Like all my stuff => this is not advice to your family. Speak with local experts before making tax, legal and portfolio changes in your life.
Iñaki asked, “what to do when the world seems crazy?”
I build my life so I don’t need to be right.
Related, I want to be able to unplug for 72 hours, without worry, whenever I feel like it.
This strategy is based on knowing that I’m prone to error and don’t want to spend my life connected to the matrix.
Further, even if you have 100% confidence in yourself, your kids/spouse are going to need something robust for when you’re gone.
Across 2019, I wanted to lean into equities but there wasn’t an event that gave me an opportunity. So I rolled along, rebalancing and living my life.
In March 2020, the pandemic created an opportunity. Personally, I leaned in (fairly hard) by increasing %age exposure to equities, at a time when rebalancing alone would have triggered buying.
In a fiduciary capacity, we only leaned a little. Two members of my investment committee, with wider views of the world, advised caution. Using the principle, most conservative view rules, we were conservative with allocation.
- Both decisions made sense at the time and worked out.
- Time matters. “Good enough” becomes more powerful the longer your time horizon.
- Returns across generations are driven by a famous Munger-ism => “just try not to be stupid.”
- The family’s position, 10 years past every generational transition, is impacted more by what you burned than what you earned.
At the end of 2021, given the whacky stuff I’m seeing around me, I don’t plan in leaning in at the next correction. Rebalancing will be good enough.
Recreational Capital and Associated Spending
A dominant focus on return/allocation in your financial portfolio, misses an important source of value creation => efficient use of “recreational” capital, and associated spending.
Recreational capital is any asset that’s held for non-financial reasons. This is a material slice of many balance sheets:
- Boats, RVs, Cars
- Second homes, vacation properties
- Sizing up personal residences
- Renovation projects, furniture, collectibles and art
- Charters, vacation spending, travel spending
- Any asset with a negative yield
You’ll see I included a line for the expenses associated with those assets. Some assets, when bought, lead to more spending.
By way of example, INVERT and consider…
When you sell all your assets in a remote location then… the spending associated with the location will plummet. Now that we spend our summers “at home” vs commuting to/from Canada, we cut spending by a big number.
Even if you don’t buy… for skiing, we stopped renting a condo in Vail. Our 2021 ski season cost will be less than what my last rental cost me. Skiing is a choice with a stack of associated spending, and negative-return investment opportunities.
It would be nice to think that these decisions were driven by being smart. That would be a mistake! The Canadian exit was driving by local tax policy and COVID forced a change in approach for skiing.
We did not realize the true cost of our “recreational” choices. We had to remove them, and watch for a couple years.
The choices above:
- Create a larger working portfolio
- Reduce annual spending
- Increase the flexibility to change one’s mind
- Don’t involve admin, maintenance or exit costs
In our financial portfolio, conservative nature means we “missed out” on much of the run up. However, because we adjusted our recreational capital, and associated spending, we greatly increased wealth over the last five years.
The wealth gain, from shrinking the recreational portfolio, is locked in. These gains are hidden from conventional metrics, that your advisor might show you.
Now we move along to KC’s questions
GB: total debt will remain modest relative to assets and cash flow
KC: How do you define “assets” and “cash flow” here? Completely paid off asset or total value of asset? All assets – or just the assets on the investment side (excluding primary home?) Cash flow from all sources after expenses? What do you define as a modest target?
I have a spreadsheet that shows me… gross asset value, deferred taxes, tax basis (as at last tax filing year) and deferred agent’s fees (for real estate). So I can quickly look at real estate from gross to net after-tax realizable value. I compare those figures to gross rental income, and net cash flow (from my tax return).
I’m conservative with gross asset value on real estate, a discount from Zillow and my real estate agent’s estimate on value.
I assume 6.3% cost to exit, from real estate gross value, then tax the realized value at 25% of the gain over basis.
I look at… total debt service, core cost of living, total cost of living => each of those numbers gets a little bigger, and I have less control over delaying payment/spending.
Then I look at the inflows by source…
- real estate (net and gross — consider vacancy risk)
- employment (by role and client — consider concentration)
- passive (royalties, dividends, distributed gains)
I want to understand my concentration in expenses (what I can cut/control) as well as income (where the risks lie). I never want to be placed in a position of being a forced seller.
My total family debt stays under 10% of net assets. Assets calculated net of all taxes and agent’s fees.
The Role of Time
My thinking in my work, and family, is multigenerational… I look at assets, leverage, cash flow and spending at many levels…
- What I actually own, owe, control, earn => me
- Family level
- Family & Corporate level => me, my family, my business
- Multi-generational level => consolidated, over time
I think about expenses, earning power, saving power, asset utility (what benefits members) over time. I have a spreadsheet that projects the age of all living family members over time (2021, 2035, 2050). This helps me consider family asset strategy and consider when generational transitions are going to occur.
KEY for assets and cash flow => When generations stop working/saving, when kids start working/saving?
It’s not just “what you own.” It’s also when you own it, and when you sell it.
I see many people buying assets they will HAVE to sell in ten years time, mainly real estate. Now, if it’s your main home, then I get it. See below for the option value in the mortgage.
In this market, Boulder up 30% this year, it’s easy to convince yourself that you are silly not to supersize your balance sheet.
But if it’s a secondary market…
- 10% in/out cost for the real estate
- Less than 1% cost to go variable (AirBnB, Hotels.Com)
- Total flexibility with capital (you don’t deploy into a low-occupancy, negative yielding asset)
- No admin hassle (I really dislike organizing maintenance and cleaning)
Why are you doing it?
If you want to dazzle peers, suppliers and key relationships… …then you might be better off with a high-end club membership.
Your mind may try to convince you the joining fee is a waste of money. Note that the club joining fee is usually < 5% of a condo cost, and club dues run <10% of the condo’s cost to own.
With leasing we compare to “do nothing” => most people with ready finance will “do something.” If you’re going to do something, regardless, then something smaller can be a better option.
Your mind doesn’t see the rest of your portfolio performing better, with less hassle, by not owning an asset that’s a drag on return.
And… my mind at least, doesn’t remember how much I hate cleaning and dealing with remote maintenance issues!
KC: Tax bill as a %age of net assets-Where do you think a healthy range should be?
Every year, I look at the tax bill relative to net assets on a consolidated basis. This lets you consider the impact of tax policy on your portfolio – smart savers free themselves from exposure to changes in tax policy. Taxes paid, as a percentage of net assets, should trend downwards over your working life.
I don’t think the taxes vs net assets number, itself, is important. What matters is trending down and asking yourself if you are worrying about the right things in your life. Lots of (wealthy) people fail to recognize how little impact the Feds have in their financial life. Others could use a nudge to save more, spend wisely.
GB: At that point, you’ll have built yourself an inflation-proof, tax-effective retirement annuity
KC: Can you help me understand the inflation-poof aspect of this strategy? Is it the income producing asset that is locked in at an low interest rate? How is RE more inflation-proof than other assets?
Real estate isn’t “more” but it can be “different”.
Local rents are influenced by local real economic growth. I like the prospects of Boulder, the Front Range and Colorado.
Local real estate values are influenced by macro (national interest rates, credit cycle) and local (replacement cost, demand) factors.
So a slice of local real estate can create an element of hedging between national, regional and local conditions. There are some other benefits…
Here in Boulder, Colorado, I believe our real estate values have a hidden option. There is a chance the best neighborhoods explode upwards towards the highest valued parts of: the Rockies (Vail/Aspen), California (Bay Area) or NYC.
Now, I don’t have the $$$s to own trophy properties, but I don’t need to. As I wrote in The Next Doubling, it’s good enough to be nearby. For the option to pay out, we don’t need to get to the highest prices per sf => we merely need to close the gap, a bit, over time. That sort of option doesn’t exist in an index fund.
Another hidden option => we own a two-unit rental. We always have the option to move into one of the units and “live for free” by renting out the other unit.
Option Value of Fixed Rate Debt
30-year fixed rate debt, with an option for the borrower to repay, is a valuable (oneway) option in an uncertain world. Unlike margin debt, the lender can’t call the loan on a whim.
Long rates have been declining for 40 years, so the value of this option is overlooked by many. In an inflationary environment, having a multiple of my core cost of living in low-cost fixed rate debt is a useful position.
A mortgage on a personal residence seems like a good deal to me……and if it turns out to be a bad deal then I exit via repayment or refinance.
Saving 2% p.a. and giving Goldman an option to close you out…
Quick note on margin debt, even at <1% p.a. cost, seems like a very bad idea.
Smart people borrowing money they don’t need, to make money they are unlikely to spend in their lifetimes. Everyone figuring they will be able to unwind their financial structure before anything bad happens to them.
This strategy never ends well and only makes sense when you are playing with other people’s money.
A general principle, some things only make sense when you ignore the rebound. Fasting, margin debt, intensity-bias for endurance sport… I have found one gets a better long-term result from building smarter habits.
Optimize over time. When I started paying attention to myself, I realized I needed a whole lot less spending, which implied less capital, which gave me much more time.
INVERT that last sentence => spending you don’t need, increases the capital you think you need, to spend more time doing what you want. I broke that cycle in 2000, got wrapped back up in it in 2005, got tossed back out during the 2008/2009 recession and, these days, cycle in/out depending on my moods!
Nearing 53, I laugh because “less” is being forced on my physical life, by time.
In my early 40s, “less” happened due to kids and a nasty recession.
In my early 30s, “less” felt liberating, and made time for a lot more self-directed time.
“Less” is a useful process!