Avoid Extreme Portfolios

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1 Avoid Extreme Portfolios I don t spend a lot of time on this site discussing portfolio construction. This is mostly because I think I can give people more bang for their reading buck talking about financial planning kind of stuff like getting your savings rate right, managing student loans well, and utilizing tax-protected accounts to the maximum. However, I am also quite liberal in what I consider to be a reasonable portfolio. I m a true believer that there are many roads to Dublin. Reasonable vs Not Reasonable Portfolio However, I think it is time to point out something that to me is very obvious but clearly is not obvious to everyone. There are certain people in this world with some very.ahem.unique (i.e. extreme) political, economic, and investing viewpoints. Sometimes these people sound VERY smart on their blogs, in comments, or on internet forums. They rattle off all kinds of interesting economic factoids, throw out a lot of fancy acronyms that you ve never heard of, and suggest that they re in the know about the future and you are not. What I prefer to do when I run into people like this is to simply ask them what their asset allocation is. Having looked at thousands of portfolios over the years, I ve gotten pretty good at identifying Reasonable versus Not Reasonable. It s a little bit like the classic emergency physician (or really hopefully any physician) skill of Sick versus Not Sick. You might not know what the patient s diagnosis is, but that doesn t mean you can t (and better) start treating them and you sure as heck don t send them home with reassurance.

2 Examples of Not Reasonable Portfolios Let me give you some examples of portfolios that are being used or recommended by some of these folks: 1/3 Land (not income property, just vacant land) 1/3 Gold (not a gold ETF, not coins, the actual bullion) 1/3 Fine Art (not an art fund, the actual paintings) I m not going to bother arguing about the reasons the investor gave for this portfolio, I m just going to tell it like it is. This portfolio is stupid. If this is your portfolio, you have a very good chance of not meeting any sort of reasonable financial goals unless you have a truly extreme savings rate. Costs (transaction, storage, insurance etc) are high, the investments are 100% speculative, and the tax treatment is poor. Here s another one: 1% Gold Mining Stocks (using an actively managed mutual fund with an expense ratio of 1.5%) 44% Gold Bullion 55% Treasury Bills (essentially cash) Now, if you knew for sure that the stock market was going to drop 90% next week, the bond market was going to drop 50% immediately afterward, and that real estate was going to be sold for pennies on the dollar 3 months from now, this portfolio might make some sense. But the number of future economic scenarios where this is the right portfolio are so limited that this portfolio is also pretty darn nutty. One more: 7.5% Commodities 7.5% Gold Mining Stocks 7.5% Emerging Market Stocks

3 15% Rare Physical Assets 5% Hobby Trading Account (primarily used to short miners, commodities, and stocks) 5% TIPS 52.5% Money Market Fund (cash) You can t make this stuff up. 15% stocks (but ignoring 95% of the market), 5% bonds, 27.5% alternatives and over 50% cash. The best part is the shorting of the assets that are held long elsewhere in the portfolio. Choice and Consequences These don t seem to be dumb people. If you listened to them make comments and talk about economics and politics they seem to read a lot. But it is very clear that they don t understand even the basics of portfolio construction and have very extreme views on the future. Some of these folks are permabears, some are goldbugs, and others are conspiracy theorists. Sometimes all three at once. But they don t seem to have insight into the fact that just being a contrarian doesn t somehow guarantee investing success. Consider what has to happen for portfolios like these to end up being the right portfolio over the long run going forward. We re basically talking about Financial Armageddon. There isn t a lot of space between these portfolios being the right portfolio and The Walking Dead where the right asset allocation is AK-47s, bullets, and canned goods. What good are your land, gold, and paintings now? The biggest consequence of holding portfolios like these (which are generally either hyper-conservative or composed of large amounts of collectibles, speculative instruments, and other alternative investments) is that long-term expected returns are low. It turns out that the typical investor needs to take a substantial amount of risk in order to reach her reasonable financial goals. She needs her portfolio to do a

4 lot of the heavy lifting. She needs growth. And to get growth, you need investments with reasonably high returns. If you don t invest in those investments, you will need an extreme savings rate to reach your reasonable goals. This is why the typical 35-year-old with a portfolio that is 1/4 cash, 1/4 bonds, 1/4 gold, and 1/4 whole life insurance is almost surely making a mistake. Just how high does your savings rate have to be with a very conservative portfolio? I ve discussed it before in this post. Here s one of the charts from the post illustrating what your savings rate has to be for a given return. The returns on the left side of the chart are afterinflation, after-tax, and after expenses. Savings Rate for 50% Pre-Retirement Income Placement Years To Save % 83.3% 62.5% 50.0% 41.7% 35.7% 31.3% 1% 76.9% 56.2% 43.8% 35.6% 29.7% 25.3% 2% 70.9% 50.4% 38.3% 30.2% 24.5% 20.3% 3% 65.3% 45.2% 33.3% 25.5% 20.1% 16.1% 4% 60.0% 40.4% 28.9% 21.4% 16.3% 12.6% 5% 55.2% 36.0% 24.9% 17.9% 13.2% 9.9% 6% 50.7% 32.1% 21.5% 14.9% 10.6% 7.6% 7% 46.5% 28.5% 18.5% 12.4% 8.5% 5.9% 8% 42.6% 25.3% 15.8% 10.2% 6.7% 4.5% As you can see, if you re only matching inflation after-taxes and inflation (i.e. a 0% return), and you want your portfolio to replace 50% of your pre-retirement income, you would need to save 50%+ of your income to retire early and 35-40% to retire after a full career. Compared to a 5% real return, you

5 would have to save 2-3 times as much of your income for retirement. That s just not doable for most people. So what that means is that folks with a hyper-conservative portfolio will simply have less money. Less to spend, less to give, and less to leave to heirs. Choices have consequences. Value Investing? Now some of these folks consider themselves value investors after the mold of Warren Buffett. Never mind that Warren Buffett s portfolio is primarily of companies completely or mostly owned by Berkshire Hathaway, plenty of common stocks, and a large dollop of cash. No gold. No fine art. No commodities. No TIPS. If you wanted to do what the world s greatest value investor recommends, go buy an index fund. Some of these portfolio extremists don t use a static asset allocation. They plan to change the portfolio when some vague future event happens and traditional assets like stocks, bonds, and real estate become a better deal. Don t get me wrong. I wish I could buy stocks with 5% yields, bonds with 8% yields, and Cap Rate 10 income properties too. But not only are they not available in our current economic environment, but they may never again be available. If you decide to wait for that moment, you could be waiting (and missing out on gains from) decades of investing. You might even die first. There is too much faith in using current valuations to predict future returns. Vanguard did a little study to see just how much predictive value the Price to Earnings (P/E) ratio of stocks had with regard to future returns. They found that stock valuations had almost no (explained less than 10% of the variance) predictive value in returns over the next 1 year, and only moderate (38-43% of the variance) predictive value over the next decade. Other markers of valuation were even

6 less useful. You don t know what the future holds and neither does anybody else. Timing the Market? It turns out that timing the market, getting out before prices drop and getting back in before they rise is exceedingly difficult to do successfully in the long run, especially after you take into account the expenses, taxes, time, and effort of doing so. You have to be right twice- when you get out and when you get back in. If you really possess this skill, there s no reason you should keep it to yourself and your measly 6 or 7 figure portfolio. You should be running billions of dollars and will be handsomely rewarded for doing so. In fact, you should use extreme amounts of leverage and you will soon control a large share of the world s wealth. If you re so smart, how come you re not rich? Even some of the brightest economic minds in the country can t seem to predict the future. Exhibit A: Alan Greenspan s Irrational Exuberance speech was given December 5th, If you had pulled your money out of the market then and kept it out, you would have missed out on a 108% gain over the next 3 years. If you managed to stay in like a fool you doubled your money. But then the market crashed, you say. Sure. It went down from But if you had just stayed put, even without any new contributions, you still ended up with annualized return of 4.42% over that 6 year period. Going to cash wouldn t have given you a different result. If you stayed the course for a couple more years, that increased to 7.62%. Bailing out of a bull market early can be almost as damaging to your long-term returns as selling out in a bear market.

7 Consider the Future When building your portfolio, you need to consider a few things. First, what are all the potential economic futures that may lie ahead of us. Which ones do you think are most likely? How likely are they? What are the consequences of you being wrong? What should your asset allocation be in order to reach your financial goals in as large a percentage of future economic scenarios as possible? Anybody who honestly contemplates the answer to these questions is likely to end up with a reasonable portfolio such as one of these 150 portfolios. Moderation is your friend. Extremism is your enemy. A wet canyon on New Year s Day is for extremists. Investing is not. Most readers of this forum are still going to be fine, even in an extreme future economic scenario. If I permanently lost 75% of the value of my stocks, 50% of the value of my bonds, half of my home equity, and my entire business, I would still be a millionaire. Per the 2013 Census, the average net worth of someone my age is $46K. And that s in the US, perhaps the richest country in the history of the world. We may have hyperinflation and an unemployment rate of 30%, but I m still going to be able to find work. I became a millionaire within 7 years once. I can do it again. I ve got skillz to pay the billz. And so do most of you. So why would you invest like even a terrible economic future is going to somehow destroy you? It s not. And if it does, you re still going to be way better off than the vast majority. People talk about tracking error (basically that your portfolio doesn t perform like most people s portfolios) like it is inconsequential. It isn t. If

8 you lose a bunch of money but so does everyone else, you re still just as wealthy relatively speaking. But missing out on a 100% gain because you read the wrong blogs and watch the wrong Youtube videos? That s going to affect your relative wealth. Avoiding Extreme Portfolios Do you have an extreme portfolio? Here are a few questions to ask yourself. If you can honestly answer no to each of them, then you don t have an extreme portfolio. # 1 Do you have less than 50% of your assets in some combination of stocks, bonds, and real estate? If more than 50% of your portfolio is alternatives, you re probably making a mistake. # 2 Do you have less than 25% of your portfolio in risky assets with a high expected return like stocks and real estate? Taking inadequate levels of risk is a good way to fail to reach your investment goals. Even a retiree needs some assets likely to best inflation in the long run. # 3 Do you have more than 20% of your portfolio in speculative investments that don t make money and rely completely on the greater fool theory to generate

9 a return? These include commodities, precious metals, non-income producing real estate, currencies, cryptocurrencies, and other collectibles. # 4 Are you invested in fewer than twenty individual securities? Failing to diversify is a rookie mistake. Individual security risk is an uncompensated risk. Come on people, this is Investing 101. # 5 Does any individual security or property make up more than 5% of your portfolio? If you don t sit on the board or haven t eaten dinner with all of the other owners of a business, there is no excuse for having more than 5% of your money in it. # 6 Do you own fewer than three asset classes? Diversification is one of the few free lunches out there, both within an asset class and between them. This portfolio construction stuff isn t that hard. Pick something reasonable, fund it adequately, keep your costs and taxes down, and stay the course with it for a few decades and you ll be able to reach your reasonable financial goals. If you run into someone that sounds smart but has some extreme economic views, ask them what their asset allocation is. If it doesn t meet these criteria, they re probably all hat and no cattle, even if they re occasional right about short-term market movements. Even a broken clock is right twice a day and

10 even a blind squirrel can find a nut. What do you think? What criteria would you use to identify an extreme or unreasonable portfolio? Comment below! Chasing Markets Can Be a Poor Long-Term Investment Strategy [[Editor s Note: The Physician Wellness and Financial Literacy Conference starts today. Follow-along at home via Twitter and Facebook using #wcicon18! This post originally ran as my December column for ACEP NOW and can be found here.] Q. International stocks are doing really well, so I m thinking about investing more money into them. What do you think? A. I grew up playing ice hockey and continued to play in high school, college, and even now. Coaches often gave us the same advice that hockey legend Wayne Gretzky s dad gave to him: Skate to where the puck is going to be, not where it has been. Ice hockey is a fast-paced game where the participants are constantly moving, often at full speed, and the ability to read the play and get ahead of it is critical to success. In

11 recent years, this quote has been pulled into the business world and is often used to encourage innovation, attempting to figure out what products consumers are going to want to buy in coming years. However, it can also be applied to individual investors and their portfolios. Investors brains are wired such that the natural tendency is to invest money into asset classes that have done well in the recent past. Recency bias, as it is termed, is the human tendency to assume that recent trends will continue. When investors see that an investment asset class, such as international stocks or real estate, has done well recently, they assume that it will continue to do so. They not only keep their money invested in those classes, they also double down on the bet by investing more. They may even sell other assets that haven t done as well to pile more money into that asset. Investors are truly skating to where the puck has already been. The problem with this approach is that the various asset classes tend to go through cycles, and when an asset class has performed well, it may be more likely to do poorly than well in the near future. This comes down to valuations. This may be most easily understood by looking at a bond (ie, a loan to a company or government). As the value of the bond goes up, its yield or how much you get paid per dollar of value goes down and vice versa. Stocks and real estate properties work the same way: The less you pay for the asset, the higher your profits per dollar invested. Performance Chasing Can Leave You Behind The tendency to skate to where the puck has been in investing is called performance chasing, and it can be hazardous to your wealth. It is difficult to avoid because it is so natural to do. In addition, the financial media encourages this behavior by highlighting investments (and their purchasers) that have recently done well. This can be seen in newspapers like The

12 Wall Street Journal, magazines such as Forbes and Money, and television stations such as CNBC. Even radio show gurus get in on the act, encouraging you to pick mutual funds primarily based on their past performance. Well, there s a reason that mutual funds are legally required to tell you that past performance doesn t indicate future performance because it s true! Performance chasing causes investors to buy high and then sell low as they move their money into the new hot investment, repeating this flawed process. You don t have to buy high and sell low very many times in your career to completely sabotage your retirement plans. As Warren Buffett has said, When hamburgers go up in price, we weep. For most people, it s the same with everything in life they will be buying except stocks. When stocks go down and you can get more for your money, people don t like them anymore. This tendency is easily displayed by looking at mutual fund cash flows. When stocks do poorly, people take money out of them, and when they do well, people invest more. Stock mutual fund cash flows were negative from late 2008 to 2012 before turning positive in 2013 to 2014, well after stocks had recovered from the bear market associated with the global financial crisis. Meanwhile, those investors who bought (or simply didn t sell) at market lows were handsomely rewarded. Bond cash flows showed the opposite, with money coming in from 2008 to 2012, then out in 2013 to Herd mentality might help groups of animals in the wild avoid predators, but it doesn t help investors achieve the returns they deserve. Most of the time, investors are rewarded most for their willingness to sit on their hands and follow a simple, boring written investment plan over decades. Performance chasing between mutual funds within a given asset

13 class can be just as dangerous as performance chasing between various asset classes. Investing giant Vanguard performed a study looking at performance chasing and discovered that, between 2004 and 2013, this dangerous practice cost investors a 2 percent to 3 percent per year performance drop in every asset class they looked at. Unfortunately, when it comes to investing, figuring out where the puck is going is just as hard to do as not skating to where it has been. Lots of self-styled contrarians think that just avoiding the crowds will lead to investing success, and they wander off into areas of the market that never have, and never will, perform well. To make matters even more confusing, markets do exhibit momentum to a certain extent. That is, something that performed well recently continues to perform well not because of any underlying economic fundamentals but simply because it has done well recently and investors are still piling into it, chasing performance. What to Do Instead It turns out that the winning strategy, returning to our analogy at the ice rink, is to get the players on your team to play their positions. By doing that, no matter where on the ice the puck goes, you have a player nearby to pick up the puck. The way you get your investing players to play their positions is by developing a written investment plan where a certain percentage of the portfolio is dedicated to a given type of investment. Perhaps your plan is 40 percent of the portfolio in US stocks, 20 percent in international stocks, 20 percent in bonds, and 20 percent in real estate. After a year, the portfolio will deviate from these percentages because one of these asset classes performed better than the others during that year, even though nobody had any idea which asset class it was going to be at the beginning of the year. So wise

14 investors rebalance the portfolio, returning it to the original percentages. This encourages investors to invest rationally, rather than emotionally, and forces them to sell high (the asset class that did best) and buy low (the asset class that did the worst). In any given year, the best asset class may be stocks, bonds, or real estate. No matter what happens, your portfolio, if adequately funded, will perform well enough over your career to reach your investing goals, allowing you to sleep well at night. If you find yourself wanting to skate to where the puck has already been, go back to your written investment plan to help you stay the course. If you don t yet have a written investment plan, you need to write one, either on your own or with the assistance of a competent, fairly priced adviser. What do you think? Have you spent time chasing performance? What was your experience? Has a written investment plan helped you stay the course instead of selling low and buying high? Comment below! An Appropriate Amount of Investing Risk [Editor s Note: This is an article I wrote for ACEP NOW on how to select the right level of investment risk to reach your retirement goals. This is difficult for many investors and a worthy subject for discussion. The original article can be found here.]

15 Q. How Risky Should I Be With My Portfolio? I don t like watching the value of my investments going up and down it feels like I m in a casino sometimes. How much risk should I be taking with my portfolio? A. The more investors learn about investing, the more they realize it s all about risk management and the risks you face matter far more than the past or projected returns of the investment. In the words of Will Rogers, I am not so much concerned with the return on my capital as I am with the return of my capital. However, it s also important to not take on too little investment risk, as one of the most significant risks an investor faces is shortfall, or running out of money in retirement. The lower returns available on lower-risk investments may not allow your money to grow fast enough for your needs. There s a reasonable range of risk for an investor to appropriately take, but there are far too many investors whose portfolios fall outside of that range. RISK VERSUS REWARD The amount of risk you take should be directly related to your need and ability to take risk. Most investors have a significant need to take on risk, but there are some who do not. For example, an investor with a $10 million portfolio who needs only $100,000 a year from it can eliminate almost all significant risk from the portfolio and still meet goals. Most investors, however, aren t nearly as fortunate. An investor with a $1 million portfolio who hopes to spend that same $100,000 per year needs to not only continue to add to the portfolio but also to take significant risk with it.

16 Risk Tolerance Likewise, it s critical to not exceed your risk tolerance. If you don t have the emotional and financial ability to withstand a 50 percent drop in your assets (and few do), a 100 percent stock portfolio probably isn t for you because once every 30 to 50 years or so, the assets of stock investors take a 50 percent haircut. Save More Money One of the best ways to lower the amount of risk you need to take is to save more money. Saving more of your income now has a double positive effect on your portfolio: Not only does it grow faster but the amount of income it needs to provide you to maintain your pre-retirement lifestyle is also lowered. Consider an investor who makes $200,000 per year and is saving 20 percent of gross income in hopes of retiring on an income of $160,000 per year, including $30,000 per year of Social Security benefits. Using a 4 percent inflation-adjusted spending rate in retirement, that investor needs to work and save for 33 years prior to retirement. By instead saving 40 percent of gross income and planning to live on $120,000 per year, including a $20,000 Social Security benefit, the investor now only needs to work and save for 19 years, which equals more than a decade of extra time in retirement. Inflation Danger of Low-Volatility Low-Return Investments Many investors prefer to invest in very safe but lowreturning investments like CDs, bonds, savings accounts, and insurance-based products such as whole-life insurance. These investments appear to be safe because the returns aren t volatile like those of higher-returning investments such as stocks and real estate. In reality, though, they can be even more dangerous. Perhaps an investor s greatest opponent is

17 inflation. Even inflation of just 2 to 3 percent a year presents a formidable threshold to investments that yield only 1 to 2 percent a year. Nobody likes to see their investments drop dramatically in value, but the alternative is to be forced to spend less than you would have otherwise in retirement or face running out of money if you live long enough. Investors who prefer low-volatility investments have likely never run the numbers to really understand what their investment preference means. For example, an investor who wants a portfolio to provide 50 percent of pre-retirement income but who achieves an investment return that only matches inflation (0 percent real) and wants a 25-year career will require a savings rate of 50 percent of gross income for each of those 25 years. Very few doctors are willing to save that much of their income. Alternatively, the investor can work for 40 years while saving 31 percent of income. A more risk-tolerant investor who achieves a return that beats inflation by 5 percent, on the other hand, would need to save only 25 percent of income for 25 years, or 10 percent of income for 40 years, to have the same retirement spending level. The bottom line is that almost all investors need to take on a significant amount of risk in order to meet their financial goals. What is A Reasonable Amount of Risk? Phil DeMuth, PhD, managing director at Conservative Wealth Management, LLC, has said, Even if risk tolerance existed and could be measured accurately, why would it be an important factor when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest safely if that locks in running out of money when you

18 are old. There are many investing products (most of them insurancebased) that are marketed as reducing the risk in investing. However, these same products are also likely to reduce the return so much that a typical investor cannot afford to have any significant chunk of a portfolio in them. Financial theorist William Bernstein, MD, said, There are no free volatility-reducing lunches that will inexpensively reduce your portfolio risk, and there is no risk fairy to insure the risky parts of your portfolio on the cheap. Yes, there are people who and vehicles that will do this for you, but they will cost you a pretty penny. While the general adage that higher risk equals a higher return is true, you should be aware that you won t be compensated for taking some risks. A risk that can be diversified away is, by its very definition, uncompensated risk. An example of this is investing in a single stock or even a handful of stocks. Since you can easily buy all of the publicly traded stocks in the world using low-cost index funds, you won t be paid an additional risk premium for investing in a single stock even if that stock is Apple. A novice investor may ask, What s a reasonable amount of risk to take in a standard portfolio of low-cost, broadly diversified stock and bond index funds? Many decades ago Warren Buffett s mentor, Benjamin Graham, recommended never holding more than 75 percent or less than 25 percent of your portfolio in stocks, with the remainder in bonds. I think that wisdom still holds true today, and you should have a very good reason to go outside that recommendation. If you do decide to leave the relatively safe confines of the publicly traded markets for your investments, limiting risk should be of the utmost importance in evaluating a prospective investment.

19 Owning stocks, bonds, and real estate isn t gambling. You re loaning money to or owning small pieces of real profitgenerating enterprises, some of the largest and most successful that the world has ever seen. Make sure the amount of risk you re taking on isn t too much, or too little, to reach your goals. How did you determine how much investment risk to take? Has that changed over the years? How and why? Comment below! Parting With Suboptimal Investments: One Physician s Story [Editor s Note: This is a guest post from the Physician On FIRE, one of the more prolific of the physician financial bloggers who have started up in the last year or two. He is not only a talented writer, but an exceptional marketer of his writing so I m proud to feature him here. In this piece he talks about how he got rid of some investments in his taxable account that he realized were not so wise. We have no financial relationship.] If you ve made unwise choices in a tax advantaged account, there s an easy fix. Exchange the investments you no longer want for something more desirable. In any Roth account, 401(k), or similar retirement account, there are no tax consequences to your buying and selling [although there may be commissions or other expenses-ed.]

20 If, like me, you ve made some less than ideal investments outside your retirement accounts, your exit strategy is not so simple. You ll have to consider a number of factors, including the tax implications of selling, the cost and opportunity cost of keeping the investment, and alternative methods to jettison the investment from your portfolio. When I was a relatively new attending, I had a cursory understanding of personal finance. I knew enough to avoid most major mistakes, but I had not taken the time to understand the finer points. It s tough to find time when you ve got a growing family, huge new house to fill, and a couple of fantasy football teams to manage. If only I had spent half the time on my finances as I did on my fake football teams, I wouldn t have gotten into the funds that I did. I could have done worse, and I imagine many of you have. I had read Andrew Tobias The Only Investment Guide You ll Ever Need as a medical student. Now that I found myself with money left over at the end of each month as an attending with a few years of experience, I was compelled to put that money somewhere. At the end of The Guide, a few fund families are listed. Vanguard was listed first, and described accurately as a lowcost provider. Well, that sounded alright, but T. Rowe Price, a more regal sounding name, was touted as great for beginners, with a mountain of resources, having great customer service, all while offering among the lowest expense ratios in the industry. That sounds good; I ll have that. I had previously started my SEP-IRA with them, which made me even more comfortable starting my taxable brokerage account at T. Rowe Price. Building Up The Taxable Account I wanted some diversity, so I chose what looked like a good potpourri of domestic and international funds. I even put a

21 little money into a tax-free bond fund. Here are the funds I chose. Did this give me diversity? Yes. I had growth funds, international funds, and a bond fund. The two Spectrum funds were actually funds of funds, holding a handful of T. Rowe Price funds in each. Did I have Total Stock Market diversification? No, but I didn t know much about index funds at the time. Were my expenses among the lowest in the industry? No, not even close. I could have been more diversified with two Vanguard or Fidelity funds, while having 1/10th the expenses. A weighted average of my current portfolio s funds expense ratios is 0.08, one tenth that of the above portfolio. What was my rationale? If I knew then what I know now, I would have made different choices. Expenses under 1% seemed reasonable. I didn t realize that investment fees can cost you millions. I did look at some graphs and charts and Morningstar star ratings, for what it s worth, which in hindsight, isn t much. When I started this account, there were some good online resources that I hadn t yet found, but The White Coat Investor site did not yet exist. [Sorry about that, I was busy making my own mistakes. As bad as Personal Strategy Growth might look, it pales in comparison to whole life insuranceed.] For three years from 2010 to 2013, I funneled as much money

22 into these funds as I could. When I worked locums, the proceeds went into the taxable account. By the fall of 2013, I had built the account up to a value of $369,000. Awesome! I had also discovered Bogleheads, rediscovered Vanguard, and realized I was losing money to fees while invested in taxinefficient funds. Not Awesome! Unwinding What I Had Done My first instinct was to sell it all and start anew, but the capital gains alone would have pushed me well into the highest tax bracket, the one where capital gains are taxed at 20% instead of 15%. I didn t know a lot, but I knew I didn t want that. We were planning a move at the time I realized I had chosen the wrong funds. We would need a new house, and I decided to buy the house with cash. I had been building up a cash reserve, but not enough of a reserve to buy a home outright, even in the low cost of living area where we were headed. That fall, I sold about half of the funds after we found a suitable home for our family. I consulted with my accountant in December. Between a busy locums schedule that added a six-figure sum to my salary and a sizable capital gain from selling off half the funds in the taxable portfolio, I was still destined for the top federal income tax bracket and the 20% capital gains tax bracket unless I did something to lower my tax burden. So I did something. I had researched donor advised funds, and decided it was time to start one of our own. I donated about $60,000 from the funds with the most appreciation, more than enough to bring our taxable income out of the top bracket. In any year, the IRS allows you to donate equities adding up to as much as 30% of your taxable income. If you re giving cash, it s 50%. Every

23 dollar donated is a dollar that s not taxed. In 2014, this taxable account was worth about a third what it was at its peak. I was done contributing to it, but it continued to cause tax headaches. In 2013, aside from the capital gains I incurred by selling, the funds spun off over $6,000 in dividends (mostly ordinary, non-qualified) and over $6,000 in capital gains distributions. In 2014, I still saw over $4,000 in dividends and nearly $7,000 in capital gains distributions despite having less than $120,000 in the account. I made another good-sized contribution to the donor advised fund late in 2014, and again in Before the first quarterly dividend date arrived in 2015, I decided to cut my losses, take my gains, and move the last of my T. Rowe Price account into Vanguard index funds. Lessons from my folly Is T. Rowe Price a bad company? No, not at all. But if you plan to be a do-it-yourself investor, you should do all you can to minimize your fees. I like Vanguard, but they re not the only company selling index funds with expense ratios below 0.1%. Tax efficiency matters. I now have a seven-figure taxable portfolio, and the tax burden imposed is about the same as it was when I was invested in less tax-efficient funds with a portfolio one third as large. Have a well researched plan before you start investing in a taxable account. Changes are easy to make in your 401(k) and other tax advantaged accounts. In a taxable account, if you ve seen any gains, you will be taxed when you decide to sell. It s not too late to make changes. While you will be on the hook for some capital gains taxes, it probably makes the most

24 sense to move on and swallow your pride when you realize you ve got investments that don t make sense in your portfolio. If I had held onto those funds indefinitely, the ongoing expenses and tax drag would easily exceed the cost of exiting out of them when I did. Giving is good. You can donate equities directly to charities, or indirectly via a donor advised fund, as I have chosen to do. While you won t come out ahead financially by giving a dollar to save forty cents, if you plan on being charitable, starting a philanthropic fund is a great way to relieve yourself of the burden of a stock, fund, or even property that you would rather not have. What do you think? How do you get rid of appreciated assets you don t want in your taxable account? Have you used a donor advised fund? What other strategies do you use to lower your investing related taxes? Comment below! Exploiting the Inefficiencies of Leveraged ETFs [Editor s Note: Here at WCI we try to keep things as simple as possible, most of the time. Not today though. Today we re going to be discussing leveraged ETFs, a classic example of a product meant to be sold, not bought. This is a guest post from Chase R. Cawyer, MD, MBA, a financial advisor at Navigo Wealth Management in which he proposes a strategy to profit from the issues with leveraged ETFs. The publication of this strategy here should not be taken as an endorsement of the

25 strategy, but simply a reflection that I found it interesting to think about myself and thought it would make for a good discussion. He is a paid advertiser on the site (although this is not a paid post.)] Leveraged ETFs (Exchange Traded Funds) and Leveraged Inverse ETFs are a sucker s bet, right? That s mostly true when buying them as long positions. Leveraged ETFs inherently deteriorate in value due to their structure and inefficient daily resetting process and as WCI and many others have correctly mentioned, it is generally wise to avoid buying these products. But what about doing something else with them besides buying them? After all, inefficiencies often breed opportunities. Beta Slippage ProShares Ultra (SSO) is a leveraged ETF that seeks to return 2x that of the S&P500. As reiterated from their literature The Ultra Proshares seeks a return that is 2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Chase Cawyer, MD, MBA The performance problem with leveraged funds is that they deteriorate with what is called beta-slippage. To best illustrate, take a very volatile asset that is up 43% one day and down 30% the next. Compare it to a perfectly double leveraged ETF that should go up 86% one day and down 60% the next and see the end results: Primary Asset: (1+0.43) x (1-0.30) = 1 Perfectly leveraged ETF: (1+0.86) x (1-0.60) =.74

26 As you can see the perfectly leveraged ETF has lost 25% of its value just due to beta-slippage. This is not some scam to take away your money, and nothing has changed in the principal asset, but simple mathematics has prevailed. Now this is an extreme example, but even if you adjust the percentage to something more realistic (2.5% up and 2% down) you will still see the impact of beta-slippage, especially over time. For every positive there is a negative, and in the case of leveraged ETFs that is certainly true with the introduction of inverse leveraged ETFs. Instead of attempting to return 2x the S&P500 (SSO), traders can invest in Proshares UltraShort S&P500 ETF (SDS) and do the opposite. The Short Proshares seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Thus, when the market goes down 1% in a day, those invested in the fund hope to achieve a gain of 2% for their positions. As previously mentioned, Leveraged ETFs, including the inverse versions, are not usually advisable funds to invest in. They reset every single day, and as we know all trades come at a cost to those who make them. Plus, beta slippage over the long-term distorts the risk/reward. See the following chart of the performance of SPY (green), SSO (blue) and SDS (red) from Nov 2010 to Nov SSO / SDS Leveraged ETFs Pair 1 Year Chart from November 24, 2010 (Yahoo!) As you can see, SSO did not return 2x the S&P 500 (SPY), not to mention SDS abysmal return compared to what it was intended to do. If asking if those poor returns are due to higher costs to make daily trades or due to beta-slippage, the answer is YES! And although these instruments are intended for day traders, investors can take advantage of them. If the

27 value of leveraged ETFs inherently goes down, then investors can actually capture that value through short selling. Short Selling Inverse ETFs Now when most people hear the term short selling they scream risky proposition, but let me show you how it can work when done in an appropriate manner. For a brief recap short selling is defined by Investopedia as the selling of a security that is not owned by the seller, or one that the seller has borrowed. Short selling is motivated by the belief that a security s price will decline, enabling it to be bought back at a lower price to make a profit. If you re fully long in the stock market at all times you wouldn t even think that shorting the 2x leveraged S&P 500 (SSO) would be a good idea. But, what is your reservation for shorting the inverse leveraged S&P 500 (SDS)? The double negative makes it a positive. In other words, being short an inverse fund in this case, means you are essentially long and own twice the S&P 500. You should be able to buy it back at a lower price at any point in the future because of the natural deterioration, correct? For instance, if you shorted SDS at inception on May 31, 2008 you could have sold it (remember you re shorting so think backwards) at (adjusted close) and bought it back at on May 31, 2016 for a total return of 925% (>110% annualized over those 9 years). Now before you start talking about how that number is too good to be true let me tell you it absolutely is. But the point is, if you understand the inefficiencies of inverse leveraged ETFs and know how to take advantage of those, then why wouldn t you? Dealing with Risk

28 Gold Level Scholarship Sponsor Shorting, leverage, inverse, huge potential returns it all sounds too risky. It could be, but let s take a look at how to take advantage of these inefficiencies more practically and safely. First, shorting can only be done in a taxable investment account. In addition, all shorting gains are taxed as a short term capital gain thus your tax bracket matters. For example, using the 35% tax bracket you have to pay 35% of each year s gains in taxes reducing that total return to 436% (48% annualized). As if we all needed another reason to show us why we should first invest in tax-deferred accounts. Next, you likely wouldn t want to go 100% equities because remember these funds are volatile. As a matter of fact, look at the start of the initial investment to the end of the bear market (June 2008 Mar 9 th, 2009). If you had shorted SDS, you were looking at a net loss of 150%!! So how do you decrease volatility? Asset Allocation. So maybe a nice 60/40 stock/bond split is the way to go. You don t want to do just any ordinary bond fund, however. You want to use the same shorting strategy on a leveraged inverse ETF to capture that deterioration. Enter Ultrashort 20+ Year Treasury (TBT) as the fund of choice resulting in a 60/40 short mix of SDS/TBT. This matters because if invested 60/40 SDS/TBT during that same bear market stretch, while your SDS short was down over 150%, your TBT short was up almost 60% resulting in a still terrible but much more palatable 66% loss (compared to the S&P loss of 51%). Since the massive drawdown of our short positions was diminished, the net return over the entire 9 year time frame was actually improved to 495% (62% annualized).

29 Our results show that you would have been able to crank out some incredible gains over time, but we know how strong an emotion fear is. While the balanced portfolio did generate 62% annualized gains over the 9 year time frame, had you been watching the maximum drawdown of 66% you would have been fearful and questioning the validity of the strategy during that time. So how about exchanging some of the volatility for lower annualized returns? If you were to hold at least 50% of the portfolio in cash thus resulting in a 30/20/50 portfolio (SDS/TBT/Cash), you would have dramatically minimized the overall portfolio volatility while experiencing a total after tax return of 158%, or 19.7% annualized. This not only reduces our drawdowns significantly (a maximum of 33%); it reduces your stress level as well. It also addresses any margin call issues that might come into play if you were not sitting on much cash. How does this more conservative 19.7% annualized return compare to a basic stock/bond portfolio mix during that same time frame? Very well! A buy/hold S&P 500 ETF (SPY) returned 7.1% after tax while a balanced portfolio (60% stock, 40% T- Bond) showed a higher 8.5% return. An even more conservative strategy holding 70% cash and being short 18%/12% SDS/TBT still outperforms the market with a net 10% annualized return on investment. So we have found an ability to handily beat the market by being long the S&P 500, long 20 year Treasury bonds, and holding 50-70% cash. Gold Level Scholarship Sponsor When you short a leveraged ETF you are essentially going long a balanced portfolio of stocks and bonds, but then continuously capturing the value/money that deteriorates due to the inefficiencies of these positions. This type of

30 shorting strategy can be incredibly volatile and obviously not for everyone, but with volatility (risk) comes rewards. You can move along that risk continuum as much as you like by including a lower cash allocation, which heightens the volatility, or a higher cash allocation, which dampens the volatility. This strategy would generally be recommended with only a portion of an overall portfolio and the concept, along with other strategies that take advantage of market inefficiencies, can be utilized to create a more aggressive tilt to your portfolios. Our experience has shown that by also adjusting allocations dynamically based on the prevalent market environment you can even enhance returns further, especially in a bear market, while simultaneously reducing volatility; but that is an article for a future time. Although this strategic idea can appear somewhat complex, having an advisor experienced with this type of approach can take some stress off the table, but for those who manage their own investments the execution of this static approach is relatively straight forward. With a simple approach using large amounts of cash as a strategic allocation as described above, market beating returns with reasonable risk are certainly on the table. When looking at the current investment climate, and shaking your head at how many inept/terrible investment funds there are, a smart shorting strategy that takes advantage of inefficiencies can result in huge dividends. [Editor s Note: I m not sure I m smart enough to point out all the potential issues with this strategy. Obviously I think going along with any of these investment products for the long-term is dumb. I ve never owned a leveraged ETF and don t plan to start now, long or short. We have a written investment plan that we follow and it doesn t include schemes like this. A physician certainly doesn t NEED to use strategies like this to be financially successful. But I do like the idea of profiting from stupid investment products. However, there are

31 a few things that are worth thinking about if you are considering adopting this sort of a strategy for a very small portion of your portfolio If it is really all that smart, why isn t there a hedge fund already doing this? Well, it turns out there is. In fact, it was the best-performing hedge fund in That gives me a weird sense of performance chasing in my gut. This strategy is expensive. Not only are the expense ratios of these ETFs times the cost of a good Vanguard ETF, but the continual buying and selling adds up too. The tax issue is not insignificant. What is your marginal tax rate? Mine is over 40%. Seems like a lot of risk to take to only keep half the gains. As a general rule, when a strategy is shown to be good (as this one apparently has in the recent past), it gets arbitraged away. I m not sure exactly what that would look like for these leveraged ETFs, but perhaps it would manifest itself by making it harder to find shares to short (none to borrow on the market) or perhaps there would be a a negative premium on them. In a really impressive market (i.e. a trend that keeps going), your losses are infinite. When you short something, you HAVE to buy it at whatever price it is selling at later. That might be more money than you have. I could imagine a scenario where beta slippage decreased somehow and the market rapidly increased or decreased and wiped you out. Read this account of a guy who took a pretty good loss doing this 5 years ago. Platinum Level Scholarship Sponsor 6. Like any strategy, staying the course is challenging.

32 Dr. Cawyer s recommendation to do so is to hold a bunch of cash, which is at best paying 1% right now. You think it s tough holding an 80/20 portfolio? Try one with a bunch of shorts and leveraged ETFs. If you re paying attention, you ll be pitched an apparently promising investment strategy at least once a month throughout your investing career. Bouncing from one to the next is the worst possible investing strategy. Investing is more behavioral than math. Even if you re the type who can tolerate a strategy like this without an advisor, will your spouse be able to if something happens to you? And if you need the advisor, add on another layer of fees. Overall, there is some promise here, but I think the negatives are enough to keep me from implementing this with even 5% of my portfolio.] What do you think? What issues do you see with this strategy? Is there a free lunch here? If not, are the potential returns worth the price of entry? What percentage of your portfolio would you use to implement something like this if you were convinced of its merits? Comment below! An Example of a Doctor Deal I get approached by people selling all kinds of different investments all the time, mostly hoping I will publicize it to blog and/or newsletter readers. Some deals are attractive, some are not. Most I simply don t have the time or expertise to evaluate properly. Many are quite clearly what I call Doctor Deals, i.e. deals that can only be sold to doctors, because they re the only ones with the money and the lack of financial sense to buy them. One of these is a company called