After reading a number of insightful comments from “Gasem” that were almost as long and complete as some of the posts I write, I asked if would be interested in sharing some of his thoughts on investing in a more formal manner.
The first was “crazed ex-commodities trader, fills out matchbook cover, goes to med school and is led to seek the zen of diversity” Too long, sorry. The second was “Fear and loathing in search of negentropy.” Intriguing, yes, but I’m not quite sure what to make of it.
Gasem has led a decidedly unordinary life, so you should not be surprised that his approach to investing is not as simple as a three fund portfolio. He’ll be walking us through a variety of standard asset classes, some additional strategies he considers additional “asset classes” and how the concept of efficient frontier could potentiall be applied to both accumulation and decumulation.
Let’s see what the electrical engineer /college professor / commodities trader turned anesthesiologist and pain doc has to say about his approach to investing, shall we?
The Zen of Diversity: Asset Classes, Epochs, and the Efficient Frontier
I recently read a paper in the Journal of Personal Finance, looking at investment mistakes among investors in down markets (page 34).
One thing I noticed in the article is how often the authors referred to various kinds of poor diversification due to psychological reasons in the time of a down market as a “mistake.” In my opinion, mistakes are the true enemy of portfolio longevity.
If you retire early, minimizing mistakes becomes even more important since even little mistakes can grow into big consequences regarding portfolio longevity when your horizon is 50 years rather than 30 or less. Diversity is the free lunch of investing. It is the basis of modern portfolio theory.
Nobel laureate Harry Markowitz published his paper on the efficient frontier in 1956. The idea behind modern portfolio theory is that a perfectly diversified portfolio (meaning a portfolio of largely uncorrelated assets), when combined in correct ratios, produces a “whole” which is much more robust in terms of growth, return and survival than a less optimized portfolio.Bogleheads regarding fine-tuning asset mix. Some of the discussion is like prescribing prunes for constipation: is six enough? Is twelve too many?? Sometimes the forest gets lost for the dang trees.
Work is about converting your time into money. Do not lose sight of this while gazing at your asset allocation navel, for at some point your time will become more valuable than its money equivalent in your life. This got me to thinking since according to Harry the only free lunch in life is diversity.
What are asset classes? Is there an expanded list of asset classes to consider when thinking about financial freedom?
Standard Asset Classes
We know stocks to be the bedrock Mack Daddy of asset classes. Stocks are ownership in capitalism, pure and simple. Once Alan Greenspan was asked, “What should you own?” His proper Mascowitzian reply was “everything”.
It was this comment that got me interested in modern portfolio theory. After all, Al ain’t a dope regardless of his exuberance. (There is something satisfying about the word picture of Greenspan vs. exuberance.) Stocks are the engine of capital appreciation.
Why own bonds? They add diversity, are sometimes income producing, less risky than stock, and get paid first. They tend to be uncorrelated with stocks and are part of the whole greater than the parts in the formula of Markowitz.
Since we are in a distorted bond market due to the Fed, alternatives are uncorrelated assets typically in funds which throw off higher yields than bonds but tend to act like bonds in diversifying a portfolio.
Here is a book title for you: “The Little Book of Alternative Investments: Reaping Rewards by Daring to be Different” by Phil DeMuth which explains the theology of alternatives. I’m about 5% in alternatives.
Cash is ballast and insurance. It’s insurance for the catastrophe and ballast against a market downturn. Its danger is inflation and the fact it returns virtually nothing. One thing I like about cash is I can spend it.
Gold (GLD) is an uncorrelated to negatively-correlated asset. When the market goes down, GLD tends to go up and vice versa. It tends to stabilize volatility without being a huge drag on capital appreciation. It also can be useful in tax loss harvesting (TLH) depending on whether it’s in a taxable or non-taxable account.
An example of the TLH technique: when GLD goes to loss, sell GLD and buy gold miners. Book the loss. Miners have about the same correlation to a portfolio as GLD. I’m about 5% in GLD. I used to be in more generalized commodities funds but I think GLD is a more responsive hedge.
Real Estate is another relatively uncorrelated asset, and its appreciation tends to be a little offset time-wise compared to stocks ,so again it tends to smooth out volatility a bit. I’m presently about 2% in REIT.
Long Term capital loss
I consider this a separate often ignored asset class. I mine this aggressively. Over several downturns, I have accumulated about $700K of LT cap loss by selling losers and replacing them with stocks or funds of similar but not identical place in my portfolio.
I’ve spent this down over the decades to about $400K. I use it to rebalance taxable accounts or pull money out of taxable accounts tax-free. Capital gains plus LT cap loss are the rich man’s version of a Roth. To use this, you need knowledge of your tax lot losses and appreciation, which is provided by your brokerage. I recently sold $450K of appreciated stock to fund my early retirement. My tax bill would have been $90K, but because of LT cap loss, my tax bill is $0. I can buy a lot of hamburgers for $90K.
[PoF: A lot of hamburgers or at my current burn rate, 12 to 18 months of expenses!]
I consider this an asset class because like LT cap loss, if I don’t pay taxes, I get to use the not-paid taxes to grab a steak and a movie. For me, this is mostly about eliminating dividends and interest as much as possible in my post tax accounts. As an example, BRK.B is the holy grail of a tax efficient stock.
Deep Money Thoughts by Gasem: Additional Asset Classes?
Pre-tax versus post-tax accounts
I’ve become less enamored of the pre-tax accounts. The idea is to stash your dough in a pre-tax account, let it grow tax-free and then pull it out at a lower tax rate when you retire.
The problem is the government forces your pretax accounts to become annuities at age 70, and if you have a lot of dough in them you may NOT be in a low tax situation. I recall the old Grateful Dead song Dire Wolf: “When I awoke the Dire Wolf, 600 pounds of sin was grinning at my window all I said was come on in… Don’t murder me I beg of you don’t murder me.. PLEASE PLEASE DON’T MURDER ME.”
[PoF: That was not my first thought… but OK]I will happily pay the taxes I owe, but I feel I’m being set up because I was successful in my life. Homey don’t play that. A solution is to convert some pretax money into a Roth, but I have read papers that say that is not always a wise strategy. It can be confusing.
I’m currently converting some money into a Roth with as little tax hit as I can stand till I’m forced to annuitize when RMD hits. I figure the different accounts (Roth v Traditional pretax) may be another form of diversity. This way I can pull money out of whatever account makes sense. [PoF: “Tax diversification” plays a big role in my portfolio]
My goal is to get RMD down to a level that doesn’t kick me into a higher tax bracket, and to not suffer bracket creep in my traditional IRA’s. My goal is to set up a low level of taxation on my annuitized income stream (RMD + Social Security) and slice off little pieces of post-tax money mated with LT cap loss for discrete extravagances, like slicing off a little dab of roast beef from a rib roast. Having considerable money in accounts that have already been taxed is what gives me flexibility. I know it’s unconventional, but to me it makes sense.
[PoF: I don’t think it’s all that unconventional for the high-income earners and big savers. There’s only so much one can squeeze into tax advantaged accounts per year. Over 80% of my portfolio is post-tax (taxable or Roth)]
Next to RMDs, this is my second annuity. I decided to hold off on claiminguntill age 70. By waiting I’m making a guaranteed 6.1% on my money. I’m also improving my wife’s financial picture once I’m dead, which is actually my main goal.
My SS take at 66 would be $31K and when my wife claims 9 years later she would get about $16K. By deferring, I will get $42K and when she claims our net will be $63K, but if I croak, her take will be $42K inflation adjusted instead of $31K. Personally, I don’t think Congress is going to fix SS so in 2034 the law mandates a 25% across the board cut, and my opinion is they will stand by and just “blame the law.”
If the cut happens (also presuming I’m dead), my wife’s $42K will become $35K where taking my age 66 distribution would drop her to about $24K. I consider this income stream as insurance anyway, but it deserves a clear understanding of how the parts work.
I engaged in a couple side businesses that generated K-1’s. They added to my LT cap loss, Not a fan, but YMMV.
This is something I didn’t do in a formal way and I wish I had. I was making plenty of money, saving plenty of money, and had a thumbnail idea of where everything was going, but I wish I had a formal idea. As you save for retirement, the most important dollar you ever save is your first one. It has the longest time to multiply.
Understanding formally where the dough is going I think captures enough extra return to make it a separate asset class. That dollar you put in 10 years into your career has far less impact on your FI. Today, I use Mint.com to track expenses, and I charge nearly everything on a FIDO card and pay it off every month. I get actual cash back and a very good annotated spreadsheet of where the dough goes. The few things I need to write a check for also get swept into Mint for a near perfect day-to-day, month-to-month snapshot of my expenses. Personal Capital monitors my assets.
Fixed Cost Saving
I see many trying to include “extravagances” into their monthly post FIRE cash flow. I have nothing against “extravagances” — what the heck it’s your money to spend like you want — but I don’t think it belongs in the cash flow when doing the analysis. I think it belongs as separate line items and funded as separate line items.
If you want to take five big trips in the first 20 years of retirement just fund each one as a line item. I think it removes uncertainty in the budget and you may decide to work another couple years to fund your extravagance.
This is an interesting one. My portfolio was allocated in the typical funds(foreign, US, large cap, small cap, etc…) as well as commodities, REIT, Bonds, Alternative, and low volatility funds (think SPLV) during the 2008 crash.
Before the crash, I had moved my money from retail funds to Phil Demuth’s management. That gave me access to very low cost commercial quality funds as used by pension fund managers, etc… These funds have slightly different tuning compared to the retail product.
In the crash, SPY (S&P 500) went down about 45% which meant it had to make 81% to get back to zero. That took till about 2013. My portfolio was less volatile due to its diversity. It fell by 38% even though it was aggressively stocks, and it got back to even in 2011, two full years before SPY recovered. By 2013 I was 18% ahead of SPY. Since I fell 38% I only needed to make 61% to be made whole.
Before I went into medicine, I was trading commodities on the side in Chicago and I got used to the concept of leverage. If you understand it, you can add it to your mix in the form of loans to improve your position. For example, if I had student loans and a home and a stable job picture, I would strongly consider taking out a home equity line to pay off the loans and write off the interest. Just an example.
Time value of money versus Money value of time
This is what caused me to retire the second time. In my practice life, I wound up being the practice owner of a group at a hospital that was deteriorating and foundering in debt. It became impossible to practice there anymore, so our partnership left.I sat out for about a year living off accounts receivable and I just wasn’t ready to be done, though I was financially independent. Some local surgeons built a surgery center and since my partner and I were available, we picked up that contract and I went back to work for another six years.
At some point, the practice became too corporate and I realized I had already made all the money, and a little dab more (even a big dab) wouldn’t make any difference so I FIRE’d again. I had achieved true financial freedom, both economically and psychologically.
Accumulation versus Distribution
I mention this as an asset class since distributions are not the same as accumulation. It’s worth the time understanding all the moving parts. What you have to spend is what’s left over after everyone else gets their mits on your dough. I recently got on Medicare and came to find out I get to pay double for part B since I made too much money in 2015. HUH?? Sing me another round about how the wealthy get all the breaks.
Your job clearly is one of your greatest asset classes and everything you are doing with your portfolio is designed to allow you to eliminate this asset. In my case I did a step down in this asset till I was ready.
I include this as an asset class since inflation and bear markets are the bane of retirement. I have traded some portfolio return for protection. My cash to live on is in short term municipal bonds as opposed to a CD ladder or something similar. Short term munis don’t pay quite as much, but they are responsive to inflation and the interest is tax free. I also have some long term TIPS.
I read a paper and the smartypants advisers suggest I should move five years before retirement and five years after retirement, to a 55:45 to 45:55 asset allocation. Bengen also did his studies with this mix and found portfolios out of this range in early retirement tended to not survive. I’m a gunner and used to running 80:20 but now that I have a “Touch of Gray” and “I Will Survive” running in my head 24/7.
I’m willing to listen to the smartypants. After all, this article started with how to not make mistakes. Chances are in late retirement your lack of respiration will occur before your late-term mistakes catch up, but according to the article, oldsters make more mistakes.
[PoF: Not to be confused with Ewoks, although I believe in those, too]
I believe retirement occurs in epochs, meaning as your history unfolds, your finances can be tailored according to a epoch approach. You did this in school when you made no money and leveraged your life. That was a 8 to 20 year epoch. You did this in residency, a 3 to 7 year epoch.
You did this as an attending when creating your nest egg (fill in the blank) epoch. Each epoch has its own financial feature which is determinate, and unique solutions to financing that period. I think retirement unfolds the same way. In my case, I’m in the “make no money while I maximize Roth conversion up to 15% tax bracket” epoch. During the next 5 y, ars I’m pulling as much as possible out of my traditional IRA and stuffing that into Roth, limiting myself to a 15% tax bite.
To do that, I had to create a way to pay for my life each month while effectively making zero taxable income on my 1040. I came up with a scheme of creating a “home brew annuity” by selling some of my post tax stocks, matching that with LT cap loss for a zero dollar tax bill, and I started moving money into Roth.
I can live on this for five years while the money machine continues to crank. At age 70, a new epoch will ensue, and I will have to create a different money machine. RMDs and Social Security will kick in and present me with a completely different cash flow. In addition, I will be 5 years closer to being dead so I may decide to change asset mixes or increase charitable giving in the annuity epoch (70+).
All that I have created (budget, diversity in accounts, etc…) are the tools I can use to tune my finances to match my epoch. I’m not a man with only a hammer, so everything doesn’t look like a nail. This is the Law of the Instrument described (invented?) by Abraham Maslow. Restated, this is simply the law of diversity repackaged. If you have more tools you have more degrees of freedom, and if you have better tools you will build a more sound retirement.
Efficient frontier of accumulation versus Efficient frontier of distribution
Markowitz got his Nobel for designing an accumulating portfolio where the combination of the parts in the right ratios made the whole stronger and more secure than the individual components. I’ve been considering the concept an efficient frontier for a distributing portfolio, as well. The real efficient frontier of distribution may be to have a very clear understanding of the liabilities of distribution and an exact knowledge of what you own and why you own it.
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[PoF: Many strategies were discussed in this monster of a guest post. Which resonate with you? Do you agree with Gasem that certain strategies such as Tax Loss Harvesting could be considered a class of their own? Do you believe in dialing back to a conservative allocation in retirement?]