We all go through four stages of competence as we learn something new:

1. Unconscious Incompetence – we don’t know enough to even know we are incompetent (Dunning Kruger Effect)
2. Conscious Incompetence – we know enough to recognize our incompetence (Socrates: “The only thing I know is that I know nothing.”)
3. Conscious Competence – we know we are competent, but we realize how difficult it is to be so
4. Unconscious Competence – we are competent, and can’t imagine how someone could remain incompetent when it is so simple

So how does this apply to investing? I think people go through the same four stages (if they progress):

1. “Investing is easy – just buy the investments that are obviously going to go up.” (And, as Will Rogers said after the 1929 crash, “if they don’t go up, don’t buy them.”)
2. “Investing is hard – I have no idea what is going to go up.”
3. “Investing is hard – I’ll just buy everything (index).”
4. “Investing is easy – why doesn’t everyone see the obvious, that due to the arithmetic of active management they would be better off if they just indexed?”

(There are higher levels of investment expertise than this for professionals, but I’m thinking of the investment approach of an individual investor without professional help.)

You may have heard of the strategy of “bunching” charitable contributions.  This is a tax optimization strategy for folks who are charitably inclined, but who might not itemize other than that (or even despite that). Obviously, the new tax law makes the strategy applicable to a much larger number of people. For example, suppose someone is MFJ with no mortgage. Other than their $10k of SALT (State And Local Taxes) they may well have no itemized deductions other than whatever charitable gifts they make – and if those gifts are less than $14k  each year (plus inflation to the $24k standard deduction limit, but I’m going to keep this simple and just use a limit of $24k) they will get no tax deduction for them. Suppose they regularly donate $10k/year to their place of worship – would it make sense (perhaps using a DAF as a holding vehicle) to donate $20k every second year (getting a $6k deduction)? $30k every third year (getting a $16k deduction)?

I was curious how many years should be bunched. I think it is a function of the following:

1. How much the taxpayer “normally” gives.
2. Their marginal tax bracket.
3. Their discount rate (they must come up with more cash initially to do the strategy).
4. How far they are from itemizing (if they would itemize even without the charitable contribution they needn’t – and shouldn’t – bunch).

Here is a spreadsheet which shows the NPV of the strategy for various levels of bunching and discount rates.

Yellow cells are the inputs. Discount rates are after-tax so think munis, not t-bills, for rates.

Using my previous example, with a 30% marginal tax bracket, and a 5% discount rate (which I think might be high), the taxpayer should do charitable contributions 8 years ($80k) at a time.

Other considerations and issues:

1. Less wealthy charitably-inclined clients tend (I think) to look at it in terms of dollars/year, as in, “I give (or want to give) $X/year to Y charity.” More wealthy clients may think of donations of large lump sums periodically. This calculator is more applicable to the less wealthy.

2. There is of course uncertainty as to future tax rates which is virtually impossible to handicap, but I think the risk goes both ways. Marginal rates could go up, marginal rates (not taxes maybe, but rates) could go down (perhaps in conjunction with a VAT for example). A few years ago who would have predicted the lower tax rates that now exist?! (English really needs an interrobang.) Of course the client’s situation can vary too so this is very similar to figure out whether and how much of a Roth conversion to do.

3. I’m not sure at this point what discount rate is “right” but it is an interesting question. Let me generalize a little bit which may make it clearer. I think it might be easier to think about an expense other than charitable giving. A client can prepay an expense. The expense is not large relative to their net worth. For example, a gym membership where you can pay annually (less) or monthly (cumulatively more). What is the cost of capital that should be used to figure out whether to do it or not? I can think of four possibilities plus four possible adjustments/other factors.

2. 1. Hurdle Rates:
   1. 1. The return on their checking or savings account because they now carry a lower balance.
      2. The return on a short-term bond fund because it is short-term “investment.”
      3. The HELOC rate because they now carry a higher balance.
      4. The expected return on their portfolio – i.e. what their 60/40 is expected to do. I don’t think this is right because the risk is different, but it is a possibility and would be analogous to the WACC for a company I suppose.

3. 2. Adjustments/Other Factors:
   1. 1. Convenience – I might prefer to pay the gym annually rather than monthly to simplify my checkbook balancing or avoid potential late fees if I forget (online banking may have made this issue largely moot).
      2. Optionality – I might prefer not to pay the gym annually because I might change my mind or want to go to a different gym. On the other hand, in this specific example, I might want to incent myself to go – it’s the sunk cost fallacy, but it seems to work for many folks. So the optionality value could conceivable be negative.
      3. Risk – I might prefer not to pay the gym annually because I might get injured, move, etc. so it could be wasted.
      4. Forced saving – I might prefer my checking/savings balance look lower, so I don’t spend the money on other consumption or unwise purchases. Or discourage spouse from same.

The calculation – here is the intuition behind the spreadsheet:

1. We want the present value of the difference between donating $X every year vs. doing it in lumps when we are $D distance from itemizing. For ease of calculation let’s assume someone is:
   1. $10k from itemizing (e.g. $14k of non-charitable deductions for MFJ)
   2. they would normally give $15k/year
   3. we want to know the value of bunching 5 years
   4. with a discount rate of 5%
   5. and a marginal tax bracket of 24%
2. In year one the incremental value is:
   1. An outflow of $60k (four extra years at $15k each)
   2. An inflow due to the incremental tax deduction of $14,400 ($60k*24%)
   3. So the net cash flow in year one is an outflow of $45,600
3. In the subsequent years (4 in this case) the value is:
   1. An “inflow” (really just less expense) of the $15k they aren’t donating
   2. An “outflow” of $1,200 (the $5k they would have been over the standard deduction at a 24% tax rate)
   3. So the net cash flow in subsequent years is an inflow of $13,800 (again it’s really a lower expense, but that is the same as an inflow to the household)
   4. The PV of a payment of $13,800 for four years at 5% is $48,934 [=PV(0.05,4,13800) in Excel]
4. $48,934 minus $45,600 is $3,334. I.e. the present value of bunching in this case is $3,334.

A related question is whether a taxpayer should use a Qualified Charitable Distribution (QCD) vs. Donation of Appreciated Securities (DAS).  Assuming the taxpayer has the choice of either (i.e. they are over 70½ and have securities with long-term capital gains) here is my analysis of the optimal choice:

1. Does the taxpayer itemize?
   1. No, not even with the prospective DAS → QCD
   2. Yes, or only with the prospective DAS → go to next question
2. Is the taxpayer’s LTCG rate greater than 0% (including through a future step-up)?
   1. No → QCD
   2. Yes → go to next question
3. Is the taxpayer subject to SS or other phaseouts?
   1. No → DAS
   2. Yes → uncertain (you have to run the numbers)

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2020

The market’s estimate of inflation can be derived simply from the spread of “regular” (nominal) treasuries and TIPS (treasury inflation-protected securities). As I write this, the 30-year treasury is at 1.4% and the 30-year TIPS is at -0.2% (per Bloomberg). So, very simplistically, inflation is expected to average 1.6% (the difference). That is slightly off though in three ways:

First, it doesn’t matter much at the current low rates, but subtraction isn’t technically correct. The returns on nominal bonds are given by this formula: (1 + yield) = (1 + real rate) * (1 + expected inflation) * (1 + risk premium)

Since we are talking about treasuries, the risk premium is (supposedly) zero so that term drops out. We can rearrange the remaining terms thus: (1 + inflation) = (1 + nominal yield) / (1+ real rate)

Plugging in the current rates we have: (1 + inflation) = 1.014/0.998 = 1.0160

Subtracting 1, we are left with 1.6% as the inflation expectation. (As I said, very close to just subtracting at these low rates.)

Second, since TIPS are slightly less liquid than nominal treasuries we would expect a small liquidity premium (much like the difference between on-the-run treasuries and off-the-run treasuries). In other words, the TIPS yield is a little higher due to being less liquid which means expected inflation is actually a little higher than the spread would indicate.

Third, since TIPS eliminate inflation risk, buyers should be willing to pay a small premium to avoid that risk. In other words, the TIPS yield is a little lower due to having less risk which means inflation is actually a little lower than the spread would indicate.

My astute readers will have noticed that the previous two items go in opposite directions, so they offset each other. They are also difficult to estimate and are likely small in magnitude. In practice that means I ignore them.

Also, a note for data nerds, inflation is:

• heteroskedastic – the volatility of inflation is correlated to the level of inflation
• autocorrelated – the current level of inflation is related to the previous level of inflation
• positively skewed – high inflation is further away from the median than low inflation

There is a natural tendency for things to become increasingly adapted to their environments and with this adaptation to be more and more successful. These successful entities (organisms or companies) grow larger and larger – until.

Until the environment changes. There is a trade-off between specialization and adaptability. The more successful an entity is in one environment, the less successful it will be in another. The bigger the “bet” you make the better you do when it works, but the worse you do when it doesn’t.

The sweet spot is somewhere in the middle. You never want to go “all in” on the current environment, but neither do you (probably) want to maintain perfect flexibility.

This applies to career choices as well. One of the highest paid college degrees is petroleum engineer, one of the lowest is liberal arts (but philosophy majors do better than you might think). But what if the world changes? Again, there is a trade-off between specialization and breadth. The petroleum engineer’s career is high return and high risk like a stock portfolio, a liberal arts major is more like a bond portfolio, their career is likely to be (financially) unspectacular, but their downside is likely lower (given equal intelligence, etc. – I’m not sure the average liberal arts major has the same qualities as the average engineer, but in this analysis, I am assuming the same student merely selected one or the other and had the ability to be academically successful in either major). The best combination is probably a technical (STEM) degree with a minor in liberal arts. Or maybe a liberal arts degree with a technical graduate degree.

In portfolio construction, this means you overweight what has worked (equities, factor-tilts, etc.) but you always remember the future could be different, so you prudently diversify too (investment grade bonds, core holdings, etc.).

Probably the best way to hedge an unknown future is to use as little leverage as possible in your business, personal finances, etc.

People don’t seem to think enough about the possibility that the landscape can change. Survival of the fittest depends on the environment, being perfectly fit for an environment is better than fitness for lots of environments – until the environment changes. I would note that this overspecialization is a bigger risk for the young since the amount of future change that can happen is greater over a longer period.

Similarly, this article parallels how I think about financial planning and portfolio construction. Wealth management is an “infinite game” – survival is more important than getting the highest score. Thus, you should not (completely) optimize for the current situation because the current situation may not persist, and we don’t know in what ways it could be different.