2019 was an incredible year for the market. In the years leading up to quitting my employment, I agonized over leaving the comfort and security of a full time job. We would be turning off a high income job to live on a portfolio, learning to live with cash coming out every month. What if the market tanked shortly after? What if our withdrawal rate was too high? How much should I put in bonds? One question I failed to ask was…what if the market returned 30% or more in my first year of early retirement? (Reminder: All Time Highs Are Both Scary and Normal). Every asset class was up for the year. It was outstanding to see the rewards of a decade and a half of savings. Lets review the portfolio and go over some of the questions I have going into 2020. Lets review the portfolio:
Asset Allocation: Equities: 55%, REITs: 12%, Bonds: 33%
We are following an equity glidepath that started at 60% Equities/REITs and 40% Bonds and slowly increasing our equity allocation over the first five years. I specifically split out REITs because we invest in two individual REITs that carry low debt and a diversified portfolio of commercial properties, giving them attributes of both equities and bonds. We’ve had a couple things change nine months into early retirement this brings me to the first question: Should I continue with the equity glidepath?
Account Balance By Type:
Pre-Tax Accounts: 59%. This includes 55% in our Rollover IRAs and a Deferred Compensation Plan and the remaining 4% in the Health Savings Account
Roth Accounts: 12%
Regular/Taxable Accounts: 29%
The majority of our assets are in pre-tax accounts. We intend on fully funding Roth IRAs at the start of the year, will receive about 1% out the deferred compensation plan in 2019, and convert some amount of the Rollover IRA into a Roth IRA in 2020. The growth in the pre-tax accounts has me wondering if I have a future tax issue?
2019 Portfolio Performance:
2019 involved a lot of “money in motion”. A 401k rollover, HSA rollover, restricted stock, and moving a chunk of our investments for a Chase YouInvest signup bonus. We moved our portfolio to a 60% Stock, 40% Bond Allocation early in the year and did not fully participate in the 30%+ return for equities in 2019. However, our portfolio returned just over 25% for the year compared to just under 22% for a 70% Stock Index, 30% Bond Index Portfolio. This means we beat a stock/bond indexed portfolio with the same allocation by 3% for the year. I’m proud of those results, but am unsure if it was worth the additional time.
What drove this performance?
1. Value Investing:
We own a number of individual equities and REITs in addition to owning index funds. The goal of individual stock ownership was to attempt to own stocks that have a lower risk/lower return profile than the total market index. This generally meant purchasing companies with lower Price to Earnings ratios and higher dividends than the total index. We sold our house in early July and I completed my 401k rollover in August, both of which freed up capital to invest. I purchased a significant number of financial sector/bank stocks along with a couple other companies that looked undervalued (Carnival Cruise Lines, Westrock, and AT&T). These type of stocks became in favor during the second half of the year and are up around 20% since August.
2. Interest Rates, Banks, and Treasuries
Interest rates were highly volatile in the middle of the year and I thought financial stocks were deeply undervalued from October of 2018 to September of 2019. I also happen to have worked in this industry and understood the banks ability to make money and return capital to shareholders via share repurchases. I also saw interest rates were volatile and invested in long term treasury bonds, which experience the most price movement as interest rates move. The prices of these assets move in opposite directions and I would shift some money between the two when one would go up and the other would go down. I was ultimately rewarded by owning both and picked up a little extra in gains from the wild price swings. This trend slowed down towards the end of the year and I’ve been slowly moving our bond allocation into the Vanguard Total Bond Market Index (BND).
3. Year End Changes and What I’m Buying Now
The portfolio was little changed for the quarter and most of what we own appear fairly valued. The only places where I thought there was some value is in REITs and Emerging Markets. If you’ve read my reports over time, you know that I’m no fan of buying the REIT index. I think there are too many companies in the index that have skewed the index into a higher risk/lower return profile. I would rather own a couple of individual REITs and pick the risk/return profile we’re getting for our investment. The REIT index fell by 5% during the fourth quarter and I took advantage of this selloff to add to one of our REITs and am looking at a couple more.
I also think Emerging Markets are attractive based on valuation. The Vanguard Emerging Markets Index (VWO) currently owns a basket of foriegn stocks yielding around 3% with a 13x Price to Earnings Multiple compared to a 1.77% yield for the S&P 500 paired with a 24x Price to Earnings multiple. Emerging Markets have underperformed for more than a decade and I’m investing in the probability this trend goes the other way in the next decade. Investing in the Emerging Markets Index is not for the faint of heart – this has been one of the most volatile asset class over the last twenty five years and as an investor in this, I will have to tolerate wild swings in both directions during its march higher.
Investment Questions I’m Considering:
Question #1: Revisiting the Equity Glidepath – Nine Months In
The biggest risk to our early retirement is a large drop in the market followed by a long recovery that happened shortly after stopping income. To protect against this, we followed Equity Glidepath. We chose a strategy of allocating 40% to bonds at the start of retirement, slowly inching that allocation back up to 100% (or near 100%) equities over the first five years of retirement. Here is the schedule I built out by quarter and how we’ve done so far:
Now that I’m nine months in, a number of things have changed which has me reconsidering if I should stay on this path:
Outside Income: I negotiated a hobby employment arrangement with a former client that now covers around 44% of our annual expenses. This is a combination of earned income plus moving into their health insurance pool, which was better quality insurance for a slightly lower cost than the ACA. I’m using substantially all of the earnings from this to fund 2020 Roth IRAs and fully fund a Roth 401k.
Market Returns/Withdrawal Rate: The market returns have put us comfortably over our Financial Independence number. For 2020, I am projecting just over a 2% withdrawal rate from our portfolio, which is less than the total dividends and interest it produces. Even without the hobby employment, our withdrawal rate would be less than 3.5% based on the year-end balances.
All of this has me questioning – Do I stay the course with the equity glidepath? I could go in a few different directions: Do I enjoy the security and peace of mind that a lower risk portfolio provides? Do I take advantage of my new lower withdraw rate to add some risk and buy more equities or invest in a couple real syndications? I’m open to suggestions as I’m wrestling with this decision and need to revisit my investment policy statement. My early thought is this will be updated to say I’ll invest in any asset at the right price with funds above our FI number. Provide me with an attractive return probability relative to the risk and I’ll consider it. Until then, holding 33% or so in bonds provides some comfort.
Question #2: Do I have a future tax issue?
After running a case study for the Landshark, I was running some IRA conversion estimates and realized we might have saved too much in pretax accounts. I always utilized the traditional 401k and a pretax deferred comp plan because our marginal federal plus state (in some years) was between 24% and 34%. I always assumed we would have 30+ years to distribute the money via Roth Conversions before 59.5 and regular distributions up until RMDs kick in (which is now 72 via the Secure Act)
We saved around $160,000 in the last fifteen months of working plus saw the market gains of 2017 and 2019 skyrocket these account balances to 59% of our total assets. If we convert out $65,000/year, that doesn’t even shrink these accounts if the market returns 6% or more over the next 20 years. That means far into the future RMDs may trigger a much higher marginal rates in the distant future and negate the pre-tax savings in these accounts. Until now, I’ve always thought we could completely empty our pre-tax accounts over 20-30 years and never see an issue.
This has me wondering: Should I eat the taxes and do a bigger conversion in our current state? We’re looking at 22-24% federal and another 7% in state taxes. It would cost around $30,000 to convert an additional $100,000 over to the Roth IRA. Does it make sense to take up Florida (or another tax free state) residency for a year and do a big conversion up to the edge of the 24% tax bracket in a single year? I can’t predict future tax policy, but in the last fiscal year the federal government grew expenditures by 8.25% while only growing revenue by 4%. The bipartisan agreement on an 8%+ spending growth is a risk for higher taxes in the future.
In the meantime, I am shifting my entire bond allocation into pretax accounts. This parks the assets with the lowest returns in the pretax accounts while allocating the highest returning assets in the Roth and regular account(s). I am also debating how to use up our 10 and 12% tax brackets for the year: We have a number of stocks with significant capital gains in our regular account and would enjoy harvesting the gains out at a 0% rate. However, we also have the aforementioned tax issue and would like to fill as much of that bracket up with a Roth IRA conversion. I’m open to suggestions/opinions on what has more value as I’m still torn on the issue. I may do a small conversion early in the year and wait to make a decision on this later in the year.
Question #3: Is Active Management Worth My Time?
I’m proud of the small incremental returns for the year, but is it worth my time? Being an average investor is easy: Own the index, reduce fees, and focus on living your life. Getting incremental return above the market is difficult. There’s a reason the people who can do it consistently are running hedge funds and making astronomical compensation for their abilities. I’m fine to sit in passive investments and match the market’s return, but will I be able to overlook what I think obvious opportunities are? I don’t know. If I were still working, the additional time required for active investing would not be providing an appropriate return on my time. The question probably comes from figuring out if I’m getting personal enjoyment out of this to continue with my tinkering.
Wrapping Up:
2019 was a great year on the market, performing better than I could have ever expected in the year I declared early retirement. A three year span averaging 15% per year that corresponded with my final three years of earned income has been remarkable. These returns should eventually reverse to average and result in some single digit return or even negative years in the market. The best we can do is be positioned for both scenarios, having enough risk based assets to participate in the upside while also owning some lower risk assets to maintain our financial independence. I’m looking forward to what the future will bring.
I have a few comments/observations. First, a basic 60/30/10 SPX/Bond Index/T-bill allocation is currently priced to offer effectively zero average annual returns over the next decade assuming reasonable valuation mean reversion – i.e. typical cycles playout. Your glidepath baseline has that inherent headwind, which your withdrawal rate helps reduce.
Secondly, Bond Indexing, while reasonable in the micro sense, has resulted in a massive bout of people making really silly decisions, with most not even realizing it. Your position in BND is not an example, but many are allocating to global and/or international index ETF/Funds and not realizing the amount allocated to negatively yielding bonds in Europe in particular. I suspect you are probably aware of this issue but thought I’d mention just in case.
The valuation disparities globally are somewhat comparable to the late 90’s but with less dispersion – meaning the “cheap” market segments are more narrow. For example, in the emerging markets, they are priced overall for about 5-6% average annual real returns (NOT cheap historically), but it is HEAVILY tilted towards value stocks, which are priced at about 10% real (definitely cheap!). The issue here is the lack of viable options in ETF’s or funds to have exposure to that specific segment – actually pretty surprising in this day and age. One that I’ve found is GVAL from Cambria which is not an explicit emerging market fund, but its strategy has resulted in the purest play on the theme that I have been able to find, and that isn’t “polluted” with significant exposure to China. That is not a political comment but rather a concern about how private capital/companies will be treated.
Two other ideas I will throw out as potential diversifiers with absolute return potential are Mortgage REIT’s and local currency EM debt. Mortgage REIT’s are trading around book value overall and offer yields around 10%. They are a more pure play than banks and/or financials on a steep and steepening yield curve. Counterintuitively, the curve typically begins to steepen prior to or early in a recession after the Fed stops tightening and reverses course. REM is the biggest ETF and dominated by Annaly (NLY). They tend to be great to hold for 2-3 years from where they currently are in the cycle and then exit as the next economic cycle matures.
Local currency EM offers two main components, with the first being significantly higher yields in low duration instruments in countries like Russia and Brazil. However, commodities and related currencies are at record low valuations relative to financial assets, recently eclipsing the late 90’s mania. Even just a “normal” mean reversion cycle could result in major currency tailwinds and result in equity-like total returns. Many commodity-related currencies are down 40-60% vs the USD since 2011-2012.
Lastly and reverting back to my first comment: given the dramatic and inarguable valuation headwinds from current levels, I think a 18-24 month dollar cost averaging strategy for whatever you decide is what you want in “core equity” would be prudent. Much of the diversification you are relying upon assumes one very important relationship remains stable – bond yields drop when stocks have a bear market. Most back tested models make this same assumption, but it is a dangerous assumption to make with high conviction. Chris Cole at Artemis (a volatility-focused hedge fund) has written/spoken about this over the past few years, so he may be worth checking out. The US had a 16 year period of higher rates and a huge bear market in equities in real terms (1966-1981) and many countries globally have experienced similar periods. Given the incredibly advantageous position you have worked so hard to achieve, these are a few ideas/issues I think are worthy of consideration. The risks at present are objectively the worst in history for someone in your position and think they warrant a deliberate and conservative approach. Fortunately, you are in a position where DCA’ing over 18-24 months is not an issue, so no reason to be greedy! I wish you the best of luck!
Wanted to circle back on something to clarify and “connect the dots.” US investors reasonably price and typically view foreign markets in USD terms. There is nothing inherently “wrong” with this, but it does introduce an attribution issue – what is currency and what is local market related?
My favorite example of this currently is the Russian market, which regularly shows up on Shiller/CAPE P/E lists etc as one of the “cheapest” markets in the world. Such lists and claims are through the lens of US dollar pricing. If one looks at the MICEX in Russian rubles, one finds that it is near an all time high and well into a clearly developed decade-long parabola.
The difference is the RUB/USD exchange rate! That rate has dropped from about 30 to 60 over the last 7-8 years. So is someone buying Russian stocks in USD really getting a “value”? Well sort of – they are buying expensive stocks in a cheap currency. I would argue the better way to achieve that exposure is via local currency EM short duration bonds. For example, the 2 year Russian Federation bonds yields about 5.6%. I would argue that people buying something like RSX to get exposure to “cheap stocks” are misguided.
When you consider an ETF such as VWO, you are buying mostly cap weighted stock indexes heavily tilted towards overvalued growth sectors and priced in USD’s after an 8 year period of dramatic decline in EM currency exchange rates. USD-based EM stock exposure gives you overvalued stocks in an overvalued currency. This is why I believe a barbell approach of deep value EM equity and local currency EM bonds is a far better risk/reward approach.
I appreciate your long and thoughtful responses.
I’m definitely expecting a “lower for longer” environment on returns. Lower returns and it’ll take a while. I’m tilted towards value stocks today because of how high valuations are in the rest of the market.
The most interesting point in all of this is the active vs. passive management when it comes to emerging markets. These markets are not as efficient and exposed to some additional risks and I own both a Fidelity active fund and the Vanguard Emerging Markets Index. I’m not a fan of the expense ratio in the former but also not a fan of the China exposure in the latter.
I can’t get on board with the mortgage REITs, they take on leverage to buy leverage and I’ve watched this turn out badly in the past. I’m happy to collect 6% or so on REITs I think are lower risk using 35-40% debt.
For now I’m happy to have a cash / conservative bond portion and waiting for valuations to improve.
I’ll compare Annaly vs Simon Property Group to express why I think your characterization regarding risk is not as simple as I think you are suggesting.
Annaly trades at book value and holds one of the most liquid assets in the world – conventional US mortgages. Yes, they use leverage typically in the range of 5-8 times to generate their ROIC. They also face prepayment risks. In many ways, they face the same risks as traditional commercial banks – borrow short and lend long with some leverage, only Annaly has a lower credit risk profile and better liquidity. The stock yields about 10% and that dividend would likely benefit from higher interest rates, as higher rates from here are likely part of a steepening of the yield curve. Bearish flattener move are the enemy of Annaly and that is typically while the Fed is tightening late in the business cycle when the yield curve often inverts. The stock is at the low end of its historic range and has historically offered relatively stable to growing dividends through recessionary periods. During the 2001 recessionary period and surrounding bear market, the dividend grew from $.14 to $.41, and during the GFC it went from $.26 to $.59 – all quarterly. The stock went from $1.12 to $3.00 during the 2000-2003 bear market and $4.49 to $4.23 during the GFC – all using quarterly closing prices.
Simon trades at 17 times book value and the stock is now looking like a broken parabola. It yields just under 6%. It’s assets are highly illiquid and have imbedded cap rates of probably below 3%, with many major commercial markets in the US having cap rates around 2%. It has effective duration risk of over 20%, so higher long term rates are likely to hit the stock hard. Its business is also vulnerable to recessionary risks and negatively correlated with broader credit conditions. It is highly unlikely to provide diversification benefits during the next recessionary bear market. Its dividend was cut from $.95 to $.75 during the 2001 mild recession, and from $2.97 to $1.24 during the GFC. Its stock went from $11 to $16.50 during the 2000-2003 bear market and $68 to $28 during GFC. Importantly, cap rates and valuations in 2000 were a mere generationally cheap/attractive in 2000 compared to coming off record levels today.
I share this as just one example and don’t know what you own, but given this historical backdrop, I would argue that something like Annaly offers someone in your situation vastly superior diversification benefits and a better chance at stable or even improved dividend income over the next 2-3 years given where we are in the US business cycle, relative valuations, and inherent business model risks.
Q1: Yea, I would stay the path, you spent all this time setting it up and its a good plan
Q2: It’s impossible to know if you will have a tax issue in 30 years, but that doesn’t mean you have to solve it now. Right now you should focus on tax the lowest rate for your RSU vesting gains (0%), then in a couple years you can figure out the conversion. Who know might hit a recession and you can convert at a lower basis.
Q3: Probably not. If you spend the time you spend actively managing the portfolio just working a job you would probably make more. All this rental, syndication stuff is just a future headache or fun exercise that you can use to write about on your blog, and it probably won’t improve your quality of life by a significant amount.
Thank you for the replies. I think on question 1 I’m more likely to slow down the equity additions at today’s valuations and catch back up if we get a decline in the market. I don’t need the returns and I’m struggling to find things where I think I’d be appropriately compensated for the risk.
On the tax issue – fair point. There’s a case to be made that paying taxes in the future is almost always preferable to paying taxes today, especially since I don’t have any “generational wealth” type plans. The RSU gains are working out nicely, the stock vested then actually dropped 8% before I could sell due to an industry drop. I was able to sell off all the RSUs, took the tax loss, then thought a diversified basket of companies in the same industry. Those gains will age out as LTCG in a couple months.