Thursday, October 31, 2019

Seeds of Change - Investments


Ok, you’ve slogged your way through the preliminaries and the warm-up bands. Now it’s time for the headline act. This is the one I suspect you’ve all been waiting for. I hope you have your cross-trainers on, or a comfortable pair of hiking boots, because we’ve got a lot of ground to cover.

But first, it’s story time again.

Let’s set the Wayback Machine for just a decade ago. It’s the darkest days of the Great Recession. The market has fallen off a cliff. Money markets almost broke the buck, which most people didn’t know. No one knew if the banks would completely unwind as they had nearly 80 years before. Many were content to let it happen with no idea what that would mean. Fear was the dominant animal spirit prowling the trading pits, preying on the weak and leaving their blood pooled upon the exchange floor as a warning to others.

I remember the day in 2008 when the Dow Industrial Average dropped 777 points. I turned to Karen at dinner and said, now’s the time to get out, wait for the bottom, jump back in and make some money. Because no one knew where it was going or how long it would last, she preferred to ride it out like most experts always advise (generally good advice). We make joint decisions, so we sat. And we knew we’d still be buying in through her 401k all the way down so wouldn’t completely miss the opportunity.

But as the carnage continued, I started getting edgy.

I’d been investing since we first got married. As I mentioned in a previous essay, for a long time we’ve contributed to various retirement accounts, both 401ks and IRAs. But we also had a side account that I alone managed where we’d dumped some of my excess money from when I was still an engineer. It, like everything else, had hemorrhaged roughly half its value.

As I listened to the debate on Too-Big-to-Fail raging through the halls of power, I spotted a potential opportunity. I marked the three Big Banks on a watch list. I identified stocks we owned that I could sell, ones I didn’t think would bounce back quickly, mainly consumer companies.

Then came the day CitiBank fell below $1 a share while the normally fiscally responsible party seemed content to let it (and the economy) fail just to damage their political rivals. It felt like the world was ending. Everything was unravelling.

But I suspected there was money to be made.

So, I pulled the trigger. I cashed out some investments in that side account and dumped it all into Citi, placing a heavy bet that sanity would return.  It took a long, sleepless, panic-fueled month, but reason finally prevailed. Fairly quickly, my little side bet jumped to three times what I’d bought it for.

I cashed out, knowing it wouldn’t last, but I didn’t stop there. I’d already identified a couple Dow stocks with price-to-earnings ratios (P/Es) down around 8 (the historic average for the S&P is around 13). So, I immediately dumped the proceeds into them. A year later, those investments were up another 30%. In a year my initial investment was now worth four times what I’d started with. Pretty neat.

I continued making changes as I spotted opportunities, desperately trying to make up our loss. Our potential reversal from 2007 was still fresh in my mind, as it would be until we were five years out.

So where did all that get us?

Well, from the depth of the Great Recession to a year or so ago, the S&P 500 was roughly 3.5 times higher than its market bottom. Karen’s 401k paralleled that (so not a bad choice on her part to hang tight). Our IRAs were slightly less because we’ve been slightly more defensive with them.

And my side account? It was worth 7 times what it was when I placed that little bet. So if you were wondering whether I’m qualified to write about this, I’ll let that serve as my resume.

But once again, I’ll invoke my mantra. I am NOT a trained professional, so DO NOT attempt this at home.

What I am is an empiricist, and likely an extremely lucky one.

Our accounts divide into three unequal pots, each managed by a different guiding principle. Pot 1 is Karen’s 401k equivalent. That gets managed by a philosophy of indexing and compound interest. Pot 2 is our IRAs (including my 401k rollover). That gets managed by our financial guy who is a trained professional. Pot 3 is my side account, stocks and mutual funds. I’m its financial guardian.

Each year, I evaluate which philosophy has performed better. And I’ll probably be content to gather data for a long time to come. To me, it’s just amusing to see how it plays out. Yes, I have a strange sense of humor.

Let’s start with Pot 2 because I think it is the least instructive.

We are on our third financial guy. The first came highly recommended, a reputation that seemed to be borne out until he lost his assistant and a number of mistakes and oversights began to appear. So, we transferred our accounts to financial guy number 2, who was also recommended and closer to home. We could have sit-down conversations with him instead of just talking over the phone. As he prepared to retire, he transitioned us to financial guy number 3. We’ve had him for over a decade. We sit-down with him once or twice a year.

Financial guys are good and bad. Good in that they know more about the markets and various investment schema than I ever will. Bad in that sometimes they push things I don’t fully understand. My general rule is that if I don’t understand it, I don’t invest in it no matter how much money there is to be made. That comes from experience. While we’ve never gotten involved in anything particularly sketchy or Madoff level too-good-to-be-true, we have occasionally had some extra icing layered on our cake. Those empty calories haven’t always worked out, though fortunately those pieces were small. So now I take a firmer hand and do more self-direction. But our current financial guy likes a balanced approach so I always listen to his advice. He’s still in the race.

Now Pot 1 is pretty boring. In investments, that’s a good thing.

Remember way back in the first essay when I talked about average S&P returns? Of course, you do because I haven’t stopped harping on them since.

In a couple previous essays, I touched on the power of compound interest but haven’t formally called it out. Compound interest is my bestest friend. It’s my soulmate. It’s the kumquat Haagen-Dazs to my Kareem Abdul-Jabbar.

I’ve pointed out that the power of compound interest has been the workhorse of our financial plan and execution, making time and money work for us. You have seen how this has paid off in the way we paid our mortgage down. And again, when I mentioned how much money a small annual tax credit could add up to over time. It really is the key to the F.I.R.E movement.

Here’s a little rule of thumb to help you remember how it works. I learned it as the Rule of 7/10, (aka the Rule of 72).

Basically, if you take an initial chunk of money, say $1000, and invest it at 10% (the average S&P 500 returns) it will double every 7 years. You can work this out on a calculator. Enter 1000, multiply it by 1.1 seven times. What do you get? You should get 1948.72 (or just under $2k). Now clear that, enter 1000 and multiply it by 1.07 ten times. You should get 1967.15 (or again, just under $2k).

So, it works both ways. If I want to double our money, I should invest it at a 10% interest rate for seven years, or at a 7% interest rate for ten years. It really is that simple.

Ok, but it’s not. Because I’ve been lying to you all along. That 10% return rate on the S&P 500? Yeah, as I’ve alluded to before, it’s not really 10%. It is on paper (so be careful with that axe, Eugene). But capturing those paper gains is somewhat of a chimera.

Why?

First, because even most S&P 500 index funds have management fees (or sales charges and commissions, or a few other hidden gems). Finding one with a 1% overhead is pretty good (you can find better in exchange traded funds, ETF, but 1% in mutual funds is the standard). So now our 10% (really 9.8%) is down to 9%.

Next up is the big bear: Inflation. For those who don’t know, inflation means your money won’t be worth as much in the future as it is right now for a variety of reasons that I won’t get into. But remember when you were a kid and candy bars cost $0.25 in a convenience store? Well, I do. And they were huge. Now they cost, what, $1.25? Ok, I don’t know how much they cost but a lot more at any rate. The same candy bar or smaller, likely made from the same or cheaper ingredients on the same machinery. That’s inflation.

Over the past hundred years in the US, inflation has run at roughly 3% a year (3.22% from 1913-2014). 3% doesn’t seem like all that much until you multiply it out like we did above and come up with something like 20 times what you started at (3.22% nets you 22.75 times over that 100 years). Which means that’s how much more money you would have needed to start with 100 years ago to have the same theoretical buying power now. It does get more complicated than that, but it’s a good working number.

Inflation is a beast.

Thankfully, for the past decade inflation in the US has only run at 2%. Though interest rates have also been at historic lows, too, which is good or bad depending on whether you are borrowing or saving. But I also remember when inflation hit double digits in the 80s (14.5%), when interest rates were also double digit (11%). I always work with the average for planning purposes and hope for the best.

What does that mean? Well, it means I have to slice off another 3% from our theoretical returns just to keep afloat with the same spending power, leaving me now with 6% returns. Just under the easy rule of 7/10, and more like 12 years to effectively double which is almost, but not quite, double the 7 years we started at.

And that’s before paying any capital gains (taxes) which we may or may not owe depending on our income and situation at the time we cash them out.

Now you begin to see where all those little matching funds and tax advantages come into play. Daddy’s little helper. That and a lot of cognac.

And yet, there is still almost no better game in town than an S&P 500 index. In Pot 1, we have access to other index funds (a small-cap index, a corporate bond index, an international index and a safe government bond index), all of which have extremely low management fees. As well, there are lifecycle funds that balance all those different indexes based on how far we are from retirement.

As a very quick rule of thumb and aside, it used to be that financial experts recommended you have your decade of age stashed in bonds or other safe investments. In your fifties, that would be 50% of your funds in bonds. I’ve seen a number of variations on this rule, more and less aggressive depending on your timeline, assets and risk tolerance, as well as different mixes that include real estate, international and value funds. More recently, I’ve seen an interesting scheme where keeping a 60/40 split between stocks and bonds and rebalancing annually might be the best to keep afloat and limit any downside carnage. I have to look into that more.

In essence, the closer you are to retirement, the more conservative you want to be. As we’ll get to in a moment.

We generally buy a mix of S&P, Small-Cap and International every paycheck (in that weighted order), though sometimes we park a significant percentage in the safe bond fund to preserve what we have. The buy strategy provides us cost averaging, meaning when the market dips, we get funds cheaper, and when it’s high, they are move expensive, which tends to average out throughout the year without us having to think about it. We tend to want to control how much or how little is at risk at any given moment through how much we park in the safe bond fund, though many people we know use the lifecycle funds to do that so they don’t have to think about it (which I recommend). Different criteria.

On to Pot 3. Daddy’s playground.

You got a taste of what I tend to do above. I am not above taking calculated risk. That’s because the purpose of this pot is a little different than the other two. But more on that in a minute. 

In general, I am a value shopper. I look for opportunities based on stocks (or assets) that are beaten down. I am not really good at spotting trends like an online friend who I sometimes trade ideas with. She has her finger on the pulse of society and is in tune with where it’s going in a way that I’m just not good at.

What I am better at is spotting opportunity. In general, I follow Warren Buffett’s advice: When others are fearful, be greedy; when they are greedy, be fearful. I’ll give you a few quick examples. Often, they involve stocks that are getting beaten down in the news cycle or ones that have fallen out of favor.

The first example goes back to the nadir of the Great Recession. I started thinking through what the long-term consequences might be. One was that consumers would likely become more frugal. Which meant they were more likely to buy and sell secondhand. I figured eBay might be a good pickup. I already owned some eBay, so I knew a little about their business. They had three prongs. First, the auction site. Second, an app called Skype which was supposed to support the auction site, but they could never make work. And third, a little payment outfit called PayPal, which drove more profit than the auction site and they eventually spun off. I knew that last one folded into the long-term trend of internet economy. eBay was beaten down at the time like most consumer stocks. While eBay has only doubled in value since the Great Recession, the PayPal spinoff is now worth eleven times what it started at from the spinoff. A tidy profit.

A better example might be from just over two years ago. After the 2016 election, all the FAANG stocks started taking a beating (Facebook, Apple, Amazon, Netflix, Google/Alphabet). Most of their CEOs had made an enemy in the President-elect intentionally or not. Their stocks plummeted. I believed they were oversold because the incoming administration had very little influence over their businesses, so near the bottom, I picked them up. In the intervening two years, they are up an average of over 70%. That beat the market average significantly, even after the carnage late last year.

Now just like I’m a value shopper, I also pretty much stick to a buy and hold philosophy. Which means I don’t turn over stocks frequently. I prefer to hold them and let them grow. Sometimes this works out, sometimes not. With a little company called Skyworks (which bought up a company called Alpha Industries which I’d bought in 2001), this has definitely worked out (to the tune of nearly twenty times return on investment). Not getting out of GE at its peak (not knowing they were lying in their accounting), cost me though I still walked away with profit. Not so with Carbo Ceramics which followed oil prices through their spontaneous boom and surprise collapse, though I didn’t lose much either.

In general, I’ve been fortunate in that technology stocks have led the way for the bulk of my investment career. Technology is something I understand, so it’s easier for me to see its implications. One of the reasons I picked up GE (aside from its low P/E, which is often but not always a good marker of value) was that it had captured a great deal of the market on wind turbines, like 70%. Even in 2009, I could see a future in alternative energy. I’ve considered Tesla if only for its battery tech, but Elon Musk is bat-shit crazy.

You get the picture. Basically, in this account I played to my strengths and background, and got lucky that it paid off over time. Though the initial learning curve to get there was at times pretty steep (which is why I don’t recommend it).

Ok, three pots of money. Each of them with a different philosophy and a different purpose.

The purpose of Pot 1 (Karen’s 401k) is to provide long-term income through our retirement. The purpose of Pot 2 (IRAs) is to bridge us from initial retirement to claiming Social Security. And Pot 3 (stocks and mutual) is a combination of bridge money, emergency money (ala 2007) and fun money in retirement. Because Pot 2 is the slow runner of the group with the highest fees, it will get tapped first.

Somewhere in here, we may have lost sight of the plot. The goal has always been financial independence and early retirement. But what does that even mean?

It means having enough money to do what we want when we want to. How much is that? Well it’s different for every person. You can find all manner of advice on that online.

But here’s where all the tedious accounting you’ve slogged through in the past bunch of essays begins to come together. Because we have a budget, we know exactly what how much money we are living on right now, not just a snapshot, a long-term, running average. Because we live debt-free, that average is well below our means, which has fueled the three accounts above. Because we have a disciplined mindset and live simply, we don’t need as much as others and can likely enjoy our current standard of living indefinitely. Because we’ve planned, we are hedged against uncertainty with both insurance and emergency funds. And should a deeper uncertainty arise, we can find other discounts and reductions if we have to. As well, we have an emergency maintenance fund for the house, and the house itself as a double-emergency fund should we need it.

But hopefully we won’t.

Because we’ve gone through the budgeting process once again, only this time looking forward rather than back.

We know from our Social Security statements what our benefits will be at various ages we might claim them. In general, we intend to defer claiming our benefits until the latest possible date because the government gives us an 8% bonus for each of three years past our full retirement date that we do so. Always take the free stuff.

We are also both very lucky in that our jobs had pensions. Karen’s is better than mine. We know what those benefits are and when they come online. We also will have access to her health insurance at the same premiums she would pay as an employee.

Now once we add all that up, then subtract off our expenses (which I’ve expanded to cover things like taxes and insurance premiums which aren’t accounted for automatically in retirement), I find we are completely covered. In fact, we’ll likely get a raise. And maybe a travel fund if we have anything left over.

Which only leaves getting from here to there now that Karen has retired early. Here is where the above accounts come into play.

Remember back in the first essay, I mentioned additional healthcare costs in retirement? That’s what Pot 1 is mostly dedicated to. It could be a little, it could be a lot. There’s no way to know exactly how or when the dice will fall.

Pot 2 (IRAs), as I said above, is bridge money. Unfortunately, that bridge money can’t be touched (without a lot of hassle or penalty) until the owner is 59.5. That’s still a few years away.

Which is where Pot 3 (stocks and mutual funds) comes into play. I can withdraw from that freely as long as I’m willing to pay the capital gains (taxes) which really isn’t much right now for people like us because, as I’ve said, we don’t make a lot of money.  Fair or unfair, it’s the way the cards lay out.

None of which answers how much we really need. So, it’s time for another rule. The 4% Rule (aka The Bergen Rule). That basically says you can withdraw 4% from a pot of money each year (adjusted for inflation) and have a great chance that your money will outlive you. So basically, in an average year, we need a 7% return to make it work. Tough but doable.

Given that again, we know our expenses (with or without any supplemental income depending on the scenario), all we need is roughly 25 times whatever that income gap is each year (1/.04). Which Pot 2 and Pot 3 cover from now until various other guaranteed income comes online (like Social Security). In fairness, there’s a bit of a spreadsheet that goes with all this, but you get the drift.

But all of this comes with a really big, huge, caveat. Order of Returns.

You can tell by the caps this one is important.

Ok, in an average year you know by now the S&P returns 10%. But you also know there is no such thing as an average year. The thing is, the timing of those down years can be really important.

I don’t have numbers handy, but let’s play a little thought experiment. Let’s say I add up my Soc. Sec. and my pension (lucky me) and then deduct my expenses and find I have a $10k annual gap. Ok, no problem. By the 4% Rule, I know I need to have $250k prepared to earn 7% a year (likely in some combination of stocks and bonds). But I’ve planned and saved and overengineered so, lucky me again, I have $300k eager to go to work. And I retire…

…in July 2008. Right on the cusp of the Great Recession.

By July 2009, my $300k suffered a drive-by, though not quite as bad as the S&P because I diversified. Which means I only lost a little less than a third rather than over half. Which means at the end of my first year of retirement, I now only have $200k. Which is less than the $250k I need to generate the income to fill the annual gap. In fact, it leaves me with a $2k/year shortfall if I withdraw at safe returns. I either need to cut my expenses, find a new source of income, or take greater risks with my investments.

And if I’d started with less and lost more? Potential nightmare scenario.

In an alternate scenario where the year before I’m going to retire, the Great Recession hits, I could likely delay retirement, save a little more and let my investments recover before I pull the trigger.

In another alternate scenario, let’s say for the first nine years of my retirement, my investment beat the returns they need by 4%, then give back that 40% (so an average wash). By the time the crisis hit, I would have $427k in my account (compound interest) which then gets chopped to $256k after the carnage. Hey, as long as I had let that extra money sit, I’m still afloat, with a tiny amount of room to spare.

Long story short, when the professionals have run through both theoretical and real-world scenarios, they find that once a retiree falls below that line of what they need in annual income, they don’t tend to recover. Which means many outlive their money instead of their money outliving them.

Order of returns matters.

To mitigate that, experts recommend that you maintain 2-3 years of reserves in cash (or very liquid assets with guaranteed resale value, i.e. savings bonds not 10-year Treasury bonds) to cover your expenses. In our case, that would be the gap between Karen’s pension (and supplemental) and our expenses. That theoretical $10k in the example above. On average, when a bear market (a 20%+ decline) lasts 18 months to 2 year before it recovers to its previous levels. Three years gives you a cushion. Which might be a little less if you reinvest any dividends (which would be bought at a reduced price). What all that means in practice is that you don’t have to sell assets at a loss in a crisis; you just spend your cash and replenish it when the market recovers. You ride it out. Time and patience solves most problems. This emergency cash fund negates Order of Returns in all but the worst-case scenario.

Which for me might have been if I’d stepped away from engineering in 2008 rather than 1998. Yeah, 2000, 2001, 2009, those years kept me up at night. Thankfully, we came out the other side at least in as good shape as we entered. But we remain vigilant.

Now that the seeds are planted, we can only wait to see what grows. But the trick to financial independence, whether to pursue a dream or with the goal of retiring early, is that you and only you are responsible for tending the garden. So be sure to choose the instruments with which you tend its rows wisely.


© 2019 Edward P. Morgan III

3 comments:

  1. --------------------------------
    Notes and asides:
    --------------------------------

    Again, I wrote this essay before Karen retired so not all the tense and examples are quite right.

    Most people think Money Markets are safe investments. In general, they are. But unlike your savings account they are not backed by the FDIC. Which means technically, you can lose money. My grandfather warned me about that possibility a decade and a half before the Great Recession. “Breaking the buck” means you get paid out less than a dollar for each dollar you put in. It happened in 2008. Thankfully only in one or two money market funds.

    When I told our current financial guy about my little foray with Citi in the Great Recession, he stared at me open-mouthed for a second before saying, “You’ve got more balls than I have.” I still think he thinks I’m half Elon Musk crazy.

    Don’t get the wrong impression about our current financial guy. I like him. I recommend him. He’s done a good job for us. He hasn’t churned us like my father’s did him. We only make changes once a year in our face-to-face. He listens and knows the strategies to get us where we want to be. He makes his case but doesn’t argue if we want a different direction. It was our first financial guy who loaded us up with some empty calories.

    Before he retired, financial guy number 2 offered me a job as his assistant based solely on our annual account review conversations. He also offered me to ghost write a novel he had kicking around. Perhaps two missed opportunities but the timing really wasn’t good for either.

    Extra geek points to anyone who gets the kumquat Haagen-Dazs reference. As an aside to this aside, we used it as a code when we were talking about houses in front of our realtor who we really didn’t want to know which one we loved.

    And rock on, Garth, if you got the Eugene reference.

    For the record, I have opposed every capital gains tax cut even though we benefit by them. My personal believe is that the nation would be better served by giving a tax break on interest (which would spark savings and benefit retirees) and treating capital gains as ordinary income.

    The 2- or 3-year cash fund is essentially the same as the 6-month to 1-year cash fund experts recommend that you maintain in case something unexpected happens to your job (layoff, plant closing, health crisis, etc.).

    I also ran across a strategy recently that said by parking retirement funds in bonds any time the S&P 500 moves below its 200-day moving average and then moving it all back in when it once again rises above that level provides a huge buffer against the downside risk. Even in the Japanese market meltdown that started in the 80s and the malaise that followed, the article said that strategy would make money. I have to look into it more.

    So many articles, so little time.

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  2. Picture notes:

    Three pots of money, or three bowls of change. First of all, we needed three "pots". My first thought was to try to find some small Halloween caldrons. Edward suggested the leaf bowls instead. We didn't have enough change to fill each bowl with each type. To make the bowls look full, I cut cardboard circles the size the of top of each bowl and trimmed them to rest about 1/4 inch below the rim. Then I used some bubble wrap to fill the bowl beneath the cardboard, with a little scotch tape to stabilize it. I filled each bowl with its own type of coin.... mostly. While I had enough pennies to give it a nice rounded look, I was a little short on dimes, nickels and quarters. To get the right shape in the "dimes" bowl, I used all the nickels first then covered them with dimes. For the "quarters" bowl I used the Canadian, Bahamian and British silver coins, then covered them with quarters. Three "pots of money".

    Next I set up out on the porch table, using my favorite black cloth as a backdrop. The pictures were taken in the morning, to get indirect light. I ended up using a tripod for the camera, with a delayed shutter, so the pictures weren't blurry from the slow shutter speeds necessary to get a good depth of field. These came out well, but after looking at them, Edward suggested adding some top light, as the coins looked a little "muddy" (a technical photography term). :-) I used two small, bright LED flashlights attached to the top of the back wall using small clips and velcro straps to position the lights.

    After I had the new shot, I cropped the image a little, darkened the background a touch and used a gradient to darken the corners of the image (faux vignetting). Lastly, I edited out some cat hairs to clean up the cloth.

    I like that it ties back to the first image in the series, the piles of coins, and how something small, seeds or coins, can grow into something much larger.

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  3. More great and detailed advice, thank you!

    ReplyDelete