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Are you over complicating your finances
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in retirement? Or are you maybe making
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things too simple? That's the theme on
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today's Ask Me Anything episode,
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including some interesting new ideas I
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learned during my research about optimal
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portfolio rebalancing strategies. Stay
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tuned. Welcome to Personal Finance for
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long-term investors, where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life. Every episode teaches you personal
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finance and long-term investing in
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simple terms. Now, here's your host,
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Jesse Kramer. Welcome to Personal
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Finance for Long-Term Investors, episode
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138. I'm Jesse Kramer. I'm a financial
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planner working with retirees and busy
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professionals thinking about retirement
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across the USA. You can learn more at
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planwithjesse.com.
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Yes, that's a new web page for those
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avid listeners. Planwithjesse.com.
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Today is our 16th AMA ask me anything
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episode. Before we dive in though, this
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week's super soft t-shirt winner is
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Growing the Valley podcast, who left a
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five-star rating and review on Apple
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Podcast. So, hey, Growing the Valley,
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thank you for the kind words. Please
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drop me an email to
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so I can get that supersoft t-shirt sent
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out to you. Now, on with the ask me
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anything episode. As a reminder, these
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are real questions from listeners just
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like you. So, please don't hesitate to
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email me a question to the email address
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jessebestinterest.blog.
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Again, Jesse bestinterest.blog. I read
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every single email that you guys send.
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Now, a few questions I've gotten over
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recent months reminded me of the the
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Einstein quote. Everything should be as
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simple as possible, but no simpler.
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That's the theme of today's episode. I
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truly think financial planning and
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investing and retirement planning is
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usually often over complicated
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especially in the DIYer world and the
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online forums where I I'll see arguments
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erupt about 3/100ths of a percent as a
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fee or whether small cap value is a
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mandatory requirement in your portfolio
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or not. I've seen groups of people kind
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of plant themselves on topics like
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social security where they say, "Hey, if
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you don't claim as early as possible,
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you're a moron." And they are opposed by
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people who plant themselves on the other
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side who say, "If you don't delay social
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security until you're 70, well then
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you're a moron." So anyway, my point is
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that a lot of people have strong
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opinions, strongly held, and sometimes
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there is complexity involved. But I do
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think something I see more often than
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not is over complexity. So yes, you
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know, retirement has its complexities,
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but we can simplify it. at least we can
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simplify it to a certain point because
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you know maybe there is 10 or 20% of the
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ideas that I hear where I feel like
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those ideas might be too simple or too
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easy. So anyway, the last thing I'll say
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in this preamble is I realize that yeah,
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there's some subjectivity to this idea
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that I'm talking about today. And and
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what I'm kind of saying is there's a
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line in between too complex and too
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simple. And I am subjectively drawing
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that line here today. Fair enough. I
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won't deny that fact. So, if you think
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I've drawn the line in the wrong place,
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feel free to call me out by sending an
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email to jessebinest.blog. I'd love to
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read your email. And we're going to dive
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into question one right now from Wes.
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Wes says, "Jesse, I appreciate the
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podcast and the blog content that goes
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beyond personal finance 101. Speaking of
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complex things, I have a question about
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generating investment losses to offset
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appreciated assets or the income from a
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Roth conversion. My adviser has been
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talking about a long short strategy that
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I'm researching. However, I was thinking
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I could either short a stock I think
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will go up, risky, or simply buy a
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leveraged ETF, less risky, that is the
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inverse of the S&P 500. It seems like a
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simple strategy, but I don't see much
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content out there about this. So, I'm
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guessing I'm missing some pitfalls. Can
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you give me some input? I Yeah, thanks
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for the question. Very interesting
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question. Now, normally I would kind of
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dive into all the details behind your
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question first. I'm going to do it
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slightly out of order listeners in this
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question, but don't worry, you will get
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an understanding of exactly what Wes is
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asking here, but I'm I'm going to paint
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a little picture first. Now, let's say
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you've invested money in the past and
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you've got $10,000 in capital gains,
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which you haven't realized yet. But when
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you do realize it, we'll be subject to a
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we'll say a 15% capital gains tax. So,
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you'd owe $1,500 in tax. But then, let's
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say you pursue a strategy, maybe similar
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to a strategy that Wes is outlining
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here, that creates $10,000 in capital
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losses. those losses offset the entire
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gain, eliminates the tax, and you're
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thinking to yourself like, "Nice, you
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just eliminated $1,500 in tax." However,
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we kind of glossed over the fact that
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you just generated $10,000 in losses.
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So, the $10,000 in losses totally wipe
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out the $10,000 in gains, and you no
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longer actually profited from your
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investment. The losses offset, wipe out
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the gains. So, the question is, would
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you rather have $10,000 in gains and and
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pay $1,500 in taxes or have no gains
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whatsoever? I would take the first
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scenario every day. You know, why lose
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$10,000 to save $1,500? Now, what I've
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just painted there is a very, very
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simple scenario. And most of the
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strategies that professionals are going
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to use are certainly more nuanced and
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yes, more complex than what I've just
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outlined. Now, what they hope to do is
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create some losses and some gains. The
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losses are going to be realized, but the
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gains will be unrealized. In other
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words, the assets that are sitting at a
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loss, the professionals will sell those
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assets so that you, the investor,
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actually have losses that appear on your
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tax return. But the gains, they say,
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we're not going to sell those assets.
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We're going to hold on to them because
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the whole point here is that we want to
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we want to wipe taxes away. We don't
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want to create more taxes for you. So,
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we are not going to realize the gains,
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at least not yet. So your realized
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losses can be used to lower this year's
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tax bill, of course, which is nice.
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Those new unrealized gains, we kick them
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down the road to a future tax year. We
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don't have to pay taxes on the
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unrealized gains, at least not yet. So
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the question becomes, will we ever have
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to pay taxes on the unrealized gains?
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And and that's why I think in some way
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whenever we're talking about these kind
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of capital gains, capital loss
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strategies, if the problem involves
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kicking the gains down the road to a
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future year, that's fine. But the truth
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is, you can't really ever outrun that
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tax problem except by dying. Yes, by
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dying. When you die, your taxable estate
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goes to your heirs at a what's called a
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stepped up cost basis. And it totally
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wipes out the capital gains and it
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totally wipes out what would have been
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your tax bill. And that brings about a
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little side note, brings about a funny
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little pattern in financial planning
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circles where we have to balance two
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competing ideas. that the first idea is
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that everyone will die someday and we
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must treat death as a reality, as an
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eventuality. But the second idea is that
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we need to be a little cautious about
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treating death as a win and treating
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living as a loss. And this scenario is
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one example. You know, sweet, you die
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with unrealized capital gains and your
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heirs get a big win. It's true, but
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you're still dead and you didn't get to
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spend that money of yours while you were
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alive. or another one. You claimed
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social security at 62 and that ended up
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being super smart for you because you
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died at 71 and age 71 is well before the
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break even age for delaying social
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security. So, it's a good thing you
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claimed early and got yours. Well, who
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are we talking to here? The dead
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71year-olds. I mean, did they really win
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the game? Another one. Oh, man. Jesse,
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you're you're wasting $2,000 a year for
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30 years on term life insurance. What a
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waste. Well, are you saying I failed
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because I'm surviving? So epicat the
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point here is that death is a a reality
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and eventuality for all of us eventually
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and I genuinely think there does come a
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time when for example we ought to
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prudently say should we realize you know
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capital gains for this ill sick
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87year-old or do we discuss the idea of
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their death because for that person if
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they're going to die soon does it make
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sense to realize capital gains right now
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yeah unfortunately at some point that
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conversation does become a reality but
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I'll get emails from a 55-year-old who
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thinks they're going to kick the can
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down the road on their highly
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appreciated tech stocks until they die
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30 years out, 40 years out in the
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future. So anyway, a funny little aside
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there. Let's go back to the main program
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here about this capital gains long short
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strategy, that kind of thing. So short
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of dying like we talked about though,
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what these sort of loss strategies
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attempt to do again is create some
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losses this year while not actually
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losing you money on net. Now for
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example, you know, Wes talks about a
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long short strategy in his question.
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these long short strategies. What
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exactly is going on here? Well, often
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what these strategies do is they use
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leverage, right? They use some form of
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borrowed money to give you extra
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investment exposure. It's a weird
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concept. Let me see if I can explain it.
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So, let's say you have $100 to invest,
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but on top of that, you borrow another
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$100 and that's the leverage. And the
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leverage comes with a cost to it, right?
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Borrowing money, taking a loan, that has
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a cost. And so, we'll put a pin in that
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cost for now, but you had a hundred of
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your own dollars and you borrowed a
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hundred more. So, you now have $200 to
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invest. and you choose to invest 150 of
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that into the S&P 500. If you want to
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get more technical, you're probably
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building a direct index of the S&P 500
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by owning all 500 companies. But either
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way, you have $100 invested in the S&P
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and that's long, right? In investment
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world, when you're betting for
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something, that's considered long. When
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you're betting against something that's
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considered a short, like the big short.
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So anyway, this is a long short
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strategy. $150 is invested long in the
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S&P and then you take the remaining $50
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you have and you short the S&P 500. Yes,
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in some way you are betting against
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yourself, but on net though you have
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$150 long and you have $50 short. So
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your net exposure is $100 long. In other
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words, you have the same investment
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exposure as if you had only invested
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your own $100 in the S&P 500. Right?
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Even though you you have that borrowed
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money, you're actually not taking any
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extra investment risk with it. You're
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not doing anything super risky, but you
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know that in most years, at least some
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part of your portfolio between the 150
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long and the $50 short, at least one of
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those two parts is going to be at a
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loss. Or if you went the direct indexing
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route, you know that some of your
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individual holdings, some of those
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individual companies are definitely
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going to lose money on an annual basis.
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So, let's say some of your shorts lose
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money, you sell them. Those losses can
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then be used to offset other gains from
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your portfolio. They can be used to
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offset the taxes from Roth conversions,
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which would be an income tax or other
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forms of income tax. The point is that
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you can use your losses to offset taxes.
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And your adviser, Wes, would likely say,
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"Hey, and you didn't actually lose any
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money because your longs are up. The
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longs have these unrealized gains that
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more than make up for the shorts losing
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money." That's a totally factual
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statement. The question is, and I'll go
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into this in more detail, the question
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is, would you have been better off just
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being 100% long in the first place and
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not dealing with any of the losses in
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the first place? I'd wager, at least for
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a lot of people, the answer there is
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yes. So, in my experience, the best
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strategies for using any sort of kind of
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capital losses to offset gains, it
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occurs when the losses are incidental,
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not when the losses are purposeful. And
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not all of us in our investing lifetime
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are going to have those incidental
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losses in our lives, let alone on a on
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an annual basis. And that's totally
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okay. In other words, what I'm saying
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here is for some people, your portfolio
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will do nothing but go up. Or at least
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it'll go up so much that by the time it
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goes down, you're still up. You're not
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below where you started because your
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portfolio has grown so much since the
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start. So if you find yourself in this
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situation, that's not a bad thing. Your
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portfolio is up. So sometimes you might
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get some incidental losses and you can
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use those incidental losses to offset
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capital gains to offset some income
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taxes. That's great. But one of the big
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questions I have is should we let the
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tax tail which might be a 15% tax tail
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wag the investing dog which is going to
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be 100% of the underlying money right
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the investments themselves. Now direct
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indexing has all the same issues. You
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know this strategy what I should say a
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long short direct indexing strategy has
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all the same issues as all direct
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indexing strategies which we discussed
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on episode 121. You know those issues
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are higher costs some tax pitfalls
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especially when it comes to the wash
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sale rule tracking error against the
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index diminishing benefits over time
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asset minimums. Only relatively wealthy
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people can even begin to participate in
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these strategies. And then it only
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applies to taxable accounts here. Right?
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None of this applies to retirement
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accounts cuz those are all qualified in
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the first place. There aren't gains,
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capital gains. There aren't capital
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losses inside of a retirement account.
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But the diminishing benefit over time is
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a really big one, Wes, that I want to
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focus on. A lot of these strategies
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require forever maintenance because if
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you recall, you're not really making the
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capital gains totally disappear. When
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your direct index, if one side of your
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long short portfolio is kicking off
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losses, the other side is creating
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unrealized gains. And so to liquidate
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this direct index long short portfolio,
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you would have to realize all those
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gains and that flies in the face of what
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you're trying to accomplish in the first
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place. Who would do that? So what ends
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up happening is you're going to have to
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maintain this this strategy for a long
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time. But the costs of a direct index
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portfolio or the costs of a long short
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portfolio where there's some some
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leverage, those costs will still be
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there for a long time. So if you're
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choosing to pursue one of these
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strategies, I think it's important to
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look at what your tax savings might be,
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you know, this year, next year, and
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other high tax years, totally important
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to look at that. And it's important to
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see how much in losses your portfolio is
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going to generate because as long as
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markets generally go up over time, the
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fact is you will have fewer and fewer
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losses as time goes on. We call that
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loss decay or tax alpha decay. And then
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you're going to need to measure against
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that how much indirect index fees you'll
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expect to pay not just this year, not
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just next year, but for decades. And it
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probably does feel amazing. It is
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amazing that an investor who pursues the
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strategy might get 3% or 4% in tax alpha
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or in extra performance that comes from
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saving so much money on taxes, but
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eventually that tax alpha will drop to
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zero and the fund is no longer creating
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any sort of meaningful losses for you to
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use. And even if it was, you might not
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be in a tax situation anymore to use
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those losses, but you're still paying
00:13:54
half a percent, 3/4 of a percent, 1% per
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year. And so the tax alpha that you got
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when you first started the strategy is
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slowly getting eaten away by the much
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higher than normal fees that you're
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paying. And the people who use the
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strategy, quote unquote, the best the
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best candidates for this strategy, I
00:14:09
should say, are not, you know, the
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late60s retirees. They're people in
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their 40s and 50s. They're the higher
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earners in the best years of their
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careers. They're getting paid maybe an
00:14:19
equity compensation from a publicly
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traded company. These are the people who
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might have to hold that direct index
00:14:24
long short strategy for 40 or 50 more
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years less they want to realize all the
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capital gains that they avoided in the
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first place. But holding the strategy
00:14:33
for 30 or 40 or 50 years as I just
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identified has its own big problems. So,
00:14:37
in summary, I have some serious
00:14:39
reservations about this strategy, and I
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think for the vast majority of people
00:14:42
out there, including many of the
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wealthier people who might be listening
00:14:45
right now, I'd be cautious here. As
00:14:47
Einstein said, this is not as simple as
00:14:49
possible. Thank you for the question.
00:14:51
Uh, Wes, here's a quick ad and then
00:14:54
we'll get back to the show. I love
00:14:56
getting your questions and some of you
00:14:57
ask me questions about the wealth
00:14:58
management firm I work for in Rochester,
00:15:00
New York. Others ask about the best
00:15:02
interest blog and this podcast, Personal
00:15:03
Finance for Long-Term Investors, which
00:15:05
operate without advertising, without
00:15:06
pushy sales, and with no pay walls. How
00:15:09
can the blog and podcast stay afloat
00:15:10
without me dumping my own money into it?
00:15:12
Well, to answer both those questions, I
00:15:14
want to point you to episode 78 of
00:15:16
Personal Finance for Long-Term
00:15:17
Investors. I intentionally recorded
00:15:19
episode 78 to shine light on those
00:15:21
topics and inform you how you are
00:15:22
actually helping and can continue
00:15:24
helping these projects carry forward.
00:15:26
So, if you've ever been curious about
00:15:27
the business of my blog and podcast, or
00:15:30
if you're curious about my day job in
00:15:31
wealth management, please check out
00:15:33
episode 78 and let me know what you
00:15:34
think. And now on to question two from
00:15:36
Cliff. As I get closer to my retirement,
00:15:38
I wonder how long my retirement savings
00:15:40
will last. My wife has some of her IRA
00:15:42
with a trusted broker who is suggesting
00:15:45
a 5% withdrawal rate. She asked how long
00:15:47
it will last and he said likely forever
00:15:49
because it should return 8% on average
00:15:51
and we would only be taking 5%. Do you
00:15:54
agree with this, Cliff? Thanks for the
00:15:56
question. And I believe the explanation
00:15:57
that this broker suggested to your wife
00:15:59
is on the too simple side of things. It
00:16:02
is too simple. After all, if we use the
00:16:04
broker's logic, if it's returning 8% on
00:16:06
average, why can't your wife withdraw
00:16:08
7.9% per year? I think the same logic
00:16:11
ought to apply, right? 7.9 is less than
00:16:13
8 and that should probably last forever,
00:16:15
too. So, there's a problem there. Let me
00:16:17
try to add a little bit of nuance to
00:16:19
what the broker said. I think what the
00:16:20
broker should have said is history would
00:16:23
suggest that your portfolio will return
00:16:24
8% per year on average and therefore
00:16:26
most of the time you could easily
00:16:28
withdraw 5% per year, maybe even a
00:16:30
little more and be totally fine.
00:16:32
However, this simple framework overlooks
00:16:35
a really important fact, which is that
00:16:37
the earliest years of your retirement
00:16:38
matter the most by far. If the early
00:16:41
years have very bad investment returns
00:16:43
for you, it creates this chain reaction
00:16:45
that affects the rest of your retirement
00:16:47
timeline. We call this the sequence of
00:16:49
returns risk. And in order to mitigate
00:16:51
that risk, we recommend planning your
00:16:53
withdrawal rate in the four to 5% range
00:16:56
at least to start and then we can
00:16:58
revisit that withdrawal rate over time.
00:17:00
Now, that's obviously a longer, more
00:17:02
complex statement than what the broker
00:17:04
said, but if the broker had said
00:17:05
something like that, I think it would
00:17:07
have been much closer to the truth. If
00:17:09
you look at how the 4% rule was
00:17:10
originally created, what you see is that
00:17:12
in more than 50% of historical
00:17:14
scenarios, we actually could have
00:17:16
withdrawn more than 6% per year. We
00:17:18
could have used a 6% rule adjusted up
00:17:20
for inflation every year and been
00:17:22
totally safe. In fact, in some
00:17:24
scenarios, you could have withdrawn more
00:17:25
than 8% per year and been totally safe.
00:17:28
But in the worst scenario, in the back
00:17:30
testing, you could only withdraw 3.9%
00:17:33
per year to avoid depleting your
00:17:35
portfolio. And again, that's with all
00:17:36
the 4% rule, Trinity study assumptions
00:17:38
of a 50/50 portfolio and etc., etc. We
00:17:41
won't get into all those details on this
00:17:42
episode. The point is that we draw the
00:17:45
line at 4% because in one of the 100
00:17:48
back tests, 3.9% was the place where it
00:17:52
failed. So that's why we draw the line
00:17:54
at 4%. And I think the question is,
00:17:56
should you let that one worst case
00:17:58
scenario define your retirement? And and
00:18:01
one of the big problems is just that
00:18:02
there's so much luck of the draw, right?
00:18:04
someone who retired in the early 1980s
00:18:06
and if you're not, you know, a student
00:18:08
of market history, a big bare market and
00:18:11
kind of the stagflationy7s
00:18:13
which were really bad that really ended
00:18:15
in in about 1982. Starting in 1982 was
00:18:19
what some people consider and and kind
00:18:20
of if you look at the numbers might be
00:18:22
the best bull market of all time. 1982
00:18:24
through 1999 stopped by the uh internet
00:18:28
bubble. And you could also point to
00:18:30
maybe like March of 2009 through today
00:18:32
as being another one of the greatest
00:18:34
bull markets of all time. Anyway, if you
00:18:35
retired in the early 1980s, you could
00:18:37
have lived your entire 30-year
00:18:38
retirement withdrawing more than 8% per
00:18:41
year adjusted each year for inflation,
00:18:44
right? They could have retired and and
00:18:45
think about that. The 4% rule means you
00:18:47
have to save 25x your portfolio. Well,
00:18:50
this particular retiree who retired in
00:18:52
the early 80s, they could spend more
00:18:54
than 8% per year. They could have
00:18:55
retired with only 12 times their annual
00:18:58
spending saved in their portfolio. They
00:19:00
don't need 25x. They only needed 12x.
00:19:03
But someone in the same circumstance as
00:19:04
retiring in the mid60s, they, as I
00:19:07
mentioned before, that was the the worst
00:19:08
case scenario. They could have only
00:19:10
withdrawn 3.9% per year and would have
00:19:13
needed the full 25 times their annual
00:19:15
spending to retire. And that's a massive
00:19:17
difference in how much you need to save
00:19:18
to retire. And it's solely due to, in
00:19:20
this case, the good or bad luck of
00:19:22
timing. So, here's my personal
00:19:25
recommendation or personal solution for
00:19:27
how to think about this problem. I think
00:19:28
you can use the true 4% rule as a
00:19:31
starting point, but only a starting
00:19:32
point because that 4% rule creates a
00:19:34
conservative bookend that kind of limits
00:19:37
one side of what your retirement might
00:19:38
look like. If you want an easy, but
00:19:41
admittedly still flawed, rule of thumb
00:19:43
to be a little more optimistic, it's
00:19:44
that a 5% withdrawal rate has been safe
00:19:47
in most historical scenarios. that a 6%
00:19:50
withdrawal rate has been safe for about
00:19:52
half of historical scenarios. And
00:19:54
obviously your specifics matter a lot
00:19:55
here. And I think if you're willing to
00:19:57
be flexible, specifically by decreasing
00:19:59
your spending during poor market
00:20:01
periods, then you're probably going to
00:20:03
avoid many of the bad outcomes that come
00:20:06
from higher withdrawal rates. When you
00:20:08
hear about the 4% rule, the 5% rule, the
00:20:10
6% rule, when you hear people like me
00:20:12
describing them to you on a podcast,
00:20:14
that particular retiree in the
00:20:16
simulation, so to speak, never adjusted
00:20:18
their spending once, right? There are
00:20:21
people, and there were investment
00:20:22
markets where the market was down 30%,
00:20:24
their portfolio was down, you know,
00:20:26
whatever, if they're if they're
00:20:27
halfinvested in stocks, their portfolio
00:20:29
might have been down 15 or 20%. Maybe
00:20:31
they lived through the.com bubble. Maybe
00:20:33
they lived through the great financial
00:20:34
crisis. Their stock side of their
00:20:36
portfolio was down 50%. And they never
00:20:39
once adjusted their spending. Now,
00:20:41
that's probably not realistic, right?
00:20:43
Most of you, most of us are going to
00:20:44
adjust your spending. So, that's why I
00:20:46
say if you're willing to be flexible,
00:20:48
specifically by decreasing your spending
00:20:49
during poor market periods, you'll
00:20:51
surely avoid many of the adverse
00:20:53
outcomes that come from higher
00:20:54
withdrawal rates. And then ultimately,
00:20:56
if you want precision, which many people
00:20:58
do, then your unique retirement
00:21:01
attributes and really what I think about
00:21:03
here is your unique kind of spending
00:21:04
profile over your retirement has to be
00:21:07
used to hone in on a better answer for
00:21:09
you. So again, because the 4% rule is
00:21:12
kind of based on some really rigid
00:21:13
inputs that went in to create it, we
00:21:15
need to add some flexibility to those
00:21:17
inputs. So what I think we should do
00:21:18
there is you should say, what exactly
00:21:20
does safely spend mean to you? How will
00:21:23
your spending change from year to year
00:21:24
throughout your retirement? How is your
00:21:26
portfolio allocated among different
00:21:28
assets? Because 4% rule is just 50%
00:21:30
stocks, 50% bonds. How long will your
00:21:32
retirement last? The 4% rule is based on
00:21:34
a 30-year retirement. Maybe your
00:21:36
retirement is going to be different.
00:21:37
What does inflation look like during
00:21:39
your retirement period? I realize that's
00:21:41
impossible to know, but inflationary
00:21:43
assumptions are extremely important for
00:21:45
any kind of projection, retirement
00:21:46
projection, especially over multiple
00:21:48
decades. And then of course, what will
00:21:50
investment returns look like during your
00:21:51
retirement? Again, impossible to know in
00:21:53
advance. But what is very uh easy to
00:21:56
find out and what I think we all need to
00:21:58
find out is basically if I spin the
00:22:00
dial, if I dial up or dial down
00:22:01
inflation, if I dial up or dial down
00:22:03
investment returns, how does that affect
00:22:06
my results? And that's where some
00:22:07
analytical retirement tools uh can do a
00:22:09
lot of heavy lifting. So, what I've
00:22:11
described here certainly isn't easier or
00:22:13
simpler than what Cliff's wife's broker
00:22:16
said. It's much more nuanced than what
00:22:17
Cliff's wife's broker said. But I think
00:22:20
it's important that we understand that
00:22:21
not everything can be simplified all the
00:22:24
way down to hey so easy that a third
00:22:27
grader can do it. So thank you Cliff.
00:22:28
Good question. I appreciate you writing
00:22:30
in. And now Q3 is from Lucy. Lucy says
00:22:33
we're both 60 years old and looking to
00:22:35
retire soon. My husband has been sending
00:22:36
me some articles that really push for
00:22:38
both of us to claim social security as
00:22:40
early as possible due to future social
00:22:42
security liquidity concerns. Can you
00:22:45
play devil's advocate against his idea?
00:22:47
Lucy, I would love to be the person. I'd
00:22:49
love to be the man who argues against
00:22:51
your husband. That's definitely a role
00:22:53
that I want. You know what? Just call me
00:22:54
up anytime you want. If you want to
00:22:56
prove him wrong, I'm sure he's going to
00:22:57
understand and uh he'll just play along
00:23:00
nicely. Hey, a strange guy on the
00:23:01
internet with a podcast is telling me
00:23:03
how I'm wrong. No, I'm kidding, Lucy.
00:23:05
I'm happy happy to help. And I hope I I
00:23:08
add enough nuance here to, you know,
00:23:10
maybe just expose your husband to some
00:23:12
interesting ideas that he hadn't thought
00:23:13
about before. Let's first discuss the
00:23:15
liquidity or viability of social
00:23:17
security itself and then we'll talk
00:23:19
about the good, better, and best social
00:23:20
security claiming strategies. So yeah,
00:23:23
will social security still be there when
00:23:24
you need it to be? Many of you might
00:23:26
have seen or heard that the social
00:23:28
security trust fund could be depleted
00:23:30
sometime in the mid 2030s. And to many
00:23:33
people that sounds like the system is
00:23:35
about to break apart and and probably
00:23:37
will stop paying benefits. But that is
00:23:39
not the truth. And that's far far far
00:23:41
from what the projections actually say.
00:23:43
So when the trust fund reserves are
00:23:45
depleted again 2033, 2034, 2035, social
00:23:48
security will still be there. What's
00:23:50
going to happen though is that incoming
00:23:52
payroll taxes are going to fund most of
00:23:54
the benefits. And and that's actually
00:23:56
what's going on today. It's just that
00:23:57
most of us don't realize it. Every
00:23:58
working person, right, pays social
00:24:00
security taxes every year. And those
00:24:02
taxes currently support something like
00:24:05
80% of all the social security outflows.
00:24:07
The trust fund, which is going to run
00:24:09
out eventually, the trust fund covers
00:24:11
the remaining 20%. So, if the trust fund
00:24:14
went away today, the current social
00:24:16
security taxes that we are all paying
00:24:18
would make retirees about 80% whole.
00:24:21
Now, that's not a good outcome.
00:24:23
Obviously, we don't want that. We
00:24:24
shouldn't accept that. We want to make
00:24:26
everybody 100% whole. But what I just
00:24:28
described being 80% whole is far
00:24:30
different than saying that your social
00:24:32
security benefit is going to zero. If
00:24:34
you'd rather have a story that deals
00:24:36
with numbers, think of this. 70 million
00:24:38
Americans collect Social Security
00:24:40
benefits today. And looking at the
00:24:41
population distribution by age, those
00:24:44
numbers are pretty unlikely to change
00:24:45
over the next 10 years. So again, 70
00:24:47
million people will be collecting social
00:24:49
security roughly by the mid 2030s. All
00:24:52
of them are voters, right? They're over
00:24:53
the age of 18. And if you tell 70
00:24:55
million people that their income is
00:24:57
going to get cut either by $2,000 a
00:25:00
month if the system just totally
00:25:01
disappears or by even $400 a month,
00:25:04
which would be if the benefit cut gets
00:25:06
cut down to the 80% number, those 70
00:25:08
million people are not going to like
00:25:10
that outcome. And so where there's a
00:25:11
will, there's a way. And I would bet
00:25:13
that the retired electorate has a will
00:25:15
to not let Social Security benefits get
00:25:17
cut. Now, according to projections from
00:25:20
the Social Security Administration,
00:25:21
closing the gap could be achieved with a
00:25:24
bunch of different policy changes.
00:25:26
Increasing payroll taxes, which wouldn't
00:25:27
be fun. Raising or eliminating the
00:25:30
taxable wage cap, that's an interesting
00:25:31
one. You might know that only the first
00:25:33
$180,000 of someone's earned income is
00:25:36
subject to social security tax. You
00:25:38
know, Warren Buffett, who you know, I'm
00:25:40
a fanboy of, he loved to call out the
00:25:41
the BS on this fact because he paid the
00:25:44
same amount of social security tax each
00:25:46
year, which was about $10,000 on the
00:25:49
180,000. So, you know, Warren Buffett is
00:25:51
paying $10,000 a year in social security
00:25:53
taxes, and so was his secretary, right?
00:25:56
Every dollar that Warren Buffett earned
00:25:57
over $180,000 in a year is not subject
00:26:00
to social security tax. So, if they
00:26:02
raise that cap, it's an additional tax
00:26:05
basically on the highest income earners
00:26:07
for sure. But yeah, it would help close
00:26:08
that gap. Other policy changes, they
00:26:10
could gradually adjust benefits. I think
00:26:12
this is possible and likely. They could
00:26:14
increase the retirement age modestly. I
00:26:16
think that is also quite possible and
00:26:18
likely. And I think there's a unique
00:26:19
take that I haven't really heard
00:26:20
mentioned very often. They could
00:26:22
actually lower the retirement age below
00:26:24
62, but then pair that with a relatively
00:26:27
severe throttling of the benefits
00:26:29
themselves. You know, right now you
00:26:31
might know that collecting at age 62
00:26:33
gives you 70% of your full retirement
00:26:35
benefit. Or in other words, you take a
00:26:37
30% haircut for life if you choose to
00:26:40
collect uh social security at age 62.
00:26:42
Well, what if they allowed you to
00:26:44
collect at age 60 with a 50% haircut for
00:26:46
life or whatever the numbers have to be?
00:26:48
Cuz again, I putting myself in the shoes
00:26:50
of an actuary. I we need to do something
00:26:52
that lessens the overall stress to the
00:26:54
social security system. And there is a
00:26:56
way to say, "Yeah, we'll let you collect
00:26:58
early, but we'll give you such a big
00:27:00
haircut that actually it ends up being
00:27:02
better for the system overall." And none
00:27:04
of those changes require dismantling the
00:27:05
system. So Lucy, I think it's fair to
00:27:07
share those ideas with your husband.
00:27:09
It's very unlikely that Social Security
00:27:10
will be going away. And now that brings
00:27:12
us to the optimal time to collect. Let's
00:27:14
start with something obvious and simple,
00:27:16
but pretty important. If you knew
00:27:17
exactly when you and your spouse were
00:27:19
going to die, then you could precisely
00:27:20
pick your best, most ideal social
00:27:23
security claiming dates. And of course,
00:27:24
you don't know that. But I think it's
00:27:26
important to make the most educated
00:27:28
guess that we can because when it comes
00:27:30
to an optimal strategy, what we have to
00:27:32
do here is say, well, the probability
00:27:34
suggests that we are going to die at
00:27:36
ages A and B and therefore we should
00:27:38
claim our social security in this way.
00:27:40
Social Security uses this concept called
00:27:42
full retirement age, FRA, full
00:27:44
retirement age, to determine how much
00:27:46
your eligible benefit you will get to
00:27:47
collect. Your personal full retirement
00:27:49
age depends on the year you were born.
00:27:51
For most of well I shouldn't say for
00:27:53
most for all of today's retirees it's
00:27:55
either 67 or 66 or maybe 66 in a certain
00:27:58
number of months as I just alluded to
00:28:00
you can start collecting at age 62 or
00:28:03
before your full retirement age but
00:28:04
there's a price to pay and your benefits
00:28:06
will be permanently reduced but then if
00:28:08
you wait to collect until after your
00:28:10
full retirement age then your benefits
00:28:12
will be permanently increased. Now if
00:28:14
there's just one person involved so
00:28:16
there's not a spouse involved just yet.
00:28:17
If there's just one person involved and
00:28:19
all you have to think about is your own
00:28:20
benefit, then the pure logic and the
00:28:22
pure math is pretty straightforward. It
00:28:24
basically says if you die before age 77,
00:28:27
then collecting as early as possible
00:28:28
would have been best. But again, we have
00:28:30
to go back to earlier where it's like,
00:28:32
well, if you die early, is that really a
00:28:33
win? I know, I know. But pure math and
00:28:35
logic says if you die before age 77, you
00:28:38
will have wished you started collecting
00:28:39
social security at age 62. If you die
00:28:42
between ages like 78 and 80, early 80s,
00:28:45
then all the scenarios, all the ages are
00:28:47
roughly equal. And then really if you
00:28:49
die after age 80, especially it becomes
00:28:52
really clear if you die like after age
00:28:54
82, then having waited until age 70 to
00:28:58
start collecting will have been best in
00:29:00
hindsight, right? I think this makes
00:29:02
sense because your benefit goes up if
00:29:04
you wait to collect till 70 and
00:29:05
therefore the longer you live after age
00:29:07
70, the more likely that is to have
00:29:09
turned out to been a smart decision. But
00:29:11
there is much more to consider here. And
00:29:12
I think to get to the real meat of the
00:29:13
answer, you know, what are some
00:29:15
applicable strategies, thought
00:29:16
processes, if then scenarios that can
00:29:18
guide you and your family in social
00:29:20
security decisions? The poker player
00:29:22
Annie Duke, she'd like to say that two
00:29:24
things determine the outcomes in your
00:29:26
life. Thing one is the quality of your
00:29:28
decisions and thing two is luck. So, put
00:29:31
another way, there are some things in
00:29:32
your control and some things out of your
00:29:34
control. And so, whatever decision you
00:29:36
make regarding social security, you have
00:29:38
to accept that luck might strike and
00:29:39
your decision won't have been the
00:29:41
optimum one. And it's not because you
00:29:42
made a bad decision. It's just because
00:29:43
of luck. Even though bad luck might
00:29:45
screw you over, you still want to make a
00:29:47
a high quality decision if you can. You
00:29:48
want to try to get this right. So, let
00:29:50
me start with this. Social Security is
00:29:52
pretty close to a one-way decision that
00:29:54
you cannot undo. But the exception to
00:29:56
that is that once you start collecting
00:29:57
social security, you do technically have
00:29:59
up to 12 months to change your mind. And
00:30:02
if you do change your mind, then you
00:30:03
have to repay any of the benefits that
00:30:05
you'd received so far. They call that a
00:30:07
withdrawal. And you get one of those
00:30:08
withdrawals in your lifetime. A little
00:30:10
known fact, you can undo your decision
00:30:12
to start claiming Social Security. But
00:30:14
once you delay Social Security, right,
00:30:15
you can never go back in time and
00:30:17
reclaim your missed benefits. You can't
00:30:19
be 67 years old having never claimed and
00:30:22
say actually I want to retroactively go
00:30:24
back to 63 and and start collecting. So
00:30:26
ideally that's why you want to get this
00:30:28
decision right. You know in a perfect
00:30:30
world you you get it right the first
00:30:31
time. So let's think about you and your
00:30:33
spouse. Spousal benefits and survivor
00:30:35
benefits two different things. Spousal
00:30:37
benefits and survivor benefits. Many
00:30:39
rabbit holes in social security
00:30:41
planning. And spousal and survivor
00:30:43
benefits are two of those rabbit holes.
00:30:44
And I I mean rabbit holes because there
00:30:46
are many paths and they go pretty deep
00:30:47
and it's easy to get lost. The upshot
00:30:50
for basic social security planning is
00:30:52
that your decision to collect social
00:30:54
security not only affects you, but it
00:30:57
could affect your current spouse. It
00:30:59
could affect your expouse andor it could
00:31:02
affect your future spouse or your future
00:31:04
widow. So basically, it doesn't matter
00:31:06
who you're married to now, who you were
00:31:08
married to in the past, or who you might
00:31:10
be married to in the future. your
00:31:11
decision to collect social security is
00:31:14
likely going to affect them. So let's
00:31:16
say Bob has a primary insurance amount
00:31:18
of $3,200 a month. Again, that primary
00:31:20
insurance amount that represents what
00:31:21
Bob would have collected if he collects
00:31:23
at his full retirement age. So if he
00:31:25
collects early, it's going to be less
00:31:26
than 3200 a month. If he collects late,
00:31:28
it's going to be more than 3200 a month.
00:31:30
But we'll say Bob's primary insurance
00:31:32
amount is 3200 a month. Bob's married to
00:31:34
Sharon. Her PIA is 1,200 a month. And
00:31:38
let's say to make this simple, they both
00:31:39
opt to start collecting at full
00:31:41
retirement age. And thus, they're
00:31:42
collecting exactly 100% of the PIA
00:31:45
numbers we just described. 3200 for Bob,
00:31:48
1,200 for Sharon. Well, right off the
00:31:50
bat, Sharon will be collecting something
00:31:52
called a spousal benefit. Now, why? It's
00:31:54
because Sharon's benefit 1,200 is less
00:31:57
than half of Bob's. Bob's 3200. Half of
00:32:00
3200 is 1,600. So, Sharon's 1,200 is
00:32:04
less than half of Bob's. So, she is
00:32:06
eligible for 50% of Bob's PIA or $1,600
00:32:10
a month. So, she's going to collect her
00:32:12
own $1,200 benefit and then she's going
00:32:14
to get an additional $400 a month at no
00:32:17
sort of penalty to Bob at all. There's
00:32:19
no penalties involved. No one is losing
00:32:21
any benefits here. It's just that as a
00:32:23
spouse, you are eligible for 50% of your
00:32:26
spouse's PIA. And yes, Sharon is
00:32:29
collecting this while she's alive and
00:32:30
and while Bob is alive. This is the
00:32:32
spousal benefit and the ages that Sharon
00:32:34
and Bob choose to collect social
00:32:36
security. Again, if they had chosen to
00:32:37
collect early, if they had chosen to
00:32:39
collect late, those decisions do affect
00:32:41
what the spousal benefit looks like. So,
00:32:43
it's important to know that. Now, what
00:32:45
if Bob dies? Well, notably, if Bob dies,
00:32:48
Sharon is going to step up into Bob's
00:32:50
full benefit, receiving the full $3,200
00:32:53
a month that that Bob was receiving.
00:32:55
Sharon's own benefit would would drop
00:32:57
away. However, if Bob had started
00:32:59
collecting early at age 62, his benefit
00:33:02
would have only been about $2,300 a
00:33:04
month. And after Bob died, Sharon would
00:33:06
step into that $2,300 per month benefit.
00:33:09
And if Bob had started collecting, say
00:33:11
at age 70, his benefit actually would
00:33:12
have been about $4,000 a month. And
00:33:14
Sharon would have stepped into that
00:33:16
$4,000 a month benefit when Bob died. So
00:33:19
the point is that Bob's decision to
00:33:21
collect at 67 and collect $3,200 a
00:33:24
month. It didn't only affect his benefit
00:33:26
while he lived. It also had these side
00:33:28
effects on Sharon's benefits both while
00:33:30
they were alive and after Bob died. So
00:33:33
the point is again that spouses need
00:33:35
careful consideration when deciding when
00:33:37
to claim social security. They need to
00:33:39
consider various scenarios for which
00:33:41
spouse dies first and at which ages. So
00:33:44
some rules of thumb for you when it
00:33:45
comes to these spousal and survivor
00:33:47
benefits. Again, it's a spousal benefit
00:33:49
when they're both alive and Sharon was
00:33:51
collecting half of Bob's benefit. It
00:33:53
becomes a survivor benefit once Bob died
00:33:55
and then Sharon steps into Bob's full
00:33:57
benefit. So some rules of thumb here
00:33:59
that apply in a lot of cases, maybe not
00:34:01
every case, but apply in a lot of cases
00:34:03
is that the lesser earning spouse, so in
00:34:05
this case, Sharon, the lesser earning
00:34:07
spouse can often start collecting social
00:34:09
security as early as possible, but that
00:34:12
the higher earning spouse should delay
00:34:14
social security as long as possible to
00:34:16
age 70 because again, their decision to
00:34:19
do so has a 100% chance of affecting
00:34:21
their own benefit, but then also has a
00:34:24
roughly 50% chance of affecting their
00:34:26
spouse's eventual benefit. with, you
00:34:28
know, the Sharon and Bob scenario being
00:34:30
a perfect example. If Bob had waited
00:34:32
till 70, his own benefit would have been
00:34:34
higher while he was alive and also
00:34:36
Sharon's benefit would have been higher
00:34:37
after Bob died. Now, I think it's okay
00:34:40
too to dig into the probabilities of who
00:34:41
dies first. You know, to think of
00:34:43
health, illness, family history, that
00:34:45
kind of thing. The most common questions
00:34:47
that you can ask yourself surrounding
00:34:49
your kind of a married couple's decision
00:34:51
to collect social security revolve
00:34:53
around your personal health and and
00:34:54
family history. You should ask, does
00:34:56
anything there in your personal or
00:34:58
family history point to either an early
00:35:00
or a late death? If you're healthy and
00:35:02
all your relatives live to 100, it's
00:35:04
reasonable to assume that you might have
00:35:06
a similar fate. If you're chronically
00:35:08
ill and your relatives have all passed
00:35:09
away early, again, you could reasonably
00:35:11
assume that you might have a similar
00:35:12
fate. Certainly not a doctor here, but
00:35:14
the idea is that they say genetics load
00:35:16
the gun and environment pull the
00:35:17
trigger. The idea is, you know, yeah,
00:35:19
you aren't condemned to your family
00:35:20
history. You do have dials to control.
00:35:22
Don't forget that. But it's worth
00:35:24
understanding what either your family
00:35:26
history or your personal health history
00:35:27
looks like. Next, I would ask yourself,
00:35:30
do you really need to take Social
00:35:32
Security early? Like truly, do you have
00:35:34
a financial need to take it early?
00:35:35
Because if that extra income is going to
00:35:37
bridge the gap between cat food and a
00:35:40
normal human diet, well, maybe you have
00:35:42
to take it early. But if you don't need
00:35:43
it, why are you taking it early?
00:35:45
Delaying Social Security acts as
00:35:47
longevity insurance. In fact, the full
00:35:49
name of the Social Security program for
00:35:51
retirees has longevity insurance right
00:35:54
there in the name. So, protecting
00:35:55
against the risk that you're going to
00:35:57
live to 90 or 95 or beyond, that's
00:36:00
pretty important. And the longer you
00:36:01
wait, the higher your benefit will be
00:36:03
and the better your long-term outcomes
00:36:05
will be. Now, going back to Lucy's
00:36:07
original question, she mentioned that
00:36:08
they're retiring soon. But what if
00:36:09
someone wanted to keep on working? Are
00:36:11
there any interactions between your
00:36:13
normal work income and social security
00:36:14
income? The short answer here is yes.
00:36:17
there's a negative interaction if you
00:36:18
are younger than your full retirement
00:36:20
age, but there's no negative interaction
00:36:23
if you are at your full retirement age
00:36:25
or older. So, for that reason, it very
00:36:27
rarely ever makes sense for someone to
00:36:29
claim social security early if they are
00:36:31
also still working. But it can make
00:36:33
sense for someone to claim social
00:36:34
security at full retirement age even if
00:36:36
they are still working. You know, I
00:36:38
think the next idea is I think using
00:36:40
social security as a possible sequence
00:36:42
risk buffer can be a great idea. Again,
00:36:44
the idea is that you might start
00:36:45
retirement without having claimed social
00:36:47
security. Your plan is to live off your
00:36:49
portfolio, but if the markets perform
00:36:51
poorly and all of a sudden you realize
00:36:53
that you're subject or you're exposed to
00:36:55
some sequence risk because of that poor
00:36:56
performance. What do you want to do in
00:36:58
that situation? Well, in a perfect
00:37:00
world, you would give your portfolio
00:37:01
time to recover. You would lessen your
00:37:04
withdrawals in order to leave more money
00:37:06
in your portfolio to recover. How do you
00:37:08
lessen your withdrawals? Of course, you
00:37:10
can cut out spending. You can be
00:37:11
flexible like we mentioned a few minutes
00:37:12
ago. You can also turn on social
00:37:14
security and boom, right there you say,
00:37:16
"Oh, we have an extra $3,000 a month
00:37:19
coming in. That's $3,000 a month that
00:37:21
doesn't have to come out of my
00:37:22
portfolio." And that really does kind of
00:37:24
dampen or buffer your risk against a a
00:37:26
sequence of return risk. And last, I'd
00:37:28
consider some uh taxability concerns.
00:37:30
So, generally, claiming Social Security
00:37:32
will reduce your ability to do smart tax
00:37:34
planning, and it's certainly not the end
00:37:36
of the world, but it is a secondary cost
00:37:38
worth considering. In a perfect world,
00:37:40
you would leave your options open to do
00:37:42
smart tax planning. And the more income
00:37:44
coming in, usually the fewer
00:37:45
opportunities you have, and social
00:37:46
security does count as income. So, in
00:37:49
short, there aren't many situations
00:37:50
where I'd recommend a married couple
00:37:52
both collect early as possible. Lucy,
00:37:54
there might be one exception for being
00:37:56
really open-minded is that if both
00:37:58
spouses have a really poor health
00:37:59
history and a poor family health
00:38:00
history, suggesting that both of them
00:38:02
are likely to pass away before break
00:38:04
even age, I could see both of them
00:38:06
claiming early. But either way, many,
00:38:08
many different considerations when it
00:38:09
comes to social security claiming. Most
00:38:11
of those considerations suggest that at
00:38:13
least one of the two spouses delay their
00:38:15
claiming to 60 or 67. Here's a quick ad
00:38:18
and then we'll get back to the show. I
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00:39:08
And last question for today from Nicole
00:39:10
Jesse, could you please do an AMA
00:39:12
question about rebalancing your
00:39:13
portfolio? I feel like different experts
00:39:15
talk about doing it quarterly, doing it
00:39:17
twice a year, doing it once a year. A
00:39:18
lot of people talk about doing it based
00:39:20
on the calendar in that way, but then
00:39:21
other people talk about drift. For
00:39:23
example, if your 60/40 portfolio drifts
00:39:26
more than 5%, say to 65% stocks or to
00:39:29
55% stocks, then you rebalance it. How
00:39:32
do you rebalance, Jesse, and why? Well,
00:39:34
this is an awesome question, Nicole, and
00:39:35
and selfishly, I admit, I think it's
00:39:37
awesome because it gives me a chance to
00:39:39
really to flesh out some of my personal
00:39:41
thoughts on something I've always had a
00:39:43
a feeling for in the back of my mind.
00:39:44
I've never really gotten it out on
00:39:46
paper. And truthfully, I've never dug
00:39:48
into any sort of like alternative view
00:39:50
or what researchers have to say. So all
00:39:52
of a sudden now through answering this
00:39:54
question, I feel like I've really kind
00:39:55
of solidified my own opinion on it. So
00:39:58
it's just a win-win. So listeners, if
00:40:00
you're not familiar with rebalancing,
00:40:02
Nicole described it pretty well in her
00:40:04
question. So thank you, Nicole. The idea
00:40:05
is that an investor might decide, okay,
00:40:07
my portfolio should be 60% stocks and
00:40:10
40% bonds. Okay, that's great. But as
00:40:12
the value of that investor's stocks and
00:40:14
bonds change over time, their original
00:40:16
60/40 allocation is going to change,
00:40:18
too. And the act of rebalancing is that
00:40:20
investor deciding to bring the portfolio
00:40:22
back to 60/40. So the question is when
00:40:25
should that happen? But first I think a
00:40:27
good place to start this answer is why
00:40:29
do we need to rebalance in the first
00:40:30
place? Well, it's pretty simple. We do
00:40:32
need to rebalance to ensure that our
00:40:34
portfolio has the proper amount of risk
00:40:36
and so that our portfolio meets the
00:40:38
needs of our financial plan. We do not
00:40:40
need to rebalance because that's the way
00:40:42
to improve our long-term returns. So
00:40:44
I'll say that again. We do not and
00:40:46
should not assume that rebalancing will
00:40:48
lead to better long-term returns. It
00:40:50
might, but it might not. Increasing your
00:40:53
returns is not one of the reasons to
00:40:54
rebalance. So, the reason, as I said a
00:40:56
minute ago, is to make sure that your
00:40:58
portfolio is still doing what you need
00:41:00
it to do. It still has the right amount
00:41:02
of risk in it. It still has the right
00:41:03
amount of potential growth in it to meet
00:41:05
your long-term needs. It's all about
00:41:06
meeting your long-term financial plan.
00:41:09
Or another thing is, you know, I've
00:41:10
talked about it here before. I usually
00:41:12
look at everyone's portfolio through
00:41:13
some sort of asset liability matching
00:41:15
lens and we want to make sure that
00:41:17
everyone's portfolio has the right
00:41:18
amount of assets to meet their
00:41:19
short-term needs, their midterm needs,
00:41:21
their long-term needs. So sometimes we
00:41:23
need to rebalance to ensure we're doing
00:41:24
that. And so what happens if you don't
00:41:26
rebalance? Well, not rebalancing a
00:41:28
portfolio will cause it to drift from
00:41:30
its original target allocation, perhaps
00:41:32
resulting in these unintended
00:41:33
concentrations in your top performing
00:41:35
assets, often stocks, which brings
00:41:37
increased vulnerability to market
00:41:39
downturns. And so while the lack of
00:41:41
rebalancing may allow for higher returns
00:41:43
during bull markets, it can lead to
00:41:45
bigger losses during bare markets. So
00:41:47
with that preamble, let's now answer the
00:41:49
question, how often should you be
00:41:51
rebalancing? So first and foremost, you
00:41:53
can and should consider using your just
00:41:55
your normal portfolio activities to more
00:41:57
easily rebalance. Meaning every single
00:42:00
portfolio has some dividends coming in
00:42:02
or some interest, some new contributions
00:42:04
going into your accounts or some
00:42:05
withdrawals coming out of your accounts,
00:42:07
right? money is already moving in and
00:42:08
out of your accounts and in and out of
00:42:10
your portfolio. So, you can and probably
00:42:12
should use that money as part of your
00:42:14
rebalancing strategy anyway. If you're
00:42:16
contributing $1,000 a month into a
00:42:18
taxable brokerage account and that
00:42:20
account currently has too many stocks in
00:42:22
it, well, maybe you decide to have all
00:42:24
1,000 of your new 1,000 per month going
00:42:26
only into bonds for a few months. You
00:42:28
can rebalance that way. You don't need
00:42:30
to sell your stocks to rebalance.
00:42:31
Instead, you just use the new deposits.
00:42:33
Similarly, you could choose to turn off
00:42:35
dividend reinvestment for a while and
00:42:37
use all those portfolio income sources
00:42:40
to only go into one specific asset to
00:42:42
achieve some rebalancing over time. But
00:42:44
often times doing something like that
00:42:46
isn't actually enough. You need to take
00:42:48
some action above and beyond that to
00:42:50
achieve rebalancing. And as Nicole
00:42:52
mentioned in her question, the two most
00:42:53
popular styles of rebalancing are
00:42:55
timebased, once a quarter, twice a year,
00:42:57
once a year, something like that. And
00:42:59
then driftbased or threshold-based. You
00:43:01
rebalance when your assets get 5% out of
00:43:03
whack or 10% out of whack or you
00:43:05
rebalance when a particular allocation
00:43:07
is 25% different when it started than
00:43:09
than when it started. You know, if you
00:43:10
have a 5% allocation to small cap value
00:43:13
and that 5% goes down to 3%. Well,
00:43:15
that's a 40% change. So anyway, you can
00:43:18
have some thresholds set there. Now,
00:43:20
strictly speaking and you know, kind of
00:43:21
in theory, a drift or threshold strategy
00:43:24
makes a lot more sense because you're
00:43:26
rebalancing based on the characteristics
00:43:28
of the portfolio itself. the portfolio
00:43:30
and its risk are out of whack. That's a
00:43:32
great reason to rebalance. A
00:43:34
calendar-based strategy, on the other
00:43:36
hand, might dictate rebalancing when
00:43:38
it's really not needed. Like, okay, it's
00:43:39
October again. Well, what does October
00:43:42
have anything to do with your portfolio?
00:43:44
It's arbitrary, is my point. But the
00:43:46
problem, and this problem exists with
00:43:48
any rebalancing strategy, is to consider
00:43:50
the costs of doing so. There aren't that
00:43:52
many trading costs these days, which is
00:43:54
a good thing. But you still ought to be
00:43:56
aware of trading costs. They do exist.
00:43:58
Some of the mutual funds you own might
00:43:59
have a trading cost associated with
00:44:01
them. Taxes are another cost at least
00:44:03
inside of a taxable account. And then
00:44:05
your time is another cost, even though
00:44:07
sure that's a bit subjective. Some of
00:44:08
you uh it might be really easy for you
00:44:10
to rebalance cuz your simple portfolio
00:44:12
and you're pretty good at the math. And
00:44:14
for others of you, it might be a real
00:44:15
chore to rebalance. But the point is,
00:44:17
the more you rebalance, the more costs
00:44:18
you might be incurring. So, if your
00:44:20
threshold rebalancing strategy has you
00:44:22
making trades every single month, is
00:44:24
that really better than a a
00:44:25
calendarbased strategy that recommends
00:44:27
you do it once a year? So, that's what a
00:44:29
Vanguard research team wanted to look
00:44:31
into. And they published a paper in
00:44:32
2022, I'll link it here in the show
00:44:34
notes, that attempted to answer those
00:44:35
kind of questions. They tested all sorts
00:44:37
of various rebalancing strategies for
00:44:39
different portfolios. And they concluded
00:44:41
that for just about any portfolio
00:44:42
allocation, the optimal rebalancing
00:44:44
strategy is either once per year or once
00:44:48
per year only if your target allocation
00:44:51
is more than 1% out of whack. And those
00:44:53
two conclusions, they're basically the
00:44:55
same thing in my opinion. So anyway, the
00:44:57
whole point is it's once a year. The
00:44:58
optimal portfolio rebalancing strategy
00:45:00
is once a year. They looked at other
00:45:02
time periods, too. They found that daily
00:45:03
rebalancing is the worst thing you could
00:45:05
possibly do, but the next worst thing is
00:45:08
never rebalancing at all. And then if
00:45:10
we're going from worst to best, then
00:45:12
comes weekly, monthly, bimonthly, and
00:45:14
quarterly. So the point there is that
00:45:16
doing rebalancing too often, especially
00:45:17
if it has some legitimate trading costs
00:45:19
to it is more detrimental. And just
00:45:22
rebalancing once a year, was their
00:45:23
optimal solution. So how do we actually
00:45:26
execute that? Well, I think we still
00:45:28
want our routine portfolio activities,
00:45:30
again, the dividends and the interest,
00:45:31
the deposits and the withdrawals. We
00:45:32
still want those routine activities to
00:45:34
take rebalancing into account. If our
00:45:37
portfolio is drifting, there's nothing
00:45:39
wrong with using those activities to
00:45:41
bring the allocation back in line. And I
00:45:43
guess the reason why I say that is
00:45:44
because those activities are happening
00:45:45
anyway. There's no additional cost to
00:45:47
them because they're happening anyway.
00:45:49
You're playing with house money is the
00:45:50
way to think about it. So, you might as
00:45:52
well rebalance if you're playing with
00:45:53
house money. But beyond those routine
00:45:55
activities, we want to set a once-yearly
00:45:58
reminder to rebalance. And candidly, I
00:46:00
think that once yearly reminder can
00:46:01
serve as a time when you revisit your
00:46:03
entire financial plan if you want to,
00:46:05
ensuring that the conclusions you
00:46:06
reached 12 months ago are still valid
00:46:08
today. You can revisit your allocation
00:46:10
itself to ensure it's still the right
00:46:11
allocation for what your financial plan
00:46:13
needs. And then, of course, you can
00:46:15
execute whatever trades are required to
00:46:17
bring your portfolio back into line. I
00:46:19
think that's a pretty simple solution,
00:46:21
possibly much simpler than some of the
00:46:23
rebalancing advice you see online, but
00:46:25
it's certainly not sitting back and
00:46:27
doing nothing. So Nicole, thank you for
00:46:28
the question and listeners, thank you
00:46:30
for the awesome questions today. I hope
00:46:31
this convinced you that financial
00:46:33
planning can be pretty simple, but at
00:46:35
the same time, there comes a point where
00:46:36
we have to say, "Ah, we can't be simpler
00:46:38
than that." Thank you as always for
00:46:40
sending in your awesome ask me anything
00:46:41
questions. You can send future questions
00:46:43
00:46:45
I look forward to reading your emails
00:46:47
and thank you once again for listening
00:46:48
to Personal Finance for Long-Term
00:46:50
Investors. Thanks for tuning in to this
00:46:52
episode of Personal Finance for
00:46:54
Long-Term Investors. If you have a
00:46:56
question for Jesse to answer on a future
00:46:58
episode, send him an email over at his
00:47:00
blog, The Bestin Interest. His email
00:47:03
address is [email protected].
00:47:06
Again, that's jessevestinterest.blog.
00:47:10
Did you enjoy the show? Subscribe, rate,
00:47:12
and review the podcast wherever you
00:47:14
listen. This helps others find the show
00:47:16
and invest in knowledge themselves. And
00:47:19
we really appreciate it. We'll catch you
00:47:20
on the next episode of Personal Finance
00:47:23
for Long-Term Investors. Personal
00:47:25
Finance for Long-Term Investors is a
00:47:27
personal podcast meant for education and
00:47:29
entertainment. It should not be taken as
00:47:31
financial advice and it's not
00:47:33
prescriptive of your financial
00:47:34
situation.
