Procrastination

Investing and procrastination seem to go hand in hand, although not necessarily in a good way.  I recently rediscovered the article Later: What does procrastination tell us about ourselves?, by James Surowiecki, who writes about economics, business and finance for the New Yorker.  It’s comforting to know philosophers are as mystified about the phenomenon as we all are. 

If you enjoy it, you might also enjoy his book the Wisdom of Crowds.

On that note, I will get back to what I am supposed to be doing.

What’s an Advisor Worth?

Is it a good idea to have an investment advisor?  The answer usually hinges on intangibles.  For those that answer “no,” often the rationale reflects confidence in their own capabilities, and a tinge of suspicion toward investment professionals.  For those that answer “yes,” often the rationale reflects confidence in an advisor’s ability to beat the market, appreciation for answering questions whenever they come up, or the most nebulous of all, “discipline.”

Are there tangible benefits?  I don’t mean pretty pie charts.  A quarterly report, although real, doesn’t put money in the bank.  Can advisors create value that is as tangible as the money you pay them?

At synthiumcapital.com, we quantified the value of five investment techniques, and concluded that together they can increase returns by up to 26%.  Few investors implement all five techniques, and many advisors don’t either.  Is it realistic for an investor to implement the techniques on his or her own?  That depends on the investor, and on the technique.  But our analysis does build a foundation for quantifying tangible benefits to having an advisor.  Here we go through the five techniques again, assessing whether individual investors can implement each technique their own. 

Technique #1: Optimal asset location

Value: up to .33% per year

Rating: Easy

    

Taxes can be reduced by placing high yield bonds, which produce a lot of income taxed at higher rates, into nontaxable accounts (IRAs, 401(k)s, etc), and placing tax efficient equity investments in taxable accounts.

Do you need an advisor to do this?  Not really.  Just sort your assets according to their tax efficiency.  To the extent you’re able to place assets in nontaxable accounts, the assets you should place there are the less tax efficient ones.  The rest of your assets, which would presumably include the most tax efficient ones, should go in your taxable account. Your overall asset allocation will be the same, but your after-tax returns will be higher.

Technique #2: Overweighting toward small and value

Value: up to .50% per year

Rating: Easy

Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk.  For a long term investor, this can be a boon – assuming the effect persists. 

Tilting your portfolio toward small/value equities is fairly straightforward.  Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds.  You just need to look for funds with acceptable expense ratios that invest in small or value equities, although an advisor familiar with this technique probably already has done that research.

Technique #3: Whole portfolio, tax-sensitive rebalancing

Value: up to .55% per year

Rating: Difficult

To recap, rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk.  Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account.  This achieves the desired level of risk, but leads to higher taxes.  Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.  

If you have more than one account, whole portfolio rebalancing gets very complicated.  Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own.  Only advisors can justify this kind of investment.  Properly doing it by hand, even with the help of a spreadsheet, is a nightmare.

Technique #4: Tax loss harvesting

Value: up to .46% per year

Rating: Moderate 

Tax loss harvesting means selling assets that have incurred a capital loss.  The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income until the loss has been used up.

After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss.

Conceptually speaking, tax loss harvesting is not hard.  But to do it on your own, you had better enjoy putting the “green eye-shade” on.  There’s a lot of record keeping, both to keep track of your cost basis and to avoid accidentally triggering the wash sale rule, especially if you have multiple accounts and proxy assets.  And to minimize your taxes, you should be using specific tax lot accounting, which involves more record keeping.  If you’re comfortable with accounting, you might consider tax loss harvesting easy; if you’re not, you’ll probably consider it difficult.

Technique #5: Enhanced index funds

Value: up to .48% per year

Rating: Difficult

Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.

Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, which is why we labeled this technique “difficult.”  Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.

Conclusion

Should you sign up with an investment advisor?  For most people, the answer revolves around intangibles, which we think is unfortunate.  Here’s a simple way to focus on tangible benefits.  Tally up the tangible benefits above that, for whatever reason, you can’t or probably won’t have the time to implement.  Assuming the advisor implements those techniques, and the tangible benefits exceed what the advisor charges, then maybe signing up is a good idea.  If they don’t cover what the advisor charges, maybe it isn’t such a good idea.

Finally, since most advisors don’t implement all the techniques, we hope our analysis will lead to some enlightening conversations between clients and advisors.

How to make $600/day the hard way

This Wired magazine article is not about investing, but some might find it as interesting as I did (I heard about it from bogleheads.org).

Mohan Srivastava, a geological statistician, found a statistical flaw in an Ontario lottery program, allowing him to predict winning tickets with 90% accuracy prior to purchasing them.  When he contacted the Ontario Lottery and Gaming Corporation,

he was referred to Rob Zufelt, a member of the lottery corporation’s security team. After failing to make contact for a few days, he began to get frustrated: Why wasn’t Zufelt taking his revelation more seriously?  “I really got the feeling that he was brushing me off,” Srivastava says.  “But then I realized that to him I must sound like a crazy person—like one of those people who claims that he can crack the lotto draw because last night’s number was his birthday spelled backward.  No wonder they didn’t want to talk to me.” Instead of trying to get Zufelt to return his calls, Srivastava decided to send him a package. He bought 20 tic-tac-toe tickets and sorted them, unscratched, into piles of winners and losers.  Then, he couriered the package to Zufelt along with the following note:

In the enclosed envelopes, I have sent you two groups of 10 TicTacToe tickets that I purchased from various outlets around Toronto in the past week… You go ahead and scratch off the cards. Maybe you can give one batch to your lottery ticket specialist. After you’ve scratched them off, you should have a pretty solid sense for whether or not there’s something fishy here.

The package was sent at 10 am. Two hours later, he received a call from Zufelt. Srivastava had correctly predicted 19 out of the 20 tickets. The next day, the tic-tac-toe game was pulled from stores.

The article also includes some troubling statistics.  Households earning less than $12,400 spend an average of 5% of their income on lottery tickets, whose expected value is 53% of the price you pay.  Thirty percent of people lacking a high school education said that playing the lottery is a wealth-building strategy.

Coincidentally, lottery tickets made an appearance in the Dilbert comic strip yesterday.

Ticker Tube Tales

After a Stairmaster workout at my athletic club, I often find several members sitting there in the locker room, fascinated by the CNBC ticker.  I am fascinated, too: not by the ticker, but by their fascination.  These are not day traders.  Why do they find cacophony so interesting?  For me, the ticker obscures more than it illuminates.

That scene underscores something remarkable about investing.  Unlike most disciplines, investing does not have a common cadence.  Cosmologists think in terms of billions of years; geologists, perhaps millions.  For politicians, there’s a natural four-year rhythm.  Musicians produce songs that are roughly five minutes long.  For computer hardware engineers, nanoseconds matter.

But investing has no common cadence, and perhaps it is better that it doesn’t.  It’s analogous to radios.  We’re all surrounded by the exact same electro-magnetic radiation, but by tuning to different wave lengths, we each hear entirely different music. 

What is signal to one person is noise to another; with radio, it’s easy to tell the difference.  With investing: not so easy.  Consider this example.  Say I plan to retire in 20 years, which is to say I don’t need the money for 20 years, and then I do need it.  As with any investment, risk matters, and sooner or later volatility of annual returns is likely to enter the discussion.

Why annual returns?  Gee, I don’t know, but to me, that seems to be the most common basis for volatility calculations; maybe providers of data are trying to split the difference between day traders and Warren Buffett.  If the 20-year investment horizon above is to be taken seriously, volatility of annual returns shouldn’t matter.  The cadence doesn’t match.  What should matter is the volatility of 20-year returns. 

Plenty of investors miss the distinction.  Watching the herky jerky ticker movement is like watching trees swaying in a stiff wind.  In the process of entertaining, it diverts attention away from the long term growth rate of the trees.  Day traders, of course, believe there is money to be made in the storm, whether or not the trees are growing.  They might be entertained by time-lapse photography of a tree growing, but they will learn nothing useful from it.

When the cadence matches, there are even more insidious ways to learn the wrong lesson.  Data breeds confidence; more of the former means more of the latter.  But even a prodigious amount of data reveals little about rarely occurring events.  Decades of video of a tree, for example, whether time-lapsed or otherwise, says a lot about the growth rate of trees, but very little about the risk of a forest fire.  This, in my view, is the main point of Nassim Taleb’s book, The Black Swan.  It is a best selling book; we can only hope it is also best read and best understood.

Truth be told, the locker room TV is just as often tuned to ESPN, where learning the right lesson from the right data can be just as challenging: think Moneyball and Moneygolf.  Whichever channel the TV is set to, the mesmerized look is the same.  Which leads to another theory: CNBC is just another sports channel, meant for entertainment only.  It sure beats breaking a sweat.

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part III of a Series)

In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location.  In Part II we discussed Overweighting towards small/value equities and Whole portfolio, tax-sensitive rebalancing.  Here in Part III, we continue by evaluating the final two techniques, and draw our conclusions.

Technique #4: Tax loss harvesting

Value: up to .46% per year

Tax loss harvesting means selling assets that have incurred a capital loss.  The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income.

After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss. Under current tax law, buying the same or similar asset 31 days before or after the sale, in any of your accounts, triggers the wash sale rule. After 31 days, if desired, the proxy asset can be sold and the original asset can be repurchased.

Let’s say your S&P-500 fund is down $20,000. You sell it, capturing the loss, and immediately buy a ‘proxy’ asset, for example an ETF (or mutual fund) based on the Russell-1000. After 31 days, you sell the Russell-1000 and buy back the S&P-500. Alternatively, you might stick with the new asset, in this case the Russell-1000.

Harvesting Capital Gains and Losses (Smith and Smith, Financial Services Review, 2008) compared the effect of various tax loss harvesting approaches on a hypothetical portfolio with the following assumptions:

• 20 asset classes
• Long term capital gain rate 15%, short term capital gain rate 36%
• 6% gross return

Examining a large number of possible outcomes with a Monte-Carlo simulation, it found that tax loss harvesting increased the portfolio by 11% over 20 years, which, annualized, equates to 0.52% growth.  Thus for the study’s 6% gross return, tax loss harvesting added 8.72%

(0.52%/6%).  To be conservative, we assumed tax loss harvesting opportunities only occurred on the equity portion (60%) of our model 60/40 portfolio.  After normalizing for our theoretical maximum return of 8.76% of our period 1990-2009, an improvement of 0.46% is calculated (0.46% = 8.72% x 8.76% x 60%).

Technique #5: Enhanced index funds

Value: up to .48% per year

Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.

While DFA funds have real and quantifiable benefits, many advisors overstate them.  A Duke University study concluded that a portfolio composed of DFA funds significantly outperformed similarly weighted Vanguard portfolios, but we felt the study overstated DFA’s advantage.  Our analysis concluded that DFA can add up to 0.48% over the long haul, for our balanced 60/40 portfolio during the study period. 

Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.

Conclusion

As always, past performance doesn’t predict future performance.  In which case, was this whole exercise a waste of time?  It’s a fair question, but we think the analysis has some merit.  First, most investors don’t implement all five techniques; for them, this analysis provides a rough idea of what they are missing.  Second, while your mileage will vary, the analysis provides at least a stake in the ground regarding their relative value.  

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part II of a Series)

In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location.  Here, in Part II, we continue by evaluating two more techniques.

Technique #2: Overweighting toward small and value

Value: up to .50% per year

Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk.  For a long term investor, this can be a boon – assuming the effect persists. 

In their pioneering studies, Fama and French found that overweighting portfolios with small and value stocks over long periods of time adds significantly to returns (Common Risk Factors in the Returns on Stocks and Bonds, Fama and French, Journal of Financial Economics, 1993; and The Cross-Section of Expected Stock Returns, Fama and French, Journal of Finance, 1992).  To quantify this effect for our purpose, we compared the return of an overweighted (‘tilted’) portfolio with excess small and value asset classes to a non overweighted portfolio with exactly the same proportions (the ‘un-tilted’ portfolio).  The ‘tilted’ portfolio returned 9.08% versus 8.22% for the ‘un-tilted’ one, a difference of 0.86%.  Thus, during the study period we see an improvement of 10.46% from the small/value effect. Since the small/value effect is only for equities, we scale the result by 60% (the portion of equities). Finally, we normalize for our study period and get an improvement of 0.50%.

Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds.

   

Technique #3: Whole portfolio, tax-sensitive rebalancing

Value: up to .55% per year

Rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk.  For instance, you might have 40% of your assets in domestic stocks, 20% in foreign stocks, and 40% in bonds.  If stocks went up more than bonds, you would need to sell some stocks and buy some bonds in order to maintain your desired level of risk.  Some experts also argue that rebalancing encourages you to sell asset classes that are at higher prices and buy those that are at lower prices.  Experts debate how frequently you should rebalance, with some arguing for every three months, and others recommending every 12-18 months.

Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account.  This achieves the desired level of risk, but leads to higher taxes.  Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.  The total of each asset class from all accounts is considered.  If there is an excess of an asset (i.e. it is above its desired threshold), tax-sensitive rebalancing will first look for that asset in taxable accounts where there is a capital loss, with short term losses preferred over long term ones.  Next to be considered are sales of that asset in non-taxable accounts (the proceeds from the sale will remain in the non-taxable account, of course, unless a distribution is desired).  Last to be considered are sales from taxable accounts where there is a capital gain, with long term gains preferred over short term gains.

The study Opportunistic Rebalancing: A new Paradigm for Wealth Managers (Daryanani, Journal of Financial Planning, 12/2008) found, over the period from 1992-2004 where the market returned 8%, that an annualized improvement of 0.50% could be achieved with rebalancing. The study attributed this improvement to two effects:

1. Rebalancing as much as possible in non taxable accounts (to avoid taxable gains), the investor improved returns 0.22%;
2. Using the “opportunistic rebalancing” techniques described in the above study, the investor achieved another 0.28% improvement.

Normalizing for our period, we get a 0.55% improvement (0.55% = 0.50%/5.84% x 8.76%).

But there’s a caution.  Properly doing whole portfolio rebalancing, even with the help of a spreadsheet, can be a nightmare.  Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own, an effort few investors can justify.

In Part III of the series, we’ll consider the final two techniques, and draw our conclusions.

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part I of a Series)

Here’s a quick test.  You have to choose between two investments.  One grows at 8.76% annually.  The other grows 26% faster, or 11.08%, but otherwise they are identical.  Which do you pick?

Thanks to the magic of compounding, that extra 2.32% would make a big difference after a few years ($281K more after 20 years on a $100K investment, before taxes, according to our spreadsheet).   And remember, we said the investments are identical.  Amazingly enough, many investors faced with this choice choose the lower return.

Everyone’s constantly looking out for outstanding investment ideas.  But for many investors, some of the best ideas are hiding right in front of them.  We’re talking about what might be called the nuts and bolts of investing, specifically five techniques:

1 – Optimal asset location

2 – Overweighting toward small and value stocks

3 – Whole portfolio, tax-sensitive rebalancing

4 – Tax loss harvesting

5 – Enhanced index funds

These are techniques that sophisticated investors employ, and you can employ them too.  They’ve been discussed in other articles.  They’re good techniques, but how much are they worth? 

At synthiumcapital.com, we sought to quantify them, well aware of the enigmatic nature of our quest.  Google autocomplete wasn’t going to be of much help, to put it mildly.  Our expedition through academic research felt at times like spelunking.  The obscure footnotes we followed had plenty of dead ends.  Illumination was a scarce commodity. 

We were in constant peril of incompatible assumptions.  Each study we found based its conclusions on a different time period with different market characteristics. For example, one article might claim a 0.50% improvement from tax loss harvesting when the market grew at 6%, while another study found rebalancing added 0.60% during a period of 8% returns.  How do these two effects, harvesting and rebalancing, compare?  Which one adds more to returns?  To get a handle on their relative value, we needed to account for each study’s underlying market conditions.  Our solution was to simply scale each study’s findings to a “standard” period and portfolio — the return of a hypothetical globally diversified allocation, 60% equities / 40% bonds (60/40), from 1990-2009, which had an observed return of 8.76%.  Here is an example: say a study found that technique A added 0.50% during a period of 10% returns. We scale the study’s results to our standard period as follows:

Study found a 0.50% improvement from technique A, when the market did 10%

5% = 0.50% / 10% - Therefore the study implies a 5% improvement during its period.

0.44% = 5% x 8.76% - Next, scale the study’s 5% improvement to our “standard” period with its 8.76% return.

But say the study was done for an 80% equity portfolio, not our 60% one, and Technique A only applies to equities.  We just need to scale this result as well:

0.33% = 0.44% x 60%/80% - Scale from 80% to 60% equity portfolio.

With this methodology, we can get the relative effect from each technique.

Now that we have resurfaced, this three-part series summarizes our discoveries.  For each of the five investment techniques, we describe them, quantify their potential impact on investment returns, and conclude with an assessment of whether individual investors can implement the technique on their own.  We’ll conclude Part I with the first technique.  Parts II and III will each cover two techniques to complete the series.

Technique #1: Optimal asset location

Value: up to .33% per year

    

Investments increase in value due to price appreciation (capital gains) and accumulation of interest and dividends.  Taxes can be reduced by placing high yield bonds, which produce a lot of income taxed at higher rates, into nontaxable accounts (IRAs, 401(k)s, etc), and placing lower yielding equity investments in taxable accounts.  This is sometimes referred to as ‘location-aware allocation’; we prefer the term ‘optimal asset location.’

The study Asset Location: A generic Framework for Maximizing After-Tax Wealth (Daryanani and Cordaro, Journal of Financial Planning, January 2005), investigated the effect of initially placing various asset classes in taxable versus non-taxable accounts. The study made the following assumptions:

• 60/40 portfolio (60% equities, 40% bonds)
• Ordinary tax rate = 30 percent; capital gains rate = 15 percent
• Stocks pre-tax return = 8 percent; bonds pre-tax return = 5 percent

It found that over a long (30-year) horizon, the after tax return was 5.84% and that 0.22% of that was due to the optimal placement of securities.  Normalizing for our period, we get a 0.33% improvement (0.33% = 0.22%/5.84% x 8.76%).

Considering the effects of compounding over many years, increasing your effective after tax returns by 33 basis points can have a really big impact.  To the extent you’re able to place assets in nontaxable accounts, the assets you should place there are the less tax efficient ones.  The rest of your assets, which would presumably include the most tax efficient ones, should go in your taxable account. Your overall asset allocation will be the same, but your after-tax returns will be higher.

In Part II of the series, we’ll consider the next two techniques.