The Arithmetic of Prudence, Part 3

Part 2 of this series dealt with the asymmetry of marginal utility and that prudence often requires maximizing the probability of reaching a minimum objective rather than maximizing the expected portfolio value. This is especially true when one or more of the following applies:

  • The time horizon is short, e.g. < 10 years.
  • The investor is a prodigious saver; i.e., less reliant on returns to reach goals.
  • The portfolio is in distribution.

The table below summarizes my portfolio recommendation depending on the life stage of the investor.

The demarcation between early and late accumulation, early and late distribution are 10 years to and from the retirement date, respectively. Other authors have referred to the decade before and after retirement as the retirement red zone. Michael Kites recommends a “bond tent” from 10 years before to 15 years after retirement. It has a more elongated taper but based on the same principles.

The recommendation is for principles only. There isn’t specific allocation recommendation due to the enormous variation in individual risk tolerances. 70% stocks/30% bonds may be ultra conservative to one and a roller-coaster ride to another. However, the relative measures of risk ought to hold for the same investor at different stages of his investing life. I also believe in the soundness of some popular advices: greater allocation to equities during early accumulation and the use of annuities (SPIAs) for baseline income during late distribution.

As laid out in Part 2 of this series I advocate sacrificing some growth for reduced volatility in late accumulation and early distribution. The need to do so is recognized by mainstream writers but I find their typical advice of increasing the fixed income allocation too simplistic. I have written about the alternative asset classes in Beyond 60/40. In my own portfolio I continue to explore cost-effective ways to incorporate these assets consistent with modern portfolio construction methods such as risk parity, minimum correlation and maximum diversification but tailored to an individual investor with a desire to reduce trading frequency.

We live in an age where competition in the financial services industry has given the individual investor access to an unprecedented array of products at reasonable costs. Of course, not all of them make sense and the onus is upon us to separate the wheat from the chaff. But quite often I see in the PF blogosphere and forums an avoidance on principle. In some there is a suspicion to all things from the financial services industry, a suspicion no doubt born out of experience with its dodgy business practices. In others, it feels like a fundamentalist fervor against anything not a 3-fund portfolio. Whatever the reason, the majority of the DIYers continue clinging to 60-year old portfolio construction methods. I have never tried to convert anybody but have always read forum (e.g. Bogleheads) exchanges about alternative assets (typically gold) and portfolio construction (slice-and-dice, factors) with interest — when emotions are high and arguments are well-thought it makes a great spectator sport!

In the table I had the same recommendation for both late accumulation and early distribution. For obvious reasons my mental efforts have been directed to late accumulation. After the retirement threshold I can see greater emphasis on income generation: increasing allocation to CEFs, higher yielding stocks, more aggressive option writing, and less emphasis on speculative assets. The asset categories will remain the same but the percentage will differ. I expect tax considerations to play a larger role than return-volatility trade-offs.

Speaking of the distribution phase, two recent opus (both are deserving of this word) contributed significantly to our understanding: a series by EarlyRetirementNow and the work by none other than the great Bill Sharpe. Bill Sharpe also called decumulation “the nastiest, hardest problem in Finance”. It is indeed difficult, if not insoluble, if the requirements are:

  • The only allowed assets are equities and bonds.
  • The allocation is static or follow a simple age-dependent formula.
  • The withdrawal rate is anywhere close to 4%.

As they say, 2 out of 3 ain’t bad. Variable withdrawal strategies can help, but critics will say they’re market-timing in disguise: in effect, if not on purpose. PortfolioCharts has repeatedly shown the benefits of gold in increasing the safe and perpetual withdrawal rates, but gold haters will continue to hate. I suppose that leaves getting more money/requiring less as the fool-proof way of ensuring success. But try to tell that to a 23-yr old ER-aspirant!

So far as my own plan is concerned, none of the three bullets apply. But since I’m far from the Epicurean ideal, I’ll be working for another 10-12 years yet!

Performance Tracking May 2017

For calculation methodology see this post.

S&P exceeded March highs and is now firmly in the 2400s territory. SPY gained 1.41% and AGG 0.69% resulting in a very respectable 1.12% gain in May for the 60/40 bench mark. My portfolio did well despite weakness in PMs which I expect to continue for another month. The total portfolio gained 1.76%. However the number is deceiving as gains from cryptocurrencies accounted for most of the extra over the benchmark. The DGI portfolio continue to struggle under the weight of energy, financials and pharma. Fortunately the growth stocks, which are tech heavy, are balancing them out. Overall the individual stocks about matched the S&P. CEFs, at 1.53% for May, continue to be a bright spot. Cash position in the active account stood at 8%. Funds are almost fully deployed for individual stocks. PMs including miners are counted separately where I’m currently underweight by 10.5% actual vs. 15% targeted. The cash position also includes funds set aside for more CEF purchases.

AllocateSmartly hasn’t yet updated numbers for May but I expect my portfolio to come out in the top half. So far the gains are on pace with my year-end goal: reaching a total invested portfolio of 20X, where X is my projected retirement spend. However, I would like to put more distance between me and the benchmarks. With the bull market unfolding according to plan there are opportunities to get the extra oomph, e.g. options. So far my model is pointing to the end of summer as the appropriate time to put on those positions.

Cryptocurrency Update

Crytocurrencies were a sea of red on Saturday (above screen shot from Bitcoin peaked at close $2800 (prices differ on different exchanges so the number is for US exchanges and not exact) on Thursday and was below $2000 at one point before bouncing back. According to this technical analysis (note the source), the first correction target is in the $1700’s. This kind of price movement is par-for-the-course for cryptocurrencies. Indeed, the movement in some of the altcoins are multiples larger.

My earlier blog post was in the middle of this vertiginous move up, amongst media exposure in many main stream outlets such as CNBC and Bloomberg. Coupled with buying pressure out of both Japan and Korea where both BTC and ETH prices were about 30-40% above US exchanges, the FOMO fueled rally was all but inevitable. It remains to be seen whether there will be a month-long consolidation as predicted in the CNBC piece or whether it will snap back to $4000+ based on my primitive similarity reading to the 2013 rally. Either way, longer term bitcoin is likely to be higher as I believe a substantial amount of “anti-establishment” capital will be drawn to this “digital gold” rather than the physical one. That said, I remain skeptical about most of the altcoins.

Here’s a quick summary of my activities so far:

  • Mar 2017: Deposited 0.1X into Coinbase/GDAX (X is my estimated annual retirement spend as usual)
  • Apr 2017: Traded LTC along side the SegWit development
  • May 2017: Took some profit and withdrew 0.028X (28% of initial deposit)
  • Value of coins remaining: >0.2X with positions in BTC, ETH, and LTC
  • I have placed several limit sell orders far above the market. Hitting all of them will mean I have sold 30% of the peak coin holdings and have withdrawn the entire initial deposit.

Obviously, I have nothing to complain about. I started this foray fully prepared to lose everything, and in two months the gains are meaningfully impacting the total portfolio. I can only hope to be able to control the position size so there is no adverse impact on the overall volatility. It’ll be a good exercise in controlling greed.

Passive Account Asset Allocation, May 2017

In the most recent market commentary, I reiterated the view that the final phase of this correction was due to start in May and events in early May might serve as external triggers. Reality again strains the limits of patience: market-friendly outcomes from the the FOMC meeting and French election propelled S&P above the March 1st high before the “constitutional crisis” surrounding Trump’s firing of the FBI director James Comey precipitated a one-day 43-S&P-points drop on Wednesday. There was a lack of follow-through however. Although I still believe there will be a final drop, I’m not sure if even 2320 on the S&P is “in play” at this point.

One may rightly ask why the correction has been much shallower than anticipated. It’s easy to come up with conspiracy theories where the Central Bank or the plunge-protection-team (PPT) surreptitiously support the market to accomplish their policy objectives. It may be true, but this is one area where I consciously decide not to have an opinion. Not “I don’t know” but “I don’t want to know” — an intentional burying-head-in-the-sand that not everyone is willing to do. Besides deliberate intervention, it’s possible that there are enough other market participants also poised to buy the dip, or the stream of passive buy-no-matter-what crowd is so overwhelming. The question itself is misplaced, it’s not about why but is. The only conclusion to be drawn is that when something refuses to go down it will go up with a vengeance. Anything else is an opinion, ideology even, that I can’t afford.

Throughout this month, I have been steadily deploying cash into the buy-list, but there is still some ways to go. I have also been looking at the asset allocation in the passive accounts. My current plan is to further increase the equity allocation by another 5%. For reference, the current AA is 50% equities/35% FI/15% PM, I’ll move into the AA under the “Aggressive” heading below, shifting out of FI.

The composition of the subclasses are limited by access to funds rather than from any quantitative analysis. I can only access EM, and REITs in my Roth IRA accounts while the LB, SB and total international from HSA and 401K that see regular contributions. So they end up taking all of the increases. The overall portfolio will be at 55-60% equities by the end of the summer. This is at least 10 percentage points higher than my baseline allocation were there not the belief that we’re in the final bubble phase of this bull market. For reference, I also outlined what a “defensive” AA would look like. Keeping the PM allocation constant at 15%, there is a 15% overall shift between equities/FI. The composition of the subclasses is also different as the emphasis is to reduce risk and take advantage of the negative correlation offered by treasuries. Of course a new plan will be needed if the next crisis is triggered by a flee from US government bonds. I still see a likely transitioning into the “defensive” AA in Q3’18.

Dabbling in Cryptocurrencies

I started dabbling in crytocurrencies in early March. I’ve just scratched the surface of a vast, previously unknown-to-me universe. What follows is a short summary of what I have learned and my experiences so far. This is not to be construed to be a recommendation to put your money in them.

Wikipedia defines cryptocurrency as “a digital asset designed to work as a medium of exchange using cryptography to secure the transactions and to control the creation of additional units of the currency”. The best known example by far is bitcoin (BTC). Bitcoin pioneered the use of blockchain, a database of continuously updated transaction records of all coins, whose maintenance and verification by a peer-to-peer network is the basis of this decentralized trust system. Bitcoin was invented and released in 2008/9 by Satoshi Nakamoto, a pseudonym of an individual or a group of individuals whose exact identity is still shrouded in mystery.

One of the more intriguing aspects of digital currency to me is being prompted to reflect on the nature of currencies in general. Due to my interest in gold, I have always understood the value of a medium of exchange which is a great simplification of what would be an impossibly unwieldy barter system in its absence; and the trust necessary in this medium. Gold achieves this trust by its long history of continued acceptance and the impossibility to conjure up matter (not at reasonable cost, i.e. fusion). Government fiat achieves it by the force of law and pain of imprisonment on counterfeiters. On the other hand, bitcoin relies on the impossibility of mustering the computing power to establishing an alternate blockchain. In other words, the solutions are nature, force and math. For those who see gold as a hedge to government monetary policies, bitcoin should have some attraction as a decentralized alternative largely outside of the current global financial system. In practice though, there is an age divide, with bitcoin acceptance far higher in the more tech-savvy young generation than among the grizzled old man whose image the term “gold bug” conjures up.

The title of the post said “cryptocurrencies” pleural. Indeed bitcoin is only the largest and most well-known. The website lists hundreds of alternative cryptocurrencies, aka “altcoins”:

At this moment, the total marketcap of all crytocurrencies are about $48 billion, with bitcoin at $26 billion or a “bitcoin dominance” — ratio of bitcoin market cap to the total of 54.1%. Despite bitcoin trading near $1600 close to a new high, bitcoin dominance is near a new low. In other words, even as bitcoin makes stratospheric gains the altcoins are rising even faster. Just take a look at some of the 24-hr moves in the screen shot! Some of that is due to intrinsic limitations of bitcoin itself such as its transaction speed, some is due some intrinsic advantage of the altcoins, and some due to “pump-and-dump” actions. Such intricacies cannot be covered in a blog post such as this. For example, just in the last two months, I was able to watch the debate on “segregation witness (SegWit)” unfold on Litecoin (LTC), mining pool signaling, UASF, etc. There were many developments like these in the other altcoins — this must be what the wild wild west was like!

Now let’s talk about where I put my money. In early March, I decided to put about 1% of my active accounts into cryptocurrency speculation. I funded an account at Coinbase, a US-based, regulated digital currency wallet where digital currencies are fully insured. I did most of the trading at the Coinbase affiliated exchange, GDAX since Coinbase itself has much higher fees (1.5%). In fact GDAX has the lowest fees (0.25% liquidity taker only, no fee for maker) even among the exchanges. I ended up establishing positions in all three cryptocurrencies that trade on GDAX: bitcoin (BTC), ethereum (ETH), and litecoin (LTC). I traded LTC a little during the aforementioned mayhem. There was non-stop (24/365) action. I could have easily gotten my trading fix there!

My actual numbers are unimportant since I was mostly lucky with my overall timing and the gains can be ephemeral. Suffice it to say that I plan to pull out a big chunk of my initial funds and let the rest ride. My advice to anyone dipping their toes into this market: control the position size and don’t be greedy! I see the likely longterm outcome as binary which justifies some speculative capital. For the individual coins though I think only a handful will survive. Forewarned is forearmed!