Category: analysis

Last week, President Obama released his 2014 financial disclosure.  Stocky Fox is going to take the liberty of analyzing the first family’s portfolio, and give my take on what he’s doing right and where he could improve.

First, here’s a quick summary of the numbers:

• $90,000 in checking account. (The disclosure has ridiculously large ranges.  For the checking accounts it says it’s between $52,000 and $130,000.  In these cases, I just took the midpoint.)
• $3.5 million in treasury notes.
• $375,000 in treasury notes in an IRA.
• $525,000 in Vanguard—the specific funds weren’t specified but let’s assume since their holdings for bonds is so high already, that this money is in stocks.
• $300,000 in 529 accounts for his daughters.
• $75,000 annual pension from state of Illinois when we was a state senator (for 7 years).
• $190,000 annual pension from US for being president.
• Owes $750,000 on mortgage with an interest rate of 5.625%.

 

The first thing you have to do is put all that in perspective.  On one hand it seems like the Obamas have quite a bit.  They have assets of about $5 million plus they’ll get almost $300,000 annually in pensions.  That’s a lot of money and more than enough to live a very comfortable life.

On the other hand it doesn’t seem like that much.  Obama has the most difficult and important job in the world.  If you think of him as a CEO of a large organization, his “company” is orders of magnitudes larger than that of any corporate CEO.  Yet Obama’s salary ($400,000 per year) and net worth are rounding errors compared to many of those in corporate America.

Also, Obama’s working career has a short shelf life.  Once you’re president, you don’t really have a real job after that.  John Quincy Adams went on to be a US Representative and Howard Taft went on to be a Supreme Court Justice after their presidential administrations, but that was over 100 years ago.  Since then, after your president, you don’t really work.  However, there is a ton of potential to make money on the speaking circuit (Bill Clinton made $13 million doing this in 2011).  So with all of this, I think the Obamas will be very comfortable in life.

That said, are the Obamas maximizing their investments?

 

Super high mortgage rate

The first thing is they have a really high mortgage rate.  They are paying 5.625%.  The going rate for a 30-year mortgage is 4%, so they could easily refinance.  Just that alone could save them about $22,000 per year in interest.  Maybe that’s not top-of-mind for Obama as he’s leading the US, but I bet one of his aides could do all the paperwork for him.  Take about 20 minutes to sign a bunch of documents and he just found an extra 5% of his pay.  That’s about $1000 each year for the next 30 year for each minute of work.  I wish I had an opportunity like that.  Seems like a no-brainer.

 

Too much in his checking account

Why does he need $90,000 in his checking account?  Seriously, what are his expenses?  I don’t know how long he’s been parking that much in his checking account, but if we assume that it’s been since at least his second term started, he’s probably missed out on about $50,000 in gains from the stock market.  I think he’s sitting on a lot of dead money there.

 

Good move with the 529s

It’s a smart move saving for his girls’ college with the 529s.  I’m guessing that they won’t get scholarships, not because they wouldn’t deserve them, but more because it might seem “inappropriate” for them to accept them.  Would the schools be kissing up to the president?  Would it create a scandal when it came to light which student didn’t get the scholarship money that went to Malia and Sasha?  Either way, if Obama knows he’s going to be paying money for college, at least he’s doing it in a tax advantaged way.

 

Way too much in bonds

He has about 90% of his assets in government bonds.  He’s 53 and Michelle Obama is 51 which is relatively young, all things considered.  That would be way too conservative for someone twenty or thirty years older than they, much less two people in their early 50s.  And that’s not even counting the value of his pensions.  The $300,000 he’s getting each year in pensions would equate to another few million dollars of bonds.

I don’t know what kind of limitations there are on presidential investing (if you do, please let us know in the comments section), but I would assume that he could have a super-broad mutual fund in some type of blind trust that made it impossible for him to favor one company to his own personal benefit.  Wouldn’t that be something like the Vanguard Total Stock Index (VTSMX)?  Maybe he could diversify to an international mutual fund too and show his counterparts that he’s invested in their economies, literally.

No matter how you slice it, he has left a ton of money on the table by having so much in bonds instead of equities.  Just to put it in perspective, stocks have more than doubled since Obama took office.  Bonds on the other hand are up about 30%.  So maybe instead of being worth about $5 million, he could be worth $10 million.

 

Of course, this is all a bit of a fool’s errand.  The Obamas and their children (and grandchildren) are never going to want for money.  If so motivated, he will never have to pay for a meal for the rest of his life.  If things do ever get tight, he could pull in a cool $10 million by doing a couple dozen speeches at corporate events.  But it’s fun to see how some of the things we discuss on this blog relate to famous people.

In fact, I think it speaks to one of the problems that exist in personal finance today.  President Obama is an incredibly smart individual, yet wouldn’t you have to give him a “D” when it comes to what he’s doing with his money?  He’s fortunate that he makes a lot of money (and has very bright future prospects), but his choices have left millions on the table.  It goes to show that it can happen to the best of us.

This is what we’ve all been waiting for.  After two weeks of amazing investing tournament challenge action (just indulge me, will you?), in this post we will crown the champion of investing strategies.  Here we have Asset allocation taking on Tax optimization.  In the Final Four, Asset allocation pounded Index mutual funds with higher returns early on and limiting risk as you approach retirement.  Tax optimization made it two thrillers in a row, beating Savings rate on the strength of major tax savings with a little bit of work and education, but not a lot of monetary sacrifice.  As always, see the disclaimer.

Obviously both these strategies have tremendous upside, otherwise they wouldn’t be here.  So how do you pick between them?  It’s no easy task, but for you, my loyal readers, I’m ready to take it on.  Let’s see who cuts down the nets.

 

Reasons for picking Asset allocation:

In some ways Asset allocation seems really easy, since all you’re doing is figuring out what percentage of your portfolio goes into stocks, bonds, and cash.  90% Stocks, 10% bonds, and 0% cash; there, I’m done.  That didn’t seem so hard.  Obviously it’s more complicated than that.  We already know that Asset allocation is critically important throughout your investing time horizon.  When you’re younger you probably want to be mostly in stocks (even now the Fox family is 99% in stocks).  As you approach and ultimately enter retirement you want to be more in bonds, but stocks still probably need to be a significant part of your portfolio.

About 10 or so years ago, the mutual fund companies came out with a really cool innovation called target-date funds.  The basic idea is that these handle your Asset allocation for you.  Imagine today you’re 35 and you want to retire when you’re 60, in 2040.  You could invest in a fund like Vanguard’s Target Retirement 2040, and it will automatically shift your Asset allocation from mostly stocks today (currently it’s about 90% stocks, 10% bonds) to gradually less stocks and more bonds as you get closer to retirement.  It’s been a wonderful innovation that has proven extremely popular among investors.

So there you go.  Problem solved, right?  Well, not so fast.  I actually don’t think these really solve the Asset allocation problem because they figure everyone retiring in 2040 is in the same situation, but that’s definitely not the case.  Let’s say you and your twin retire in 2040, but you will get $1000 from Social Security while she’ll get $3000.  What if she had her house paid off completely while you have always rented?  What if you worked for a company with a 401k and she worked for a company with a pension?

All those scenarios are very real for investors, and require more individualization than knowing you want to retire in 2040 can give.  For all those, conventional wisdom would say that your twin should take on more risk (French for “invest in more stocks”) than you because she has other “assets” that are generating more cash.  Reasonable people can debate that last point, but clearly the idea is that Asset allocation is much more complex than just picking a year and being done with it.

So where does that leave us?  I am a firm believer in investing DIY, and Asset allocation is no different.  But I think this is one of the areas where the degree of difficulty is much higher just because you’re balancing a couple opposing forces and there’s never a clearly “right answer”.  You want to be in stocks but not too much in stocks, and then that changes over time.  Oh yeah, and the stakes are super-high.  Getting it “right” whatever that means could give you an extra few percentage points in return and it could also save your nestegg from catastrophic failure if another 2008 rolls around.  When I work on the Fox’s nestegg, this is probably where I spend the most time.

 

Reasons for picking Tax optimization:

As we’ve said ad nauseam, Tax optimization is important and can lead to enormous savings.  What makes taxes so difficult is that the tax code is constantly changing and the stakes are super-duper high (the stakes for Asset allocation were only “super high”).

Every year there are hundreds of changes to the tax code which keeps accountants employed and programs like Turbo Tax (the Fox family uses Turbo Tax) flying off the shelves.  Just a couple weeks ago, President Obama floated the idea of eliminating the tax-free features of 529 accounts, only to see the public outcry and pull back on that.  But imagine if he went through with that; your whole approach to saving for your kids’ college education would have completely changed.  And that one made the news.  What about the others that do hit the media’s radar and you never hear about?

There’s always talk about possibly means-testing the interest deduction on home Mortgages or changing the income levels to qualify for IRAs.  You have to keep up.  Also, it can get really confusing.  I think I’m fairly knowledgeable on these matters but I am still befuddled by the Alternative Minimum Tax, and I know I screw up the foreign interest paid on my international mutual funds.  This stuff definitely isn’t easy.

Also, look at the stakes.  If you screw up on your taxes, theoretically you could go to prison.  If it’s an honest mistake I don’t think the Internal Revenue Service will push it that far, but horizontal stripes are definitely in play as Wesley Snipes can attest.  What is more likely is the IRS will hit you with a fine composed of a penalty plus interest.  Oh, by the way, that interest rate is about 6%; that’s not “Pay-day Loan” high, but it’s still pretty freaking high these days.  That certainly can make someone cautious about how far to push Tax optimization, even when they’re clearly in the right.

However, there is a silver lining.  If you want professional help, there are thousands of Certified Public Accountants who are there to help you out.  For under a few hundred dollars most people can probably have their taxes done by a CPA who can make sure that you stay on the IRS’s good side.  Unfortunately, when it comes to developing creative Tax optimization strategies, my experience says there’s a huge range in quality that you’ll get from CPAs.  Several years back I had a horrible experience with H&R Block and thought they were border-line incompetent.  No way would I trust them to advise me on the finer points of maximizing the tax advantages of investing.  But there are amazing CPAs out there right now (like David Silkman who currently does our small business’s taxes) who I do think can really help.  But this is a real caveat emptor situation.  Maybe Angie’s List might help.

 

Who wins it all?

It all comes down to this.  In the end, I have Asset allocation pulling it out 76-70.  Obviously both investing strategies are amazingly important and getting them right can have an exponential impact on your portfolio.  For me I gave the nod to Asset allocation over Tax optimization for a couple of reasons:

First, if I met a total train wreck of an investor (he was just stuffing cash in his mattress) and I could only give him one piece of advice, I think it would be to get that money invested in some combination of stocks and bonds.  Tax optimization strategies like an IRA or 401k are nice, but first things first.

Second, I think the big rocks for Tax optimization seem to me better understood and more accessible than for Asset allocation.  Most investors probably know that investing in your 401k or an IRA is a good idea, and probably most could tell you why (at least be able to say “it helps with taxes”).  I think that’s different for Asset allocation where you have a lot of investors who are totally off on what is probably appropriate for their situation (age, income, other assets, etc.).

Third, there’s no real “right” answer for Asset allocation.  I could have a lively debate with my dear friends/loyal readers who work in the financial industry like Jessamyn and Mike, where we argued whether the Fox family should be more in stocks or more in bonds.  But there’s no right answer (other than if stocks go up a year from now, then you know you should have been more in stocks).  It depends on so many variables as well as risk tolerance which are super-hard to quantify.  With Tax optimization you can get closer to a right answer—either the tax code allows you to do that or not.  Of course, you typically sacrifice ease of access to your money for tax benefits, so that does add a complication.

Finally, I think it’s easier and cheaper to get expert advice on Tax optimization.  As I mentioned, a good CPA can probably really help guide you on Tax optimization.  Sure, the quality of CPAs is pretty wide, but good ones are out there, and probably they’ll charge you something with in the three-digit range.  With Asset allocation if you want professional help you typically need a financial adviser.  Unfortunately, and this is just my opinion, it’s a little more Wild West for financial advisers than CPAs.  A really good financial adviser is probably worth her weight in gold (140 pound of gold is worth about $2.6 million, so maybe they aren’t worth quite that much), but the range of quality is staggering; there are some real shysters out there.  Also, they’ll probably charge you in the four- or five-digits range.

So there you go.  Put that all together and I think Asset allocation comes out on top, finishing the sentence, “if you only do one thing in investing make sure you get Asset allocation right.”

 

I hope you have enjoyed reading all these posts on investing as much as I have enjoyed writing them.  While Asset allocation “won” remember that all eight of these are important and should be definitely be considered as you think about bulking up your portfolio.

Welcome to the second game of the Final Four of my investing strategies tournament.  Here we have Savings rate taking on Tax optimization.  In the first round, Savings rate beat Mortgage just on the sheer power that saving more money can have on the ultimate size of your nestegg.  Tax optimization squeaked by Starting early due to the enormous value created with minimal sacrifice by setting up the accounts to minimize your taxes.  As always, give the disclaimer a peek.  With that out of the way, let’s see who wins.

 

Reasons for picking Savings rate:

Savings rate is a simple but overwhelming force, maybe like Patrick Ewing when he dominated the Final Fours during his years at Georgetown (I don’t mean to call Ewing’s game simple, but you’ll see what I mean).  Ewing just owned the basket—any shot you put up he blocked, if you did get the shot up he got the rebound, when he got the ball you weren’t stopping him.  It all revolved around Ewing, and his dominance on the inside covered up for his shortcomings (outside shot, passing) as well as those of his teammates.

In the investing world, the sun really rises and sets with Savings rate.  Without any savings, you can’t invest so it really doesn’t matter what you do with things like Index mutual funds, Asset allocation, or Free money.

Also, unlike any other investing strategy, Savings rate can make up for any other mistakes you make along the way.  It’s a lot like Ewing protecting the rim on defense; if your guy beat you, you could be pretty confident that Ewing would bail you out by blocking his shot.  You could completely screw up Asset allocation and stuff all your money in a mattress—just crank up your Savings rate and there’s no problem.  Don’t participate in your 401k and walk away from the Free Money—save a little more and you’re okay.  You get my point.

Let’s use the same example of Mr Grizzly starting out at age 22, making $50,000 which will eventually rise to $100,000, and who wants to be a millionaire by the time he’s 60.  Let’s say he does everything right, plus he has a horseshoe growing out of his rear end, and over his investing career he averages a 10% return; he would only need to save about  3% of his income.  That’s probably a breeze.  Now, instead he has an average investing track record with returns of about 6%, he would need to save about 9% of his income.  So Savings rate was able to make up for his lack for tremendous luck.  Keep going down that path and let’s say he put all is portfolio in a local bank earning 1% interest, which I think we would all agree is a pretty terrible investing strategy, and he still becomes a millionaire so long as he saves about 24%.

 

Return	Savings rate
10%	3%
6%	9%
2%	20%
1%	24%
0%	29%

 

So you can see that Savings rate can make up for all manner of investing sin.  Pretty much any other investing strategy has its limits to how far it can take you before you exhaust its benefits.  But of course there are no free lunches.  Increasing your Savings rate comes at a much higher cost than other investing strategies, namely all that money you’re saving means you can’t spend it on other things.  So when Mr Grizzly needs to crank up his Savings rate, that money has to come from somewhere—he passes up on that salmon fishing trip, or buying Mrs Grizzly some artisan honey from the farmer’s market, or getting some detangling shampoo for his coat.  We can debate whether those purchases are worth the money, but to Mr Grizzly they are (cut to Lady Fox nodding and pulling out a Pottery Barn catalog).  Sure, you can start by cutting away the layer of winter fat, but the higher you make your Savings rate the more you start cutting into muscle and eventually into bone.  That, my friends, is the rub with Savings rate.

 

Reasons for picking Tax optimization:

Taxes are to investing what water damage is to a house—unwelcome, can really ruin stuff if not attended to, and it gets into everything.  The tentacles of taxes traverse tremendous territory to touch your total transactions (I challenged myself to see how many “t-words” I could use in a sentence).  Seriously, taxes pretty much affect everything in investing.

There are the obvious big rocks, some of which we’ve already discussed, like a 401k and an IRA; using those accounts to defer taxes can save you hundreds of thousands of dollars.  Medium-sized rocks like 529s and tax-deductible interest on your mortgage can save you tens of thousands in taxes over a shorter time span.  Then there are tons of small rocks which can certainly add up—flex spending accounts and dependent care spending can save you thousands.  Add all that up and that’s a lot of clams (if you didn’t read yesterday’s post, I am trying to use as many slang phrases for money as I can).

And then you can get into the really obscure Tax optimization strategies.  “Loss harvesting” is when you sell investments at a loss so you don’t have to pay taxes on your winners.  “Dividend location” looks to put your high-dividend investments in tax deferred accounts like a 401k, so you don’t have to pay taxes on the dividends during your high-income/high-tax rate years.  There are millions of these little loopholes and strategies that allow you to pay less taxes.  A major part of the accounting industry is based on this fact.

Just to illustrate the point, I’ll share a story from Medtronic.  If you’re a high-compensation employee (I do not qualify, so I can’t take part in this) you can participate in the Capital Accumulation Program (CAP) which allows you to defer a portion or all of your bonus into a tax-advantaged account—think of it like an extra 401k without the match.  This is a veritable tax goldmine, and sadly very few of the people I talk to take advantage of this.  Let’s assume Mr Executive makes $300,000 per year, with $100,000 of that being his bonus; and assume that he’s working hard to build his nestegg, so after maxing out his 401k he saves $50,000 in his brokerage account.  That’s probably pretty close to the people I’m describing.

What Mr Executive could do but probably doesn’t is defer his entire bonus.  He’s already saving $50,000 per year and since he’s in a pretty high tax bracket, that’s probably pretty close to what his take-home would be on that $100,000 bonus.  However, by deferring his bonus he avoids paying the 40% on taxes now and only pays 5% in taxes when he pulls the money out in retirement.  If you do the math, that’s a potential savings of $35,000 ($100,000 x (40% – 5%)) on top of what he’s already saving.  When I ask executives why they don’t do CAP they tend to say they never thought of it or they didn’t understand it.  When I show them the math says they’re leaving at least $35,000 on the table, their eyes bug out and they need to sit down.

That’s just one example of the power of Tax optimization that is out there that goes largely unutilized, even by really successful people, even by those who have tax advisers helping them out.  And there are thousands of other examples like that out there.  That’s $35,000!!!  That’s a lot of money, even if you are pulling in $300k.

My point with this and the others is that in the US (and probably every other country) the tax code is super convoluted.  Add to that that when you’re making more and more money, you pay more and more in taxes, so the stakes start to get pretty high.  That’s a perfect recipe for hidden 1% coupons; some of them are easy to find, some a little hard, and some require serious digging—but they’re there.

 

Who goes on to the championship game?

Just like in the Elite Eight, I think Tax optimization pulls out a squeaker over Savings rate, 71-68.  While Saving rate has unlimited potential, it comes at a real cost of foregoing purchases today.  Tax optimization isn’t necessarily unlimited.  There are only so many wrinkles and loopholes you can take advantage of, but there are an awful lot of them and I bet you’d run out of time and energy before you’d run out of tax strategies.

But what tips the scale is that most of the Tax optimization gambits are free.   You’re already going to save for your retirement so why not do it with a 401k and not pay taxes on it right now?  You’re already going to save for your kids’ educations so why not use a 529 and not pay taxes on the appreciation?  You’re definitely going to need to pay for childcare so why not use a Flex spending account and do it tax free?  You and the family are going to get sick so why not use a Flex spending account for that, too?  None of those cost any more than you would have paid already, but you’re cutting Uncle Sam out of his 40% (legally, of course).

Tomorrow we will see who wins it all, Asset allocation or Tax optimization.

Welcome to the first game of the Final Four of my investing strategies tournament.  Here we have Asset allocation taking on Index mutual funds.  In the first round, Asset allocation blew out Diversifying mostly due to the higher returns that younger investors can get by investing more in stocks early in their investing career.  Index mutual funds upset Free money on the strength of lower management fees that can apply throughout an investor’s career and across every account type.  As always, check out the disclaimer.  With that out of the way, let’s see who wins.

Reasons for picking Asset allocation:

Last round we saw how being too conservative with Asset allocation can really reduce the returns of younger investors who aren’t as heavily invested in stocks as they should be.  If you go to the other end of the investor’s time horizon, when he or she is older and nearing retirement, you can make equally harmful mistakes.

On one end of the spectrum older investors can become way too risky.  As the years tick by and people get closer to retirement, they begin to take stock (pun intended) of where they are probably a little more closely than they did in their 20s or 30s.  If they aren’t quite where they want to be, knowing that on average stocks have higher returns than bonds, one natural response is to allocate more of their nestegg to stocks to “catch up”.  According to generally accepted investing theory, this is the exact wrong thing to do—as we get closer to retirement you should be reducing your allocation of stocks to lower your risk, not increase it.  Here you’re stepping away from the world of investing and into the world of gambling.  Maybe you’ll get lucky and ride a bull market up to get your portfolio back to where you want it, but you’re definitely putting yourself at risk of hitting a market pothole and putting yourself further behind.

On the other end of the spectrum, they can become way too conservative.  Some people have the natural instinct to want to get completely off the investing train in retirement because they don’t want to have any risk, so they put all their money in bonds or cash.  This is understandable because they’re going to be depending on that nestegg, so it’s got to last.  But the problem is that even in retirement, many people still need the higher returns that stocks provide to balance out the relative safety of their bonds.  This is especially true in a world where people are living longer and it’s not unreasonable to expect retirement to last a few decades or longer.  And actually, that time element also makes the case for stocks being a significant part of your retirement portfolio—you have time to ride out the storms, just not as much time as you had before.

These are what make Asset allocation one of the harder investing strategies to get right, because it’s changing over time and there are shades of grey (at least 50 shades of grey).  Other strategies like Diversification and Free money are much simpler because your strategy is absolute.  Diversification—you should be diversified at all times.  Free money—you should get as much of it as you can at all times.  But with Asset allocation, the right thing to do gradually changes from being mostly in stocks during your early years, and then slowly switching to more bonds and cash as you start to near retirement, but never shifting completely to bonds.

There’s no strict rule on what your Asset allocation should be at different stages of life, but I always look at Vanguard target retirement funds as a bit of a guide (although I’ll write about some of my issues with these types funds in a future post).  With 40 years until retirement, right around when you’re first starting out, Vanguard suggests about 90% stocks and 10% in bonds.  Once you hit retirement Vanguard suggests 40% stocks and 60% bonds.  Notice that even in retirement a very significant portion is still in stocks.

Vanguard target date funds	% in stocks	% in bonds
2055 (40 years to go)	90%	10%
2035 (20 years to go)	85%	15%
2025 (10 years to go)	70%	30%
In retirement	40%	60%

 

So what does that all mean?  Well early on Asset allocation done properly can get you higher returns over the long run, historically about 3-4% higher than if you completely screwed it up.  Later on, it’s going to help protect you from any market crashes, market corrections, or general market zaniness that occurs.

 

Reasons for picking Index mutual funds:

We know from the Elite Eight round, that one of the major advantages of Index mutual funds is their lower management fees, which are on average about 1% less than actively managed mutual funds.  We also know from The power of a single percentage that saving 1% of your portfolio year after year can lead to some serious ducats (I’ve decided to use as many slang terms for money over the next few posts, so prepare yourself).  But we’re in the Final Four now so we need something more than that.

Not above a little chicanery, Index mutual funds is going to steal a page from Asset allocation’s playbook.  Often with actively managed funds, they keep a significant portion of the fund’s assets in cash so they can buy an investment when the opportunity presents itself.  Of course we know from above that holding cash over the long term leads to lower returns than holding stocks.  Index mutual funds are able to be almost 100% invested in stocks (or whatever asset class you want) because they aren’t picking investments so much as just following the index.  Just doing some simple math, if actively managed funds have 5% of their assets in cash, and over the long term stocks return 6% more than cash let’s say, that comes to a long term benefit of about 0.3% (5% x 6%).  That’s not going to change the world, but even those little bits compounded over decades can make a huge difference.

Index mutual funds is also copying Tax optimization.  When your mutual fund sells shares there are tax implications on that (death and taxes, baby).  That’s why you get that statement every year from your mutual fund telling you what you need to report to the IRS. The more frequently your mutual fund trades stocks, the more likely it is that you’ll have short term gains which are taxed at higher rates.  But with Index mutual funds, trading is minimized because the fund is only following an index like the S&P 500 which doesn’t change that often.  That leads to lower taxes which we know can add up to some serious cheddar (see, I did it again).

There are also people who argue that Index mutual funds do better than actively managed funds because they take the human element out of it.  This is pretty controversial, and if you believe in the theories from A Random Walk Down Wall Street, which I unabashedly do, then shouldn’t active managers do just as well as a passive index?  Hmmm, that sounds like fodder for another post.  People debate this all the time and I’m not convinced that this really drives the needle.

The final major benefit of Index mutual funds is that they’re super easy, especially compared to some of the more difficult investing strategies like Asset allocation.  You can go to a place like Vanguard (that’s where the Fox family’s money is) or Fidelity or a dozen other places and sign up for one of their index funds, then as Ron Popeil says, “you set it and forget it.”  That means you’re getting pretty incredible value for a relatively small amount of work.

 

Who goes on to the championship game?

Index mutual funds pulled out all the stops, but in the end Asset allocation was just too strong.  Index mutual funds will definitely help build your nestegg, probably juicing your returns 1% compared to actively managed funds and maybe even 1.5% if you’re feeling charitable.  That’s nothing to sneeze at, but we’re talking about punching your ticket to the Championship round here, people.

Let’s say you completely abandoned the idea of Index mutual funds and went totally with actively managed funds.  How bad would that be?  It wouldn’t be ideal (just my opinion and one not shared by my good friend Mike), but you’d be fine in the end.  Actually this is what millions of people do all the time and it tends to work out.

Compare that worst-case scenario to Asset allocation’s and you see why they won.  Screwing up early on and investing too much in bonds and cash instead of stocks can cost 3-4% on your returns.  That dwarfs what Index mutual funds bring to the table.  Screwing up closer to retirement can put your whole financial plan at risk.  Ask near-retirees who were to heavily invested in stocks before the 2001 or 2008 crashes what they think.  In the immortal words of Winston Zeddemore “I have seen s%$t that will turn you white.”

With Asset allocation the stakes are just too high.  I have Asset allocation pulling away, 68-59.  Be sure to come back tomorrow to see who they take on in the final, either Savings rate or Tax optimization.

 

We’ve made it to the last contest of the first round, and this one is a doozy.  In true Kentucky versus Duke-style, this is a match of the real bluebloods of the investing world.  As always, check out the disclaimer.  Let’s go to the game.

Reasons for picking Starting early:

Starting early is one of the sage pieces of wisdom everyone gives, and for good reason.  The earlier you start investing, the more time you give the incredible power of compounding.  In this way, Starting early is very similar to Savings rate which we saw won the last game.  Because of the compounding the numbers seem to act “funny” (not funny “ha ha,” but funny as in not a way you would expect unless you are an expert in exponential algebra).

So let’s say Mr Grizzly just got his engineering degree at age 22 and wants to retire with $1 million on his 60^th birthday.  Similar to the previous examples his starting salary is $50,000 and it gradually increases to $100,000, and he can get a 6% return on his investments.

If he starts saving at age 22, he will need to save about 9% of his salary to get to the $1 million mark by 60.  However, let’s say he can’t start right away, and instead he starts saving at age 30; now to become a millionaire by age 60 he needs to save about 13% of his income.  Wow!!!  By delaying a measly 8 years early on, he has to increase his savings rate about 4%.  If he puts it off until he’s 40, he needs to save 25%–that’s doubled his savings rate compared to starting at 30!!!  And if he delays starting until he’s 50, it will require he save about 67% to become a millionaire by the time he’s 60.

Starting age	Savings rate to become millionaire by age 60
22	9%
30	13%
40	25%
50	67%

 

Clearly the earlier you start, the easier it is.  9% of your income isn’t trivial, but it certainly seems manageable.  On the other end of the spectrum, it seems just plain unrealistic to be able to save 67% of your income; even 25% would be a tall order for most.  So everyone can agree it’s better to start earlier rather than later.  Done deal.

But the problem with these types of analyses is saving more comes at a cost.  That $4500 you saved at age 22 (9% of your $50,000 starting salary) meant you couldn’t spend that.  Perhaps that’s not so bad if you were wasting it on clubbing and mani-pedis, but who am I to judge?  But maybe clubbing and mani-pedis are what makes life worth living.  Broadening that out, nearly all of us are making less early in our careers, so how realistic is it for us to be saving right away?

Also, early on you actually have higher expenses like repaying student debt, buying furniture for your new place, buying a work wardrobe, and just kind of experiencing life.  That’s not to say that people can’t be disciplined about those things, but there’s got to be a balance.  I personally started saving about 30% when I first started working and I think maybe I should have traveled a little bit more and enjoyed that time of my life (I was living right outside of New York City after all).

Nonetheless, Saving early is a tremendously powerful force if you can afford to do it.  There’s no doubt in my mind that the Fox family is at a comfortable place right now in large part due to the fact that I started squirreling money away so early.

 

Reasons for picking Tax optimization:

Taxes are a tremendously important part of investing.  It is a dominant force like Shaquille O’Neal on those LSU teams from the early 1990s.  Taxes impact every facet of investing—whether you’re young or old, no matter the type of account you have (401k, IRA, brokerage, Mortgage).

Obviously taxes take a chunk out of nearly every financial transaction you do.  What makes Tax optimization so important is that during your earning years, that chunk can be in the 30-50% range, obviously depending on a number of factors like your income and the state you live in.  However, in retirement when you’re income is lower, that tax rate might fall to 10% or even less (of course, as my good friends Rich and Mike pointed out, no one knows what future tax rates will be—I am just assuming that tax brackets remain the same as they are today).  Many of the Tax optimization strategies to some degree involve finding ways to not pay taxes at the higher rate when you’re working, but rather pay when you’re retired and your rate is lower.

Just how big of a deal can taxes be?  Let’s look back at that example from The tax man cometh.  Mr and Mrs Grizzly are ready to save $1000 per month, either in a taxable account like a brokerage account or a tax deferred account like a 401k.  Using a regular brokerage account after 30 years (let’s assume a 2% dividend and a 5% stock increase) they have about $815k—certainly nothing to sneeze at.  However, had they invested the exact same amounts in the exact same stocks but instead in a tax deferred account, they would have had $1.12 million.  That’s almost $300k more, just for Tax optimization!!!

The only difference is when they paid taxes on the money and at what rate.  In a taxable account they were paying taxes on the $12,000 each year at their high-income tax rate (34%) and they were paying taxes on qualified dividends (thanks Rich) at a pretty high rate too.  In the tax deferred scenario, they were paying taxes on the money after they were retired which I estimated at about 2% because at that time their income is only what they are spending.

That’s just one example, and there are tons just like that where Tax Optimization can really add up to tons of money.  There’s no such thing as a free lunch, but this gets pretty darn close.  When you put your money in a tax deferred account, it gets more difficult to access if you need it right away, but that seems a pretty small price to pay compared to the massive benefits of tax deferral.

 

Who wins?

This clash of the titans was super close.  In the end I have Tax optimization winning on a Christian Laettner-esque (sorry to all my Kentucky friends) miracle shot to push it to the Final Four.

To me I think this comes down between something that is not very complex but involved sacrifice (Starting early) and something that is fairly complex to pull off but doesn’t involve a lot of sacrifice (Tax optimization).  Ultimately, when Starting early you’re taking money that could have been spent on something else and started investing it.  So long as you weren’t planning on setting the money on fire, that will involve a sacrifice.  Conversely if you do Tax optimization you really aren’t foregoing anything, except a little bit of liquidity.  All it is is being smart with taxes and setting up the right accounts.

There are a lot of pretty easy Tax optimization maneuvers like 401k, IRAs, etc., that only take a few hours to figure out and then you’re set for decades.  So you’re getting those huge benefits without a lot of effort.  But Starting early is requiring a fairly significant sacrifice in your early years that could cause quite a sting.  Put all that together and I have Tax optimization coming out on top 83-82.  I have to confess though, I think Starting early would have beaten a few of these other strategies if it had lucked out a little bit in the draw.

Well, that was a wild first round.  I hope you enjoyed this and we’ll see you tomorrow for the first match of the Final Four, Asset allocation versus Index mutual funds.