Personal Finance Lessons From GE

General Electric has been an American corporate success story for generations.  Founded by Thomas Edison in 1889, GE has symbolized American business drive and ingenuity.  It’s this history that makes GE’s spectacular fall from grace so shocking. After years of bad judgment and decision-making, the company is in shambles and it’s stock has suffered a 75% collapse in the last two years.  The longer-term performance has been even worse, with GE stock down 85% from it's all time high in 2000. There are many lessons to be learned from the events at GE, but I will focus on two personal finances ones.

A first lesson is not having excessive exposure to your employer’s stock.  In looking at prospective client portfolios, it is not unusual to find inappropriately large concentrations in company stock, either public or private.  The combination of receiving compensation in stock, coupled with options and RSUs, and discounted stock purchase plan, year after year, can conspire to create a large concentration.  An employee already has a high degree of financial dependence on his company, primarily through income, but also through benefits like health insurance. To magnify this by having a large position in the company’s stock materially heightens this dependence and increases financial risk.  

We’ve all heard the success stories such as the executive assistant who started at Google at its founding, was paid mostly in stock and retired fabulously wealthy.  That’s great. But what about the experience of long-time employees of AIG or Bear Stearns in the financial crisis, or more recently, employees at GE. Before the recent stock collapse, GE’s 401K plan had nearly one-third of plan assets in GE stock.  The perception that the stock was stable and conservative coupled with an appealingly high dividend leads me to believe that many GE employees likely had very large allocations to the stock. They’re not alone. Consider Enron’s 401k plan in 2000, the year before the it’s bankruptcy.  An astounding 60% of plan assets were in Enron stock.

I personally recall hearing friends and colleagues at various highflying financial firms who had enormous allocations to company stock in 2005, 2006, 2007.   Many openly bragged about how much of their net worth was in company stock, and how sound their judgment had been for not trimming. In the subsequent financial crisis, however, many of these same people lost their high-paying jobs.  The financial stress was made considerably worse by the fact that the large allocation to company stock had now devastated their net worth and severely impacted their financial security. Ten years later, many still haven’t financially recovered.  

How much concentration is too much?  That is too nuanced and complex a question to answer with a blanket number on a blog.  Only when looking holistically at a client’s financial picture, can a proper exposure be determined.  Regardless, anybody with more than, say, 10% of their net worth in company stock should be looking into their options and talking with an advisor.  

The second point I take from GE is a lesson in how not manage your balance sheet and investing. Once a sterling AAA credit with a conservative balance sheet, GE, grasping for short-term growth, dramatically leveraged its balance sheet in the lead-up to the financial crisis.  The company bought back billions of dollars in highly-valued company stock and made several large acquisitions, all in the quest for near-term earnings growth. When the crisis hit, GE’s short-term orientation and imprudent financial behavior forced it to take dramatic action to shore up its precarious balance sheet.  The company sold billions of dollars of depressed company stock to the public near the lows. It was a textbook example of buying high and selling low.

The lessons are simple, but hard to stick with: Don’t chase short-term performance, focus on the long-term, be financially conservative-particularly in good times, and have a patient and sound investment philosophy that strives to buy low and sell high.  GE was led by very smart and very capable people who nevertheless could not control their emotions and be disciplined. Make sure you aren’t making some of these same mistakes in your financial life.

The Power of Compounding

A recent episode of the “Invest Like the Best” podcast got onto the topic of compounding.  Investor Patrick O'Shaughnessy and doctor Peter Attia agreed that in fields as different as health and longevity, and investing and finance, compounding plays an enormous, and often underappreciated role.  “All the best investing advice is fairly straightforward and very boring, because it needs time to work,” O'Shaughnessy said. “All the fun comes at the latter half. Everyone uses the example of [Warren Buffett], who wasn’t a billionaire until he was 65.  And now he’s [worth] $80 billion-because of compounding. It's so hard when it comes to health to convince yourself of that, because it’s so easy to eat a cookie today, and especially when you’re young, [and] really feeling no ill effects of that. It’s all about simple daily decisions.”  Attia agreed, saying “For no human can compounding be truly intuitive, because it’s just so non-linear. We tend to think a lot of the things that go wrong [such as a heart attack or cancer] appear suddenly. We have to remember that none of those things happened suddenly. A cancer spends 80% of its life undetectable, because it is just simply so small.  Heart disease begins at birth.”

In an age when seemingly everybody is looking for the quick fix, the shortcut, the hack, to quickly and easily achieve difficult goals, it is of primary importance to see this human tendency for what it is-a lie. The core tenant of compounding is that good decision making and behaviors, when consistently applied over long periods of time, compound to create surprisingly large positive outcomes.  Compound growth is exponential, which is difficult for the linear-thinking human brain to grasp. If you asked a room full of people to guess how much a penny would be worth in 30 days if it doubled everyday, the average guess would be vastly smaller than the actual answer: $5,368,000. What’s interesting is to see the progression of the growth over the 30 days. On day 10, you would only have $5.12.  But by day 20 you would have $5,200. By day 25: almost $168,000. From there the growth is almost hard to believe:

Day 26: $335,500.  

Day 27: $671,000.

Day 28: $1,342,000.

Day 29: $2,684,000

Day 30: $5,368,000

As can be seen, the truly exponential growth occurs in the last few years.  Admittedly, nobody is going to double their money everyday. But the point remains: today’s positive actions, whether resisting the impulse to spend money frivolously or not adopting a speculative or unproven investment approach, takes effort and discipline, and the payoff is decades in the future.

When it comes to your financial life, building an appreciation for compounding is the first step toward improving behaviors.  Small increases in savings rates, a focus on the reduction of fees and taxes, working to achieve modest improvements in annual investment returns, and elongating your time horizon, can result in profoundly improved financial outcomes.  However, just like losing weight, we need to resist our innate desire for the quick fixes and the fads and focus on adopting the right tenets and principles to let compounding work for us.

The first is managing cash flow. The reason so many great investors tend to be frugal, is their deep appreciation for compounding.  Just think of famed investor Shelby Davis’ reaction to his grandson’s request to buy him a $1 hot dog at a street vender. “Do you realize that if you invest that dollar wisely, it will double every five years?” Davis exclaimed.  “By the time you reach my age, in 50 years, your dollar will be worth $1,024. Are you so hungry you need to eat a $1,000 hotdog?” Though extreme, the point is a good one.  An intuitive grasp of compounding provides the incentive and discipline to reduce needless spending and delay gratification.  

With investing, the point is the same.  Adopt a logical, disciplined, long-term, and patient investment approach.  Work to reduce turnover, costs and taxes. Invest prudently-nothing gets in the way of compounding more than large losses.  Remember that if your portfolio loses 50% you need to make 100% to get back to even. Avoid getting caught up in envy, fear and greed.  Do not chase investment fads. Work on improving your emotional balance. Remind yourself that the stock market is a fantastic place to build wealth over the long-term, put a dangerous one to try and get rich quick.  Realize that, with a long enough time horizon, even modest amounts of capital growing at unheroic rates can compound to very large amounts given enough time.

The last point I’ll make is: start today.  Avoid negative interia and myopia. Don’t think that the power of compounding can't work for you because you waited too long.  Most people have a longer investment time-horizon than they realize. Modestly changing behaviors today, and adhering to them over time can have pronounced effects with even a ten year horizon.  Work with an advisor who understands that sound financial planning and investment management is a long-term game centered on keeping their clients disciplined and accountable, and helping them keep their eye on their long-term goals.  

ryanpdolan@dolanpartners.com

Interest Rates, Inflation and Your Financial Health

Interest rates and inflation play a pivotal role in financial planning and investing.  Every asset and liability on a family’s balance sheet is directly influenced by these factors, and all financial projections must make future rate and inflation assumptions to hope to achieve any degree of accuracy.  For several decades, rates and inflation have been falling, which has served as a potent tailwind for traditional assets: stocks, bonds and real estate, while also compelling the typical household to take on high debt loads at the cost of savings.  So what’s the problem? In my estimation, a majority of financial plans and investment portfolios today are geared to perform well only in a continuation of this backdrop. The financial implications of a changing landscape, should it occur, would badly impact these plans and portfolios.  

For nearly 40 years, interest rates and inflation have been falling.  The 10-year Treasury yield peaked at 16% in 1981, and hit a low of 1.4% in 2016, and has been gradually rising to 3.2% today.  Whenever a trend in financial markets persists for as long as this downtrend in rates, it becomes increasingly perceived as a permanent reality.  And yet, a cursory look at the history of rates shows that this is unlikely. For example, rates rose from the early 1940s until the early 1980s, moving from 2% to a peak of 16%.  This trend accelerated in the 1970s and had, by the early 1980s caused a remarkable decrease in asset prices and valuations, particularly in inflation-adjusted terms.

When that previous cycle reached its crescendo in 1982, most investors could not conceive of an environment where rates and inflation did anything but go up.  This assumption led most to see little opportunity in assets, and debt was a four letter word. This negative backdrop, paradoxically, served to create an incredibly fertile ground of investment opportunity.  Asset valuations, across the board, were astoundingly cheap. One didn’t need to forecast when rates would peak, just recognize that assets were cheap, and have the imagination to conceive of a world were interest rate and inflation trends could reverse.  Those conditioned to believe that a world of rising rates and inflation were a permanent condition subsequently missed a monumental 20 year bull market for most asset classes.

What about today?  In many ways, the landscape is the polar opposite of the early 1980s.  Interest rates, though slowly rising, are still near historically low levels which has led to a dramatic rise in asset prices and valuations.   Rising asset prices combined with falling rates has also incentivized households to increase debt levels and dramatically reduce savings rates. The broad consensus seems to believe that central bankers will simply not let rates rise to a level which would negatively impact asset prices.  

Sound financial and investment planning, however, is always about asking the fundamental question: “What if I’m wrong?”  Should today’s pervasive investor assumptions prove misguided, they could result in very poor financial and investment outcomes.  A good financial advisor knows better than to make forecasts, particularly about interest rates. Nonetheless, most clients would be better served working with an advisor who can conceive of a change in financial conditions and build plans and portfolios that can better navigate a range of financial outcomes, and aren’t geared to just a continuation of the status quo.  The impacts of a potential change in the behavior of rates and inflation would have a profound impact on almost every aspect of a household's finances. Don’t settle for a generic financial plan and investment portfolio built by an advisor that can’t conceive of a changing environment. Now is a particularly good time to take another look at your financial plan, your investment portfolio and, quite frankly, your financial advisor.  

The Problem With Do-It-Yourself Investing

The last decade has seen a surge in individuals going it alone when it comes to investing, either investing themselves, primarily through passive instruments, or through the use of robo advisors.   While a do-it-yourself approach can work, it is a rare individual who can both determine a sound investment strategy and, more importantly, stick to that strategy over time through all the emotion and temptation of markets.  In my admittedly biased view, the majority of investors would achieve far better long-term investment outcomes if they worked with a trusted and competent investment advisor who could both structure proper portfolios while also preventing self-inflicted investment mistakes that bedevil most individual investors.

The core issue I see with do-it-yourself investing is that portfolio asset allocation, the central question of investing, is given superficial attention at best, and is unlikely to be properly answered.  Individualized asset allocation combines elements of both science and art, and demands considerable time and consideration at the beginning of the investment process. The science comprises what asset classes to invest in, what to avoid, diversification, asset-class valuations, the investor's time horizons and objectives, among many other factors.  The “art” involves an objective view of the investor’s psychology and past investment behavior and mistakes to determine risk tolerance, while taking a comprehensive account of the investor’s financial assets and cash flow, not just investment assets.

In reviewing the portfolios of prospective clients who are self-managing their investments, the asset allocations often look materially inappropriate.  Typically, these portfolios have considerable “rear view mirror” characteristics. They tend to be aggressively exposed to the asset classes that have performed best in the past few years, and underexposed to those that did worst.  The opposite of sound investing. In the financial crisis, many investors went into the crisis with too much equity exposure, which increased the likelihood that they would make an emotional fear-based reaction to sell stocks, just at the wrong time.  It was a classic example of the dangers of getting asset allocation wrong: you are likely to compound those mistakes by making belated adjustments, typically at the worst time, the dreaded whip-saw.

Robo advisors attempt to address these self-inflicted investor mistakes, and on paper sound great.  Robos help you determine asset allocation, rebalance your portfolios regularly, and do so for a fairly low price.  The issue is that the methods used for determining asset allocation are incredibly superficial and simplistic. Asking a few basic questions about an investor’s time horizon, income, retirement age, and perceived risk tolerance is unlikely to generate an accurate result.  This is compounded by the fact that robos take no account of the highly important “art” component of asset allocation: the client’s relationship with money, their realistic risk orientation based on behavior in the past, etc. The biggest issue with robos is that they assume their customers will always behave rationally, particularly in market extremes.  Anybody who has worked in financial advisory knows this is far from reality.

In my opinion, the surge in popularity in do-it-yourself investing is partly due to the fact that equity markets have been in a 10 year bull market.  Investor mentality becomes: who needs to pay an advisor or an active investment manager when you can just buy the S&P 500 or the NASDAQ at 0.05% and just be fully invested?  This is reminiscent of the surge of individual investors into passive equity mutual funds in the late 1990s. David Swensen in his book “Unconventional Success” noted that in 1993 investors’ allocation to equities was just 30%.  By 1998, as the market surged, it pushed to 50%. At the peak of the market in 2000, investors had a peak equity allocation of 60%. As Swensen noted, “At the market peak in March 2000, investors exposed the maximum amount of assets to the maximum amount of risk.”  When stock markets bottomed in 2003, with the S&P 500 down 50% and the NASDAQ down 80%, and poised to begin the next bull market, investor allocations had been slashed to 40%. The wrong allocation at a market peak increases the risk that an investor will slash exposure at the worst possible time.  

In truth, an advisor earns his fee in two ways.  First, in having both the quantitative and qualitative ability to collaboratively determine the optimal asset allocation for the client-defined as one the client can stick with through the rising and falling tides of financial markets.  When clients are invested in the right way, they are less likely to want to make the rash emotional decisions which can be so damaging to their long-term investment outcomes. Nevertheless, even with a sound allocation, there will be those rare times when investment markets’ alluring siren song can reach even these investors.  It is at these times when the advisor really earns his fee. A competent advisor is able to keep his clients focused on the long-term, resist fear and greed, and prevent large self-inflicted investment mistakes.

The Financial Implications of the Family Home

It is difficult to think of a financial topic that is surrounded with more emotionalism and misinformation than home ownership.  It’s understandable. The family home, where you raise your children and create memories, means far more to us emotionally than stocks and bonds in an investment portfolio.  But given that the home is one of the largest, if not the largest financial asset on the balance sheet of most households, it is critical to step back and take a dispassionate and rational look at housing and the role it plays in our financial lives.

I’ll open with my first (and only) home buying experience.   My wife and I met in 1999, got married in 2003, and lived in an apartment in San Francisco.  We chose to rent, because we knew that we would soon have children, and move out of the city within a few years.  We committed to saving as much as we could for an eventual down payment. By 2006, we had 2 young children, and our once spacious apartment was feeling increasingly cramped.  I tangibly felt how personal life events were dictating my need to buy a house, and not any rational investment considerations. Our timing was unlucky, with the bay area real estate market, already strong for many years, beginning to really surge.  Just as we started the search process, housing inventory became nonexistant, bidding wars were the norm, and prices were rising dramatically. By early 2007, I distinctly remember the pervasive psychology surrounding housing at the time. Many thought the market was crazy, but no one I talked to, literally no one, thought it would-or could-go down.  Even friends and family who had been advising us to wait were now saying we just had to get in, or risk getting priced out.

Totally worn down by the process, we finally found a great home, probably 20% above our original budget, and purchased it in the spring of 2007.   We put 35% down, and as someone who never had debt, took on what seemed to me an ominously large mortgage. Additionally, as a young couple in a very expensive market, the home represented an uncomfortably large percentage of our net worth.  Upon moving in, my reaction was part relief that the whole thing was over, coupled with a sense of dread and almost immediate buyer’s remorse.

We all know what happened next.  The real estate peaked just prior to our purchase and began its dramatic fall.  I remember thinking sometime in 2009, that we likely had negative equity in the home.  After saving and scrimping for over a decade, our equity was more than wiped out in less than 2 years.  While we had no intention of selling the home, it was a sobering and disconcerting time. Now over a decade later, we still live in the home, our kids our growing up in it, and we have created many memories.  And after a pronounced recovery in real estate values, we likely have a profit in it. But that personal experience, coupled with my career financially advising others has given me a few perspectives.

My experience reminds me of a quote from Warren Buffett: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”  Though I considered myself fairly financially astute, about housing I was clearly uninformed and naive. Everyone involved in the industry and the process is incentivized to overstate the benefits of home ownership and to get transactions done.  When it came to fundamental questions of what should I buy, rather than what could I buy, to understanding where we stood in the real estate cycle, to long-term real estate returns, I was in the woods. What I needed was an impartial advisor who understood my financial condition and by goals, and could provide advice accordingly.  

Some simple observations and thoughts:

Residential real estate is highly cyclical, and it’s long-term real returns are poor:  Despite the rosy projections the real estate industry promotes, residential real estate has historically been a poor investment.   The inflation-adjusted annual returns on US housing over the last hundred years is below 1%. However, when you net that number against interest costs (net of tax breaks), repairs and maintenance expense, property taxes, and significant transaction costs, the actual returns on real estate are likely flat to slightly negative.  These low returns come with unfortunate side-effect of high cyclicality. That cyclicality, when combined with large amounts of mortgage debt, can be a potent combination. Yes, you can make dramatic short-term returns, but you can also get wiped out. Think about the financial impact of investing a huge proportion of your net worth in an asset that shows nominal or negative long-term returns.  

Your returns are dictated by when you buy and when you sell your house, and you don’t make those decisions for investment reasons:  Most of us don’t make home purchase and sale decisions based on rational investment merits that exist at the time, but based on your life track and events.  You don’t buy your home because the market has just crashed and you like the risk-adjusted return projections. You buy because you just got married, or had a child, or had a third child- factors completely disconnected from what the real estate market is doing. Conversely, you don’t typically sell when you think prices are reaching peak euphoria.  Rather, you sell when you retire, or when you get transferred, or when your kids leave the house. If you get lucky and lived in California in the early 1980s, had kids and bought a house, and are now retiring-your life path conspired to create a great financial outcome for you. Don’t assume it always work this way. Does it make sense to have so much of your net worth tied up in an illiquid asset that you don’t really have control of the timing of buying and selling?

Give thought to how much you want to invest in your house, and at the expense of other priorities:  A 2014 study by CLSA looked at the spending habits of middle-class families in a dozen Asian countries.  These families spent, on average, 16% of their income on housing/transportation. In the US, that number is three times that, at 50%.  Bear in mind that the size of the typical new house built in the US today has increased nearly 60% since the early 1980s (1700 square feet to 2,700).  Where did these Asian families prioritize their spending? 15% of total income was spent on supplemental education, or tutoring, for their children. In the US that number is a paltry 2%.  We can spend our money how we chose, but it has been my experience that we are most happy with our financial decisions when they truly align with our values. Generally speaking, the people I know with the smallest allocation to personal real estate, in relation to their net worth, tend to be the most satisfied with their finances.  That may not be the case with you, but you should reflect on it.

Don’t buy the forced savings argument:  A popular argument in favor of homeownership is that it forces people to save money, which they wouldn’t otherwise have had the discipline to do on their own. You pay a high cost for having that discipline imposed on you by a mortgage.  In most cases, buying a more modest home, and working with an advisor who can hold you accountable to save whatever you would have spent on a bigger mortgage, and investing that money in assets that generate far superior real returns to housing (think stocks and their 6-8% annual real returns) results in superior financial outcomes.  

Work with an advisor who thinks about your financial life holistically, including home ownership, and not just the assets he manages for you.  The right advisor can help you to develop an understanding of housing cycles, valuation trends, recent changes in housing related tax policy, return projections, and mortgage and interest rate considerations.  Equally important is to couple these asset class factors with the client’s unique financial considerations such as personal goals, values and objectives, to help determine how to fit home ownership more optimally into their financial life.  

Ryan P. Dolan

ryanpdolan@dolanpartners.com

www.dolanpartners.com

"Psychology and Asset Allocation"

When meeting with prospective clients, I will ask what they think their current asset allocation (percentage in stocks, bonds, cash)  is for their investment portfolio. If they don’t know, and they often don’t, I ask what they think, given their circumstances, a reasonable allocation would be.  Typically their answer and their actual asset allocation bear little resemblance. Why does this matter? Simply put, properly constructed asset allocation frameworks are critical to long-term investment success.  Study after study illustrates that asset allocation accounts for over 90% of total portfolio returns, with security selection and market timing comprising the balance. Determining your optimal long-term asset allocation is the central task for any investor, and yet few devote careful consideration to it.  By not doing so, an investor is much more likely to get caught up in the rising and falling tides of conventional wisdom and his own psychology, which leads inevitably to behaviors which damage long-term investment success and financial health.

A look at the last twenty years highlights the ever changing tides on Wall Street, and how many investors are damaged by them.  This period has produces three large bull markets, and two pronounced bear markets. The late 1990s saw investors pile into very highly-valued, surging technology and growth stocks, and piling out of cheaply-valued old economy value stocks. Passive investing was also en vogue, at the expense of underperforming active managers.  One final trend saw US stocks far outpacing the performance of international stocks. When these elongated trends are in place, they are self-reinforcing, picking up more and more believers, which propels assets ever further, which then begets even more consensus and asset flows. In bull markets, this process continues until the ultimate peak, when by definition the maximum amount of capital is invested in assets with the maximum degree of risk.  When the tide turns, the unwinding of these trends is often violent. Following the 1999 peak, value stocks dominated growth and tech, active management dominated passive index investing, and international stocks dominated US stocks for nearly a decade. The trend reversed once again just after the financial crisis, with growth and tech, passive investing, and US equities outperforming to this day.

I contend that most individuals and households have no real allocation framework and tend to pay only cursory attention to their portfolios while markets are calm.  The amount of attention increases dramatically, however, in times of market excess. It’s typically only in a severe bear market that an investor thinks seriously about risk, which leads to a strong desire to reduce the allocation to equities.  Alternately, in a long-building and later-stage bull market investors feel the drag of cash in their portfolios and feel compelled to increase equity exposure and reach for return. As humans we are hardwired to seek comfort and consensus, and the consensus is never more compelling and persuasive than when it is nearing a crescendo.   

A couple actual examples of investor allocation behavior illustrates this phenomenon.  Since 1995, the cash allocation for all of Charles Schwab customers has averaged 16%, with three instances of peak cash allocations (20-23.5% cash), and three instances of trough allocations (11-13.5% cash).  High cash allocations signify investor caution and low enthusiasm for stocks, and yet the times when Schwab customers had the most cash (1996, 2002, 2009) occurred right before equities went on to post superb forward performance.  The average compound annual return for equities in the subsequent 5 year period following these periods was a robust 23%. How about when Schwab clients had the lowest cash allocations, when they were the most enthusiastic about stocks (2000, 2007, 2017)?  Unfortunately, this bullish allocation shift was as poorly timed as the bearish one. While it is too soon to say what will happen post 2017, the average compound annual return for equities in the 5 years following 2000 and 2007 was 0%.

 In a similar vein, BofA Merrill Lynch data shows that its wealth management clients had peak equity allocations of 56% in the spring of 2007 roughly six months ahead of the market peak.  As the financial crisis intensified in 2008 and 2009, client equity allocations fell to a trough of 39% in February 2009, nearly concurrent with the bear market low. Once again, investors had peak exposure to equities at the time of highest risk, and trough exposure when equities offered the most reward.  

What’s the answer?  In my estimation, the solution is to build proactive investment safeguards to prevent a client from falling prey to this reactive self-sabotage.  The key is to work with an advisor who understand these psychological pitfalls, and has the tools to equip you with a battle plan to avoid them. It is imperative for the client and the advisor to spend considerable time collaboratively crafting a well-articulated and individualized asset allocation framework that fits the client’s unique financial picture and internal psychological wiring.  It is critical for the client to buy into the allocation, and be willing to stick with it, particularly when it is out of step with market conditons.  The client must both intellectually understand the rationale behind the framework and also be psychologically committed to adhering to it-particularly when it feels wrong.  In a bear market, the allocation framework will dictate trimming outperforming cash and bonds and adding falling stocks. Conversely, in elongated euphoric bull markets, the process entails trimming equities and adding to cash and bonds.

Working with an advisor who will construct a personalized allocation framework with you and will keep you on that path, particularly when your emotions are telling you to do the opposite, is an important component of building long-term investment and financial success.

Ryan P. Dolan

Managing Partner

Dolan Partners LLC

ryanpdolan@dolanpartners.com

www.dolanpartners.com

The Central Importance of Household Budgets and Savings Goals

Creating and sticking to a household budget and savings goal strikes most people as about as much fun as going to the DMV.  And yet, when people start and commit to the process they often experience a newfound sense of empowerment and control, and liberation from the vague anxiety and uncertainty they had before.  The fear of not really knowing where your money is being spent, coupled with the nagging suspicion that you are not saving enough for future goals can often lead to even more undisciplined, stress-relieving spending, exacerbating the problem.  

This reminded me of a conversation I had with a friend a few years ago in which he confided that, despite being in his mid-40s, he hadn’t had a physical in over a decade.  What had started as fairly excusable complacency in his early 30s had, over time, morphed to a point where increasing levels of anxiety and uncertainty about his health kept him, paradoxically, from going to the doctor.  As a husband and father, I didn’t need to tell him how irresponsible this was, and I could tell how the regret about his behavior was affecting him. I realized he needed a friend who would both empathize with him, but also firmly hold him accountable to take action.  I insisted he call and make an appointment with my doctor right then in front of me, and made sure he later went to the appointment. I can still remember the sound in his voice when he called me on the drive home from his appointment. Thankfully, his health was fine. But what struck me was the palpable sense of relief in his voice.  Furthermore, since taking that initial action, my friend has turned a negative cycle into a positive one, eating better, working out, and never missing a yearly physical. He now says that he only realized how much subconscious anxiety he carried around with him all those years when it was gone.

Budgeting and saving is similar.  As the saying goes: “by not making a choice, you are making a choice.”  Apathy and fear are the biggest barriers to change. If you don’t have a concrete budget/savings goal plan, you are running on autopilot with the typical outcome being unfocused overspending and material undersaving.  An advisor who properly helps a client construct a budget is not telling him what he can and can’t spend money on. Rather, he illuminates what current baseline spending patterns are, helps define how that spending and saving differs from a client’s unique values and financial aspirations, and then works to better align behavior with those core traits and goals.  The benefit comes from proactively defining what you want from your money, and then coming up with a structure that compels you to behave in line with those principles.

Once a client articulates what he hopes to achieve with his money, the next is to drill down on what his short, medium and long-term financial goals are.  Next we take a look at their spending patterns over the prior 12 months, and see where they are in relation to client  goals. Most find that their current spending behavior leaves their medium and long-term goals woefully underfunded.  Taking action in the face of these unpleasant and sometimes demoralizing facts is crucial, but it is important to understand that observable progress can be achieved in as little as a year, with large benefits accruing over longer periods.  After defining goals and understanding where the client currently stands, the next component is rationalizing fixed spending such as debt service costs (mortgage, student loans, car loans, etc), insurance rates and coverages, and taxes.

Next we move to discretionary spending.  When clients realize how much they spend on eating out, or travel, or just daily discretionary purchases, they are often dismayed.  Again, the goal is not to become an ascetic monk, but to make sure this spending is adding true value to your life, and worth the hit to goal planning.  Typically, just the simple realization of how much is being spent in these areas, coupled with a modest reduction in the budget is enough to gain momentum, which can be built on over time.  An example would be the client who admitted his family had a far better time, and made better memories, on a road trip vacation through the pacific northwest than on an earlier vacation to Hawaii, despite costing a quarter of the amount.   Is your spending aligning with what truly adds value to your life?

Often attacking discretionary spending can be done through simple tactics, such as making increased saving automatic by making automatic deposits every pay period into savings account.   If you never see it, you generally will not miss it. In a similar vein, it can be constructive to make more of your bill paying manual. Turning off auto bill pays (cell phone plans, utilities, cable/internet, country club memberships, etc), and paying bills manually increases cost consciousness and a closer scrutiny of expenses.

Like my friend who took action, and now takes far better care of his health, clients who take the initial step of creating a budget tend to feel they are spending better with more value to their lives, while also having the peace of mind that they are making real progress toward their financial future and goals.  Defining your goals, crafting a dynamic budget, targeting a healthy savings rate, and having an advisor who regularly holds you accountable can result in profound changes. Don’t let fear and apathy prevent you from taking action. As the title of a book by Navy Seal Jocko Willink says: “discipline equals freedom.”

Taxes and the Investor

Taxes: just the word can conjure anxiety, fear, and confusion. I am sometimes surprised by the number of intelligent and successful people I meet with very little tax knowledge. Often when you broach the subject, they say something along the lines of “my tax guy takes care of all that” before they quickly move on. And yet taxes play such a profound role in people’s financial lives, that they demand serious attention and thought in crafting a financial plan and investment strategy. While the immensely wealthy have always had a strong focus, bordering on obsession, on tax minimization, the majority of people do not-to their detriment.

An extreme example of tax minimization is Warren Buffett. In 2016, Buffett reported $11.6 million in gross income, and after $3.5 million in charitable contributions and $5.5 million in deductions, paid $1.8 million in federal income tax. While Buffett’s 16% effective tax rate sounds attractive on the surface, Buffett’s net worth increased by $12 billion in 2016. This bears repeating: Buffett’s net worth grew by $12 billion, and he paid $1.8 million (0.015%) in total federal tax. Why? The $12 billion was comprised almost entirely of unrealized capital gains.

Some initial steps we can take to build tax efficiency into our financial lives: 

Step 1: Build your tax IQ, work with a competent tax professional, and maximize your deductions.  

The first step is to legally shield as much income as possible. In addition to working with a tax savvy accountant, it is very important for a client to steadily build tax knowledge and sophistication, tax IQ as I call it. This should be seen as a steady accumulation of insights over time, which accrue to a solid working knowledge of taxes. This is analogous to having a rudimentary understanding of the human body, anatomy and medicine. From this more educated perspective, we can ask deeper and more probing questions, and better leverage our doctor’s ability to foster better health outcomes.

Step 2: Maximize contributions to tax-deferred accounts.

Tax-deferred accounts are enormously powerful weapons in the investor’s arsenal. A client should look to maximize the amount of pre-tax income he can put into these accounts. From 401ks and IRAs to Health Savings Accounts and 529 education accounts, clients need to work with their advisor to understand their optimal tax-deferred account options.

Step 3: Adopt an investment strategy that looks to maximize long-term after tax returns. 

For a long-term investor, the optimal investment strategy is one that is equity-oriented, with a long holding period, and minimal portfolio turnover. Why equity-oriented? Economist James Poterba of MIT published a study that looked at the tax impact on different asset classes from 1926 to 1996. Here are his findings:

Large stocks: pre-tax return: 12.7% after-tax return: 9.2% tax-burden %: 28%

Treasury bonds: pre tax return: 5.6% after-tax return: 3.4% tax burden %: 38%

Treasury bills: pre-tax return: 3.8% after-tax return: 1.6% tax burden %: 42%

While equities are clearly the highest returning asset class, they also have the lowest percentage tax burden. The result is that equities’ relative return advantage to bonds and t-bills is even greater on an after-tax basis. The lesson: long-term, tax-sensitive investors should have portfolios which are equity-focused.

With an equity-oriented portfolio, the next step is to try and optimize that portfolio to minimize after-tax returns. The best way to achieve this is with a long-term equity portfolio with low turnover. Consider a recent example given by investment management firm Ruane Cunniff. 

Two investors: Investor A invests $100,000 in a portfolio with 100% annual turnover (all holdings bought and sold within a year) that returns 7% pre-tax per year for 10 years. 

Investor B invests $100,000 in a long-term portfolio with 0% turnover (no sales) until the end of 10, when all the holdings are sold. This portfolio also returns 7% pre-tax per year for 10 years.

Two investors, two very different portfolio styles, with the same pre-tax returns. How did they do on an after tax basis after 10 years? Investor A had all of his yearly gains taxed as short-term capital gains, or ordinary income (we will use 35% in this example). His compounded annual return for the 10 year period: 4.6%, or $156,800.

Investor B’s long holding period, coupled with all the gains being taxed as long term capital gains (20%) at the end of the 10 years, resulted in compounded annual return of 5.9%, or $177,400. Of this 130 basis point return advantage over investor A, fully 100 basis points was attributable to simply avoiding short-term capital gains. The remaining 30 bps resulted from letting unrealized gains compound tax-free for years before finally paying tax.

The final point centers on portfolio management. An investor should concentrate his equity exposure in tax-deferred accounts and bond and cash exposure in taxable ones. I see far too many people with too much cash and liquidity in their IRAs and 401ks and too much equity exposure in their taxable accounts. Think of another tax savvy investor, Mitt Romney and his much publicized $100 million SEP-IRA. How do you amass $100 million in an account where you can contribute at most, say, $30,000 a year? Romney concentrated the highest risk/reward component of his overall investment assets in this IRA, generated remarkable returns, and let these gains compound tax-free for decades. A powerful, if extreme, lesson in tax sophistication.

In conclusion, don’t bury your head in the sand and avoid the topic of taxes. If the only certainties in life are death and taxes, you owe it to yourself to reduce your tax burden and maximize your after tax returns. Dolan Partners can help construct a financial plan and investment strategy, while working collaboratively to build tax sophistication and awareness in clients.