I have had a bit of time lately and have found myself pondering a number of different subjects, none of which is really long enough for a blog post on its own. So I’ve combined them all into one big post. I hope you find something here useful.
Why Not Combine Investing and Transportation?
Regular readers know I’m generally not a fan of combining insurance and investing using insurance based investing products like permanent life insurance (whole life, index universal, variable universal) or annuities. The whole idea of having to buy one product in order to get into an investment is kind of silly when you think about it.
What if you had to buy a car in order to get into an investment? In this case, it would be a salesman coming up and showing you something like my crappy old Durango. “But,” you say, “I already have a nice shiny A6, it works just fine and it’s perfect for me.” The salesman replies that its the only way to get this awesome investment, so you either park that extra Durango in the driveway and use it once a year or worse, get rid of that A6 you liked so much in order to drive the Durango. Does that make sense? About as much sense as buying an expensive insurance policy you don’t need. Don’t combine your transportation and your investments.
I Don’t Need More Income Right Now
I often get into silly arguments on the internet with people who are big fans of income investing, both dividend-focused stock investors and real estate investors. I’ve written before about the errors income-focused investors sometimes make but they seem to just be focused on income, income, income. Well, the fact remains that I have far more income than I need right now and its getting taxed at ridiculously high rates. In fact, I’m doing all I can right now to DECREASE my taxable income by investing in tax-protected accounts (both tax-deferred and Roth) and deferring as much income as possible. Exchanging current income for capital gains is EXACTLY what I’d like to do. Long-term capital gains are far more tax-efficient than real estate rents (taxable at my full marginal tax rate, at least after depreciation) or even qualified dividends (since you can defer the tax for decades on capital gains, or even avoid it all together with the step-up in basis at death or by flushing the low basis shares out of your portfolio by using them for your charitable contributions.)
Houses Really Do Depreciate
While we’re on the subject of real estate investing, real estate investors seem to be under the impression that depreciation is some kind of free lunch. The government lets you depreciate the improvements (buildings) on your property, but not the property itself. That’s because the building is worth less each year. That’s why you have to spend money on upgrades, repairs, replacements, and eventually, bulldoze it and start over. It’s a real expense, just like utilities, management etc, rather than some awesome tax break because the government loves you. Don’t get me wrong, I claim depreciation just as much as the next guy to improve the tax-efficiency of my investment, but it’s not a free lunch. The companies whose stock you buy when you purchase an index fund are also depreciating all their property and equipment and passing that savings on to the owners.
Many Roads to Dublin
Taylor Larimore, perhaps the wisest 90 year old investor I know, is fond of saying, “There are many roads to Dublin.” Sometimes people get all religious about their particular style of investing, whether it involves index funds, actively managed funds, individual stocks, trend-following, precious metals, cash value life insurance, or real estate. Perhaps that’s because it usually represents a life-long commitment to be successful and requires at least some faith in future performance of the asset or method. However, it’s important to remain somewhat agnostic on this point and consider not only the likelihood that you are wrong, but also the consequences of being wrong. Keep the principles of investing (such as keeping costs low) and the simple principles of getting rich (make a lot, save a good percentage of it, and invest it in some reasonable manner) in mind first and foremost, rather than getting bent out of shape about particular methods. There are many roads to Dublin, and if you judge your road as likely to meet your financial goals, more power to you.
Skipping out on IRAs/Roth IRAs
I still find it bizarre to see people missing out on the benefits of retirement accounts. Sometimes its a person who really thinks he will have a higher marginal rate in retirement than right now, whether it’s because he’s a super-saver or simply due to his misunderstanding of how the process works. Often it is a real estate investor who somehow thinks the tax benefits inherent in real estate (primarily depreciation followed by serial exchanges to defer capital gains) are better than those obtained in retirement accounts. It really doesn’t make sense when you think about it though. You can buy most investments, including individual real estate properties INSIDE of IRAs and Roth IRAs. Might as well open up a SEP-IRA, fund it fully, convert it to a Roth IRA (one version of the Mega Backdoor Roth), transfer it to a self-directed IRA, and buy your real estate there. Tax-free forever, even without ever doing a 1031 exchange. It doesn’t make sense to skip out on retirement accounts and buy real estate or permanent life insurance because you’re afraid of high future taxes. Just do more Roth conversions. My favorite is the argument people make that “the government is going to put a tax on Roth accounts.” They might also make life insurance proceeds taxable, eliminate 1031 exchanges, or even just confiscate everything. But only a fool bases his financial plan on those worries.
Warren Buffett and “Diworsification”
I often preach the benefits of diversification, both among the various asset classes and within them. A frequent argument made against it is that Warren Buffett derides it as “deworsification.” At this point, it’s worth noting that there are actually three definitions of deworsification floating around out there. The first is used by a stock picker, when he buys ten stocks. The first stock represents his best idea, and by the time he gets to the tenth stock, it’s only his tenth best idea, so therefore it is probably a worse investment than the first stock. The more he diversifies, the worse his investments. The second definition was first proposed by Peter Lynch in his surprisingly useless One Up On Wall Street, and applies only to a single business whose management gets distracted by businesses outside of its core expertise. The third definition, which I actually agree with, is the investor who buys 5 mutual funds that all invest in the same stocks.
At any rate, this claim that “Warren doesn’t diversify” seems to be a strong one at first glance. The logic goes like this: Warren Buffett is rich and the world’s best investor. Warren Buffett doesn’t diversify. Therefore, if I want to be rich, I shouldn’t diversify. So I’m going to put all my money in one stock or I’m going to put it all into a rental property or two in the same geographic area. However, correlation is not causation. You cannot invest like Warren Buffett.
First, consider that most of Warren’s outsized returns were earned decades ago, when the market wasn’t nearly as efficient. Warren’s mentor, Benjamin Graham, noted a major difference in market efficiency between the start of his career (in the Great Depression) and the end and concluded you were better off indexing. You can’t go back to the 50s or 60s and invest like Warren did.
Second, what Warren does now when he buys a stock is insert himself into it’s management. It’s far easier to put all your eggs into one basket and watch it closely when you’re on the board for the company. Unlike Warren, if you buy a stock, nobody is going to put you on the board of the company (although I suppose you could buy a small business or real estate property and take a management role.)
Third, Warren Buffett isn’t even beating the S&P 500 lately.
Fourth, Warren Buffett actually does diversify quite a bit more than most assume. Berkshire Hathaway, Warren’s company, owns large chunks of 64 different companies. Sure, it’s not the thousands in an index fund, but it’s a far cry from 1 or 2 stocks or properties. Apparently one of those companies is only his 64th best idea.
Fifth, Warren Buffett recommends that investors just buy a good S&P 500 Index Fund. So, while Warren Buffett might not diversify as much as some investors, it is what he recommends you do because he knows YOU CAN’T DO WHAT HE DOES.
Diversification protects you from what you don’t know about an uncertain future. If you’re honest with yourself, you’ll acknowledge there is an awful lot about the future that you don’t know.
What do you think about all this? Want a Durango with your investments? Are you purposely skipping out on retirement accounts? Do you diversify? Comment below!