Free-quent Flyer
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There's an apocryphal story about a young Bob Dylan, who was visited by his friend Allen Ginsberg. Dylan asked if he could borrow some money to pay the rent, and Ginsberg asked why he needed to borrow money when he had a jar full of it on the counter. Dylan is supposed to have told him, "that's the dope jar, not the rent jar. The rent jar's empty."
This is supposed to be a story about the fallacy of designating accounts for specific purposes; Dylan's problem is that his income doesn't meet his expenses, so he needs to borrow to make up the difference. It doesn't make any difference whether part of his income is "designated" for rent, utilities, or dope.
With that in mind, the near-universal advice of economists and investment advisors alike is to use a model of asset management, in which the only inputs are age, expected retirement date, and risk tolerance.
The key to this model is that given a person of a given age and expected retirement date, the asset allocation will depend exclusively on their risk tolerance: a person with low risk tolerance will need to invest more, in safer assets, and a person with high risk tolerance will need to invest less, in riskier assets, while bearing the corresponding risk that they'll need to live on less in retirement.
While this principle makes mathematical sense, it does so only as a definitional matter: if assets pay higher returns as compensation for more risk, over the long term they'll return more than less-risky assets, although those returns will be more volatile.
Here are some conceptual issues I have with this model which are rarely, if ever, discussed.
What role do the different assets play in your asset allocation?
When I wrote about Future Advisor on my blog, I explained that they cannot do what they claim to do since they do not include liquid, FDIC-insured, high-interest accounts in their portfolio assessments.
In my case, they suggested allocating my cash savings, earning a little over 5% APY in a liquid savings account, to an array of bond funds with the goal of earning an average of 5% APY — but which would be marked to market if at any time I needed to liquidate them.
The fact that my high-interest, FDIC-insured accounts are liquid allows them to play two roles: serve as a floor on returns, as they would over the very long term if invested in bond funds, but also serve as an emergency fund if I have a sudden need for cash. Even if they theoretically play the first role roughly as well as the same money invested in bond funds, they serve the second role much better, since I am guaranteed to receive back the face value of my savings balance, unlike a bond fund subject to market volatility when sold.
In other words, an asset allocation between stocks and bonds, optimized for a far-off retirement, is extremely unlikely to provide the anticipated returns if unexpected withdrawals are ever necessary. The common solution of holding a separate emergency fund in cash drags down returns by decreasing exposure to equities as a percentage of the entire portfolio. In other words, any given "correctly" risk-weighted asset allocation pre-emergency-fund becomes too risk-averse once you add thousands or tens of thousands of dollars of cash to it.
The conceit of the "emergency fund" is that having one, and using it to cover unexpected expenses, will keep you from having to mark your other investments to market when selling them, and allow you to maintain your expected returns over the long term. But remember, your expected returns are in fact being dragged down over time by your insistence on maintaining your emergency fund as a separate pot of money from your "investments."
How do withdrawals affect your asset allocation?
Let's say your roboadvisor of choice suggests an asset allocation of 33% domestic equities, 37% foreign equities, 12% real estate and 15% bonds, and you need to make a withdrawal from your account.
There are three ways you could make the withdrawal: you could sell your winners; you could sell your losers; or you could sell a cross-section of your account in order to maintain the same overall asset allocation.
But since your asset allocation is a mechanical product of your age, anticipated retirement date, and risk tolerance, whichever one you choose will cause the roboadvisor to reallocate your assets so they have the same overall allocation.
But buying and selling stocks and bonds out of necessity, which were purchased in anticipation of a long investment horizon, is almost guaranteed to sabotage your long-term returns!
Replacing bonds with funds in FDIC-insured, liquid accounts allows you to spend those funds if necessary without affecting the upside offered by your equities and without having to sell your bonds at market prices. When the exigency passes, you can build your balances back up, restoring the original asset allocation and risk profile, all without being subject to the vagaries of selling your holdings at the market's price.
What role do taxes play?
The obvious response to all the foregoing seems to me to be something like this: "using my tax-advantaged accounts as an emergency fund makes sense because even if I experience lower returns and more volatility than I would using taxable savings accounts, I'll save so much money avoiding capital gains taxes on my investments that I'm likely to come out ahead."
For an accountholder in the 35% tax bracket, a 5% APY account will return just 3.25% (or less after state taxes are considered). Suddenly we're talking about returns significantly lower than our promised 5% return, which makes Future Advisor's 5% long-term return on the bond component of a portfolio look newly appealing.
But if taxable accounts are used to offset bonds in the tax-advantaged portfolio, allowing a greater allocation to equities, there should also be a corresponding increase in tax-advantaged returns.
In other words, replacing tax-advantaged bonds with taxable high-interest accounts has two advantages: increasing the returns in tax-advantaged accounts and minimizing the risk of a fire-sale of more volatile assets, but just one disadvantage: the taxes owed on the interest your accounts earn each year.
But feel free to avoid taxes
Of course, alternatively you can simply avoid taxes by generating interest on your cash savings through backdoor tax-advantaged methods: fund accounts with cashback credit cards, fund Kiva loans, or just MS and designate the proceeds as your emergency fund. Since cash back earned on credit card spend isn't currently taxed as earned income or interest income, you'll be able to achieve the same 5%+ annualized return without owing a cent in taxes (under current IRS guidance).
This is supposed to be a story about the fallacy of designating accounts for specific purposes; Dylan's problem is that his income doesn't meet his expenses, so he needs to borrow to make up the difference. It doesn't make any difference whether part of his income is "designated" for rent, utilities, or dope.
With that in mind, the near-universal advice of economists and investment advisors alike is to use a model of asset management, in which the only inputs are age, expected retirement date, and risk tolerance.
The key to this model is that given a person of a given age and expected retirement date, the asset allocation will depend exclusively on their risk tolerance: a person with low risk tolerance will need to invest more, in safer assets, and a person with high risk tolerance will need to invest less, in riskier assets, while bearing the corresponding risk that they'll need to live on less in retirement.
While this principle makes mathematical sense, it does so only as a definitional matter: if assets pay higher returns as compensation for more risk, over the long term they'll return more than less-risky assets, although those returns will be more volatile.
Here are some conceptual issues I have with this model which are rarely, if ever, discussed.
What role do the different assets play in your asset allocation?
When I wrote about Future Advisor on my blog, I explained that they cannot do what they claim to do since they do not include liquid, FDIC-insured, high-interest accounts in their portfolio assessments.
In my case, they suggested allocating my cash savings, earning a little over 5% APY in a liquid savings account, to an array of bond funds with the goal of earning an average of 5% APY — but which would be marked to market if at any time I needed to liquidate them.
The fact that my high-interest, FDIC-insured accounts are liquid allows them to play two roles: serve as a floor on returns, as they would over the very long term if invested in bond funds, but also serve as an emergency fund if I have a sudden need for cash. Even if they theoretically play the first role roughly as well as the same money invested in bond funds, they serve the second role much better, since I am guaranteed to receive back the face value of my savings balance, unlike a bond fund subject to market volatility when sold.
In other words, an asset allocation between stocks and bonds, optimized for a far-off retirement, is extremely unlikely to provide the anticipated returns if unexpected withdrawals are ever necessary. The common solution of holding a separate emergency fund in cash drags down returns by decreasing exposure to equities as a percentage of the entire portfolio. In other words, any given "correctly" risk-weighted asset allocation pre-emergency-fund becomes too risk-averse once you add thousands or tens of thousands of dollars of cash to it.
The conceit of the "emergency fund" is that having one, and using it to cover unexpected expenses, will keep you from having to mark your other investments to market when selling them, and allow you to maintain your expected returns over the long term. But remember, your expected returns are in fact being dragged down over time by your insistence on maintaining your emergency fund as a separate pot of money from your "investments."
How do withdrawals affect your asset allocation?
Let's say your roboadvisor of choice suggests an asset allocation of 33% domestic equities, 37% foreign equities, 12% real estate and 15% bonds, and you need to make a withdrawal from your account.
There are three ways you could make the withdrawal: you could sell your winners; you could sell your losers; or you could sell a cross-section of your account in order to maintain the same overall asset allocation.
But since your asset allocation is a mechanical product of your age, anticipated retirement date, and risk tolerance, whichever one you choose will cause the roboadvisor to reallocate your assets so they have the same overall allocation.
But buying and selling stocks and bonds out of necessity, which were purchased in anticipation of a long investment horizon, is almost guaranteed to sabotage your long-term returns!
Replacing bonds with funds in FDIC-insured, liquid accounts allows you to spend those funds if necessary without affecting the upside offered by your equities and without having to sell your bonds at market prices. When the exigency passes, you can build your balances back up, restoring the original asset allocation and risk profile, all without being subject to the vagaries of selling your holdings at the market's price.
What role do taxes play?
The obvious response to all the foregoing seems to me to be something like this: "using my tax-advantaged accounts as an emergency fund makes sense because even if I experience lower returns and more volatility than I would using taxable savings accounts, I'll save so much money avoiding capital gains taxes on my investments that I'm likely to come out ahead."
For an accountholder in the 35% tax bracket, a 5% APY account will return just 3.25% (or less after state taxes are considered). Suddenly we're talking about returns significantly lower than our promised 5% return, which makes Future Advisor's 5% long-term return on the bond component of a portfolio look newly appealing.
But if taxable accounts are used to offset bonds in the tax-advantaged portfolio, allowing a greater allocation to equities, there should also be a corresponding increase in tax-advantaged returns.
In other words, replacing tax-advantaged bonds with taxable high-interest accounts has two advantages: increasing the returns in tax-advantaged accounts and minimizing the risk of a fire-sale of more volatile assets, but just one disadvantage: the taxes owed on the interest your accounts earn each year.
But feel free to avoid taxes
Of course, alternatively you can simply avoid taxes by generating interest on your cash savings through backdoor tax-advantaged methods: fund accounts with cashback credit cards, fund Kiva loans, or just MS and designate the proceeds as your emergency fund. Since cash back earned on credit card spend isn't currently taxed as earned income or interest income, you'll be able to achieve the same 5%+ annualized return without owing a cent in taxes (under current IRS guidance).
