Imagine I have 1,000 shares of stock with a price of $20/share; a basis of $4/share; and a marginal tax rate (now and forever) of 25% (just for simplicity).

I can think of that as a combination of:

1. A stock position worth 1,000 * $20 = $20,000
2. A liability of ($20 – $4) * 1,000 * 25% = $4,000. This is the tax I owe at-the-money (ATM hereafter).
3. A short ATM call option on 25% of the position. So I have essentially sold a call option on 250 shares with a strike price of $20 and an expiration of whenever I think I will sell (or death, given a step-up). This is the additional taxes I owe if the stock goes up.
4. A long ATM put option on 25% of the position. So I have essentially bought a put option on 250 shares with a strike price of $20 and an expiration of whenever I think I will sell (or death, given a step-up). This is the taxes I save if the stock declines. (And if it goes below the basis, I assume I can use the loss against another gain elsewhere.)

That description above is sort of a collar on 250 shares of stock. A collar has treasury equivalent value. In other words, a collar with the positions all at the money, would be a short call plus a long put, plus the stock which equals a Treasury. Plugging in the previous values, I can create a treasury by using 25% of the stock (250 shares), plus the ATM short calls on 250 shares, plus the long ATM puts on 250 shares. Assuming everything is ATM initially, and we assume no time value on the options, that would be a “value” of 250 * $20 = $5,000 for the Treasury. No risk. (Leaving aside the other 750 shares of stock I own.) Plus I owe $4,000 in embedded taxes. So that nets to long 750 shares of stock plus $1,000. (Which is the tax rate times the basis of the whole position.)

So, when you buy a stock, it’s like owning one minus your tax bracket percent of it in a Roth (so 75% or 750 shares in this case) plus your tax bracket times the basis of dollars (no interest on this fixed income position; it’s like holding actual currency). So if I purchased, right now, 1,000 shares of the stock at $20 and I have a marginal tax bracket of 25%; it’s like having $5,000 plus 750 shares of tax-free stock. That is much lower risk (beta) than the 1,000 shares of the stock in a Roth.

This is one reason why you should hold riskier assets in taxable accounts rather than in retirement accounts.

(For more on these issues, see After-Tax Portfolio Allocations and Asset Location Strategy.)

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Fall 2022

When asked, we refer to ourselves as “wealth managers” and this month I thought I would explain that term and a few related things.

Wikipedia defines Wealth Management as:

[S]ervices to a wide array of clients ranging from affluent to high-net-worth (HNW) and ultra-high-net-worth (UHNW) individuals and families. It is a discipline which incorporates structuring and planning wealth to assist in growing, preserving, and protecting wealth, whilst passing it onto the family in a tax-efficient manner and in accordance with their wishes. Wealth management brings together tax planning, wealth protection, estate planning, succession planning, and family governance.

I want to explain it in a slightly different way. You may remember Maslow’s Hierarchy of Needs (probably from an Introduction to Psychology class in college). In Maslow’s Hierarchy, each need must be satisfied before the next one is relevant (though there is frequently some overlap). In other words, if you are in immediate physical danger you don’t really worry that much about whether you are loved and respected. I believe there is a similar paradigm that I call the “Financial Planning Hierarchy of Needs” which proceeds from a focus on the individual’s immediate personal finances to a focus on needs that are more distant both temporally (i.e. much later) and relationally (i.e. for more distant people):

1. Desire to be okay financially in the short run. This is the most pressing need. If an individual can’t pay their current bills, the next items aren’t really a concern. (This typically isn’t an issue for our clients, but it is for much of the population.)
2. Desire to be okay financially in the long run. Once the current bills are paid it is time to be concerned about the future. This is a focus on the individual still, but incorporates a longer time period – including retirement.
3. Desire to help your descendants. The next goal is usually to help the children (or grandchildren, and possibly even more distant descendants). Frequently this starts with education expenses, but also potentially includes other gifts or bequests.
4. Desire to help others. This usually takes the form of charitable giving or bequests.

Generally these are funded in order. Item one is generally funded (or is on track to be so) before two, two before three, etc. Financial planning focuses more on the top of the list compared to wealth management.

Over time most people start with a lot of human capital and little financial capital. In other words, in your 20’s you typically don’t have much money but you have a lot of future wages expected. In your 70’s (hopefully) the reverse is true as you have converted wages to financial capital over time by working and saving. Thus, there are two categories of obstacles to achieving the goals mentioned previously that are of varying importance depending on the specific situation:

1. Human capital impairment
   1. Disability
   2. Premature death
   3. Job loss
2. Financial capital impairment
   1. Expropriation (primarily through inflation and taxes)
   2. Divorce
   3. Personal liability (e.g. you cause a car accident)
   4. Unexpected health costs (including long-term care)
   5. Low returns
   6. Casualty (e.g. your house burns down)

Generally financial planning can address most of those risks and at least mitigate if not eliminate them by using appropriate insurance, portfolio construction, legal documents, legal entities, etc. As noted earlier, as compared with financial planning, wealth management addresses these issues in a more integrated and comprehensive manner, and typically for people with somewhat higher net worth.

To summarize, as the wealth of the individual or family increases, the focus typically includes more distant descendants (in time) and more distant people (in space). In other words:

• If you don’t have a particularly high net worth you may just be trying to pay for your children’s college. (financial planning)
• If you have a significant net worth you may be trying to make sure there are trust funds that will provide for your family for generations, or that your gifts to local charities are made as efficient as possible. (wealth management)
• If you have enormous net worth you may move to another whole level and try to end malaria in Africa! (large-scale philanthropy)

There seems to be view (particularly on the left) that some wealth distributions are grossly unfair (and government should do something about it), but they have not thought through the implications of their beliefs.

Take whatever distribution you think is the outer limit of fair, for example suppose you think no one should have more than $1 billion dollars net worth or less than $100,000 of net worth. Or (equivalently) no one should have a net worth in excess of 10,000 times someone else’s. The actual distribution doesn’t matter. It could be that everyone should have exactly the same amount, whatever. As long as you think there should be some limit on either end (I’ll use the $X for the top end and $Y for the bottom end) then:

• If you are at $X maximum you are (functionally) not allowed to work or invest. If you do so you would go over the limit.
• If you are at the $Y minimum you are not allowed to spend any of your money because then you would be under the minimum. So you really don’t have $Y since you aren’t allowed to spend it!
• Suppose the $X person is an entertainer and wants to do a show, and suppose the $Y person wants to pay to go to the show. The tickets are $1. They are not allowed to transact! Even though both would like to, it would be illegal if you really believe that no one should have more than $X or less than $Y.
• If “everyone” gets $Y net worth regardless of what they do then they should spend extravagantly and the government will give them back what they spend because they would be below the minimum “fair” amount.
• Alternatively, if “everyone” gets $Y net worth regardless of what they do then they could take that $Y and buy deep out of the money options (or lottery tickets, or whatever). If they win, then they are rich, but if they lose the government gives them the money back!

This is insanity!

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2022