Early Retirement Portfolio Update – June 2014 Asset Allocation

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I want to get back to doing quarterly updates to our investment portfolio, which includes both tax-deferred accounts like 401(k)s and taxable brokerage holdings. Other stuff like cash reserves (emergency fund) are excluded. The purpose of this portfolio is to create enough income on its own to cover all daily expenses well before we hit the standard retirement age.

Target Asset Allocation

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I try to pick asset classes that will provide long-term returns above inflation, regular income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (and if you don’t do that, there’s no point).

Our current ratio is about 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With low expense ratios and low turnover, we minimize our costs in terms of paying fees, commissions, and taxes.

Actual Asset Allocation and Holdings

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Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Stable Value Fund* (2.6% yield, net of fees)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
US Savings Bonds

Changes
I joined the exodus out of PIMCO Total Return fund earlier this year after their recent management shake-up. It actually coincided with my 401(k) allowing a self-directed brokerage “window” with Charles Schwab that allows me to buy Vanguard mutual funds, albeit with a $50 transaction fee. But my 401k assets are finally large enough that the $50 is worth the ongoing lower expense ratios. I’m buying more REITs and TIPS in order to take advantage of this newly-flexible tax-deferred space. I’m still holding onto my stable value fund, but I may sell that position as well in the future.

I think I mentioned this elsewhere, but I am now accounting for my Series I US Savings Bonds as part the TIPS asset class inside my retirement portfolio. Before, they were considered part of my emergency fund. They offer great tax-deferral benefits as I don’t have to pay taxes until they are redeemed. I don’t plan on selling any of them for a long time, at least until my tax rate is much lower in early retirement.

Why Non-Traded REITs Are a Horrible Investment

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housemoneyJust as important as finding a good investment is knowing what investments to avoid at all costs. If you simply manage to avoid putting any money into financial sinkholes, you’ll come out ahead. I’ve already mentioned the common mistake of cashing out your 401(k) when moving jobs.

Joshua Brown of The Reformed Broker has some great insights into the sales-driven world of products peddled to us retail investors. He talks about non-traded REITs (real estate investment trusts) as opposed to publicly-traded REITS that you can buy via a low-cost, diversified fund like the Vanguard REIT Index Fund (VNQ or VGSIX). Non-traded REITs have been increasingly popular in the current low interest environment as they are structured to look like they provide a solid income stream.

In this recent post, he shares a hilarious fictional conversation that would happen if the broker was abnormally honest about the fees involved. Read the whole thing, but here’s a snippet:

With your portfolio size and risk tolerance I would recommend a $100,000 investment. Given that amount let’s first go over the fees. If you invest $100,000 I will be paid a commission of $7,000. My firm is going to get $1,500 – $2,000 in revenue share. My wholesaler, the salesman that works for the investment’s sponsor company, will get $1,000. He is a great guy, buys me dinner all of the time and takes me golfing. The sponsor company is going to get around $3,000 to pay for some of the costs they incurred in setting up the investment. So all in on Day 1 there will be around $87,000 left over to actually invest. I bet you are getting excited.

You hand over $100,000, and after everyone has gotten their cut, there is only $87,000 actually left over to invest in anything. It doesn’t matter what property they buy, the odds are completely stacked against you already. Studies have shown that publicly-traded REITs have higher historical returns than non-traded REITs. On top of that, non-traded REITs have poor liquidity and you may be locked in for 5 years or more. Despite all this, over $20 billion of non-traded REITs were sold in 2013.

Here’s a Reuters article by James Saft that goes into more detail about the many disadvantages of non-traded REITs. Amongst the more amusing excerpts:

When a financial advisor tried to sell my sister a fee heavy non-traded REIT last year, pitching it as an alternative to fixed income, I told her she ought to fire him. [...]

The Financial Industry Regulatory Authority, an industry funded oversight body, went so far as to issue an “investor alert” about non-traded REITs in May of last year, warning about inaccurate and mis-leading marketing of the vehicles as well as other risks. Just to give a flavor of the company in which non-traded REITs are traveling, the most recent FINRA investor alert was about marijuana stock scams.

Bottom line: Avoid non-traded REITs. If you want commercial real estate exposure, buy a low-cost fund like VNQ or VGSIX.

Recommended Reading List for Young Investors

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ifyoucanbookI just finished reading If You Can: How Millennials Can Get Rich Slowly, a free starter book on personal finance by respected author William Bernstein. As the PDF was only 16 pages long, you could probably finish it during a lunch hour or commute. I recommend it, but even Bernstein notes that his “inexpensive, small booklet” is more of a map than a complete book. Included were several book assignments to address specific topics. The idea is a young person could read all of these books over the span of a year or two and round out their financial education. In the meantime, start saving 15% of your income!

Here is the recommended reading list:

Bernstein thinks it tacky to recommend his own books, so let me do it. Back when I was a young lad with no investing knowledge (2004), my favorite introductory book was Four Pillars of Investing by William Bernstein. (The new edition is really just the old edition though, so buy a used copy of the old edition and save some money.) However, more recently I have heard good things about Investor’s Manifesto which supposedly has less math-y stuff.

I’ve read all but two of these books and agree that they were all excellent building blocks of knowledge. Most if not all of these books have been around for a while and should be readily available for free at your local library. Even if you pay for them, the return will be well worth the investment. I added a new copy of all seven books to my cart and it came to under $100 at Amazon ($91.48 to be exact). Good graduation gift ideas?

Vanguard Personal Advisor Services Review – Low Cost Managed Portfolio and Guidance

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vglogoMany people hire a financial advisor because they aren’t comfortable investing on their own, and they appreciate having an experienced person to talk to whenever they have any questions. However, this usually means paying at least 1% of your portfolio assets every year to that person. Especially given the current low interest rate environment, 1% is a huge number and could eat up a large percentage of future returns.

Vanguard has recently rolled out a new product called Vanguard Personal Advisor Services (PAS) where someone will work with you to create a financial plan, implement your portfolio for you, and be available to update and discuss that plan as needed. The minimum asset size is $100,000 and the cost is 0.3% of assets annually, which is much lower than the industry standard. As a DIY investor, I was interested in this service for my spouse in case I am somehow incapacitated one day. Here are my findings based on calling in as a customer to three different Vanguard reps and various online sources*. Anything quoted below is taken directly from this detailed Vanguard brochure [pdf].

Qualifications. You must have a minimum of $100,000 of investable cash or securities. Eligible accounts include individual accounts (including IRAs), joint accounts, and certain trust accounts. Note that 401(k) plan assets are not included.

Fees and costs. Vanguard PAS will charge you 30 basis points (0.30%) annually. Fees will be calculated quarterly and based on your average daily balance the prior calendar quarter. The fee will be calculated across all securities in the portfolio, with the exception of money market fund positions. This does not include the underlying expense ratios of any mutual funds or ETFs that you may own in the portfolio.

Annual Financial Plan and Personal Review. First, Vanguard will gather information from you via an online questionnaire (and telephone discussion if needed) in order to “understand your financial objectives, such as your age, specific financial goals, investment time horizon, current investments, tax status, other assets and sources of income, investment preferences, planned spending from the Portfolio, and your willingness to assume risk with the cash and securities being invested in the Portfolio.” They will focus on your specific goals, which can include planning for college, saving for a home, establishing a rainy-day fund, or saving for retirement. They will take into account things like Social Security, pensions, IRAs, 401(k) plans, and other investment accounts held outside of Vanguard.

Vanguard PAS will then create a draft financial plan for you based on this information, which you will discuss with a Certified Financial Planner (CFP) to finalize and approve. At least annually, your advisor will schedule another phone conference with you to see if there have been any changes in your “financial situation, other assets or sources of income, investment time horizon, investment objectives, planned spending from the Portfolio, or desired reasonable restrictions” that may require a new Financial Plan to be approved.

(Side note: There is a separate Vanguard Financial Plan product that is similar to the plan part of this service, but you must implement the recommended portfolio yourself and it is a one-time consultation. The recommended portfolio for both products should very similar if not identical. The cost is $1,000 for those with under $50k in combined assets at Vanguard, $250 for $50k-$500k in assets, and free for over $500k in assets. The Finance Buff got one and did a review.)

Portfolio construction and Investment methodology. Their investment methodology incorporates Vanguard’s company values of advocating low costs, diversification, and indexing. As a result, recommended portfolios will mostly include Vanguard’s broad index funds and/or ETFs. They can and will take into account your existing positions or special requests, as long as they meet certain standards. Taken from their brochure:

The recommendations made by VAI in connection with the Service will normally be limited to allocations in Vanguard Funds and will generally not include recommendations to invest in individual securities or bonds, CDs, options, derivatives, annuities, third-party mutual funds, closed-end funds, unit investment trusts, partnerships, or other non-Vanguard securities, although you may be able to impose reasonable restrictions upon our investment strategy.

They will work to maximize after-tax return. They will not attempt to “predict which investments will provide superior performance at any given time”. No market timing here.

Quarterly portfolio review and rebalancing. Each quarter (with timing determined by your contract anniversary date), they will review your portfolio. If your portfolio asset allocation deviates from the target asset allocation by more than 5% in any asset class, they will rebalance your portfolio by buying and selling the appropriate funds. There is a prescribed fund hierarchy in order to do this will minimal tax impact.

Ongoing contact and advice. At any time, you can contact a Vanguard PAS advisor to talk about your financial plan. There are no set limits on how many times you can contact them. I was told that if you have $100,000 to $500,000 in assets, you will be directed to a team pool of CFP advisors. If you have 500k or higher, you will be assigned a specific person to be “your advisor”. Of course that person may change from time to time if they switch jobs, etc.

No DIY Trading! You are not allowed to make any trades yourself in any portfolio managed by VPAS. You must call your Vanguard advisor and discuss and proposed changes for them to execute. Online trading will be disabled in your account. This may be weird for long-time DIY investors.

In your Service Agreement, you’ll agree not to purchase or sell securities in your Portfolio while enrolled in the Service, and you’ll be blocked from such activity until you terminate the Service. You’ll also be prohibited from establishing or maintaining other services on any accounts in the Portfolio, including but not limited to checkwriting and automatic trading services (such as automatic investment/withdrawal/exchange) and setting required minimum distribution (RMD) payments. Other account transactions or services may be restricted or unavailable through the web experience, but can be processed or enabled with the assistance of your advisor.

Recap and Commentary

This is a managed portfolio product. That means that they will determine a low-cost portfolio of Vanguard funds (mostly index) based on your specific needs, implement it for you, and provide ongoing advice and adjustments as needed. Everything will be done through a Vanguard representative, not with the click of your mouse. Such guidance will ideally help you handle your emotions when it comes to investing, as there will be someone to help you keep following your plan during both up and down markets. There will be someone to talk with whenever you have any life changes or additional questions.

0.30% of $100,000 is only $300 a year, making this quite a bargain at that level. At much higher asset sizes, I would prefer switch to a flat fee as paying $5,000 or more every year starts to feel a bit steep. I would say that if you have under $100,000, don’t fret and just buy a Vanguard Target Retirement Fund as that is essentially a simple managed portfolio.

After doing my research, my new suggestion to my wife is to pay for Vanguard Personal Advisor services if I am unable to manage our investments. She is brilliant but lacks the interest (and time if I’m gone with our kids and all) to do it on her own and I trust Vanguard to do a fine job. The reasonable fees, ability to keep my assets at Vanguard, and assigned human advisor make it better in my opinion than any other “robo-advisor” option. Still, I hope she never has to sign up. ;)

* More coverage: Bogleheads blog, NY Times, Michael Kitces, InvestmentNews

Is P2P Lending So Successful That It Doesn’t Need You Anymore?

lcvsprBeing a peer-to-peer lender been a bumpy ride. Prosper Marketplace was first, but if you were an early investor/lender you’d have been lucky to have gotten back what you put in as most people had negative returns. Then came LendingClub with stricter credit standards and preset interest rates. Both companies operate with similar structures now and appear to have created a viable business model. In fact, LendingClub is planning an IPO with their last funding valuation at $3.8 billion. That’s pretty rosy considering they made just $7 million of profit in 2013, their first year of profitability in 7 years.

I’m not a big lender but I have invested over $15,000 of my own money into P2P loans. In the beginning, I would read every single loan listing as it usually included a story about what the borrower was going to do with the money (pay down debt, start a new business, buy a 200 sf tiny house). After a while, I started using automated software to match with loans, but it still felt like individuals lending money to other individuals. Today, a significant portion of loans are sold to institutional investors like hedge funds, pension funds, and even banks according to the New York Times article “Loans That Avoid Banks? Maybe Not“:

At Prosper, which has been courting institutional lenders over the past year, more than 80 percent of the loans issued in March went to those firms. More than a dozen investment funds have been formed with the sole purpose of investing in peer-to-peer loans. [...] Santander Consumer USA, the United States arm of the Spanish bank, has an agreement to buy up to 25 percent of Lending Club’s loans.

I spoke to a LendingClub representative, and they stated that their investor base is currently “about 1/3 direct retail investors, 1/3 high-net-worth investors, and 1/3 institutional investors.”

Here’s a thought experiment: If somebody like Chase Bank goes to a P2P lender and buys a bunch of unsecured loans made to individuals, is that really much different than that same person just carrying a balance on a Chase credit card?

It used to be individuals who took the risk of lending and reaped any rewards of higher interest. The P2P company just cares about volume as it takes a fee from every loan. But if that volume comes from big financial firms that want first dibs, does that mean the individual investors will only get left with the scraps?

The loans not taken by these sophisticated investors go back to a fractional lending pool that is open to both individual investors and institutions. That doesn’t sit well with some. “The institutional investors are snapping up all the worthwhile loans,” one investor wrote on Prosper’s blog, echoing many comments. [...] “By cherry-picking, almost by definition what they leave behind is not as good,” says Giles Andrews, founder and chief executive of Zopa, a British peer-to-peer lender that so far has dealt only with individual lenders.

Perhaps the best sign that P2P lending sites have become a legitimately good investment is that Wall Street and other professional investors are now crowding us out?

Sustainable Withdrawal Rates from Merrill Lynch Wealth Management

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Here’s another data point in the debate about safe withdrawal rates, or how much money you can safely withdraw from an investment portfolio each year without running out of money. Merrill Lynch Private Banking recently released a whitepaper on “sustainable wealth” aimed at high net worth individuals. Supposedly, in more than 67% of rich families, their wealth fails to outlive the generation following the one that created it, and 90% of the time, assets are exhausted before the end of the third generation.

Rich people problems? Sure, but one of the reasons for this high failure rate is that many people don’t have a reasonable idea of what makes a sustainable spending strategy. This applies to anyone who will eventually draw income from a portfolio for an extended period of time. Making a portfolio last generations is very similar to planning for early retirement. As we are talking about percentages, the numbers apply just as well to smaller portfolios.

Here are the results from a survey of wealthy families ($5M+):

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Here are the safe withdrawal rates they calculated for a 60% stocks, 35% bonds, 5% cash portfolio based on “Merrill Lynch capital market and fee assumptions”.

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I couldn’t find where they state what their confidence level is or what their “fee assumptions” are but I would assume they would at least be in the neighborhood of 1% annually. If you invest in low-cost index funds, that would theoretically mean you could increase the provided withdrawal rates by another 0.8% to 1%.

It looks like 3% is a good number if you want to be safe for 50 years, which is close to my investment horizon. Unfortunately, it is just a matter of luck whether you really need to take things that safely. From this other Merrill Lynch paper, starting with the same portfolio balance you could have taken out 5% a year (67% more income) starting in 1974 and your portfolio would have lasted just as long as if you withdrew only 3% starting in 1972. That is the potential effect of retiring just two years apart.

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If I do use the 3% sustainable withdrawal rate, that works out to putting aside 33 times my annual expenses. To increase flexibility, I also like the idea of making the withdrawal rate somewhat dynamic (adjusts with investment returns) similar to how Vanguard Managed Payout Funds are structured.

Merrill Lynch whitepaper (via BusinessInsider)

Betterment Retirement Income Review – Automated Safe Withdrawal Tool

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bettermentlogoOnline portfolio manager Betterment recently rolled out a new Retirement Income feature that will help you withdraw money from your nest egg. Unfortunately, even though I have a Betterment account I couldn’t test it out directly as it is currently only available to customers with a $100,000+ balance that have designated themselves as retired. But through a combination of reading through their website materials, press releases, blog posts, as well as asking an employee specific questions, I was able to get a good idea of how this feature works.

Factors taken in account. Here’s what they ask about your individual situation:

  • Current portfolio value. You can add outside accounts manually.
  • Asset allocation (Betterment portfolios are built-in).
  • Inflation is assumed to be 3% annually.
  • Time horizon (age and entered longevity).

Dynamic withdrawal strategy. This is very important! Betterment’s calculations assume a dynamic strategy where you come back every year to and reassess to determine a new safe withdrawal amount. Dynamic strategies are more flexible and resilient than static strategies which simply set a number at the beginning of retirement and stick with it regardless of portfolio performance. However, as a result you’ll have to deal with varying income, and it does not appear that they perform income smoothing. Here is an example scenario of how income might fluctuate with (rather optimistic) market performance (source):

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If you follow their advice, updating at least annually, Betterment estimates that there is a 1% or less chance of depleting your portfolio before the end of your designated time horizon. As with many similar calculators in the industry, their numbers are based on Monte Carlo simulations.

Sample numbers for 65-year old retiree. I asked Betterment Marketing Manager Katherine Buck about the following hypothetical situation: $1,000,000 portfolio, 60% stocks and 40% bonds invested at Betterment, with 30-year time horizon (age 65 to 95). In that case, the current model income recommendation would be $2,879 per month ($34,548 a year), or roughly 3.45% of the $1M portfolio.

Automatic withdrawals. To recreate a paycheck in retirement, you can set up an auto-withdrawal to deposit money into your linked bank account on a regular basis. You can go with their recommended amount, or you can adjust the amount as you wish.

Cost. The Retirement Income feature is included in their existing fee structure. At a $100,000 minimum balance, a Betterment charges 0.15% annually and that fee is inclusive of all trading costs and rebalancing costs. 0.15% works out to $150 a year per $100,000 invested. So a $1,000,000 portfolio would cost $1,500 a year. This is much cheaper than a traditional advisor from a major brokerage firm.

Finally, here’s a video about the feature that includes some (blurry) screenshots of the tool in action:

Overall, I think this is a smart move on Betterment’s part to start offering more features that a human financial advisor would offer that a discount brokerage like TD Ameritrade wouldn’t. The numbers appear to be reasonably conservative and the tool is definitely easy to use. A competing product that I’ve also written about is the Vanguard Managed Payout fund. In comparison with that product, I wonder if Betterment shouldn’t add a smoothing component to their recommended income amounts so that the withdrawal amounts don’t swing too wildly from year-to-year. Betterment has historically shown a good willingness to make changes in response to feedback, so I am hopeful they will consider it.

Also see my previous full Betterment review. The current Betterment sign-up promotion offers 3 months free with a $5,000 initial deposit, 4 months free with a $25,000 deposit, and 6 months free with a $100,000 initial deposit.

Flash Boys by Michael Lewis: Book Notes and Highlights

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flashboyscoverIf you’ve read any financial news at all over the past month, you know that Michael Lewis has a new book out called Flash Boys: A Wall Street Revolt. I finished it over a week ago, but it’s rather intimidating to write a review when everyone else already has an opinion.

Perhaps I just seek out the critical reviews, but I see many financial pundits basically saying “Pfft. Everyone thinks this Michael Lewis guy is just sooo smart and sooo clever. Well, I’m smarter than him so here are all the things he didn’t get exactly right.” I’ll keep with my usual format of notes and highlights:

  • The book was an entertaining and educational read. If you like other books by Michael Lewis (The Big Short, Liar’s Poker, Moneyball, The Blind Side), you’ll probably like this one. As a gifted storyteller, he made learning about high-frequency trading (HFT) into an intriguing adventure complete with heroes and villains.
  • The most impactful form of frequency trading is slow market arbitrage. Here, HF traders use their speed advantage of microseconds (gained by paying off exchanges or drilling through mountains):

    …a high-frequency trader was able to see the price of a stock change on one exchange, and pick off orders sitting on other exchanges, before the exchanges were able to react. Say, for instance, the market for P&G shares is 80–80.01, and buyers and sellers sit on both sides on all of the exchanges. A big seller comes in on the NYSE and knocks the price down to 79.98–79.99. High-frequency traders buy on NYSE at $79.99 and sell on all the other exchanges at $80, before the market officially changes. This happened all day, every day, and generated more billions of dollars a year than the other strategies combined.

    Each trade may make a penny or even a fraction of a penny, but it all adds up. You could view it like a small tax of less than 1/10th of 1% of every trade.

  • Many people in the industry have come to the defense of HFT in the wake of the book. Some say that HFT improves liquidity, but others say that HFT actually makes the market more volatile and fragile. Others rationalize that someone is always screwing you, it’s just different people this time. (How comforting.) Traditional market-makers make money from trading but expose themselves to risk by providing valuable liquidity. In contrast, the successful HFT traders took nearly no risk:

    In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experienced just one day when it hadn’t made money, and that the loss was caused by “human error.” In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses. This sort of performance is possible only if you have a huge informational advantage.

  • HF traders should just admit that they’re doing it for the money. I think the best defense would simply be that these traders are operating within the current laws and regulations (although Providence, Rhode Island is now suing several HFT traders, stock exchanges, and large brokers). Is it ethical or helpful to society? Questionable. Consider this analogy from the book:

    It was like a broken slot machine in the casino that pays off every time. It would keep paying off until someone said something about it; but no one who played the slot machine had any interest in pointing out that it was broken.

    Do we hate the player or the game? Brad Katsuyama, one of the primary heroes who eventually creates a new stock exchange to neutralize HFT:

    “I hate them a lot less than before we started,” said Brad. “This is not their fault. I think most of them have just rationalized that the market is creating the inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done within the bounds of the regulation. They are much less of a villain than I thought. The system has let down the investor.

  • Another common argument is whether it really affects the little guy investor, or just the big institutional investors. Yes, it’s easy to think of hedge funds trading on behalf of the super-wealthy and not really feel sorry for them. But institutional investors include pensions, mutual funds, and life insurance (annuity) companies. Of course, on a relative basis the big money managers often charge their own layer of fees which are much higher than any HFT “tax”. But since HFT is essentially a transaction tax, the less that your mutual fund or pension plan trades, the less they’ll be affected.

    The CEO of Vanguard actually stated in an interview with Financial Times that HFT firms had actually helped investors cut their transaction costs through tighter trading spreads. Perhaps things aren’t so black and white. Excess trading has long been linked with worse performance, so my index funds are probably barely affected at all. (Vanguard does support some HFT-related reforms.)

  • Can you stop HFT without opening the door to another form of skimming? Maybe Vanguard’s CEO is hinting that HFT is the lesser of many possible evils. Whenever there is big money sloshing around, there will always be splashing. I don’t know. But now that Michael Lewis had thrown a big spotlight on this issue, that in itself may get rid of this market inefficiency. People have written about HFT before but this finally got people’s attention.

If you want to learn about high-frequency trading or like a good investigative story, I would recommend reading the book for yourself. If you’re still on the fence, here are two links which are essentially direct excerpts from the book:

Retirement Portfolio Spending Strategy – Withdrawal Order Flowchart

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According to research from the Vanguard Group, another area where a skilled financial advisor is supposed to able to add value is helping retirees manage withdrawals from their portfolios in order to minimize taxes. According to their paper:

Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of their clients’ retirement, thereby increasing their clients’ wealth and the longevity of their portfolios. This process alone could represent the entire value proposition for the fee-based advisor.

The paper goes on to show how correct ordering can improve returns by up to 0.70% annually versus people with multiple different account types withdrawing in the wrong order. The thing is, ordering your withdrawals properly isn’t all that complicated. Most of it is summarized in this flowchart:

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  • RMDs stand for required minimum distributions. In general, these are forced withdrawals from pre-tax “traditional” IRAs (including SEP and SIMPLE IRAs) and pre-tax workplace defined-contribution plans (including 401(k) and 403(b) plans) once you reach age 70.5. Since it is mandatory and taxed at ordinary income rates, you may as well spend them first.
  • Next, taxable flows include things like interest, dividends, and capital gains distributions that are already being “spun off” from your taxable portfolio. These are also going to be taxed no matter what anyway.
  • Next, spend your taxable portfolio itself by selling shares and paying any capital gains taxes that may be due. Sell investments with the lowest gains first to minimize taxes. Don’t sell if you don’t need the money.
  • What you have left are tax-deferred or tax-free (Roth) accounts. Do you want to pay taxes now, or later? If you think your marginal tax bracket will be higher in the future, then you should pay taxes now (withdraw first from tax-deferred account). If you think your marginal tax bracket will be lower in the future, then you should pay taxes later (withdraw first from Roth accounts). You could make your decision differently each year depending on your current situation.

How Good Portfolio Management Can Improve Real-World Returns

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Vanguard has released a research paper called Putting a value on your value: Quantifying Vanguard Advisor’s Alpha, which provides the data and methodology behind its previous statement that a good financial advisor should be able to affect the performance of client’s portfolio by about three percentage points. The areas where good management can add value are summarized in the graphic below:

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As a DIY investor, this chart also provides suggestions for areas to focus your energy. The biggest single “value-add” appears to be in the area of behavioral coaching. This basically boils down to convincing the client/investor not to abandon their previous plans during times of extreme greed (bull market) or fear (bear market). In other words, do nothing. In my previous post, I posed that a simple Vanguard Target Date Retirement fund would provide both low expense ratios and regular rebalancing – no advisor required. It turns out that if you can buy one of these Target funds and leave it alone for a long time, you’ll do even better…

Vanguard analyzed the performance of 58,168 self-directed Vanguard IRA investors from 1/1/2008 to 12/31/2012, a 5-year period which includes both the financial crisis and subsequent recovery. These self-directed investors were compared with an appropriate Target Date fund benchmark. The authors even state “For the purpose of our example, we are assuming that Vanguard target-date funds provide some of the structure and guidance that an advisor might have provided.”

An investor who made at least one buy/sell exchange between fund over the entire five-year period trailed the applicable Vanguard target-date fund benchmark by 1.5% annually on average. Investors who made no exchange lagged the benchmark by only 0.19%. The chart supplied is a little tricky to read, but illustrates the performance gap.

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(You want more “area under the curve” on the positive excess return side, and less “area under the curve” on the negative excess return side.)

I agree a good financial advisor can add value. Many people are doing none of the strategies listed above. However, a motivated DIY investor can implement most of not all of these strategies themselves. If you can buy a Vanguard Target Retirement fund and leave it alone (easier said than done), you can get much of the way there without an advisor. The problem is that you may have to go through an extreme market cycle to know if you can actually do it. Excerpted from the paper’s conclusion:

This 3% increase in potential net returns should not be viewed as an annual value-add, but is likely to be intermittent, as some of the most significant opportunities to add value occur during periods of market duress or euphoria when clients are tempted to abandon their well-thought-out investment plan.

Vanguard Managed Payout Funds and Safe Withdrawal Rate Strategy

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paycheckreplaceA key component of retirement planning is figuring out how to draw an income from all that money you’ve invested. “Create your own paycheck.” The trick is figuring out how to take a stable amount out every year without running out of money.

This has led to a debate about “safe withdrawal rates”. The 4% number has been thrown around a lot, where for example if you retired with $1,000,000 in a balanced portfolio of stocks and bonds you might take out $40,000 a year (increasing with inflation) for 30 years with confidence. The problem is that if you simply take out 4% of your starting balance and then keep taking that number out every year robotically then your outcome depends a lot on sequence of returns. If you hit a prolonged bear market just a couple years into retirement (i.e. value drops to $700,000), your nest egg is much less likely to survive. On the other hand, if you hit a bull market for the first 10-15 years and only experience the bear market afterward, then you may die with more money than you started with.

This is why many experts encourage a more flexible “dynamic” withdrawal strategy that adjusts withdrawals based on portfolio performance. There are an infinite number of ways to implement this, so I looked for an industry example and found it in the Vanguard Managed Payout Fund (VPGDX)*. This all-in-one fund uses a 4% target distribution rate and with regular, monthly distributions that you can indeed treat like a (somewhat variable) paycheck. The fund is actively managed for total return, although a majority of its components are passive index funds.

How does the Vanguard Managed Payout fund calculate how much you can spend each year? Reading through the prospectus, we find that the monthly payout is calculated on January 1st every year, then kept constant for the next 12 months, and then reset again the next January 1st. If you started January 1st, 2014 with a $1,000,000 in this fund you would get a payout every month of 2014 for $2,995 ($35,940 a year). Why isn’t it 4% or $40,000?

The fund’s dynamic spending approach uses a “smoothing” method that keeps the monthly payout from changing too dramatically from year to year. Specifically, the 4% withdrawal rate is based on a 3-year rolling average of hypothetical past account value (assumes you spend the monthly distributions, but reinvest any year-end capital gains and dividends). Screenshot from prospectus:

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So since the average of the past 3 years is lower than the current value, you’re getting 4% of a smaller number. As you can see, with smoothing your annual income from this fund can vary significantly over time. A starting portfolio size of $1,000,000 might get you an annual distribution varying from less than $36,000 or more than $44,000. Other smoothing methods include setting a maximum ceiling or minimum floor value, but this fund does not do that. Ideally, you would use the income from this fund to supplement other income from more reliable sources like Social Security, pensions, or guaranteed income annuities. That way your overall income will vary even less, and you’ll only have to cut back a little during down years.

(* Previously, Vanguard had three different Managed Payout funds with three different target spending rates of 3%, 5%, and 7%. I think this was confusing for many investors who didn’t really understand that the 7% fund would most likely experience a significant loss of principal over time. This is only speculation on my part, but the 7% payout fund did gather 8 times the assets as the 3% payout fund, even though 3% is a more realistic number for most folks. Vanguard now says that 4% is best for the “typical retirement period of 20–30 years”.)

The Power of Compound Interest Shown in a Single Chart

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It’s not just how much you save, it’s when you save that matters. The best time to start is now. This is the power of compounding returns, which this single chart will help you visualize:

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  • Susan (grey) invests $5,000 per year from age 25 to 35 ($50,000 over 10 years) and stops.
  • Bill (green) invests $5,000 per year from ages 35 to 65 ($150,000 over 30 years).
  • Chris (blue) invests $5,000 per year from ages 25 to 65 ($200,000 over 40 years).

You’ll note that Susan still ends up with more money than Bill, even though he invests three times as much money over 30 years, all because Bill starts late. Susan and Chris start out the same, except that Susan stops after 10 years while Chris keeps going. Chris only invests $100,000 more than Susan, but ends up with $500,000 more money in the end. A 7% annual return is assumed.

The chart is from a JP Morgan slide deck for their asset managers, via Business Insider.

I’m also reminded of Warren Buffett and his Snowball biography – “Life is like a snowball. The important thing is finding wet snow and a really long hill.”