Continuing the theme from last month’s post, in a recent NYT magazine article, Madeline Albright said, “I’m an optimist who worries a lot.”

We should be optimists because, in general, economies grow and life gets better (see Triumph of the Optimists). But we should worry about risks in the short run. The concept of “permanent impairment of capital” is relevant here. While you should expect success, you should avoid risks that, if they occurred, you could not recover from (hence the “permanent”). So, it’s okay to be predominantly exposed to stocks, but not exclusively, and only in a diversified manner. Also, buy appropriate amounts of life insurance, disability insurance, umbrella insurance, etc. Have an adequate emergency fund. Save more than might seem to be strictly necessary.

Another key phrase in financial planning is, “but what if it doesn’t” and variations.

Some examples you may have heard or said yourself:

• Stocks have earned 10% a year historically. (But what if they don’t?)
• I plan to work until 70. (But what if you can’t?)
• My job is safe. (But what if it really isn’t?)
• Etc.

Bottom line: “Expect the best, plan for the worst, and prepare to be surprised.” – Dennis Waitley

I think I have touched on this before, but not at length and some of the things that happened in the world in 2020 are good illustrations of the point so I think it will resonate more right now.

I want to explain the difference between being a specialist vs. a generalist or, what is the frequently the same thing, optimizing vs. hedging.

If the world (or your corner of it) doesn’t change, you are more successful by specializing. But if it does change, the generalist does better. Similarly, in normal times, an all-stock portfolio has a higher expected return than one that includes bonds. But the portfolio with some bonds is more resilient (in a depression for example).

Here are some instantiations of these contrasting approaches:

• Buying vs. renting
• Fixed costs (e.g. automation) vs. variable costs (e.g. people)
• One product/service/skill vs. many
• One supplier vs. redundant supply chains
• Necessary personal relationships vs. expansive relationships
• All family work in the business vs. diversified incomes
• Honing your narrow skills vs. broadening them

All of this is very clear to me, but I’m not sure I can communicate it adequately. In a steady state (no catastrophes) the first “wins.” I’m going to use a depression as the trigger in the examples, but it could be anything: pandemic, natural disaster, technology changes, societal changes, political upheaval, etc.:

• You buy your home vs renting. Makes it hard to downsize easily (or quickly, or at all) in a depression, but it is cheaper (you keep the landlord’s profit margin) if there isn’t a depression.
• You buy a widget-maker that costs $500,000 and can produce 10,000,000 widgets (over its life) at $0.50 each vs. hiring people to produce them more manually at a cost of $0.60 each. But the depression causes sales to plummet and now you have an expensive widget-maker that is barely running (and that no one will buy in a depression). (Ignoring TVM, the breakeven for the widget-maker is $500,000/(0.7-0.6)=5,000,000 widgets and you would have made an extra $500,000 if times had stayed good.)
• You have been making only advanced widgets because they were the most profitable, but the market for those widgets is mostly gone and you have no other real lines of business or skill sets.
• You sourced all your raw materials from the very cheapest supplier (because you got a volume discount to concentrate your purchases), but that supplier went out of business in the depression and it will take a while to get an alternative source lined up. So now your widget-making machine is completely idle.
• You maintain great relationships with the people you need right now to work for you, buy from you, or supply to you. Why maintain relationships with your old college friends? Because if your business goes away, you may need contacts in other areas.
• Your (competent) spouse and children work in the business, which, because of high trust, leads to increased efficiencies (you have lower monitoring costs and higher efficiencies if you can really trust your business colleagues) but the business fails in the depression and no one in the family has an income.
• You chose to get a PhD in the field of widgets rather than a generalist MBA.

In general (there are exceptions), the less you have to lose (younger, poorer, etc.) the more you should specialize or do the first of the options listed. But as you experience success you have more to lose and should increasingly diversify or do the second (although renting seems to go the other way in practice for happiness reasons). As an extreme example, if you have the resources (a billionaire for example) you should maintain homes and holdings on multiple continents – just as a hedge against catastrophe in one country. At very high wealth levels it’s not extravagance, it’s merely prudence.

This isn’t all or nothing, in most cases you should be somewhere in the middle – you need to balance your risks. If you buy the house, probably don’t buy the widget-maker, and definitely don’t borrow to do both if you don’t have the cash!

So here’s the safe approach: use cheap debt to have cash on hand (i.e. instead of cash, not because you don’t have the cash), have diversified income streams (really diversified, and it can be tricky, the FIRE folks thought they were diversified because they had both stocks and Airbnb rentals but were gobsmacked last year), keep low fixed costs in business (and personally too – have low “needs” but liberally enjoy “wants” in good times), spouse and children with safer and/or very different jobs from you. All of those things will lead to lower net worth in good times (and on average), but higher net worth in bad times. In other words, the standard deviation of net worth is lower but so is the mean (just like bonds vs. stocks). In other words, your life (not just your portfolio) should get more bond-like and less stock-like as your net worth increases because the downside is more painful than the upside is pleasurable (see prospect theory).

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Winter 2021

I’ve talked about related topics before (most recently in Signs of a High-Quality Advisor), but I want to come at this from a different angle.

This will start with substance and end with marketing. Both are important, I think.

First, I was thinking about what attributes a high-quality (by which I mean they do an excellent job) financial planning/wealth management firm must have. I think there are three:

1. Technical excellence (including good judgement) – more than the CFP^® body of knowledge (which is just entry level)
2. Extremely caring – either caring about doing a good job, or caring about the clients personally, or (even better) both
3. Operational excellence – ability to get things done in a timely and error-free manner

Let me explain those a little further. If any one of those items is missing, the quality is a fail. For example, suppose the question is whether a client should do a Roth conversion or not (and how much):

1. An advisor/firm cares about the clients and can fill out conversion paperwork perfectly, but doesn’t know when a Roth conversion would be appropriate (technical issue) or assumes a liberal is going to win the next election and double tax rates so recommends converting 100% this year even though it puts the client into a much higher tax bracket (judgement issue) – FAIL for lack of technical competence.
2. An advisor/firm knows exactly what should be done and is capable of doing it perfectly, but it seems like a lot of work and the client won’t know, so blows it off – FAIL for lack of caring.
3. An advisor/firm knows exactly what should be done and cares about doing it, but is so disorganized the paperwork got misplaced, and then it turns out it was filled out wrong, and they forgot they would need a signature, and then it was the next calendar year so they missed a conversion opportunity at lower rates – FAIL for lack of operational competence.

The intersection of all three areas in the Venn diagram is the sweet spot.

Second, let me come to the marketing portion of this. In biology there is a concept of signaling. You can be very fit, but your genetic survival won’t be very good if no one knows you are fit. In other words, you can be a self-made multi-millionaire (economic fitness), but if everyone thinks you are broke you still might not have a boyfriend/girlfriend (and your genes don’t get propagated) unless you have some credible way of signaling your wealth. (I’m not suggesting that net worth is the only or even best definition of fitness, it’s just an easy example to use.)

A problem is that people fake fitness. For example, keeping with our economic example, they buy counterfeit name brands, ape a lifestyle they actually can’t afford (hello, fake Instagram life). So what signals fitness are things that are very easy for fit (in whatever domain) folks to do but very difficult for others to do. For example, if someone is very smart, then getting advanced degrees is easy (well, easier) than for someone who is dumb. So a graduate degree from an Ivy is a very good indicator of intelligence. An unintelligent person can’t fake that signal.

Let’s take this to the advisory realm. I’ve known advisors, as I’m sure you have as well, who talked a great game on the three items above. They could spout MPT terminology (but didn’t actually know what they were talking about), talked about how much they cared for their clients (but called them muppets behind their backs), and tried to look like they were very organized (but really weren’t).

So what credible (hard to fake) fitness signals on these three areas can we send to help clients recognize our excellence? In other words, items that are relatively easy for those with the actual skills, but difficult for others to fake:

1. Technical signals:
   1. Quality credentials (CFP, CFA, etc.)
   2. Writing analysis on a blog or newsletter (original, not purchased, content)
   3. Speaking to professional groups (not dinner seminars of lay people)
2. Caring signals:
   1. Frequent and meaningful conversations with clients (if you really don’t care about them this is hard to do over extended periods of time)
   2. Remembering details about their lives (CRM can help fake this to some extent, but going deeper than just knowing the children’s names is a credible signal)
   3. Sending thoughtful gifts or notes at opportune times (if you care then you both know what is going on with them and what would be meaningful to them)
3. Operational signals:
   1. Error-free paperwork
   2. Fast responses to phone calls and emails
   3. Timely reminders to do RMDs, conversions, retirement plan contributions, etc.
   4. Consistent follow-ups (friendly nags) to complete estate planning, get insurance coverage, change employee benefit elections, etc.

We are blessed at our firm that while we all care about each area and have multiple competencies, we have one person who really excels in each domain. (As I’m sure you would guess, I’m technical, Anitha is caring, Kaitlyn is operational. That doesn’t mean that Kaitlyn and I don’t care, or that Anitha isn’t technically competent, etc. but we each stand out in our strengths.)

Purchasing life insurance on a child is almost always foolish.  It might feel like the “responsible” thing to do, but the responsible thing it to carry appropriate life insurance (and disability insurance) on the child’s parents (or whoever is financially supporting the child).

Here is the math:

The highest odds of death, from ages 1 (after infant mortality risk has passed) to 18, is for a 1 year old male and the chance of death (all mortality figures from the RP-2014 tables) is 0.00041 or 1 in 2,439. The lowest is a 10-year-old boy with a chance of death of 0.000072 or 1 in 13,889.

So, the value of the insurance itself for a juvenile, while they are a juvenile, is the death benefit divided by somewhere between 2,439 and 13,889. In other words, if the death benefit is $20k (just to have an arbitrary number to work with) then the true cost of insurance is just $1.44 to $8.20 per year! So the vast majority of the annual premiums are just overhead. In fact, the value of the death benefit is so low, you can ignore it as immaterial and just do a straight time value of money calculation. What is the guaranteed cash value (FV) in year N for an annual premium of PMT (PV is zero)? It’s an annuity due (premiums collected up front), solve for I. I suspect it will be a negative number which means on average you would do better to just put the money in a sock drawer.

Let me do it another way. If you took out a policy for a child age 1 and held it until age 18 and it had a death benefit of $20,000 (sticking with my earlier arbitrary choice) then the total cost of insurance for the whole period is just $61.24 for a boy and $46.70 for a girl. If you have all the rest of the premiums paid in available as cash value at 18 then you still earned zero rate of return. (And I would be shocked if the cash value was that high.)

Don’t buy life insurance on children.  Fund a Coverdell or 529 plan for them instead.