Tom’s Quarterly Reads

Here is what I’ve been thinking about, plus the best articles I read over the past three months, mostly all finance-related. Your feedback is always welcome, and please share this with anyone else who might be interested. Subscribe here.

Save Like A Pessimist, Invest Like An Optimist (Collaborative Fund): 2020 has, if nothing else, highlighted the need to have a sufficient emergency fund in place. But we all need to embrace the cognitive dissonance of maintaining today’s buffer while not passing up the opportunity to invest for the future.

As an advisor, I spend time giving people recommendations about their investments and in many other areas of their personal finances. In the interest of transparency, I want to provide a view in the other direction and talk about how my wife and I manage our own finances. This is quite a long piece, and may not appeal to everyone – if you want to skip down to the rest of the articles, be my guest. Nothing here is meant as a recommendation for how anyone else should do things; every situation is different, and what works (or has failed) for me may not be a fit for someone else.

The premise here is completely unoriginal; many advisors and financial professionals who have written similar pieces of late. I’d encourage you to read as many as you can, since each provides a different perspective. In particular you can read posts by Ryan Frailich (another advisor based in New Orleans), Peter Lazaroff, and finally Josh Brown, who turned his post into a book of the same name by collecting a wide array of other professionals’ stories.

Privilege and Luck

Before discussing our current situation, I am compelled to admit that privilege and luck as an upper-middle class white male in the United States have played an outsized role in where our finances are today. Growing up I was extremely fortunate that I never had to worry about money. I learned about saving and investing relatively young, and am privileged to have had a Roth IRA since before I went to college. The fantastic public schools I attended were due to my parents’ ability to choose a strong school district, which subsequently got me into a good college and put me in a position to graduate without student debt, and so on.

All of that background is essential to understanding my financial outlook, which is dominated by a very long-term view coupled with a high level of risk tolerance. Our situation, as I sketch out below, if a very fortunate one. But I didn’t create that through what I’m doing today – hence none of this is a prescription for anyone else to follow.

Cash

About 5% of our net worth is in cash; this provides operating funds in our checking account and an emergency fund in our savings account. I tend to view the cash in these accounts in terms of water levels. The checking account always has enough cash to cycle through a normal month without any worry that the water level will bottom out, leaving everything high and dry. When we have a major purchase, we move cash into the checking account from savings (not from the emergency fund) to pay for the purchase and move on.

The emergency fund is just that – for emergencies, like a loss of income or sudden medical expense. An emergency fund is not a cash reserve for great investment opportunities, nor is it a vacation fund. I generally aim to have 3 months’ worth of expenses in the emergency fund, but we will probably increase this a bit over the next year as my wife moves to the end of her training pipeline.

All of our expenses are automated, and the vast majority go on a credit card that provides 2% cash back. We try to keep things as simple as possible when it comes to bills and to credit card rewards. I also have an HSA with a small balance that used to be invested, but that moved to all cash when we entered a period of potentially higher medical expenses.

Housing

We currently rent, and have done so for the past 8+ years. And I’m completely fine with that; in that time, we’ve lived in 4 different apartments/homes (in six months that will increase to 5), and never had any measure of certainty about geography due to our careers. So long as there’s a decent likelihood that we will move within 3 years, I’m usually against buying a house because of the transaction costs on each end, the potential for very high maintenance costs, and the extremely concentrated bet on the value of the property.

To parse words (a favorite activity of mine), I believe there’s a large difference between a) an investment property and b) a home. We own an investment property that I bought during my time in the military, which accounts for roughly 20% of our net worth. As an investment property, I evaluate it based on the numbers alone, and we’ll keep it so long as the Excel spreadsheet say it makes sense.

A home, on the other hand, involves emotional attachment and provides a place for our family to live and grow. If we find someplace to settle in the next few years, we will likely buy a home. The purchase price and ongoing mortgage payment have to make sense in the larger scheme of our finances, but the primary criteria will be finding the right place for us to live.

My Business

I started my business just over three years ago, and the place it occupies in our finances shares some characteristics with a home. While it does provide my income, it also provides me with flexibility (as the worker) and control (as the business owner) – enormously valuable qualitative factors, as 2020 demonstrated time and again.

Investments

Our investment accounts consist of two taxable brokerage accounts and two Roth IRAs – one for each of us. These accounts are evenly spread between Fidelity and Schwab since they are large investment firms that provide cheap and plentiful investment options. Finding a brokerage firm that doesn’t charge commissions and offers very low-cost index funds is an absolute necessity in my opinion.

We also have a 529 college savings account for our 2-year-old daughter, but it is not well-funded. This will (hopefully) increase as our incomes do over the next 5 years, but it is a few steps down the priority list. Going forward, I will create a business retirement account in the next year or so (as my business grows), and if my wife finds a job where there is an employer match for 401(k) or 403(b) contributions, that will be a priority to set up as well. Both of those changes will once again automate our retirement savings, which will be a significant improvement.

We focus on funding our Roth IRAs first each year because I’m confident – although not at all certain – that tax rates will be the same, or higher, three or more decades from now when we tap our retirement accounts. And given our current low tax bracket, it makes all the sense in the world to utilize Roth accounts as much as we can. As a result of focusing on Roth contributions (and opting for Roth 401(k) contributions when I worked in the corporate world, plus the long time my Roth IRA has been open, our Roth IRAs are a little over 50% of our net worth.

So, how do I actually invest the money we have saved? My focus is on choosing the asset classes (large US stocks, emerging market stocks, US Treasury bonds, real estate, etc.) to invest in, writing down the target asset allocation, and then sticking to those targets. I utilize cheap index funds for almost every investment in order to invest in a diversified mix of assets and take what the market will give me over the long term. We own zero individual stocks; I am not and have never been a stock-picker.

While the mix of investments is diversified, it is also very aggressive. Across the Roth IRAs and brokerage accounts, we own zero bonds or bond funds. An all-stock portfolio can be very volatile, and not something that works for everyone. Since time horizons drive how I look at investments, the lack of any short-term need for the money we have invested means I could take a very long-term view amid the carnage in early 2020. Of course, over time our goals will evolve and if the time horizon for our non-retirement money changes, then the way it is invested will also change accordingly.

Finally, I also have a steam valve account, which is a small pot of money (less than 5% of investments) that sits outside the rule-based investments for our larger portfolio. Having a small account to play with makes it more likely that I’ll leave the rest of our investments alone so they can do their long-term-growth thing. Not everyone needs or wants this sort of arrangement, and how often someone trades is completely individual. Personally, day trading holds no appeal; I made a grand total of two moves in 2020, and don’t have any plans to make another move anytime soon.

Conclusion

I cannot recommend anyone take what I’ve written here and blindly follow it as some sort of recipe for success. Everyone manages their finances differently, and that’s how it should be. The key is to find a system that works for you – then automate everything you can, and write down rules for the portions that you can’t automate.

Coronavirus Stimulus 2.0 (Kitces): This is still a moving target given the ongoing political battles over stimulus payments and other items, but this can’t be beat for a detailed overview of the new stimulus bill. The size of stimulus payments may increase from $600 to $2,000, but details on the mechanics of getting they payments can be found on the IRS website.

Biden’s Tax Plan (Lexology): The most concise, yet detailed, overview of the Biden tax plan that I’ve seen so far. The section on individual taxes is below the business tax items. Alternatively, if you like pictures here’s a chart showing current and proposed tax brackets, which comes from a much lengthier piece on the proposals and planning implications.

What I Learned From Reading Over A Thousand Letters To Santa (Defector): A gut-wrenching piece that looks at letters to Santa in 2020. Well worth your time (by all rights it should be the “Just Read This” article), but consider grabbing a tissue first.

Asset Destruction (Blair Belle Curve): Blair’s takedown of sales pitches for life insurance products is fantastic. There is no one-size-fits-all rule, but I completely agree with her view that a term life insurance policy is all that most people need.

Fidelity Charitable Ends DAF Account Minimums (ThinkAdvisor): Just as the cost of trading has recently dropped across the major brokerage firms, so has the minimum needed to open a charitable investment account. Fidelity, Schwab and others have reduced the initial deposit needed to open a Donor Advised Fund, or DAF, creating a very interesting opportunity for charitably-inclined investors who don’t have $5,000 just sitting around. DAFs are very interesting accounts that enable current tax benefits while keeping open your options to grow the money and choose exactly where to donate it later on.

OTC Markets Group Welcomes the Bitwise 10 Crypto Index Fund (BITW) to OTCQX (Yahoo): There is now a tradeable ETF that provides exposure to cryptocurrencies. However, among the myriad things to understand before buying such a product is the massive gap between NAV and actual trading price; as of December 28, 2020 a share the ETF cost more than three times the actual value of the underlying assets.

The Wages of Fear (Convexity Maven): “The high-end for a COVID relief package is tagged at $3Tn, and the notion of forgiving all college debt would cost $1.68Tn. But this is my bar bill at the club compared to the funding gap to support Social Security.”

The Sharpe Ratio Broke Investors’ Brains (Institutional Investor): “Most practitioners fail to understand that the Sharpe ratio is intended for one’s whole portfolio… Looking at the individual Sharpe ratios of managers or investments inside a portfolio doesn’t make sense.”

Investing in the Intangible Economy (Sparkline Capital): “The rise of the intangible economy has changed the rules of investing. Intangible assets comprise almost half of the capital stock and their importance grows steadily each year. Their omission from financial statements distorts our perception of value at the levels of market, country, industry and company.”

Coming Into Focus (Howard Marks): “In my view, the low interest rates represent the dominant characteristic of the current financial environment, creating the dominant consideration for investors: the lowest prospective returns in history.”

Tom’s Quarterly Reads

Here is what I’ve been thinking about, plus the best articles I read over the past three months, mostly all finance-related. Your feedback is always welcome, and please share this with anyone else who might be interested. Subscribe here.

How Much Lifestyle Creep is Okay? (Of Dollars and Data): “I believe that some lifestyle creep can be very satisfying. After all, what’s the point of working so hard if you can’t enjoy the fruits of your labor? But … there is a limit to how far your lifestyle can “creep” before you start affecting your financial future.”

Now seems to be a good time to invoke Rudyard Kipling: “Oh, politics is politics, and investing is investing, and never the twain shall meet in my financial decision-making.” Or maybe that was from Dr. Seuss; I was never very good in English class. But the point stands: never let your political views impact your investment decisions.

Studies have shown that political views do impact financial decisions, and this applies to all of us. (If you think it doesn’t consider starting here and coming back later.) Further, Kempf and Tsoutsoura found that “The effect is more pronounced in periods of high partisan conflict and for [those] who vote frequently.”

Humans are bad at forecasting in general, but possibly one of the most interesting and relevant biases is that we’re bad at predicting futures we don’t want to see happen. And when we’re proven wrong, we tend to look for proof that the evidence is wrong instead of changing our views.

Having a diversified investment portfolio is a goal at any time, but it makes even more sense to have a well-constructed portfolio in place before the election, because having that structure in place gives you more confidence to ride out whatever might happen in the markets. If you don’t have a plan, it’s much easier to succumb to the emotions and fears that short-term news can provoke. And what if the results of the election are contested one way or the other? It’s a sample size of one, but the last time election results were contested, the market did nothing other than follow the general trend it was already on. (Tip of the cap to Blaire, who is another fantastic advisor in New Orleans.) Have a plan, and stick to it.

And regardless of which side of the aisle you sit on, or if you’re standing in the aisle, or if you’ve stood up and walked outside, keep these two tips in mind:

1. Don’t assume you know what political outcome will occur – and be most wary if you project the outcome you want.
2. Definitely don’t assume you know how markets will react to your projected outcome.

And yes, this has largely been a rehash of something I wrote almost two years ago – but it bears repitition.

3 keys to building an emergency fund (Vanguard): An emergency fund is key to weathering financial storms without having to rely on any outside agency. This article makes an interesting distinction between income shocks and spending shocks when considering how best to prepare for emergencies.

The Economics of Homeownership (Animal Spirits): A good podcast that those who own a house, or are considering owning one, should listen to.

What’s The Best Investing Advice Parents Can Give Teenagers? (Tony Isola): “Explain the concept of compound interest and help them open up a Roth IRA. It’s that simple.”

Alternative Forms of Wealth (Collaborative Fund): Finding ways to define wealth outside of the strictly monetary arena are important. Two of my favorite from this list:

• You have enough time to prioritize eight hours of sleep with stress levels low enough to allow sleep.
• You can say, “I have no idea” when you have no idea.

Two other ways to think about wealth I saw recently are never having to spend time with a-holes and MJ saying no to an easy $100 million. (The MJ article headline overlooks the name and image rights that the money is really paying for, but we all have a price on our time, endorsement and reputation.)

Americans Stayed Inside Even as Cities and States Reopened (Bloomberg): The article is interesting in general, but what I found particularly striking – if also unsurprising – was the chart showing a strong correlation between income and working from home.

Structural Diversification for All Seasons (Invest Resolve): This article as a whole goes under the category of “investing deep dives”, but the idea that the general economic situation at a given moment can be classified into regimes based on economic growth and inflation s an important one. Further, once you decide what economic regime we are currently in, there are particular investment assets that tend to perform best in that regime.

How To Win $1,000,000 (Trace Wealth Advisors): “If I asked you to construct a portfolio that would automatically underperform an index, there’s no guarantee that you could do it. This is the simplest explanation for the presence of luck in investing.”

What Risk Isn’t (Of Dollars and Data): In investing, the terms risk and volatility are often used interchangeably. However, I’m in agreement with this article in looking at those as two different things: volatility is the value of investments jumping up and down, while risk is the probability of not achieving your goals.

5 Thoughts on a World with No Yield (A Wealth of Common Sense): Interest rates are extremely low, and could remain that way for a long time. Some good food for thought here on what that means.

Public to Private Equity in the United States: A Long-Term Look (Morgan Stanley): An extremely detailed piece that looks at public markets (stocks you trade at a brokerage like Apple) and private markets (venture capital, etc). Understanding the difference and what drives private market returns is particularly critical as private equity funds slowly enter workplace retirement plans like 401(k)s.

Wall Street’s Crypto Cold War (Institutional Investor): Large financial institutions have been wary of cryptocurrencies, but some seem to be warming up to the idea. Key drivers of this shift appear to be the growing familiarity with cryptocurrencies, plus investors of all types seeing the promise of huge investment returns. What remains unclear is the impact of large institutions entering the space, where they will throw large amounts of money around but also call increased attention to the assets – luring more dollars but also raising the levels of public and regulatory scrutiny.

Tom’s Quarterly Reads

Here is what I’ve been thinking about, plus the best articles I read over the past three months, mostly all finance-related. Your feedback is always welcome, and please share this with anyone else who might be interested. Subscribe here.

How Big is the Racial Wealth Gap? (Of Dollars and Data): “The actual wealth gap between a typical Black household and a typical White household is a factor of 10. We shouldn’t have to adjust for education or income to explain it away. This, in itself, is defeat. Instead, we should ask ourselves why there is a massive gap in education and income between Black households and White households in the first place. This is where we must start.”

Everyone has something they enjoy doing with their money. In fact, the purpose of having a financial plan is so that there is money available to be spend of something that you get enjoyment out of. But structuring your accounts and decision-making process is essential to enjoying yourself while not impacting your larger financial life.

Structure on a day-to-day level is the difference between paying for each drink at the bar with cash versus having an open tab that you might run up too fast. Structure on a longer-term level is having your 401(k) contributions taken out of your paycheck before the money even comes to your bank account.

So find where you want to play, and then build what I like to refer to as a sandbox. I like this analogy because it’s where you can let your inhibitions go and truly enjoy yourself. But most importantly, as long as the sandbox is built correctly, whatever you do inside the sandbox doesn’t matter – the sand can be re-leveled and you’ve done no lasting damage to your financial future.

A specific example of this sandbox idea involves those who like to play in the stock market. This is a conversation I’ve had with quite a number of people so far this year, and it’s very timely with the recent focus on day-trading in general, and Robinhood in particular, in financial media. While playing around in the stock market certainly doesn’t appeal to everyone, the concept of structuring things so you can play without doing damage applies to all of us in one way or another.

Similar to going out for a nice dinner, or playing in a fantasy football league with a buy-in, those that enjoy making moves in the market get enjoyment from more than one source. There is enjoyment in researching all of the restaurant options, or players available, or stocks that might perform well. There is the enjoyment of the food itself, watching your fantasy players perform well after you put them in your line-up, and watching the stocks you picked go up and up. And then there are the bragging rights, which we all love: posting a picture of your meal on social media, talking trash to the team you played against in the fantasy league, and bragging at parties about the awesome stocks you picked.

In all of these cases, the money spent, or deposited up front, is the cost of enjoying the process; on a budget, these expenses would all be best categorized under “Entertainment”. None of these is a question of “or”, but rather of “and”. You don’t choose between nice dinners out or a nice retirement; you want to figure out how to do both. It usually makes sense to avoid eating at a Michelin-starred restaurants every night of the week. And I don’t put up a house as my fantasy league buy-in. If someone gets enjoyment from taking chances in the market, we want to set up a way to do that and to maintain a long-term investment plan.

My approach to building an investing sandbox is to create what I call a “steam valve” account. It is a small amount of money (in percentage terms), usually in a separate account, that can be invested however you see fit. The advantage of the steam valve account it that it provides an outlet to make moves and feel like you’re doing something when the market is making big moves up or down, so that you leave the vast majority of your portfolio on autopilot.

The steam valve sits alongside a large, well-diversified, long-term investment portfolio that properly takes your risk tolerance and risk capacity into account. How small is the account? Optimally it’s no more than 5% of your portfolio; small enough that if it goes to zero it won’t hurt your long-term financial situation.

To be clear, I don’t want your steam valve account to go to zero. In fact, I’d love to hear about how well it’s doing and what smart stock picks you made. But the key is to never depend on the steam valve account to provide the funding for any of your goals. Given that the investment approach is likely to be on the much riskier side of things, you wouldn’t want to put your financial plan at risk of a sudden market drop or bad decision. But if the account grows immensely, and some funds can be pulled out to spend more that you planned, then that’s just the cherry on top.

Given that the steam valve is often an entirely separate account – to reduce the temptation to mix up funds that have different purposes – you can put that wherever you’d like. And a cheap way to set up a small trading account these days is Robinhood. To be clear, I’m not specifically in favor of using the app; it’s designed to get your adrenaline going and increase your trading speed, which leaves less time for considered investment decisions. But many of the macro concerns about Robinhood – that it has been manipulating the market, that trading costs are exorbitant, that they are selling order flow, etc – are probably overblown (the story does a good job of looking at some Robinhood myths and concrete examples of the costs of trading with them). But, if you’re going to use Robinhood, then you certainly should understand exactly how Robinhood makes money, And more importantly understand the stocks that you’re buying and selling – particularly if you get into options trading. Understanding what you own makes it more likely you’ll stick with the position through a temporary rough patch, and it can help avoid shockingly sad stories.

But no matter what platform you use to trade, the idea is the same: put a structure in place so that you don’t impair your long-term finances.

No matter what you like to do with your money, build a sandbox so you can play in the way that’s most enjoyable for you.

It’s OK to Spend Your Savings (She Picks Up Pennies): Your emergency fund is for emergencies. A night out with friends (remember those?) isn’t an emergency. Don’t use your emergency fund for that. A pandemic is an emergency. Use your emergency fund for that.

Who Pays For This? (Collaborative Fund): Government spending for Covid-related relief has been massive; so how do we pay for it? Possibly taxes; here’s a VAT proposal. But from Morgan Housel’s perspective: “You don’t pay it off. You grow your way out of it. This isn’t intuitive because it doesn’t apply to people… because people have finite careers and lifespans, so there’s an “end date” where all debts have to be repaid. Countries (and to some extent companies) are different. They have indefinite lives.”.

The Worst Dilemma in Investing (Blair Belle Curve): Selling all of your stock and going to cash means you are presented with an impossible problem: when to buy again.

What Prior Market Crashes Can Teach Us About Navigating the Current One (Morningstar): A comprehensive look at market crashes over the last 150 years, with charts for visual people like me.

Stock Market’s Wild Mood Swings Can Be Explained by Mr. Spock (Bloomberg): Not as inane of an article asthe headline suggests. Why does the stock market seem to be moving completely opposite the direction of the economy as a whole? The stock market is both rational and irrational; it is both efficient and inefficient. We understand less than we think.

Market Update X: A Corporate Life Cycle Perspective (Aswath Damodaran): “It should therefore come as no surprise that just as the virus has had its most deadly effects on the elderly and the infirm, the market is meting out its biggest punishment to mature and aging companies.”

Debate: Should Advisors Have Taken PPP Loans? (Barron’s): An interesting question in the advising community, but very relevant for clients to consider, especially since taking PPP loans will likely have to be disclosed on regulatory filings going forward. I did not take out a PPP loan, or even apply for one. However, that doesn’t make me better or worse than advisors or other business owners who did take the PPP loans – it just means we were in different situations.

Farewell Yield (Humble Dollar): Could this rough of interest rate drops means the end of safe yields in bonds? While rates may not stay low forever, it makes sense to readjust our savings, and revisit how our investment expectations compare with the loans we’re currently paying down.

A Look at the Mushrooming Menu of Thematic Funds (Morningstar): Marketing is everything; the company that puts together an ETF makes money from more people buying the ETF. Always know what you are buying and specifically what it’s investing in – don’t let a fund name lure you in. Also worth noting that a new breed of less-transparent ETFs is entering the market as well.

Vatican calls on Catholics to divest from fossil fuels (CNN): This one got an audible whistle from me. In ‘Laudato Si’, Pope Francis said “Building safe, accessible, reliable and efficient energy systems based on renewable energy sources would make it possible to respond to the needs of the poorest populations and at the same time limit global warming,” and among other topics it also included support for a carbon emissions tax.

DOL Gives Green Light for Private Equity in 401(k)s (ThinkAdvisor): This approval lets 401(k) plans include multi-asset funds that have private equity holdings – very different from allowing funds that are solely private equity, but seems like a step in that direction. As always, understand what you are buying.

A Thrift Savings Plan Update (Morningstar): More positive changes to TSP that were long overdue; the L Funds (lifecycle, or target-date funds) are moving much closer to industry averages and best practices. Good to see continuing changes; TSP has improved immensely in the last 10-15 years.

When poignant stories outweigh cold hard facts (ScienceDirect): Academic paper that finds “anecdotal evidence to be more persuasive than statistical evidence when emotional engagement is high, as when issues involve a severe threat, health, or oneself.” Seems like something we should all keep in mind these days.

Nearly Half of Men Say They Do Most of the Home Schooling. 3 Percent of Women Agree (NY Times): I’m shocked, shocked. Had to include this since we could all use a good laugh. (My money is not on the guys here.)

The Price of Isolation (Rolling Stone): “A study of the 2003 SARS epidemic — localized though it was — found that ‘quarantined persons … exhibited a high prevalence of psychological distress,’ with PTSD observed in almost 30 percent of cases. The longer someone was isolated, the greater their chance of developing PTSD grew.”

The Coming Disruption (New York Magazine): While it should be noted that the guy making the predictions in this article has founded his own virtual classroom start-up, it is certainly interesting to try and see what the future of higher education will look like. An interesting vision: “There will be a dip, the mother of all V’s, among the top-50 universities, where the revenues are hit in the short run and then technology will expand their enrollments and they will come back stronger. In ten years, it’s feasible to think that MIT doesn’t welcome 1,000 freshmen to campus; it welcomes 10,000. What that means is the top-20 universities globally are going to become even stronger. What it also means is that universities Nos. 20 to 50 are fine. But Nos. 50 to 1,000 go out of business or become a shadow of themselves.”

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. 

Your feedback is always welcome, and please share this with anyone else who might be interested. Subscribe here!

Analyzing The CARES Act: From Rebate Checks To Small Business Relief For The Coronavirus Pandemic (Kitces): The recently passed CARES Act has many different features, and this helps break them down depending on what is relevant to you. For a quick summary, see this graphic.

Use the terms below to find relevant topics in the article. Are you:

• An American human? “Recovery Rebates”
• Paying back student loans? “Relief For Student Loan Borrowers”
• A business owner? “Paycheck Protection Program And Forgivable Loans”
• Facing unemployment? “Unemployment Compensation Benefits”
• Facing RMDs? “Required Minimum Distributions Are Waived In 2020”

Small business owners in particular should review this, with special attention to the Paycheck Protection Program, Deferral of Payroll Taxes, and the Employee Retention Credit. See this article for more specifics on getting cash for your small business.

It’s impossible to avoid the topic of Covid-19 this quarter, despite my contrarian nature’s push for me to ignore it in this space. I’ve also moved this section up in the newsletter; last quarter I talked about the relationship between human capital and your asset allocation, but hid it at the bottom. Please feel free to skip down to the article links below if you haven’t already.

As the Covid-19 pandemic spread across the world, the initial market panic was a bit different from past crises; everything went downhill together. Further, the volatility in the market – all those days with huge losses and huge gains mixed together – was essentially identical to the Great Depression. The numbers and data points trying to quantify the impact have boggled the mind, and will continue to do so. As others have done, I’ll quote Lenin: “There are decades where nothing happens; and there are weeks where decades happen.”

Through all of this, I remain optimistic even though the impacts of this pandemic have been massive – and will likely be more persistent than I initially supposed. Supply chains will be disrupted or broken. Personal liberty and the greater good will continue to wrestle. But a combination of human perserverence and science will eventually win out. After all, good news and bad news can coexist.

There’s been a bit of a recovery in the market recently; are we currently seeing a dead cat bounce, or have we already seen the bottom? I have no idea. No one does. Investing is pain; anyone who says differently is selling something.

But what do we actually do during this crazy time? Everyone gets to play their own version of March Madness: just survive and advance. Track your income and spending. Identify sources of liquidity (cash) in case you need it. Try not to sabatoge your long-term goals; stick to the investment plan you laid out before the pandemic broke out. For some perspective: the S&P 500 is down only 10% from a year ago. And it’s almost unchanged from January 9th of last year (yes, I cherry-picked that date). Remember: the stock market and the economy are two different, albeit related, things.

This is a time for personal finance basics. Keep things simple. But simple doesn’t necessarily mean easy.

7 Reasons Why Video Gaming Will Take Over (Matthew Ball): Video games have already taken over; we just don’t fully realize it yet – and this was published before we all had to start social distancing. One of many great nuggets in here: “Pokémon has now generated more revenue than any other franchise, including Marvel, Star Wars and Mickey Mouse”.

How to Fake a Traffic Jam on Google Maps (Vice): “By pulling 99 phones down empty streets, artist Simon Weckert made it look like they were gridlocked on Google Maps.” We certainly are all morphing into cyborgs; I rely extremely heavily on my phone to tell me what the traffic or the weather is, and I react accordingly. This also seems – to me – to push the boundary of what can be defined as ‘art’.

Do you sometimes feel like a fraud? (The Economist): A little impostor syndrome might be good: “We want successful people to have both enough self-awareness and enough self-doubt to question what they are doing and why…. the more expert you become in a field, the stronger your feeling of impostorism.” (Side note: when this came out in January, the use of “epidemic” in the article didn’t seem as strange.)

An elegy for cash: the technology we might never replace (Technology Review): In 2006, cash accounted for 64% of the total value of transactions in Japan. By 2016, it was only 23%. This takes a privacy-centered look at the disappearance of cash transactions.

The End of the Beginning (Stratechery): “The beginning era of technology, where new challengers were started every year, has come to an end; however, that does not mean the impact of technology is somehow diminished: it in fact means the impact is only getting started…. That is exactly what happened with the automobile: its existence stopped being interesting in its own right, while the implications of its existence changed everything.”

One Portfolio Risk to Rule Them All (Movement Capital): First and foremost, I’m a sucker for a Lord of the Rings-themed article. Secondly, it’s very important for savers and investors to understand the concept of sequence risk. The current market downturn illustrates just how important managing sequence risk is for all ages, but particularly for those nearing retirement.

Centuries of interest rate data (mrzepczynski): The increasing prevalence of negative real interest rates may not be all that abnormal; it may be the natural continuation of a multi-century trend (really interesting charts here). What may be abnormal is how wildly interest rates have fluctuated over the last 100 years. But at the very least, don’t use trends over the last decade or two when extrapolating interest rates; it’s far too short a timeframe.

Does Personal Finance Still Work in Our Changing Economy? (New York Times): Rules of thumb in personal finance are a good place to start (as opposed to winging it), but they are not iron-clad guarantees of success. Understanding you situation and then tailoring your approach to best fit that situation is the best way to move you towards financial goals.

Selecting Income-Driven Repayment (IDR) Plans To Manage Student Loan Obligations (Kitces): A guide to IDR plans for those with student loans. The author, Ryan Frailich, is another phenomenal financial advisor located in New Orleans.

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.