Tom’s Quarterly Reads

Here are the best articles I read over the past three months, mostly all finance-related. I’ve moved to grouping the links by topic, but the topics will shift each quarter based on the set of articles. 

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The Internet and the Third Estate (Stratechery): The masterful Ben Thompson proposes that social media is not the fifth estate (as Mark Zuckerberg claims) but rather a tool that gives the third estate a voice. The effects of this are still playing out all over the world, but we must remember to think on the scale of nation-states when considering what we want the future to look like.

Who Wins a Brokerage Price War? (Investopedia): The fee wars continued with Charles Schwab eliminating commissions on most trades. They were followed in quick succession by other major investment brokers like Fidelity, TD Ameritrade, E*TRADE and Merrill Lynch (Merrill only did so for loyalty program customers). This is a great time to be an individual investor, but it’s important to remember two things: 1) there are still trading costs (like bid-ask spreads on ETFs) and 2) these brokerage houses still make lots of money – particularly on your uninvested cash.

Highlights from the new SECURE Act (The Human Advisor): The newly passed SECURE Act has a number of impacts that everyone should be familiar with. Among the changes are: a new age for Required Minimum Distributions (RMDs); more ability to raid your retirement funds for non-retirement purposes; and (most cringeworthy of all) the ability to have an annuity inside your 401(k). If you want to learn more about the SECURE Act, see this deep dive and/or this great Twitter thread.

How Do We Preserve the Vanishing Foods of the Earth? (Literary Hub): Hard to summarize this succinctly; it’s a book excerpt that’s well worth the read. Among the threads snaking through this piece are: the declining biodiversity of foods in the world; the struggle to bring new and flavorful versions of fruits to commercial success; and the search for the origin of what we know today as the apple.

What Internet Search Patterns Can Teach Us About Coping (The MIT Press Reader): Analyzing the searches of patients recently diagnosed with cancer (and the people around them in their life) shows the stages of grief in action, and points to the different resources required in different situations.

Three Theories for Why You Have No Time (The Atlantic): A great reminder that even with amazing technologies that save us lots of time, we’re always going to be just as busy. The theories are interesting and perhaps one will appeal to you more than the others, but the major point is to reframe time-related goals away from “have more free time” towards just using the time you have the way you want to.

The new dot com bubble is here: it’s called online advertising (The Correspondent): Moving past the hyperbolic title, this was a very interesting (if lengthy) read that made me rethink the assumptions I tend to make about the effectiveness of online advertising.

How Gen X, millennials and Gen Z became the low-inflation generations (Washington Post): A tribute to Paul Volcker, who passed away December 8, 2019, and the job he did slaying the inflation dragon. It is an amazing gift to many generations that they haven’t experienced or even had to think about inflation, but it is wise to both remember how bad it got for a decade, and to not take the current inflation regime for granted.

Three Big Things: The Most Important Forces Shaping the World (Collaborative Fund): “Nothing is as influential as World War II has been. But there are a few other Big Things worth paying attention to, because they’re the root influencer of so many other topics. The three big ones that stick out are demographics, inequality, and access to information.”

The Key Macro and Equity Themes Of The Last Decade In Ten Charts (Koyfin): The title says it all; ignore the noise of what’s happened in the last month or quarter or year, and look at what the past decade has seen in the investing world. In particular it’s interesting to look at the 20 largest companies from 2010 and see where they are today – it’s likely that some of the behemoths we see entering 2020 are going to decline significantly by 2030.

The Dumb (Timing) Luck of Smart Beta (Newfound): Most major equity benchmarks are rebalanced once or twice a year. Timing luck alone may contribute between 1% and 4% of performance difference *per year*, meaning it’s very hard to evaluate whether a strategy is truly effective versus its benchmark.

When Frugality Bottoms Out (The Simple Dollar): There are diminishing returns once you’ve made a decent number of frugal changes to your lifestyle. Focusing instead on maximizing the total utility of your money, time, and energy gives you new areas for meaningful improvements to your lifestyle while allowing you to find the balance that’s right for you. Another great post on the same blog deals with the feeling that you’re not making progress towards your financial goals, since the time horizons are often long-term.

Escape the Fee Prison Now (Of Dollars and Data): Often people have annuities in their retirement plans and either don’t know about it or don’t want it. This is particularly true in 403(b) plans for non-profit and government employees (many teachers, nurses and others fall under these plans). This piece looks at the killer fees associated with annuities in retirement plans and shows why it often makes sense to pay the surrender fee and get out now.

This quarter, I found myself thinking a lot about why we allocate investments between stocks, bonds, etc, the way we do, and I kept coming back to the concept of human capital. We all get one shot to convert our human capital into ownership of other assets so that we grow our wealth for the long term.

A normal step in the financial planning process is to look at a balance sheet to determine one’s net worth – the difference between all of your assets (bank accounts, car, house, etc) minus your liabilities (student loans, mortgages, etc). Additionally, a major conversation topic is how your investments are allocated; for example, what proportion of your retirement account is in stocks vs bonds vs other things.

However, there is one major item that does not get addressed in either place, yet which is incredibly important in both interpreting your net worth and helping determine an appropriate investment allocation. This vital, invisible and unquantified asset is often referred to as your “human capital”.

You are born with human capital, and it is the only asset you start with. The essence of your human capital is your ability to convert time and energy into money, but for an indefinite and ever-shortening period of time. (For the purposes of this discussion, I’m going to ignore inheritances, lottery winnings, and other things that are essentially deus ex machina devices.)

We convert our human capital into money in the pursuit of two general goals: #1) to reach the point where we are financially independent, or able to spend our time in whatever way we choose, and #2) to live an acceptable life along the way to that independence. #1 means a different thing to almost everyone, despite the common label that I’ll use for shorthand going forward: retirement. #2 has an even more infinite set of definitions; I’ll use the term “daily life”, but it includes all the other goals along the way: living in some sort of structure, providing food and maybe an education for our children, having an automobile for our convenience, a “phone” that we use for anything but making calls, etc.

We control the beginning of our working life – the period over which we convert human capital into dollars – but often have less control than we might like over how it ends. Age, disability, the usefulness of our skills, competing life priorities and a myriad other factors combine to deplete our human capital to the point that it is no longer possible or desirable to convert any more of it.

We spend many years while we are young increasing the total value of our human capital by going to school and learning new skills (even while the time we take in doing so reduces the quantity of our human capital). The costs along the way – often captured on the balance sheet as student loans- can be a huge barrier, but hopefully increase the value of our human capital enough that we can pay back those costs and still accomplish our primary uses for money: daily life and retirement.

To retire we have to own enough assets to cover our expenses without the need to convert more human capital into money. For the purposes of this discussion, we will classify assets as either capital or non-capital assets.

Non-capital assets include cash (money in the bank), pensions (i.e. Social Security), annuities, and other income streams; they all count as assets when building wealth towards the goal of retirement, but have serious limitations. Since non-capital assets don’t increase in value, we can be at risk of having our lifestyle eroded by inflation, and non-capital assets do not grow on their own during our working life (making it harder to amass the assets needed to retire). Bonds fall into this category as well; a bond is basically a loan and while it can increase or decrease in value, the bondholder owns nothing but cash once the loan is paid off.

Given the limitations of non-capital assets, it makes sense to accumulate capital assets in order to grow our wealth towards the goal of reaching retirement. Capital assets (or just “capital”) involve owning things that can reasonably be expected to increase in value at a faster rate than inflation. Examples of capital include: stock (ownership of a company), real estate, your own small business, intellectual property, etc.

To put it bluntly: this is a capitalist society, so if you don’t convert your human capital into capital assets, you’re not in control of your own destiny.

So why, you ask, have I waxed philosophical here about human capital? Most of what I just talked through is intuitively included in our analysis of the future. A young professional who has just finished graduate school but took out loans to pay for it knows that her earning potential is higher, and so she expects the graph of her net worth graph to go from a downhill slope to looking like a V. In her case the point-in-time balance sheet (assets vs liabilities) is a wildly incomplete picture of her finances. However, things become more cloudy for someone who is older, or perhaps didn’t increase his earning potential as much as he hoped relative to the education cost he incurred. Using the terms defined above help us think through the full picture in less clear-cut situations.

A more actionable take-away than how to interpret someone’s balance sheet is how to consider the mix of investments that may be appropriate for them. This does not address an individual’s risk tolerance – a completely separate conversation that revolves around someone’s behavioral ability to deal with investment uncertainty and volatility or market crashes. This instead looks at the types of assets a person has to make sure there is a diversified mix across their net worth – and it is highly dependent on their exact circumstances.

Consider our young professional above; she has an advanced degree, reasonably high earning power and likely a long period of time left in her working life; in short, she has a large amount of human capital. But her retirement account has next to nothing in it; she owns zero capital assets. Looking at her human capital as a non-guaranteed stream of cash flows, the question of what mix of stocks and bonds diversifies that asset would lean towards stocks. Bonds do have the advantage of being guaranteed cash flows, but stocks (or real estate) have the larger long-term expected growth in value and are literally ownership of something besides herself. (And yes, to a small degree this entire ramble can be boiled down to “buy stocks when you’re young”.)

In contrast, the young founder of a start-up who pays himself only a very small salary but owns the vast majority of his growing company has a very different profile. He already has ownership of an intangible asset, and so real estate (a tangible asset) or bonds (ownership of future cash payments) are the most dissimilar assets to what he already has. Further, he has a long-term need to diversify his capital holdings; while he owns a large amount of stock it is concentrated in a single venture, so purchasing stock index funds over time would help spread his risk over multiple companies.

For those later in their careers, with less human capital, a more even mix of capital assets with income-producing assets may be appropriate. Eliminating growth possibilities from a portfolio may increase the risk of outliving their money, but with fewer paychecks in their future it also makes sense to not be completely invested in capital assets. A major caveat here would be someone with a large number of pension, annuity or other guaranteed payments; these won’t grow in value, but do produce income, meaning there may be room for more capital assets in their portfolio.

Every situation is different, which is why having a framework for considering different options is vastly preferable to having a cookie-cutter set of recommendations based on a single factor (which is usually age).

Consciously consider your human capital when thinking about your current financial situation and how diversified your assets actually are; otherwise you’re missing a key part of the picture.