19. My Financial Plan (Part 1)

One of the recommendations I read while doing my research was to put my plan in writing. It sounded easy enough, but once I started writing it down I realized how many details are involved. It's a good exercise in making sure you got all your bases covered, as well as committing yourself - at least mentally - to doing the right thing.

As a reference, below you can find my plan - with some $ amount removed. I hope it can help you build yours. I added in red comments that are not part of the plan.

Is it perfect? No, but it's a basis. The important thing is not to tweak it endlessly. Flexibility is good, but don't make it too easy for yourself to change the plan. Consistency and keeping your direction and plan through turbulent water will win at the end.

So here it goes - part 1 of my plan. My next post will contain the rest of it.

My Financial Plan

1           Retirement Goal

My goal is to secure after-tax annual income of $75,000 with no debt (including mortgage) and no dependency of inheritance, social security, home equity or additional income. This number was calculated at the end of 2010 and should be adjusted to inflation. 

The most accurate way to calculate your required funds is to start with what you spend now. I downloaded my 2010 expenses from my bank account, and then removed all irrelevant entries: salary, transfers, mortgage, etc. To the total, I added new expenses I expect to have: more money for medical coverage, travel, hobbies, etc. Regarding the mortgage, since it's a variable expense with a limited lifetime, for this calculation only (!) I assumed I'll pay it off on my first day of retirement. This of couse is not what I'm going to do, but it makes the calculations much easier. 

Assuming 20% average tax on withdrawals, I'll need $93,750 before tax. With 3% annual withdrawal rate, this translates to $3.125M in 2010 dollars.

Yup, that's a huge amount but it's because I'm calculating the required funds to retire now, when I'm only 43. As I'm getting older, I'll need to save for less time (i.e., I don't expect to live to 200). This will reduce the goal.

This SWR (Safe Withdrawal Rate) is based on conservative assumptions: a portfolio with growth of 5% with inflation of 3%, lasting for 50 years.

You can read more about SWR in this previous post. 

Assuming 15% tax at retirement reduces all these amounts by about 6%.

I had long discussions with my CPA regarding this number. My calculations showed an average of 15%; his (more conservative) calculations showed 20%. It's pretty difficult to calculate your tax bracket at retirement, since your income will come from different sources, some taxed as income (interest, bonds), some as capital gain (stocks) and some not taxed at all (401K, principal of your savings.) Also, it depends on how much taxes you've already paid. For example, since I recently converted all my savings to index funds and paid taxes on all my accumulated gains, my base is close to my total savings - meaning lower taxes in future.

2           Asset allocation

My investment methodology promotes low-cost broad index funds. Whenever possible I will choose no-load, low-commission, negatively correlated, well-diversified index funds in the segments I invest in.

Why not managed accounts? Start with my first post and go from there... 

A current exception is my choice for Municipal bonds (MUNI), which is actively managed. 

Yup, my plan is not perfect. I couldn't find an index fund for MUNI that satisfied me. But, remember, the greatest enemy of a good plan is a dream of a perfect plan!

Asset Class	Low Risk	High Risk	Accounts	Funds	Comments
US economy		30%	Fidelity, 401K	SCHB, FSEMX	Broad market fund (Spartan index fund in my 401K)
		5%	Fidelity	SCHA	Small-cap
		5%	Fidelity	WMCR	Micro-cap
Real Estate (US)		5%	401K	VGSNX	10% of total US stock
International		15%	Fidelity	FSIVX	All world ex. US
		7%	Fidelity	VWO	Emerging Markets	Counted together as 15%
		8%	Yahav	TA-100 Meitav	Israel
Bonds	8%		Fidelity	BND	Tracking Barclays Aggregate (corp, government, municipal bonds)
	5%		Fidelity	MUNI	Municipal Bonds (PIMCO)
	5%		Fidelity	SCHP	TIPS bonds
		5%	401K	PHIYX	High-yield bonds (PIMCO)
Cash	2%		Fidelity, BOA	Money-market, BSV, BOA saving account	For immediate expenses, highly liquid. Grow to 4% at retirement.
	20%	80%

The table came out more complex than I anticipated.This is mainly because I split my savings between my 401K account and my Fidelity account. While the Fidelity account is very flexible, I'm limited in my 401K account to the funds chosen by my employer. This resulted in some asset classes (such as US economy) split between the two. Additionally, I have investment in Israel, which I count as "emerging markets". Probably, your table will be simpler.  

3           Managing my 401K

ñ  In a couple of cases I chose alternative funds due to the limits of my 401K plan (VGSNX, Pimco High-Yield). At retirement I’ll rollover my 401K to an IRA where I’ll have more flexibility.

ñ  The balance of the 401K is invested in Spartan Extended Index Fund (mid-cap and small-cap), creating further diversification. Currently this is 28% of my 401K, where the rest is REIT (36%) and High-yield bonds (36%). These correspond to 5% positions in my portfolio.

ñ  To minimize taxes, I should try to keep tax-inefficient funds in the 401K: bonds, REIT and mutual funds with high turnover.

ñ  However, since the 401K is going to be used last (at age 70.5), it should have more volatile stocks. These two considerations are incompatible.

It's never too early to capture future plans. As you can see, I'm not 100% sure how to manage my 401K in future, and I might change my plan by the time I get to retirement. Still,  it's easier to capture what I know now and revise it later than trying to figure it all out from scratch 5 or 10 years down the road. Write it down, and revise it as you learn more!

Part 2 -- next week!

18. Write it down

One of the best recommendations I read when I was working on my financial plan was simply to "write it down": decide how you want to manage your finances, and then create a detailed written plan. It turned out to be a harder exercise than I thought - the act of committing my vague plan in writing forced me to consider many subtle points. For example, I'm comfortable with a stock/bond ratio of 80/20 for now, and know that I'd like to increase the bond ratio as I go, but in what pace? Where should it be in 1 year, 5 years, etc?

Besides making you "think it through", a written plan also helps you to commit to your plan. When the going gets tough, you'll have the plan reminding you what you had in mind when you could think coolly without succumbing to emotions.

And the last benefit, in my opinion, is the peace of mind. Once I put it all in writing, I'm done! Almost... at least done in the sense that I don't need to consider every morning if 80/20 is too aggressive, if VAMPT is better or worse than WTAXA, if a high turnover ratio of one of my funds is a dangerous signal, and what not. In other words, I don't need to worry if the plan is not perfect.

It doesn't mean that the plan cannot be reversed and changed. In fact, it would be a good idea to revise it at least annually. But, and this is the important part, you should never revise your plan based on recent events. Markets go up and down. Our fear and greed go up and down with them. Revise your plan only when you are in a position to think rationally about your goals, the level of risk you're comfortable with, and any new knowledge you have acquired. Revising your plan once a year is probably enough, and since I also recommend an annual rebalance, you can combine the two into your own "financial holiday". Mine, btw, is on Christmas.

I'm going to go naked in upcoming posts and share with you my financial plan. It's not perfect - and it will never be. But, as the Prussian General Karl von Clausewitz said, "the biggest enemy of a good plan is the dream of a perfect plan". Stick with the good plan!

17. To Muni or not to Muni

I'm having a hard time deciding if a portion of my portfolio should be allocated to Municipal bonds. These bonds, issued by state governments and agencies are free from federal tax. If you buy bonds from your own state (Massachusetts, in my case), they're free from state tax as well (this is a pretty small peanut though; assuming 5% state tax and 5% annual growth, the state tax saving amounts to 0.25% annual gain.) If you're an AMT casualty, you should also make sure that the fund you choose avoids any AMT liability.

Once you do all that, you can get a fund whose income is tax free - about a 40% gain compared to treasuries. For example, a 3% annual yield in tax-free municipal bonds is equivalent to a 5% yield in treasury (or corporate) bonds.

Sounds simple, but of course it's not, for the following reasons:

• Lenders know that the yield is not taxed, and therefore offer lower interest
• It might be difficult to find a fund specific to your state, and even if you do, this will limit your diversification (bonds from one state instead of bonds from possibly all 50 states). Is it worth the extra 0.25% in annual yield? 
• Long-term muni bonds seem to have had (historically) a slight edge over intermediate-term bonds, but they carry higher risk. Are they worth the extra 0.2-0.3% in annual yield?
• Fees for muni bonds can be high: from 0.27% to 0.50% annually, and Vanguard funds have an additional $75 purchase fee (unless you have your account with them.)
• There are way too many options to choose from, and none of them is passively managed, meaning that none of them tracks the Barclays Municipal Bonds index. Coincidently or not, this also means that all of the funds I checked lag behind the index they track. 

The funny thing is that once you compare the returns of all these different options, they end up being about the same!

I focused on 5 funds: FTABX (Fidelity tax-free), FDMMX (Fidelity MA Municipal), FLTMX (Fidelity intermediate Municipal), VWLTX (Vanguard long-term tax exempt) and VMATX (Vanguard tax-exempt MA). If we forget for a second the state tax advantage of FDMMX and VMATX, looking over 10 years there's not much difference between them.

So what should I choose? FTABX since it had the best performance? VMATX since it's exempt from state taxes and has the lowest expense rate? FDMMX since it's also exempt from state taxes, but unlike the former fund has no transaction fee? FLTMX since it focuses on intermediate-term bonds, which should deliver lower volatility? Or VWLTX? Or VWUIR? Or... 

Or perhaps it doesn't matter, at the end of the day. The differences are small, and the ability of past-performance to predict the future is even smaller. I think I'll choose FTABX, because it has the lowest turnover ratio and it looks nice on the chart. Check with me again in 10 years to see if I could have made 0.375% more!

16. Friends Don’t Let Friends Get Into Finance

I recently heard that a group of friends of mine is busy working on a new startup, that will find and utilize inefficiencies in markets to perform micro-trading: buying and selling frequently, based on complex stochastic models of markets behaviors. I don't know if this can work or not. Secretly, I hope it can't. There's something inherently wrong, in my opinion, in investing your time and efforts in an endeavor whose sole goal is to take some percentage of market trades without putting anything back into the system. What is the contribution of their startup, besides (perhaps) making money for their customers? How does it help the economy, human prosperity, people's well-being, or any other ideals? In other words, what value do they create, as opposed to the value they extract from other traders?

This is the same group of people who created a successful hi-tech company 10 years ago, based on novel ideas of data protection and replication. Their product enables small business to protect their vital data against corruption and disaster, and gives a real, quantifiable value to their customers. They're very smart and very talented. Isn't this game a waste of their talents?

The same is unfortunately true for a lot of what's going on in the finance world. In the US, Finance grew to  be the biggest sector in the list of GDP components. But Finance is all about moving money from one hand to another, not about creating anything. Yes, some amount of finance is necessary: to help people and institutions raise money, protect and grow their savings, and to add liquidity to the system. But should it be more than 1-2% of the economy?

All these resources don't come for free. As Vivek Wadhwa points in his excellent post, Friends Don’t Let Friends Get Into Finance, the human resources invested in the Finance world come on the expense of academic research, technology development, science, medicine -- in short, all those boring productive disciplines that are not focused on getting some Wall St sharks rich quickly. Let me quote his last paragraph:

Paul Kedrosky says that the virus that infects scientists and engineers and causes them to go to Wall Street rather than create something of societal value is “economic Ebola”. He wants to be an “economic virus hunter”. Let’s all help him. Let’s save the world by keeping our engineers out of finance. We need them to, instead, develop new types of medical devices, renewable energy sources,and ways for sustaining the environment and purifying water, and to start companies that help America keep its innovative edge.


I would add to that my opinion that every billion dollars earned by a hedge fund or an Investment bank is a billion dollar taken away from private investor, pension funds, enterprises, factories and every other part of the economy responsible for our growth and success.

The big question is how to cure this "economic Ebola". Any ideas?

15. Q&A

Today I'll respond to a few questions that readers have asked me since I started the blog. Got more questions or feedback? Add them as comments below.

Q: How do you pick a mutual fund?

A: Let's start with how not to pick a mutual fund: looking at past performance. Morningstar and other publications have a rating system that takes into account past performance over short and long term, and gives funds high ratings if they beat their peers in the same investment class.

What they don't tell you is that the best funds of one year are often below average the following year. In fact, on average, 5-star funds will underperform in following years! This amazing result, confirmed again and again in research, is due to multiple reasons:

• Fund managers who bet on a sector and win (say, Internet stocks in 1999 or Real Estate in 2002), will stay with this sector when it loses steam and comes crashing back to Earth
• Since on average all the stock funds do the same (a bit less than the index), the return-to-the-mean phenomenon will mean that good years are often followed by less-than spectacular year
• Only a tiny fraction of lucky managers (0.1%) manage to beat the index consistently over long periods. Everyone else will have to balance their good years with bad years. 

So how do I choose my funds? I first zoom in on the sector I want to cover (say, US market or Muni bonds or International stocks). I look for funds with high diversification. I then narrow the selection to low-cost index funds, and look for low turnover. In some cases (such as Muni bonds) this is more difficult due to tax issues, but in general I end up with a few options that have more or less the same performance. Sites like Fidelity and Morningstar make this sorting easy. 

Q: When is a good time to buy a mutual fund?

A: The answer to this question is always the same - "Now". You can't predict the market. Maybe in hindsight, you'll enter right before a crash. Or maybe you'll enter right before a boom. But your best bet is not to enter at all - just be in the market all the time, keeping your preferred stock/bond ratio, and investing in small amounts any savings you have. I do not recommend sitting on a pile of cash and trying to time the market - this is way to risky.


Q: How to split the pie?

A: This depends on your level of risk tolerance, your investment horizon and how well you sleep at night. I'm a pretty aggressive/adventurous guy, and my split is 80/20 (stock/bonds). Others go with a more balanced 70/30 or even 60/40. I wouldn't recommend less than 60% in stocks for people under the age of 60. A good test of your risk tolerance is to ask yourself how you'd sleep at night if the stock portion of your portfolio drops by 25%. Note that with a 60/40 split, this means only 15% drop in your total portfolio, while with a 80/20 split this amounts to 20%. Try to run the numbers in your head - if you're going to lose sleep on a big drop, increase the bonds ratio. If you can see the longer time horizon and stick with the plan, go with a more aggressive approach. The one thing you don't want to do is to change the pie allocation in response to market events.


Q: What are your main DOs and DON'Ts?

A: There are so many of them... check my earlier posts for the essentials. You can start with Dilbert's advice.


Q: What is the mathematical background for these recommendations?

A: This is a little too much to cover here, I'll try to cover it in more details in a few weeks. But the basis is the following: while stocks have given, on average, the highest returns, they also carry with them the highest risks. It turns out that for any given return you wish to achieve, there's a certain mix of stock and bonds that can be predicted to achieve this return (based on historical averages) while minimizing the risk. For example, a 50/50 stock/bond portfolio with no rebalancing has gained 8.6% over the last 60 years, with a risk (standard deviation) of 12.2%. The same portfolio, with annual rebalancing, has gained 9% annually - or 25% more over the life of the investment. Moreover, the risk for the latter portfolio, as measured in standard deviation, is 25% lower (9.3%). In other words, more rewards, less risk. Achieving the same gain without rebalancing would have required you to increase the stock ratio and take even more risk.

The reason is that a balanced portfolio enables you (or rather, forces you) to sell stocks when they increase in value and buy more of them when they lose value - "sell high, buy low." Ferri's "All about asset allocation" gives many more details and graphs. In particular, the numbers I'm quoting here are from table 3-3.