The title of this piece is “guaranteed” to make financial regulators hyperventilate and plaintiff’s attorneys salivate, but I think you will find it hyperbole-free. Of course, as Benjamin Franklin famously observed, “in this world nothing can be said to be certain, except death and taxes” but I think these rules come very, very close.

Before we get to the rules, two initial items need to be clarified. First, we need to define “financial success.” As I have noted before (here) financial success can be defined as simply having more than you need. With these rules I’m thinking more along the lines of lifetime consumption smoothing (which Milton Friedman, among other economists, showed maximizes happiness). Second, these rules get you “guaranteed” and they may seem extreme. Many people will be successful doing less than suggested here, but the further you are from following these rules, the less certain your financial success.

So on to the rules…

The first rule is to start young. These rules will help at any age, but for “guaranteed” financial success starting young is imperative.

The second rule is to maximize all tax-advantaged retirement plans such as your 401(k), 403(b), SEP, SIMPLE, IRA, Roth IRA, etc. There are two pieces to this, 1) make the maximum permitted contributions while working, and 2) take only the required minimum distributions upon retirement. (If you don’t have access to a plan through your employer, or your income is high, you may need to save in a taxable account as well. The idea is to have about a 25% savings rate – just for retirement, other saving, such as for children’s higher education, would be in addition to that. Note that in reaching 25%, principal payments on a mortgage count as savings, as do Social Security contributions.)

The third rule is to never borrow money for a depreciating asset. A depreciating asset is one that declines in value over time such as a car, consumer goods, etc. For this rule it is easier to explain the things that it is acceptable to borrow for. I think there are only three:

1. A prudent education. Prudent in two ways – the field of study and the cost. For example, borrowing $60,000/year to go to an exclusive private university for a bachelor’s degree in theater arts is likely to be a terrible investment for most students. Borrowing $20,000 to go to the state university for an engineering degree is likely to be a very good investment for most students. Obviously not borrowing at all is optimal, but if it is the only way to get the degree it can be a good use of debt.

2. A primary residence. Obviously homes can decline in value, but assuming you make a reasonable purchase (purchase price no more than 2x gross income) this can be a “good” debt.

3. A low-risk investment. Many businesses appropriately borrow money to fund expansion or for seasonal working capital. Borrowing conservatively to purchase a rental property can be prudent as well.

The fourth rule is to hedge all the risks you reasonably can. This would include buying appropriate amounts of life, health, and disability insurance, as well as liability insurance. Also, avoid concentrated stock and business investments and further diversify your portfolio between stocks and bonds, domestic and foreign holdings, etc.  Finally, realize that divorce is one of the biggest risks of all.

It may be possible to follow these four rules and still end up a financial failure, but I can’t think of a way.

This is an excellent list of how to evaluate scientific evidence.  Almost all the issues are applicable to evaluating whether a manager or investment approach will demonstrate outperformance in the future.  To wit:

• Differences and change cause variation – that outperformance is subject to a very high level of sheer randomness.
• Bias is rife – particularly given the huge rewards to finding (or claiming to find) an edge.
• Bigger is usually better for sample size – a 3-, 5-, or even 10-year track record is essentially meaningless.
• Correlation does not imply causation – self-explanatory.
• Regression to the mean can mislead – just when a manager or effect looks great (or terrible) performance will become much more typical.
• Extrapolating beyond the data is risky – it may have worked before, but the future is out-of-sample.
• Beware the base-rate fallacy – given the rarity of true alpha, historical alpha is probably meaningless.
• Controls are important – and you generally don’t have a control in investing.
• Randomization avoids bias – and again you generally don’t have this in investing.
• Seek replication, not pseudo replication – rolling periods are not separate tests because of the overlapping data.
• Scientists are human – and product providers are even more prone to bias given the enormous incentives.
• Significance is significant – if you try 20 things, one, on average, (by sheer randomness) will appear to be significant at the 5% level.
• Separate no effect from non-significance – the sample sizes (track records) are probably too small to find the effect even when the manager or strategy in fact does have true alpha.
• Effect size matters – differentiate between results that are statistically significant and those that are economically meaningful (generally not a problem in investing, if it is significant  it will generally be meaningful)
• Study relevance limits generalizations – the market/economy/etc. isn’t the same now as it was in the historical data.
• Feelings influence risk perception – self-explanatory.
• Dependencies change the risks – we rarely have independent factors.
• Data can be dredged or cherry picked – and in our industry it will be not just dredged or cherry picked, but tortured to death.
• Extreme measurements may mislead – lots of things led to the performance, not just the factor you are focused on.

In my head I have had a hierarchy of items I disseminate:

1. Quick simple thoughts or forwarding of things to my coworkers via email.
2. If it is a little more interesting also share (via email) with my consulting clients. (These are other RIA firms that have me on retainer for my perspective.  If you are interested in this let me know.)
3. If it is an item worthy of even broader distribution, email it via my “financial professionals” list at the end of the quarter.
4. If I think it is a useful analysis of a topic, flesh it out into a blog post.
5. If I think it is a really useful analysis of a topic, do a whitepaper (pdf) on it and put it on our web site.

In other words, I have always felt that a white paper is more important and permanent than a blog post, which in turn is more weighty than an email.  I never felt most of my random musings and comments were blog-worthy, but rather reserved them for (ephemeral) emails.

But Michael Kitces has been bugging encouraging me for a long time to put the content of the quarterly Financial Professionals email on this blog.  So I have (finally).  That email goes out the 15th of the month (or the next business day, if the 15th isn’t one) after the end of each calendar quarter (so January, April, July, and October).  From now on I’m going to post that missive here too (on the first of the month following that date).

So, this being May 1st, here is the first one.  I have uploaded the ones back to the beginning of last year as well.  They were never intended to be permanently available on the web, but I hope you find them worthy!

Financial Professionals Winter 2017

Financial Professionals Spring 2017

Financial Professionals Summer 2017

Financial Professionals Fall 2017

Financial Professionals Winter 2018

Financial Professionals Spring 2018

John Bogle has cautioned, “Too many investors-individuals and institutions alike-are constantly making investment decisions based on the lessons of the recent, or even the extended, past.”

Here is a chart of the major asset classes sorted by the differences between the penultimate downturn and the last one:

Asset Class	8/2000 – 9/2002	10/2007 – 2/2009	Difference
DJ US REIT	21%	-66%	87%
Alerian MLP	59%	-28%	87%
R2000V	8%	-51%	59%
GSCI	6%	-49%	55%
R3000V	-18%	-54%	36%
R1000V	-19%	-54%	35%
MSCI EAFE Small	-25%	-57%	32%
Barcap Long	30%	4%	26%
R2000	-25%	-51%	25%
Barcap 5-10yr	30%	6%	24%
MSCI EM	-34%	-57%	23%
CSFB HY	-2%	-24%	22%
Barcap AGG	25%	7%	18%
Barcap 1-5yr	22%	8%	14%
MSCI EAFE	-42%	-55%	13%
ML Conv.	-27%	-39%	13%
3Yr TSY	23%	11%	11%
R3000	-40%	-50%	10%
DJ Broad Stock Mkt.	-40%	-50%	10%
R1000	-41%	-50%	9%
S&P 500	-41%	-50%	9%
3Mo TSY	8%	2%	5%
6Mo CD	11%	6%	4%
3Mo CD	9%	5%	4%
BLS CPI	5%	2%	3%
R2000G	-51%	-50%	0%
R3000G	-58%	-47%	-11%
R1000G	-58%	-46%	-12%

As you can see, owning REITS, commodities, small value stocks, and MLPs all were great in the dot com aftermath and fixed income did really well also.  While the S&P 500 was going down 41%, equal weighting of the four assets mentioned earlier would have been up 24%, and an equal weighting of the four fixed income indexes highlighted would have been up 27%.  Thus a 75/25 portfolio (pretty aggressive) of 50% S&P 500, 6.25% each in the 4 fixed income assets, and 6.25% in the 4 other assets mentioned would have been down 8.1% in the earlier downturn.  But in the more recent financial crisis it would have been down 35.7%.

Suppose a client is going to contribute $X per month.  A trade could be done every month, incurring a transaction fee, or every other month, or every third month, etc.  When is the optimal time?

It depends on the spread of expected return of the asset class to be invested in over the expected return on cash (that isn’t really right, because they actually ought to be risk adjusted returns, but I am going to ignore that for simplicity), the amount of cash, the expected next inflow and amount, and the transaction cost.

For example, assume a client is going to add $1,000 to their account each month, the cost of the trade is $10, the expected return on cash is zero and on the prospective investment 8%.

The first month there is $1,000 in cash and investing it will cost $10.  That is a 100 bps cost but the expected return (monthly) is just 64 bps [1.08^(1/12)-1] so that is a bad deal.  The next month there is $2,000 and investing it costs only 50 bps, but the return for a month is still 64 bps so now it should be invested.

Here is the formula:

((1+I)/(1+C))^(T/12)-(T/D)-1

Where:

• D is the dollar amount of the proposed trade
• T is the transaction cost of the trade in dollars
• C is the expected annual return on cash
• I is the expected annual return on the proposed investment
• T is the time in months until there will be additions to the account or a rebalancing, etc. (I am assuming these changes will be of significant size.  Obviously, if the upcoming deposit is $1 it wouldn’t be worth waiting for.)

If the solution to the formula below is positive, do the trade, if negative, don’t.