primer for those willing to dive in beyond the baby pool (probably a good idea) is William Bernstein’s The Intelligent Asset Allocator (http://a.co/bfriM8e). After reading that you may start seeing the artistry in such mosaics as this one –

mosiac

Perhaps we can dive into deeper detail in future posts on the broad range of asset classes and how more value can be added by more diversification.