Do ETFs belong in Tax Advantaged Accounts?

5/3/2022

Most advisors are aware of the advantages of Exchange Traded Funds (ETFs) over equivalent mutual funds (MFs) for taxable accounts. These include:

• Lower taxable capital gains due to the structure of the vehicle (creation/redemption mechanism).
• Lower taxable distributions, for the same reason.
• Lower fees for equivalent funds, due to reduced overhead expenses in both the way the fund is maintained and compliance requirements.
• Lower ticket fees or platform commissions for trading ETFs vs some MFs.
• Additional transparency of holdings for many ETFs. Index ETFs report holdings daily. Active non-transparent funds may be as opaque as mutual funds, reporting only semi-annually.

To see these advantages in action, look at the differences in fees, distributions, and returns for VOO vs. VSPVX.  These are the Vanguard funds tracking the S&P 500.  (Data from Morningstar as of 5/2/22)

Symbol	TTM Yield	Fees	Total Return, 2021
VOO	1.46%	0.03%	28.78%
VSPVX	2.01%	0.08%	24.81%

As expected, fees and distributions are lower for the ETF. But why the difference in total return? It looks like part of it is that some cash flows are distributed rather than reinvested. But there must be more to it. And this is the biggest reason to use ETFs in tax advantaged (TA) accounts, like IRAs and HSAs.

The share creation/redemption mechanism is the root cause of the difference in performance. When shareholders buy or sell shares of MFs, the fund must invest or divest those funds rapidly, rather than hold cash or maintain a cash negative position. The NAV is calculated at the end of each business day, and this is the price that investors pay and receive. However, the fund company transacts at market prices during each trading day, buying and selling shares of the underlying investments to balance out inflows and outflows of funds.

Shares of ETFs are bought and sold on the open market throughout the day, trading at market prices, which may reflect a discount or premium to the actual value of the underlying. When the ETF is trading at a premium, the Authorized Participant (AP) will buy a quantity of the ETF (typically 50,000 shares) and trade them as an even in-kind exchange with the ETF provider for a basket of shares of the underlying, equivalent to the holdings of the ETF. The AP pays most of the taxes on the gains and losses of these transactions, while the fund simply creates or destroys shares. The transactions are made during the trading day with both the ETF and underlying holdings being exchanged at actual market prices.

The tax benefits of this arrangement are evident, but how does this impact performance? Let’s say a bear market is beginning. Many investors decide to sell. The mutual fund will receive redemptions that settle at that afternoon’s price. The fund trading desk may get notification of this overnight, or as late as mid-morning the next day. They must then sell positions out of the MF, into a declining market, for which they paid the previous day’s closing price. For rising markets, the reverse is true, and funds must purchase shares that have been rising.  

The impact is clear. Now consider less liquid securities, like municipal bonds or foreign holdings. ETFs will reflect this illiquidity cost by trading at a discount because the APs determine how much risk they are comfortable taking to make the in-kind exchanges of shares. MFs, however, may be forced to trade at less advantageous prices. Index MFs will need to trade some portion of most or all of their holdings, regardless of price or liquidity. Actively managed MFs will select the securities to buy and sell, and in times of volatility, this may result in style drift.

The biggest downsides to using ETFs in tax-advantaged accounts are operational for the advisor. Mutual funds allow for set-it-and-forget-it automatic periodic investments, and rebalancing can be accomplished to the dollar. Use of ETFs requires more effort in rebalancing, investing, and trading, although the advent of fractional share trading may be helpful in this regard.

Exchange Traded Funds started with SPY in 1993. 30 years later, the advantages over mutual funds have proven to be overwhelming. Innovations continue, to include ETNs, active ETFs, and other exchange traded products. Advisors have a duty to understand the technical differences between funds that can lead to significant impacts on client results.

Compliance for Digital Assets

2/1/2022

One year ago, my topic was “Cryptoassets and Advisors,” which gave an overall look at the investment space and how advisors might begin to think about allocating client funds to digital assets. This article expands on the regulatory requirements for advising clients on digital assets.

For those of you who hold fiduciary certifications or are registered as RIAs, it is becoming a fiduciary responsibility to understand digital assets and be able to determine if they are appropriate in client portfolios. Onramp Invest has produced a 55-page review of how cryptoassets might be incorporated into the CFP® Curriculum (report can be requested here: https://onrampinvest.com/cfp-professional-conduct-and-regulation/).

With that in mind, an understanding of the compliance requirements is also necessary.  The SEC issued two documents during 2021 addressing digital assets. An SEC Risk Alert dated 2/26/21 (https://www.sec.gov/files/digital-assets-risk-alert.pdf) identified 6 categories of risk on which they intend to focus:

• Portfolio Management, including due diligence, evaluation and management of specified risks associated with digital assets, and fiduciary duty.
• Books and Records, to include records of trading activity.
• Custody, which covers controls around safekeeping, business continuity plans, software, and security around software and digital platforms.
• Disclosures, including marketing materials and regulatory brochures and supplements, with a focus on the specific risks associated with digital assets.
• Pricing client portfolios, which looks at valuation methodologies as well as fee calculations.
• Registration issues, which considers AUM calculations and how digital assets are characterized in pooled vehicles and private funds.

Their 2021 Examination Priorities were released on 3/3/21, also selecting 6 areas of focus, but slightly differently. Keystone Compliance Consulting (info@keystonecomplianceconsulting.com) summarizes the requirements in this document as follows:

To date, there is very little clarity around how digital assets will evolve in the future. What we do know, is that the SEC Division of Examinations’ 2021 Examination Priorities calls out digital assets, specifically, as an area of focus. (https://www.sec.gov/files/2021-exam-priorities.pdf).

The guidance highlights six areas that can be expected to be reviewed in an SEC exam. Compliance professionals should take the following actions to address these areas.

1. Investment Suitability – Document investment suitability for each client, specific to digital assets. For example: Digital assets are/are not suitable for the client because (list reasons).

• Portfolio Management and Trading Practices – Establish policies and procedures specific to how digital assets will fit within portfolio construction and management. Establish when and how the assets will be traded.

• Safety of Client Funds and Assets – Discuss the custody of digital assets in your compliance policies and procedures. Consider what documents would be produced to evidence the custody of the assets.

• Pricing and Valuation – Review your current pricing and valuation policies and procedures. Be sure to incorporate specifics about digital assets.

• Effectiveness of Compliance Programs and Controls – Digital assets should be reflected in the inventory of risks. The policies and procedures established for digital assets should be reviewed, at a minimum annually, for efficacy and completeness as the digital asset space changes.

• Supervision of Employee Outside Business Activities – Review Outside Business Activity policies and procedures and make any amendments needed to include digital asset activities. Services related to digital assets offered by employees, outside of their employment arrangement, should be evaluated. Additionally, these arrangements should be assessed to determine if they qualify as securities activity.

The digital asset world continues to change quickly. In these early days the due diligence required to select legitimate investments and evaluate the requirements listed above is ongoing and can seem overwhelming. Newsletters I have found most informative and actionable to stay up to date on all topics relating to digital assets are from Fidelity Digital Assets (send an email to digitalassets@fmr.com and request research updates) and Galaxy Digital (sign up at https://www.galaxydigital.io/newsletter/). To stay current on SEC requirements, bookmark the SEC examinations page https://www.sec.gov/exams  and check the Priorities Memos and Risk Alerts on a regular basis.

Portfolio Protection: At What Cost?

11/1/2021

Although interest rates have risen from their generational lows, real rates are still negative. In fact, due to inflation (whether “transitory” or not), real rates have fallen off a cliff in mid to late 2021. As a result, many investors who would prefer a conservative investing approach have invested much more than they would ideally prefer into equities. This includes people who are in the accumulation phase of their careers and some who are approaching or already in retirement.

Market valuations, by all measures, are approaching or at all-time highs. As of early November, Shiller’s P/E 10 is over 39, which is a value only eclipsed by the irrational exuberance of 2000 (data from https://www.gurufocus.com/shiller-PE.php). Advisor Perspectives provides a variety of metrics updated monthly at https://www.advisorperspectives.com/dshort/updates, all of which are currently showing highly overbought conditions. And if you really want to be terrified, read John Hussman’s latest piece (https://www.hussmanfunds.com/comment/mc211015/).

These conditions together are causing clients and advisors a great deal of discomfort. How can portfolios be protected from the next drawdown? We’ll look at two types of protection.

The first line of defense has traditionally been diversification. To protect against equity losses, keep a position in bonds. The 60/40 portfolio (example data is from Kwanti.com, and assumes annual rebalancing, where the bond allocation is represented by the Treasury 20+ index). The cost of diversification is lower expected long-term performance, since expected bond returns are lower than expected equity returns. What is the price you pay, and what kind of protection does that buy?

First, the price (annualized returns shown):

	S&P 500 TR	60/40	Performance difference (cost of bond allocation)
1 yr	41.20%	23.71%	17.49%
3 yr	22.53%	15.87%	6.66%
5 yr	18.91%	12.68%	6.23%
10 yr	15.91%	10.90%	5.01%
20 yr	9.67%	7.95%	1.72%
25 yr	9.85%	8.35%	1.50%

And how much protection against portfolio losses does this provide?

	60/40	S&P 500 TR	1-Ratio of drawdowns (protection provided)
Tech bubble (9/00 – 10/02)	-23.51%	-47.41%	50%
Subprime crisis (10/07 – 3/09)	-33.80%	-55.25%	39%
CoronaVirus (2/20 -3/20)	-20.58%	-33.54%	39%

So the cost (at least in the last 10 years) is quite high, and the protection is incomplete at best.

A more direct hedge against losses is to buy puts on the equity position. Data regarding put strategy is from Harvey, Rattray, and Hemert, Strategic Risk Management, Wiley, 2021. Because puts, unlike equities, are time limited, the mechanics of any given strategy must be defined. This strategy uses front month puts, which are held to expiry.

See below the overall return of at-the-money puts from 1985-2018 as well as selected crisis periods shown above. Although one might expect this to be a perfect hedge from a returns standpoint, due to the roll of the put positions, it is not:

	ATM puts	S&P 500 TR
Tech bubble (9/00 – 10/02)	48.3%	-47.4%
Subprime crisis (10/07 – 3/09)	41.6%	-55.2%
Overall (1985-2018)	-3.9%	10.8%

To hedge your entire portfolio, the cost of the puts is on average more than double the cost incurred from the lower returns of long bonds (-3.9% over 33 years vs. -1.5% over 25 years). Additionally, the returns of the puts are negative during normal market environments (86% of the time in this analysis). And even with the near-constant losses and high expected total cost, there may still be some amount of drawdown in a crisis.

As predicted by theory, the price of safety is lower returns. Behavioral finance should be considered with regard to any specific client – what pattern of portfolio returns would be best tolerated, and why? How can the advisor best construct the portfolio and frame expectations so that the client understands the likely outcomes and will be able to withstand them, both financially and emotionally?

What is China up to?

7/29/2021

According to the IMF, World Bank, and CIA Factbook, China currently produces around 25% of global GDP. Recent WFE data shows that Chinese exchanges (A-shares only) control 11% of global market cap. Any investor interested in a global allocation must include Chinese equities in their portfolio. Even if Chinese equities are specifically excluded, the impact of the Chinese economy cannot be removed from a diversified investment portfolio.

The leap from emerging to developed economy depends on a number of factors that facilitate the flow of capital, and some of these have been seemingly going in the wrong direction recently in China.

Rule of law: An ongoing issue – can investors count on ownership of assets?

• The reach and power of the CCP cannot be overstated.
• The VIE structure used for listing Chinese companies on US exchanges, which has been in place for many years, does not provide the same direct ownership of a corporation as a US stock.

Regulatory crackdown: China recently brought several enforcement actions against Chinese tech companies, which included suspension of new accounts and removal of apps from the marketplace. Different analysts have viewed ascribed varying possible motives to these actions:

• Cyber security issues for the Chinese state and people – this is the official reason stated for action against Didi following its recent IPO in the US.
• Consumer protection from monopoly power – this is the official reason stated for recent actions against Alibaba and Ant, as well as new restrictions on for-profit education sector in China.
• Political power – preventing the founders/owners of these companies from becoming a threat to existing power structure by reducing their wealth and stature within China.
• Realignment of sectors within the Chinese economy – this interesting theory by Noah Smith (https://noahpinion.substack.com/p/why-is-china-smashing-its-tech-industry) proposes that China is purposely removing profits from the consumer facing software industry in order to encourage entrepreneurs to focus resources on hardware and firmware sectors.

Transparency:

• The SEC is currently threatening to delist Chinese companies due to disagreements regarding financial audit practices. Although the companies are audited, China will not allow the auditing firms to release their workbooks to the SEC for inspection. It’s important to note that listing requirements in China and Hong Kong are more stringent than in the US, including profitability and share classes/voting rights.
• State owned enterprises make up 25% of the Chinese economy, but encompass 40% of listed companies. Although all Chinese companies ultimately answer to the government, SOEs have a somewhat different set of risks, and are not going away.

Various geopolitical struggles: The US/China relationship can be viewed as adversarial, although the two economies are interdependent. According to ustr.gov, China is the third leading export destination for US goods, while the US is the top export destination for Chinese goods and services. Any difficulties or disagreements must be viewed through this lens. Ongoing issues include:

• The assimilation of Hong Kong and Taiwan into China, eliminating their independence while still keeping their developed economies status.
• Border and ownership disagreements in the South China Sea.
• Human rights abuses, which have resulted in blacklisting of Chinese firms in the US.

What is actionable here? The large, dynamic and growing Chinese economy must, in theory, be included in a globally diversified portfolio. Whether or not an investor decides to maintain an explicit position in Chinese equities, we are all exposed to this large economy indirectly. Decisions to be made include:

• Share classes to include in any allocation to China. This may be a way to limit exposure to specific risks.

Share Type	Where traded	Currency	Notes
A-shares	Mainland China (Shanghai and Shenzhen)	Renminbi (Chinese Yuan)	Ownership by foreigners still somewhat limited
B-shares	Mainland China (Shanghai and Shenzhen)	US Dollars or HK Dollars
H-shares	Hong Kong Exchange	HK Dollars	Often correspond directly to A Shares
Red Chips	Hong Kong Exchange	HK Dollars	State owned companies
P-chips	Hong Kong Exchange	HK Dollars	Non-state owned companies
S-chips	Singapore	Singapore Dollars
N-shares	USA	US Dollars
ADRs	USA	US Dollars	ADRs of H-shares and red chips are often called N-shares
	Taiwan	Taiwan Dollars

Notes: A, B, and H Shares consist of companies that are primarily Chinese and are incorporated in China.  The other share types are incorporated in foreign countries, although the businesses exist within mainland China.  Many companies are traded using more than one of the share classes listed above.  Taiwan has a complex relationship with China, but economically, it is a separate state, and like Hong Kong, is a developed market. 

• Amount to allocate specifically to China. Emerging market indexes vary in China exposure, as well as share types.
• Active vs. passive exposure. Fund managers bring their own perspectives. Every index is a result of the decisions of a committee. All of these must be examined carefully.

Social Security Planning

Social Security income is often a substantial part of a retiree’s income. When deciding when and how to claim benefits, there are many consequential choices to be made and data to be gathered:
• Age of retiree when social security is claimed
• Age and claiming status of spouse
• Earned income during retirement
• How long the claimant worked, and amount earned during working years
• Earnings that were not subject to social security taxes
• Any government pension benefit
Benefits can be claimed starting at age 62. Claiming benefits earlier results in lower payments, and these differences can be significant. The maximum benefits are paid out starting at age 70, and can be more than 75% higher than the benefit received starting at age 62. Waiting to get the maximum dollar benefit per month, however, often does not result in the maximum amount of benefits received over a full retirement. Various claiming strategies are compared using the break-even age. This is the age at which total payments of any two strategies converge. Note that not all calculators include time value of money in the calculations.
The rules governing benefits are so complex that the Social Security Administration website includes a dozen different benefits calculators (https://www.ssa.gov/benefits/calculators/). These calculators are helpful but do not provide all the information needed to make these difficult filing decisions, and neither the SSA website nor SSA employees will provide any recommendations as to best strategies for an individual. SSA does provide links to other benefits calculators that are more comprehensive than their own (https://www.ssa.gov/policy/docs/rsnotes/rsn2016-03.html – this is 5 years old and not all the tools are still available). Internet searches result in additional tools. Using a combination of tools will result in a range of likely benefits amounts that the financial professional can use for planning purposes.
Situations that are in any way complicated should be evaluated by a consultant or specialized software package. Many planning software packages include social security calculators within the package, but these vary greatly in terms of extensiveness. Be sure you understand the underlying considerations and calculations in the software you are using.
When making a recommendation for claiming age(s), total benefits received is not the only consideration. If a person wants to retire at 62, but the benefits-maximizing age for them to claim benefits is 67, then they will need to fund the intervening years in some other way. As the break-even age of various strategies increases, expected longevity becomes more of a factor. Comprehensive planning software should factor in these important considerations. Social security planning is best not left to rules of thumb or assumptions, but is a multi-step process for the financial professional.

Cryptoassets and Advisors

Bitcoin, Blockchain, DLT, Cryptocurrencies, Tokens, Altcoins, DeFi, Digital Assets – these are all terms related to cryptoassets. Everyone is aware of 2020’s meteoric rise for Bitcoin, and lots of clients have been asking how it might fit into their portfolios. Advisors must approach this new asset class in a disciplined manner:

• WHAT & WHY: Learn about the asset class, including at least a basic understanding of available assets, securities, platforms, and other investment vehicles used to make investments, tax impacts and risks involved with each, and methods of valuation.
• WHEN & WHO: Determine suitability criteria.
• WHERE & HOW: Determine the best method of investment for clients and verify that you and the recommended investment meet all regulatory and compliance requirements before investing for clients.
• Client communication.

The first step is to gain competence around this new asset class. This can be done formally. RIADAC and Interaxis offer courses specifically for advisors, covering all of the steps shown above. This approach allows the advisor to have confidence that all pertinent topics are adequately covered, and that information is up to date and accurate. You will also receive a credential or certificate to demonstrate your education to clients.

Self-study options are typically free and without any resulting certification or acknowledgement. It’s up to the advisor to determine whether the information presented is complete, correct, and timely. The following list is a starting point, although none of them completely cover the topics listed above:

• CFA Institute recently released a brief on the topic. A copy can be requested directly from author Matt Hougan via Bitwise Investments.
• “Cryptoassets” by Chris Burniske and Jack Tatar
• River Financial’s Bitcoin Learning Center: https://river.com/learn/
• a16z: https://a16z.com/2018/02/10/crypto-readings-resources/
• Fidelity Digital Assets Basics: https://www.fidelitydigitalassets.com/digital-asset-basics
• The private placement fund companies have published useful information that can be used for your education and also for clients. They frequently sponsor or are guests on webinars as well, which can be much more accessible for beginners in the space.
• RealVision Crypto channel (free registration) for videos, including this classic: https://www.realvision.com/shows/the-interview-crypto/videos/the-deliberate-corporate-strategy-to-adopt-the-bitcoin-standard
• To stay current, Twitter is an excellent source of information, although, caveat emptor, you will need to choose your follows carefully.

Cryptoassets are a complex and quickly changing asset class. Investable cryptoassets have at minimum 3 unique use cases, although any given asset may include more than one of them:

• Store of value or Money: This is Bitcoin’s primary claim to fame; it is a secure store of value that cannot be diluted.
• Medium of exchange or Currency: Some cryptoassets are better suited than Bitcoin to use for small or frequent transactions, the way cash is used.
• DeFi: Decentralized finance, or smart contracts, offer a way to conduct more complex transactions using blockchain technology. This includes crypto’s newest concept, blockchain based art and collectibles.

These various use cases mean that there is room for more than just Bitcoin in the cryptoasset universe, and investments can and should be diversified. There are over 8,000 cryptoassets currently being traded. Advisors must consider allocations beyond Bitcoin alone. Like documentation of suitability, we must be able to show our work on investment recommendations. Any recommendation to buy an asset must include some assessment of its value. Brian Estes of Off The Chain Capital explains 3 ways to value Bitcoin using Gold-to-Bitcoin ratio, Stock-to-Flow ratio, and Metcalf’s Law: https://youtu.be/x3lv-W2Dm0U

What are the vehicles available to advisors to allocate client funds to cryptoassets? Options are less than ideal in this new investing space.

• Institutional-focused platforms: Fidelity Digital Assets works with advisors for Bitcoin (only) investments. Large minimums are required, and this solution is currently best suited for large financial intermediaries.
• RIA-focused platforms/SMAs: Blockchange.ai and Eaglebrook Advisors offer SMAs for cryptoassets. OnrampInvest.com platform is currently in development. The goal of these platforms is to provide a compliant investing solution that allows advisors to access expertise in selection and transactions in cryptoassets, along with maintaining custody.
• Private placement funds: Grayscale, Galaxy Digital, Bitwise, Permian Capital and Sarson Funds are examples of investment firms that offer these funds to accredited investors. There are specific asset focused funds, index funds holding multiple assets, and actively managed funds. All of these require considerable due diligence.
• OTC traded products: These are private placement funds that trade shares OTC. GBTC, GDLC, ETHE, BITW are examples. They trade like closed-end funds, at premium/discount, and are available to add to brokerage accounts.

Additional difficulties with investing in cryptoassets from the advisor’s standpoint exist in the form of regulatory and compliance issues, as well as risk management. US regulators have been slow to deal with the asset class, and have mainly responded to its growth by limiting access. SEC regulated funds (mutual funds and ETFs) may include a small allocation to Bitcoin, but not enough to consider the fund a cryptoasset-based investment. Funds invested in cryptocurrencies trade on the OTC Market, but the pricing is similar to closed end funds in that these funds trade at either premiums or discounts, often far from NAV, and the funds are not regulated. Recently the SEC filed suit against XRP (Ripple), alleging that it is a security. This has resulted in its delisting from most of the major trading platforms. It was one of the top 3 cryptocurrencies by market cap when this action occurred. On the bright side, regulators have made some progress. The OCC has not only approved qualified custodians to hold cryptocurrencies, but has approved a federal crypto trust charter for the establishment of a crypto bank. The SEC is once again considering Bitcoin ETFs. What can we do now to be compliant?

• Be aware of custody issues. If you have access to trade or move the cryptoassets themselves, then you have custody. If you are directing a broker or fund manager to make trades, then they have custody. Be sure you understand who has custody of the assets and how they safeguard the assets and transactions.
• Be aware of what regulators oversee the funds or platforms that you use for clients, and understand the associated risks. Private placements will require that investors are accredited. This highlights the lack of regulation and increased risks for the clients.
• Know what you are buying for the client. Is the investment in cryptoassets or options? What are the fees and other costs?
• Risk management: How are the assets insured? Are there adequate cybersecurity policies and procedures in place?
• Onramp Invest has put together a summary of risks to consider and specific compliance (ADV) considerations: https://medium.com/onramp-invest/top-things-for-advisors-to-consider-before-advising-clients-on-bitcoin-ffbab1fe4bc9

Cryptoassets are an exciting new asset class, and it’s every advisor’s obligation to learn about them on behalf of our clients.

Oblivious – Barry Ritholtz

Not that he is. It’s the title of a blog post he wrote. Excellent: https://ritholtz.com/2021/02/oblivious/

Consider the following questions:

-What area should we have an expertise in, but don’t? (And are we aware of our own lack of expertise in these areas?)

-What do we think we know or understand but in actuality do not?

-What we are wholly unaware of, but should know about?

-What are the unknown unknowns — things collectively none of us could have anticipated?

As someone who has spent most of his life more or less oblivious to oh so many things (I don’t read social cues, can’t remember names, am wholly lacking in self-awareness, etc.) I find the above video to be one of the most amazing things I have ever seen. It is utterly fascinating to me, and because of my own tendencies towards being oblivious, I find it more than a little horrifying. Give it a quick two minutes view.

Here’s the explainer from the BBC:

“Pumping her arms back and forth, fitness instructor Khing Hnin Wai dances for the camera, performing ordinary exercises on an extraordinary day in Myanmar. At first glance, the video appears to show a routine dance workout. But in the background, a convoy of armoured cars can be seen streaming by, suggesting all is not as it seems. Ms Khing, an aerobics teacher, posted her exercise video to Facebook on Monday morning.”

Aerobics juxtaposed against the coup in Myanmar is what makes the video fascinating. Even the music is perfect. What makes it so horrifying is simply the thought as to how often I have engaged in some act or commentary or any other behavior where I was every bit as clueless as to what was going on above.

This video should strike self-examination and fear into anyone who ever thinks they have this market figured out. Humility should be our default position.

Question: What convoy of armored SUVs is behind my field of vision that I am completely oblivious to? What is your blind spot? 

Also WordPress editor is so awful. I don’t use it much but sorry I couldn’t figure out how to do a quote with paragraphs.

The Futility of Financial Planning

“Everyone has a plan ’til they get punched in the mouth.” – Mike Tyson

Given the comeback bout scheduled for September, the cliche Mike Tyson quote is especially relevant today. And as it applies to financial planning, in particular. Imagine being his planner when he earned over $700 million boxing, then ended up declaring bankruptcy in 2003. Now Tyson runs a cannabis business said to earn $500,000 per month, and his return to the ring is not for the money (his paycheck will go to charity), but rather to satisfy some non-financial goal.

This is one of the conundrums of financial planning. No one can foresee what they will want or need to do with their time or money far in the future. Current events have further exposed this concept – who planned for 2020? However, human nature for most people would result in no savings at all without some sort of savings discipline, and far too little without some semblance of a plan.

“All models are wrong, but some are useful.” – George E.P. Box

Current planning software uses the George Box idea, and approaches the task from two angles: goals-based planning, or cash flow planning. Some combine the two. Goals based planning starts with the end in mind, and often uses bucketed strategies to get there. Cash flow planning starts from today’s budget and looks ahead. From the practitioners standpoint, there are reasons to use one or the other depending on the client:

Goals-based:

• Can be used with limited information about client spending and still adequately cover the essential planning topics.
• Can be used for clients who are savers by nature.
• Best for plans that are limited in scope.
• Can be overly simplistic and may not adequately represent all the relevant factors (taxes, social security, medical costs, etc.)

Cash flow based:

• Helpful for folks who are just starting out, to see the impact of their major life decisions
• May help motivate spenders when they see how saving can make a difference in the future
• Good for detail-oriented clients.
• Can be overly burdensome to both initially develop and to maintain – the more detail that is included, the more that has to be updated going forward.

The other big difference between planning packages available today is the method of calculation available; the “engine” of the software. Most planning software estimates a likelihood or probability of plan success based on the savings and spending plan, some assigned asset allocation, and associated capital market assumptions.  Here are a few highlights of options available today:

• The engine driving the calculation. Most software uses normally distributed Monte Carlo methods. Market returns are known not to match a normal distribution, but it’s the closest and simplest method of estimation. Right Capital uses a complex fat tails stochastic model that more closely matches actual market returns. GDX360 options include bootstrapping samples from actual historical returns. NaviPlan only includes the Monte Carlo calculation as an option – this software calculates outcomes using a CFP-style deterministic method, which gives a very different feel to the process than using a more probabilistic method.
• The CMAs:  Capital Market Assumptions (includes returns, standard deviations, and correlations between assets). Most common are historical actual data. However, many planners and software providers feel that historical norms are overly optimistic today, and use CMAs that are derived in other ways.  CMAs for MoneyGuidePro are provided by Harold Evensky. CMAs for Orion Planning (Advizr) are from J.P. Morgan. Other software providers set up their own CMAs. Many allow advisors to enter custom CMAs. The importance of CMAs in planning cannot be overstated – these assumptions determine the outcome of the plan, and the planner must know where they came from and understand and agree with the underlying philosophy behind them.
• The level of detail in the assumptions, inputs, and calculations. As mentioned above, some planning software includes incredible levels of detail on tax burdens, social security strategies, and medical expenses. This can have a positive impact on the client, with added confidence in the care and competence of the software and the professional. It may also add an unwarranted level of comfort – taxes, medical costs, and other assumptions modeled into the software will certainly change going forward, which will impact the plan.

Financial planning software is an important tool. It’s the obligation of the advisor to understand its underlying assumptions, how it works, and the strengths and weaknesses of the software package we select for our clients.

Carl Sagan on Skepticism

From the Skeptical Enquirer:  https://skepticalinquirer.org/1987/10/the-burden-of-skepticism/

I view skepticism as very much a part of critical thinking. This was written in 1987.  It’s called “The Burden of Skepticism,” which is a great title. A few excerpts:

If you were to drop down on Earth at any time during the tenure of humans you would find a set of popular, more or less similar, belief systems. They change, often very quickly, often on time scales of a few years: But sometimes belief systems of this sort last for many thousands of years. At least a few are always available. I think it’s fair to ask why. We are Homo sapiens. That’s the distinguishing characteristic about us, that sapiens part. We’re supposed to be smart. So why is this stuff always with us? Well, for one thing, a great many of these belief systems address real human needs that are not being met by our society. There are unsatisfied medical needs, spiritual needs, and needs for communion with the rest of the human community.

There may be more such failings in our society than in many others in human history. And so it is reasonable for people to poke around and try on for size various belief systems, to see if they help.

Skepticism challenges established institutions. If we teach everybody, let’s say high school students, the habit of being skeptical, perhaps they will not restrict their skepticism to aspirin commercials and 35,000-year-old channelers (or channelees). Maybe they’ll start asking awkward questions about economic, or social, or political, or religious institutions. Then where will we be? Skepticism is dangerous. That’s exactly its function, in my view. It is the business of skepticism to be dangerous. And that’s why there is a great reluctance to teach it in the schools. That’s why you don’t find a general fluency in skepticism in the media.

I want to say a little more about the burden of skepticism. You can get into a habit of thought in which you enjoy making fun of all those other people who don’t see things as clearly as you do. This is a potential social danger present in an organization like CSICOP. We have to guard carefully against it.

It seems to me what is called for is an exquisite balance between two conflicting needs: the most skeptical scrutiny of all hypotheses that are served up to us and at the same time a great openness to new ideas. Obviously those two modes of thought are in some tension. But if you are able to exercise only one of these modes, which ever one it is, you’re in deep trouble. If you are only skeptical, then no new ideas make it through to you. You never learn anything new. You become a crotchety old person convinced that nonsense is ruling the world. (There is, of course, much data to support you.) But every now and then, maybe once in a hundred cases, a new idea turns out to be on the mark, valid and wonderful. If you are too much in the habit of being skeptical about everything, you are going to miss or resent it, and either way you will be standing in the way of understanding and progress. On the other hand, if you are open to the point of gullibility and have not an ounce of skeptical sense in you, then you cannot distinguish the useful ideas from the worthless ones. If all ideas have equal validity then you are lost, because then, it seems to me, no ideas have any validity at all.

Some ideas are better than others. The machinery for distinguishing them is an essential tool in dealing with the world and especially in dealing with the future. And it is precisely the mix of these two modes of thought that is central to the success of science.

Propelling emotional predispositions on these issues are present, often unconsciously, in scientific debates. It is important to realize that scientific debates, just like pseudoscientific debates, can be awash with emotion, for these among many different reasons.

Advice

From kk.org (https://kk.org/thetechnium/68-bits-of-unsolicited-advice/).

Here are a few selections from the 68 pieces of advice (emphasis mine):

• Gratitude will unlock all other virtues and is something you can get better at.

• Don’t be the smartest person in the room. Hangout with, and learn from, people smarter than yourself. Even better, find smart people who will disagree with you.

• Don’t take it personally when someone turns you down. Assume they are like you: busy, occupied, distracted. Try again later. It’s amazing how often a second try works.

• The purpose of a habit is to remove that action from self-negotiation. You no longer expend energy deciding whether to do it. You just do it. Good habits can range from telling the truth, to flossing.

• Promptness is a sign of respect.

• When you are young spend at least 6 months to one year living as poor as you can, owning as little as you possibly can, eating beans and rice in a tiny room or tent, to experience what your “worst” lifestyle might be. That way any time you have to risk something in the future you won’t be afraid of the worst case scenario.

• Trust me: There is no “them”.

• If you are looking for something in your house, and you finally find it, when you’re done with it, don’t put it back where you found it. Put it back where you first looked for it.

• To make mistakes is human. To own your mistakes is divine. Nothing elevates a person higher than quickly admitting and taking personal responsibility for the mistakes you make and then fixing them fairly. If you mess up, fess up. It’s astounding how powerful this ownership is.

• Never get involved in a land war in Asia.

• Perhaps the most counter-intuitive truth of the universe is that the more you give to others, the more you’ll get. Understanding this is the beginning of wisdom.

• You are what you do. Not what you say, not what you believe, not how you vote, but what you spend your time on.

• When crisis and disaster strike, don’t waste them. No problems, no progress.

• On vacation go to the most remote place on your itinerary first, bypassing the cities. You’ll maximize the shock of otherness in the remote, and then later you’ll welcome the familiar comforts of a city on the way back.

• When someone is nasty, rude, hateful, or mean with you, pretend they have a disease. That makes it easier to have empathy toward them which can soften the conflict.

• Over the long term, the future is decided by optimists. To be an optimist you don’t have to ignore all the many problems we create; you just have to imagine improving our capacity to solve problems.

• The universe is conspiring behind your back to make you a success. This will be much easier to do if you embrace this pronoia.