Archives for December 2011

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Investing Blog Roundup: CPA News and Happy New Year

As of this last week, I’m officially a Missouri Licensed CPA. The licensing process took me somewhat longer than normal (just over 3 months since learning I passed my final exam) because we lived in Illinois when I started taking the exam, so I was an Illinois CPA candidate — which meant I had to become an Illinois CPA first, then apply to become a Missouri CPA via reciprocity.

The only change you should notice around here is that, in order to comply with the requirements of Treasury Department Circular 230, my blog posts (and tax-related emails) will now contain a lovely disclosure at the bottom, essentially stating that you can’t use any tax advice contained here on the blog to cheat on your taxes.

In any case, thanks to everybody who cheered me along through the process, and Happy New Year to all of you. 🙂

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More on Switching to Vanguard’s LifeStrategy Growth Fund

Last Monday’s article caused a bit of a hullabaloo. Many readers were surprised to hear that my wife and I had elected to swap our old portfolio in exchange for Vanguard’s LifeStrategy Growth Fund. Today I wanted to take one more crack at explaining the reasoning and answer some related questions.

Why We Did It

If you look at the logo at the top of this site, you’ll notice that the site’s tagline is, “Simple, Low-Maintenance Investing.”

In short, the purpose of the change was to make our portfolio simpler and lower-maintenance — both of which I value for their own sake and for their assistance in preventing mistakes.

But I Am Not You

Some readers were (understandably) confused as to how to apply the article to their own portfolio. The truth is, I hadn’t really meant for anyone to do that.

The point of the article was simply to share a change that my wife and I had made and to explain our reasoning — because I know many readers find that sort of information interesting. There was no intention to suggest that you should be using an “all-in-one” fund for your own portfolio.

In other words, while I value a portfolio that is simple and low-maintenance, that doesn’t necessarily mean that you should. Perhaps you don’t mind rebalancing between several funds. And perhaps you are never tempted (as I am) to make changes that are likely influenced by recency bias.

Smart People Make Mistakes (Sometimes)

Some readers were surprised to hear me say that I worry that I’ll make a big investment mistake someday. To be clear, I’m not worried that I’ll suddenly pull everything out of our index funds and invest it in a single stock or anything along those lines. I’m far more worried about the smallish, performance-chasing, “tinkering” type of mistakes (which can add up over time).

Still, I’ve seen very smart, financially-educated people do some obviously-stupid things when it comes to their own money. This perplexes me. I do not have a satisfactory explanation for it. And I’m therefore reluctant to assume that I am — and always will be — totally immune to it. So anything I can do to automate success seems advantageous to me, especially when the cost is so little.

…which brings us to my next point:

Asset Allocation Is Not a Precise Tool

Some readers wanted to know why I was happy to change to an allocation other than the one I’d hand-selected before.

For reference, our old allocation was:

  • 40% Vanguard Total Stock Market Index Fund,
  • 40% Vanguard Total International Stock Index Fund,
  • 10% Vanguard REIT Index Fund, and
  • 10% Vanguard Intermediate-Term Treasury Fund.

But I would have been happy with any of several different bond funds for the bond allocation (e.g., Vanguard’s TIPS fund, their Short-Term Treasury fund, their Short-Term Federal fund, their Short-Term Bond Index fund, their Total Bond Market fund, or their Intermediate-Term Bond Index fund).

Similarly, I would have been happy without a specific allocation to overweight REITs. Or with an allocation to overweight small-cap/value stocks. Or with Vanguard’s Total World Stock Stock ETF for the entire stock portion of the portfolio.

You get the idea.

In other words, the LifeStrategy Growth Fund’s allocation is not the allocation I would have used if I’d been put in charge of building the LifeStrategy funds. I am, however, satisfied with it — as I would be satisfied with any of a hundred other allocations. (Note: This view that numerous different allocations would be acceptable is a part of what leads to my temptation to tinker.)

Asset allocation is not a particularly precise instrument, and I’m skeptical of attempts to treat it as such. (The only way to give it precision is to use specific assumptions about asset class returns — that they will look like historical returns, for instance. Of course, most assumptions we make will be wrong in one direction or the other.)

I Cannot Predict the Future

Other readers were puzzled about how I plan to use this fund — which doesn’t change its allocation at all — as a part of a long-term plan that shifts to become more conservative with age.

The first part of the answer is that I don’t expect to change our allocation any time soon. While I think rules of thumb like “have your age in bonds” can be useful as a starting point for planning, I certainly don’t think there’s any need to stick to them so rigidly that you move precisely 1% of your portfolio from stocks to bonds every year.

The second part of the answer is that, while I plan for our allocation to become more conservative as we move toward retirement, I don’t know the specifics. I can’t know them.

I can’t know, because:

  1. I don’t know what investment products will be available over the next few decades (e.g., will the Treasury continue to issue TIPS? Will insurance companies continue to offer inflation-adjusted lifetime annuities?), and
  2. I don’t know how our circumstances will change over the next few decades (e.g., what portion of our portfolio will be in taxable accounts as compared to retirement accounts?).

Without knowing those things, there’s no way I can say precisely what allocation I’ll want to use many years from now. I’m happy to say, “this is good enough for now, and I’ll reevaluate the decision as things change.”

Going on a Financial Media Fast

Last weekend, I read Carl Richards’ new book The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money. (Full disclosure: The publisher sent me a free copy.)

In case you aren’t familiar: Carl is a CFP who has become rather well known for his clever sharpie drawings explaining personal finance topics — you can see his full gallery here — and for his recent controversial New York Times article, “How a Financial Pro Lost His House.”

But the reason I’m mentioning the book has nothing to do with the sketches or with that article. Rather, I want to share a passage I enjoyed. In the chapter “Too Much Information,” Carl writes:

“Monitoring market moves, watching stock market shows on CNBC, and poring over financial forecasts takes a lot of time. Worse, it makes people anxious — and anxious people often screw up. […] Try going on a media fast. When thoughts about the markets arise, let them go. Go for a bike ride.

[…]

I know this may seem like a scary idea. And for the record, I don’t support sticking your head in the sand. I just think you need to balance your money anxieties with perspective.”

The suggestion to block out market news is the primary idea I was trying to communicate when I started this blog — hence the name and the logo.

Of course, in the three years since this blog was started, it’s branched out to cover a broader range of topics. But I still think the idea is a good one. I think most investors would benefit from scaling back their intake of financial news.

What do you think? Would you be willing to try it? How about a complete financial media fast between now and the beginning of next year?

(This blog will still be here when you get back.)

What’s In My Portfolio? (Updated)

Last week, my wife and I made a big change to our retirement portfolio — one that we’ve been discussing for a little over two months now.

Background: In September, Vanguard announced significant changes to their LifeStrategy funds (specifically, lower expense ratios and a change to fixed, all-indexed allocations). Those changes have now gone into effect.

The change my wife and I made was to move every dollar of our retirement savings over to Vanguard’s LifeStrategy Growth Fund. It’s now the only fund in our individual 401(k) and our IRAs — with the exception of a portion of my Roth, which, as mentioned before, is in Vanguard’s Short-Term Treasury fund because we use it as part of our emergency fund rather than as retirement savings.

For reference, the underlying allocation for Vanguard’s LifeStrategy Growth fund is as follows:

  • 56% Vanguard Total Stock Market Index Fund,
  • 24% Vanguard Total International Stock Index Fund, and
  • 20% Vanguard Total Bond Market II Index Fund.

Why We Made the Change

The primary reason we made the change was to defend against what I’ve come to see as the biggest threat to our investment success: me.

To be more specific, it’s my temptation to tinker that scares me.

Because of my work, I’m constantly reading about different investing strategies. Most, of course, are nonsense — nothing more than methods of using the stock and bond markets as a lottery. But there are still countless ways to invest that are reasonable.

And when I go to rebalance our portfolio, I’m often tempted to make little changes. Most such changes would probably be fairly benign, like the one we discussed here. But my fears are that:

  1. One day I’ll do something truly stupid, or
  2. I’ll bounce back and forth between reasonable allocations, but do so at exactly the wrong times (for instance, choosing to overweight small-cap and value stocks, then bailing out after a period of relative underperformance).

My hope is that this automatically-rebalanced, everything-in-one-fund sort of portfolio will keep me from such temptations — both because I won’t have to execute any transactions other than buying more of the same fund and because that fund is an explicit reminder to myself that I’m not supposed to mess with anything.

I see two other benefits as well:

  1. It’s less work, and
  2. It puts my money where my mouth is, given that the whole point of this blog is to show that investing in a simple, hands-off way really can be quite prudent.

A Slightly Different Allocation

Obviously this change adjusts our asset allocation somewhat. Relative to our old allocation:

  • We now have 10% less in REITs and approximately 10% more in non-Treasury bonds (mostly government mortgage-backed bonds and investment-grade corporate bonds), and
  • We now have 16% less in Total International Stock Market and 16% more in Total (U.S.) Stock Market.

Overall, I think the effect of these changes will be rather minimal. As I’ve said before, asset allocation is a sloppy science. Small shifts one way or the other between asset classes don’t usually make much difference in an investor’s long-term success.

Still, the decrease in international allocation did give me some pause. (In fact, it was really the only thing that made me hesitant about the switch at all.) In general, I’m somewhat more comfortable with a higher international allocation rather than significantly overweighting U.S. stocks relative to their market weight.

In the end, I decided that I’m more worried about a Mike-messing-something-up scenario than I am about a scenario in which the U.S. stock market significantly underperforms the total world market for an extended period.

One potential drawback is that Vanguard could change the allocation of the fund at some point in the future in a way that I don’t like. Because I follow Vanguard-related news fairly closely though, I’m confident I’d hear about any upcoming changes in plenty of time to move out of the fund if we decide the changes don’t make sense for our needs.

Overall Conclusion

As with any change, it has its pros and cons. It’s not perfect. But I like it. I like that it’s simple. I like that it’s easy. And I like that it will (hopefully) keep my meddling hands off our portfolio.

Asset Allocation is Not a Goal

More and more often these days, I see people trying to cram their entire financial lives into a stock/bond asset allocation.

For example, a recent retiree might count his Social Security as a bond (because it provides income) and his house as a stock (because its value bounces around a lot). And this is done for the purpose of adding everything up to check that his asset allocation matches the recommendation from a rule of thumb or online calculator.

But So What?

The above approach seems entirely backward to me. Asset allocation is not a goal. Asset allocation is a tool to help you meet your goals.

For example, our hypothetical retiree might know that he needs $45,000 of income per year. From that, he can subtract any non-investment income (e.g., Social Security, pension, part-time work) to determine how much income he needs from his portfolio. Then, he can select an asset allocation that he believes is most likely to satisfy the required level of income without taking on an unacceptable level of risk.

In other words, first look at your overall financial picture (necessary expenses, available sources of income) to determine what gaps will have to be filled by your investments. Then you can use asset allocation-related tools (online calculators, historical studies, rules of thumb, etc.) to design a portfolio that’s likely to fill in those gaps.

The purpose of asset allocation is to help you fit your portfolio into the rest of your financial life — not the other way around.

Variable Annuities for Tax Planning

Rebecca writes in to ask,

“Because of my work (I’m a physician), I’m in a high tax bracket (33% federal). I was recently contacted by a financial advisor who suggested a variable annuity as a way to minimize my taxes because the growth in a variable annuity is tax-deferred. I’ve also heard plenty of bad things about variable annuities though. What do you think? Would an annuity be useful in my situation?”

First let’s cover some background information to make sure we’re on the same page.

How Deferred Variable Annuities Are Taxed

You are not taxed on growth that occurs within a variable annuity. You are taxed, however, when you take money out of the annuity.

How you are taxed depends on whether or not you have “annuitized” the annuity. (To annuitize an annuity is to convert it to a series of substantially equal periodic payments over a specified period — the rest of your life, for instance.)

If you have not annuitized the annuity, distributions of earnings will be subject to ordinary income tax, while distributions of the original cost of the contract are tax-free. Note, however, that distributions are assumed to come from earnings until all earnings have been withdrawn.

If you have annuitized the annuity, distributions will be partially taxable as ordinary income and partially tax-free. The portion that is non-taxable is calculated so as to return the original cost of the annuity to you, without taxation, over your life expectancy. If  you live long enough to receive the original cost of the annuity tax-free, any remaining payments will be entirely taxable.

Finally, distributions from a variable annuity prior to age 59½ will also be subject to a 10% penalty — with a few exceptions.

Note: All of the above assumes that the variable annuity is not held within a qualified retirement plan such as a 403(b). If the annuity is held within such a plan, the annuity will be taxed just like anything else in the plan. (In other words, you get no additional tax benefit from using an annuity within a qualified retirement plan.)

When Are Variable Annuities Useful for Tax Planning?

While variable annuities do have the benefit of tax-deferral, they have two major disadvantages.

First, they’re expensive. According to Morningstar, the average variable annuity (without any optional riders) costs 2.42% per year. Even at Vanguard, the average variable annuity costs 0.59%. This is in contrast to index funds or ETFs, which can be found for less than 0.20% per year in most asset classes.

Second, they turn income that would ordinarily be taxed at advantageous rates (e.g., qualified dividends and long-term capital gains) into ordinary income.

Because of these two drawbacks, variable annuities generally aren’t beneficial as a tax planning tool for most investors. In general, the only time they should be considered for such purposes are when three conditions are met:

  1. You have already maxed out your contributions to IRAs and qualified retirement plans,
  2. You’ve filled up your tax-advantaged accounts with your least tax-efficient asset classes (e.g., REITs and high-yield bonds), and
  3. You still want to own more of those asset classes (such that they’d have to go into a taxable account or a variable annuity).

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