132: Modular Financial Planning 10: Portfolio Optimizers

Working Edit

[00:00:00] Intro: Do you think money takes up more life space than it should? On this show, we discuss with and share stories from artists, authors, entrepreneurs, and advisors about how they mindfully minimize the time and energies. Spent thinking about money. Join your host, Jonathan DeYoe, and learn how to put money in its place and get more out of life.

[00:00:33] Jonathan DeYoe: Hey there. Welcome back to Mindful Money. We are in the final stage of describing the Mindful Money Modular financial planning process. Next week we’re gonna be back to some interviews. If there’s anyone you’d like me to bring on the show or any topic you’d like us to cover, please let us know. I.

[00:00:47] Jonathan DeYoe: so last time we talked about, , how to invest all your portfolios, both retirement and taxable in the simplest way possible without requiring any specific market or economic knowledge.

[00:00:57] Jonathan DeYoe: We talked about the three most important elements of portfolio [00:01:00] design, asset allocation, diversification, and rebalancing. We discussed the two ways the market are gonna test us, , envy and fear.

[00:01:09] Jonathan DeYoe: Today I wanna talk about a few portfolio optimizers. Now these are totally unnecessary if you have a very simple, , properly asset allocated portfolio that’s broadly diversified, , and you’re rebalancing on a regular basis, , as long as you’re saving enough into it and investing , in this process, then.

[00:01:28] Jonathan DeYoe: doing everything you need to do, this will get you there. This will get you to enough. So the items we’re talking about today might each add a little bit to your long-term returns, but that may not be worth it due to sort of the complexity they might create. I. If you’re using an advisor, I would expect that they would be incorporating these items for you for sure.

[00:01:46] Jonathan DeYoe: , if you ask your advisor and they’re not thinking of these, then you may wanna find a new advisor. I’m happy to raise my hand and introduce you to someone on my team if that’s the case. So this episode is the 10th in our 10 part series, covering everything you need to [00:02:00] know about creating or being on your own modular financial plan.

[00:02:04] Jonathan DeYoe: So at some point in the planning process, if you’re a. Do it yourself. Modular financial plan like this one, , that we’re talking through in this series, or a comprehensive lifetime cash flow plan you might create with an advisor, a person might ask. I. Am I doing enough? Or when is it enough? So we could always find a reason to stress a bit more, , decide that there really is something else additional for us to do.

[00:02:29] Jonathan DeYoe: So the question of how much is enough, you know, worrying and stressing, and how much action becomes, , this is a common issue. If you’ve come this far down the list of these items, , to take care of your personal financial life. If you’ve implemented the prior nine steps, you are already doing enough.

[00:02:47] Jonathan DeYoe: If you’ve completed the prior nine, , you understand what matters. You’ve developed your vision. You’ve started the savings habit. You’ve built your emergency fund, you’ve eliminated a high interest debt. You’ve begun , investing for retirement. , you’ve paid down low interest debt.

[00:02:59] Jonathan DeYoe: You’ve [00:03:00] started investing additional, , funds in a taxable portfolio, and you’ve implemented simple, basic, mindful investing. Seriously, this is enough. What we’re talking about now are just little optimizers, little tweaks to enhance your outcomes modestly over time. These are all just a little bit extra work or costs or just a little bit extra boost in long term outcomes.

[00:03:20] Jonathan DeYoe: So there’s a handful of additional investment knowledge that’ll help you earn a little bit better returns and keep more of your returns. These are the portfolio optimizers we’re talking about. When correctly put into action, they can increase. The probability of achieving your goals and sooner. So the five optimizers I wanna introduce are, you know, first we’ve talked about this a couple times, maintaining low cost, second managing taxes.

[00:03:43] Jonathan DeYoe: Third, there’s these factors of performance, , or return premiums that we’ll talk about. Fourth is securities lending, and then fifth is flexible trading. So first. Reduce your expenses, and we’ve already touched on this a lot, but it is so important. It bears [00:04:00] repeating here. The fees you pay for transactions, for the tools you use for advice, et cetera, cause an instant reduction in portfolio size and reduce all future compounding on that small size of your portfolio.

[00:04:14] Jonathan DeYoe: Repeat this annually, and this becomes a very large reduction in portfolio. You have to pay some fees. You’ll choose to pay some others, but be aware of the total costs and choose wisely.

[00:04:24] Jonathan DeYoe: So I built a little cost of an advisor calculator that you can use to review the long-term costs of working with someone.

[00:04:31] Jonathan DeYoe: One-on-one. It can’t tell you whether it’s worth it for you, but it can tell you, you know how much it might cost and put you in a better position for answering the, is it worth it? Question for yourself. You can find that calculator free on the resources tab of Mindful Money, , on our website. So for Mindful Money members, there’s a list of securities in the members area that I use that fulfill all of last week’s portfolio design decisions and our low cost.

[00:04:57] Jonathan DeYoe: You can find that same list in the back of my book, mindful [00:05:00] Investing.

[00:05:00] Jonathan DeYoe: And then the second optimizer is tax management. So portfolio optimization isn’t about maximizing what you earn. But maximizing what you keep. The largest most persistent investment cost is taxes. Though taxes are inevitable, there are several ways to minimize the tax bite on your portfolio.

[00:05:22] Jonathan DeYoe: First, choose the right fixed income. If you’re in a higher tax bracket, make sure you’re looking at after tax yields, You will likely want to use tax free municipal bonds, and if you’re in a state with a high income tax like New York or California, you want to focus on local municipal bonds.

[00:05:39] Jonathan DeYoe: Second, whenever possible, avoid short-term investment decisions. Short-term gains. Gains taken within one year of making the investment are subject to ordinary income taxes. Long-term gains receive more favorable capital gains tax treatment if you must take gains. Look to take [00:06:00] long-term gains. Third, harvest your losses.

[00:06:03] Jonathan DeYoe: You owe the IRS only on your net capital gains. So by harvesting losses when you have them, you are offsetting gains and reducing your taxes. You may not take gains every year, but you should always be on the lookout for losses you can capture because you can carry them forward and apply them to future tax years.

[00:06:22] Jonathan DeYoe: Fourth. This gets a little bit more complex, but consider asset location. Some types of investments spin off more taxable income or require more frequent trading. These investments are best suited for tax advantaged accounts, IRAs, and other retirement accounts. If you place your buy and hold low income, creating investments in taxable accounts and your more active high income creating investments in a non-taxable account, you will reduce your tax burden overall.

[00:06:53] Jonathan DeYoe: Fifth, definitely utilize tax advantaged accounts like IRAs, Roth IRAs, , health savings [00:07:00] accounts, 4 0 1 Ks, 4 0 3 Bs, et cetera. If you have a consistent high income, consider a cash balance plan.

[00:07:07] Jonathan DeYoe: Finally, as you build and save into your different portfolios, you should consider tax bracket arbitrage. In retirement?

[00:07:14] Jonathan DeYoe: Pensions and social security kick in and . We fill the gap between our expenses and these fixed income sources from our portfolios. So we have a choice about which accounts in our portfolios we draw from. And that choice has an impact on our taxes for the year. So make sure you are withdrawing from the right place relative to your tax bracket.

[00:07:37] Jonathan DeYoe: Use your taxable withdrawals, traditional IRAs and 401ks and your non-taxable withdrawals, HSAs and Roths strategically to stay in lower tax brackets.

[00:07:48] Jonathan DeYoe: So the third optimizer, this can get kind of technical, it’s these investment factors or return premiums. So we’ve already touched on the first broadly accepted [00:08:00] factor or premium , , , this is the equity risk premium.

[00:08:05] Jonathan DeYoe: So put simply, equities have a higher expected return than bonds. Given stocks long-term average of 10 to 11 percent or seven to eight percent after inflation and bonds, a long-term return of five to 6%, or two to 3% after inflation. It should be obvious that the more of the 10% stuff you own relative to the 5% stuff, the better your long-term returns will be, even if your short term.

[00:08:30] Jonathan DeYoe: Outcomes vary widely. So owning equities or as I like to say again, shares in the great companies of the US and the world, provides a premium return relative to owning bonds. The cost of owning equities is the variability of their short-term returns. The longer you hold them, however, the higher the probability that you will ultimately outperform.

[00:08:51] Jonathan DeYoe: The equity risk premium is not the only available premium in equity investing. In 1992, Eugene Fama and Ken French published a paper [00:09:00] that added two additional risk premium factors, the size factor and the value factor. What they discovered is that a broadly diversified portfolio. Tilted towards smaller companies, didn’t exclude large companies, but tilted more heavily towards smaller companies and or companies that had, , a higher book value relative to their market price tended to outperform over long periods of time.

[00:09:24] Jonathan DeYoe: The three factors became known as the Fama French three factor model. So, , equity risk, premium, small cap factor, and the value factor. That was the Fama French three factor model. And then 20 years later, this is in 2014, the payer added a fourth and fifth factor to their model.

[00:09:44] Jonathan DeYoe: The research discovered the profitability factor and the investment factor. They determined that companies reporting higher future earnings. Have higher returns in the stock market, and then companies who reinvest their profits in future growth. , the [00:10:00] projects that produce future growth tend to have higher returns in the stock market as well.

[00:10:04] Jonathan DeYoe: So their model was subsequently renamed the Fama French. This is genius, right? Five factor model. So there have been hundreds of potential factors that academics have researched to find an edge in investing. There have been thousands of investing products that have been created to capture the additional potential return of this cornucopia factors.

[00:10:23] Jonathan DeYoe: If you decide to take advantage of factors, you’ve gotta be careful. There’s a lot of options out there. Most of these options over promise and then probably under deliver in my book. Which is right out of dimensional’s playbook. , a factor is only investible. If it is persistent. It must work over long periods of time across , different, , periods of investing.

[00:10:45] Jonathan DeYoe: It must be pervasive, meaning it’s gotta work across geographies and sectors has to be investible, which means, , it’s gotta work in markets after we consider costs, not just on paper. It has to [00:11:00] be intuitive. It’s gotta make some kind of a rational sense as to why that premium might exist, and it has to be robust.

[00:11:08] Jonathan DeYoe: , has to work for multiple similar definitions. So a factor that cannot claim all five is not a fact that I would invest in to be safe. You know, I stick with the Fama French five factor models and I ignore most of the rest. , I believe. Though I can’t prove that these factors will generate above market returns over time, and I invest my own portfolios along these lines.

[00:11:32] Jonathan DeYoe: I do it personally using dimensional funds and Dimensional ETFs. They’re a little bit more expensive. I think the value is there. So when you rely on these factors, you can increase the probability of higher returns. However, they will go in and out of favor, which is why it can be extremely difficult to follow this strategy for the long term as you work towards your goals.

[00:11:53] Jonathan DeYoe: No matter what diversified portfolio tools you use, there will be periods where different diversified [00:12:00] portfolios, , different tools than the ones you chose are outperforming yours and you will feel the pull to change. You must fight this urge. I use the factors because the academic research says they work over long periods of time, even while they fail over some shorter periods of time.

[00:12:17] Jonathan DeYoe: I know at the outset there will be periods where I feel stupid because one or a number of these factors will be out of favor and I will not be keeping up with a similarly indexed benchmark. It is on me in those moments of underperformance to remain faithful to their research and patient for the long term to arrive.

[00:12:36] Jonathan DeYoe: If this sounds insane to you, where you know you can’t, , hold while things around you are doing better, then factor investing may not be for you. It’s not a good idea. Instead, just stick with your portfolio of global indices again. That’s good enough.

[00:12:48] Jonathan DeYoe: The fourth thing, and we’re gonna add a little bit of complexity here just in understanding of how markets work.

[00:12:53] Jonathan DeYoe: Securities lending. So securities lending is the practice of loaning out securities for a short period of time [00:13:00] in exchange for both collateral. And fees. It’s a common strategy among investment managers that can enhance an investment portfolio’s return. If you invest in individual securities, then you likely give your broker dealer or your custodian the right to lend your securities to institutional borrowers and collect the collateral in fees which they likely keep for themselves.

[00:13:22] Jonathan DeYoe: If you own individual equities and wish to benefit directly from securities lending, then you should look into your broker dealer, custodian’s fully paid lending program if they have one. If they don’t, you might want to consider a different broker dealer or custodian. Because of their broad holdings and modest trading activity.

[00:13:40] Jonathan DeYoe: Index and index, like mutual funds and exchange traded funds are primary sources for securities loans in most cases. If you wish to benefit from securities lending, the best way to do so is by owning mutual funds and ETFs active in securities lending. This is especially true among funds that strive for maximizing revenue for shareholders.

[00:13:58] Jonathan DeYoe: I think of. [00:14:00] Vanguard and dimensional funds , or DFA, , that additional revenue can offset investment costs, leaving more of your money working towards building wealth. , in rare cases, there’s actually enough securities lending revenue to pay all the costs and actually fund to add a little bit more oomph in return to your mutual fund, your ETF and kinda a small way adds to your total return.

[00:14:18] Jonathan DeYoe: Finally, I actually think flexible trading is important. Now, this is gonna sound like , I’m choosing non index , and maybe it is, a little bit. So in addition to the costs associated with trading, there’s also opportunity.

[00:14:33] Jonathan DeYoe: So flexible trading is a strategy that allows you to lower the former and increase the latter, right?

[00:14:39] Jonathan DeYoe: So you reduce the cost of trading you increase the opportunity of trading with flexible trading. So millions of trades are executed in the markets every day between buyers and sellers. Each person is seeking prices that are not always aligned. If you execute a trade immediately without consideration of those price differences, you risk buying too high or selling too [00:15:00] low Funds that can be guilty of that are those that need to adjust their holdings on schedule to stay consistent with the markets. They’re known as index funds. So with a more broadly diversified portfolio focused on reducing turnover, you adopt a more flexible and patient trading strategy for all the investment factors mentioned above.

[00:15:19] Jonathan DeYoe: For instance, there’s going to be many stocks with similar expected returns, so they can be viewed as interchangeable in the short term. If you’re not needing to trade a particular stock on a particular day, you have the option to trade whichever one provides the biggest price advantage. This more dynamic portfolio management approach can lead to higher expected returns and lower costs over more fixed or rules-based portfolios, again, index portfolios.

[00:15:47] Jonathan DeYoe: So just to put this in a little bit more context, when you own an index and that index changes it reconstitutes, then , everyone that builds a portfolio based on an index has to make the change at the same time. And , that [00:16:00] has to make is non flexible trading. So that’s what we’re talking about.

[00:16:04] Jonathan DeYoe: Again, just as we mentioned, , at the outset, none of these five optimizers are necessary. If you’ve completed the prior nine steps, you are already way ahead of the game and likely well on your way to personal financial independence. Each of our five portfolio optimizers requires a little extra work and research to understand and implement, and each provides an additional opportunity to earn an incrementally tiny, higher net total return.

[00:16:28] Jonathan DeYoe: Add them, don’t add them. It’s entirely up to you. And if you have faithfully completed the first nine steps and you don’t wanna do anymore. Just know that you’ve done enough. If you’re working with a professional advisor, then they should be doing all or most of these things on your behalf. , if you don’t know whether they are or not, ask If they aren’t, you know, you can do a little bit better.

[00:16:52] Jonathan DeYoe: If you want a second opinion, don’t hesitate to reach out, , to me through the Contact us button on the Mindful Money website. Simply select looking for [00:17:00] a wealth advisor from the dropdown and write second opinion in the questions box, and I’ll be back to you within 48 hours.

[00:17:06] Jonathan DeYoe: As always, thanks for listening.

[00:17:07] Jonathan DeYoe: This concludes the entire 10 part modular financial planning process. Next week we’re gonna return to our regular interview format for the Mindful Money podcast. Thanks for being with us for the entire program.

[00:17:18] Outro: Thanks for listening. Full show notes for each episode, which includes a summary, key takeaways, quotes, and any resources mentioned are available at Mindful Money. Be sure to follow and subscribe wherever you listen to your favorite podcast. And if you’re enjoying the content and getting value from these episodes, please leave us a rating and review ratethispodcast.com/mindfulmoney. We’ll be sure to read those out on future episodes.