INVESTING AT LEVEL3

Figures, Updates, Errata

Updates to �Investing at Level3� Book

Changes to Chapter 6, Passive Approaches Section, pages 192–193 (Third Edition)

Posted: December 29, 2017

Improvements on Plan Z

The weightings of the exchange-traded funds in the two-ETF passive portfolio have been changed.

• Guggenheim S&P 500 Equal Weight ETF (RSP): Originally given an 80% weight; increased to 90%
• Vanguard REIT ETF (VNQ): Originally given a 20% weight; decreased to 10%

The weightings of the exchange-traded funds in the four-ETF passive portfolio have been changed.

• Guggenheim S&P 500 Equal Weight ETF (RSP): Originally given an 40% weight; decreased to 30%
• PowerShares Russell 1000 Equal Weight Portfolio (EQAL): Originally given a 20% weight; increased to 30%
• Vanguard Mid-Cap Value (VOE): Originally given a 20% weight; increased to 30%
• Vanguard REIT ETF (VNQ): Originally given a 20% weight; decreased to 10%

The four-ETF passive portfolio with a safe portion of fixed income added therefore has the following adjustments.

• Guggenheim S&P 500 Equal Weight ETF (RSP): Originally given an 32% weight; now 24%
• PowerShares Russell 1000 Equal Weight Portfolio (EQAL): Originally given a 16% weight; now 24%
• Vanguard Mid-Cap Value (VOE): Originally given a 16% weight; now 24%
• Vanguard REIT ETF (VNQ): Originally given a 16% weight; now 8%
• iShares 1-3 Year Treasury Bond ETF (SHY), or insured CDs or other short term fixed income: No change to weighting of 20%

Addition to Chapter 6, Setting the Stage Section, page 181 (First Edition)

Posted: October 18, 2016

The values used in the analysis in this chapter are long-term averages. There will be a great deal of variation over short-term periods. This is particularly true of short-term risk-free investments. Over the years, I have seen T-bills as high as 14.7% (1981) and as low as they are today (2016) at 0.3%. Over the long term they have yielded 3.6%, and other very safe investments have averaged about 4%. Typically, safe investments yield just under 1% above inflation. So in “real” (above inflation) yield, safe investments are more consistent than they appear when viewing their basic yields.

If you would like to feel better about only getting 1% on the safe portion of your portfolio, here is a rationale. Later in this chapter, I give a short cut way to estimate how much you can withdraw on average from your portfolio without using principal. The process is to take your average expected return during the withdrawal stage (for example 10%), reduce it by estimated tax burden (for example, 20%) and then reserve enough to cover next year’s inflation (average 3%). So 10% reduced by 20% equals 8%. If you reserve three percentage points for average inflation, you can consume 5%.

But instead of using the average inflation rate as is done in almost all analysis of withdrawal rates, say you use the actual inflation rate (0% in 2015) and withdraw 8% instead of 5%. The three additional percentage points make up for the low return you are getting on the safe portion of your portfolio.

Of course, if you use the actual rather than the average inflation rate, you will have to reduce your withdrawal when inflation jumps up to 6%, but your safe investments will be providing a higher return.

Addition to Chapter 6, page 218 (First Edition)

Posted: September 12, 2016

Transitioning to a Level3 Portfolio

Most of the exposition on the Level3 approach has been written as if you were just starting to invest or had the money waiting to be invested—say, if you just turned a retirement account over into a cash IRA. That might be the case for some, but for many, probably most, substantial existing positions bring up the question of how best to transition assets to a Level3 portfolio.

For those who want to stop paying for insurance that isn’t needed and wish to invest more of their assets in equities, transitioning should be relatively easy. Selling bonds or cash equivalents generally incurs a low transaction cost and little capital gain concerns. The only problem might be assets such as CDs that must be held to maturity. In such cases, you can make changes gradually as holdings mature.

If you have substantial stock or mutual fund holdings, you can divide them into those that don’t fit with your new approach and those that might be fairly close to a suitable Level3 passive portfolio or that might represent your approach to the active part of your Level3 portfolio.

However, if you are going to reorient your investing approach, it is likely there are many holdings that do not fit. Selling them will trigger both transaction costs and tax liability.

Transaction costs probably pose less of a problem than taxes. Unless you have substantial holdings in small-cap stocks or other illiquid holdings, the bid/ask spreads and commissions should not be significant. If they should be problematic, making the changes gradually will help. Those who wish to transition a substantial portion of their portfolio into equities should apply the concept of time diversification. While it is not likely that you will be converting almost your entire portfolio from bonds to stocks, making the change gradually will prevent you from buying a preponderance of stock at an intermediate high. This is likely not a concern if the market is substantially below its all-time high.

Capital gains taxes on profitable holdings, particularly very long-term holdings, may well be a significant consideration. This problem disappears for holdings that are in a tax-deferred plan, since you pay ordinary income taxes on profits when they are withdrawn (in the case of a Roth plan, contributions are aftertax).

The only way to cope with the tax consequences of selling holdings that are very profitable is to try to sell gradually when you have losses to offset the gains. Successful investors will be blessed with the problem of not having enough losses to significantly offset the gains.

If the holdings no longer fit into your strategy, even if they are profitable, you will have to give up the tax deferment on the profit and count on the better performance of your new strategy to make up for the deferment value that is lost.

This raises the question of what goes in tax-deferred accounts and what goes in regular accounts. The tax rules keep changing and your decisions can be influenced by personal factors. However, at this time, it is probably best to keep holdings that are likely to provide qualified dividends and higher capital gains (a tricky prediction) outside of the tax-deferred accounts and interest-bearing investments in the deferred accounts.

Ultimately, higher returns and real risk control are more important than tax considerations, but “a penny saved is a penny earned.”