Financial Negativeland

Today I joined the erstwhile Masters of the Universe, and entered the red.  My investments are now worth fewer dollars than I put into them.  Am I freaking out?  No.  Not yet anyway.  Another 25% down and we’ll see.  I thank Bill Bernstein, Jack Bogle, and Burton Malkiel for this calm.  Am I even surprised?  No, and the thanks for that has to go to neo-Popperian Nicholas Nassim Taleb.

I started on summer solstice, 2005 (just over three years ago), and have since deposited $89,295.13, for a cumulative exposure of almost 160,000 dollar*years in the market.  I’m now down a little less than 3%, or about $2,600.  You might say that, since the world’s stock markets have on average risen by about 12% during that time period, I must be doing something wrong.  But of course, I didn’t have all of that money in for the entire three years.  The cumulative deposits have grown monotonically since I started, and so I have been disproportionately exposed to market movements that have taken place later in the time period, and those market movements have mostly been down.  This isn’t a particularly special case of investing; this is what happens to just about everybody over the course of their investing lifetime.  A bear market just as you reach retirement can really make a mess.  This realization prompted an economics grad student going by the ironic moniker “Market Timer”, on the Bogleheads investing discussion board, to suggest a strategy for intertemporal diversification, in which an investor goes into debt early on in their investing lifetime, invests the borrowed capital, and pays it off slowly over the course of the first half of their life, before actually moving into the black around middle age.  Actually, he did more than suggest the strategy, he implemented it, using unsecured credit card debt, options contracts, and brokerage accounts on margin, to invest in the broad global stock market.  This is, in microcosm, the same strategy that investment banks and hedge funds use, except they can usually borrow at lower interest rates, and they have the option of comprehensive bankruptcy protection (which, you may recall, the American consumer often no longer does).  And it’s working out about as well for him as it is for them at the moment.

But the motivation is understandable, and in moderation the idea is fundamentally sound.  What “moderation” means to me in this context is that, even if a scenario akin to the 1930s occurred early on, in the investor’s period of maximum leverage, the debt service would not be oppressive.  Embarrassing maybe, but not soul-crushing.  Of my overall deposits of $89,295.13 fully $82,730.94 is offset by debt with a 30 year repayment term, and a fixed interest rate of 4.5%, which translates into approximately a $500 monthly payment.  In exchange for my solemn promise to make those payments, I get to have exposure to the markets earlier on in my investing lifetime.  Where does someone get a huge lump sum of cash at 4.5% with no collateral?  If you’re Bear Stearns, you get it from the Fed.  I, on the other hand, have had to resort to student loans (and sums about 10⁶ times smaller).  Once upon a time, I occasionally felt a pang of guilt for this strategy, but now I know better.  That money didn’t exist until I promised to pay it back.  That’s all our money is: promises.  The subsidy that the federal government offers in connection with student loans is just a loan guarantee (which lowers the interest rate you pay), and possibly the payment of a little interest, while you’re in school.  It’s nothing compared to the subsidies that are being handed out on Wall Street these days like candy.  I’m not taking $80k from someone else, I’m creating a Ginnie Mae asset backed security that’s collateralized with my education and future earning power, and guaranteed by the federal government, just like the five trillion dollars worth of mortgages held by Fannie Mae and Freddie Mac.  Am I being unethical?  No more so than our entire economic system.

So what am I doing with my hard earned cash?  My reference asset allocation is as follows:

• Overall: 70/30 stocks/diversifiers
• Within stocks: 55/45 international/US (market cap weighted)
• Within stocks: 60/40 large cap/small+mid cap (slight tilt toward small cap)
• Within stocks: as much of a value tilt as I end up getting by using exclusively small value funds to achieve my tilt toward small caps.
• Within diversifiers: equal parts TIPS, US Bonds, Commodities (CCF), and REITs.

My actual current asset allocation:

• 71/29 stocks/diversifiers
• 55/45 Intl/US
• 67/33 large/small+mid caps
• 12.5/8.5/4.0/4.0 Bonds/TIPS/CCF/REIT

The allocations are pretty close to being spot-on, especially where it counts most (stocks vs. diversifiers, and US vs. Intl. stocks).  Most of the discrepancies have arisen because of the limited amount of space in my retirement accounts.  Less than 1/3 of my investments are tax-sheltered, which means that I can’t really invest in things things like REITs, CCFs, bonds, and small value funds to the extent that my allocation would nominally demand.  But that’s okay.  Eventually the retirement accounts will grow… assuming I get a job with a 401(k) plan, or set up a business with its own real retirement plan (SEP-IRA, SIMPLE, etc.), and I can deal with the rebalancing then.  The US bonds I have are actually in my taxable account now, because they’re  destined for a down payment on a house or condo some day soon, and because I don’t have space in my Roth IRA.  When I do look at my finances, I try to focus much more on the asset allocation than on the dollar values.  I can control the asset allocation.  I can’t control what the market did today (or next week).  I can also control how much I pay to implement the asset allocation.  The dollar weighted average expense ratio of the funds I’ve invested in is 0.27%, whch means I pay about a quarter of a percent of my assets each year, in management and other fees, almost all of them to Vanguard.  The average mutual fund charges almost 5 times that much (1.22%).  Here are the funds I’m using:

Rows in gray are held within tax sheltered accounts.

The main components are clearly the all world and US total market stock funds.  I have both ETFs and normal mutual funds for both of these, because monthly, I’m only putting in a small amount of money.  There’s a transaction fee on ETFs (since they trade like stocks), and if I’m only putting in a couple of hundred dollars, it’s not worth paying the transaction fee.  Every once in a while though, I have several thousand dollars to put in, at which point it makes sense to buy ETF shares, since their expense ratio is lower.  So I end up holding both, but really VTI and VTSMX are the same asset class, and so are VEU and VGTSX for all practical purposes: broadly diversified total market index funds.  Because their turnover rate is very low (things don’t come in and out of the index when the index holds everything), and the dividends they pay are very moderate, they’re reasonable to hold in my taxable account (when a fund sells something to buy something else, you end up paying taxes on the profits – capital gains – made in the sale, and dividends are taxed as normal income for the most part).  I also have small-cap value funds both for the US (VISVX) and abroad (DLS).  Those really have to be held in a tax sheltered account to be worthwhile, because they have higher turnover and throw off bigger dividends.  Similarly, the REITs (VGSIX) in general throw off relatively large dividends, and so have to be tax sheltered to be worth holding at all.  Similarly with the collateralized commodity futures (CCFs – DBC).  The extra emerging markets index (VEIEX) is there to make up for the fact that the international small cap value fund doesn’t really hold emerging markets stocks.  Without it, I’d be underweighting countries like Brazil, Russia, India, China (the BRIC…) relative to their nominal importance in the worldwide tradeable stock markets.

I divide the portfolio into two major pools.  There are the global equities (stocks) that I’m holding because I expect that in the long term (20+ years) they’ll increase in value (VTI, VEU, VTSMX, VGTSX, VEIEX, DLS, VISVX), especially with dividends included.  Then there are the things that I’m holding that should reduce the overall volatility of the portfolio, because they tend to have returns that are poorly correlated with equities (DBC, VBMFX, TIILX, VGSIX).  I call these things “diversifiers”.  They’re certainly working so far.  Bonds and commodities have done just fine over the last year, while stocks have gotten hammered.  The diversifiers probably reduce my expected long term rate of return a tiny bit, but they make the volatility of the portfolio as a whole bearable, which is important.  A portfolio that causes you to bail out at some point is unacceptable.  The fact that I have diversifiers in my portfolio is the only thing that’s kept my returns from going negative a long time before now.

Previously, I’d had more in the way of value oriented funds in my taxable account.  One tax season like that convinced me it wasn’t worthwhile.  Any plausible value premium will be wiped out in the long run by the associated tax burden.  So now I’ve resigned myself to the fact that, given my taxable/sheltered split (a variable over which I only have control going forward…) I just can’t implement exactly the portfolio I’ve decided to want efficiently.  C’est la vie.

Three percent net down after the headlines we’ve been hearing may not seem that bad, but, because most of that money is actually debt, it’s not long before I actually end up with a negative net worth.  It’s only $4,500 away.  What do I do then?  Does it change anything?  Will I feel different about the whole scheme after crossing the zero point?  Worse, the real “baseline” comparison I should be making isn’t against the amount of money I’d have if I’d stuffed it all in my mattress, it’s against the so called risk-free rate of return, i.e. how much money would I have now, if I’d just socked all the money away in the safest of possible places… say, inflation protected treasuries (TIPS)?  By that measure, I’m now $8500 behind.  Of course, there really wasn’t any way to know what I ought to have done, three years ago, and there still isn’t today.  Which is why people use asset allocations.  It’s a way to keep doing the same thing, even when the world gets crazy, and generally, doing the same thing consistently (almost irrespective of what it is you’re doing) ends up doing better in the long run than chasing the thundering horde.

So here’s to another year of mind numbingly boring investing!