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:
|Vanguard All World Ex-US ETF||VEU||24.23%|
|Vanguard Total (US) Stock Market ETF||VTI||18.97%|
|Vanguard Total Bond Fund||VBMFX||12.17%|
|CREF Treasury Inflation Protected Securities (TIPS)||TIILX||8.55%|
|Vanguard Total (US) Stock Market Fund||VTSMX||7.67%|
|WisdomTree International Small Cap Dividend ETF||DLS||6.43%|
|Vanguard Small Cap Value Fund||VISVX||5.36%|
|Vanguard Emerging Markets Fund||VEIEX||4.82%|
|Deutche Bank Commodity Index Tracking Fund||DBC||4.26%|
|Vanguard Real Estate Investment Trust (REIT) Fund||VGSIX||4.04%|
|Vanguard Total International Fund||VGTSX||3.30%|
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!
3 replies on “Financial Negativeland”
So, I am a financial dunce, and barely get all that. I do have one question though. How do you feel about the potential of a peak oil economy (assuming you accept such a thing) changing the rules of the game, and does your strategy live through that? I’m way too ultraconservative. I have $7000 in my 401k, lost $90 in the last month – lowish because I’ve got 50% bonds and 50% socially responsible fund. I’ve been putting my house down payment money and my kid’s college money in CD’s at my credit union. Yes, I have already stated I am a financial dunce! My CD earnings in the past 2 years may have just balanced my 401k losses – I’d have to check!
Regarding Peak Oil – I accept that such a thing will certainly happen someday, possibly even in the near future (or even now-ish), but I suspect that the global economy and society will be more resilient to it than the doomsayers suggest. We haven’t seriously tried to be efficient in our use of energy, or liquid hydrocarbon fuels, and when we eventually get serious about it, I think solutions will be forthcoming. The solutions may transform the way society works, but I don’t think it’s going to catapult us into a new dark age by any stretch of the imagination. In fact, I think Kunstler and his ilk display a pretty amazing lack of imagination in envisioning what a future without oil and natural gas would look like. We have a shortage of liquid hydrocarbons, not of energy, so long as the sun keeps shining. It might be a WWII/Manhattan Project/Apollo style effort, if energy becomes an emergency, or it might look more like the tech boom/bubble/(bust?) of the late 1900s if it’s left up to private enterprise, but one way or another we’ll figure out how to power our societies and economies with the sun. Additionally, there are large portions of the world’s potential economies which are not yet (and hopefully never will be) as dependent on liquid hydrocarbons as we are, and I try to be as non-nationalist as possible in my asset allocation. And I think there are many interesting possible economies which do not depend on increasing material consumption geometrically forever. We can increase the information content of our economies essentially indefinitely, and, as with the biosphere, “consume” negative entropy. I know, I’m being weird here, but I really do think that’s where we’re headed in the long run (assuming we don’t screw things up monumentally with, say, a nuclear war, or an abrupt change of climate states that starves 3 billion people to death in a year… though darkly, part of me thinks that something like that might be best in the long run)
Regarding investing, if society collapses, it won’t matter what you had your savings in (just ask anyone who lived through a bloody revolution in their home country…), so to my mind, you might as well invest as if society isn’t going to collapse. I wrote a series of essays about investing on Ideotrope a couple of years ago, and I think I pretty much stand by what they said. Essentially, nobody knows what the markets are going to do, but a lot of people will try and make money off you by telling you a convincing story. Some of them will, in hindsight, turn out to have been right, by pure luck. The people who have turned out to be the most right most recently will have the largest bullhorn, but it’s really just a horn full of bullsh*t. You can’t control (or predict) the markets, but there are several investing variables you can exercise some control over: how much you pay to invest (the expense ratio), how much you pay in taxes on your investments (really just another kind of “expense”), and most importantly, what your asset allocation is, most basically, how your investment portfolio splits between stocks and bonds, and between the different markets around the world within each of those categories.
I cannot recommend Vanguard highly enough as an institution. They are, in effect, organized as an enormous, trillion dollar, financial cooperative. Instead of being beholden to outside investors that want to skim a profit off the top, the owners of the funds that they sell are the owners of Vanguard, and they really do have your best interests at heart. Read around on their website for more information than you could possibly ever digest about how to invest in a dull and non-stressful way that will still probably let you retire and pay for college. If you want books, I highly suggest The Four Pillars of Investing and The Intelligent Asset Allocator by William Bernstein. The titles are a little cheesy, but he’s not selling snake oil (or anything else), and The Intelligent Asset Allocator especially is good for a more mathematically inclined audience (it didn’t sell very well, but I liked it!). I’ve also liked reading many of the papers and articles in the Altruist Reading Room, but you’d have to actually find this stuff interesting for that to be worth your effort.
Let me know if you have any questions about any of the money stuff. I’m more than happy to help get you pointed in the right direction. Investing isn’t really complex – it’s much simpler than, say, Ph 106 – except for the fact that there’s an entire industry (which is now collapsing under the weight of its own hubris) built around trying to convince you that investing is hard, and that you need their help, and that you ought to pay dearly for it. A CD or money market fund is exactly the right place for your house down payment to be (Vanguard’s Prime Money Market Fund pays better interest than most CDs, and is a lot more convenient). That’s probably not the greatest location for the college fund though. You can open a 527(b) tax-deferred college savings account, and invest in a couple of index funds (say, total world stocks, and total bond market), slowly shifting the allocation toward bonds as high school graduation approaches, or just use one of their pre-defined life-cycle funds that does that reallocation for you. Is the 401(k) with someone you currently work for? If so, what are the options within it? If not, you can roll it over into a Roth IRA at Vanguard relatively easily, have a lot more options, with lower expenses, and eventually tax-free withdrawals (that’s the Roth IRA’s special power).
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