I know you have probably heard far too much about taxes lately and I am not going to review the recent tax bill here. I want to talk about tax strategies more generally.

“No man’s life, liberty or property are safe while the Legislature is in session.”
– Gideon J. Tucker, 1866

While many people spend their lives trying to find a ten bagger, it is generally more profitable to focus on more mundane – but more certain – opportunities.  In other words, to become financially successful, both offense and defense are important.  Due to the glamour and excitement of offense, people tend to ignore important defensive strategies.  Both are vital to “winning the game.”

Taxes are one of these relatively boring yet important topics.  Here are just a few items related just to investments that people frequently overlook:

Holding the wrong types of investments in the wrong accounts.  If you have both taxable and tax-advantaged funds (IRA, 401(k), etc.), where you place various investments is important.  Not only are some holdings inherently more tax efficient than others, but different tax rates apply.  Placing the less tax-efficient investments in the sheltered accounts and the more tax-efficient investments in the taxable account can make a large and meaningful difference.

Maximizing tax-advantaged vehicles.  Not only is maximizing the use of retirement plans and other tax sheltered vehicles important (including those for educational funding), but so is wisely choosing between the various options.  In addition, there is a wide disparity in the tax efficiency of various investments held in a taxable account.  Obviously it is more important to maximize after-tax return than it is to maximize before-tax return.

Using Roth vs. traditional retirement accounts optimally.  The decision to save in a traditional IRA, 401(k), etc. vs. the Roth versions of those accounts (or the decision to convert into a Roth) is multifacted and extremely complicated but very important. (See Ruminations on Roth vs. Traditional IRAs for more information.)

Insurance vehicles.  Generally, insurance products (like annuities) are not efficient vehicles for saving even given the tax advantages, but there are cases where they make sense.

Spending down assets in the optimal order.  In retirement, there is an optimal way to liquidate investments for living expenses to minimize the tax bite. (See Tax-Efficient Spending from a Portfolio for more information.)

Taking advantage of low earning years or “room” in a relatively low tax bracket.  Occasionally an individual will have a tax year when they have little or no income due to a sabbatical, job transition, or a brief time after retirement before pensions and social security begin.  There is an opportunity to use the low bracket to save taxes in the future.

Maximizing the use of the step-up in basis.  Property is inherited as though the recipient bought it at the current value.  This can lead to large tax savings in many situations.

Harvesting losses.  As investments rise and fall in value there are opportunities to take losses to offset against gains and to a limited extent against ordinary income.

Gifting the best assets.  Whether to charity or to family, some gifts are better than others from a tax perspective. (See Charitable Giving for more information.)

As you can see, this is a very complex topic. If you are one of our clients, we are monitoring all of these issues for you but if you have any questions, please feel free to call or email us.

Recently (here) I discussed two common mental mistakes. This month I thought I would add three more: a need to save face, improper extrapolation, and conscious weakness.

Saving Face. What I have termed “saving face” is an attempt to not feel stupid, or to avoid regret. People can go to elaborate lengths to feel they are smart and made good decisions. Here are some results of this need to avoid feeling foolish:

• An unwillingness to sell investments at a loss (selling before it “comes back” would be tantamount to admitting an error), or selling too quickly when investments go up (if it then went back down, the selling opportunity would have been missed). As we have explained in previous newsletters, research indicates the market is reasonably efficient – this means securities tend to be reasonably priced (except in hindsight!). Therefore, whether an investment is above or below the purchase price should be wholly irrelevant to selling decisions (except for tax consequences). Imagine a stock that was at $40 and Person A purchases it, then it declines to $20 and Person B purchases it and it is now at $30. Both investors should merely decide if the stock at $30 is likely to be a good investment for the future, and if so hold it, and if not sell it. However, Person A tends to hold it (sometimes forever, hoping to “get even”) while Person B tends to sell quickly (while he has the opportunity to feel good about his intelligence and foresight in making the purchase). This is an example of loss aversion.
• Taking risks to avoid perceived losses yet avoiding similar risks for similar gains. Here is a two question quiz to explain this. Answer truthfully!
  • You are given $1,000. In addition to that thousand, you have an opportunity to choose an additional $500 or flip a coin – tails you get nothing, heads you get $1,000. Do you take the guaranteed $500 or the coin flip?
  • You are given $2,000. However you now must either pay $500 or flip a coin – tails you lose $1,000, heads you lose nothing. Do you pay the $500 or flip the coin?

Most people would chose the guarantee in the first question and the coin flip for the second. This is mathematically irrational and occurs because of the way the questions were asked. Both questions are actually identical, and a rational person should either choose the guarantee in both, or the flip in both. (Notice in both questions the choice can be restated as $1,500 for sure or a 50/50 chance at $1,000 or $2,000.) Since the first question is phrased as going for a gain, people tend to be risk averse. Similarly, the second question is phrased as avoiding a loss so people tend to be risk-seeking in an attempt to avoid the loss. This is another example of loss aversion.

• Buying “popular” investments and avoiding “unpopular” ones. It appears people may value large, popular companies too highly, relative to the alternatives. We believe this is attributable to this same regret avoidance. If a large or popular (“growth”) company subsequently performs poorly the investor (or portfolio manager!) won’t feel foolish (or lose their job) because he or she had lots of company and no one could have seen the problem coming. Conversely if the same problems happened to a small or unpopular (“value”) company the investor would tend to feel foolish. For this reason, it appears small cap and value companies may be systematically underpriced.

Improper Extrapolation. We use this term to refer to mental mistakes people make in evaluating information:

• Overweighting recent data over long term data.
• Overweighting events that have a miniscule chance of happening (lottery tickets, a mutual fund averaging 20% a year going forward).
• Overweighting extreme events.
• Seeing patterns where they don’t exist (securities prices are widely accepted in academia to be primarily a “random walk with drift”, market forecasters notwithstanding).
• Changing frame of reference too slowly (e.g., as stock prices change, acting as though the “value” of the investment is still the old price). This is known to academics as “anchoring.”
• Believing a trend must reverse itself (sometimes inaccurately called “reversion to the mean”). This is known to academics as “gambler’s fallacy.”
• Placing undue weight on readily available information in a decision. This is known to academics as “availability bias.”

Conscious Weakness. People frequently make decisions that are irrational from an objective standpoint because they do not trust themselves and seek to restrain their own behavior. In these cases, they make decisions that are illogical to restrain their consumption:

• Inconsistent required rates of return. Examples include having too much withheld from taxes to get a big refund check as a form of “forced” savings; simultaneously having a college savings fund in a low yielding account and balances on high interest credit cards; or refusing to use a home equity loan to consolidate higher interest loans.
• Irrational spending rules. Never spending “principal” and consequently holding too much in bonds and ignoring inflation.

(That last category may not be a mistake in the sense that even though it’s not logically optimal it may be behaviorally optimal if it keeps someone from making a worse decision.)

Recognizing these tendencies toward illogical behavior and consciously avoiding them can improve your financial planning and help you reach your financial goals.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2025

Most of us are prone to systematic errors in our decisions, and I would like to review two of them that seem to come up frequently. (For more, see here and here.)

The first issue is sunk costs. A sunk cost is something that is already spent or some action already taken. The logical error comes when we consider these costs when making decisions about the future. An example may help. Suppose you pay $100 for a ticket to a concert and then lose the ticket. Should you purchase another $100 ticket? Yes. Attending the concert was worth $100 when the original decision was made, and assuming you have $100 more to spend, it should be worth it still. But many people look at the $100 sunk cost (on the first ticket) and phrase the question, “Do I want to spend $200 to go to the concert?” Similarly, if for some reason on the day of the concert you really didn’t want to go (maybe the weather is terrible and you are tired), would you go anyway because of how much the ticket cost? Many people would. However, if they had been given a free ticket (or it was a free concert) they wouldn’t go. We shouldn’t proceed on paths that are no longer optimal because of the consideration of these irrelevant (at this point) costs. Some examples:

• I can’t change careers – I have too much invested in this one.
• We can’t abandon construction on our home – we have too much invested.
• I can’t sell that stock – I paid double what it’s worth now.

It may make sense to stick with your career, house, investments, etc. but the decision should ignore costs to that point. We should look at it as:

• All things considered, will changing careers make me happier than sticking with my current one?
• Will the future value of the home to me be worth more than the estimated future construction costs plus what I could get for selling right now?
• If I had cash instead of the stock, would I pay the current price of the stock to own it?

In short, sunk costs are irrelevant to the decision at hand.

The second issue I want to address is confusing good (bad) decisions with good (bad) outcomes. Not infrequently, poor decisions have good outcomes and poor decisions have good outcomes. For example, suppose someone offers you $100,000 to play a single round of Russian Roulette. If you decide to do so, and pull the trigger on an empty cylinder, you still made a very poor decision even though the outcome was good. Similarly, purchasing appropriate life insurance is a good decision even if you don’t end up dying while the policy is in force. Investing your retirement savings in lottery tickets is a poor decision even if you happen to win. Diversifying a portfolio is the correct decision even if your neighbor didn’t diversify and made a lot of money on a speculative stock.

In short, while it is profoundly counterintuitive, previous investments shouldn’t affect decisions and the quality of the decision is not determined by the outcome!

“Alternative” investments (aka “Alts”) are probably best defined as investments that are anything other than stocks or bonds (and cash is just a bond with a really short duration).

A few years ago I got the CAIA (Chartered Alternative Investment Analyst) designation, and I attend alternatives conferences periodically to be well informed. A recent conference prompts this note.

The attendees at this conference (like all the others) were very enthusiastic about alternative investments, and I was frequently asked about our usage. I usually responded, “I got the CFA to mostly index and the CAIA to own no alternatives at all – it’s a severe level of overkill.” I also sometimes just said we didn’t use them, but I was “alt curious,” which usually got a laugh. Here I thought I would set forth in detail my reasons for avoiding alts.

Though some of my reasons may apply to them as well, in what follows I am not talking about alternatives that have no current or prospective cash flows (other than from selling someday) and are impossible to value mathematically. Proponents will argue with me about that impossibility, but, in my opinion, they are merely grasping for rationalizations to own the investments – particularly since I have never seen anyone do a mathematical analysis on them that concludes they are overvalued.) Those alternative investments are frequently called “collectibles” and would include art, wine, stamps, coins, watches, antiques, beanie babies (at one time), NFTs (more recently), rare cars, trading cards, gold, cryptocurrencies, etc. (That last one, crypto, people would argue isn’t a collectible, but outside of the narrow use of facilitating crime there is no significant current use case for crypto despite a lot of hype. Blockchain, yes. Stablecoins, yes. Bitcoin, et al, no.) Some of those are more ridiculous than others as investments, of course, but all of them share the property that the investment case boils down to, “I think it will go up.” That opinion could, of course, turn out to be right, but it’s vibes-based, not empirical, and since they were first issued in 1997, TIPS are a far better option for protecting wealth against the ravages of inflation.

With those preliminaries aside, let me explain why I am unpersuaded to invest in currently popular alternative investments such as Venture Capital/Private Equity, Private Credit/Debt, and Real Estate (Hedge Funds too, though those are less popular today because the returns have been relatively abysmal for a while).

The trivial (and well-known) reasons are:

1. The fees are very high (compared to traditional investments). Indeed, in economic theory the returns will flow to the scarce factor of production. Supplying capital is not that factor. You would expect (and I do) that more or less all of the excess returns flow to the managers of the funds to the extent they have skill. (You may wonder about the “more” – many, probably most, managers are better at purporting to have skill than they are at having skill. They charge a lot either way.)

2. There is a hassle factor to investing in these. The investment process is onerous. The redemption process is onerous (frequently on purpose). They generally produce K-1s rather than 1099s, and those K-1s are notoriously produced very late – often running up against the extension (not regular) tax deadlines. These things aren’t terrible, but they do tend to annoy the investors. In addition, the work to research and perform due diligence is substantial, which would require us to increase our fees to cover researching and managing them.

3. Alts are illiquid, and more illiquid precisely when you don’t want them to be. This illiquidity is frequently touted as an advantage in the sense that you earn an illiquidity premium, but it isn’t clear why that would be so. Suppose you own shares in a partnership that invests in real estate, for example, that underlying property is illiquid, so it’s purchased at X% off some “true” value. You will also sell at X% off some true value on the back end. Consequently, on the price appreciation there is no advantage whatsoever (though the cash flows from the investment would be higher as a percentage of the amount invested). Even aside from that, it appears that today many investors will happily pay an illiquidity premium because in poor markets they can pretend the value of their investment has not declined when it really has. (Cliff Asness has eloquently made this point here.)

4. The purported low volatility and low correlations with traditional investments are simply not true (or at the very least greatly exaggerated). It’s merely a function of the assets not being appropriately marked to market, which makes the apparent risk and correlations seem low as a matter of pure mathematics. Further, many investors (and advisors) give these factors far too much weight. The return of the proverbial cash stuffed in your mattress has zero volatility and zero correlation with all other investments – but it’s still a terrible investment. (Lottery tickets are also completely uncorrelated to the rest of your portfolio.)

So far, so banal. I think there are four other substantial reasons though:

1. There is extreme positive skewness in the distribution of returns of the investments. This means most of them do poorly, but you are “saved” by the very few that do extremely well. This means you need to own a lot of them, but you would have to be extremely wealthy to afford to do so. This can be partly mitigated with funds-of-funds, but those produce another layer of high fees causing investors to start even further behind.

2. The “good” funds won’t let you in. As Marx (Groucho, not Karl) said, “I refuse to join any club that would have me as a member.” That should be your attitude toward alternative investments unless you are (again) extremely wealthy or a very large institutional investor. The funds with excellent track records are not only closed to new investors, they may also be returning capital to outside investors and converting into family offices for the owners and employees. The capacity of any very lucrative strategy (if you can find one) is very limited. If they need capital from you (or me!) that is a sign that it probably isn’t a great investment. Many remember David Swenson (of the Yale endowment) for his enormous success with alternative investing and writing Pioneering Portfolio Management touting that approach, but fewer realize he subsequently wrote Unconventional Success: A Fundamental Approach to Personal Investment for individual investors telling them not to do that – they aren’t the Yale endowment!

3. You can’t differentiate luck from skill because you will never have a long enough track record. To know whether a portfolio manager who has been beating the market by 2% annually (which is enormous) has skill would require a track record 56 years long. (This is a difference of means test assuming a normal distribution, 2% alpha, 20% standard deviation, and 90% correlation with the benchmark.) Thus, realistically, you will never know with any high degree of confidence whether a portfolio manager is skillful. I wish it were otherwise, but it simply isn’t. With alternative investments it’s even worse. The “uncorrelated” nature of them means the time horizon needed goes up even more. Returning to the earlier example, if the correlation is reduced from 90% to 85%, the time horizon necessary increases from 56 years to 83 years! And keep in mind that many alternatives promise zero correlation (if that were true, the time horizon needed to know with 95% confidence that the alpha is positive, not 2%, simply not a negative number given the other listed parameters, is 543 years). The investment industry, particularly in the alternatives space, is almost entirely faith-based rather than evidence-based.

4. Proponents of alternative investments will tell you to be very careful in what you purchase because one alt is not like the other – even in the same sub-type. (And, of course, their company sponsors the good ones.) With traditional index funds, there are advantages and disadvantages of full replication vs. sampling (though full replication seems better). With alternatives you definitely need full replication, which is impossible because of investment minimums. (It’s impossible for access reasons as well, but I’m focusing on the minimums here.) In academic theory you would start with a market-cap weighting methodology and then deviate from that based on the strength of your belief in the investment. How much belief do these alternative investments require us to have? The market cap of the U.S. stock market right now is roughly $60 trillion. Suppose you are contemplating investing in a real estate limited partnership that owns property worth $60 million. For every $1 million invested in U.S. stocks, how much should you put into the partnership? One dollar. But, of course, the investment has a $100,000 minimum (minimums vary, but that’s typical). So, suppose I have $10 million in U.S. stocks, I should invest $10. But the promoter requires me to be 10,000 times overweight that holding to access it. I’m sorry, I will never have enough confidence to overweight something by that much in my portfolio! Obviously, this is just one example with made-up numbers, but you will always be massively overweight the holding and thus should have confidence approaching certainty that it will have a high return. Arguably, you could also use the Merton share calculation.

TL;DR: Friends don’t let friends buy alts! (IMHO, of course.)