The Zen of Diversity: Asset Classes, Epochs, and the Efficient Frontier

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 result is today’s post that spans a wide range of topics, including those mentioned in the title: asset classes, epochs, and the Efficient Frontier. The author suggested a couple titles to me.

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.

The average investor on this site uses this theory based on asset allocation.  There are big discussions on 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

 

Stocks

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.

 

Bonds

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.

 

Alternatives

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.

[PoF: Full disclosure: Phil DeMuth is Gasem’s financial advisor and a good buddy of Ben Stein of Ferriss Bueller’s Day Off fame, among other things.]

 

Cash

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

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.

 

REIT

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!]

 

Tax efficiency

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]

1% Yield Bump on Your 1st Investment for PoF Readers

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)]

 

Social Security

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.

 

Illiquid assets

I engaged in a couple side businesses that generated K-1’s.  They added to my LT cap loss, Not a fan, but YMMV.

 

Budget

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.

 


Track your investments for free with Personal Capital. That's how I track the PoF portfolio.

 

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.

 

Volatility

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.

 

Leverage

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.

 

Job

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.

 

Worries

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.

Between my portfolio’s proven behavior in a bear market and the inflation protection I’ve included, I sleep OK at night.  I safely withdraw less than 3% and I continue to fine tune my budget and tax picture, but in general, I’m with Alfred E Neuman: “What me worry?!!”

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.

 

Epochs

[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+).

 

Minister's Tree House

the no more fun epoch

 

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.

 

[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?]

 

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33 comments

  • Fantastic post!

    I agree that diversity is key, and I should likely have more in my portfolio. I am pretty much just in index funds (though there are 7 different ones I am in), and probably 90/10 in terms of American versus International. I am also 100% stocks because I just started as an attending. Maybe 5 to 10 years from now I’ll be less aggressive.

    What I really liked was your discussion on heading towards more Roth contributions! I’ve actually made a similar decision, and had a post come out on that today!

    I am curious to know a little more about REIT’s and exactly how/where to execute that vehicle? Is that performed mostly from your taxable accounts? Do you prefer individual stocks there or REIT mutual funds?

    TPP

    • REITS are not tax efficient. I don’t like the idea of a single REIT company, so I’d use Vanguard’s REIT index as my vehicle in a tax protected account.

    • Gasem

      Thank you for your comments.

      REITS are not tax efficient so they should be held in pre-tax accounts. REITS are actually very volatile when they are analyzed on a risk/reward basis and tend to be about 57% correlated with total stocks (TSM) as an asset class. REITS yield 11.62% with 19.36% volatility compared to TSM of 10.68% and 14.81% vol. This is based on data going back to 1994 so it’s pretty robust. I’ve use Vanguard VNQ ETF and presently use DFREX from DFA funds. My present allocation strategy is to try and reduce vol in my portfolio so I have reduced my REIT exposure but I think they are worth owning. The efficient frontier calculator says 5.23% REITS in a TSM/Total Bonds/REIT portfolio.

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  • Interesting take, I’ve never thought of ‘worries’ and ‘epochs’ as asset classes. Thanks for the post!

  • Long and interesting read.

    Few questions for you:

    What is your equities to bonds ratio ? International allocation ? Or do you you believe when US sneezes, the rest of the world will catch a cold?
    What percentage of cash do you hold?
    Do you believe in a glide path strategy to actually increase your equities over the course of retirement? Much good work on this topic and it will be part of our plan.

    One suggestion – if you travel as part of retirement, have you though of strategies to invoke travel hacking instead of just having a cash back credit card. We save about $5-6K per year with travel hacking…..a very decent impact on our SWR

    • Gasem

      Hi Mr PIE

      My current AA

      44% US equity correlation 1.0 risk 14.9%
      14% Foreign correlation .84 risk 16.8%
      5% Emerging correlation .77 risk 23%
      26% Bonds correlation -.2 risk 7%
      5% Alternatives correlation 0.01 risk (not enough data)
      4% Gold correlation 0.03 risk 16%
      2% REIT correlation .57 risk 19%

      For a total of about 63% equity exposure. This % has grown with the market this past year and I will re-balance at some point to below 60%

      26% Bonds including LTIPS MUNI’s and various Government maturities with a tiny bit of foreign bonds. Given the markets (stocks bonds credit) are at +90% of their mean when I retired I moved some trading accounts into bonds so I have some ammo in case of a crash. One way or another I expect some revision to the mean over the next decade so yes I am pre-positioned to take advantage of the “next” run-up, and in the mean time I have some inflation protection.

      4.25% Gold
      5% alternatives
      2% REIT

      I consider the bonds plus the above true diversifiers. I listed the correlation compared to Stocks, so 37% of my assets are very uncorrelated to negatively correlated to stocks, 19% are moderately uncorrelated.

      I also have some cash and property not considered in the portfolio. I also own BITCOIN

      I do believe during times of expansion (like now) stock diversity adds value but during the Bear market all stocks have vectors that largely normalize into the ground.

      My point is you can know your diversity return and risk with relative numerical precision using a efficient frontier calculator and not just as a guesstimate.

      I believe in a glide path but not necessarily a smooth glide path which is why I have bond money ready to be deployed into stocks when the time is opportune. A glide path changes the risk profile and I don’t see any reason to do that “just because”.

      The question of travel hacks is interesting. Presently I have 2 kids in college and I’m caring for an elderly parent so my travel presently is limited and the cash back is useful, but looking at PoF’s recent trip that may change

      Best

  • hatton1

    What a great post! You are concerned about several things that bother me. I really like Phil Demuths books. Do you mind revealing how much he charges?
    1. I agree with you about taking advantage of big bear markets and accumulating LT capital losses. I did this in 2008 and had 300k of carry forward losses. This allowed me to leave a broker at Merrill Lynch and transition to Vanguard and re-align things with no cost. Unfortunately I have no carry forwards left.
    2. Do you hold other stocks other than Brk.B that pay no dividends.
    3. I agree with you that pre-tax accounts become a monster that lots of people do not realize.
    4. I plan to take SS at 70 also. I think they (our government) will come up with some fix so as not to cut it by 25%. If they do oh well I don’t really need it.
    5. I use mint (quicken) and PC exactly the same way.
    6. I view extravagances or some type of expensive item such as a car as an extraordinary expense like a company does on an earnings report in my mental accounting system.
    7. I worry about that part B medicare expense also. I will temper roth conversions after 63 in view of this.
    8. How many years worth of expenses are you keeping in short term munis.
    9. Explain your Tips allocation. I have never owned any.
    10. What is your current asset allocation?
    11. Are you doing anything different in regards to sequence of returns issues?

    I am trying to roth convert as I am a part-timer at 60. Enough questions.

    • Gasem

      1. Given the new tax bill my be going to FIFO on cap gains this strategy is in transition but it has been a great boon to me over the years. Like you it has allowed me to re balance post tax accounts at no cost.

      2. I own other stocks but they act more specifically as diversifiers than tax efficient investments. I try to risk adjust my portfolio to a lower volatility so some of what I own like SPLV is designed for that goal TooMuchInformation for this post.

      3. My biggest problem with pretax is they are a HUGE sync of untapped tax dollars and I don’t trust the Gov’t not not tap them. Plus once you RMD your ability to control your tax bite is hindered.

      4. SS’s future is a mystery but the contingencies are knowable, and so plan-able.

      5. I LOVES me some MINT. It is so simple to keep track. I consider this app vital. Phil has a custom aggregater called BD reporting associated with my funds I like even better than Personal Capital for data analysis. It means when we go over my portfolio we both are apples to apples and on the same page even though we live 3000 miles apart.

      6. Line items are useful especially in retirement. I have 2 air handlers that are going to need replacing in the next couple years. The money is budgeted.

      7. SS and Medicare is like looking across an event horizon. Little data lotta hoping

      8. My Roth conversion “epoch” is 60 months so I have 66 months of projected budgeted expenses in Muni’s (110% projected). This gives a kind of auto glide path. As the Muni’s spend down my AA automatically tilts more toward stocks, but I don’t have to perturb my portfolio for that to happen. When I turn 70 a new “annuity” epoch ensues.

      9. LTIPS are a product and strategy from DFA funds. DFA does a LOT of research on market efficiency. The brains are Nobel winners Gene Fama and Ken French from U of Chicago. Their research says Long Term Tips seem to provide best portfolio protection in case of inflation. TIPS are inflation protected treasury security’s that are values over inflation. I consider this investment insurance and hence diversity

      10. See MR PIE’s answer

      11. I’m limiting volatility, re-balancing allocation, I’m prepared to deploy some money PRN, living within my budget, and I’m not over extended on my WR. I use Big ERN’s spreadsheet to analyze my WR and I am able to include my SS and my wife’s SS into the projection. I think “epochs” are also very useful in combating SORR

      Thanks for the thoughtful questions … my fingers are sore gotta go ice them 🙂

      Give Phil a call at Conservative Wealth Management

  • Thanks Gasem for this epic, detailed post. Sounds like you are well diversified.

    Once we pay off our mortgage a couple of years from now, we will need to use some tax loss harvesting since the majority of our income will be going into non-tax advantaged accounts (after maxing out our tax-advantaged accounts).

  • I really enjoyed this high level broad view. Thanks.

    Another aspect of diversification that I have subscribed to is “diversification against political risk.” It is probably similar to POF’s “tax diversification.” Our government can change the rules affecting any asset or account type whenever it likes. For example, here (in Canada) our government just changed the rules on how we can pass money to our adult offspring to fund university/college. We had two options. We could use an RESP (a tax sheltered account with a small grant each year) or save all the money in our prof corp and pay them dividends at school time. The prof corp way resulted in a bit more money, but poof that option just disappeared and those who put all their eggs in that basket can’t make up the lost RESP grants retrospectively. I used both RESPs and my corp to diversify. Glad I did. I think we will see more of this type of thing here as our government spends beyond its means and needs revenue.

    • Gasem

      Thanks LD. I agree on the government being like a razor back hog when it comes to ripping up good plans in the name of political expedience, but overall I’d rather live here than anywhere else

      Best

  • What’s the formula to calculate how high the S&P must climb to be back to even after a decline?

    Ex: A 30% drop needs X% increase to get back to even.

    • RonS

      If 1 equals even, and percentage expressions are in decimal format [i.e., 30% is 0.30], with D being the percentage decline, this formula works to calculate the percentage gain needed to get back to even:

      (1 / [1-D]) – 1

      Using your 30% decline, (1 / .7) – 1 = 42.857% gain required to get back to even.

      A 50% decline, (1 / .5) – 1, requires a 100% gain to get back to even.

      Of course, with a 100% decline you start a recovery with 0, so no percentage gain will bet you back to even.

      • Thank your for posting the formula. Many people get this wrong, including the author (sorry, Gasem!). The first draft used a simple 2:1 formula — a 38% drop required a 76% return — but that only works for a perfect 50% drop.

        I used the formula above to correct the data to give you the numbers you see in the published post. A 38% (0.38) drop requires a 1/.62 increase = 61%, not 76%.

        A 90% ( 0.90) drop requires a 1/.10 increase = 1000% ,not 180%.

        Cheers!
        -PoF

        • Gasem

          PoF

          I didn’t use a formula but a graphical solution. I took the local high for SPY in Oct 2007 before the crash and then traveled along the chart till that value was once again achieved which was Mar 2013. Peak to trough to peak was 155 (Oct 2007) to 68 (Mar 2009) back to 155 (Mar 2013). I went through the same exercise with my own portfolio and peak to trough to peak was in Jun 2011 and by Mar 2013 I was up 18%. The graphical solution gives a very clear picture of how a relatively lower volatility works in a portfolio and its relationship to SORR. This is where the free money of the efficient frontier comes from.

    • Gasem

      This points out why I think risk adjustment is as important as return adjustment when it comes to AA. It seems to be often ignored. The efficient frontier is a curved line on a plane of points where the X axis standard deviation (volatility or risk) and the Y axis is return. There is a tangent line to the efficient frontier curve called the “tangent portfolio” which is the portfolio AA which has the greatest return for the lowest risk. This kind of thing helps with SORR and sleeping at night.

  • This is the ultimate savant post. Like speaking to those rare friends in the “brilliant, manic” category, there’s a lot of brain fodder that has my thoughts ricocheting like bullets in a barrel.

    Thanks giving this hobo a ride on that remarkable train of thoughts.

  • ENT Doc

    Enjoyed the read and ESPECIALLY liked the Dire Wolf reference.

    • Gasem

      When I was in grad school we had a bluegrass/southern rock band. Grateful Dead was our specialty. Red whiskey I believe refers to a single pot distilled mixed mash of malted and un-malted hops. Generally of a reddish hue and sure to make one eye flop closed if not both. I’ve had it for supper before a time or two.

  • MBC

    What are your thoughts concerning QLAC (qualified longevity annuity contract)?
    QLAC vs SPIA (single premium immediate annuity)?
    I am 68 yrs. old.

    • Gasem

      In general I’m not a fan. Annuities unless self funded are a drag on your returns no matter the pretty labels and boiler plate they place on them. They are the money ball for the “investment industry” as in you pays them the money. I know these products are touted by Wade Pfau specifically but I think ol’ Wade is a bag man for the insurance industry, not the insurance customer. The financial industry is about spinning yarns designed to separate you from your money. I like ol’ Wade’s writing but I understand also the agenda. I view all of my investments with this kind of jaundice.

      The way to wind up with money when you’re dead is to not overspend when you are alive and take advantage of portfolio choices which improve your portfolios longevity. This for me is a highly and properly diversified low cost portfolio. When you buy this kind of portfolio you are buying the work ethic of the men and women who underlay the corporations and the rule of law of the government where these corporations are housed. In other words you are leveraging your neighbors work and turning that into your security. Also by owning that kind of portfolio you are leveraging creative destruction which IMHO is capitalistic engine that generates the “GO” in the economy. By owning diversity you are properly reducing your risk. This is the secret sauce of security.

      If you look at a chart of the S&P or the DOW with a decades long perspective you see a line that goes relentlessly up and to the right. When that line falters from a decades long perspective the “insurance company” guaranteeing your future will no longer exist. You simply have to answer one question “do I believe in America or not?” Maybe a kind of corny question in the face of cynicism and manufactured media narrative and coolness, but in fact I think it is the essential question. I believe.

  • Lots of good information. I am confused on tax lost harvesting. The reason is because it locks in the sold for loss assets into a lower cost basis and increases the tax paid later as capital gains. I suppose it doesn’t matter if you are in the 0% CG bracket when you sell them later or you die and get stepped up cost basis. But, if you are planning on using that money and get taxed on it, the taxes will be paid later and will be larger than if you didn’t harvest the loss. It might matter less if your are in a lower CG tax bracket when you sell for the gain.

    Is my line of thinking correct?

  • Gasem

    Cap gains are applied to tax lots when sold. Modern vendor s like Fidelity allow you to pick which lots to sell. You may accumulate shares of lets say VTI over years. Each purchase constitutes a tax lot but it’s all the same stock. Let’s say you have 1,000,000 of VTI accumulated over 20 years purchased yearly. Not taking into account dividend reinvestment that would be 20 lots. Let’s say the Bear comes and your 1,000,000 drops to 500,000 some of those oldest lots may still have positive cap gains because they have tripled or quadrupled over 20 years, but more recent lots may be underwater now with capital loss. Let’s assume you sell the underwater lots and you book 200,000 of cap loss and continue to hold the VTI lots which are still capital gainers. You reinvest the money from what you sold into SPY to keep from getting a wash sale. The Bear goes away and you once again appreciate to 1,000,000 VTI+SPY but you still have 200,000 of cap loss on the books. This is how you tax loss harvest.

    You retire and have 42,000 in SS of which you are taxed on 80% or 33,600 as ordinary income. You also have tIRA money and VTI in a taxable account. Your taxes (assuming the ’18 tax bill passes and you are married) will be 0 on the first 24,000 (deduction) then 10% on the next 19,050, (43,050 net including 24k deduction) then 12% on the next 58,350 (101,400 including the 24k deduction). This 101,400 is the top money you can make and pay 0% cap gains and is the top of the 12% bracket when the 24K is figured into the AGI.

    Let’s say you need 120K per year and you have taxable SS of 33,600 and a RMD of 50,000. Your “regular” income therefore is 83,600. You need to sell 36,400 of VTI to bring your income up to 120,000. That 36,400 generates let’s say 17,000 cap gain and the rest is basis. 83,600 + 17,000 cap gain =100,600 taxable and you should be still in the 0% cap gain range (taking into account the 24K standard deduction), so all you would owe is your income tax on your regular income. (1,905+4,866=5,061 on 83,600)

    New problem: Lets say you need 156,400 which means you sell VTI and you sell from the same lot another 36,400 which generates another 17,000 cap gain. You will now owe some cap gain tax money. Your previous limit was 101,400 so you had 101,400 – 100,600 or 800 of 0% cap gain left. 17,000 – 800= 16,200 and you will owe 16,200 x .15% or 2,430 cap gain tax in addition to your income tax. (1,905+4,866=5,061 on 83,600) With your 200,000 tax loss you can erase that additional 2,430 cap gain and in fact write off an additional 3K of loss if you want which would leave you 194,570 of cap loss to apply to more cap gain in the future. This means your effective tax rate is 5061/156400 or 3.2% v 4.8% if you didn’t have the cap loss write off. I’ve had people criticize this analysis but if you have tax lots which are in loss why not claim the loss? You have to use the loss during the course of your life it does not transfer to your heirs, except your wife can use it if the accounts are joint. You just added nearly 500/month spending money to your retirement cash flow.

    Because your SPY likely has a lower cap gain since it’s had less time to accumulate cap gain, come the next Bear you can tax loss harvest now from this stock, and with the proceeds put those back into VTI. Glow and rotate PRN! You can also use LT cap loss to re-balance your portfolio without inuring cap gains. Re-balancing is a way to combat SORR and adds diversity

    A good article is from Kitces:

  • Gasem

    The Kitces article is using 2017 values

  • Really interesting thoughts about the concept of non-traditional asset classes. I remember one of my colleagues when I worked on Wall Street talked about how one of the benefits of him leaving his Wall Street job and going to medical school was that he and his girlfriend would have “job diversification” if he was a doctor and she worked on Wall Street.

    • Gasem

      When I was in residency in Chicago one of the Orthopod’s had a wife who was a CBOT trader. Now that’s real job diversity. In ’79 I was trading on the Chicago market while working as a communications engineer and applied to med school and managed to get in. I had saved enough to buy my own seat on the Chicago mini-market or pay for med school and decided on med school. I think it was the right choice. All the traders I knew were total burn-outs. I have serial job diversity. I’ve had 15 different jobs and hustles in my life and learned something unique from each o f them. TNX for the comment WSP

  • Gasem

    Phil DeMuth sent this link along. It’s a tax calculator based on the new code. Some may find it interesting.

    http://taxplancalculator.com/

  • The NeuroDoc

    Hi, not sure I understand this:

    ” 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. ”

    If we can only use $3000 against capital gains, how did you reduce the $90K tax to 0?

    Thanks for the reply.

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