Financial Policy Statement

Investing

The fundamental method to achieve success in investing is by creating a written investment policy statement and following it exactly as written. Don’t modify this statement based on current events or beliefs about future events. Unplanned changes are likely to derail your long term goals. Modification based on changes in your personal life may be acceptable.

When creating the investment policy statement, keep the following principles in mind:

• Wealth is created by earning a lot and saving a lot.
• Asset allocation and portfolio management are relatively easy and universal. Other aspects of financial planning (estate planning, taxes, retirement withdrawal, and insurance) are more dependent on personal circumstances or age.
• Begin investing as early as possible and as much as possible (no matter how little that happens to be). Time invested is critical to a successful outcome.
• Understand the difference between a product that is sold and one that is bought. Many financial ‘advisers’ are neither regulated nor fiduciary. Hence, most financial products only exist because there is someone who can sell them, not because there is demand for them.
• Only purchase products/funds which the financial community unanimously agrees is a low cost, low fee, superior investment. See https://www.bogleheads.org and other reasonable advice as given by these sources.
• More money is lost by trading and timing the market than by following a pre-specified investment plan.
• A successful stop loss requires you to be correct twice, once when selling and again when re-entering a position. Outside of random luck, you won’t profit from this strategy.
• On average, lump-sum investing provides higher returns compared to dollar cost averaging.
• It’s inevitable the market index will have high variability and will drop more than 50%. Despite this, you will realize long term gains by maintaining and rebalancing your investments.
• You may only sell investments after they are sufficient to support you in retirement, you create a tax-advantaged withdrawal plan, and you have decided to retire.

vtsax <- c(Giant = 41.6, Large = 30.9, Medium = 19.1, Small = 6.2, Micro = 2.2)
vfiax <- c(Giant = 49.1, Large = 35.2, Medium = 15.6, Small = 0.1, Micro = 0)
vexax <- c(Giant = 0, Large = 8, Medium = 38.1, Small = 40, Micro = 14)

mod <- lm(vtsax ~ vfiax + vexax)
summary(mod)

## 
## Call:
## lm(formula = vtsax ~ vfiax + vexax)
## 
## Residuals:
##    Giant    Large   Medium    Small    Micro 
##  0.06333 -0.10981  0.04869 -0.03637  0.03416 
## 
## Coefficients:
##             Estimate Std. Error t value  Pr(>|t|)
## (Intercept) 0.019539   0.144382   0.135  0.904742
## vfiax       0.845563   0.003354 252.135 0.0000157
## vexax       0.153307   0.004035  37.992  0.000692
## 
## Residual standard error: 0.1023 on 2 degrees of freedom
## Multiple R-squared:      1,	Adjusted R-squared:      1 
## F-statistic: 5.225e+04 on 2 and 2 DF,  p-value: 0.00001914

# Or, more simply
X <- cbind(vfiax, vexax)
Y <- vtsax
round(solve(t(X) %*% X) %*% t(X) %*% Y, digits = 2)

##       [,1]
## vfiax 0.85
## vexax 0.15

df <- data.frame(
  Size = factor(names(vtsax), levels = c("Giant", "Large", "Medium", "Small", "Micro")),
  vtsax,
  vfiax,
  vexax,
  replicated = round(predict(mod), 2)
)

df[c("vtsax", "replicated")]

##        vtsax replicated
## Giant   41.6      41.54
## Large   30.9      31.01
## Medium  19.1      19.05
## Small    6.2       6.24
## Micro    2.2       2.17

df <- gather(df, key = "Index", value = "Percent", vtsax, vfiax, vexax, replicated)

ggplot(df, aes(x = Size, y = Percent / 100, color = Index, group = Index)) + 
  geom_line(aes(linetype = Index), linewidth = 1.4) + 
  scale_y_continuous(labels = scales::percent) + 
  scale_linetype_manual(values=c("solid", "solid", "solid", "dashed")) + 
  scale_color_manual(values = c("#f8766d", "#00bfc4", "#c77cff", "#7cae00")) + 
  labs(y = "Percent of Index")

Financial advice

Most people can manage a simple and efficient investment plan without help. Hiring help is a reasonable choice, but you must choose well, because the title someone uses tells you almost nothing. “Financial advisor”, “wealth manager”, and “financial planner” are marketing labels that anyone can use. What matters is how the person is regulated, the legal duty they owe you, and how they are paid.

Seek an advisor who meets all four of these requirements.

• Registered. The advisor is a registered investment advisor (RIA) or an investment adviser representative (IAR) working for one. Verify the registration yourself on the SEC’s adviser search at https://adviserinfo.sec.gov.
• Fiduciary at all times, in writing. A fiduciary must act in your best interest and disclose conflicts of interest. Get this in writing, because some advisors act as a fiduciary only part of the time.
• Fee-only. The advisor is paid only by you and earns nothing from selling products. A flat annual fee, an hourly rate, a retainer, and a percentage of assets under management (AUM) are all fee-only models. The label “fee-based” is not fee-only, because it still allows commissions.
• Fair total price. Convert whatever you pay into a yearly dollar amount and check that it is reasonable for the work performed.

Avoid an advisor who shows any of these warning signs.

• Paid by commission. Commissions reward selling products over giving advice. The advisor earns more by placing you in a product, which biases every recommendation toward the highest-paying option.
• Insurance agents selling investment products. An agent who presents whole life insurance, indexed universal life, or annuities as investments is usually paid a large up-front commission, often 5% to 7% of the amount placed in an annuity and higher still on whole life. In most states the agent’s legal duty runs to the insurance company, not to you. These products are sold, not bought.
• Bank and “private wealth” advisors. Wealth management programs at banks and brokerages typically pay their advisors through commissions and steer you toward the firm’s own proprietary funds and products. You see only what the firm sells, not the whole market, and the advisor is usually a broker rather than a fiduciary.
• Held only to a suitability or “best interest” standard (Regulation Best Interest for brokers, the NAIC model rule for annuities) rather than a full fiduciary duty. These weaker standards require disclosing conflicts of interest, not removing them.
• “Fee-based” rather than fee-only. Fee-based mixes client fees with commissions, so the conflict of interest remains. True fee-only advisors take no commissions.

A professional credential such as CFP signals training, but it does not guarantee competence and does not replace the four requirements above. A registered fiduciary can still give mediocre advice at an unfair price. Confirm registration, fiduciary duty, fee-only pay, and a fair total price before discussing anything else.

The assets under management (AUM) fee deserves special attention. It is a fee-only model, so it can be reasonable, but only when the resulting dollar amount stays fair for the lifetime of their management. A 1% fee may be fair on a $300,000 portfolio yet unreasonable on $3 million, because managing the larger balance is no harder to manage. Multiply your balance by the rate each year and judge the dollar total, not the percentage. The next section shows how that percentage compounds when left unchecked.

# Balance after a number of years when an advisor takes fee f of the
# balance each year alongside a gross return r.
# r = gross annual return
# fee = annual AUM fee charged on the balance
balance <- function(principal, r, fee, years) {
  principal * ((1 + r) * (1 - fee))^years
}

df <- expand.grid(year = 0:30, fee = c(0, 0.005, 0.01))
df$value <- balance(principal = 1e5, r = 0.07, fee = df$fee, years = df$year)
df$fee <- factor(
  df$fee,
  levels = c(0, 0.005, 0.01),
  labels = c("0.0% (no advisor)", "0.5%", "1.0%")
)

ggplot(df, aes(x = year, y = value, color = fee)) +
  geom_line(linewidth = 1) +
  scale_y_continuous(labels = scales::dollar, limits = c(0, 800000)) +
  labs(x = "Years invested", y = "Portfolio value", color = "Annual AUM fee")

# Percent of final portfolio value lost to a constant annual fee.
fee_drag <- function(fee, years) {
  1 - (1 - fee)^years
}

years <- c(10, 20, 30, 40)
fees <- c(0.001, 0.003, 0.005, 0.01)

drag <- sapply(fees, function(f) scales::percent(fee_drag(f, years), accuracy = 1))
colnames(drag) <- scales::percent(fees, accuracy = 0.1)

data.frame(years = years, drag, check.names = FALSE) |>
  flextable() |>
  set_caption("Percent of final portfolio value lost to AUM fee.")

Financial independence

When investments are equal to at least 33x expected annual spending in retirement (i.e. 3%), employment is no longer necessary :)

• Track expenses and calculate expected annual spending as the average of the previous decade.
• Multiply your expected annual spending by a safety factor (1.25x, 1.5x) to cover unexpected events in government policy, the financial system (sequence of returns risk), and your spending. You need to be prepared for a scenario where the market halves and stays flat for 30 years.
• Does this seem unreasonable? Fix that by spending less.

The code below estimates how many years of saving it takes to reach financial independence at a given savings rate. Normalize salary to 1, so each year you save save_rate and spend the remaining 1 - save_rate. You reach financial independence when the portfolio equals the target (1 - save_rate) / swr, your annual spending divided by the safe withdrawal rate. The yearly contributions form an ordinary annuity that compounds at the return r, and solving it for the number of years until the balance reaches the target gives the estimate.

This estimate assumes a constant savings rate, a constant real (inflation-adjusted) return, contributions invested at the end of each year, and a starting balance of zero. Using a real return absorbs inflation into the return itself, so spending and the target stay fixed in today’s dollars and need no separate inflation adjustment.

# Years of saving needed to reach financial independence.
# Assumes a constant real return, a constant savings rate, and
# contributions invested at the end of each year (an ordinary annuity).
#
# save_rate = fraction of salary saved and invested each year
# swr = safe withdrawal rate. FI portfolio size = annual spending / swr.
# r = expected real annual return
years_to_fi <- function(save_rate, swr, r) {
  spend  <- 1 - save_rate # fraction of salary spent (salary normalized to 1)
  target <- spend / swr # portfolio needed, as a multiple of salary
  # Solve  save_rate * ((1 + r)^n - 1) / r = target  for n.
  log(target * r / save_rate + 1) / log(1 + r)
}

df <- data.frame(save_rate = seq(0.1, 0.9, by = 0.1))
df$years <- years_to_fi(save_rate = df$save_rate, swr = 0.03, r = 0.05)

flextable(df)

ggplot(df, aes(x = save_rate, y = years)) +
  geom_line() +
  scale_x_continuous(labels = scales::percent) +
  scale_y_continuous(breaks = seq(0, 60, 10), limits = c(0, 60)) +
  labs(x = "Savings rate", y = "Years to financial independence")

Insurance

Protect your assets with insurance.

• Term life insurance
  1. Hold term life insurance when you have dependents and are not financially independent.
  2. Many jobs provide term life insurance. Keep a personal policy as you don’t want this tied to the job.
  3. If traveling, and while during transport, credit cards often offer automatic term life insurance if used to purchase travel method (airlines).
  4. If you are young and the insurance amount is less than one million, most insurance providers do not require physical health checks before approval.
  5. It’s usually a pretty easy process to acquire by going through a local insurance agent who can get quotes from several companies (verify these with instant internet quotes).
• Renters or Home insurance
  1. Be sure your homeowners policy includes extended dwelling coverage as it will replace or rebuild your property even if the cost exceeds your policy’s coverage
• Car insurance
  1. Liability coverage: If you’re responsible for an accident, your liability coverage will cover the costs of any injuries or property damage caused in the collision. If the other person is responsible, and they have liability coverage, then they will pay for your damage. Most states require you to carry a minimum amount of coverage.
     • Minimum property damage liability you should have is $100,000 (i.e. plan max).
     • Minimum bodily injury liability you should have is $250,000 (i.e. plan max).
     • Liability coverage is the most important part of car insurance and you can only further reduce exposure to this liability through umbrella insurance!
  2. Collision coverage: No matter who is at fault, collision coverage pays to repair or replace your car if you’re in an accident with another vehicle, object, or even yourself. Can be useful for filing a claim with your personal insurance company so that they are the ones who get you money from other insurance company when someone else is at fault. Collision coverage is needed to insure rental vehicles. Is quite expensive. Only needed if your car is worth more than 3x your deductible?
  3. Comprehensive coverage: This level of insurance covers your losses that aren’t caused by a car crash such as theft, vandalism, flood, fire and hail. Probably the most common use for this is to replace window glass? Usually pretty cheap. Only needed if your car is worth more than 2x your deductible?
  4. Uninsured and Underinsured coverage: It will pay you if the other person is at fault, but they do not carry insurance or are underinsured and broke (i.e. the majority of people who drive cars).
     • If you carry collision, then separate un/underinsured property damage coverage isn’t needed. If you don’t carry collision, then property damage coverage is pretty cheap for what is usually a very small maximum coverage ($7,500).
     • Minimum bodily injury liability you should have is $250,000 (i.e. plan max).
  5. If renting, credit cards often offer automatic rental insurance if used for purchase. Though, recently, many have been canceling these additional benefits. Otherwise collision coverage will be needed to cover rentals.
• Health insurance
  1. Unfortunately health insurance has little to do with covering unexpected costs. It’s more of a middle-man payment system that, in combination with healthcare providers, means the market for healthcare is not a service/good to be purchased, but rather a rent to be extracted.
  2. If not supplied by your employer, use the ACA marketplace at healthcare.gov to search for policies.
  3. Alternative healthcare sharing accounts through faith based companies are also available. These contracts are often not as robust as traditional insurance and can have maximum payouts ($150,000) or drop clauses for who knows what (smoking, no support from pastor, etc.). They generally operate by expecting you to pay cash for all bills. After submitting these receipts, they will provide partial refunds.
• Long-term care insurance
  1. Purchase in 50s
  2. Reassess as needed as it is currently very expensive or no longer reasonable with current healthcare inflation?
• Umbrella insurance
  1. This insurance gives protection for you and your assets when you need liability coverage that exceeds the limits of your homeowners or auto insurance. You want an additional buffer between traditional insurance liability limits (~250-500K) and your at-risk assets (anything held outside of ERISA-qualified plans, e.g. 401k or other non-governmental retirement savings accounts) when they become large enough to be enticing. About 80% of umbrella claims are a result of car crashes. This coverage usually doesn’t cover personal business issues (malpractice, etc.), extreme sports and racing, pollution/chemical/radiation incidents, any intentional damage caused by covered entity, transmission of disease, damage resulting from serving alcohol, damage caused by mold/mildew, etc.
• FDIC (bank) insurance
  1. The FDIC insures up to $250,000 per depositor. If you have more than $250,000 in a bank account, there are two methods for extra protection. First, you can open multiple accounts across different banks, or within the same bank (one spouse and one joint (2x250,000) for 1,000,000 total). Second, the FDIC will protect $250,000 per beneficiary noted as payable on death (POD; and informal revocable trust), up to five beneficeries for a total of $1,250,000 protected assets per account (https://www.fdic.gov/resources/deposit-insurance/financial-products-insured/). Financial products not insured by the FDIC: https://www.fdic.gov/resources/deposit-insurance/financial-products-not-insured/
• SIPC (brokerage) insurance
  1. The SIPC is a non-profit corporation established by the securities investor protection act. It oversees the liquidation of covered brokerages that close when they go bankrupt or are in financial trouble, and customer assets are missing. The SIPC will return missing customer property by protecting each customer up to $500,000 for securities and cash (including a $250,000 limit for cash only).
  2. Although created under a federal law, SIPC is not an agency or establishment of the United States Government, and it has no authority to investigate or regulate its member broker-dealers. It is important to understand that SIPC is not the securities world equivalent of the Federal Deposit Insurance Corporation (FDIC), which insures depositors of insured banks.
  3. Any respectable brokerage will also have ‘Excess of SIPC’ insurance in addition to SIPC. However, in a truly catastrophic event, the total excess insurance is usually pitifully small compared to total assets under management.
• Service/contractor insurance
  1. Before entering a business agreement, require a Certificate of Liability Insurance. It will verify the policy holder, insurance company, policy number, limits of coverage, and type of liability. Ask/require that you are added as an “additional insured” to this policy. This all must be done prior to start of work. Make sure to stipulate in the contract requirements that notice must be given before any cancellation or change in insurance status, a waiver of subrogation applies to you?, and coverage provided is primary and non-contributory. Other forms of interest are the rider and floater.

Estate planning

Create an estate plan once you have dependents. Update documents and account beneficiaries with each new dependent. Beneficiary designations on retirement accounts and life insurance override the will, so keep them current. Laws vary by state, so confirm requirements locally.

• Incapacity planning (alive but incapacitated)
  • Advance Healthcare Directive (umbrella term for medical wishes)
    • Living Will: Written instructions for end-of-life or terminal care. Does not name a person.
    • Healthcare Power of Attorney: Names an agent to make medical decisions when you cannot. Also called healthcare surrogate, proxy, or representative depending on the state.
  • Financial Power of Attorney: names an agent to manage money and property. Two activation styles.
    • Durable: effective on signing, continues through incapacity.
    • Springing (also called standby): effective only when a trigger occurs, usually physician-certified incapacity. Some states do not allow it.
    • A durable springing POA activates on incapacity and then stays valid.
• Death planning
  • Last Will and Testament
    • Guardian for minor children: the single most important reason a new parent writes a will. Name a primary and a backup. The court decides, but it gives strong weight to your choice.
    • Executor (personal representative): settles the estate through probate, pays debts, then distributes assets.
    • Testamentary Trust: created by the will, takes effect at death. A trustee manages a child’s inheritance and can stagger payouts by age instead of a lump sum at 18. The trustee can differ from the guardian for checks and balances.
• Optional
  • Revocable Living Trust: avoids probate. A will passes through probate. If you live in a state with difficult probate processes, it may make sense to create a revocable living trust in addition to the last will and testament.

Other Financial Items

• Annual credit report
  • https://www.annualcreditreport.com/index.action
• Credit card advertising opt-out
  • Visa: https://marketingreportoptout.visa.com/OPTOUT/request.do
  • Mastercard: https://www.mastercard.us/en-us/vision/corp-responsibility/commitment-to-privacy/privacy/data-analytics-opt-out.html
• Credit reporting agency opt-out
  • https://www.optoutprescreen.com/
• Equifax “the work number” opt-out
  1. Go to https://theworknumber.com/view-my-data-sign-up
  2. Create an account and make note of your account ID (that you choose yourself). You will be asked for it.
  3. Download your report to see what information they have collected on you.
  4. Go to https://theworknumber.com/employee-data-freeze/
  5. Call their number 866-222-5880.
  6. Choose the option option to report a possible identity theft.
  7. Tell them “I’d like to put a freeze on my employment data”.
  8. When asked why, just say “For personal reasons”.
  9. They will ask for your account ID, SSN, and other information to verify your identity.
  10. They will send you a text code to verify and the process should be over.

References

• https://www.bogleheads.org/wiki/Main_Page
• https://www.bogleheads.org/wiki/Tools_and_calculators
• https://www.bogleheads.org/forum/viewtopic.php?t=7353&highlight=collective
• https://www.madfientist.com/how-to-access-retirement-funds-early/
• https://earlyretirementnow.com/2016/12/14/the-ultimate-guide-to-safe-withdrawal-rates-part-2-capital-preservation-vs-capital-depletion/
  • https://dx.doi.org/10.2139/ssrn.2920322
• https://www.portfoliovisualizer.com/