The Magic Box

A week ago I received a message from a reader, who just finished university and is starting his first internship in a few months. Considering the new phase of his life, he wanted to discuss saving and investment strategies.

I immediately felt the guy deserved the very best answer I could give him. I mean, not that I cared less about similar conversations I had in the past. But this request stroke me differently for various reasons. It was the first time I had the opportunity to advise on these topics with someone so young; typically, the person(s) on the other side of the table/screen are older and have already an established career.

When I was his age and learning about trading and investing, I read a lot but I never had the opportunity to have an exchange with anyone (save maybe during my last university year when I was writing my thesis): information was flowing one way and one way only. I was reading blogs and online forums but I never had the guts to ask any question, mainly to avoid a harsh reply that would have made me feel stupid or, even worse, to be ignored. Obviously, those fears were just in my head…and yet, I am not that much better now…

He could have asked anyone. Well, he probably did ask other people and now I do not want my reply to sound less smart than the competitors (If you listen to Corey Hoffstein, Cliff Asness might reply to internet randos. I would def try him first if I was you ;)).

His email was well written and I could understand he is in that “sweet but hard to achieve spot” where he knows some but he does not think he knows it all. Not like those guys that ask you something not because they want to know but because they want to show they know more than you do (maybe it is just me missing those days when I was playing pickup basketball, crossing into the guy who thought he was LBJ while warming up with his Beats on and less so after the first elbow-hit in his mouth).

Serendipity

Last week I also landed on this post on BankerOnFire.com. I would not put BoF as one of my go-to-read blogs but I found plenty of interesting material there over my time in the UK. Definitely, someone that has endured an investment banking career AND built a multi-million Real Estate portfolio on the side deserves my ear (remember, RE investing ain’t no passive income. More so if you do it on the commercial side). Plus, the dude runs the blog…and has kids, if I remember correctly (ok, if you have money to throw at the problem, kids are not that of a hindrance, at least in their first years).

The post is about “things you need to do to elevate your investing game to the very top“. These things overlap almost perfectly with my reader questions…but I have a different take on some of them.

How early should you start saving

This is a complex topic to tackle because it largely depends on each person’s circumstances (I wrote a post about it some time ago). BoF uses some data and a graph that honestly triggers me every time I see it:

Yes time in the market, aka compounding, is really important. And yes, “early on in life (or when you have fewer assets to your name) your savings have a bigger impact on your wealth [than investments]”, as reminds us Nick Maggiulli.

But no one has $500/month to save when they are 21. Especially outside the US where initial (and in many cases, even not-so-initial) salaries are low. If you are lucky, you get the chance to potentially save that amount towards the end of your 20s. That’s because your savings capabilities depend on your salary AND your costs. Jobs that allow you to earn the big bucks down the line are usually in a big city and they require you to spend most of the time in an office (either because it is required, or because it will give you the best chances to get a promotion). That means that basics, like rent and food, will eat most of your salary. Sure you can save living far from your office, you can save if you plan your grocery shopping and cook all of your meals. But your day has still 24 hours, 9/10 of which you want to spend giving your best because…you remember…you want to progress in your career. Living close(r) to the office, going out to eat, are also investments to improve your chances to reach your goal.

And then, believe it or not, there are people, like me, that work to live. My first salary was my first chance to do whatever I wanted, to experience stuff that I (almost) never had the chance to do before. Travel with my friends. Buy new snowboard gear whenever I wanted. Stop counting every single Euro in my pocket…you know? As Shaquille O’Neal once put it “you need to feed the dog”: he wanted to be involved on the offense, so he would be motivated to give his best during the defense. I could not postpone all the fun and maximize savings, because I would have lost fast my motivation to perform at work.

The BoF graph creates an unhealthy type of FOMO, pushes people to feel bad about themselves because “they should have done more”, when I do not think it was possible anyway, and be even counter-productive in some circumstances. Compounding for 40 years at 8% looks great, nice Excel file, now show me the real life. The good news is that your salary will grow much faster than your expenses, the basic ones at least. Well, until you have kids 😉 If you are disciplined and have a good understanding of which things bring you real happiness, you can definitely reach a great saving rate. Just do not try to run before you know how to walk…that’s my idea.

The myth of the balance

“This advice is for people who have decided that economic security and success is their goal and one of the key components of how they define success. If you are part of that group, you need to recognize what I would call the myth of the balance. The media and books will always highlight famous examples of people who are great at what they do, they have great relationships, they have an awesome partnership with a spouse, they have time to donate, and they have a food blog. However, you should assume you are not that person. I am not suggesting you buy into this whole emerging industry of struggle porn in which you are supposed to kill yourself, be miserable, and go work for free somewhere. I believe that is unhealthy. That said, nearly every successful person I know has spent the majority of their 20s and 30s focused on work and their career. The exception to this are those who have inherited wealth, which is still the best way to be successful. We live in an extremely competitive society, so you need skills and grit to differentiate yourself. I do not remember much about my 20s and 30s other than working. I am sure I took two or three vacations in those decades, but I do not remember any of them. This is because my focus was on my professional success. I grew up with economic insecurity, so I decided early on that having security was going to be a major goal of mine. My mom had cancer, and I felt as if we were getting bad healthcare. I felt so powerless and emasculated as the man of the house. There was nothing I could do about it because we did not have the connections or the money. I decided then and there that I was going to be in the top one percent. If you make the same decision, you have to acknowledge that while there are people who can balance and have a good life while being marvelously successful, most people cannot. You have to say to yourself, “This is going to be hard. I am almost going to pass out, but I am going to get through it.”

This is Scott Galloway in an interview on Forbes. I think he nails the point perfectly. Life is made of trade-offs and some decisions require a big judgment call, a leap of faith since it is really hard to quantify how much you are giving up, how much you will gain and how much regret you will have.

Later, he addresses as well the saving matter:

“Saving when you are young is the equivalent of saving a great deal when you are older. I did not have that discipline because I naturally assumed that I was going to be so awesome that money was never going to be a problem for me. Most people, including myself, do not have the discipline to put several thousand dollars away in their 20s and 30s. If you do so, you will have economic security when you get older, and you will have the satisfaction that you set yourself up for it. I describe it as a magic box. If you need to put $10,000 into a magic box, you went back to the box after you lived your life, and there was $300,000 or $400,000 in the box, how much would you put in? Everybody has that box, so you need to ask yourself what you want to put in it.“

As for investing, I think you can hardly make a mistake if you diversify. It is important to acknowledge the existence of the magic box but how much you put into it should be up to you. Pushing to maximize the magic box output will not necessarily maximize your overall happiness, throughout your life.

Where to Invest

They say there is no free lunch in investing but…taking advantage of tax deductions is a very close one. Before tackling any asset allocation question, any investor should first look at these opportunities; especially if you are young, because these deductions are usually capped at rather low amounts, so relatively speaking they deliver more returns when your salary is low.

They are important because to get an additional 1% of returns moving from one asset allocation to another requires either taking additional risk, either a lot of research (or both); tax savings can easily equal a 20%+ return (depending on your income tax bracket, if you get a full deduction or simply a tax defer, etc etc), a completely different ball-game that also requires a limited effort: you have to understand the rules once, or find someone to do it for you, and you are set…until your Government changes the rules again.

Usually, these opportunities come with investment constraints: an investment in a private pension can shield you from income tax but you have to invest with specific providers chosen by your Regulator, you cannot YOLO it on Interactive Brokers. So even if you designed the best Risk Parity portfolio ever, the chances you can use that strategy in a tax-shielded manner are slim. You might also incur liquidity constrains: invest in a pension fund but you can access funds only after you are XYZ years old.

The asset allocation has to be optimized for these constraints. For example, I do not have any issue with having my private pension 100% in stocks: I could be laid off tomorrow, starve to death and still could not spend those savings; considering that I am (still?) far from the XYZ date, stock volatility is a non-issue for me. I also know, after many years of dealing with financial markets, that I will not be spooked by a 50% drawdown in stocks.

The other pseudo-free lunch investors have is to keep fees at a minimum level. Any saving in fees equals an additional return, easy peasy. That said, lower fees do not always imply a better experience for EVERYONE. Consider the difference between using a robo-advisor that charges 0.8% and building your own portfolio on Interactive Brokers for zero. If you take the IB route, you have to choose the funds, the weights, do the rebalancing, etc etc; the cost is not the time it takes you to do it, 10 minutes a month if you are super efficient?, but the time you dedicate to learn and research your strategy. You could have used that time to get better at your job, for example. The cost opportunity is different for each of us; while I would always push anyone to have at least a basic financial knowledge, something that would allow building a simple robo-advisor-like portfolio independently, there are people that would prefer to run for 80km than to sit down and learn the difference between a stock and a bond. A robo-advisor, or even better a financial planner, would be the optimal choice for them, even if it comes with a seemingly higher up-front cost.

OK but what about the asset allocation?

A 1% difference in returns between two investment strategies is negligible over a short time horizon; compound the same difference for 40 years and you have two completely different results. This is the most used example to push for a 100% stock allocation for savers.

Unfortunately, reality is more complicated than that.

First, there is a lot of survivorship bias implied in that statement. US stocks worked great in the past 100 years but the same is not true for every country. Since 1970, the S&P500 compounded at 10.6 %/year while the MSCI World returned 8%. Using an “unbiased” benchmark will already lower the advertised advantage of stocks over everything else.

Still, 8% is comfortably above the c4.5% (depending on how the index is built) that a Global Government Bond investor would have gained in the same period.

Second, no investor knows how they will react when the market punches them in their mouth for the first (and second, maybe even third) time: reading about past drawdowns and having your life savings on the line while it happens is as different as watching a documentary about Mike Tyson and facing him on the ring. You might think you will be cool but…I do not think you should trust yourself ONLY because you did your research.

How you will react depends on the beliefs you have, which depends on who you decided to trust. Continuing to attend the Just Keep Buying temple in 2022/23 is easier when you saw this:

It is harder if the picture was like this:

In 2008 Nick Maggiulli would have had the same appeal as Jim Cramer has today. It does not matter what is right, it is really hard to stay sane when everyone else around you is going mad, especially if it is your debut at the party. You have to be humble enough to admit “you know nothing” and bold enough to declare “it is going to be fine”. I can tell you good luck with that, at least because I have been there.

Third, you do not know what are you gonna do with those savings. You are a 20 to 30something, remember? One day you swear you would lose a finger before losing your freedom, the next day you are moving to the other side of the world to follow the love of your life. Sure, you can say you will never touch your retirement pot and then…life happens again. Yes but I already have an emergency fund, a new car in 5 years fund, a maybe I’ll buy my first apartment fund, so there is no risk of having my retirement savings 100% in stocks. Well, all of this means you are already not 100% invested in stocks 😉

All of this is simply to say that the stocks all-in should not be the no-brainer many sell you, that’s it. You do not marry your initial asset allocation either. Nothing prevents you to dial up the risk as you go and learn. Or (god forbid) use a bit of leverage to play catch-up once you know what you are doing. I understand the purpose of showing how wealth compounds when stocks are involved; I think there should be at least an asterisk next to it.

Also, “I do not have all the answers” (but I understand how silly it is to link a scene from a movie that probably makes sense only to my generation in a post for young lads).

Also, after the infamous Odd Lots podcast episode with Matt Levine and SBF, I imagine 99% of readers thought this post would have been about something else.

What I am reading now:

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