Updated: October 2020 (the world went crazy in 2020)

Human Emotion is a powerful force which, among other things, helps us to make decisions. Not necessarily good or rational decisions, but decisions nonetheless. It helps us get past the forks in the road. Our emotions essentially encode and intricately tie together our life experiences, biases, likes and dislikes. Now, emotion can work out brilliantly for some. But, consistenly relying on one’s emotions to make decisions can very quickly derail into something akin to playing a lottery. Even if you win, you know you can’t explain it, let alone repeat the process. And one of the last things you want to do is to use all your hard-earned money to buy lottery tickets.

Which brings us to the daunting subject of financial planning. And one strategy to systematically eliminate emotion from it. This strategy is exceedingly simple by design. It is clearly not the cleverest thing you can do, but again cleverness is emotion wearing a top hat. As we go through the strategy, keep in mind, the concept of net worth which we will keep alluding to. It is basically your assets minus your liabilities. We will use N to denote it.

A common misconception

A common misconception is when people confuse an account-type with an investment vehicle. Think of account types as a partition (independent compartments of money) of your portfolio. Most people will have a handful of different account types (savings account, checking account, 401(k), IRA, etc) and the money in all those accounts will constitute their portfolio. An investment vehicle is what that money does sitting in those accounts. Some account types offer more options for investment vehicles than others. For eg., for a savings account, you only get a single option: a so-called “Money market fund” that matches the inflation rate. On the other hand, a 401(k) offers a broader set of options including stocks, bonds, bitcoin, etc. Please take a moment to review these popular account-types and the investment vehicles they offer

Account Type Investment Vehicles Offered
Savings Account Money Market Funds
Checking Account None
401(k) Typically set by the employer, usually just broad stock & bond index funds
IRA Full gamut of investing options like money market funds, individual stocks, options, futures, index funds, etc
After-tax brokerage account Full gamut of investing options like money market funds, individual stocks, options, futures, index funds, etc
529 Typically set by the plan offering this account, usually just broad stock & bond index funds
CD Typically a higher-rate Money Market Fund with more access restrictions

Your Savings Rate

Believe it or not, you have a “savings rate” too. And that is one of the best indicators of your financial health. I am not talking about the savings rate offered by your savings bank account. I am referring to (I - E) / I where E is your monthly expenses and I is your monthly income. Later in this article, we will discuss what to do with (I - E).

The strategy is to have plans of action for a variety of time horizons: 1 day, 6 months, 3 years, 10 years, and on and on. For each time horizon, you set aside an amount of money that you promise not to touch within that time frame. Below I present the plans for the various time horizons. These may not align perfectly with you and your life goals. But the idea is to get you to think of how you could adopt and adapt such a meta-plan.

1 day

We’re basically talking about who’s paying for your dinner tonight. The you from many months ago has hopefully already made this a simple choice for the you today. Tip: Always keep some cash for urgent situations. Still, prefer using credit cards for their rewards.

6 months

Time for today’s you to pay it forward. You have to budget for your expenses in the next 6 months. Ask yourself, how much rent do you pay every month? How much do you spend on your daily means? The transportation costs? Let’s say this number is X. That means if you cut all income streams today, it will take 6 whole months for you to drain X. See what % of N is X. Is it more than 100%? Ouch, that means you really got to save much more than you do today or make more than you do. Hustle! Basically, stop reading until 2 things happen: 1) you save X in a checking/savings account, and 2) X drops to <20% of N.

A quick note about Savings and Checking accounts

While a Savings account offers a higher interest rate but only up to 6 outgoing transactions a month, a Checking account offers a debit card, check and no restrictions on number of transactions every month. It is ideal if you can have it so that a Savings account is all you need, but you should still keep some money in a Checking account in case you need to write checks, make emergency transactions, etc.

Recommendations for a Savings account are (as of June 2019)

At all costs, avoid a big name brand’s (Chase, Bank of America, etc) savings account as they offer close to 0% when you can get a lot more.

Recommendations for a Checking account are (as of June 2019)

  • Capital One
  • Bank of America
  • Charles Schwab (offers a debit card which can be used on any ATM internationally with no fees)

Refer to doctorofcredit for the latest info on sign up bonuses, etc.

1 year

If you are reading this, I’m assuming N is now at least 5X. Good job! Uptil now, all of N was a store of value. You didn’t expect it to grow over time. All you expected from it was that it kept pace with inflation (i.e. if N could buy you 10 packets of Lays today, it will buy you 10 packets in 2040). So, what do you do with 4X (N after leaving out the emergency fund)? From here on, you have to think of 2 additional dimensions: taxes and risk-adjusted-return. For the tax dimension, you have two choices for account types:

  • “tax-advantaged account” (401k, Roth, 529, etc)
  • after-tax account (brokerage, savings, checking, CD, etc).

For the risk-adjusted-return dimension, the various options for investment vehicles are:

Investment Vehicle Ticker Symbol Short-term risk Long-term risk Preferred account type
Money Market Funds VMMXX Low High Savings
Bonds VBTLX Medium Medium 401(k)
US Stocks VTSAX High Low Roth / Brokerage
International Stocks VTIAX High Medium Roth / Brokerage
(“Fancy”) Emerging Markets VEMAX High Medium Roth / Brokerage
(“Fancier”) India ETF INDA High Medium Roth / Brokerage
(“Fanciest”) Individual Stocks Name-Your-Favorite-Company ??? ??? Roth / Brokerage
(“Fanciester”) Tail risk hedges Deep OTM Call or Put options ??? ??? Roth (because of crazy upside)
(“Fanciestest”) Bitcoin Open a Coinbase account and start Extremely High Extremely Low (jk) Roth / Brokerage

Why is the long-term risk of Money Market Funds high? Because they barely match inflation and will ensure that you continue to need a steady stream of income outside of your portfolio.

Regarding the tax dimension, in almost all cases, prefer to fill up tax-advantaged space whenever possible and then spill over to after-tax space. The amount that you may choose to invest for 1 year (remember the time horizon of 1 year means you decided you don’t need this money for 1 year) may depend greatly on your personal situation. But mathematically, the money you have is 4X (one-time) and I-E (monthly income minus expenditure) every month. If you are just starting out, you can simply pick a fraction say 0.5, and equally divide 0.5*(I-E), contributing into VMMXX, VBTLX, VTSAX and VTIAX every month. Setting up automatic investments on Vanguard is easy, see this. As you learn more about this space, feel free to adjust these fractions.

1 - 3 years and beyond

Things are getting really interesting now! If you are thinking this long term, you have a stable job that’s making you more than you need right now and even for a year. That’s great news. So where does this new money go? If things are going as planned, X should be 5-10% of N by now. All the difference is in a combination of the funds outlined above, completely filling out the tax-advantaged space. As you move to plan for the longer time horizons, it is important to realize 2 concepts: 1) power of compounding, 2) strength of human productivity and innovation. The more time you let an investment compound, the more non-linear and delightful it is! This is where the second point comes in. By buying companies, specially companies that are innovative in a competitive environment, you can reap the benefits of millions of humans (company employees) putting their minds together to find newer and more efficient ways of doing things. The benefits reach you in the form of appreciated stock prices after multiple years of holding the stock. But which company will be the most dominant in 5 years? Will it be the same as the dominant one 15 years in to the future? Probably not. Wouldn’t it be nice if you never had to take this call? Well, that’s where index funds (the Vanguard funds above are all the index funds you’d typically need) come in. So you basically keep buying more and more of US and International stock markets and capture part of the productivity gains made by the 10s of 1000s of companies in the world.

A quick note about Options

An option is a time bound contract you enter with another party to buy or sell an underlying security at a set price. For eg., a “NFLX 200p 11/01/2021” is an option (aka PUT option) where the buyer buys the option (if they so chose to, but are not required to) to sell 100 Netflix shares at $200 at any time between date of option purchase and November 1, 2021. Once that date passes, the option is said to have expired. The buyer of this option “has found a potential buyer”.

OTOH, the seller of this option (technically the party who wrote this contract) has agreed to buy 100 shares of Netflix from whoever owns the contract at the time it is executed. The seller agreed to be the potential buyer.

Instead of executing this option, the buyer can sell it to another buyer (aka sell to close the position). The seller OTOH doesn’t have the option to execute the contract. Besides not upholding their side of the agreement (which is the counterparty risk), they can sell their position to another party (aka buy to close this position, they can’t technically sell an option they don’t own).

Similarly, a “NFLX 200c 11/01/2021” is an option where the buyer buys the right to purchase 100 NFLX shares at $200 at any time between date of option purchase and November 1, 2021.

What is Tail risk hedging

Markets are non-ergodic which is a fancy term for random processes that are sequence dependent.

A drop of Requires a rebound of
10% 11.11%
20% 25%
50% 100%
75% 300%

There is a non-zero albeit very low chance of the market dropping by 75%! Unfortunately, there is no way the market can rebound 300% in the same amount of time. So what is one to do? Here are some options to protect the downside:

  1. Market timing
    • Very very hard, see argument about n best and worst days
  2. Asset allocation [Modern Portfolio Theory]
    • Sorta works but best paired with clearly defined financial goals
    • Easier to do, albeit somewhat arbitrary and often leads to local optima
    • Examples of assets to pair with stocks: Precious metals, Bitcoin, Bonds, Land, Commodities
    • Assuming uncorrelation of underlying assets is a fallacy
    • Blunt hammer that doesn’t specifically address tail risks
  3. Buying insurances aka tail risk hedging
    • Tail is where the damage really happens; cut the tail, you win big!
    • Harder to do, but very precise & target outcome based

Why do it?

  • Hybrid of market timing & asset allocation → a semi-passive time bomb defuser!
  • Heads you win, tails you don’t lose much

An insurance of the form

  • For a premium, you’re assured that if the market drops >x%, you will be compensated
  • Possibility of winning big make the premium payments worth it
  • Cuts off the left tail which generates outperformance in the long run

How is it done (a simple strategy against S&P 500)

  • Buying PUT options that are far OTM (out of the money i.e. >20% below current market level)
  • If / when option goes ITM (in the money), you sell and buy equities

So, to recap the strategy, here are the key points

  1. Calculate your “savings rate” i.e. (I - E) / I.
  2. Find X which is your 6-month expenses.
  3. If X is >20% of N, save, save and save (all into a savings account).
  4. Once X is <20% of N, start buying one of 4 Vanguard funds (and onwards as per your risk apetite) in order of their risk (VMMXX < VBTLX < VTSAX < VTIAX < ….)
  5. Always fill out tax-advantaged accounts first.
  6. Don’t worry yet about how much you are putting in each of these, you can always rebalance, readjust and reassess periodically.
  7. Remember time-in-the-market » timing-the-market.
  8. Depending on your risk profile, put some of the 4X out of N, and a lot of (I - E) every month into these investment vehicles.
  9. Once X becomes 1-10% of N, you’ve already become financially savvy enough not to need such a list. But still, shift to riskier investments (still stock though)
  10. X is now ~1% of N, ~5% of N in bonds, 40% of N in US stocks, 40% of N in International stocks, 5% of N in cash/checking accounts, some stock picking for fun, and start to layer in riskier investments like stocks, Bitcoin, tail risk hedges.

Why Vanguard?

Vanguard was founded by a brilliant man with a self-less mission. I have compiled a list of some of Jack Bogle’s sage advice here, these videos are highly recommended!

There you have it. Note that you can potentially do all of 1-10 today, depending on what X and N is for you. But it’s more about the journey and you enjoying it. Best wishes!