What's the optimal amount of home-country (currency) bias?

I have the view, which I consider fairly obvious but not always clearly articulated, that virtually all low-enough-cost, adequately-diversified investments will yield positive nominal returns over the appropriate investment time horizon. If you own yen-denominated Japanese bonds, you should expect to receive a positive yen-denominated return over the term structure of the bonds. If you own euro-denominated stocks, you should expect to receive a positive euro-denominated return over the (potentially infinite) time horizon of your equity investments.There are exceptions. If you're a yen-denominated investor who inherited a fortune on December 31, 1989 and immediately invested it in a Nikkei 225 index fund (I'm not sure such a thing existed at the time, but bear with me), then even with dividends reinvested your fortune today would still be somewhat smaller in yen than it was on that date. Likewise communist upheavals and sovereign defaults have completely wiped out bond investors at various intervals around the world.Diversification is a sensible way to secure part of the return of various global assets classes with unknown (but presumably positive) nominal growth, while reducing the risk of total loss in case of war, communism, or default. It is so sensible, in fact, that I think people can get a bit too enthusiastic about its merits. That's because diversifying internationally reduces your concentration risk but adds a new risk, currency.If yen-denominated assets rise by 6% a year but the yen declines by 6% per year against the dollar, you'll enjoy positive yen-denominated returns but flat dollar-denominated returns. That's a big deal if you plan to retire to a country that sells goods and services in dollars!

Home country bias

"Home country bias" refers to the tendency of investors to allocate a disproportionate amount of their capital to domestic assets. That begs the question, "disproportionate" compared to what? To say an investor allocates "too much" capital to a given country implies there's also a correct amount to be allocated there.Two ways you might define an "unbiased" asset allocation are by the market capitalization of a country's investable securities, or the share of global economic activity in a given country. A market capitalization approach has the advantage of automatically rebalancing over time as markets rise and fall in value, while an economic activity-weighted allocation would need to be manually rebalanced since a country's rising or falling share of economic activity may or may not be reflected in its market capitalization.A market capitalization-weighted portfolio would hold about 36% in US equities and 64% in international equities, while an economy-weighted portfolio would hold somewhat less in US equities, perhaps 25%. If you hold more US equities than whichever you think is the "real" benchmark, then congratulations, you have home country bias!

It makes sense to be overweight the currency you intend to spend

Most people, in most of the world, are born, grow up, and die in the same country. That means most people's income and expenses are denominated in the same currency.This general rule is not, however, universally observed. While I was there, Russian banks offered certificates of deposit denominated in rubles, dollars or euros, with different interest rates depending on the currency you chose (ruble deposits paid the most). Likewise in Europe we recently saw the revaluation of the Swiss franc punish Polish homebuyers whose income is denominated in zloty but who took out franc-denominated mortgages to take advantage of lower interest rates.If international diversification is a way to reduce the risk of concentrated bets on a single country, then home country bias is a way to reduce the risk of exchange rates moving against you. Most large-country exchange rates are mostly stable most of the time. But as the Poles learned, you also don't want to be left holding the bag if the currency you intend to spend suddenly gets much more expensive.What this logic means is that you should be biased not towards your home country, or even your home currency, but rather the currency where you intend to spend the value of your investments — and you can be biased towards different currencies for different reasons!For example, a 529 plan you intend to liquidate to pay for an education in the US might be biased towards US stocks and bonds, while a retirement account you intend to use to retire in the Eurozone might be biased towards euro-denominated stocks and bonds. In the one account you're protecting yourself from a stronger dollar, which would raise the price of US higher education in non-dollar-denominated assets, while in the second you're protecting yourself from a stronger euro.

What's the optimal amount of home-currency bias?

The funny thing about home-currency bias is that it tends to provoke absolutism in people. If you believe that home-currency bias is an investor "error" and that it should be eliminated completely, you arrive at the strange view that everyone in the world should have the same asset allocation (at least within their stock and bond "buckets"). A Greek, Chinese, Polish, Canadian, Ecuadorean, and US investor should all hold 36% of their stocks in a market-cap-weighted US mutual fund and 64% in a market-cap-weighted international fund.On the other hand, Jack Bogle's view has long been that international investing is unnecessary for US investors. US companies do business all over the world, so you get the same currency and economic risk exposure you would get by investing in international companies directly.I think the right answer is not 100% home-currency bias or 0% home-currency bias, but rather the terribly unsatisfying "some home-currency bias." To the extent that your future expenses are predictable, shading your asset allocation to the currencies those expenses are denominated in makes perfect sense. If you have a Swiss franc-denominated mortgage, you should be "overweight" franc-denominated assets (or save up several years worth of mortgage payments in francs). If you plan to send your kids to US colleges, you know for a fact those expenses will be high and dollar-denominated, so logically those savings should be overweight US dollars.

What if you can pick the currency your expenses are denominated in?

So far I've been talking about future expenses that are denominated in a known currency. You know as soon as you sign the paperwork what currency your mortgage payments will be in, and US colleges and universities only accept US dollars. But not all expenses are like that, or at least they don't have to be. You don't have to decide which currency to retire in until you're ready to retire. Then you can consult the latest edition of the Economist's Big Mac index and move to the country with the most undervalued currency.To the extent that you can pick the currency your retirement expenses will be denominated in, then your goal should logically be to maximize the dollar-denominated value of your portfolio (the one that appears on your statement). If the dollar falls in value, you can stick around in the US where our goods and services are dollar-denominated, while if it rises in value, you can pick the retirement destination of your choice. In that case, you really might want to eliminate home country bias in your equity portfolio because you aren't exposed to the same exchange rate risk.You can apply the same logic to education expenses. If international institutions get cheaper in dollar terms, you can ship your kids overseas, while if they get more expensive, well, US colleges will continue to accept your worthless dollars.

Conclusion

One reason it's hard to think clearly about currency risk is that if you work with a US brokerage, your account's value is only shown to you in US dollars, so it's difficult to keep in mind that the value of your portfolio can rise in dollars while falling in another currency (if that currency appreciates relative to the dollar), and vice versa.Obviously anybody can look up current exchange rates and calculate the euro-denominated, ruble-denominated, or zloty-denominated value of their portfolio whenever they want, but I have long though it would be a cool feature for a brokerage to automatically calculate and display your account's value and its change in value in 3 or 4 major currencies.I know my portfolio's value has risen in US dollars, and I know the US dollar has fallen compared to the Swiss franc. Which effect is larger? Have I grown wealthier or poorer in Swiss francs? I think that would help people think more clearly about currency risk, and perhaps even improve their ability to design an investment portfolio that targets returns in the currency they actually intend to spend.

Indexed annuities are bad

To call the finance industry a "mixed bag" would be a gross understatement. There are a few functions essential to industrial capitalism that banks, bill brokers, and financiers mastered centuries ago, like moving funds from savers to borrowers, a process described marvelously by Walter Bagehot in 1873. Then there's the constant stream of financial "innovations," as bankers churn out new and exciting products to separate people from their money — and that's when they're not simply robbing their customers.The problem with financial innovation is that there are only a few fundamental functions a financial company can perform. For example, an insurance company can spread the risk of an early death across a population by selling insurance to every member of population, moving money from those who survive to the survivors of those who live. A bank can make you a loan today that will be paid back with your future income, in effect "accelerating" your salary by moving it forward in time. A bank can borrow money from you today, promising to pay it back over time, while giving the money in a lump sum to a borrower.What the finance industry can't do is create value. You may be grateful to a stock broker for facilitating a profitable trade, but any trade that's profitable for you is unprofitable for the guy on the other side of it. You may be glad to loan your money to the bank for interest, but the guy borrowing the money would surely rather not pay interest on his loan. The finance industry simply rests in the middle, taking a cut of every transaction.

Indexed annuities make no sense

I have to assume these products will be banned eventually since they are marketed and sold in extremely abusive fashion, but for now, here's how they work. A fixed annuity is combined with an index (for example the S&P 500), so that the value of the annuity contract is adjusted according to the performance of the index.Usually the value of the contract is adjusted upwards annually or biannually according to the change in the value of the index since the last adjustment date, up to a maximum adjustment amount, typically between 3% and 6%. If the index rises by more than that, you get the maximum adjustment but no more. If the index declines between adjustment dates, the value of the contract isn't adjusted downward.There are three big problems with this product:

• Maximum adjustment. If the insurance company buys options against the relevant index in order to hedge against changes in the contract's value, and the index rises by more than the maximum adjustment amount, the insurance company gets to keep any profit it shows on the options' value.
• Dividends excluded. If you were to own the relevant index itself, instead of an annuity indexed against it, you would also earn any dividends paid by the stocks in the index. Reinvested dividends and bond coupons represent a significant part of any investment's return, and you give them up when you buy a price-indexed annuity.
• High fees. In exchange for giving up "excess" price appreciation and the dividends paid by the underlying index, you also get to pay your insurance agent a commission several times higher than the one on an immediate fixed annuity. The same premium mechanically has to buy a smaller annuity if more of it is going to pay commissions (remember, finance doesn't create value).

Michael Kitces has a good post focused on the idea of principle protection and equity participation, which is, in principle, the "problem" variable indexed annuities were designed to address. But of course the purpose of annuities is not principle protection and equity participation — it's to provide a stream of lifetime income!

Single premium immediate annuities make a lot of sense

Today it's very fashionable to talk about "sequence of return" risk: a retiree might expect their investments to return 6% per year on average over the next 30 years, but if the first 15 years return -6% and the second 15 years return 18%, the 30-year average doesn't do them any good since they won't have any assets left by the time the 15-year bull market comes along.It's not a terribly popular view, but I think annuities are a perfectly reasonable way to foist sequence of return risk onto somebody else.Most US retirees' income will consist entirely of their Social Security old age benefit, which is why their first priority should be maximizing that benefit by delaying their old age benefit as long as possible, even if it means spending down their retirement savings before filing.But for retirees with expenses in excess of their Social Security benefit, buying a single premium immediate annuity is a sensible way to achieve a guaranteed income that meets those needs.

Just buy the annuity you need

There's a simple rule of thumb in annuity pricing: the more you want your annuity to resemble an investment, the smaller the annuity will be, or the more you'll have to pay for it. But investing is cheap and easy! Don't pay insurance agents and insurance company shareholders a premium to do something you can do yourself for next to nothing.Figuring out your lifetime retirement expenses isn't "easy," but it's possible. You can even pay a real, professional, fiduciary financial adviser to help you out while calculating those expenses, instead of an insurance salesperson who's paid more depending on the amount they can convince you that you need.Once you have a sense of your annual expenses in retirement, you can deduct your Social Security old age benefit and buy an annuity that makes up the difference. It doesn't matter to me what you do with the difference: you can leave it to your heirs, give it to charity, or buy ornamental bookends. All I want is for you to not pay for "protection" you don't need given your actual expenses and actual net worth — however much those end up being.

The low-hanging fruit of personal finance

On Friday I wrote about how people making payments in excess of the minimum to student loans need to make sure their student loan servicers have instructions to credit the excess payments to their highest-interest-rate loans first. It's the kind of simple measure you can take to save money on student loan interest, and all it takes is a single letter to put the appropriate instructions in place.It's also the kind of simple measure I'm confident virtually no student loan borrower takes.That got me to thinking: what are the other low-hanging fruit of personal finance? What are the simplest things you can do to improve your financial well-being, broadly considered?Here are a few more that I came up with.

Maximize the interest your cash earns

I love cash. I don't think you need to justify holding cash by calling it an "emergency fund" or pretending to save for a house down payment or car repairs or whatever. Cash is great and it doesn't need any excuses. But if you're going to hold cash, you should want to earn the highest possible return on it. That means ignoring the "high-interest" savings accounts offered by Discover, American Express, or your local bank and going straight to the highest-interest checking accounts, like the Consumers Credit Union Free Rewards Checking account.You can earn 3.09% APY on up to $10,000 by buying 12 $0.50 Amazon credit reloads each month with your Consumers Credit Union debit card.If you want to earn even more interest on even more money, you can sign up for one of the Consumers Credit Union Visa credit cards and earn 4.59% APY on up to $20,000 by making the same 12 Amazon credit reloads and spending $1,000 on the credit card each month.The Amazon credit reloads take 5-7 minutes on the first of each month. How's that for low-hanging?

Be fully invested (in something)

When it comes to investment accounts, particularly accounts that feature tax-free or tax-deferred growth, you will probably be ill-served leaving large amounts of cash in your account's default settlement fund. Even if you don't want to invest in equities at their current or future valuations, you can direct contributions to a short-term inflation-protected bond fund, or even just a money market fund offering slightly higher yields than your brokerage's default settlement fund. As with student loan interest, it's the kind of small election that has the ability to earn you much higher returns with virtually no effort.

Use the right credit cards

My other blogging project is dedicated to the very high-hanging fruit of maximizing credit card rewards, but that is a hobby that consumes an enormous amount of time and attention. If you don't want to do that, you don't have to. Instead, you can use these simple rules to pluck the lowest-hanging credit card fruit:

• Earn at least 2% cash back on all your purchases.
• Don't pay foreign transaction fees.
• Don't pay annual fees.
• Use balance transfer offers to minimize the interest you pay on ongoing credit card balances.
• Use introductory financing offers to minimize the interest you pay on new credit card balances.

Debt moralizers will tell you that credit card rewards, balance transfer offers, and introductory financing offers are traps to get you to fall into debt. Maybe they're right!But I don't care whether you're in debt or not, I care whether you're paying interest on your debt or not, and my concern is that most people, most of the time, are paying too much in credit card interest.

Make good behavior easy and bad behavior hard

Behavioral economics is all the rage these days, and the economists are hard at work testing all sorts of rules and defaults to get people to save more, eat better, smoke less, and whatever else they think is best for us. Good luck to them, I suppose.But in your own life, you don't need a marionettist to pull your strings: you can pull your own strings, by automating as much as possible the behavior that you, personally, recognize as good and necessary, and staying out of your own way.Set up automatic contributions to investment accounts. Reinvest automatically. Rebalance quarterly at the most frequent; annually is probably fine. Delete your investment accounts from Mint, Personal Capital, and any other tools you use to track your finances. If seeing your balances bounce up and down is making you exhibit behavior you know to be bad, the answer is as simple as not seeing your balances bounce up and down.If you're a compulsive gambler like me, give yourself a small amount of cash to gamble with using a free trading app like Robinhood. Treat the money as gone as soon as you invest it, and then have fun buying and selling stocks as much as you'd like — especially when you get the temptation to mess with your actual investment portfolio.

Open a solo 401(k) if you have self-employment income

A solo 401(k) is an important tool for self-employed people for a few big reasons:

• You can make pre-tax employee contributions if your employer doesn't offer a 401(k) at your day job, or if their 401(k) provider offers inferior investment options.
• You can make pre-tax employer contributions even if you've already maxed out your employee contributions at your day job.
• You can make post-tax employee Roth contributions if your employer doesn't allow them at your day job.
• You can choose your own 401(k) custodian if the custodian your employer uses at your day job is terrible.

Now, I agree this may not seem like "low-hanging fruit," but if your small business is an unincorporated sole proprietorship you don't have to actually do anything throughout the year once your solo 401(k) is up and running. While you're calculating your taxes, just figure out how much you need to contribute to your solo 401(k) to get your income where you want it to be, and make the appropriate combination of pre-tax employer and post-tax employee Roth contributions.Things are somewhat more complicated for small business that have made an "S corporation" election, which is one reason I'm more skeptical of S corporation elections than some small business owners.

Trigger your employer's matching 401(k) contributions

This is the most boring of my low-hanging fruit suggestions (which is why it's last), but it's still good advice: if your employer matches any part of your elective 401(k) contributions, make at least the minimum required elective contribution to maximize the employer's match.I don't think much of employer-sponsored 401(k) plans as a rule due to the high-cost, conflicted investment options they frequently offer.On the other hand, I think very highly of free money. If you make at least the contribution necessary to maximize your employer's match, you can leave the money in cash and still walk away with a guaranteed tax-deferred rate of return that's difficult to imagine getting elsewhere.

Conclusion

What's your favorite low-hanging fruit of personal finance, and just how low-hanging do you think it is?I think people have a natural tendency to treat the things they think of as fun and easy as intrinsically fun and easy. It's a tendency that, as you get older, you hopefully start to realize has no connection to reality.So which of my suggestions do you think is preposterously complicated and which is so simple it doesn't even bear mentioning?

On compound interest (and peeking)

There's no subject personal finance bloggers love gushing over more than compound interest. Conjure up a conveniently "assumed" rate of return, give it a few decades or a few centuries, and presto, you're worth more than Warren Buffett.The thing about compound interest, though, is that it doesn't work over long time periods, it works over many time periods. I was riffing on Twitter the other day about the "sideways" stock market that had nonetheless doubled in the last 5 years, and suddenly wondered: what would a steadily compounding investment portfolio look like in real time?The answer, which is obvious after a few moments of reflection, is it would look completely and utterly boring.Imagine a diversified portfolio of stocks and bonds that you expect to compound annually at 6% APY for 30 years, which I treat as the maximum realistic return to expect from such a portfolio. This would result, in 30 years, in a portfolio that's about 5.7 times as large as your starting investment. The magic of compound interest, etc.Then imagine that rather than the actual rollercoaster of the stock and bond markets, the value of the portfolio rose steadily each and every day for the entire 30 years. What would that look like in real time?

• If you checked the value of your portfolio each of the 252 days the US markets are open each year, you would see it rise by 0.02% per day.
• If you checked the value of your portfolio each of the 52 weeks in the year, you would see it rise by 0.11% per week.
• If you checked the value of your portfolio each of the 12 months in the year, you would see it rise by 0.49% per month.
• If you checked the value of your portfolio once a year for 30 years, you would see it rise by 6% per year.
• If you checked the value of your portfolio each of the decades in 30 years, you would see it rise by 79% per decade.
• And if you check it just once at the end of 30 years, you'd see it rise by 570%.

Don't peek, but if you do peek, know how to interpret what you're peeking at

Jack Bogle deserves — and receives — all the credit in the world for making low-cost, tax-efficient indexed investment vehicles available to retail investors.But you've also got to pay respect to Bogle's investment aphorisms, my favorite of which is "don't peek." When your brokerage statements arrive, Bogle wants you to throw them in the recycling, unread.Then "when you retire, open the statement and believe me if you've been putting money in there for 40 or 50 years, you'll need a cardiologist standing by you when you open it."Now, you're probably not going to do that. I certainly don't do that (I don't even know any cardiologists). I check my account balances every day, like some kind of digital Scrooge McDuck.But if you open up your Vanguard account at the end of each day to see "how you did" and your balance has increased by 0.02%, it hasn't "moved sideways," it isn't "flat," and it isn't "uneventful."It's compounding at 6% APY — let it!

401(k)'s are a bad idea, poorly implemented, that doesn't and can't work

Status quo bias is one of the most powerful forces in American political life, and to overcome it a party or faction usually requires some combination of internal unity, lobbyist and interest group solidarity, and, if push comes to shove, popular support among the voters they're ostensibly in Washington to represent.The current Republican push for "tax reform" does not appear to enjoy any of the above pillars of support, so I would very slightly shade the odds against the passage of a tax reform bill this year (no, I'm not taking bets, I got burned once already last November). Nonetheless, what has been truly remarkable to watch is the interest groups coming out of the woodwork to defend the most indefensible parts of the current tax code. Even worse has been seeing their arguments passed along by journalists as if they were objective observers making good faith arguments, and not just folks trying to protect their own interests by any means necessary.I follow the financial press closely enough to see, in the last few weeks, an outpouring of handwringing about the briefly-mooted suggestion that Republicans would drastically reduce the amount of pre-tax payroll that could be contributed by employees to 401(k) plans. The only problem with this proposal is that it doesn't go far enough: 401(k) plans are a plague, and getting rid of them completely can't come soon enough, within or without the context of tax reform.

Giving employer-sponsored benefits tax privileges is bad

While this argument has traditionally focused on the exemption of employer-based health insurance plans from taxable income, it's equally relevant to retirement savings programs. I don't have an objection to employer-based retirement savings programs any more than I have objections to employer-based health insurance programs.My objection is to privileging such programs in the tax code, leaving the employees of organizations which do not sponsor retirement or health insurance schemes, and the self-employed, with the duty to pick up the tax burden avoided by those firms that do so.

Employers are not good at administering 401(k) programs

The quality of the 401(k) programs administered by employers varies both qualitatively and quantitatively:

• Employers hire different management firms with access to different fund families with different cost structures;
• Employers accept kickbacks from investment management firms because, due to a legislative drafting fluke in ERISA, only fund management, not fund selection, decisions are required to be made with employees' best interests in mind;
• Employers have different plan rules, with some allowing and some disallowing loans, some allowing and some disallowing in-service rollovers, etc.

Even if you believe that savings by workers during their careers is essential to retirement security when they stop working, why would you put this responsibility in the hands of employers who have no interest or demonstrated ability to fulfill it?And what would you do about those employers who have no interest in even trying to fulfill it?

Brief aside: my favorite episode of 401(k) apologetics

The genre of 401(k) apologetics is diverse and beautiful, but I have to point out my single favorite entry in the genre. MarketWatch recently published the following passage without a trace of embarrassment:

"This year, the maximum pre-tax contributions an employee can make to a 401(k) plan is $18,000, and next year will be $18,500. (Some plans allow for additional after-tax dollars to be contributed as well). But it would be nice for employees if these contributions were even higher, said Rose Swanger, a financial adviser at Advise Financial in Knoxville, Tenn. Only about 10% of Vanguard participants maxed out their 401(k) contributions in 2016, according to an analysis by the Center for Retirement Research at Boston College, down from 12% in 2013, but the option could be encouraging for people who do not understand the scope of how much they need for their retirements [emphasis mine]."

Did you follow the logic here? Since only 10% of employees maximize their contributions, therefore the contribution limit should be raised, giving employees a more poignant sense of falling behind their retirement savings goal. Or something like that.Of course the increased limit would be a direct subsidy to those high-income employees who do currently and would under any contribution limit regime maximize their pretax contributions, paid for by employees who do not take advantage of or have access to pretax retirement savings vehicles.

The solution isn't a secret, you just won't personally like it

The most interesting thing about 401(k) plans is that you, if you participate in one, probably think they're the key to securing a dignified retirement in the 21st century. But you're wrong. There is no source of data which suggests people need or use 401(k) accounts in order to finance a dignified retirement.401(k) accounts are used by a small minority of wealthy individuals to shield income and capital gains from taxation during their lives in order to maximize the amount of wealth they leave to their heirs.Just as with the use of 529 college savings accounts for higher education expenses, you're allowed to use 401(k) plans for retirement savings, but that's not how they are actually used by wealthy families trying to shield as much income as possible from taxation.The solution is easy: eliminate preferences for employer-based retirement savings accounts. Increase individual retirement account contribution limits. Enforce strict quality and fiduciary standards on retirement account advisors.But you don't want the easy solution because you don't want a solution at all: you want to shield as much of your earned income and capital income from taxation as possible, to leave as much as possible to your heirs. So, at least for now, we muddle along.

On the dryness of powder

I sometimes come across a moderately sophisticated intuition, and find that while I don't strictly speaking agree or disagree with it, I do find it basically meaningless without additional context. This intuition says, "anything that can be done in an urgent situation can and should be done before the situation becomes urgent."So, for example, if you would need to tap your home's equity in order to pay for a medical bill of a certain amount, that's a sign that you don't have adequate cash available and you should take out the home equity line of credit now, before you have a medical emergency, rather than wait until you actually need the cash.When it comes to investing, people are often willing to accept a permanent drag on their portfolio in the form of less volatile short-term and intermediate-term bonds in order to preserve so-called "dry powder" should the equity markets tumble and put stocks on sale. The premise underlying this behavior is that people invest 100% of the income they have available to invest, and then they decide how to allocate that investable income according to their meticulously-calculated "risk tolerance" (or some other metric, like age or target retirement date).My sense is that people both have more financial resources at their disposal then they generally think, and that waiting to tap those resources until a promising investment opportunity arises makes perfectly good sense.

Sources of cheap liquidity

Many people have sources of cheap liquidity available they aren't aware of and spend no time thinking about:

• if you make more than the minimum payment on your student loans, you have excess liquidity;
• if you make more than the minimum payment on your mortgage, you have excess liquidity;
• if you replace your phone before it stops working, you have excess liquidity;
• if you buy food or drinks in restaurants instead of at retail merchants, you have excess liquidity;
• if you replace your wardrobe more often than necessary, you have excess liquidity;
• if you replace your car more often than necessary, you have excess liquidity;
• if you buy new cars instead of used cars, you have excess liquidity.

Now, unlike your average moralizing personal finance blogger, I don't see any virtue or sin in any of the above. I don't think debt is terrible and that you have to get rid of it as soon as humanly possible, and I don't think new cars are terrible and that you have some kind of moral obligation to never buy another one in your life.

Deciding when and where to deploy excess liquidity is hard, but everything is hard

My point is that spending behavior which may make sense in the low-expected-return investment environment we have today may not make sense in a future, high-expected-return investment environment. Today, accelerating payments towards loans in order to secure a modest but guaranteed investment return may make sense. After the next financial crisis those excess payments may be better used to load up on cheap equities. Today, eating out and networking with colleagues may offer a better return than the modest expected future gains of the stock market. Tomorrow, plowing that money into high-yield corporate bonds may offer a better prospective risk-adjusted return.If your project is to reach a million dollars, or two million dollars, or ten million dollars, in net worth before any of your friends, then sure, you should strip away all your excess expenses today and invest entirely in an aggressive-but-well-diversified portfolio of stocks. But life is more than a net worth statement, and spending more and investing less this late in a bull market makes perfect sense to me.

How you might be, but probably aren't, affected by the TIAA "scandal"

A little bit of knowledge is a dangerous thing, and last week the New York Times published a pearl-clutching article that contained a little bit of knowledge. They reported that a TIAA (formerly TIAA-CREF) insider had filed a whistleblower complaint alleging:

"that TIAA began conducting a fraudulent scheme in 2011 to convert 'unsuspecting retirement plan clients from low-fee, self-managed accounts to TIAA-CREF-managed accounts' that were more costly. Advisers were pushed to sell proprietary mutual funds to clients as well, the complaint says. The more complex a product, the more an employee earned selling it."

This is, obviously, not ideal behavior. But the Times article seems almost deliberately written to confuse investors about the behavior being alleged and its relevance to individual investors.

There is no allegation of wrongdoing in TIAA-CREF mutual funds or annuities

TIAA-CREF offers a range of mutual funds, including a social impact bond fund I've mentioned favorably in the past. There's no indication that any of those mutual funds were mismanaged in any way.TIAA also offers annuities. While annuities aren't for everyone, they are a good fit for some people, and I don't have anything against annuities in general for folks who want to pay up front to finance some or all of their retirement with a fixed or inflation-adjusted income stream (although I would generally urge against anything fancier than that). Just as above, there's no indication in the Times' reporting that TIAA annuities are being mismanaged or that annuitants are being taken advantage of in any way.

The wrongdoing is alleged against TIAA's advisory business

What is really being alleged, and what is really troublesome, is that TIAA advisors are being incentivized to move TIAA's captured investors (mainly public-sector employees) out of products which are best for the investor into products that are more profitable for TIAA. If true, that's unacceptable and will hopefully lead to fines and sanctions against TIAA. If false, well, hopefully the Times will run another article when the claims are disproven or dismissed.

It is difficult to get objective advice

All this may come across as nitpicking, but there are a few reasons I think it's important to take seriously the different kinds of claims that can be made against an investment manager or investment advisor.An investment manager can abuse the trust of their customers in a range of ways. Perhaps most notoriously, a fund that claims to be "actively managed" and charges correspondingly high fees can be a "closet indexer," in fact hugging an index that can be invested in for next to nothing. Likewise a mutual fund with a large cash holding and which charges a management fee on its entire portfolio, including cash, will be charging a disproportionately high management fee on its actual investment decisions.An investment advisor also can abuse clients' trust, for example by liquidating annuities, insurance policies, or real assets in order to "gather" assets under management, upon which the advisor will collect a fee or, as in the case of the allegations against TIAA, moving clients from low-cost self-managed accounts to high-cost TIAA-managed accounts.

If you're not paying for your investment advice, who is?

In the interests of avoiding legal action for as long as possible, let me make the broadest possible argument and let you judge it on its own merits.The responsibilities of mutual fund companies and insurance companies to their investors and annuitants are fairly clear in American law. A mutual fund can make bad investment decisions, and it can charge more than it deserves to charge, but it mostly can't run off with the money to play roulette in Monte Carlo. An insurance company can go bankrupt (ahem, AIG) but it can't simply decide not to pay annuitants their contracted payouts because it would prefer not to.The responsibility of the employees of banks and insurance companies to direct clients to the mutual fund, annuity, or other investment product in that client's best interest is much more unsettled in American law. And if you're not paying someone to provide you with unconflicted investment advice, it's not obvious that anyone is paying to provide you with unconflicted investment advice.That creates an opening for any company, and I mean any company, to provide you with conflicted investment advice instead. That's not unique to TIAA; there is a very large, very boring area of employment law addressing the question of whether companies have to select their 401(k) provider in their employees' best interests or if they only have to select the investment options within the 401(k) in their employees' best interests.

I'm not blaming victims, I'm trying to prevent victims

Obviously it's infuriating to read about someone who has worked hard as a public servant, saved their whole life, and played by the rules discovering that they've been hoodwinked into an unsuitable investment. I'm not trying to minimize that: if TIAA really gave conflicted advice to their captured customers, they oughta pay for it.But if you don't want to be the next sympathetic story in a New York Times article, it's up to you to identify those potential conflicts in advance and either make your own educated decisions or find an unconflicted advisor to assist you in making the decisions that are best for you, rather than for your 401(k) custodian.That's an annoying, burdensome responsibility. But if you aren't willing to take it upon yourself, you're likely to find someone else is willing to take it upon themselves to take advantage of you.

What should you do if your Vanguard 403(b) account is getting access to Admiral shares?

Workplace 403(b) retirement plans are, very roughly speaking, the non-profit and public sector's answer to the 401(k) retirement plans offered by private companies. If your workplace 403(b) account is administered by Vanguard, you probably recently received a letter explaining some changes to your account. The most important changes are:

• a change in fee structure from a $15 annual fee per fund held in the account to a $60 annual fee regardless of the number of funds held;
• access to low-cost Admiral shares with no minimum investment requirement.

My understanding is the changes will go into effect in early November for plans affected by the change.

Why it matters

Previously, like 401(k) accounts held at Vanguard, 403(b) accounts only had access to higher-cost Investor shares. Combined with the per-fund fee, that meant many investors were best off investing in a single target retirement date fund or fixed-allocation LifeStrategy fund in order to pay as few per-fund fees as possible. Since those funds hold higher-cost Investor shares, they're a bit more expensive than a 3-fund or 4-fund portfolio built with Admiral shares or Vanguard ETF's, so many investors prefer to assemble lower-cost portfolios with those instruments in their personal accounts.That wasn't possible in 403(b) accounts until now.

Who wins?

There are two ways 403(b) participants might benefit from this change:

• People with balances below $50,000 who already held 4 or more funds with Admiral shares in their account by definition will save money after the changeover: they were paying $60 or more per year ($15 per fund) for higher-cost Investor shares. Now they'll pay a flat $60, plus save money by paying lower expense ratios on each fund they hold, as long as it has Admiral shares.
• Anyone who held funds with Admiral shares that are sufficiently cheaper to offset any increase in annual fees. For example, if your only holding is Vanguard High-Yield Corporate Fund Investor Shares (hopefully as part of a diversified portfolio) you're currently paying $15 plus a 0.23% expense ratio. Admiral shares have an expense ratio of 0.13%, so if your balance is over $45,000, you will pay less in combined annual fees and management fees after the changeover.

Who loses?

The biggest loser in this changeover is folks with over $50,000 held at Vanguard and who intend to remain in funds that do not offer lower-cost Admiral shares. Previously, having Flagship status with Vanguard waived their per-fund fee in 403(b) accounts, so folks with $50,000 or more in assets at Vanguard paid no annual fees no matter how many funds they held in their accounts.Now, they'll pay a flat $60 annual fee no matter how many funds they hold or how many assets they have with Vanguard. As explained above, folks who hold Admiral shares in their accounts will see an offsetting reduction in fund expense ratios. But target retirement date and LifeStrategy funds are popular as simple, one-and-done investment allocations, and neither kind of fund offers lower-cost Admiral shares. That means folks exclusively invested in those funds will be paying higher annual fees (unless they were invested in 4 different funds for some reason), but still won't benefit from access to Admiral shares.

How to play it

I've laid out all of the above because of my unfortunately literal tendency, and the fact that money is one of the fews things in life that benefits from being taken literally. I think there are basically two ways a 403(b) participant can react to these changes:

• Do nothing. Remember, the absolute maximum you'll be paying in additional annual fees is $45 per year, since you were already paying $15 per fund in your account. If you are holding funds that offer Admiral shares, you'll see your Investor shares automatically converted and you'll make back some of the additional fees in lower expense ratios. If you aren't holding funds that offer Admiral shares, you'll remain in your Investor shares and pay the higher annual fee without seeing any benefit. Obviously it doesn't feel great to pay an extra $45 above what you were paying before, but that still only works out to what, four and a half bananas a year?
• Convert from a loser to a winner. If you are currently holding target retirement date, LifeStrategy, or other funds that don't offer Admiral shares, you can convert your current holdings into an identical allocation to the individual funds, which do. So instead of $10,000 in a Lifestrategy Growth fund, you could move to $4,780 in Total Stock Market, $3,210 in Total International Stock, $1,410 in Total Bond Market, and $600 in Total International Bond, all of which offer Admiral shares. Then you'd also want to tell your 403(b) administrator to change your payroll contributions to reflect those ratios. Between once a year and once a quarter you'll also want to log on and rebalance your account to reflect changes in the market value of those securities (I don't see any benefit to rebalancing more often than quarterly. Don't peek).

Finally, if you have other investments outside your workplace 403(b), you may benefit by being able to use Admiral shares to create a more appropriate overall asset allocation than you currently have. For example, if you previously held LifeStrategy or target retirement date funds in your 403(b), you may have struggled to appropriately allocate risk in your IRA's and taxable accounts taking into account that fixed asset allocation.Now, by holding the underlying securities, you can more finely tune your asset allocation across all your accounts. Of course, whether or not you actually benefit depends on how much time you want to spend micromanaging your investments!

Accelerating payments versus making good decisions

Here at Saverocity, our glorious leader Matt and I have a difference in opinion, which is always more fun than agreement, so I thought I'd take a few minutes to give the strong form of our disagreement. I don't think either of us actually holds the strong form of these opinions, but the strong form illustrates the difference most dramatically.Anyone who has met Matt knows he's an excellent financial planner and thus takes the sensible view that accelerating the payment of debt offers a guaranteed return (the interest rate on your debt) while investing in risk assets offers an unknown return (whatever return the asset you invest in happens to produce). That's a view I emphatically share.The confusing thing about this to me is that accelerating payments on a loan is still more expensive than taking the right loan out in the first place. It may be true that making two mortgage payments per month will let you pay off a 30-year mortgage in 23 years, but it's also true that for all 23 of those years you'll be paying the interest rate on a 30-year mortgage. Why not just take out a 23-year mortgage to begin with?That's not a rhetorical question: there are reasons you might prefer a lower "minimum" payment while reserving the option of making excess payments in any given year. But if you're planning to make excess payments every single year for the life of the mortgage, you should take out a shorter-term mortgage at a lower interest rate!Similarly, the way student loans work in the United States is that you are offered a loan with a fixed amount based on your year in college, you take out the loan, you spend the money, then you repay it (hopefully using income-based repayment, the best form of repayment). But of course one thing you might do is borrow less money, if you knew you didn't need the full amount of the loan, for example if you could supplement your financial aid with work while in school. In other words, just as above, accelerating repayment of a loan is a poor substitute for borrowing less money and paying less interest during the lifetime of the loan.This thread in the Saverocity Forum sums up both of our views in our own words. But since this is my blog, I'll close with my words:

"If something has changed since you made that decision, or if you have learned more things and consider yourself better-informed and better-educated about the risks and rewards of investing in the market while carrying a mortgage, good, reassess your situation and potentially arrive at a different conclusion."On the other hand, if you made the decision impetuously, and are now making another decision impetuously, then your problem is making impetuous decisions, not carrying a mortgage while investing in the stock market! Fix the real problem, which is not your mortgage/stock allocation."And finally, you need to consider the possibility that your younger self was right. Maybe it was that younger self that thought through everything and decided that carrying the mortgage while investing in the market was worthwhile, and he thought through all the risks and rewards and arrived at a sensible conclusion, and would be furious that you, older self, are second-guessing his careful homework."

Bitcoin seems fine, but there's no reason to own any

The other day someone on Twitter linked to this very interesting essay by Marc Andreesen of Andreesen Horowitz, the prominent venture capital firm, which I highly recommend if, like me, you missed it when it was published in 2014. I think the essay crystalized for me two points in the cryptocurrency/blockchain discussion that are sometimes passed over or muddled.

The fundamental value of Bitcoin is the value of dedicated computing power

If you're of a certain age, you may remember a program called SETI@home, which took advantage of your computer's processing power (and your home electricity) when idle to search the vast amount of data cataloged by the SETI project for signals which might be signs of alien civilizations. Many of my friends enabled it as their screensaver, and we got a little philanthropic (xenophilic?) rush whenever we saw our crummy little computers parsing through millions of bytes of data. We never found an alien, though.The same principle applies to Bitcoin, except instead of feeling good about using (wasting?) the free electricity our college provided, Bitcoin miners get to feel good about earning Bitcoin, which has value in the real world when converted to money, which can be exchanged for goods and services.As I think the Andreesen essay makes clear, the value of Bitcoin is the value of being able to call upon the electricity and computing power of Bitcoin miners to process, verify, and record Bitcoin transactions.Bitcoin as a currency is utterly irrelevant to this process — miners' compensation is denominated in Bitcoin but they are free to instantly exchange their Bitcoin for their home-country currency at the prevailing exchange rate. That exchange rate, meanwhile, is set as all such rates are by the supply and demand for Bitcoin or by the laws of the country in question. It may be illegal to exchange a country's currency for Bitcoin, for example, or a country may set a fixed Bitcoin exchange rate. A sustained high exchange rate between Bitcoin and a country's currency is supposed to bring more miners online. But they don't have to keep the Bitcoin they earn; on the contrary, the reasonable thing to do would be to sell the Bitcoin for their country's currency, because money can be used to pay for goods and services.Note that I said this is the logic behind the fundamental value of Bitcoin. That's to distinguish it from the price of Bitcoin. The price of Bitcoin is established by the amount people are willing to pay for it, and the price people are willing to sell it for. But its fundamental value is established by the amount people are willing to pay for the computing power needed to process transactions on the Bitcoin blockchain in a given amount of time (the more computing power is available to the system the less time a transaction takes to be verified).The difference matters because the price of Bitcoin should be irrelevant to the users of Bitcoin. If you are using the blockchain to transmit money from the United States to Canada, you should be concerned with the exchange rate between the US and Canadian dollars. Assuming the exchange rate between each currency and Bitcoin corresponds to the exchange rate between the two currencies, and assuming all 3 exchange rates remain stable during the time the transaction takes to process on the Bitcoin network, the price of Bitcoin is irrelevant to the transaction. Whether US$1,000 buys 4 Bitcoin or 0.25 Bitcoin is irrelevant if the Bitcoin are immediately converted to CAD$1,219.60 (as of today).That's a lot of assumptions! Maybe the USD:BTC and BTC:CAD exchange rates don't correspond to the USD:CAD exchange rate. Maybe the value of Bitcoin is so volatile, and there's so little computing power available to the system, that one participant or the other is unwilling to take the risk of seeing their payment swing wildly in value either up or down: after all, no one wants to pay $1,500 for something they planned to pay just $1,000 for, and no one wants to receive $500 for something they planned to sell for $1,000.On the other hand, this is the kind of problem late capitalism is extremely adept at solving. A company offering international transfers using the Bitcoin blockchain could buy insurance contracts against short-term swings in the value of Bitcoin relative to the currencies it operates in. A sufficiently large company could even choose to self-insure against those swings. In other words, they could guarantee a given USD payment would be a worth a given amount of CAD to the recipient, even if the BTC-intermediated exchange rate fluctuated in that time.

Bitcoin is not a way of opting out of the real world

The other thing that Andreesen's essay makes clear is that Bitcoin and its blockchain will only ever be overlaid onto a world of humans, governments, and laws — what some wags used to call "meatspace."Consider the Dread Pirate Roberts, who ran the Silk Road marketplace on the dark web in the early days of both the TOR anonymous browsing service and Bitcoin. To be as reductive as possible, Silk Road served as a non-state intermediary between buyers and sellers. A buyer would send Bitcoin to Silk Road, the seller would send the guns, drugs, porn, or whatever to the buyer, and then Silk Road would release the Bitcoin to the seller.This system only worked for as long as it did because people trusted the Dread Pirate Roberts, whether because of his libertarian screeds online or the simple reputational value of having successfully executed so many transactions.But the fact is, Western civilization is built upon an extremely similar system, whereby trust between buyers and sellers isn't necessary because the state is present to mediate complaints between them. If you pay someone for something and they don't provide it, you don't need the Dread Pirate Roberts to take out a hit on them; you can sue them. If you sell something and the buyer never pays you, the courts are likewise open to you. It can be a real hassle, but it's a lot less of a hassle than tracking them down and killing them.

Conclusion: I am optimistic about Bitcoin and remain totally agnostic about Bitcoin's price

Thinking through Andreesen's essay I found myself thoroughly convinced that distributed blockchain technology is an important technological advance which will eventually be used to verify and record many kinds of transactions. The financial press has an unfortunate tendency to focus on the price of Bitcoin, since that's the metric they're used to covering and Bitcoin devotees have elected to call Bitcoin a "cryptocurrency," as if there were goods and services denominated in Bitcoin, rather than mechanical conversions between Bitcoin and real money (which Bitcoin's devotees derogatorily and hilariously call "fiat" money).But it would be perfectly reasonable to report news about the average time Bitcoin transactions take to complete, the typical volatility of exchange rates between Bitcoin and real currencies, and any resulting distortions introduced in those exchange rates. That would give news consumers a real idea about how ready the Bitcoin blockchain is to handle large numbers of real-world transactions.But the price which speculators are willing to pay for Bitcoin will never matter, except to the extent it brings additional computing power online or pushes it offline as unprofitable.

How good are Roth IRA's for emergency funds?

Roth IRA's are interesting vehicles because, among other things, contributions can be withdrawn at any time penalty-free. Since contributions are capped annually but can be withdrawn at any time penalty-free, this leads to the following logic: make your maximum contribution each year whether or not you intend to invest it. After all, if you need the money later you can always withdraw the contribution penalty-free, but if you don't need the money you haven't forfeited that year's contribution eligibility.I think this is good and true, as far as it goes, but if you plan on doing it there are some things you need to take into account.

An advantage of tax-advantaged accounts is tax-free compounding

Depending on which marginal income tax bracket you fall into, long term capital gains and dividends paid on taxable accounts are subject to a marginal income tax rate between 0% and 23.8%. Capital gains and dividends realized within a tax-advantaged account like a Roth IRA aren't taxed when they accrue, and if withdrawn during retirement or for other qualified distributions are never taxed at all (in a traditional IRA they're taxed at your marginal income tax rates in retirement). Hence the "advantage" in "tax-advantaged account."The problem with using a tax-advantaged account — even one without penalties for the early withdrawal of contributions — is that in order to preserve your capital you have to invest in risk-free or low-risk assets, which won't produce the dividends and capital gains tax-advantaged accounts are designed to shield from taxation!

To use a Roth IRA as an emergency fund, pair in-account and out-of-account transactions

The solution to this riddle isn't very complicated, but you need to be aware of it if you're going to implement it properly. To explain, I'll give a stylized example.Say your desired emergency fund is $11,000, whether that's 3 months, 6 months, or 2 years of emergency expenses — I don't have a preferred theory for how many months' expenses you need in your emergency fund. You have room in your budget to save $105 per week — $5,500 per year, the current annual IRA contribution limit.In order to keep from losing your current-year IRA contribution limit, you contribute $105 per week to a Roth IRA, and leave it invested in cash, a money market account, or very short term bonds. Should you need the money for emergency expenses, it'll be there waiting for you (assuming you can communicate with your custodian to request the withdrawal!).At the end of the second year, you'll have $11,000 in your Roth IRA, and your emergency fund will be "full." God willing, you won't have faced an emergency, and so can start directing your weekly contributions to actual investments with an appropriate risk profile and time horizon.What happens if you find over the course of time that you're able to save more than $105 per week? Each dollar you save outside your Roth IRA can be paired with a dollar moved from your Roth IRA "emergency fund" to actual investments. This pairing of in-account and out-of-account transactions mean that your investments most likely to increase in value (creating capital gains) and pay dividends or coupons are inside the advantaged account, while your safest, least likely to appreciate assets are held outside the advantaged account (I like Consumers Credit Union's Free Rewards Checking).

I don't think much of Roth IRA's as emergency funds, but they're great for investments on different time horizons

The objection I have to using Roth IRA's as emergency funds is that an emergency fund, by definition, has a time horizon of zero, and on a zero time horizon you're forfeiting a key advantage of a tax-advantaged account.On the other hand, using Roth IRA's for tax-free compounding of assets on time horizons other than retirement is a great idea! That's because in addition to contributions, earnings on Roth IRA's can be withdrawn penalty-free under a variety of circumstances, including most importantly the purchase of a first home (up to $10,000 in earnings) and paying for qualified education expenses (unlimited earnings).I don't know if a perfect solution exists for doing this, but it would be easy to come up with a simple kludge. For example, if you plan to buy a house in 5 years, and pay for higher education in 25 years, you could split your contributions between appropriately-dated target retirement date funds:

• In the event of a bull market the higher education fund would rise faster than the housing fund (being more heavily allocated to equities), and when you achieved $10,000 in earnings you could move your total contributions to date, plus $10,000, to cash in preparation for your withdrawal and house purchase;
• In the event of a bear market, the housing target date fund would decline less than the higher education fund (being allocated more heavily to bonds), preserving your housing purchasing power.

Conclusion

The high degree of flexibility in Roth IRA withdrawals makes them so useful that it leads some people to become a little too enthusiastic about the accounts. They are flexible, and they are useful, but they're most useful when they're used for the goals they're best designed for.

Investing your values, from easy to hard

I've been meaning to write this post for a while, but this afternoon a podcast I was listening to finally inspired me to put digital pen to internet paper. The question is simple: what is a wealthy individual who despairs over the excesses of capitalism to do with their wealth? The traditional answer provided by capitalism, conveniently, has been to invest their wealth in order to maximize their return on capital, and then use that return to promote the philanthropic causes of their choice.This is, needless to say, unsatisfactory to many people who seek to integrate their values into every aspect of their life, whether it's their profession, their housing choices, or the schools they send their children to. Why should they choose to profit from sweatshops in their investment portfolio when they refuse to wear anything but union-made clothes?There are other answers, and they range from easy to tricky to hard to implement. Here are a few.

Secondary Markets: cheap and easy

The easiest, but least impactful, way you can invest your values is by recreating a traditional asset allocation, while using funds that correspond to your values instead of traditional market-capitalization-weighted index funds. For example, a simple 60/40 portfolio could be replaced with:

• 60% Vanguard FTSE Social Index Fund (VFTSX, 0.22% expense ratio), and
• 40% TIAA-CREF Social Choice Bond (TSBIX, 0.4% expense ratio).

You'd have a blended expense ratio of 0.292%, which is higher than the expense ratio on a similar market-cap-weighted portfolio, but honestly, not that much higher. Paying $3,000 per year in expenses on a million-dollar portfolio that you find better reflects your values feels to me very close to a rounding error.If you want to get some more geographic diversification, TIAA-CREF also offers a Social Choice International Equity (TSONX, 0.4% expense ratio) fund you could use to replace international equities in your portfolio as well.Of course, the flip side of this being the cheap and easy way to invest your values is that it's also the least effective. Investing your values in secondary markets is first and foremost declining to profit from the behavior of firms whose actions don't reflect your values. In other words it's divestment, not investment.On the other hand, investing on the secondary market isn't completely ineffective: the more people who invest in such funds, the more deep and liquid the market for their shares will be, and the more firms will be encouraged to adopt policies that lead to their inclusion in them. The claim that your particular investment will be ineffective is identical to the claim that your vote is ineffective. On its own, sure, but if 80,000 individual votes had been cast differently in 2016 we'd be living in a different world entirely.Collective action is the sum of lots of individual actions so as for me, I politely decline to claim that individual actions don't matter. The fact that they do underlies our political and economic system.

Primary Markets: tricky, but fun

Another option for investing your values is to identify and buy appropriate securities on the primary market. In general this is a bit tricky, but if you read in the newspaper that your city is issuing bonds you can generally find out a way to buy them during the "retail order period." You'll need to have an account with one of the underwriting banks, and your order may or may not be completely filled — like I say, it's tricky.On the other hand, this is just about as close you can come to the "war bonds" issued to finance World War II — the funds go directly to the project being financed, giving you participation in the projects of your choice, whether it's schools, sewers, waterworks, or stadiums and ballparks.If your goal is to finance projects within your community, another option is to find a local "Community Development Financial Institution." This is a designation made by the Treasury Department for banks, credit unions, and other institutions that "expand the availability of credit, investment capital, and financial services in distressed urban and rural communities." You can easily Google the name of your community and CDFI and find a slew of institutions. The simplest way to invest is to simply buy certificates of deposit from such an institution, providing stable, long-term financing they can use to make loans to individuals and businesses in your community. Keep in mind the $250,000-per-institution cap on federal insurance for such deposits — if you're investing more than that you may want to invest with multiple institutions in order to ensure your certificates are completely insured.

Private Markets: effective and difficult

Another option for even wealthier individuals is to invest directly in — or even better, start — businesses that put your money to work directly in service of your values. If you think union-made apparel is too hard to find in your community, you can start a business selling it. If you think it's too hard to find fresh fruits and vegetables in your neighborhood, you can start selling them. If you think there's not enough affordable housing in your city, you can buy or construct a building and start renting it at below-market rates (this is, interestingly, what George Lucas tried to do in Marin County before his neighbors lost their shit at the idea of poors living among them).Private markets are the place you can see your money deployed most directly to effect the changes you want to see in the world. After all, when you donate to the Gates Foundation there's no way to know exactly which vial of vaccine you paid for, versus which 10,000 vaccinations Warren Buffett paid for this week. If you find that dispiriting, investing directly in businesses or organizations that act according to your values is one solution.This is, needless to say, hard. But if you've reached the point, in retirement or before, where you have accumulated a significant amount of money you may not ever need, why should it be that investing that money is easy? Maybe a new challenge is exactly what you need.

Things I learned from an actual big bank advisor portfolio

If you follow the world of financial advice at all, you know that professional financial advisors don't have much patience for the so-called advisors you find tucked away in the corner of bank branches or affiliated with brokerage houses. Unlike fee-only Registered Investment Advisors, such firms have substantial flexibility to give "advice" that operates in the best interests of the firm, instead of the best interests of their customers. They may accept commissions for the sale of certain products, and they may be restricted by their proprietary platforms from offering clients certain funds.I knew all that in the abstract, but a concrete example is always more useful than abstract knowledge. Fortunately, last weekend I had the chance to examine an actual portfolio put together by an advisor with a big bank's advisory arm, and it was illuminating. Here are some of my biggest takeaways.

Ignore the equity/fixed income allocation

The portfolio I was looking at ostensibly had a 65/35 equity/fixed-income allocation. At least, that's what it said on the front page. Digging into the actual fixed income portion, I found a large portion of the "fixed-income" position was a long-short PIMCO fund. Now, I'm not here to tell you whether PIMCO is good or bad at buying and selling bonds. They may be the best at buying and selling bonds. But some PIMCO fund manager gambling with your money is clearly not what most people think of as a "fixed-income allocation." It's simply a bet that you've picked the right active manager, and he happens to be gambling in bonds instead of equities.I don't have any bonds in my portfolio, but I don't have any problems with bonds in the abstract. I've even written before about what you might do if the risk-free rate of return was enough to meet your investing goals. If you are nearing retirement, or have near-term obligations like down payments or educational expenses, it might make perfect sense to move assets into short-term or intermediate-term bonds in order to preserve your purchasing power against the coming economic calamities. That's what the "fixed-income" portion of a portfolio means to me.But if the actively-managed fund you're invested in just happens to use bonds in order to gamble with your money, that's properly allocated to your "gambling" asset allocation, not your fixed-income allocation.

Beware of fake diversification

There are two essential things you need to know about diversification. First, the purpose of diversification is not to improve the total return of a portfolio; it's to improve the risk-adjusted return of a portfolio. Second, diversification only improves the risk-adjusted return of a portfolio if you diversify into uncorrelated assets. The lower the correlation between assets, the better they play the role of portfolio diversifier (if diversification is something you want in your portfolio).The portfolio I examined had 11 mutual funds with equities (10 equity mutual funds, 1 "balanced" fund). I looked at the top 5 holdings in each mutual fund, and discovered the following:

• 4 held Microsoft;
• 4 held Google;
• 3 held Apple;
• 2 held Johnson and Johnson;
• 2 held Proctor and Gamble;
• 2 held Verizon;
• 2 held Investors Bancorp.

Meanwhile Amazon and Berkshire Hathaway were each owned by one fund.The Vanguard Total Stock Market Index Fund's top 10 holdings are:

1. Apple Inc
2. Microsoft Corp
3. Alphabet Inc
4. Amazon.com Inc
5. Facebook Inc.
6. Johnson & Johnson
7. Berkshire Hathaway Inc
8. Exxon Mobil Corp
9. JPMorgan Chase & Co
10. Wells Fargo & Co.

This isn't an endorsement of the Vanguard Total Stock Market Index Fund (although it's a very good, very cheap domestic stock fund). It is an indictment of obfuscating a client's actual holdings through overlapping mutual funds. When you own a market-capitalization-weighted mutual fund you know exactly what share of each fund is represented by each company (if you can do a little math). When you own 11 equity mutual funds with overlapping holdings, how can you possibly hope to know what your actual exposure is to any given company or industry?Maybe Facebook, Exxon Mobil, JPMorgan Chase, and Wells Fargo are bad companies and you don't want to own any mutual funds that hold them (at least in their top 5 holdings — I didn't check every single holding). That's up to you. What doesn't make any sense is to own 11 different mutual funds just to avoid 4 individual stocks.Worst of all, in addition to mutual funds holding the largest domestic US stocks, the portfolio also included the individual stocks themselves! Under these circumstances it's virtually impossible to determine how exposed the investor is to a single large company.Simply put, this isn't what people mean when they say "diversification."

Costs Matter (1)

The cheapest domestic equity mutual fund (actually an ETF) in this portfolio had an expense ratio of 0.5%. The most expensive had an expense ratio of 1.08%. The cheapest held, in its top five holdings, both Google A shares and Google B shares. The most expensive held Google A shares. I do not care if you want to overweight or underweight Google in your equity portfolio. But there's no earthly reason to pay over twice as much to hold Google in one mutual fund when you're already holding it in another, cheaper fund.

Costs Matter (2)

This portfolio included as its primary real estate holding the Cohen & Steers Global Realty Majors ETF, ticker symbol GRI. This ETF aims to hold an allocation of 55% North American securitized real estate (mainly US) and 45% securitized real estate outside North America. It has an expense ratio of 0.55%.I took the liberty of comparing GRI to an identically composed portfolio of Vanguard's domestic (VNQ, 0.12% expense ratio) and international (VNQI, 0.15% expense ratio) real estate holdings. You may or may not be shocked to learn that the low-cost Vanguard blended portfolio outperforms GRI.But you shouldn't be.

Even blind squirrels find the occasional nut

I was modestly surprised to find in this expensive, weirdly-weighted portfolio that the advisor had also included what seems like an excellent intermediate-term socially-responsible bond fund, the TIAA-CREF Social Choice Bond. It has a not-unreasonable expense ratio of 0.4%, and is actually invested in legitimately interesting issues like water and sewer projects around the country. If that were the entire fixed-income allocation in this portfolio, I wouldn't have anything else to say about it. Unfortunately, it was far outweighed (by an order of magnitude) by the kind of speculative "fixed-income" products I mentioned above.

Conclusion

If you've made it this far (hell, if you've even made it to this blog) you may think this is all old news and anyone who knows anything about investing, or has any money to invest, is already in a sensible Boglehead 3-fund or 4-fund portfolio.The fact that you think that is why I wrote this post. Lots of people are not in sensible 3-fund or 4-fund portfolios, and it's not their fault. It's the fault of the people they trust to advise them.It's not unreasonable to pick an investment portfolio that reflects your values. There's no law that says investments must be made with the goal of maximizing risk-adjusted returns, or even to produce any returns at all.If you want to invest in socially- or environmentally-responsible companies, or buy the bonds of countries or municipalities that reflect your values, you have no obligation to put financial returns ahead of your values.But no matter what your investment philosophy is, there's no reason to let middlemen pocket 1-3% of your capital per year in order to implement it.

My stubborn preference for mutual funds over ETF's

I understand that I sometimes come across as a bit crotchety when it comes to the early retirement blogging community. Nothing could be farther from the truth! I retired at 29 and haven't regretted it for a day since (if Mitch McConnell manages to scrounge up 50 votes to take away my health insurance we can revisit this discussion). Anybody who advocates quitting your job and doing what you love for the rest of your life is alright in my book.Of course, there are things that I disagree with. The idea that "graduate with the most lucrative degree you can," "get the highest-paying job you can," and "save as much money as possible" constitute some kind of secret insight, instead of being perfect distillations of middle-class American values (for good and ill) is a somewhat bizarre affectation.On the other hand, there are other prejudices of the early retirement folks that I endorse whole-heartedly. One of those is the preference for mutual funds over exchange-traded funds.

It has become very fashionable to prefer ETF's over mutual funds

You can't open the business section of a newspaper these days without reading about exchange-traded funds. You'll virtually always hear their virtues described using the same formula:

• they're traded throughout the day so you can buy and sell ETF's any time you want while markets are open, while mutual fund transactions are only settled once per day;
• unlike mutual funds, ETF's aren't required to distribute capital gains and losses to shareholders at the end of each year, making them more "tax-efficient" investing vehicles.

The important thing to keep in mind is that both of these statements are true. I'm not here to tell you that you can't buy and sell ETF's throughout the day, or that ETF's do, in fact, make taxable capital gains distributions each year.I just don't care.

Why I stubbornly prefer mutual funds to ETF's

I can boil down my preference for mutual funds over ETF's into three main ideas.First, low-cost passive indexed mutual funds do not, in general, distribute taxable capital gains. Here are some examples of funds you might include in a broadly diversified portfolio, if you were so inclined:

• Vanguard 500 Index Fund (VFIAX): no capital gains distributions in previous 10 years;
• Vanguard Emerging Markets Stock Index (VEMAX): no capital gains distributions in previous 10 years;
• Vanguard European Stock Index Fund (VEUSX): no capital gains distributions in previous 10 years;
• Vanguard Pacific Stock Index Fund (VPADX): no capital gains distributions in previous 10 years;
• Vanguard REIT Index Fund (VGRLX): capital gains distributions in 2007, 2008, and 2016 (so-called "return of capital" distributions may reduce your taxable basis, which is largely irrelevant in this context);
• Vanguard Global ex-U.S. Real Estate Index Fund (VGRLX): no capital gains distributions in previous 10 years.

It doesn't make any sense to privilege one fund structure over another for a reason that doesn't actually exist.Second, mutual fund transactions are settled at the daily net asset value, while ETF purchases and sales have to cross the bid-ask spread existing at the precise moment of sale. This is the flip side of being "able" to buy and sell shares throughout the day. In order to buy at 11 am you have to be willing to pay what sellers are asking, and in order to sell at 3 pm you have to be willing to take what buyers are offering. In extremely liquid ETF's during periods of market tranquility that friction will be trivial. In illiquid ETF's and during periods of market volatility you can pay handsomely for the privilege of trading in and out of ETF's at will.Finally, the argument for ETF's begs the question: what are you doing trading in and out of investments on a daily, let alone hourly, let alone minute-by-minute basis? If you had a great batting average, if you had finely-tuned instincts for when an index would tick higher and when it would tick lower, if you really could "read the tape," you would still be crossing the bid-ask spread over and over again, and for what? I'm no fan of so-called "behavioral" economics or "evolutionary" psychology, but you don't need to conjure up some fantasy of cheating death on the savannah to understand that the more opportunities you give yourself to fail, the more likely you are to fail. Systematically adding funds to a portfolio of low-cost passively-indexed funds (as few as possible, but no fewer), with a maximum(!) transaction frequency of once per day, is a way of methodically reducing the opportunities you have to screw up. The high liquidity and low trading cost of ETF's isn't a feature — it's a recipe for disaster.

The use and abuse of "the 4% rule"

I had a good time recently appearing on the Saverocity Observation Deck podcast with Noah from Money Metagame and host Joe Cheung.One thing that I think got a little muddled in our conversation was my feelings about "the 4% rule," which is much beloved by financial independence and early retirement enthusiasts. Rather than try to tell you I'm right and they're wrong about financing early retirement, I think it might be more useful to isolate a few different factors that go into planning a stream of retirement income.

I don't have anything against "the 4% rule" — as it actually exists

Back in the 90's some erudite finance scholars got to work on a historical asset price dataset and determined that in the overwhelmingly majority of cases a retiree could withdraw 4% of their starting portfolio value as of their retirement date, adjust the withdrawal for consumer price inflation annually, and still have a positive portfolio value at the end of a retirement period ending 30 years later.There are two key elements of this analysis to keep in mind: it's based on historical data, and it describes a retirement period that ends 30 years after it begins.To adopt such a rule to finance your retirement, you would therefore have to make two assumptions: the future will be like the past, and your retirement period will end 30 years after it begins.I don't have any clue how members of the early retirement community arrive at the conclusion that those two conditions are true. The first is a violation of the obligatory maxim that "past performance is not a guarantee of future results," and the second is absurd in light of the very premise of early retirement: having more, in some cases many more, years of retirement than the 30 that traditional retirees have had (if they get lucky).

An important aside about Social Security retirement income

Most people are aware of the importance of adjusting prices and income for inflation: the general tendency under conditions of growth for prices to rise over time. A $1 avocado today doesn't cost the same as a $1 avocado in 1970: it costs much, much less, since a dollar is worth much less in 2017 than it was worth in 1970 (no, I don't have any idea how much an avocado cost in 1970).That means to maintain the same absolute standard of living, retirement income needs to be adjusted for consumer price inflation, so that in retirement you'll be able to afford the same standard of living you had upon retiring.The Social Security Administration made the important observation that indexing retirement benefits to consumer price inflation was inadequate: a 95-year-old retiree with benefits indexed to consumer price inflation would today be able to afford the same standard of living as she had in 1987, at age 65. In other words, she wouldn't be able to afford any of the conveniences of modern life, none of which existed in 1987!Instead, Social Security retirement benefits are indexed to wage inflation, so that retirees don't fall behind as productivity and output rises. Their benefits keep up with the rise in technology and productivity that the US economy provides.

An early retirement rule that successfully provides consumer price inflation-adjusted income will immiserate you in old age

The reason the above aside was necessary is that over a retirement stretching not 30 years, but 60 or more years, a rule that provides consumer price inflation-adjusted income will not maintain your relative standard of living. A simple way to illustrate this is using the Social Security Administration's wage deflator. Earnings in 1990, just before a decade-long rise in productivity and earnings, are indexed at a rate of 2.29: each dollar earned in 1990 is worth $2.29 towards Social Security retirement benefit calculations in 2016.Meanwhile, a dollar in 1990 was worth just $1.84 in 2016 according to the consumer price index. The difference? Wage growth tracks productivity growth, which usually exceeds consumer price inflation in a growing economy. Between 1990 and 2016, wage growth exceeded consumer price inflation by 24.5%. That means across the economy at large, wage-earners became 24.5% wealthier than those who successfully tracked consumer price inflation with their investment decisions.At age 35, or 40, or 45, are you willing to lock in your absolute standard of living today? Are you willing to forego flying cars, neural implants, and vacations to Mars? The mass market innovations of tomorrow will remain affordable to people who participate in productivity growth; people whose income merely tracks consumer price inflation will fall further and further behind.

Equity investing gives you a chance to participate in productivity growth

Of course, the easiest way to participate in wage-inflation-adjusted standards of living is to earn a wage. But earning a wage, for obvious reasons, doesn't feel like retirement, let alone early retirement.The other way to participate in national, and even global, increases in productivity is to invest in the companies involved. Today, it's fortunately possible to do so through low-cost indexed investment vehicles. While workers might participate in productivity growth both through increased wage income and the increased value of their investments, one out of two ain't bad: owning a broadly diversified portfolio of stocks will at least allow you participate in one side of the global growth in output.Across a broadly diversified portfolio, the dividends that companies pay out to shareholders will rise along with profits, which reflect the companies' participation in overall economic growth. Think of this as the flip side of Henry Ford's desire for his factory workers to be able to afford Model T's: the more Model T's the workers can afford, the fewer his shareholders can afford. While individual firms strike that balance in different ways ("This is frustrating. Labor is being paid first again. Shareholders get leftovers.”), across the entire economy all profits will be split between labor and capital.

A viable plan for early retirement requires goals, not rules

Of course, as Noah, Joe and I get into during the podcast (which I really do recommend if you want to hear us discuss these and other issues in more detail), many early retirement types also belong to a kind of loosely-organized ascetic community that treats as extravagant luxuries purchases which most Americans treat as staples. It's more than possible that such people experience price inflation lower than the consumer price inflation which the federal government records.But that's a question that actually has to be answered before developing a plan for retiring radically early. A plan to simply save up 25 times your 2016 expenses and withdraw 4% per year, adjusted for consumer price inflation, will leave you relatively destitute in 30 years even if your early retirement goes exactly according to plan.

The Robinhood free stock catch (and an easy workaround)

I don't think you should invest in individual stocks, but gambling is, famously, fun, and when I want to gamble on individual stocks I use the Robinhood iPhone app, which offers commission-free trades for stocks and ETF's listed on US exchanges. If you were so inclined, you could even use it as your primary taxable brokerage account, although I don't believe you can link it to services like Mint or to roboadvisors that would help you periodically rebalance your portfolio.A little while ago they launched a referral program which gives new users and the existing user who referred them a free share of one of a few stocks. The exact stock you receive is determined randomly among the stocks they offer, which seem to currently include Facebook, Apple, or Microsoft (expensive) and Ford, Sprint, or Freeport-McMoRan (cheap). Apparently the stocks available change periodically based on share price and market capitalization.If you aren't a user, feel free to use my referral link: http://share.robinhood.com/stephes23.

Free stocks "lock up" your account's withdrawable cash

According to the terms and conditions of the free stock referral offer, "[t]he cash value of the stock bonus may not be withdrawn for 30 days after the bonus is claimed."That seems reasonable enough, since the point of the referral bonus is to get you onto the platform and trading. They want you to leave the value of your free stock on the platform for 30 days, whether you hold onto the stock or sell it and buy something else.However, they've implemented this restriction in a particularly sneaky way. As the terms and conditions go on to say:"You have to keep the cash value of the stock in your account for at least 30 days before withdrawing it. After the 30-day window, there are no restrictions on the money.

• "If we add 1 share worth $10 to your account, you cannot withdraw the $10 you receive by selling the stock for 30 days.
• "If we add 1 share worth $10 to your account and you deposit $100 dollars into your account, you can only withdraw $90 until you sell the stock bonus. After you sell the share, you will be able to withdraw an additional $10" [emphasis mine].

Read that second bullet carefully: it says that as long as you hold your free stock, up to 30 days, you can't withdraw money added to the platform from your own bank account.I've referred a couple of people to Robinhood, and just ran into this exact situation. I received one share each of SPLS (Staples) and VER, a real estate investment trust. I had previously made a few profitable bets on China, which I was ready to sell. To my surprise, when the trade settled, my withdrawable cash was $8.96 lower than the proceeds from the sale. I couldn't for the life of me figure out what had happened, until I started scrolling back through the "history" tab and spotted precisely that figure: it was the value of a share of Staples on the day I claimed my free share (I had received my VER share more than 30 days ago).The amounts involved in my case are very small, but you can imagine if you lucked into a share of Apple or Facebook that having a few hundred dollars of your own money tied up could be a real nuisance if you were counting on withdrawing it as soon as a trade settled and the cash became available.

I don't like this restriction but it's easy to work around

I had been holding on to my two free shares as a kind of laugh, since they didn't cost me anything, so I was disappointed to see that I had been punished for doing so. To withdraw the $8.96 of my own money, I would have to sell my share of Staples (now worth $8.84). Then I could reinvest the $8.84 or wait a few more weeks to withdraw it. That's a weird hassle for a platform that I've praised in the past for its simplicity and ease of use.The workaround is simple: if you plan on using Robinhood to actually gamble or invest, simply sell your free shares as soon as possible, two days after receiving them. That will tie up your own cash deposits for the shortest possible time.

Five ways to capitalize asset price movements

I am on the record as skeptical of the value of paying a roboadvisor to execute capital-loss harvesting, but capital-gain and capital-loss harvesting is a subject that excites financial independence bloggers (e.g. here, here, and here), so I don't want to brush off the subject completely.For those unfamiliar, capital-loss harvesting allows you to offset capital gains you realized during a calendar year or, if none, apply up to $3,000 of losses against ordinary income (and roll unused losses forward to the next tax year) while capital-gain harvesting allows you to sell appreciated assets and pay the long-term capital gains tax rate on your profits. The key difference is that while capital losses are subject to the wash sale rule, capital gains are not, so you can repurchase substantially identical securities immediately with the proceeds of the original sale.

Two notes on the logic and illogic of these practices

There are two things it's important to keep in mind about the practices of capital-loss and capital-gain harvesting.The first is that these antics are entirely products of two decisions made by the authors of the current tax code: the ability to apply capital losses against ordinary income (thereby getting up to a 39.6% rebate on your bad investment choices) and the decision to tax long-term capital gains at lower rates than short-term capital gains. These are very bad decisions, but they are currently enshrined in law, so I don't pretend to criticize anyone taking advantage of them.The second is that under the most popular current interpretation of the tax code, the rules around wash sales are interpreted so loosely as to be practically meaningless. For example, selling an S&P 500 ETF and using the proceeds to buy a total stock market ETF is not treated as a wash sale, nor is the reverse transaction, despite their near-perfect correlation. Likewise the IRS doesn't seem to object to selling a developed-market ETF at a loss and using the proceeds to buy one European and one Pacific developed-market ETF. This is a bad interpretation of a bad rule, but it is the current prevailing understanding of the rules.This second point is important because it means your capital-loss and capital-gain harvesting doesn't need to affect your overall asset allocation, since you can use the proceeds of your transactions to replicate your original holdings through differently-though-similarly-indexed ETF's (I'm not a tax lawyer, and I'm definitely not your tax lawyer, so please consult with him or her before actually attempting this).With that out of the way, I want to take a closer look at five ways you might, if you were so inclined, harvest capital gains and losses.

Harvest all losses

This strategy would work by identifying a certain number of correlated but not "identical" ETF's, and swapping between them each time you see a loss, while keeping the 30-day wash sale rule in mind. For example, you could use the Vanguard 500 ETF and Vanguard Total Stock Market ETF, and sell on every day with a loss that brings your share price below your purchase price and move the money to the other, as long as the transaction wouldn't put you in violation of the wash-sale rule (i.e. put you back in the original ETF within 30 days of sale).It would be relatively easy to configure such a rule with stop-limit orders, although you'd have to actively execute the subsequent purchase order and actively monitor your wash sale compliance.

Harvest all gains

Another approach would be to look at your holdings just once a year and sell all your securities that have long-term capital gains, paying the lower long-term capital gains tax rate and using the proceeds to repurchase the same securities at a higher basis.A sub-strategy here would be to only sell appreciated securities up to the total income limit of the 0% long-term capital gains tax rate ($37,650 AGI for single filers).This strategy is far simpler than the above because it only requires you to know the date you purchased your securities, without needing to reallocate between similar-but-not-identical securities, capital gains not being subject to the wash-sale rule.

Harvest everything

Every year-and-a-day, you could sell all your year-old securities and either deduct your losses or pay long-term capital gains taxes on your gains. The advantage of doing so would be to, over time, step up your cost basis more-or-less in line with inflation and price appreciation, while paying only the long-term capital gains tax rate and also accruing tax losses in down years to offset future capital asset appreciation.This would require more extensive book-keeping and compliance with the wash-sale rule, but would only need to be done once per year, making it potentially less burdensome than the "harvest all losses" option above.

Offset all losses

One of the advantages of a diversified portfolio (I do not have a diversified portfolio) is that your assets aren't supposed to be perfectly correlated. That means a portfolio with a total US stock market ETF, a total developing market ETF, a European developed market ETF and a Pacific developed market ETF will experience different returns at different times: some gains and some losses.One way you could respond to this is to sell your loss-making securities (which can be either short-term or long-term) and offset those losses with gains-making securities, preferably those with short-term capital gains. You can use the proceeds of those sales to buy similar-but-not-identical securities to the loss-making ones, and identical securities to the gains-making ones.If properly executed and reported, this should result in no net tax bill.

Offset all gains

The converse of the above strategy is to sell capital-gains-making securities and offset those with loss-making sales. The advantage of this strategy would be avoiding paying capital gains taxes (while securing a stepped up basis for your securities by re-buying your gains-making securities immediately) while also avoiding the necessity of tracking and rolling forward capital losses year to year.

Conclusion

The decision whether to pursue any or none of these strategies ultimately depends on a number of factors:

• do you believe touching your investments more often will make your investments perform better or worse than leaving them alone?
• what is your level of confidence in your ability to choose and successfully execute one or more of these strategies?
• what is your level of confidence that you understand the rules surrounding wash sales, capital gains, and capital losses?
• what is your marginal income tax rate, marginal short-term capital gains tax rate, and long-term capital gains tax rate?

My personal answers to those questions are "worse," "low," "low," and "0%," which explains why my interest in these strategies is purely academic. If your answers are "better," "high," "high," and "40%," then these strategies will understandably seem more appealing!

Everyone needs, and no one has, compounding discipline

I have written elsewhere about the importance of what I call "compounding discipline:" the deliberate choice to take the return you earn on alternative, irregular, and weird activities and reinvest them, instead of spending them. Exercising compounding discipline is essential to realizing the full benefits of those activities over medium and longer terms, but is next to impossible for humans.

Gaming the tax code can't make you rich without compounding discipline

While financial independence types have raised it to an art form, people in all walks of life engage in what I consider fairly outlandish antics in order to minimize the income taxes they pay. And these antics, more or less, work. On the extreme side, you can harvest capital gains, harvest capital losses, recharacterize contributions, or roll 401(k)'s over, under and through IRA's. Even setting those aside, ordinary people cheerfully deduct mortgage and student loan interest and claim this means they're "saving money" on their home or education.Consider the case of a single homeowner with $50,000 in income who paid $10,000 in mortgage interest in 2016. Since $10,000 is higher than the standard deduction of $6,300, the homeowner decides to itemize her deductions, and reduces her adjusted gross income from $39,650 by $3,700, to a total of $35,950. By deducting mortgage interest, the taxpayer reduces her tax liability from $5,690 to $4,933, a savings of $757.My question for you is, what does she do with the $757?The answer, of course, is that she does nothing with the $757. She never, in fact, sees the $757 unless she overpaid her taxes during 2016 (note that making interest-free loans is an odd way to get rich).

Compounding discipline turns savings into assets

I wrote back in February about bringing my adjusted gross income below $18,500 each year in order to trigger the maximum Retirement Savings Contribution Credit, and wrote:

"In 2016 my income was about $22,500, or $4,000 above the cutoff for the maximum credit, but leaving me eligible for a $200 credit. Contributing $2,500 raised that to $400, and contributing $4,000 raised it to $1,000 (I had an excess premium credit repayment in 2016 so I was able to claim my whole credit).An $800 return on a $4,000 contribution was a no-brainer for me."

Making a $4,000 contribution to my solo 401(k) saved me $800 in federal income taxes, but it didn't do anything to make me wealthier because I didn't invest the $800. I never even saw the $800! I have $800 more in my bank account than I would have without the contribution, but I didn't make a "special" $800 contribution to any of my investment accounts.But that's exactly what I would have to do if I wanted to use my tax savings to become wealthier. Likewise, a homeowner deducting mortgage interest really could become debt-free faster by applying his tax savings to his mortgage, a student borrower could use her tax savings to accelerate the repayment of her loans. That's compounding discipline, and no one does it.

It's fine not to have compounding discipline (no one does), just be realistic

Financial independence types love to talk about how important frugality is because every dollar you save will become a zillion dollars in 100 years compounding at 50% APY (or something like that). I don't dispute the math, although it will certainly be interesting to see how FIRE bloggers react when their investments start negatively compounding in the next bear market. What I dispute is that financial independence types actually exercise compounding discipline and invest the savings they achieve with their tax minimization antics.That doesn't mean the savings aren't real! But saving $1,000 on your taxes makes you $1,000 richer. It only makes you a zillion dollars richer if you invest it, which you won't. In fact, you'll never even see it.

What's the advantage of tax-advantaged accounts?

On Sunday I wrote about what I consider a fairly important oversight in the world of financial independence enthusiasts: a glaring disregard for just how minimal the taxes they spend so much time avoiding really are. Capital gains harvesting, for example, is the practice of realizing long term capital gains as often as possible in order to pay minimal taxes on the proceeds. That's all well and good, and perfectly legal and whatnot, but for the overwhelming majority of investors it's also completely unnecessary.However!I don't want that to shade into saying that tax-advantaged investment accounts don't have advantages. They do, but they're somewhat orthogonal to the ones people generally emphasize. So today I want to spell out the advantages tax-advantaged accounts really do have.

Internal tax-free compounding

Once funds are invested in a tax-advantaged account, whether it's an IRA, 401(k), 403(b), 529, HSA, or any other vehicle that suits you, they have the great advantage of offering internal tax-free compounding: instead of owing taxes, however minimal, on dividend and capital gains distributions each year, those distributions can be reinvested (or not) within the account without incurring any income tax liability.It is treated as an article of faith that this feature of tax-advantaged accounts is an unalloyed good and a key to increasing your net worth, achieving financial independence, and all the other things to be mined from the Big Rock Candy Mountain. Since I take money literally, I have to break it to you that it's just not so.Consider an account holding $10,000 in a mutual fund paying a 2% annual dividend. Actually, let's be rich people, and hold $1,000,000 in a mutual fund paying a 2% annual dividend. In a taxable account, we'll earn $20,000 per year in dividends and owe the maximum marginal capital gains tax rate of 23.8%: the maximum 20% long term capital gains tax rate plus the 3.8% net investment income tax.This, all things considered, sucks. $4,760 of our annual dividend goes straight to Uncle Sam and his bizarre effort to provide health insurance to the working poor.Now consider the case of the millionaire who, thanks to frequenting financial independence blogs and forums, has managed to squirrel away the whole million into a Roth IRA. Each year the investment spins off $20,000 that he's able to reinvest tax-free, thus realizing the dream of internal tax-free compounding.The question is: what does he do with the $4,760? I have never met anyone who looks at their tax-advantaged investment accounts each year, calculates the amount they saved by avoiding the federal capital gains tax, and then invests that amount. In the past I've called that "compounding discipline," and no one has it. You don't have it, I don't have it, no one has it.

Make decisions without tax consequences

Friend of the blog Alexi over at Miles Dividend M.D. has explained his adoption of Gary Antonacci's "dual momentum" investment strategy, whereby you invest in domestic stocks, foreign stocks, or cash, depending on which has performed best over the last 12 months (I'm not doing the strategy justice, for obvious reasons).While such strategies may not trade "frequently," they certainly trade more frequently than "buy and hold forever," which is my preferred strategy. If you've been convinced that such a strategy will best serve your financial interests, you'll be much better off pursuing it in a tax-advantaged account than in a taxable account where moving in and out of funds will incur annual short-term capital gains, taxable at your marginal federal income tax rate.While such strategies are an extreme case, there are other reasons you might want to make investment decisions without tax consequences. When I took control of my IRA, it was invested in a number of funds which I simplified into a Vanguard target retirement date fund. Several years later, as I learned more about investing, I simplified it further into the Vanguard 500 fund. I have yet to hear a compelling argument for doing so, but someday I may simplify it even further into the Vanguard Total Stock Market fund. These aren't market timing decisions, but simply the natural course of my investing education, and I'm certainly grateful not to have incurred any taxes or even significant paperwork along the way!

Manage adjusted gross income

While it isn't applicable to everyone, the ability to use pre-tax retirement savings vehicles to manage your reported adjusted gross income can sometimes provide an outsized return on investment. It's why I earn $18,500 every year, for example. Other than the reasons explained above, I do not generally think that it's worthwhile aggressively managing your adjusted gross income, unless you are able to bring it below a threshold that triggers special tax benefits (these benefits shouldn't exist, but as long as they do I understand and share the impulse to game them).

Lock in today's tax rates

Finally, I'm not trying to ignore the elephant in the room: assets that can be shielded in Roth IRA's and Roth 401(k)'s, and withdrawn in retirement, will never be taxed again. The same is true of 529 college savings plans when the funds are spent on qualified higher education expenses. Such accounts give you access to internal tax-free compounding, reallocations and reinvestments without tax consequences, and tax-free withdrawals.It's no secret that I believe capital gains should be taxed as ordinary income (perhaps with an inflation deflator if held for a long enough period), but if that dream ever becomes a reality, then people with the foresight to seize every possible opportunity to shift their investment balances into after-tax Roth accounts and tax-free inheritance vehicles will surely be laughing at all the suckers who figured that long-term capital gains taxes were too low to bother shielding their investments from it.

Conclusion

There are reasons to contribute to tax-advantaged investment vehicles, particularly after-tax and never-taxed vehicles like Roth retirement accounts and 529 college savings plans. But if you don't know why you're doing something, you're vanishingly unlikely to be doing it for the right reasons. So before harvesting your losses, harvesting your gains, or harvesting your artichokes, be sure it actually makes sense for your situation.

Financial independence, early retirement, and real estate

If you have your eyes open, one of the first curious things you notice about the "FIRE" community (Financial Independence, Retire Early) is their fixation on real estate. For example, Mr. Money Moustache "retired" from his job as an engineer in order to become a residential property manager, writing that "many of us consider property ownership to be a key part of our early retirement strategy." One of the very first real life conversations I had with a FIRE enthusiast very quickly turned to his plans to buy up residential real estate in Memphis. And of course the Saverocity Forum has extensive threads on the promise and peril of real estate management.Residential real estate is a fairly curious asset class. It's a depreciating asset (the structure) resting on top of a commodity (the land). Meanwhile, converting the asset into a revenue stream requires active management. It doesn't have to be actively managed by the owner, of course: there are residential real estate management firms that will handle tenant screening, maintenance, and so on for a fee. But whether it's managed by an amateur or a professional, the size and steadiness of the revenue stream ultimately depends on the competence of the management in addition to the quality of the structure and desirability of the land.Based on everything I've seen and heard, here are four things that I think make residential real estate appealing as an investment to people in the finance hacking and FIRE community.

Ease of leverage

If you simply want to invest in real estate as an asset class, Vanguard offers mutual funds that give you exposure to domestic (VGSLX) and ex-US (VGRLX) real estate investment trusts. The Admiral shares have expense ratios of 0.12% and 0.15% and have non-SEC yields of 3.92% and 4.73%, respectively (I had to manually calculate the yield on the ex-US fund so it's as non-SEC as it gets).I recently listened to a podcast episode with someone who decided to coin the term "house hacking" to describe buying multi-unit properties, living in one unit and renting out the rest of the units to cover his mortgage payments. One of his key concepts is "the 1% rule," whereby you should aim to buy properties where the monthly rent is 1% of the property's purchase price. If you bought a property outright according to this rule, you'd earn 12% annually, minus taxes, maintenance and vacancies.But if you buy the property with a 20% down payment, your return on equity is suddenly five times that (minus the interest on the 80% of the purchase price you borrow).The key advantage of doing so is not the leverage itself: you can buy stocks and bonds on margin if you're so inclined. The key advantage is that the underlying asset is never marked to market! Even if you found a broker willing to let you buy VNQ or VNQI (the ETF equivalents of the mutual funds mentioned above) with 20% equity, even a modest decline in real estate prices or change in interest rates would wipe out your equity and trigger a margin call. In the residential real estate market, you can take advantage of rising real estate prices through cash-out refinancing, but even if housing prices decline you'll never lose your shirt as long as you keep making your mortgage payments (which are currently being offered on very generous terms).

Value of specialized knowledge

The stock market is a brutal place to try to apply specialized knowledge. You can know everything there is to know about solar panels, electric storage technology, and self-driving cars, and it still shouldn't give you the slightest hope of guessing whether Tesla's stock will go up or go down, or whether it will do so tomorrow, next month, or in a decade.The residential real estate market, on the other hand, is the kind of place where a person feels they should be able to fairly easily apply their knowledge, experience, and intuition. Everyone knows the neighborhoods in town which are becoming more popular and those which are becoming less popular. Everyone knows where students and young families like to live, and where drug dealers and vagrants gather. You can flip open the local newspaper and see where hip new bakeries are opening and where storied local institutions are closing because of lack of foot traffic.All this means that a person feels like they should be able to pick the "right" properties to invest in even if they're fully aware they're incapable of picking the "right" stocks to invest in and sensibly choose a low-cost indexed portfolio instead.

Tax advantages

No matter how pure your intentions, nobody stays a residential real estate investor for long before they also become an amateur CPA. If you'll allow me to quote at length from the Saverocity Forum:

"Now seeing that we have a positive cash flow on the year most people might think that we're due to owe uncle same based on this cash flow. What most people don't realize is that when you own rental real estate, you are required to depreciate the cost of the property and apply that towards your income/expenses on your Schedule E(real estate profit/loss tax form). Without getting too complicated this means that a portion of the property value(not including the land it sits on) gets to count as an expense over the next 27.5 years of your ownership. So while you get the benefit of claiming an additional expense(albeit an invisible one) on your profit/loss sheet, this does effect the basis value of the property for when its time to sell. For now, based on the property value I get to claim $3000 of depreciation for the year. If I count this against the 1080/year in cash flow, I have a $1920 tax loss on the year. The nice thing about losses from your Schedule E is that they can be counted against your primary income(as long as your income is below 150K, between 100K-150K the amount of losses you can claim against income is phased out and above 150K you can only carryover those losses to use against future capital gains from sale of property). In this case, assuming I am able to claim the loss against my income, that $1920 loss could equate to about a $500 in tax savings(assuming a 25-30%ish tax bracket)"

Obviously I don't have anything against CPA's, amateur or professional, but it's hard to argue that becoming an amateur CPA looks anything like "retirement." To me, it looks like spending a lot of time poring over the tax code making sure all your T's are dotted and all your I's are crossed.Nonetheless, being able to deduct depreciation against earned income gives middle- and upper-class taxpayers a big incentive to actively invest in real estate, essentially supplementing their rental income with subsidies in the tax code.

The triumph of the material?

Together, I think the three features above explain 85% of the appeal of investing in residential real estate for finance hackers and FIRE enthusiasts, and if you asked 85% of them they would say that those features explain 100% of the appeal.But I think it's worth mentioning, at least, that there's something potentially uncomfortable about "just" owning a slice of the S&P 500, or the total US stock market, or the total world stock market. In fact, it might not feel like you own anything at all when the only thing you can see are digits bouncing up and down on your quarterly brokerage statements.Owning real estate isn't like that. If you manage your own properties, you can drive by and see them every day. You have deeds that are recorded in government offices that meticulously spell out the boundaries of your property. You can mow the lawn, lay down new pavement, replace the appliances. The properties, in other words, exist in your own material world, and I think some people find comfort in that above and beyond their tax-advantaged, highly-leveraged, compounding-revenue-stream-generating residential real estate business model.