See that house over there? It’s an investment!

Few topics in personal finance and in the early retirement community stir up emotions as nicely as the pros and cons of homeownership. Some folks in the FIRE community are renters and swear by it and others are very happy homeowners and/or real estate investors. Neither side is wrong. Those with more nomadic lifestyles probably prefer renting and the those with kids in school and strong ties to the local community are apparently happy homeowners. Normally, the two sides just coexist peacefully but discussions normally get heated and sparks fly when one side accuses the other of doing something wrong. If I had to distill the arguments of the two sides into bumper stickers it would be:

  • Homeowners: Renting is just throwing away money!
  • Renters: A house is not an investment at all. Or it’s a terrible investment!

But of course, both claims are just that: bumper stickers. And both claims are demonstrably false and/or crude generalizations! Let’s look more into the math of the rent vs. own tradeoff…Read More »

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The Shockingly Simple/Complicated/Random Math Behind Saving For Early Retirement

One of my favorite Mr. Money Mustache articles is the “Shockingly Simple Math” post. It details how frugality is able to slash the time it takes to reach Financial Independence (FI). That’s because for every additional dollar we save we reduce the time to FI in two ways: 1) we grow the portfolio faster when we save more and 2) we reduce the savings target in retirement by consuming less.

That got me thinking: Is the math really that simple? How sensitive is the savings horizon to different rates of returns? What happens if we use historical returns instead of one specific expected return assumption? How important is the asset allocation (stock vs. bond weights) on the path to early retirement? How much does the equity valuation regime (e.g. the initial CAPE ratio when starting to save) matter?

So, in typical Big ERN fashion, I take an ostensibly simple problem and make it more complicated!

Let’s get the computer warmed up and start calculating…

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This fund returned over 100% year-to-date. I’m still not buying it!

I was hoping to tell you about a great new investment I researched recently. It’s an ETN (ETN=Exchange-Traded Note, similar but not identical to an Exchange-Trades Fund) with a phenomenal track record; year-to-date (as of October 20 when writing this) it’s up 141%! Since inception (November 30, 2010) it’s up by 1,079%, over 40% annualized compound return! But, as you can see from the title, I’m still skeptical!

Why do I even look at some exotic ETN/ETF? Aren’t we all supposed to be index investors? Buy your VTSAX and be done? Nope! I consider myself an index investor with an open mind. It’s very hard to outperform the index by picking individual stocks, but there are many other ways to deviate from index investing. For example, I like real estate investing and options trading. In both cases, it’s not really about beating the VTSAX but I like the return profiles and the diversification benefits.

So, back to that amazing ETN. The ticker is XIV and here’s the cumulative return chart since 2010. $100 would have grown to almost $1,200!

XIVstudy Chart02
XIV (inverse VIX ETN) and SPY (S&P500 index ETF) returns. 11/30/2010=100.

That looks like a pretty impressive run. It definitely got my attention! But after doing some more detailed analysis I realized this ETN is not for me. At least not right now. But what’s not to love about 1,000% return since 2010, when the S&P500 returned “only” 150% since then? That’s the topic of today’s blog post…Read More »

Our Net Worth as of 9/30/2017

Time flies! It’s been six months already since our inaugural Net Worth report. For some reason, we never did a Q2 update! Actually, there is a reason. Watching the ERN family portfolio progress is a little bit like watching paint dry. It’s slooowwww, at least in percentage terms! Every year in the first quarter, we get a nice noticeable bump when the annual bonus rolls in, but outside of bonus season, we feel a bit like living paycheck to paycheck! OK, that’s an exaggeration because we still max out our 401k contributions and pay down the mortgage principal (which we consider savings). But about half of our savings come from one single paycheck and the other half is spread over the remaining 23 paychecks. That’s the privilege of working in the finance industry! So in Q2 and Q3, we might have added a little bit of savings, but the growth in our net worth came mostly from the pretty solid returns in our different investments.

Let’s look at the numbers in detail…Read More »

The Ultimate Guide to Safe Withdrawal Rates – Part 19: Equity Glidepaths in Retirement

One of the most requested topics for our Safe Withdrawal Rate Series (see here to start at Part 1 of our series) has been how to optimally model a dynamic stock/bond allocation in retirement. Of course, as a mostly passive investor, I prefer to not get too much into actively and tactically timing the equity share. But strategically and deterministically shifting between stocks and bonds along a “glidepath” in retirement might be something to consider!

This topic also ties very nicely into the discussion I had with Jonathan and Brad in the ChooseFI podcast episode on Sequence of Return Risk. In the podcast, I hinted at some of my ongoing research on designing glidepaths that could potentially alleviate, albeit not eliminate, Sequence Risk. I also hinted at the benefits of glidepaths in Part 13 (a simple glidepath captures all the benefits of the much more cumbersome “Prime Harvesting” method) and Part 16 (a glidepath seems like a good and robust way of dealing with a Jack Bogle 4% equity return scenario for the next 10 years).

The idea behind a glidepath is that if we start with a relatively low equity weight and then move up the equity allocation over time we effectively take our withdrawals mostly out of the bond portion of the portfolio during the first few years. If the equity market were to go down during this time, we’d avoid selling our equities at rock bottom prices. That should help with Sequence of Return Risk!

GlidepathPlot
Static Asset Allocation vs. Glidepath in (early) retirement. 80% static equities vs. a glidepath going from 60% to 100%.

So, will a glidepath eliminate or at least alleviate Sequence Risk? How much exactly can we benefit from this glidepath approach? For that, we’d have to run some simulations…
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The Ultimate Guide to Safe Withdrawal Rates – Part 18: Flexibility and the Mechanics of CAPE-Based Rules

Welcome back to the newest installment of the Safe Withdrawal Rate Series. To go back and start from the beginning, please check out Part 1 of the series with links to all the other parts as well.

Today’s post is a follow-up on some of the items we discussed in the ChooseFI podcast a few weeks ago. How do we react to a drop in the portfolio value early on during our retirement? Recall, it’s easy not to worry too much about market volatility when you are still saving for retirement. As I pointed out in the Sequence of Return Risk posts (SWR series Part 14 and Part 15), savers can benefit from a market drop early during the accumulation phase if the market bounces back eventually. Thanks to the Dollar Cost Averaging effect, you buy the most shares when prices are down and then reap the gains during the next bull market. That has helped the ERN family portfolio tremendously in the accumulation phase in 2001 and 2008/9.

But retirees should be more nervous about a market downturn. Remember, when it comes to Sequence of Return Risk, there is a zero-sum game between the saver and the retiree! A market drop early on helps the saver and thus has to hurt the retiree. What should the retiree do, then? The standard advice to early retirees (or any retiree for that matter) is to “be flexible!” Great advice! But flexible how? We are all flexible around here. I have yet to meet a single person who claims to be completely inflexible! “Being flexible” without specifics is utterly useless advice. It’s a qualitative answer to an inherently quantitative problem. If the portfolio is down by, say, 30% since the start of our retirement, then what? Cut the withdrawal by 30%? Keep withdrawals the same? Or something in between?

How flexible do I have to be to limit the risk of running out of money?

That’s today’s post: Using dynamic withdrawal rate strategies, specifically CAPE-based withdrawal rules, to deal with the sequence of returns risk…

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How useful is international diversification?

I have a confession to make! In the ERN family portfolio, we have almost no international diversification. We invest the bulk of our financial portfolio in U.S. index funds; FUSVX and FSTVX, which are Fidelity’s (lower-cost) alternatives to the Vanguard Admiral shares VFIAX and VTSAX, respectively. Our international exposure is in the low single-digit percentages. How come, you ask? How useful is international diversification, anyway? Jack Bogle, for example, claims that with a diversified U.S. equity portfolio you will capture pretty much the entire global economy already because U.S. corporations do business all over the world. That argument, of course, is not very convincing. Doing business abroad obviously means that you get some diversification, but it definitely doesn’t imply you get enough diversification from a U.S.-only portfolio. To see how flawed that “revenue from all over the world” logic is, keep in mind that Apple is generating revenue from “all over the United States” but nobody in their right mind would ever call for investing exclusively in Apple stocks as a good proxy for the entire U.S. stock market.

Let’s look at the chart below to see how the U.S. stock market is clearly not a very precise proxy for international stocks. It’s a scatter plot of U.S. monthly equity returns on the x-axis and global returns (both non-U.S. and all global stocks). World ex USA has only a 0.65 correlation with U.S. equities. If for most x-values the blue dots are scattered around the 45-degree line +-/10% or even +/-15% (monthly!!!) then we clearly don’t capture everything going on in the world with a U.S.-only equity fund. (Of course, the overall World index has a much higher correlation; the orange dots are closer to the 45-degree line, but that’s mostly because global stocks already include the U.S. with a weight of about 50%.)

Diversification Chart01
Scatter Plot of U.S. equity returns (x-axis) and global equity returns (y-axis,). The correlation with non-U.S. stocks is only 0.65. All index data from MSCI.

So, diversification could theoretically work! Then why am I not more enthusiastic about international diversification? Very simple:

It’s less about whether diversification works. It’s more about when diversification works and especially when it doesn’t.

Let’s look at the data some more…

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U.S. Equity Returns: History and Big ERN’s 10-Year Forecast

Expensive equities are a hot topic these days. Jack Bogle warned of lower expected equity returns recently (only 4% nominal!) and the CAPE has finally crossed 30 this month, according to Prof. Shiller. What does that mean for investors? What does it mean for early retirees? There has been a flurry of activity in the FIRE blogging world on this topic with posts by Physician on FIRE, JL Collins, Think Save Retire, and two consecutive ChooseFI Monday podcasts with JL Collins and with yours truly just two days ago discussing this topic, too.

I don’t think anyone has recommended selling equities and running for the hills. I certainly haven’t, and I am probably one of the more pessimistic FIRE bloggers. Please don’t buy gold coins! Personally, I would never bet against the U.S. stock market. If you had invested $1.00 in large-cap equities in 1871, your investment would have grown to over $13,000 by July 2017, even adjusting for inflation. In nominal terms, to more than $260,000! How amazing is that?

S&P500 Cumulative Returns
Real, CPI-adjusted S&P500 returns. $1.00 would have grown into over $13,000! (for full disclosure, the index didn’t exist back then and has been back-filled with historical stock return data by some smart economic historians)

So the good news is: Stocks have the tendency to go up, on average. The broad index not just recovered from every possible disaster we have ever encountered (2 world wars, the Great Depression, several financial crises, the Dot Com bust, 9/11, etc.) but rallied to reach one all-time high after the other. After every cycle of fear, we see a quick recovery back to economic fundamentals. But buried in the equity return chart above is one small piece of bad news; the flipside of the market bouncing back from disasters and returning to the trend is that stocks also underperform after long periods of above-average performance. And this is where Jack Bogle is coming from. He doesn’t forecast a new bear market – nobody can – but simply predicts a decade of underwhelming returns after the strong bull market over the last 8 years. How do you even make a forecast like that? That’s the topic for today’s post…

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Check out ChooseFI today for Big ERN’s first podcast appearance!

A few weeks ago I had the honor of talking to Jonathan and Brad over at the awesome ChooseFI podcast. Today, this long-awaited episode finally went online, so I hope everybody heads over to check out this podcast:

—> ChooseFI episode with Big ERN <—

We covered safe withdrawal rates, sequence of return risk, the Bogle expected equity return projection, haircuts (only financial ones, though), and many more exciting topics. And if you ever wondered what are Big ERN’s favorite blogs, worst financial mistake and advice to a younger self, you have to listen to find out!

ChooseFI

Have a great week, everybody!

Big ERN

Active Investing: Opportunity vs. Futility

Almost everywhere in life, the word “active” has a positive connotation. An active lifestyle, an active personal life, an active participant in a discussion, etc. In contrast, “passive” stands for low-energy, dull and boring. Imagine setting up a friend on a blind date with a nice gal/guy who has a really great “passive lifestyle” and see how much excitement that generates.

But investing is different. Passive investing is the rage right now! It is a noticeable market trend in finance overall and the Financial Independence blogging world seems particularly subscribed to the passive investing idea. For the most part, I agree with the superiority of passive investing. But then again, not all active investment ideas are created equal. And that means that we are at risk of throwing out the baby with the bathwater!

Has the Personal Finance Passive-Pendulum swung too far? Are we willfully ignoring some useful principles from active investing for fear of shaking the foundations of the Passive Investing Mantra? 

Take the following five examples of active investing. They all fall into different spots on the Futility vs. Opportunity spectrum:

  1. Stock picking.
  2. Style investing, i.e., tilting the portfolio toward a theme such as dividend yield, small stocks, value stocks, low volatility stocks, etc., or a combination of them.
  3. Allocation to different asset classes (e.g. stock, bond, cash, alternatives) in response macro fundamentals (P/E ratios, bond yields, volatility, etc.).
  4. Changing the major asset weights over the life cycle, e.g., using an equity glidepath to retirement and even throughout retirement.
  5. Setting the initial safe withdrawal rate in retirement and all subsequent withdrawal rates in response to changing market conditions.
FutilityVsOpportunity diagram
Not all forms of “Active Investing” are created equal!

It would be a mistake to apply the same passive investment mantra to all five aspects of personal finance. So, that’s what today’s post is about: Where should we stay away from active investments and where can we learn something from active investment principles? Let’s look at the five active investment themes in detail…

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