Wednesday, September 4, 2013

Nuts and Bolts of the Joe Dominquez Investment Strategy are Still Valid

Joe Dominguez
The book that has made the biggest impact in the way I think about money is "Your Money or Your Life : 9 steps to transforming your relationship with money and achieving financial independence" (a.k.a. YMOYL) by Joe Dominquez and Vicki Robin. Although I didn't follow all of the 9 steps as meticulously as described in the book, the lessons did stick. Well, maybe with the exception of the last step, managing your finances. Basically, Joe Dominguez suggested keeping a six month reserve of cash and investing the remainder in long term government bonds. There's more to it than that but perhaps that chapter created so much dissent in the retirement forums, book reviews and opinions expressed by financial planners that when the book was revised and updated in 2007 that final chapter was mostly rewritten. Was this a good move? In my opinion, no. What separated YMOYL from other books on investing or personal finance or retirement or personal growth or self help (YMOYL was all of these) was the concept of going all in on government bonds. I must admit that until recently I thought that putting all your eggs in one asset class, especially treasuries, was not a great idea but the more I studied retirement planning, it became clear to me that this is what made YMOYL stand apart from other authors who claim to show you the most secure path to financial independence. If you want to read, or re-read YMOYL I suggest finding a copy before the 2007 revision. At the very least, skip chapter 9 and read that chapter from original version, fortunately is it archived online. If you'd like to get a bit more personal with Joe you can hear him lecture on the audio series that preceded the book, "Transforming Your Relationship With Money" which is still available. The audio series are recordings from Joe's lectures that preceded the book, the message is presented differently than the book and works well on its own.

A while back I wrote a multi-part article on investment lessons for one of my nephews and although I recommended YMOYL, I don't think Joe would have approved of the advice I was offering. As unconventional as his methods may seem at first, he had some very compelling reasons to do what he did and to suggest that the reader do the same.

Before getting into to it, a disclaimer. Nothing in this blog is to be construed as investment advice.

Joe Dominguez died on January 11, 1997 at age 58 which is coincidentally the same age that I am today. Joe quit his job and never returned to work, at least not for money, when he was only 31 years old. Obviously Joe knew a lot more about investing than I do and probably a hell of a lot more than most retirement experts. He worked as a stock analyst until 1969 saving $100,000 that provided him with a steady income of $6,000 per year. There are reports about how Joe lived an extremely frugal lifestyle yet gave away a small fortune to charities. At the time of his death his nest egg had grown to more than that original amount though I could not confirm his final balance. All this despite having major medical expenses on cancer treatment towards the end of his life.

Many people reading the original YMOYL would think that what Joe accomplished in 1969 was unique to that era and funding your retirement these days requires exposure to equities and a risk managed approach to investing. I disagree.

How much is enough?

When the book was published in 1992 and I was single I could get along just fine on $20,000 a year, now that I'm married and have a more upscale lifestyle (two can't really live as cheaply as one) let's double it up to $40,000 per year. Mind you this is a big downsize considering that this is closer to my yearly tax bill rather than my current salary.

I got these figures using the steps outlined in YMOYL, not the advice given by retirement experts saying you'll need 70% of your pre-retirement income. The figures are based on my somewhat frugal lifestyle and are pretty close to my actual expenses while I'm still working. For more on frugality as defined by Joe refer to chapter 6 of the original YMOYL archived online.

Who are you going to trust?

If I were to ask a retirement expert for advice the expert would most likely run a few calculations and recommend that I invest $1 million in a balanced portfolio made up of a balance of stock and bond index mutual funds or electronic transfer funds (ETF's) along with an annuity for good measure in order to withdraw 4% annually and increase my withdrawal in subsequent years by the Cost of Living Index (CPI) in order to keep up with inflation. This plan should give me a steady cash flow for the next 30 years or until I'm dead, whichever comes first. If you have researched retirement planning this will sound very familiar to you.

Joe doesn't recommend going to a financial planner or a stock broker or to buy mutual funds. To quote Joe directly:
Step 9 is about empowering yourself to make wise financial choices, and your first lesson involves educating yourself so as not to fall prey to unscrupulous brokers, financial planners and salespeople who want to put you into all manner of investment vehicles that pay them handsome commissions.
He also doesn't suggest you try to figure out what the next hot investment will be or to listen to economists:

There is an old saying, "If you get ten economists together, you will get fifteen different opinions."

The more I think about it the more it seems that Joe was one of the few people making sense of the confusing world of personal finance. When the book was revised the book's original co-author, Vicki Robins along with her new collaborator, Monique Tilford, sought out advice from Mark Zaifman, a fee-only financial planner (his company is, Tom Trimbath, a stock trader (author of Dream. Invest. Live.) and others that were probably more knowledgeable in the products and services that they were selling rather than the philosophy behind Joe's investing strategy.

Here are Joe's words:
One of our primary missions in this book is empowerment-allowing you to take back the power that you have inadvertently given over to money. As we will see later, this includes the power you have turned over to various financial "experts" to external circumstances and to financial beliefs and concepts.
Becoming "knowledgeable and sophisticated" does mean learning enough so that you can free yourself from the fear and confusion (or pride and prejudice) that pervade the realm of personal investments. The principles and financial strategies outlined in this chapter are safe, sensible and simple. They are also very inexpensive to implement and do not require extensive financial management or expertise.
Compare that to this passage in the revised edition:
However, there are independent financial consultants who work for a fee, not for commissions on products. Be sure to hire a "fee only" consultant. This is the only way you can be sure that your advisor will never benefit financially from any of the specific investments she/he recommends to you. (You can find a list of them at Also, try to find a consultant that supports the principles in this book. Otherwise, your planner is likely to recommend higher-risk investments that are not in alignment with a typical FIer's* investment objectives.
* FI can mean Financial Integrity, Financial Intelligence or Financial Independence something that was disambiguated in the revised edition by using FI1, FI2 and FI3, though I find it more confusing than helpful.

According to Joe, his methods are safe, sensible, simple and free from fear and confusion. So why seek out an advisor that will charge you a fee and will most certainly instill some fear, add risk, confusion and throw in a little greed--after all if the advisor can't get you a better return than Joe, what's the point in hiring an advisor?

In my opinion a better update to the last chapter would have been to tell the reader to forgo advisers and brokerage firms altogether and simply open an online account with Treasury Direct where you can buy treasury notes bills and bonds in denominations as low as $100 without paying any fees whatsoever. There's quite a few choices at Treasury Direct including I Bonds and Treasury Inflation-Protected Securities (TIPS) for those who fear inflation but Joe's favorite would probably be the longest term (30 year) bonds.

Is investing in treasuries still a viable option?

If I would have invested in long term bonds when I first started saving and kept at it I would have caught the record high yields of the 80's, peaking out at over 15%, and the average return of my portfolio would be in the vicinity of 7%. The value of the bonds rise as interest rates fall (and vice versa) so most of the older high yield bonds would be worth more than their face value. This didn't matter to Joe because he recommended holding them to maturity, though this is something even he admits that he hasn't always followed.

Sure, that's all well and good but bond yields are low and what if they drop even lower? Let's go to the extreme and say that I don't trust the government so I stuffed that $1 million into my mattress. According to Joe, "mattresses produce income for only a small part of the population" and in fact the best I can do is to draw that $40,000 per year for 25 years without any cost of living increases or just under 19 years with 3% yearly increases at which point it will be depleted. Mind you this mattress strategy will cannibalize the investment, a.k.a. capital, but then again that's what you do with a portfolio of stock and bond mutual funds. The only upside to the mattress method over collecting interest is that I won't have to pay income taxes. Think about it though, provided that I don't tell anyone that I've got $1 million in my mattress, there isn't much risk. Though this isn't something any sane person would do, how terrible can it be? In my case I would only need to fully rely on my mattress money for the next 12 years until I am obligated to apply for Social Security at age 70 and receive monthly checks, with yearly cost of living increases, for the rest of my life. In addition I'll be receiving a pension from work. Include my wife's benefits into the equation and that's two Social Security and pension payments that will amount to substantially more than $40,000 per year. So I should be doing fine even after my mattress money is spent and that's without any interest. Treasuries pay interest, maybe it isn't much right now but at least it is more than the mattress.

Alas, I don't hold any treasury bonds and I'm not a young lad that might be able to catch the next rise in interest rates. As I write this the yield on 30 year treasury bonds are at 3.7% so if I drop that entire $1 million nest egg the financial advisor told me I needed on long term bonds I would be getting $37,000 per year in interest payments albeit without cost of living increases but with a government guarantee and I'll get the $1 million that I invested back when I'm 88 years old. The hit is only 0.3% less than the 4% quoted by the advisor. Investing in treasury bonds would most likely make up this difference because U.S. treasuries are exempt from state and local income taxes while other investments may not be as tax efficient. Now a government guarantee might not seem very secure these days, but ask people who have lost money in the stock market or real estate what a guarantee of getting back their original investment is worth.

What about inflation?

Sure, we've all heard stories of how Social Security will go bust, the government will default on its debt and inflation will take what's left of your pension and savings but how likely is that, really? The first two haven't happened yet so let's look at inflation.

Joe believed that our fears of inflation were inflated. Indeed he made it through years of double digit inflation. The most common measure of inflation is the Consumer Price Index (CPI) which is a list of items weighted by consumer preference. According to Joe the CPI isn't a cost of living index. You don't buy a refrigerator every year and if cold weather makes the price of orange juice skyrocket while simultaneously a bumper crop of apples makes the price of apple juice plummet a financially intelligent shopper switches to apple juice.

He listed the 1970 prices of several items that have remained the same or even decreased by 1990. Now in 2013 several of his examples are still valid. In his example of a family of 4 going to a movie was $15 to $20 in 1970 while in 1990 it was only $4 including the drive, popcorn and soda, I suppose he was referring to being able to rent a video in the 90's. Today a Netflix or similar subscription is only $8 per month and you don't need to drive, the trimmings can be bought at a discount and practically every night can be a movie night. When I was in the Navy in the 70's I had a Volkswagen fastback that cost $5 to fill up for a week of driving around San Diego. Now I use a Vespa to get around the neighborhood where I work and can get everything I need in a smaller geographic area. Though gas prices seemed high in the '70's they are much higher now yet I can fill the tiny Vespa tank for about $5 and it lasts me nearly a month. Joe's usual lunch in the '70's costs around $2 while his '90's lunch was only $.60. He didn't elaborate on what was on his menu but I sometimes buy a 10 pound bag of potatoes for $2 which lasts me over a week, I simply microwave them at work so I don't even spend anything to cook them. If you fancy something more interesting Ellen Jaffe Jones wrote a recipe book titled "Eat Vegan on $4 a Day" and Dr. McDougall claims that you can get by fine on just $3 per day.

I've read studies that show as people get older they tend to spend less. They must have studied healthy old people because medical expenses have most definitely increased. According to Joe you can lower your medical costs with proper lifestyle choices. Indeed one of the top causes of death today is misuse of prescription drugs so avoiding doctors as much as possible might even increase your longevity.

It may seem that Joe was recommending not to factor in inflation but that's not really the case. He did make a point not to fear inflation but one of his mantras was "enough and then some." By living below his means, even on interest payments alone, he was able to keep buying treasury bonds and increase his income. Going back to my example of needing $40,000 per year income, Joe's method  at determining the Crossover Point to financial independence was to base it on your total expenses while working. In another step he had you ask, "How might this expenditure change if I didn’t have to work for a living?" So if I could raise my investments to $1,081,081 to make my goal income with a 3.7% bond yield but really end up getting by just fine on $37,000, the $3,000 surplus is invested back into bonds and provided I can keep living below my income the surplus will continue to compound and the investment income will increase every year.

So that's all there is to it, just put all your money in treasury bonds?

There's more to it than that. Joe recommends having at least a 6 month cash reserve put aside for emergencies. He recommends the following criteria to whatever you do with your capital:
1. Your capital must produce income.
2. Your capital must be absolutely safe.
3. Your capital must be in a totally liquid investment. You must be able to convert it into cash at a moment’s notice, to handle emergencies.
4. Your capital must not be diminished at the time of investment by unnecessary commissions, “loads,” “promotional” or “distribution” expenses (often called “12b-1 fees”), management fees or expense fees.
5. Your income must be absolutely safe.
6. Your income must not fluctuate. You must know exactly what your income will be next month, next year and twenty years from now.
7. Your income must be payable to you, in cash, at regular intervals; it must not be accrued, deferred, automatically reinvested, etc. You want complete control.
8. Your income must not be diminished by charges, management fees, redemption fees, etc.
9. The investment must produce this regular, fixed, known income without any further involvement or expense on your part. It must not require maintenance, management, geographic presence or attention due to “acts of God.”
If Joe is right does that mean that the financial experts are wrong?

There are lots of people claiming to be experts though most are just adding to the noise. I wanted to find out what the "real" experts were discussing. When I did my research I looked up scholarly papers and what I found was very scary.

In their paper, "The 4% Rule is Not Safe in a Low-Yield World," authors Michael Finke, Ph.D., CFP®, Wade D. Pfau, Ph.D., CFA and David M. Blanchett, CFA, CFP® claimed that withdrawing 4% from a typical balanced stock/bond investment portfolio is too optimistic. Considering that the 4% rule was a worse case scenario that has gone through exhaustive regression tests, that's a grim outlook.

Books on investing have almost universally pointed out that stocks have always outperformed bonds in the long run and nobody can predict the future. That isn't quite true. Long term treasury bonds were the best investment during the several years of the Great Depression and most recently they have once again outperformed stocks. Low interest rates and a stagnant stock market can last for decades like what happened in Japan since the 1990's. As far as predicting the stock market's future, it is possible to look 10 years forward with a fair amount of certainty. In the paper, "Can We Predict the Sustainable Withdrawal Rate for New Retirees?" Wade Donald Pfau of the National Graduate Institute for Policy Studies (GRIPS) presented a formula that predicted the Maximum Sustainable Withdrawal Rates (MWR) and back tested it to 1883. The following graph not only shows you how closely it tracked the actual MWR, but it shows a frighting prediction of where we're headed. That 60% stock, 40% bond balanced portfolio will have a predicted MWR of less than 2%. In addition, the pessimistic side of the 96% Confidence Interval hit bottom so it could be much worse.

Of course there are some studies that show a more cheerful future but even at today's 3.7% long term treasury rates, a relatively comfortable and worry free retirement is possible using Joe's treasury bond investment strategy.

What will I do?

I'm not really sure but reading the latest studies and re-reading the original YMOYL is a good start.