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IN THE SUMMER of 1966, author John McPhee spent two weeks lying on a picnic table in his backyard. Why?
McPhee was suffering from writer’s block. As he described it, “I had assembled enough material to fill a silo, and now I had no idea what to do with it.”
Investors find themselves in a similar situation today. There’s no shortage of financial information around us. But that doesn’t make it easier to know what to do with it.
When it comes to financial decision-making, there is, of course, one fundamental problem: None of us can see around corners. But that doesn’t leave us completely empty-handed. Whenever possible, I suggest employing decision frameworks. They can help us to do the best we can in the absence of complete information.
Here are four such frameworks you might consider as you look ahead to the new year.
Trading decisions
Suppose you’re lukewarm on an investment and thinking of selling it. How should you think through this decision?
To start, you might evaluate the investment’s merits. If it’s an individual stock, you could examine its valuation and study the company’s financials. If it’s a fund, you could look at its track record and management fees. And if it’s held in a taxable account, you could also check its tax efficiency.
Against those factors, you would then assess the tax impact of selling your shares. But how should you weight each factor in your decision? A fund might be tax-inefficient, for example, but have a good track record. When making decisions like this, the framework I suggest is to evaluate three factors: risk, growth potential and tax impact. And I would consider them in that order.
Estate taxes
The federal estate tax can be punitive for those with assets over the lifetime exclusion. Under current law, that’s $15 million per person, but it’s a political football and could easily change down the road. Many states also impose their own estate taxes, with much lower exclusions. For those with assets even in the neighborhood of the applicable exclusion, it might seem like an obvious decision to pursue estate tax strategies.
Indeed, many families conclude that it’s worth virtually any amount of time, effort and cost to limit their exposure to these steep taxes. That’s a logical conclusion, but it’s not the only way.
Other families take a different view. They reason that if their estates will be subject to tax, then, by definition, their children will be receiving substantial sums. Since that’s the case, they don’t see the need for acrobatics to leave their children even more, especially since those strategies usually introduce cost and complexity.
The most typical estate tax strategy, for example, is an irrevocable trust. In addition to the legal work required to set one up, these trusts require third-party trustees, and trustees typically ask to be compensated. This kind of trust also requires a separate tax return each year. Also, assets in trusts like this don’t benefit from a cost basis step-up at death, making the tax benefit a little more uncertain.
Estate tax strategies, in other words, might make sense, but they aren’t the obvious “right” answer in all cases. That’s why, as you think through this question for your own family, you might employ this simple framework: Start by asking yourself which objective is more important: to keep taxes to an absolute minimum or, on the other hand, to keep complexity to a minimum. Let that be your guide.
Portfolio construction
How much effort should you put into your portfolio? Author Mike Piper draws an apt analogy. Building a portfolio, he said, is like making a fruit salad. Here’s how he explained it:
“If you choose to have just 3-4 ingredients in your fruit salad instead of 7, that’s fine…There’s no one single recipe that beats the others…And you don’t have to be super precise about it—a little more or less of something than you had intended is not a disaster.”
It’s an important point. Because there are so many available investment options, and because there is so much information and commentary around us, it can sometimes feel like we need to do more to optimize our investments. The reality, though, is that this is a choice.
Just as with estate tax strategies, you might yield a benefit by fine tuning your portfolio, but you shouldn’t feel compelled to. The most important thing is that it be reasonable. As long as you aren’t taking inordinate risk, it’s a choice whether you choose to have five, 10 or 500 holdings in your portfolio. As Piper points out, you won’t necessarily go wrong with whichever path you choose, so choose the path that suits you.
A 360-degree view
Earlier in my career, I worked as an investment analyst at a firm where we were responsible for picking stocks. In discussing an idea with a colleague one day, it occurred to us that if you knew enough about any given stock, you could easily make an argument either for or against that stock. It was in the eye of the beholder.
Consider a stock like Nvidia. On the one hand, it’s the dominant player in a fast-growing market and has enviable profit margins. But those margins are inviting competition, and there are concerns that the market is becoming saturated.
Which set of arguments is correct? As with all financial decisions, we can’t know without the benefit of hindsight. That’s why I suggest what I call the “five minds” approach. Instead of taking a single position on a given question, try to look at it from all sides, balancing the viewpoints of an optimist a pessimist, an analyst, a psychologist and an economist.
How would this work in practice? If there’s an idea that looks like it makes sense, pause and ask what the opposing argument might be. If you’re looking at a question through a quantitative lens, pause and ask what the qualitative factors might be.
And always consider the broader context. Suppose, for example, you’re considering a Roth conversion. A key element in that equation is whether future tax rates will be higher or lower than they are today. To help answer this question, we could consult history as a guide, looking at historical tax rates and government debt levels.
No one has a crystal ball. But since that’s the case, frameworks like this can help us manage through decisions with incomplete information.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Adam, you’ve provoked a great deal of thought. As I think about where to realize capital gains before year end, I find myself returning to this section on trading decisions (emphasis mine):
“Against those factors, you would then assess the tax impact of selling your shares. But how should you weight each factor in your decision? A fund might be tax-inefficient, for example, but have a good track record. When making decisions like this, the framework I suggest is to evaluate three factors: risk, growth potential and tax impact. And I would consider them in that order.”
I have been thinking I would sell an actively managed fund (a global value fund). According to Morningstar, it’s priced high for its category. However, its risk adjusted returns are higher, and its 3-yr tax cost ratio is lower, which help explain why it’s still a silver medalist fund (gold until Morningstar changed their rating metrics, but not because of diminished confidence).
Now thinking of the highlighted section in the article: The tax impact is what has made me think I’d sell it, but the 6% capital gain distribution this year isn’t terrible in the active world, and it does well on the two other more important criteria. Risk is lower than peers, and because it’s a value fund, it’s arguably lower than the index. And because it’s a value fund, return potential is likely lower than the index. (I know the arguments in favor of indexes over active management, but that by itself isn’t a good enough reason to realize the gains involved.)
Something is getting sold this month. It’s either this or some individual stocks. For now it’s an open decision but the highlighted advice is challenging my default thinking.
Thanks for this, Adam. Your essays are always instructive and worth reading.
Thank you. The most well known proponent of frameworks was probably Charlie Munger. It’s a great way to approach questions.
Good post. I spent 42 years in the wealth management biz, at the end of which I had reached the conclusion that our business spent a lot of time, energy – and our clients’ money- to come up with the performance and product sizzle that would keep us employed. Unfortunately, it always seemed that our sizzle exceeded our performance.
In retirement, I have fully embraced the KISS approach to investing – Keep It Simple Stupid. I hold no individual securities and and have fully embraced low-cost funds, based on a mix of 6-7 funds at most. The fee savings alone have significantly enhanced my returns, which are now running at a compound rate of about 8.0% over roughly 15 years.
While the thrill of having picked a winning stock is undeniable, it does not offset the pain caused by the number of dogs with fleas we have suffered through before finding that one winner. At this point in my life, I find that I am happy to accept a more boring approach to investing that has over time provided steady returns.
Thanks for sharing your story. I’ve seen this up close too. I think a key challenge is that you can spend all day analyzing an investment (as I once did myself), but since no one can see the future, it’s still hard to get it right. In other words, a lot of people in wealth management are well-intentioned, but in many cases, they’re trying to do something which is nearly impossible.
Always good to hear from someone who has been in the trenches and is no longer justifying their strategy . Thanks.
those moments on the picnic table were not wasted….
understanding what we are doing; risk benefit, upside downside, and as father buffet opines avoiding the big errors are the basics in the game. understanding the ‘bet’ and investing is about hopefully careful betting while managing known known’s and unknowns.
the most powerful word i’ve learned in my humble trials and tribulations of investing for the goal of a good night’s sleep is just two little letters..no.
Very true. Organizing your thoughts is at least half the battle. When I was in school, I remember being most impressed by the kids who asked questions that I hadn’t even thought of.
A very good set of suggestions. You don’t have to be precise. Don’t spend a lot of real time and money to protect yourself against a speculative harm. Simplicity sometimes wins out, for reasons more important than incremental gains. While money is important, there are lots of other things in life that are also important.
Thanks, Martin. I’m 100% with you on simplicity. It’s a virtue in my general, I think, but especially when it comes to investments. It’s an uphill battle, though, because Wall Street loves financial engineering and is very good at marketing their latest concoctions.
Good one, Adam.
A tweak to your Trading Decisions, for those approaching or in retirement. Consider four factors: risk, income, growth, and tax impact.
An excellent read about making better decisions is Annie Duke’s Thinking in Bets.
Thanks, David. I’ll second that recommendation on “Thinking in Bets.”
Those are great aids to making decisions when that crystal ball is murky, Adam. Then there’s the age factor.
We could pull research on cognitive decline as we age, but most of us have also seen it first-hand in others. We know that it’s the rare individual who stays mentally sharp at an advanced age. Will we be one of those folks? We–and our families–may not know until it’s obvious we aren’t.
Edmund, this is such an important topic. Often, finances are where signs of cognitive decline first appear — e.g., missed bills. Sadly, some number of people inadvertently let their life insurance policies lapse each year after years, or even decades, of making payments. There’s also a lot of elder financial abuse. It’s great when older folks allow their adult children to be involved, if only as another set of eyes.