The 50% Doctrine

Mostly I’m posting this so my wife (a real blogger) can have something to make fun of.  It seems I had the temerity to make fun of her blog post on Muk Luks.  But that’s only half the story, he says in a clumsy segue.

Today I want to talk about investing philosophy and how to make choices between two options.  One example of this is when making an asset allocation (AA) choice between stocks and bonds.  Say you’re a Boglehead and have decided to go with a stock index fund (Vanguard Total Stock Market Index, VTSMX) and a bond index fund (Vanguard Total Bond Market Fund Index, VBMFX).  Well congrats on your wise choice;  you are well on your way.  But what split on the AA?  90/10 (% stocks/% bonds by convention) because we really like stocks or because we weren’t paying attention to the stock market in 2008?  30/70 because we’re super conservative?  There is, of course, advice from John Bogle himself that says “your age in bonds.”  How to choose?

The 50% doctrine, on the theory that one can only be so wrong doing so.  And in the absence of a priori information, splitting the difference is not that bad a choice.  In full disclosure, my target AA is about 60/40 in honor of my recent 40th birthday, and in full shuddering hindsight view of 2008.  Like a lot of others, I re-thought my AA after watching the 40% drop, and found it to be way, way too aggressive.  Live & learn.  If I had chosen 50/50 from the get go, and assuming 60/40 is “correct” for me at this age, I would only have missed the mark by a little.  The same goes for an early retirement allocation of 40/60:  a close miss in the other direction.  Even if the “correct” or “optimum” AA was 70/30 (we are gifted with prophesy after a long night of drinking;  humor me), an AA of 50/50 would still hit closer to the mark than 100% stocks or 100% bonds.  Lest you think it simplistic, Adrian Nenu over at the Bogleheads forum states repeatedly that most investors should be at 50/50.

If I had been 50/50 from the very beginning of my investing career, I would likely be ahead of where I am now.  Bygones, but young(er) investors take note.  One should only take on as much risk as one has to.  If you are investing early, do you really want to be 80-90% in stocks?  Or should you focus on capital preservation from the start (and have faith in your earning and saving abilities) and go with something more like 50/50?

I was reading the excellent Bogleheads’ Guide to Retirement Planning, and in the context of whether to choose a 401(k) or Roth 401(k), the advice given was to go halfsies.  One’s marginal tax rate in retirement and the future tax rate whims of Congress fall into the realm of the truly unknowable, so the author advised 50% in each for tax diversification.  Full disclosure here:  I did this split one year, but have not since.  When there are taxes to be paid, I will defer them if I can.  Hence traditional 401(k) for me.

One final example before I go.  I caught the mortgage prepaying bug in 2008, and dedicated 100% of my after-tax investing funds to it.  Turns out that was one of the better moves I could have made, getting a guaranteed return of +5% by paying down debt, as opposed to -40% in the stock market.  At the beginning of 2009, with the economy still shaky and stocks being “cheap” I was wondering whether to continue prepaying the mortgage or to stay a bit more liquid by investing.  I decided in the end to go 50% on each with the available funds.  So how did I do as of December, 2009?  The mortgage prepayments still “paid” roughly 5% in forgone interest payments, while my rate of return from shares of VTSMX I bought was about 33%.  Aggregate return was 19% by splitting the difference.  Not too shabby.  Sure I missed out by not going 100% in the market, but that 33% return was improbable, and could easily have been lower.

If you find yourself on the horns of a financial dilemma, consider choosing the middle ground.  Not because it is the “best” solution, but because it may be the least wrong one you can pick in advance.

Back In Black

With an appropriate head thrash to Brian, Angus and the boys, it’s been too long.  I’m glad to be back.  To make up for lost time, and on the off chance this is my April post, I’ve decided to treat each of my topics:  books, brewing, movies, music, personal finance, and an other if it occurs to me.  My blogging has been sparse of late, but life goes on.

I have been reading a lot.  Some personal finance stuff:  Automatic Millionaire (Bach), The Smartest Investment Book You’ll Ever Read (Solin), Wise Investing Made Simple (Swedroe) — standard Boglehead stuff.  And for what it is worth, I am following a 50/50 strategy of paying down my mortgage and socking away excess in Vanguard Total Stock Market in a taxable account.  Still, investing for the long haul is fundamentally boring, so my mind has turned to other titles like (nobody knows you’re blushing on the Internet) Goals! (Tracy), How To Get Rich (Dennis), and The 4-Hour Workweek (Ferriss).  The latter has been described as snake oil by some reviewers on Amazon, but parts of it have me intrigued.  It is a new year;  time to try something new, money-wise.  No fear;  no retreat;  nothing to lose.

On the brewing front, I haven’t been lately.  Tonight that all changes — planning a blueberry-pomegranate mead and a pyment (grape mead).  After that, as soon as my primaries clear out, it’s a few extract batches of beer, likely American brown, amber, a porter, and a stout.

I haven’t watched many new movies, except Quantum of Solace, which was excellent.  I watched Serenity (one of my faves) again last night on a new Roku Netflix player.  What a cool way to do on-demand movies and TV without paying the cable co for the privilege.  This is the wave of the future.

So music:  currently loving the latest from A Shoreline Dream and Silversun Pickups.  Also TV on the Radio and Thriving Irony.  And if listening to music weren’t enough, I bought a bass guitar.  Because, well, playing in a rock band is just plain fun, and of the three (bass, drums, guitar), it seemed to be the easiest to pick up.  Not that it’s easy.  As I get older, my patience for repetition has diminished, while my conception of how hard things are has increased.  Not a good combination.  But feh, I will persevere and regale the world (or a basement-sized part of it) with my amplified genius.  Or loud competence.  Anybody know a great guitarist in the Chandler AZ area looking for a bass player?

In personal finance, a lot of getting rich involves saving (particularly pre-tax) and living below one’s means.  There is, particularly at bogleheads.org (link at right –>), a lot of debate about which investing philosophy trumps what, and which investments belong in taxable accounts verses tax-deferred.  This is all well and good, but if one ups their savings rate from 10% to 15% or even 20% it will positively swamp those other considerations.  It is boring;  it is unsatisfying; it is not particularly fun;  BUT it is important.  Save, save, and save.  If you do, you will be rich.  Sooner or later.

Blog For Sale

Ha, ha, ha, just kidding.  Like I would sell this masterwork.  Ah me, this blog has gone from quasi-daily to weekly to less frequently than that.  So effective immediately, I hereby renounce my quasi-rule of at least one link per post.  Screw it;  I’m just going to type stuff.  Linking slows me down.

I have been brewing recently.  Just bottled a Belgian Pale ale last weekend — may sample tomorrow or the next day.  Also went over to my friend Steve-o’s house a couple of weekends ago and brewed my second all-grain batch, a Brown Porter.  Currently have two secondaries full of it, and I probably should bottle one.  Or buy a fridge for the garage and keg them both.  Decisions . . . .

And the economy . . . WTF is up?!  Some of this is self-fulfilling (golly THANKS media — can’t you come up with a good missing person story to distract everybody?).  My employer seems to be doing OK, which is nice.  Keep buying computers, y’all.  Good news is the new low prices on gas, travel, real estate, mortgage rates, etc.  I am pondering whether the 2009 plan should be to continue debt reduction, or to dollar cost average (DCA) into the market, or maybe both.  The middle path does have some appeal . . . . except that it limits the upside along with the down.  Again, screw it;  I should re-read my own “can’t predict the future” post.

Finally books — I have listened to both Tribes and The Dip by Seth Godin.  Both spoke to me, the former in a strategic sense and the latter in a tactical sense.  Together they should give me just enough rope to hang myself next year at work.  Or succeed wildly, if the author is to be believed.  Which reminds me . . . given the opportunity, should one speak the truth to power?  There are definite downsides. I may have the chance tomorrow.  Generally, I think yes — there are different types of loyalties:  to people, organizations, ideas, institutions, symbols, leaders, authority figures, ideologies, etc.  My chief loyalty is to people, but this requires a strong personal relationship, and is relatively rare.  A good second-place proxy is the organization/client, who I am meeting with tomorrow AM.  Wish me luck.

Dave’s OK, Except . . .

For a financial writer, critiquing Dave Ramsey is like the compulsory figures in ice skating.  Not very exciting, but everyone has to do it.  Dave Ramsey is known for his book the Total Money Makeover (among others), including the much-discussed seven baby steps:

1)  Establish $1000 emergency fund.  2)  Pay off debts with debt snowball.  3)  Three to six months of expenses in savings.  4)  Invest 15% of income for retirement.  5)  College funding for children.  6)  Pay off home early.  7)  Invest in mutual funds and real estate.

This list, like all general advice, suffers some from lack of specificity, but I will not ding it on that basis.  It is the nature of the beast, and it is (not to give away the ending) ultimately good advice.  Some have quibbled with the “snowball” part of debt payment, where debts are tackled from littlest to biggest, regardless of interest rates.  Whatever.  I agree with those who think that the psychology is more important:  getting them paid off matters, and not the extra month or three paying on a higher rate loan.  Some even question the order of the steps, but really, cut the guy some slack.  Debt payment is second, and everything after that is asset allocation, really.

So what are my differences?  #1 is a relatively minor niggle with the 15% number for retirement.  Call me a dirty delayer of gratification, but I think everyone should strive to save the maximum allowable each year in tax-deferred accounts, such as 401k(s), (Roth) IRAs, etc.  I realize that sometimes this may not be possible, depending on total income.

My main critique, however, is with the suggested vehicles of “four types of mutual funds” in his last, investing step.  No, no, no, you do not tell people to be in 100% equities.  Particularly, when you throw in statements indicating that it is relatively easy to make, say 10% returns.  Repeat after me, Mr. Ramsey in your southern drawl, that past performance says nothing about future performance.  Equities as a class of investments may, or may not, perform in the future as well as they historically have.  No, Dave, you are not doing these newly debt-free folks any favors there.  DO NOT listen to Dave Ramsey on investing.  Listen to the Bogleheads, the early retirees, or Jane Bryant Quinn instead.

Don’t get me wrong.  Dave’s (mostly) OK.  I read the TMM, and it convinced me to stop babying my various debts and allowing them to hang around.  My sister also benefitted from the book.  Definitely worth a read for most folks.

No It Is Not Different This Time

Interesting things may be happening in macro-economics.  Thankfully, that is not my concern.  I, like almost everybody, am concerned about personal finance.  So a little more about my philosophy of money.  First, I have my eyes on the prize.  My goal is financial independence, in particular having the return from my investments exceed my living expenses by a margin of safety.  That would be nice.  So how does this drive my investment philosophy?

Glad you asked.  My first bedrock principle is that nobody can predict or time the market.  Let that soak in a bit.  You and I cannot time the market.  If we could, we’d be sitting on a beach drinking fruity drinks with little umbrellas in them and throwing another couple mil into the market on a sure thing just because we can.  But here we are, talking on the Internet instead.  Nobody can time the market;  not you, not me, not the financial advisers, not the stockbrokers, not Jim Cramer, not the pundits on CNBC, not the titans of Wall Street.  Nobody.  My evidence is that all of the above are still working.  If you or I could really see the future, it just wouldn’t take that many trades to be set for life.  Maybe four or five in a row, highly leveraged, would be sufficient if you bet the farm each time.  Still here?  Not on a beach?  Me too.

The second bedrock principle is to get as far away from zero as possible.  Given the uncertainty of investing (i.e., the S&P 500 is down about 35% year-to-date), maybe we should focus on something we can control:  debt.  In other words, if adding to the plus column is a bit chancy, maybe we should concentrate on lowering the minus column.  The largest single debt most folks have is their mortgage.  After fully funding tax-advantaged retirement accounts (401k and IRA), I firmly believe in paying the mortgage down.

There are differing opinions on this topic.  In a falling market, it certainly makes sense.  Reducing one’s mortgage debt at a rate of 6% (a guaranteed return of 6%) in the face of 35% market losses puts you about 41% to the good.  The best analysis I have seen was succinctly stated by rogersteciak in this thread:

While it’s true that one can do an arbitrage play (i.e., invest money at a 12% return while paying mortgage interest at a 6% rate), the downside to being leveraged is when Mr. Market becomes depressed. Debt payments continue regardless of what Mr. Market does. Less debt means more room to maneuver when times become tough.

Quoted for truth.  If this sounds like something your parents or grandparents would have done, it is.  When in doubt, go with that.  It is not particularly fun, sending a check to principal, and it is certainly not sexy.  Still, it is a wise thing to do, because it is exactly the same this time, financially speaking.  See you at the mortgage burning party.

Stay The Course

A few thoughts on investing in the midst of the current market drop.  Here is how I invest:  low expense index mutual funds.  There are countless arguments against buying individual stocks;  one of the best IMHO is the Bogleheads’ Guide to Investing.  The Bogleheads are disciples of John Bogle, the founder of the Vanguard Group, and a large proponent of mutual fund investing.  There are regular discussions among this group at the Boglehead forum.  Go there and learn.    

To continue, among mutual funds I choose index over actively-managed, because they tend to outperform the latter in absolute terms, and they definitely cost less to own (think 0.1-0.2% verses 1-2% fees).  Expenses matter, particularly compounded over time.  Having chosen the vehicle, all that remains is to choose an asset allocation — which types of investments (stocks, bonds, real estate, commodities, US or foreign, etc.).  The Four Pillars of Investing provides a good explanation of risk, return, and volatility on this topic.  

Once you have chosen an asset allocation you feel comfortable with (hint:  falling markets such as today’s are a good test of what you are truly comfortable with), the task becomes periodic rebalancing to maintain the allocation (i.e., things go up, and all of a sudden your 80/20 stock/bond allocation sits at 90/10 by value, or things go the other way and now you are at 70/30).  As explained by Jane Bryant Quinn in her book, Target Retirement funds (Vanguard’s flavor) or Freedom funds (Fidelity’s flavor) maintain an asset allocation that changes over time — becomes more conservative (more bonds, less stock) as you get closer to your retirement date.

One fund to rule them all!  Of course, you don’t have to pick your actual retirement date for your fund — just pick the allocation you are comfortable with.  In my IRA, I have one fund right now:  Target Retirement 2035, (click on the 36-40 year old bar) which has about (gulp) 90% stocks and 10% bonds.  If you are more conservative, say 60% stocks & 40% bonds, you might go with Target Retirement 2015 (the 56-50 year old bar).  Whatever you choose, remember to take a hard look at the fees — mine is 0.19% which is why I prefer Vanguard.  And, yes — I have one fund.  It does everything I want it to do, contains a breadth of assets, and has low expenses.

Not Everyone Defaults

I was talking to a relation of mine yesterday about the current meltdown in the credit markets.  He said that he had not really been affected, doing his banking with Bank of America.  Then he remarked (a new homeowner as of a year or two ago) that he probably could not qualify for his mortgage if he had to do so today.  He then admitted that he had benefited from a “subprime” loan when buying his condo.  Specifically, it was a stated income-type loan — state what you make, not much documentation required.

Then he pointed out a crucial distinction:  he and his wife bought only as much home as they could afford, and with a 30 year fixed rate loan.  Here is a subprime success story — I fully expect them to pay their motgage in full and on time for as long as they are in that house.  The subprime loans of the past few years certainly caused some financial harm, but they also caused some financial benefit.  Some folks borrowed responsibly.

Which leads to the bigger point I want to make.  In addition to the mortgage brokers that pushed the product, the Wall Street types who packaged it, the rating agencies that blessed it, and the investors that bought it, there is another culpable party in the subprime meltdown:  the home buyers who applied for and received these mortgages.  These buyers do not tend to get the ink in the financial press, perhaps because they are suffering, and perhaps because the theme of personal responsibility is currently out of style.   But if these borrowers had, say, not bought unreasonably big houses for their income, and not used products where the interest rate adjusts (the belief that rates will never tick upward is akin to the belief in a free lunch), perhaps the scope of this mess would not be as large.

But people will always chase, and especially when it comes to financial products, the free lunch.  Repeat after me:  there is no such thing.  You should consume financial products like you consume anything else — comparison shop and do the research (particularly when large amounts are involved), with a cynical eye to why (hint: commission) your “independent advisor” is pushing this one product.