But this apparently normal behavior somehow escapes the process of purchasing financial assets. And hence, an entire field of finance devoted to trying to understand why investors act the way they do while exhibiting perfectly rational behavior in other walks of life.

But I think investors behave the way they do because most fail to make a connection between buying say a box of Tide detergent versus buying shares in Procter & Gamble that makes that detergent.

And if we dig deep enough with anything we do or consume in our daily lives, there is always somewhere a connection between a product or a service and a business that delivers that product or a service. And that business, if publicly-traded, we can also own a piece of.

My younger daughter is all things LEGOs these days. I mean she spends hours building things like these…

And her gang is into it as well so we know she is not alone.

So then the discussion as usual leads to buying a piece of the LEGO making business. But she can’t because LEGO does not trade publicly.

But then that plastic that makes those LEGOs could be coming from a publicly-traded business. Or that oil that was dug up to make that plastic had to have a publicly-traded entity behind it. And so would the businesses that make those machines to injection mold these pieces or that steel that was used to make those machines or those semiconductor chips that control those machines and on and on.

So if she owned a diversified basket of global stocks, somewhere, somehow, she owns a piece of the supply chain that went into making those LEGO pieces. So she is all squared then.

Talk about supply chain, if you never came across this Milton Friedman video, well, you did now.

So the other day, I dug up some old notes and this one dates back to June 2nd of 2012. And that scribbling was all about yields – bond yields vs. earnings yield for a portfolio of global stocks. Earnings yield by the way is the inverse of price to earnings ratio.

So the 10-year Treasury bond yielded 1.5 percent at the time when global stocks were yielding 8.5 percent (price to earnings ratio of about 12). Global stocks here refers to the FTSE Global All Cap Index.

Stocks were a bargain then. How sweet of a bargain? The last time the spread was as wide was all the way back in 1962.

And yet investors were dumping stocks left and right, for some reason or the other and at the time, that reason appeared to be the Eurozone debt crisis. In just the April of that year (2012), U.S. investors sold a net total of 20 billion dollars worth of stocks. In May, they withdrew 26 billion dollars from the stock market.

All in all since 2007, investors withdrew some 530 billion dollars out of stocks and stock-type investments.

And where did most of that money go? Into the apparent safety of bank savings account and into bonds.

But that at the time could be considered as a reasonable behavior. Not right, not logical but reasonable. Investors were terrified of the slightest of turbulence. The trauma of the Great Recession was fresh in everyone’s mind.

And hence the equity risk premium. Stocks are risky because profits are not guaranteed. But if there was no risk, the earnings yield for stocks would collapse to meet that of bonds.

But earnings or profits for businesses can and do fall. And that causes the value of these businesses and hence the stock prices to fall. So the risk.

But in hindsight, that was THE time to plow everything you had into the markets.

And what was predicted at the time to be a great time to invest was indeed a great time to invest. I mean if you were anywhere close to the stock markets this past decade, you made money.

So where are we now? The bond yields are about the same but the earnings yield for stocks have basically cratered. That is, the equity risk premium got reduced.

And most of that reduction in the equity risk premium happened because of the expansion in multiples. I mean you were paying 12 times earnings for a portfolio of global stocks in 2012. Now you are paying 17 times that.

But then it sort of makes sense. Besides that small hiccup at the onset of COVID, we have basically forgotten what risk is. The Great Recession is a distant memory. The Dot-com crash of the early 2000s is like it never happened.

And hence the complacency.

What do I personally wish? I wish for a renormalization of interest rates. That’s assuming we know what “normal” is in the interest rate world. Maybe we are in a new era and maybe we never go back to the way things were but I think we must considering all the craziness that is out there in the markets these days.

I want things to reset a bit. I want the bond yields to grow and the equity risk premium to expand back up. So technically a double hit on the price of stocks.

Painful yes, in the short run but ideal for most of us in the long run. We rather take the medicine now than having to surgically remove a tumor later. Bubbles are painful when they deflate.

So if you are a millennial or a Gen Xer, you should get down on your knees and pray for a decade of flat returns. That’ll allow you to pump as much powder as possible into the markets while the bond yields normalize and the equity risk premium reflates.

None of it says that you sell your stocks. Because no one knows the future and you don’t want to get into the game of predicting the future. But if you’ve got a reasonable plan and a decent portfolio that fits that plan, you can tweak and make adjustments to that portfolio where and when necessary but you must stick to that plan.

That of course requires conviction and conviction only comes with knowing what you own is what you should own but once that’s done, all you can and all you should do is throw as much savings as possible into that plan and wait.

Thank you for reading.

Cover image credit – Tran Long, Pexels

Or does it?

First, because it is market-cap weighted, the biggest companies occupy too much of your portfolio if this is all you own. Nothing wrong with that but just to give you some perspective, these were the companies that occupied its top 5 slots in the year 2000: General Electric, Exxon Mobil, Pfizer, Citigroup and Cisco Systems.

Things change so diversify.

Second, S&P 500 is a large cap index. It owns the biggest 500 public-traded U.S. businesses. So when you own just this, you own only one flavor of the market.

Third, tech businesses have come to occupy too big of a share of the index lately. And many of the tech businesses trade at valuations far richer than the overall market, some justifiably so, many not so.

And the reason the market affords a much higher multiple to these growth-oriented names is because of the historically low interest rate environment we find ourselves in. And low interest rates means equally low discount rates.

But then they are also more sensitive to changes in interest rates so if and when rates rise, the value of these growth-aligned businesses will decline, oftentimes precipitously.

And if what you own in your portfolio is skewed towards these names, your portfolio will suffer. It will eventually recover but that recovery could take much longer than your patience can handle. The decade of the 2000 is a perfect example. If a portfolio of S&P 500 is all you owned, you had less money at the end of that decade than at the start. We often forget but then we have the data.

But enough with the ramble and on to some number crunching. We’ll run through some test portfolios that are exclusively invested in one type of stocks and compare that to the one that’s globally-diversified across size and value spectrum yet still 100 percent invested in stocks.

The first is an S&P 500 only portfolio. Of course, this is past performance and future performance can and will differ but one thing I can almost reliably say is that if you expect an S&P 500 only portfolio to do over the next decade what it did over the last, it’s not going to happen. It could if business profits suddenly explode to the upside due to some breakaway technological advancements but these things don’t happen that often and hence.

So this below is the best and worst-case rolling returns of an S&P 500 only portfolio over these past many decades.

And just to give you some perspective on all the things that transpired during this timeframe:

• The 1987 stock market crash.
• The Savings & Loans crisis of the late 1990s.
• Gulf War I.
• Real estate recession of the early to mid-1990s.
• The Asian financial crisis 1997-1998.
• Dot-com boom and then a bust 1995-2003.
• 9/11.
• Gulf War II.
• The housing market crash and the ensuing global financial crisis of 2008.
• The European debt crisis 2012.
• And of course the pandemic.

And embedded in between these major events are the many micro booms and bursts that happen from time to time. They will always happen because it’s systemic. It’s the nature of the markets.

This below by the way is the exact annualized performance of an S&P 500 only portfolio over these last two decades…

What stands out is how most of the gains are back-loaded. That’s because S&P 500 sucked wind the entire decade of the 2000s. All the gains are packed in the decade that just ended.

So the best time to have loaded up on large-cap U.S. stocks was in 2010, exactly the time of maximum despair for a large-cap only portfolio.

But then there are businesses that are not in the S&P 500 that are smaller in size that can be found in say the Russell 2000 index. Smaller businesses are usually risker, both in terms of price volatility and in terms of their ability to survive.

The best and worst-case rolling returns for a small-size companies only portfolio over these last many decades…

And the actual annualized return for these businesses going back 20 years…

The shocker is not that small companies earned more over time. That’s expected. Not guaranteed but expected.

The real shocker is that they made you more money with less risk than their large cap brethren (compare the 10 and 20-year rolling portfolio returns for the S&P 500 only portfolio vs. the Russell 2000).

Now spreading our wings a bit more and looking beyond our borders with international stocks with a great barometer for that being the EFA index, EFA as in the Europe, Far-East and Australasia.

The same rolling returns for an EFA-only portfolio of stocks…

And the exact annualized returns for that EFA-only portfolio over the past two decades…

So not that hot compared to say the S&P 500 or the Russell 2000 but that’s expected. International stocks have treaded water for quite some time but that’s the nature of the game. They will shine again at some point, no one knows when yet no big deal.

But now we’ll mix and match all these and bring in emerging markets, value stocks, mid-size companies etc. that exposes a portfolio to all available factors and possible outcomes. The exact portfolio is not as relevant because there are tilts and tweaks you can apply based on where you find a better bang for your buck at any given moment but assuming a portfolio that’s designed keeping first principles in mind, you won’t go wrong. And of course assuming a portfolio that you will stick with, come hell or high water.

The rolling returns first…

And the exact annualized return for that global all-stock portfolio over the last two decades…

A few condensed takeaways…

• First things first, this is diversification within a category of investments (stocks) so it’s not what a true diversified portfolio can and maybe should look like.
• Small-caps (Russell 2000) did better than their large-cap brethren (S&P 500) not only from the performance perspective but also from the perspective of delivering better risk-adjusted returns. That’s with comparing the 10 and 20-year rolling returns as well as the exact annualized performance over the last 20 years. Not what you would have expected considering the hype around S&P 500 this past many years but that’s expected considering how recency bias plays tricks on us. But then we got the data.
• International stocks sucked in this timeframe and that is and should be expected from any asset category from time to time. They say that you only know when you are truly diversified is when you always own one or two segments in a portfolio that are treading water at a given time. If everything does good or bad at the same time, you have a problem. That is to say that your portfolio should own a lot of uncorrelated investments though these days with correlation of literally everything with respect to everything else approaching one (perfectly correlated), it’s not that easy but that’s our world today.
• And when you sprinkle the ‘right’ type of investments in the ‘right’ proportion, though individually they might suck, the blended portfolio almost always overcomes that individual performance disadvantage over the very long-term. For the statistically inclined, that’s because when the variance of one investment is added to the variance of the other, the resulting combined variance of a portfolio is always lower. And hence that shows up in better portfolio outcomes, not only with what you make in returns over time but making those returns with a reduced portfolio volatility. So a win-win all around.

That’s all I have to say.

Thank you for reading.

Cover image credit – Chris F., Pexels

So first a snapshot of the many goals you might have to plan for…

And with life after work (retirement) being the most expensive amongst them, we will use that as a use case to lay out the construct since the same process can be replicated for other life goals.

But before anything, a thing or two about perpetuities. Back in the day in 1751, the British government issued something called Consolidated Annuities or Consols that paid a fixed 3% rate of return each year (cash flows) and had no maturity date (cash flows go on forever).

The modern day equivalent of a Consol is a perpetuity as in the cash flows continuing forever.

And quite elegantly…

The present value (the price today if you were to buy it) of a perpetuity = C/r

C is the cash flow you receive each year if you were to buy this perpetuity and r is the interest rate or the rate of return.

Most long duration assets are perpetuities. Stocks, especially of the growth kind, in theory are the ultimate perpetuities because the present value of the cash flows that they’ll generate that’ll flow to you in the form of dividends twenty, thirty, fifty years down the road is very close to zero. And hence their valuation today can be condensed to a very simple perpetuity type model shown above.

So that was some necessary sidetrack but not to dwell on it much, the most important takeaway is the estimation of the present value of a perpetuity.

Back to planning for retirement, this is what the accumulation and the distribution phases look like for that goal.

Though two different rates of returns are assumed for the two life phases, there is not and there should be not a clear demarcation between the two. Those rates of returns should change gradually, abruptly or none at all depending upon individual circumstances and market conditions but let’s assume these two distinct phases exist for you for now.

And we’ll start with the ‘in retirement’ phase first to help us quantify the $ value of the goal and then work backwards.

The first thing you’ll need to know are your income needs in retirement. I know it’s not easy to know that yet when you are like 25 but you should have some idea about the amount of money it takes to afford you a good life today. You then inflation adjust that to the year you retire and through retirement.

So during retirement, you’ll know the cash flow you’ll need and you have an estimate of the rate of return that the portfolio you’ll own is expected to deliver (r2 in this case).

Hence,

The $ value of the goal at retirement = The present value of a growing perpetuity that you buy right when you retire – The value of a growing perpetuity that you’ll buy at 100, discounted to the year you retire

Growing perpetuity is another flavor of a perpetuity where you assume growing cash flows (inflation-adjusted income need in retirement) instead of the constant cash flows we assumed in the original perpetuity equation.

So now that we know the $ value of the goal, we tackle the first phase of planning for retirement. And these are your accumulation years where you need to set aside a fixed amount of money each year to reach that goal.

We start with first discounting the $ value of the goal and bringing it to the present (at 25 in the plot above) using the assumed rate of return (portfolio growth rate = r1). Any savings (earmarked for retirement) that you already have now needs to be subtracted from the present value of the goal to calculate the gap you have to fill over the years to reach your goal.

That is…

The Gap = Present value of the goal – Savings you already have, earmarked for retirement

With this gap in savings required known, you can then reverse calculate the amount you need to set aside each year using the same perpetuity logic.

That is…

The Gap = The present value of a perpetuity you buy at 25 – The value of the perpetuity you buy at 65, discounted to the present (at 25)

You know the gap, you know the years to retirement and you know the portfolio growth rate during accumulation years and with that, you can back calculate the amount you need to save each year to fill that gap.

There is a lot that I skipped over to give a brief overview but for those interested in diving into the nitty-gritty of how this is done, a video tutorial is in the wings that I’ll release when ready.

Thank you for reading.

Cover image credit – Pixabay

This and the Capital Asset Pricing Model that Dr. Sharpe subsequently developed led to him winning the Nobel Prize in economics in 1990.

The Sharpe ratio…

In English, it is the excess return of a risky investment over and above the return that a safe investment yields per unit of risk (volatility) of that risky investment. This is another way of stating that what counts is not just returns but risk-adjusted returns.

The risk-free rate of course is not constant. Many use T-bills (Treasury bonds with a maturity of less than a year) as the benchmark for the risk-free rate but that’s not always right. Stocks as we know are long-duration assets (perpetuities in theory) so if you own an all-stock portfolio, you need to match that with a comparable duration asset like say a long-term bond with a 10-year or a 30-year maturity for instance.

And if you add shorter duration bonds to that all-stock portfolio, the duration of the risk-free asset and hence its return to calculate the Sharpe ratio needs to be adjusted accordingly to match duration for duration.

But in today’s never seen before interest rate world, the risk-free rate of return difference between long and short maturity bonds is not going to make or break things. In fact, you are free to ignore duration entirely and use a flat 1 percent rate of return in lieu for the risk-free rate.

So that was a bit of a technicality but what Sharpe ratio tells us is that you better get compensated for the risks you take in your portfolio. And the higher the Sharpe ratio for a portfolio, the better designed a portfolio you have. Within reasons.

Because you can play games using leverage etc. to prop up the Sharpe ratio of a portfolio but we know the thing with leverage. When things blow up, they blow up spectacularly.

But Sharpe ratio or anything to do with long-range portfolio construction and prediction does not work with individual stocks. Or individual bonds. Or a single piece of real-estate. Or your entire angel investment portfolio.

It only works with broad-based asset classes that you can derive meaningful statistics from to build a portfolio around which then forms the core part of your financial plan (more on that later).

So someone just starting out in his career could have owned an all-stock portfolio that is globally allocated, across size and value factors. Of course an all-stock portfolio means being exposed to the full brunt of the volatility of stocks but that’s expected.

And this is what you would have had to endure over the years. We are going to run through three different portfolios with this one being the one with a lower Sharpe ratio than the other two. A lower Sharpe ratio isn’t necessarily bad but if you are comparing two likewise portfolios, you’d want to the pick one with a higher Sharpe ratio as long as you understand what’s in that portfolio.

The exact mix of this all-stock portfolio is irrelevant because you can always implement your own tweaks based on which corner of the market you think offers a better value but this is what you should expect. Or at least this is what you did get going back in time.

Now these are rolling returns which means that say for the 3-year bar in the plot above, you’ll start out in 1987 and end in 1990, then move to 1988 and end in 1991, then to 1989 and end in 1992 and so on. That way, you are not picking and choosing timeframes.

So what stands out is there was a year when this portfolio declined in value by 41 percent but then there was also a year where the portfolio gained an equivalent amount. But there was never a 5-year period where this portfolio lost you money. So that’s the perk of remaining invested for the long-term.

And depending upon how lucky or unlucky you were, the difference in returns between different 20-year periods is huge. I mean there was a 20-year band in the same 1987-2020 time-period where you did almost 12x your money (+1072 percent) in one versus just 4x your money (+323 percent) in the other.

And that worst 20-year band most likely corresponds to the last 20 years that ended in 2020 as can be seen with the exact annualized returns that you were able to achieve with this all-stock portfolio.

But this 20-year band saw a lot. Starting out of the gate was the Dot-com crash followed by the housing market crash of 2008 and then of course the pandemic. Not saying that the next 20 years can’t be worse but just saying.

So if you endured through this, you should be able to endure through anything the market throws at you except for world-ending calamity. But then, your portfolio would be the least of your worries and hence.

Now someone mid-career who had amassed a reasonable amount of money towards retirement could start to temper down on the volatility by allocating say 20 percent towards bonds. Bonds are less volatile and don’t generally yield more than stocks but the lower volatility of bonds and their inclusion in a portfolio shows up in the increase in Sharpe ratio of that portfolio. Again, not necessarily good or bad but a metric you can use to compare across similarly constructed portfolios.

And the best and worst-case returns below.

The annualized returns for the same portfolio going back in time.

Not that much different from an all-stock portfolio but that was for the last 20-years where stocks were literally cut in half twice in one decade.

Now someone nearing retirement could have increased the allocation to bonds to say 40 percent. The Sharpe ratio for this portfolio as expected goes up so if you are comparing two portfolios with a similar stock/bond mix, you’d know which one’s more efficient.

And the best and worst case performance data below…

…as well as what this portfolio did going back 20 years.

Again, the anomaly with the last 20 years shows up with stocks not doing as well as they did historically and with bonds absolutely crushing it. This is unlikely to be repeated for a portfolio with 40 percent allocation to bonds over the next 20 years though.

So what kind of portfolio should you own? But before that, a bit on what I do with my (our family’s) money.

We use a core and explore approach to how we deploy our savings. The core is the can’t miss, can’t fail segment of our money that must be there when we need it and hence is invested accordingly. That makes up about 90 percent of all the money we have though that percent allocation is higher now for reasons I’ll elaborate on more below. And it’s invested in an all-stock portfolio like the one shown above for three reasons:

• 4 percent is what is typically used as a safe withdrawal rate from a portfolio to live on during retirement though that might need some adjustments considering the interest rate environment we find ourselves in. But a 4 percent withdrawal rate means your portfolio cannot afford a lot of volatility and hence bonds become an important component of that portfolio. But if say a 2 percent withdrawal rate is plenty to live on during retirement then there’s no need to add bonds as dividend income alone can fulfil your income needs and that is where we expect to find ourselves at.
• There is unlikely to be a repeat of bond market performance of the last 40 years over the next 40. So if you don’t need bonds, you should not need bonds. Yes, the right kind of bonds can and do make the ride smoother but if you don’t care about the ups and downs, you don’t need bonds either.
• And though an all-stock portfolio will have an inferior Sharpe ratio than a portfolio with a decent allocation to bonds, that in and off itself is not necessarily bad. Because there is no guarantee that adding bonds will enhance the volatility reduction benefits bonds provided in the past. So though Sharpe ratios are important to compare two similar portfolios, that is where that comparison stops. Just because a portfolio’s Sharpe ratio is lower does not automatically imply inferiority.

I also do a bit of exploring with our money and that’s where the tiny explore portion of our money is invested. We haven’t done much to this in the last many years due to the valuation environment we find ourselves in but we will at some point again when wonderful businesses could be had at reasonable valuations when this current cycle turns. And turn it will.

But of course there is no need to do the explore if you are not meeting your plan goals. And it also comes down to whether you enjoy doing all the work needed to explore because work it does take.

Plus since statistical calculations can’t be done with the explore segment of my portfolio, Sharpe ratios and things like that goes out the window. This is an attempt to eke out a bit more than what the core-only portfolio can deliver but of course there are no guarantees.

The explore portion of our money is currently invested in a bunch of businesses that are small, cash flow rich with predictable business models. At least, businesses that I can do some modeling and projections on. Businesses like Raven Industries that make precision agriculture products and engineered films. It’s been in the news lately as it is getting acquired in an all cash deal.

Other companies that were acquired since the time I first built this portfolio almost a decade back…

• Pall Corp., a maker of water filtration systems was acquired by Danaher Corp. August 28, 2015 was the last trading day for the stock.
• Mead Johnson Nutrition Co., maker of infant formula such as Enfamil brand, was acquired by Reckitt Benckiser Group. June 14, 2017 was the last trading day for the stock.
• Clarcor, a maker of filters for automotive and heavy industrial applications was acquired by Parker-Hannifin. February 27, 2017 was the last trading day for the stock.
• Kaydon Corp., a maker of industrial bearings and shock absorber systems was acquired by SKF. October 15, 2013 was the last trading day for the stock.
• Bio-Reference Labs, a provider of clinical laboratory testing services for the detection, diagnosis, evaluation, monitoring, and treatment of diseases in the United States was acquired by Opko Health. August 19, 2015 was the last trading day for the stock.
• Sigma-Aldrich, a company that develops, manufactures, purchases and distributes a range of biochemical and organic chemical products, kits and services that are used in scientific research was acquired by Merck. November 17, 2015 was the last trading day for the stock.

Then there are business like International Flavors and Fragrances. And W.W. Grainger. And Copart. And C.H. Robinson Worldwide and a few others that we’ll continue to own for a long time.

Hope this helps.

Thank you for reading.

Cover image credit – RF Studio, Pexels

Venture capital as a funding model didn’t exist back then. And back then is 1960s. You needed capital to start your business? You’d rely on the faith and generosity of friends and families or you’d go down to your local bank to pitch them on the promise that was your startup.

And banks were and still are in the business of lending. They lend instead of taking a stake in your business. So a completely different business model.

And conservativeness is the name of the game. Return of capital is more important to them than a return on capital. An excerpt from that book is indicative of those times.

“Here I’d built this dynamic company, from nothing, and by all measures it was a beast – sales doubling every year, like clockwork – and this was the thanks I got? Two bankers treating me like deadbeat?”

Phil Knight in Shoe Dog

So imagine where we would be if we had to rely on capital from banks to fund our bleeding edge businesses of today.

But then we also have the landscape of today. Apoorva Dutt wrote a piece that is based off of excerpts from Dan Lyons book titled Lab Rats which talks about how Silicon Valley’s business model of moving fast and breaking things is making life miserable for the rest of us. This was in 2018 and things have just gotten crazier since then. Some choicest excerpts from her piece about Dan Lyon’s book…

“Silicon Valley has no fountain of youth. Unicorns do not possess any secret management wisdom. Most startups are terribly managed, half-assed outfits run by buffoons and bozos and frat boys, and funded by amoral investors who are only hoping to flip the company into the public markets and make a quick buck. They have no operations expertise, no special insight into organizational behavior. All they have is a not-very-innovative business model: they sell dollar bills for 75 cents and take credit for how fast they’re growing.”

Apoorva Dutt, Tech in Asia

“The vast majority of these new companies are losing money. Traditionally, to get rich in business you had to build a company that turned a profit, and then the profits were shared with investors. The new VCs have invented a form of alchemy in which they make a fortune for themselves while skipping the step about building a profitable company. I call it, Grow fast, lose money, go public, cash out. You pump millions (or billions) into a startup, so that it grows rapidly. You generate hype, flog the shares to mom-and-pop investors in an IPO, and scoot away with the loot. In 2017, I made a list of 60 tech companies that had gone public since 2011. Fifty of them had never made a profit. Some new companies lose incredible amounts of money.”

Apoorva Dutt, Tech in Asia

That’s harsh but there is also truth in that. And we can see some of that play out lately with many of the newly listed companies with their values down 50 percent and more. And they are still nowhere from being reasonably priced.

Venture capital as an ecosystem is not designed to work with a lot of capital. In fact you make things worse for startups who are doing things right and playing by the books on their plans to grow a business with profits as the end goal. And that must be the end goal for the system to flourish.

Because you can always throw junk in the public markets and the public might lap it up. To a point. It’s that same fool me once, shame on you, fool me twice, shame on me endgame.

And we don’t want that endgame.

Of course, few businesses start out of the gate being profitable. But there must be a point beyond which profitability becomes imperative. We cannot have billion dollar businesses perpetually losing money.

Mihir Desai, professor of finance at Harvard Business School and an author of one of my favorite books, The Wisdom of Finance, wrote a piece in New York Times right before Uber was about to go public and why you should root for that IPO to fail. That’s cruel but hear him out.

“This cycle – in which unsustainable start-ups make ever-larger promises to bloated venture capitalists, who promise more than they can deliver to flush sovereign wealth funds, who are too eager to believe them – distorts the allocation of capital and talent. The rush to invest, no matter the underlying economics, diverts entrepreneurial energy toward unviable business models.”

Mihir Desai, New York Times

Of course that’s nothing to do with Uber but that’s what we get when so much capital is chasing returns wherever it can find in this ultra-low interest rate environment with pension funds, endowments and even John Q public piling in.

Now that I’d depressed you enough, there’s still a decent justification for you to still participate in this ecosystem because not many avenues exist that can add sparkle to your portfolio with returns beyond what you already have access to. Plus all that thing about backing entrepreneurs and helping turn their dreams into a viable product or a service.

So how do you decide how much can you afford to invest in this space?

I’d start with my 10 percent rule. That’s your play money and venturing into venture capital is equivalent to that. Very high risk with a potential to knock it out of the park.

For those that are into statistics, traditional stock and bond investing have returns that are more normally distributed. Venture capital returns follow a power-law distribution.

And data shows that you’ll need a minimum of 50 investments to even have a shot at this.

So assuming you deploy $10,000 in each one of them, that’s $500,000 right there.

But you can’t just invest once and be done with it. You need to invest at the minimum in a follow-on round to make sure you don’t get diluted out of your initial stake.

So that’s another $10,000 for each of those 50 bets.

So you need to carve out a million dollars from your portfolio to play this game. And since this can’t exceed 10 percent of all the money you have means you can only afford to play this game if your net worth is in the 10 million dollar range.

So that’s the hard math.

The way around it is to invest in a pool with other like-minded investors. That way, you can get exposure to this asset class even with a lot less.

To me, investing in this sphere if opportunity presents itself is to be an enabler of this ecosystem. Not that it needs any of mine or yours help in the current environment.

But if there is a chance to strike it big, there is also a chance it all flames out. That’s the nature of this game and you must play the game to find out.

Thank you for reading.

Cover image credit – Startup Stock Photos, Pexels

And as it is with anything exotic and of the swash-buckling kind, the media couldn’t get enough of him. The New Yorker pronounced him the stock market’s ‘certified golden boy’. Investors’ money of course followed. And by the boatload. Assets under management in his fund grew from a mere $12.3 million in 1959 to $340 million by the time he called it quits in 1965 to venture out on his own.

He then launched the Manhattan fund seeking to initially raise only $25 million. And we know investors chasing performance never gets old and hence they clamored to get into his fund. He ultimately wound up with 10x more money than initially planned.

And you probably know how that movie ends. The Manhattan fund had two middling years and then the roof caved in. By July 1968, it was the sixth worst performing fund in the country. And just a year later, it had lost 90 percent of its value never to recover again.

About a generation later, in March of 2000 just as the bubble created by the Dot-com boom reached its zenith, Merrill Lynch, the then world’s largest brokerage firm jumped on the bandwagon with not one but two new funds to sell. The first was a “Focus Twenty” fund. The other was an “Internet Strategies” fund.

The offering of course was an incredible success. It always is towards the tail end of a mania. The funds collectively pulled in $2 billion at the onset.

But then again, we know how that movie ends. It was a money-making bonanza for Merrill but a disaster for their clients. The Internet Strategies fund tanked almost immediately. By the end of 2001, less than two years after the launch, investors lost 86 percent of their money.

The Focus Twenty did the same with a cumulative lifetime return through 2006 of minus 79 percent.

I bet if I were to try harder, I could come up with countless such stories across the many booms and busts the world over. They might all start differently but they end the same.

Something similar appears to be transpiring with some hot funds and investments du jour of the day. And you don’t have to look hard to find bubble assets. In fact there are many. Maybe I am too old-fashioned but sometimes amazed at all these businesses selling at twenty, thirty, fifty times revenues with never a sight of profits. And profits are the only thing that matter eventually.

One or two of these bubbly assets could grow into their valuation if ever but these many, never.

So we know how this movie will eventually end and that end’s not going to be pleasant. But you have a choice to make. You can either be a willing participant in the making of that movie or you can watch it on Netflix whenever it comes out. I prefer the latter.

Thank you for reading.

Cover image credit – Jonathan Borba, Pexels

So I have to commute and commute means cars. No way around it with a big thank you to how we have designed our cities and our obsession with the way we have chosen to live. Even if there was a will, there’s no way an efficient public-transport system pencils out except in places where density is abundant.

So we are screwed, our quality of life is screwed and our environment, incrementally and then all of a sudden, screwed as well. There’s this thing floating around the enlightened alleys of the net that talks about how stupid and implausible an idea it is to think that we can have a backup to Earth. There’s no backup. This is all we’ve got. And what we do and how we choose to live is what’s going to make a difference in preventing an environmental apocalypse we’ll one day face.

But I digress. So I need a car and car means $$$$. We as a family are big on used cars. And the collective price we’ve paid when we paid for the entire fleet we’ve owned for almost a couple decades could be had at half the price of what an average new car costs today.

Our fleet…

They are great cars, still going strong but with paint literally falling off, they don’t look anywhere as pristine as you see them in these pictures. But I don’t care. And I have no interest to care. A vehicle to me is just a machine that takes me from one place to another, reliably and safely. That’s it.

A side-perk of driving older cars – you don’t care where you park and who you park next to. No need to shell out extra $$$ on collision and comprehensive insurance like forever.

And if you think I am an outlier, my wife is outlier-squared. I’ve basically won the wife lottery with near perfect compatibility in how we have chosen to live our lives. But we don’t skip a beat to splurge on experiences that we know are bound to enrich our time on this planet.

Oh and I have a milestone to report on the chotu (small) car that I drive. I mean that thing delivered on its promise like a charm.

Will report back at the 300,000 mile marker .

And buying used and driving until the wheels fall off means that you get to literally drive for free for the rest of your life. How? Some numbers…

We bought the van (2000 model year) in 2004 right before our oldest daughter was born. I think we paid about $10,500 for that. The tiny one (2004 model year) we bought in 2006 for $7,000.

A new one at the time could have easily set us back $25,000 a pop. And that’s for a run of the mill car. So some numbers on the impact of our decisions…

The van first…

Purchase price (bought in 2004) = $10,500

What we could have spent = $25,000

Difference = $25,000 – $10,500 = $14,500

Cash in hand at the end of 2020 if the difference was invested @ 7% annual return for 16 years = $43,000

For the small car next…

Purchase price (bought in 2008) = $7,000

What we could have spent = $25,000

Difference = $25,000 – $7,000 = $18,000

Cash in hand at the end of 2020 if the difference was invested @ 7% annual return for 12 years = $40,000

Total cash in hand because we decided to buy used instead of new and drive till they eventually fell apart = $83,000

So where’s the sin? We were in the market for another car but then someone showed me crash test videos of some of the cars we were considering and holy $#@&. Now we are all safety with reliability and economy taking a way backseat.

So we went looking for a used car again with the safety features we desired but not having the bandwidth to spend the extra time and effort required to secure a deal, we caved. We committed that sin that we promised we would never commit and went all YOLO. We bought a new car. Not just any car but an SUV. Not just any SUV but the safest of the breed in our price range (~$38,000) knowing perfectly well that the moment we drive that thing off that dealership lot, it’s going to lose 20% of it’s value.

But so be it. We could afford it. It’s got adaptive cruise control this, lane departure warning that and a myriad of other safety features that we are still in the process of figuring out.

But then we didn’t commit no sin because we know we will drive that car into the ground. Or until say autonomous driving completely takes over. That’s an easy 15 years. Until then, the remaining pile of money ($83,000 – $38,000 = $45,000) compounds away into a bigger and bigger pile which we will use to someday draw upon to buy that next car. And the car after that and so on. There is a maybe somewhere there but we’ll see.

So a few tips…

• Buy used when and where possible. A three to five year old model gives you that perfect mix of relative newness and a minimal depreciation hit.
• Pay cash when you can. If you had to borrow, keep the loan term at or below 36 months. If you need more months to payoff that loan, you are buying too much car.
• Skip the luxury. I bet you’ll find more multi-millionaires driving around in Camrys than in BMWs. Nothing against BMWs though. Oh and on BMWs, I can’t find the source but I think it was William Bernstein, an investment writer extraordinaire, who once wrote and I am paraphrasing here that a BMW is not a motor vehicle. It’s an IQ test that measures one’s ability or inability to save towards a decent financial future. So don’t fail that IQ test.
• And the best, if you are in that fortunate position where you can walk or bike to work, school, stores etc., chuck this whole car buying thingy. Not only can you shave years off of your time to reach your money goals, you and many more millions like you will slowly and then suddenly save this planet.

I have committed the sin. Don’t commit yours.

Thank you for reading.

Until later.

Cover image credit – Oleg Magni, Pexels

But whether it is different or not can only be known in hindsight. But when a majority of investors believe that this time is indeed different and are getting rich of it is when the chasm between asset prices and their underlying value grows. That’s happened in the past and will continue to happen in the future. That’s human nature.

So is this time different? Similarities are aplenty between the current stock market boom, especially in tech, with the Dot-com boom at the turn of the last century. New public listings were seeing euphoric rise in prices then as they are seeing now. Investors were willing to fund anything and everything that moved back then whether a viable business existed or not. Something similar appears to be the case now.

And a viable business of course means not just revenues but profits and cash flows. And sustainable at that.

So though there are a lot of similarities, there are BIG differences.

The price to earnings ratio of the stock market today stands at around 30, about the same as it was during the late 1990s. So the earnings yield of the stock market hence is 3.33% (earnings/price), about the same during both periods.

Now if you had money to invest, did you have viable alternatives to bypass the craziness with the stock market back then? You indeed did.

Back in the day, a 10-year Treasury bond yielded 6.5% so you could have locked in that yield every year for ten straight years. And mortgage rates are tied at the hip with Treasury bond rates so real estate had to yield the same or more. And it did.

No such luck now with yields on that same bond at less than 1%. There is no suitable alternative. Yields are low on pretty much everything and prices are hence, sky high.

One more thing that’s different between now and back then is the sheer size of the market debuts of many businesses going public today versus in the past.

Amazon went public in 1997 at a 438 million dollar valuation, literally a small-cap. Microsoft, a decade before that had its public market debut at $700 million valuation. Apple at a billion.

So public market investors at the time were literally getting in on the ground floor. They were the venture capitalists of the day.

And we know the venture capital business model. Most investments go nowhere with only a tiny fraction of them making up for all the losers. And that is what happened back then. You had to spray your money at many businesses going public at the time to get one Microsoft or Amazon or Netflix. That’s how it works. That’s how it was supposed to work. That was the 1980s and the 1990s.

And then the market crashed. Investors who were happy making money when all was great cried foul. So the politicians intervened to ‘protect’ the mom and pop investors from themselves but in that process, they killed that golden goose of letting investors participate in the growth phase of many of the businesses of today.

Now part of that intervention was justified because of the Enrons and the Worldcoms and the Tycos of the day but I believe that the pendulum swung too far in the other extreme.

But if investors were a little prudent back then and knew how to behave and participate right in the markets, the situation could have been different. And we sure hope the story ends for the better now but it looks less and less likely with each passing day.

And hence going public today means dealing with all the bureaucracy associated with quarterly filings and reporting to ‘protect’ investors. That takes time away from actually running and growing a business so a big hassle for newly formed companies. Plus the inability of investors to think beyond the next quarter doesn’t help either.

So businesses are making their public market debuts a lot later in the cycle than they did in the past. These are big businesses. Many are a decade old enterprises with established brands generating boatloads of revenues. The only thing that is amiss are profits.

So that’s a troubling sign. And valuations are outright outrageous but investors don’t care. No price is too high because this time is…

The only silver lining with owning these newly public businesses is that a lot of the losers that would have existed in their midst in times past have already been weeded out in the private sphere.

So private investors are absorbing a lot of the failures and only the ‘real’ ones are getting to you and me. But then we miss out on the growth phase of many of these businesses so both good and bad. I think it eventually cancels out but the process of going and remaining public needs an overhaul.

So my advice, if you care, to you is this:

• Limit this craziness to a portion of your portfolio that if it all goes to zero, will not disrupt your life. Start today and slice off say 10% of your chunk and go at it. That’s your Vegas money. Don’t add more. You don’t have to do any of it but if you must insist.
• Future returns are going to be low. There is no way that risk-free rates could be zero and yet you continue making double digit returns. That’s theoretically not possible. So don’t get used to this and plan to save more.
• The party will be over at some point. Low interest rates amplify asset volatility and the only side we are getting to see is the positive side of that volatility. The negative side is coming. That’s not to fear though. Just expect it and embrace it by sticking to your plan.
  

Rounding this off with this snapshot of a tweet from Chris Sacca, an early investor in some of the hottest brands around (Twitter, Uber, Instagram). I like him a lot. He means well. And there are many more in this business today who mean well. They are a different crop who care about all stakeholders and for them, making money is just one aspect. That should remain and that’s great.

So that’s that.

Thank you for reading.

Until later.

Cover image credit – Andrey Grushnikov, Pexels

But then you didn’t have much roads to build and maintain or government programs to run or the school system to educate or much of police, fire or military. They all came about and they cost money and hence the situation now.

The Federal income tax started out small with a base rate of just 1 percent on personal income but that came along with an exemption (no taxes) of $3,000. That virtually exempted the entire middle class from paying any taxes. On incomes above $20,000, there was an additional surtax of six percent.

And we are talking 1913 dollars here so a $20,000 income back then was huge. So only the super-rich had to worry about paying any taxes at all. 1913 by the way was also the birth year of the form 1040 that you still use to date to report and file your Federal income taxes.

So a simple little form that even a fifth grader could understand and file. But that was in 1913. That same form today goes on for pages and pages with all the modifications and additions to the tax code over the years. So not a simple process to file anymore.

But Federal income taxes are not the only taxes you owe each year. There are payroll taxes (Social security, Medicare) you pay that directly come out of your paycheck. Then there are state and local taxes, taxes on dividends, capital gains taxes etc. So taxes and more taxes. Approaching that 50% mark in terms of the total taxes you pay each year is completely plausible in some cases.

Now that you are happy, the system the way it’s designed is also fair. Or say fairer. That is, it’s progressive. As you make more money, you pay more in taxes. We’ll dig into that a bit more but before that, this is the general outline of our tax code.

Income is a combination of all things below.

Wages and salaries are typically what’s reported on Box 1 of your W-2 that you’ll need to file your taxes. Unless of course you are an independent consultant/contractor and receive a 1099-MISC with income reported on Box 7 of that form. That’s akin to running a business and hence is reported as business profits (or losses) in the income section above.

You could have both W-2 and 1099-MISC incomes in any given year if you have any sort of a side-hustle apart from your day job. And many do.

So what’s on a W-2? A detailed breakdown below…

The total Social Security taxes you paid for a year are reported on Box 4 of the W-2 and Medicare taxes on Box 6. Now it’s not completely fair to call them taxes as these are monies that you put in a system that pays for retirement and healthcare expenses for folks who are currently retired. But when you are done working and reach an eligible age, you’ll get some or most of it back from folks who are working and paying into the system then. So it’s a societal construct and a promise that’s made between generations and it’s an overall good thing. Not perfect but good.

But there are questions with respect to the sustainability of these constructs which we hope the leaders we elect will help resolve over time.

Apart from W-2 and 1099-MISC incomes, there is interest income that’s reported on something called 1099-INT that you’ll get from your bank that reports the interest income you earned on your savings for the year. You likely won’t have to worry much about earning anything on your savings these days though but you could if your stash has any heft.

Then there is dividend income that you’ll have to pay taxes on if you own stocks (publicly traded businesses) and when those stocks distribute profits back to you, the owner (stockholder).

Capital gains (or losses) are exactly that – gains or losses on an asset from the time it’s purchased to the time of its sale.

And business profits (or losses) we know. It could be anything that you make money off of and making money means paying taxes.

So that’s all the income but you don’t pay tax on all of that. You get to deduct a few things from that income to arrive at net taxable income.

What can you deduct? The most common ones below…

Your taxable income reduces by the amount of deductions allowed. So say your gross income is $50,000 for the year and you are filing as a single person and you rent instead of owning a home, your taxable income reduces by the standard deduction of $12,400 and you get taxed on the remainder of that.

Then comes the actual calculation of the tax due. We are part of a system that taxes income progressively. Almost all taxes are by the way. The more money you make, the more taxes you pay. It’s debatable whether it does an overall good or not and one can argue that at the margins, it does tend to discourage incentives to make more. I mean if you are in the highest tax bracket and the fact that the next set of dollars you earn, almost half of that is going to be taxed away anyway, that does create a little bit of discouragement to go out and make those dollars.

But then a healthy country needs a healthy middle class else we’ll all be living in armed and gated communities like many affluent folks do in other parts of the world where extreme gaps between the haves and the have nots persist.

But the system we are part of (capitalism), if not corrected from time to time, does tend to perpetuate accumulation of capital in the hands of the few. That’s the way it is designed so a bit of income and wealth distribution is for the overall good. Hence the tax structure the way it is.

And this is how taxes are calculated…

But then there are credits that directly reduce your tax bill. They are again designed to help folks on the lower income segment of the society to potentially help reduce or eliminate any tax liability thrusted upon them.

Tax credits fall into two camps; refundable and non-refundable. If a refundable tax credit exceeds the amount of taxes owed, the difference is paid as a refund. If a non-refundable credit exceeds the amount of taxes owed, the excess is lost.

Let me clarify that with an example. Say your tax due comes to a $1,000 and a refundable tax credit that you qualify for is in the amount of $1,250, you’ll get the difference in $250 back as a refund. But if that tax credit were non-refundable, your tax bill will drop to zero but you will not get any money back.

So not only do you pay no tax but you could get money back from your fellow taxpayers, if you qualify.

And after all that math, you get to your final Federal tax due bill. Then you’ve got state income taxes if they apply. Plus city taxes in some cases (New York City).

Now that we know a bit about how taxes work, let’s run through some scenarios to see what an individual’s total tax bill could amount to and what could be done to lower that.

This, for example, is a W-2 this single wage-earner residing in CA gets at the end of the year.

The taxes he or she ends up paying when filing a tax return that everyone MUST do come April 15^th of each year…

But that’s not all the taxes this individual pays for the year. A complete list…

Let’s take this same individual but this time around, he or she contributes to an IRA and to an HSA. The updated W-2…

The tax math when filing taxes…

His or hers total tax bill for the year…

So not only was this individual able to lower his or hers tax bill but now there is money that is invested on a tax-deferred (IRA) and tax-free (HSA) basis till retirement. So much better.

Let’s look at a few more scenarios. Here’s one where now we have two wage-earners with no kids (dual income, no kids, I mean DINKs) making great incomes and also CA residents. Both partners get a W-2 each at the end of the year and for simplicity’s sake, we’ll assume that to be the same for both.

So even with access to a retirement plan at work, both decide not to participate. The tax math hence…

The combined W-2 Box 1 income is 2x of what’s shown in the W-2 because dual income. The total of all taxes paid…

So not fun. But doing the same tax math assuming they had done what they should have done…

And the impact on total taxes paid…

So about $15k in total tax savings for the year by doing it right.

Of course, there are many permutations and combinations with the complex tax code we have but this hopefully gives a good overview of how our taxes work. And this applies to most of us.

Now only if we could figure out a way to make our government spend our tax dollars ‘right’.

That does it. Thank you for persevering through something as dull and dry as taxes. Not as fun to write about but necessary.

Until later.

Cover image credit – Oladimeji Ajegbile, Pexels

So what’s a wrong market environment? This…

Are you seriously telling me that people are willing to lend money today to the U.S. government for 30 looooong years to earn a puny, pathetic 1.3% a year for that entire duration? What does that tell us about the state of our economy and our future? Nothing good as such.

That grey curve by the way, literally hugging the floor for close to a decade, that’s what the Federal Reserve had to do to keep the economy afloat in light of the banking crisis of 2008. And short duration rates are the only rates the Fed or the European Central Bank and other Central Banks around the world control. The longer term rates are decided by the markets. If investors in aggregate expect that the lowering of rates by the Central Banks will ignite inflation out in the future, they will expect to be paid for taking on that risk. And hence, longer-term rates are usually always higher than the shorter-term ones.

But before all of that, a bond as we all know represents a loan an investor makes to an entity. That entity could be the U.S. government, a local municipality, a corporation or a foreign country. They need money and you have money so you lend it out at an agreed upon interest rate that the market decides.

And interest rates and bond prices move in the opposite direction. As interest rates rise, bond prices fall and vice-versa. So say you buy a 30-year bond today yielding 1.3%. If you hold that till maturity (for all of 30 years), you will get that yield every year and at the end of that term, you’ll get your principal back.

But say rates rise to 3% next year and for some reason, you decide to sell that bond. Would you be able to sell at the same price you bought it at? Hell no. You will have to discount that bond to a price that equates to what the market yields are. So you’ll take a hit on a supposedly safe investment.

The lower the rates and the longer the duration, the harder the price falls when interest rates rise. So if you are buying a bond with a duration longer than say 5 years, expect a lot of volatility if interest rates change.

You add bonds to a portfolio to dampen the overall volatility of a portfolio and if that is the intent, short-duration bonds are your only choice now. Short-duration bonds yield zilch today and hence any portfolio that includes them in a proportion that was historically deemed reasonable will not return as much. And that’s the reality.

But don’t show that light to the many city and state pension funds that are still assuming a 7% rate of return in their calculations. And even with that, they are so deep underwater that bailouts would be the only recourse. Or a significant haircut in what as a pensioner you should expect. So it’s best to plan for it and don’t assume that the income that’s promised will be there for you when you need it.

So what are some of the other implications of the interest rate predicament we find ourselves in? For one, it inflates prices of everything around us. Take for example that rental property you were exploring a few years back. You might have been balking at the 8% net yield thinking it was low.

But then the interest rates cratered and suddenly you are on board even at a 5% yield. How did the yield get to 5%? The price of that property rose. Or maybe the landlord marked down the rents. Ha…

Or say that iffy investment you were trying to make in your business just a few short years back. It doesn’t look as iffy anymore. You will gladly pursue that high risk, low reward deal because the hurdle rate is so damn low.

Or take stock market valuations for example. I hate to pick on Apple but let’s use that as a way to prove a point. It’s a 1.7 trillion dollar market value company that trades at a price to earnings multiple of 30. That’s an earnings yield of 3.33% for a company that did $260 billion in revenue last year.

But that yield is not that far away from what a 30-year bond yields today. Granted, the bond will never yield more than the stated yield but a business can for sure grow its revenues and profits. And that is the expectation.

Buying a stock in a sense is like buying a bond but without a maturity date. It basically is an annuity that pays indefinitely (perpetuity) because businesses in theory can last forever. But they don’t and we all know that. Someday, even the mighty Apple will not be Apple and will be replaced by something new. And history is replete with that scenario panning out.

Investors are willing to pay that much more for a company that size is because of something called TINA (there is no alternative).

But then Apple is a cash generating powerhouse so maybe it deserves that valuation. Time will tell. But the rest of the market and especially with tech has completely gone off the rails. I am not saying a crash is imminent because there is a theoretical backstop to that with all this liquidity being pumped into the system. That money has to go somewhere.

But it should not come as a shock to anyone if there is one because the fact that you have money in your pocket does not mean you pay whatever you want for an asset. Fundamentals rule, eventually.

And there is one place this interest rate situation impacts all of us and that is with housing. The interest rates first…

Your mortgage of course will be at a rate a percent or two higher than what the Treasuries yield (imagine a 10% mortgage rate back in the 1990s…) but let’s just go with this.

And since bond prices rise if and when rates fall, this is the corresponding rise in the price of a 30-year bond over time…

So if you bought a home in 1990, the value of that asset quadrupled just because the rates dropped and dropped and dropped, all other factors remaining constant of course.

So you have about the same risk of buying a home now as you have with any long-term bond.

But then a home is where a heart is and if it was not a quality of life ONLY decision in the past, it better be one now. Because that interest rate magic is going to work against you if and when rates turn, all other factors remaining constant again of course.

So that’s about it. Thank you for reading.

Until later.

Cover image credit – Cottonbro, Pexels