FOR MANY INVESTORS, the unfortunate outcome of following the accepted wisdom of having a diversified portfolio is to realize that they cannot be sure that their investment portfolio will adequately fund their financial objectives and life goals. In addition, they may not realize that they're taking on a great deal of additional risk. A client we'll call Peter is a typical example. He came to us well into his career but early enough for a change in his investments to make a difference.
Peter is forty years old and in the prime of his life. He is married to Jane, and they have two beautiful children ages eight and ten. Jane looks after the children, and Peter works at Bigco, a major international consulting firm. Peter is well regarded at Bigco and was promoted to the position of senior consultant last year. Peter has worked his entire career at Bigco and is well compensated.
Peter and Jane live the American dream. They have a huge house, expensive German cars, a single-engine airplane, and a Harley motorcycle. But all is not well with Peter and Jane despite their lavish lifestyle. Although Peter's work is challenging and exciting, he has become a road warrior and is away from home all week. Peter's absence and out-of-town travel is having an adverse effect on him and on his relationship with Jane and his children. To save his marriage and his relationship with his children, Peter has decided that he must leave Bigco and set up his own consultancy, even though he will take a big cut in pay, at least initially.
In addition to his distress about his family situation, Peter had become very concerned about his financial well-being. At work he found himself checking the movements of the stock market several times a day. He was especially concerned about the safety of his investment portfolio, particularly since he was leaving Bigco and his large monthly paycheck.
Peter has three financial objectives, which he explained to us:
To have enough liquid and easily salable assets to launch and support his new consulting business.
To provide for his children's college education.
To provide a savings program for his retirement.
Before becoming our client, Peter had a traditional financial adviser who worked at a large brokerage house. The adviser allocated Peter's $400,000 of financial assets into the investment portfolio, as set forth below. The only investment asset held in a tax-sheltered retirement account was the stock fund in the 401(k) plan. All other assets were held outside of tax-sheltered retirement accounts.
20 percent in stock mutual funds—in a 401(k) plan
30 percent in stock mutual funds
10 percent in a variable annuity that holds stock funds
20 percent in bond funds
10 percent in a real estate partnership
10 percent in a commodity partnership
Peter's financial adviser told him that this diversified portfolio would maximize his returns while minimizing his risks. The series of mutual funds, partnerships, and an annuity that the adviser bought for Peter were designed to provide a balance of large-cap stocks, mid-cap stocks, small-cap stocks, foreign stocks, and emerging-market stocks. He also bought Peter an annuity and investment partnerships in commodities and real estate to provide an allocation to alternative investments.
Peter's financial adviser told him that based on past performance this portfolio would generally appreciate at the 10 percent historical rate for stocks and would always outperform bonds. He advised Peter that it was best to ignore the daily and even yearly performance of the stock market and other markets; all would be well, eventually. He assured Peter that his children would have enough money for college in ten years and that he would retire rich in twenty-five years because his $400,000 nest egg would be worth more than $4,000,000 when it compounded at 10 percent per year, the historic rate of return on stocks, even if he added no more savings to it. Peter's adviser never factored in the need for liquid assets for the new start-up consulting business because the adviser generally used the same asset allocation for all his clients. A one-size-fits-all approach like this one is not uncommon at large brokerage firms.
Although this investment portfolio is not unusual, Peter's initial concern was that it did not support or align with his financial and life objectives. He had no idea what these investments would be worth in the future, how much income they would produce from year to year, or what their tax consequences would be each year. As a result of these unanswered questions, he could not get comfortable with or understand how the investment portfolio selected by his adviser would be worth enough for him to fund his new business start-up, his children's college expenses, and his scheduled retirement. He read articles about the many pension funds that bet on stocks to fund retirees' benefits and later found themselves with huge budget gaps between the value of the pension funds and the amount needed to pay retirees.
Peter had other concerns about his investment portfolio as well. He noticed that when the stock market went down, all his stock funds and the variable annuity went down as well despite the portfolio's diversification. He didn't see how these investments, although diversified, would protect him in hard financial times. Even when his stock investments were doing well, he worried about the market's unpredictable changes. He knew about the 1929 stock market crash and the 1987 crash, when the market dropped by 22.6 percent in one day. And he witnessed the bear market, when the S&P 500 declined by 47.5 percent—from 1,527 on March 23, 2000, to 801 on March 11, 2003. The Nasdaq did even worse, declining by 77.9 percent—from 5,048 on March 10, 2000, to 1,114 on October 9, 2002.[27] Peter's adviser told him that quick movements in the market were called "volatility" and that even if the market was inconsistent day to day, it would ultimately achieve the 10 percent growth rate based on past history. This assurance did not make Peter feel any more secure. He took an analytical approach to his investments, but the stock market moves seemed to him to be without rhyme or reason.
Another of Peter's major concerns was the high fees embedded in his stock funds and other investments. The stock funds had high front-end fees, high management and maintenance fees, and some had back-end fees. To add insult to injury, he was paying hefty fees for funds that often did not outperform stock index funds. The annuity and the partnerships—which also had high front-end fees, high management fees, and other fees—were difficult if not impossible to value. They also had long lockup periods, when they could not be sold at all, and penalties for early withdrawal. The partnerships were illiquid, in that they were hard to sell at a fair price.
Peter's stock mutual funds traded frequently, which generated a lot of short-term capital gains (when there were gains at all), which were taxable at ordinary income rates, creating a very tax-inefficient investment. Peter detested the idea of risking his hard-earned principal and paying high taxes. His concern was magnified in light of his view that the economy was vulnerable to a decline in these highly unstable times.
In the late 1990s, Peter thought that his investments in the stock market would fund his children's college education. After the losses from the dramatic stock market decline in 2000 to 2002, however, he no longer knew where the money would come from to fully fund their college expenses. Peter decided that he could not bet his and his family's financial well-being on what the stock market might be worth in the future. He also wondered what would happen to him and his family if the stock market declined significantly either at the point when he needed cash for his business or before his retirement. He didn't know how he could rely on the historical past performance of the stock market, commodities market, or real estate market when he knew that the world of the past was different from the present, let alone the future.
Peter terminated his engagement with his financial adviser because despite his portfolio's diversification he found that his investments were volatile, unpredictable, and expensive. But worst of all, he didn't believe that his investments supported his financial or life goals or that he would reach those goals safely.
Peter came to my office to investigate whether the strategy of the 100 percent bond portfolio might address his concerns. Peter wanted help. As we shook hands and sat down for an initial consultation, Peter was uptight and sat anxiously in his chair. He told me about his plan to leave Bigco and start his own consultancy. He also shared his fear that his investment portfolio might not be adequate to provide for his children's college education or his own retirement.
Peter asked if I could create a predictable financial plan that aligned with his financial life objectives and was not dependent on the unpredictable future performance of the stock market, real estate market, or commodities market. Peter no longer had any interest in listening to the "noise" of these markets and struggling to detect a signal that would indicate when to buy or sell these investments. These markets seemed to him to be driven more by luck and randomness than by skill, knowledge, and certainty.
I introduced Peter to the strategy of the 100 percent bond portfolio as a key part of his financial plan. It would work better than stocks, commodities, or real estate to secure his family's financial future. I explained that although stocks, real estate, and commodities might have performed well during certain periods in the past, there was no way of knowing whether they would have significant losses or gains in the future.
With investments in stocks, real estate, and commodities, the investor must make two right decisions—when to buy and when to sell. Those decisions are either right or wrong. There's no middle ground. Until an investor closes the position by selling, the money is at risk. In other words, with all investments, except safe bonds, the "chips are on the table" until the sale. Safe bonds are the only asset class in which an investor's chips are not on the table because a bond automatically pays off at its face value if the buyer holds it until its due date. For example, a stock investor in the 1990s made big money only if he purchased stocks early in the 1990s and then sold before March of 2000, before the bear market wiped out most of their gains.
I told Peter that a key question in financial planning is whether an investor has enough financial resources so that he can withstand the consequences of being wrong. If not, we tell him he should not play. Relying on an optimistic reading of financial history to plan your financial future may end badly. To be safe, place your savings in safe investments like plain-vanilla bonds rather than rely on risky investments to do the heavy lifting.
I explained the strategy of the 100 percent bond portfolio and how it would reduce his anxiety and allow him to focus his energy on his new business and on his family and life interests. Because of the safety and predictability of bonds, we could prepare a conservative and comprehensive financial plan.
I described the four-step procedure that we use to create a financial plan based on the 100 percent bond solution:
The client determines his life objectives and financial needs with the help of some coaching.
The client divides his investment portfolio into two categories:
Assets to be invested in plain-vanilla bonds. We call this category "investments" because they are safe and we can determine the return on these investments.
All other investment assets such as stocks, real estate, and commodities. We call this category of assets "speculative" because it is not clear what the value of these assets will be in the future or how much cash flow they will provide each year.
Determine the tax consequences of existing and proposed investments taking into account the client's overall tax position.
Determine which selection of bonds and other investments will align with and support the client's life objectives and financial needs taking into account the tax consequences.
Peter's major objectives are clear:
Preserve his marriage and continue his good relationship with his children.
Launch his new consulting business, allowing him to be self-employed and in control of his life.
Have enough assets available to pay for his children's tuition.
Provide for his retirement.
Peter's decision to leave his job at Bigco and set up an independent consultancy is a major objective and creates the need for a substantial amount of liquid assets. He will no longer have a monthly paycheck and may need additional assets to launch his business while supporting his family's personal expenses.
Peter decided to invest his financial assets in plain-vanilla bonds and money market funds to support his new business. He understood from my explanation that he must, at this time, keep all his investment assets safe because he could not take the risk of a decline in his stocks, commodity, or real estate investments (other than his house). Thus, he decided to sell his stock mutual funds, real estate partnership, and commodity partnership. In addition, he could not take the risk of continuing in his bond fund because bond funds don't come due at a fixed date and if interest rates went up, his bond fund would decline substantially in value.
Peter understood that the 100 percent bond portfolio was not in reality an extreme position because he had other assets, such as his house, which is a real estate investment. In addition he had cars, an airplane, a motorcycle, and collectibles. Even when he put all his investment assets in bonds, he had a substantial allocation to real estate and other assets.
Peter sold his investments in the year after he resigned from Bigco so that he was in a low tax bracket to minimize the taxes to be paid on his investment gains.
After his tax review, Peter was able to decide which investments would give him the best after-tax return. Because Peter was just starting a new business, it was prudent for him to invest a great deal of his financial assets in taxable cash equivalents, such as money market accounts and Treasury bills, to fund his start-up needs. These taxable investments yield more than tax-free investments, and Peter will initially be in a low tax bracket because of his startup business.
Once his business becomes profitable, Peter's financial plan is to extend the maturities of his bonds to get a higher return and invest some of his assets in tax-free municipal bonds.
After Peter sold his stock funds, cashed in his annuity, and sold his real estate and commodity partnerships, he decided to invest his $400,000 as follows in plain-vanilla bonds:
$50,000 in taxable money-market funds. Money market funds will not go up or down in value no matter what interest rates are doing. However, the interest rate will vary. Peter will first draw from the money market fund as a substitute for his salary from Bigco. See chapters 14 and 15 for a discussion of money market bond funds.
$100,000 in taxable Treasury bills. Of these, $50,000 will come due in three months, $25,000 in six months, and $25,000 in one year. These Treasury bills may yield more than the money market fund and will be free of any state or local income taxes. The Treasury bills will be drawn on to fund business expenses as needed and to fund Peter's living expenses. Treasury bills can be sold easily before they come due and at a very small spread (that is, the fee to sell is small). See chapter 6 for a discussion of Treasury bills and bonds.
$50,000 in one-year CDs. The CDs will yield somewhat more than the money market funds and Treasury bills. If purchased directly from a bank, they will not decline in value whether interest rates go up or down. However, if they are cashed in early, there may be a penalty. Peter found a bank that has only a three-month penalty. See chapter 12 for a discussion of CDs.
$100,000 in taxable agency bonds. These bonds will come due in two years. Agency bonds are essentially low risk and the interest from some varieties is exempt from state and local income taxes, although subject to federal income tax. Peter may even be able to reinvest the proceeds of these bonds in tax-free municipal bonds if his business is successful and he finds himself in a higher tax bracket at the end of the two-year life of the bonds. If not, he can buy more agency bonds. Agency bonds yield somewhat more than Treasury bills and bonds of the same maturity. See chapter 8 for a discussion of agency bonds.
$50,000 in TIPS bonds. These bonds will be part of Peter's tax-sheltered retirement account where they won't be subject to income tax until he withdraws cash from the account. Treasury inflation-protected securities(TIPS) provide a hedge against inflation and will serve as a first building block of his pension savings. The value of a TIPS bond increases if there is inflation. This increase results in taxable income even though no cash is currently paid to the bondholder. Thus, TIPS are generally suitable only for retirement accounts. If Peter's business goes well, he will add cash to his retirement account, which he will use to buy additional plain-vanilla bonds. See chapter 6 for a discussion of TIPS bonds.
$50,000 in zero-coupon municipal bonds. These bonds will come due eight, nine, ten, eleven, and twelve years from the purchase date to help pay his children's college tuition. If Peter invests $10,000 in bonds maturing in each of these years, none of the increase in value of these bonds will be subject to federal income tax at any time, and the face value of the bonds will be available on their due dates. (See chapter 17 for more on portfolio construction.) If Peter gets into a financial jam and needs these bonds for living expenses, he can sell them at their fair market value at that time and use the proceeds for his family's needs. If all goes well, he will keep the bonds until they come due and use the proceeds to help pay tuition each year. If Peter's business goes well, he will add bonds earmarked for his children's education but keep them in his and Jane's names. Another possibility for funding education expenses is U.S. savings bonds. (See chapter 7 for more on funding education expenses and why this makes sense tax-wise. See chapter 10 for more on municipal bonds.)
The 100 percent bond portfolio changed Peter's life. The bulk of his investment portfolio is now in safe plain-vanilla bonds, which are essentially risk free. His bonds pay predictable interest income each year, and they align with his financial and life goals. As a consequence, he no longer worries about stock market fluctuations or stock market performance. He now has a realistic, tax-efficient, low-cost, and predictable financial plan. Peter knows that if he can maintain his savings rate, his plain-vanilla bonds will create adequate cash flow and growth so that he will have enough money to fund his retirement and meet his other financial obligations. And, best of all, he understands how his bond portfolio supports his financial and life objectives and the reason why he purchased each bond.
Chapter Note
[27] See the tables set forth on the Yahoo Web site at http://finance.yahoo.com for the S&P 500 and Nasdaq past performance data. Click on the following links: Investing, Stocks, Research Tools, Historical Quotes.