June Insights: The Missing Ingredient

The Missing Ingredient

“Security Analysis” by Benjamin Graham and David Dodd was published in 1934. It is the bible of investment management and, one could argue, of the entire field of what we now call analytics. Long before “Moneyball” introduced the idea of using quantitative analysis to manage a sports franchise, Graham and Dodd argued that analysis of data could lead to better investing outcomes.

Like the real Bible, far more people own “Security Analysis” than have read it. It is thicker than the real Bible and harder to read. I read it once, but I have also run a marathon, so I have the ability to endure long hours of pain. Most of the people I know in the investment world use it more as a reference guide. However, everyone in this business should read the first chapter. In this chapter Graham and Dodd tell their readers what is in store: They are going to go into incredible detail on how to analyze bonds, and if you have the endurance to get through this first half of the book, they will then tell you how to value a stock. They then let you in on a big secret, the one people who use the book only as a prop in their perfectly staged office don’t ever get: No matter the effort or detail of your models, or the rigor of your analysis, you are going to be wrong.

That’s right: The big secret from the greatest investing instructors of all time, Warren Buffett’s mentors, is that no amount of analysis will correctly project the future. So, why do it? Simple: One does not need to know exactly what a stock is worth. It suffices to know it is worth substantially more than it is selling for today. They called this the margin of safety. If one used the analytical tools spelled out on those pages to carefully value a stock at $100 and it was actually selling for $10, then that investor has a large margin of safety. It doesn’t really matter if the stock ever makes it to $100; if the analysis is sound, then there is a very high probability that it will be selling for more than $10 in the not-too-distant future. The smaller the difference between the estimated value and the current price, then the smaller the margin of safety and the less room for error.

This doesn’t just impact investing in a stock; it impacts any use of data to predict the future. The one thing any analyst knows for sure is that their models will never be exactly right. The future is always uncertain. Analysis can help to make better decisions, but it needs to be coupled with some humility. This is true when analyzing securities, the weather, or sports, and when constructing a financial plan.

Planning seems so concrete. We are going to retire at age 62 and have $X in our retirement account. We will have traditional retirement funds, and Roth funds, and we will take social security on X date. We are going to downsize our home to exactly X square feet, which will cost exactly X, and on we go. It is all so official and it is right there on the computer screen with all the very official looking graphs. Who could possibly argue? If you don’t believe me, search online and you will find lots of very confident planners telling you exactly what taxes will be when you retire and which strategy will work best.

Then something happens that’s not part of the plan. The government decides to replace all income taxes with tariffs. You put all your son’s savings into a 529 college plan and then he tells you that he is going to work on a yacht and sail around the world. You plan on retiring at normal retirement age and then one day you wake up and just say no, I’m doing it now. You plan a wonderful retirement with your life partner and then when the work stops you both realize that you have drifted apart and now wish to go your separate ways. You are in your peak income years, working hard for your well-spelled-out goals when your spouse is diagnosed with a rare disorder and gone in a matter of months.

Those are not random examples, but real situations that have happened to clients and friends over the last several months. I got the idea to write about this from another real conversation. A friend, who is not a client, wanted me to explain how she could put money into a Roth IRA even though she didn’t qualify to do so because her income is too high. I asked her why she was trying to put money into a Roth, and she replied that she maxed out her retirement plan at work but still had money to invest.

It never dawned on her that she could simply put that additional money in a brokerage account. The financial services industry has become so product focused and has marketed this message so effectively that people forget that in the end it is about saving enough money. It isn’t about having the right types of accounts; it is about having the right amount of money.

I hear the objections now. What about taxes? Yes, we want to be tax efficient, but not paying taxes is not a good goal. If one really wants to avoid taxes, then she should simply go broke. If she gets broke enough, the government will give her money. Is that really what we are after?

Besides, there is hardly anything as tax efficient as good old-fashioned stock investing. The investor invests with after-tax money and does not pay taxes until a gain is realized by selling the stock. If the stock goes down in value, the loss can be realized and offset other income. Long-term gains are taxed at capital gains rates and not income rates. So, the marginal tax benefits of a Roth are not nearly as great as touted.

However, even if those tax benefits were tremendous, there is a giant cost that no one talks about: The loss of flexibility. The one thing that can be guaranteed in any financial plan is that the future will not be exactly as predicted. It may be close, but it could also be dramatically different. The one universal thing that every single financial plan needs is flexibility. Yet, it is hardly ever discussed. It is the missing ingredient.

IRAs, Roth IRAs, 529s – they all have their places, but don’t get so caught up in the product that you forget the simple brokerage account. It can be more tax efficient than most people realize and more importantly, the money in it can be used for whatever, whenever. Planning is a good thing, but don’t forget that life happens, and your plans need to include the flexibility to deal with it.