Retirement

8 Principles for Happiness in the FIRE Movement

by

Quiz!

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -8M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left.

8 Principles for Happiness in the FIRE Movement

FIRE stands for: “Financial Independence, Retire Early”. People aiming for FIRE save aggressively, as much as 50%-75% of their income, aiming to retire at a young age. They typically retire once they reach enough savings to support 3%-4% annual spending.

While the result may sound very appealing, the plan can result in an unhappy life or be abandoned, if not done right. Here are 8 principles that helped me in my process, and may help you:

  1. Spend for happiness: Drop all expenses that won’t make you much happier in life today or in the future, but keep and emphasize the expenses that are important to the core of your happiness, or to build a good future.
  2. Experiment and adapt: Keep dropping additional expenses, even if everyone tells you that the expense is as important as drinking water. Question every conventional wisdom, and you are bound to enjoy some pleasant surprises. When needed, reintroduce expenses.
  3. Keep low-frequency & lower-scale expenses: Eating out once a week (or month) instead of never can add to your happiness far more than the 5th weekly meal out. Going on a road-trip to a national park off season, and sleeping outside the park costs a small fraction of a flight to another continent with a stay in a nice hotel. Such a trip still gives you time away, with family or friends, nature, and relaxation – providing the bulk of the happiness.
  4. Save most when your spending/investment ratio is high: You will save more (1) early, compounding every dollar saved exponentially for longer – giving you free extra money, and (2) when your investments are low, and expected returns are higher.
  5. Invest for high growth: High growth helps reach independence earlier. In addition, high growth investments tend to be more volatile, providing excess gains to a consistent saver (read https://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/ to understand). Two caveats: (1) Stay highly diversified across sectors and countries; (2) Be prepared to stay consistent through multi-year declines – something that comes with all high-growth investments.
  6. Aim for a conservative outcome: Aim for a 3% annual spending rate, to support a potential of many decades in retirement. Spending includes non-recurring and surprise expenses, including car upgrades, major home repairs, and healthcare costs, to name a few.
  7. Keep working at what you love: Once you reached financial independence, keep working at something you love. It can be your current job, a new lower- or higher-paying job, or a new business.
  8. Maintain 3% spending: As your investments reach higher peaks, you can raise your spending proportionately to enjoy the fruit of the optimizations leading to that point. You can call this modification the FIRES movement = Financial Independence, Retire Early, then Spend, Save or whatever makes you happiest. Whatever you choose, the compounded growth of investments is expected to grow the benefit exponentially over time.

There are several benefits to these principles:

  1. Maximum happiness gained from every dollar spent.
  2. Enjoying work in retirement from a position of power with no pressure.
  3. Decades of financial independence + growing spending. You are likely to enjoy far greater lifelong spending than the typical person.

Quiz Answer:

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -2M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left. [Correct Answer]

Explanation:

The frontloading of spending created a disadvantage that was impossible to recover from, despite doubling the number of working years. Details:

  1. The extra spending in the first 20 years of scenario #1, led to a balance of 460k relative to 2.3M in scenario #2.
  2. 7 years later, with 13 years of work remaining for scenario #1, the annual spending of 90k was lower than the spending level of the person who retired already 7 years earlier.
  3. By the end of the working career, the 90k spending compares to 173k for the person retiring 20 years earlier. The investment balance grew nicely to 2.6M, but short of the 6.1M of the early retiree.
  4. By the end of retirement, the spending jumped to 196k relative to 460k for the early retiree. The investment balance reached nearly 7M vs. 16M for the early retiree.
Disclosures Including Backtested Performance Data

Should Higher Earners have Higher or Lower Saving Rates?

by

Quiz!

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your savings nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year.

Should Higher Earners have Higher or Lower Saving Rates?

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. Should you keep your saving rate of 10%, increasing your savings to $16k/year? Should you increase your savings by less than that or even more? For many reasons, you should increase your saving rate, leading to new savings greater than $16k/year. Here are a few reasons:

  1. Usually, the higher your income, the lower your job security. Many more people compete for CEO or VP roles, than a fast food restaurant employee. You need to build security through savings faster to make up for your declining job security.
  2. If you lose your job, there are fewer jobs to choose from, the higher the income.
  3. The excess happiness obtained by increased spending goes down quickly as the amount goes up. Reducing financial stress typically brings much greater happiness.
  4. Social security covers a smaller portion of high incomes. If you earn $30,000 per year, social security will give you a retirement greater than half of your earnings. But, at $300,000 per year, social security income covers a small portion of the income you got used to. It is up to you to make up the difference. To get income of $300,000 from a portfolio that can generate 3% per year, you would need to build savings of $10,000,000. If you want to enjoy anywhere near the standard of living you got used to, you need a very high saving rate combined with investing for high growth compounded over many years.

The good news is that even at 20% = $32k saving rate, your income available to spending grows by a substantial: (160k – 32k) – (100k – 10k) = 38k minus income taxes. You get the double benefit of higher spending along with a big increase in your saving rate.

Quiz Answer:

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your saving nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year. [The Correct Answer]

Explanations: Read this months’ article for an explanation.

Disclosures Including Backtested Performance Data

Your Neighbor’s Grass is Brown!

by

Quiz!

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that.
  2. He is wealthy.
  3. He lives in a fancy house.

Your Neighbor’s Grass is Brown!

Have you ever seen a friend’s or neighbor’s fancy car, or heard about her fancy trip, and thought how lucky she is? After nearly 1.5 decades in this business, I’ve heard many people’s stories, and learned that things are rarely what they seem. Specifically:

  1. Each person emphasizes certain expenses, while often keeping other expenses much lower. A person can fly business class, while living an otherwise modest life. Another may lease a fancy car, while renting a modest home. A third may live a simple life in a fancy home. A fourth may pay for a very expensive private school for her children while living a modest life. These are all examples based on people I personally know. I believe that only a small fraction of people who spend big in a few categories, can afford to spend big in all categories. It makes sense to choose the most important things in your life and focus your spending on them, rather than spending evenly across all categories, whether important to you or not, leaving less money to your top priorities.
  2. Many big spenders are chronically stressed. It fits with a recent study showing that income above $105,000 in North America paradoxically leads to diminished happiness. Anyone with high income faces the temptation to spend a big portion of their income. Say you gross $1M and net $600k per year. You save what feels like a respectable 20% of your net income: $120k, and spend $480k. After a number of years, you built a nice investment portfolio of $1M. You are still highly dependent on your income, and replacing such high income can be a big challenge. This can lead to unusually big stress. In addition, high income often comes with big responsibilities (CEO, business owner), putting extra pressure. To sustain $480k of spending from a stock portfolio that can handle sustainable 3% withdrawals, you would need to reach savings of $16M. Such a level of savings is not common, and probably a lot less common than spending of $480k per year.

If you are able to satisfy your basic needs (food, a place to sleep, basic clothes, etc.), and spend modestly relative to your savings, you are under a fraction of the financial pressures of many big spenders. You may think that their grass is greener, but it is brown compared to yours. Peace of mind, lesser dependency on work, and appreciation for the little things in life are worth a lot more than what big expenses can buy along with the stress involved. You are the source of envy of some very big spenders who realize that your grass is greener. Next time you see a big spender, you may replace feelings of envy with some compassion.

Quiz Answer:

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that. [The Correct Answer]
  2. He is wealthy.
  3. He lives in a fancy house.

Explanations:

  1. People often spend money on things they value.
  2. People usually spend money based on their income, even if their total wealth (savings/investments) is low.
  3. People usually spend big money on several categories, but not all.
Disclosures Including Backtested Performance Data

Outpacing the Longevity Escape Velocity

by

Quiz!

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling your biggest risks (any number of answers may be correct):

  1. Limiting yourself to fast growing investments.
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including stocks, bonds & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales.

Outpacing the Longevity Escape Velocity

Ray Kurzweil, director of engineering at Google & inventor, predicts that in 10-12 years we will reach longevity escape velocity. This is the point when science and technology will add more than a year to our lifespan for every year we remain alive, leading to an infinite life. With an 86% accuracy rate for his prior predictions about the future, there is some chance that this will be true as well. He may be almost completely wrong, with a lifespan of a mere 200 years or 2,000 years, instead of infinity. When planning my investments, I wouldn’t bet with 100% confidence that he is completely wrong, especially when losing the bet would mean spending most of my long life broke.

Unfortunately, many retirement plans do make this bet. A retirement plan with a 95% chance of providing 30 years of retirement income is typically considered appealing. That means a 1-in-20 (5%) chance that if you live for 30 years, you will go broke later in life, just when financial stress is the toughest to handle. If you live longer than 30 years, the odds of failure go up. I have personally known a retired woman that gradually depleted her assets, and faced one of two tough cases: dying soon or going broke. This memory is carved in my mind, and I am not ready to see any of my clients reach the same position.

Accepting some chance of an infinite life, or simply a very long one, requires infinite income. While the word infinite sounds dramatic, it is not impossible to plan for infinite income with very high odds. You simply need to apply a similar principle of escape velocity to your investments, with more growth than spending, in an average year. Stable investments (bonds, money market) grow too slow to support long-lasting withdrawals that accelerate with inflation. So, we need to seek faster growing investments, and handle the volatility, by accounting for withdrawals during downturns. By using investments that grow fast enough, you can make up for the penalty of withdrawals during declines, as long as the investments are diversified, and the withdrawal rate is low enough. Two stock portfolios fit the requirements:

  1. Long-Term Component (LT) is likely to support 4% withdrawals forever.
  2. Extended-Term Component (ET) is likely to support 3% withdrawals forever.

For the disciplined investor with low withdrawal rates, longevity risk turns some common risk-planning principles on their heads: bonds and cash become risky, and diversified stocks become safe! This is because running out of money becomes a greater risk than losing it all during a temporary decline (through small withdrawals).

Once your withdrawal rates from these portfolios go below the stated rates, you would likely reach escape velocity, providing you with income for as long as you live, even infinitely. But instead of just solving the longevity financial risk, you get a big bonus. After reaching a sustainable withdrawal rate, your portfolio is expected to keep growing over full cycles despite your withdrawals. You can choose between higher security or higher income (or some of each) with every new peak.

My clients tend to be conservative, and don’t count on any specific limited lifespan. I tend to reject more aggressive investors.

Quiz Answer

If you are retired, can stick to an investment plan, and spend 3%-4% of your money per year, which of the following are important for handling the biggest risks you may face (any number of answers may be correct):

  1. Limiting yourself to fast growing investments. [The Correct Answer]
  2. Picking the right stocks, to avoid big losses.
  3. Diversifying into various asset types, including bonds, stocks & real estate.
  4. Staying disciplined with your plan, and avoiding panic sales. [The Correct Answer]

Explanations:

  1. If you end up living a long life, you need high enough growth to support annual withdrawals that grow with inflation. With low growth, you can run out of money.
  2. Trying to pick the right stocks introduces the risk of picking the wrong ones – this is a big risk to take when your lifelong income depends on it.
  3. Low-volatility investments are necessary for high withdrawal rates for a short horizon, and for people who panic during stock declines. You have the benefit of discipline and low withdrawal rates, and may face a long horizon.
  4. It is critical to stay disciplined with your plan, and avoid panic sales. A couple of panic sales can negate the entire benefit of the high average gains.
Disclosures Including Backtested Performance Data

Your Financial Health in a Single Number

by

Quiz!

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio.
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Your Financial Health in a Single Number

People use various numbers to measure their financial health. Let’s review some common ones, and see where they fail, through examples:

 

Measure Person 1 Person 2 Person 2 has better financial health
even though… because…
Net worth (total assets minus total liabilities) Net worth: $10M

Annual spending: $1M

 Net worth: $1M

Annual spending: $50k

 His net worth is x10 smaller His money can support double the years of living expenses
Income Income: $1M per year

Savings: $0 per year

Total saved: $0

 Income: $100k per year

Savings: $20k per year

Total saved: $200k

 Her income is x10 lower She has some financial security in case she loses her job
Annual savings Income: $1M per year

Income taxes: $400k

Annual spending: $500k Annual savings: $100k

Liquid assets: $200k stocks

 Income: $100k per year

Income taxes: $20k

Annual spending: $50k

Annual savings: $30k

Liquid assets: $60k stocks

 His annual savings is x3.3 smaller He is building security faster, saving 60% of annual spending vs. only 20%. His savings in stocks are also greater relative to spending.
Withdrawal rate from stock portfolio (annual withdrawals from the stock portfolio divided by its value) Expenses: $1M per year

Stocks: $1M

Annual withdrawals: $0k

 Expenses: $40k per year

Stocks: $1M

Annual withdrawals: $20k

 Her withdrawal rate is infinitely greater Her total spending (4%) can be sustained with no work, while the other has only 1 year of expenses saved
Spending rate from liquid assets (total annual spending divided by the value of all liquid assets) Liquid assets: $1M cash

Spending: $40k per year

 Liquid assets: $1M stocks

Spending: $44k per year

 His spending rate is 10% greater Stocks provide growth, and are more likely to sustain a 4.4% withdrawal rate than 4% from cash

Is there a single number that can give some indication of your financial health? Yes! It is the spending rate from your stock portfolio: total annual spending divided by the value of your stock portfolio. This assumes that the stock portfolio is diversified, and held for the long run, with no market timing, and no panic sales during stock declines. Also, you can reduce your spending measure by any amount that is guaranteed for life by an inflation-adjusted source, such as social security.

Why does this measure work?

  1. It shows progress towards financial freedom / financial security / retirement. Once your spending rate is below 3%-4%, depending on the specific portfolio allocation, the portfolio is likely to sustain the spending for as long as you live. If your spending rate is 6%-8%, you know that, between savings and investment growth, 100% increase will make you independent of work.
  2. It is not sensitive to a loss of job. It ignores income from work, that can be lost in various ways. In addition, if you want to ever be independent of the need to work, you want to measure your position assuming no income.
  3. It can withstand high inflation, given the focus on stocks.
  4. It does not suffer from liquidity concerns related to real estate, private equity and small businesses. Exception: If you have a diversified collection of properties, you can consider their income, after accounting for vacancies and repairs, if they are diverse geographically (and ideally enjoy country diversification, same as with stocks).
  5. It focuses on current health instead of potential. Even if you save a large amount every year, the saving can stop completely if you lose your job. What matters is money on hand (prior savings).

What are the implications? How can you improve your financial health?

  1. Maximize your allocation to stocks, but not beyond the point of risking getting into trouble during stock declines, either through large withdrawals, or panic sales. This requires a careful risk analysis.
  2. Keep your spending under control. A 10% reduction in spending provides an instant 10% gain in your financial health – this is powerful.
  3. Maximize your savings, either through lower spending or higher earnings. Note that higher earnings will not have any immediate impact, but the saved money from your increased earnings will build up gradually.

Quiz Answer

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio. [The Correct Answer]
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Explanations: See article above. Note that the last option “withdrawal rate from liquid assets” is not addressed by the article, since it suffers from the combination of flaws of the two options above it (5 & 6).

Disclosures Including Backtested Performance Data

How Does the Book “The High-Beta Rich” Apply to You?

by

Quiz!

Which of the following should be elements of a plan to provide lifelong income through all market cycles? (Multiple correct answers)

1. Hold a rainy day fund.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate.

3. Commit to low spending relative to your assets.

4. Diversify your stock allocation across companies and countries.

5. Start a profitable business.

6. Dedicate your money to high growth investments.

7. Limit your mortgage(s).

How Does the Book “The High-Beta Rich” Apply to You?

This article discusses an issue raised by the book “The High-Beta Rich” by Robert Frank, and explains how QAM’s plans address it.

Historically, wealthy families were more immune to market cycles than the general population. The book shows that starting in 1982, the income of the top 1% earners became more volatile than the income of the overall population. While they enjoyed high growth, their income declined further during economic downturns. This is due to more of their income depending on volatile investments, including leveraged real estate, individual companies and concentrated stock investments.

The book presents stories of people that amassed substantial wealth, and later lost most or all of it. A common strategy to avoid losing it all, is to hold some money in stable investments. While this solves one problem, it introduces another one – it slows down the overall growth, which increases the risk of outliving your money.

Is there a solution that lets you enjoy the high growth without taking excessive risks?

Such a solution exists in certain cases. Here is a list of goals with details of how to achieve them:

1. Having your money last: Dedicate your money to high growth investments – stocks of profitable companies that are priced low (value stocks).

2. Recover from declines: Diversify across thousands of stocks in many countries.

3. Provide stable income through the declines: Commit to low spending relative to your assets, with a clear trend towards 3%-4%.

The beauty of this solution is that it doesn’t require lifelong financial sacrifices. What it does require is:

1. Disciplined spending, even as you see your savings reach high levels, or when your income is much higher than 3%-4% of your savings. Lack of this discipline is a big reason some wealthy people get into trouble during downturns.

2. Strength in the face of downturns, and commitment to the investment plan.

3. Permanent diversification at all times; avoiding the temptation to put a substantial portion of the money in a single company or real estate investment.

Does the list of these requirements seem too easy to follow? During over 11 years of service, QAM learned that many people find these requirements to be very difficult to adhere to. If you are able to adhere to them, you have a good chance at sustaining lifelong (and multigenerational) growing income. In addition, successive downturns are likely to become easier to handle, if you limit the growth in spending.

Quiz Answer

Which of the following are key elements of a plan to provide lifelong income through all market cycle? (Multiple correct answers.)

1. Hold a rainy day fund. Sometimes correct: A rainy day fund, such as 3-6 months of living expenses in cash, is necessary for surviving declines early in your saving years, especially if you have low job security. Once you build meaningful savings, the benefit of such an allocation gradually becomes outweighed by the benefit of maximizing the growth of your investments, for lifelong income.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate. Incorrect: While maximal diversification helps survive declines, including slower growing investments hurts the necessary growth for lifelong income that grows with inflation.

3. Commit to low spending relative to your assets. Correct: This is a key element. There are a number of benefits to low spending relative to your assets: (1) It helps handle declines combined with lack of work without depleting your money; (2) It helps build your savings faster, to provide the nest egg needed for lifelong income.

4. Diversify your stock allocation across companies and countries. Correct: Diversification helps avoid total loss during declines.

5. Start a profitable business. Sometimes correct: Running a business combines pay from work and profits of the business ownership. As a small business, it has the potential of outperforming stock investments. The benefit of higher growth comes at a price of liquidity constraints and the risk of a total loss. Therefore, for the goal of lifelong income, it is best to limit your investment in your business to a small portion of your savings.

6. Dedicate your money to high growth investments. Correct: As long as you stick with high-growth investments, diversification provides a benefit of higher low points during declines, without the price of hurting your average returns.

7. Limit your mortgage(s). Usually incorrect, but read further: Real estate with no (or limited) mortgages tends to grow more slowly than diversified stocks, and is less liquid. If you are going to limit your mortgage for any reason (can’t qualify for high mortgage, short-term risk is too high, don’t like volatile investments along with the mortgage obligation), you are better off investing in diversified stocks instead of owning a home, for the purpose of lifelong income. There are non-financial benefits to owning your home, which may lead to accepting a lower mortgage along with less optimal lifelong income.

Disclosures Including Backtested Performance Data

2 Reasons to Reinvest Dividends

by

Quiz!

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.
  2. Keep the dividends in cash and use them for income.

Look for the answer below and read this month’s article for a discussion.

2 Reasons to Reinvest Dividends

In recent years, it has become tougher to automatically reinvestment dividends. Despite this difficulty, it is still beneficial.

What is the difficulty with automatically reinvesting dividends? When reinvesting dividends (as with any other “buy” trade), there is a 61-day window (30 days before and after the reinvestment) in which selling and recognizing tax-losses is disallowed. This is called the “Wash Sale Rule”, and is established to prevent people from selling and buying for the pure sake of getting a tax deduction. Complying with the wash sale rule, requires knowing the date of upcoming dividends at least 31 days in advance, to avoid sales in that window.

How has it become more difficult to automatically reinvest dividends? Brokers & custodians are required to report the cost basis of mutual fund purchases on form 1099-B, in order to shed light on wash sales, and discourage them. By not reinvesting dividends, you reduce the number of buys, including the number of wash-sale windows, and retain more freedom to sell without violating the wash sale rule.

What are the benefits of reinvesting dividends?

1. Full participation in gains: Reinvested dividends never stay in cash, allowing you to get the investment returns at all times, and avoid missing returns while money sits in cash. For every 1% that you avoid keeping in cash in the account, and instead keep in an investment that averages 10% per year, you get a benefit of 0.1% per year (1% of 10%). This is a material portion of the investment performance.

2. Tax deduction: When there is a need for cash (e.g. retirement income) or a rebalance, you can sell the most appealing mutual fund shares (outside the 61-day wash-sale window), allowing to realize tax losses.

How can you avoid wash sales? To avoid wash sales, you need to be strategic, and sell away from the time of dividend reinvestments. Dividends are often given quarterly. After excluding the month before and after the dividend, you are left with one month per quarter to sell while realizing tax losses. One strategy is to sell once per quarter (whether for rebalancing or for withdrawals). If you need cash throughout the quarter, you can choose between keeping it on margin (borrowed against the brokerage account) if the amount is small, or selling in advance for large amounts.

Quiz Answer:

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.  [The Correct Answer]
  2. Keep the dividends in cash and use them for income.

Explanation:  While keeping the dividends in cash is the easiest thing to do mechanically, there are many benefits to reinvesting them. The article above explains the benefits.

Disclosures Including Backtested Performance Data

Money Can Buy Happiness with One Powerful Action!

by

Money can buy many things that give happiness in life.  But, once you cross a moderate standard of living, more money leads mostly to temporary increases in happiness until you get used to the new normal (e.g. new car, private jet).

One thing that can stick is the ability to stop worrying about money.  This happens when you save money, and have enough available for surprise needs, beyond the routine expenses, such as a major repair or unexpected health care expenses.

The key factor that makes this work is the extra unused money.  $1M invested in Quality Asset Management’s portfolio Long-Term Component is likely to provide perpetual annual income of $40k, growing with inflation.  Any unexpected expenses up to this amount can be handled with great piece of mind.

The ultimate worry-free life (financially) is reached when your investments can cover all of your ongoing + unexpected expenses perpetually (e.g., $5M providing $150k for routine expenses + $50k for surprise expenses, at 4% annual withdrawals).  At that point, you can avoid worrying about money, and feel the lasting happiness.

The good news is that you don’t need to wait for decades to reach the ultimate goal, to start reaping the benefits.  With every bit of increased savings (relative to spending), you get reduced stress and increased happiness.

Disclosures Including Backtested Performance Data

Better than Dividends!

by

In the article  6 Problems with Dividends for Income [December 2013] you saw a long list of disadvantages of dividends when compared to selling from your investments to generate any required income.  Yet, retirees still like dividends.  Why is that?  The reasons are psychological, and several are listed below:

  1. Disciplined spending:  By limiting spending to dividends, you can resist the temptation to spend the principal.  It gives structure.
  2. Avoiding selling at a loss:  Dividends are given whether the investments are up or down.  A dividend withdrawal at a decline doesn’t require actual selling at a loss.
  3. Avoiding regrets over missed gains:  If you spent dividends, it feels like you spent cash.  But, if you sold from your investments, and they gained substantially, you may regret the sale.  People tend to regret action more than inaction.

Since income can be generated by selling from the portfolio instead of dividends, it is best to avoid focusing on high-dividend investments just for the sake of income generation.  By sticking with selling, you gain control over the amount, timing and regularity of income, as well as investment choice and improved tax-loss harvesting.

The missing piece is the psychological comfort.  That can be obtained by sticking to a conservative cap on withdrawals from the portfolio (typically 3%-4% of the peak value of the investments).  Having an outsider (investment advisor, family member, close friend) track the withdrawals can strengthen the discipline.  As a Quality Asset Management client, you receive the available withdrawal amount in your quarterly email, so you can view your investments very clearly as a sustainable income stream.

Disclosures Including Backtested Performance Data

6 Problems with Dividends for Income

by

If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data