In Praise of Sitting Still

“Truth is the daughter of time, not of authority.”  Sir Francis Bacon

Investing is full of truisms: flavor-of-the-day stocks come and go. Currencies fluctuate. Markets go up and down. Diversify! Platitudes are cheap. The rustling bush sensations that our DNA tells us to run in times of danger, compels us to overreact in investing. We sell high and buy low. We panic. But when markets are frothy, we don’t have to sell, especially if we don’t need the money. Warren Buffett isn’t thinking about dumping American Express when he drives to Mcdonald’s1Yes he’s different than us, and much older, but the point still holds. for breakfast. He’s more likely to be thinking about opportunities, figuratively rubbing his hands together when markets are in turmoil. 

Nobody sells their house just because real estate prices drop 10% over a 3-month period. There’s too much friction in fees, taxes, the cost of searching for a new place, and sore backs. We sell our home when it no longer fits our needs, we relocate to another city, or to use the cash for a better purpose, among others. Those are real motives. 

We’re in a golden age of investing, especially in the US. Public markets boast of quick execution, narrowing bid/ask spreads, and the ability to sell $1 million worth of a blue chip without moving the price. We (should) sell when an investment thesis deteriorates or when there are better opportunities elsewhere. The data support this. The temptation of moving around a lot in and out of trades doesn’t correlate with long-term success. Study after study shows that. Taxes eat into returns too. 

There is some good news on how we collectively behave. Most designated “long-term” assets surprisingly stay still, with trades happening in only 8% of accounts, according to Vanguard, and only 1-2% of retirement assets are out on loan, even during economic upheaval2Those in single target-date funds traded even less, with 97% of account holders not changing allocation during the year.. Very few are day-trading their retirement funds. We have guardrails in place, we see our 65-year-old future selves with whatever future glasses we have on, and we tune out the noise. The structure with benevolent gates and rules helps protect us from our baser impulses. We all have blind spots, but we have spouses, partners, rules, and the goldilocks of diversification, to help protect us from ourselves. 

We cast aside what doesn’t work and we’re left with learning, lots of reading and sitting, and little investment activity3This is our routine and philosophy at Diamond Lake Capital.. We can ask ourselves daily for one week, “Do I really want to do this based on facts, or based on feelings or momentum from a European fund’s pension liquidation?” As Munger says, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.” That is our focus.

With that focus, we help in some of the forgotten corners of investment spaces. One is Health Savings Accounts (HSAs), where, still, less than 7% of account holders invest any of their balance.  A few hundred dollars a month in an HSA, consistently invested, goes a long way to hedging our healthcare costs in retirement, with the beauty of boosted tax savings. Ask about our free assessment of your HSA.

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Our First Birthday Update

DLC’s core portfolio at its one-year birthday has returned 3.2% in excess of the market S&P 500 total return index1One year through July 28, 2022, and a return of -3.3% compared to the S&P 500 Total Return of -6.5%.. First laps don’t tell much but we feel good about it given the economic challenges. We did it through slow, but deliberate activity. This means lots of learning, reading, and sitting still. Our clients’ portfolios of course will have different inception dates and slight drifts in performance but we’re on the same ship, regardless of when each passenger gets on.

We’re committed to our investment philosophy. Longer holding periods, annual letters (not quarterly) and patience compound as investment advantages. It can be very challenging to not panic. We don’t know what the macro environment will exactly bring but we have prepared the portfolio in a way we believe will likely outpace the S&P, with bets on the cloud, e-commerce, market volatility, search, annuities, inflation, insurance, electronics, entertainment, and healthcare. In orthodox diversification circles, this still counts as being highly concentrated. Concentration in life abounds: at any given time most people have one job, one spouse, and one house. We invest in 8-12 different businesses (stocks) we feel we know, and understand, with solid prospects. That’s enough diversification for us.

One of our values in life and investing is that there’s no substitute for doing. We learn to ride a bike by riding a bike, not by reading about the physics or history of bike riding. We’ve invested personally for over two decades but doing it for others creates new challenges. One year on, we’ve learned and begun to hone our skills in compliance, client onboarding, processes, fees, portfolio monitoring, pitching, annual letter writing, and research, all in a more formal, real way. This builds callouses, figurative muscle memory, and patience. We’re working with imperfect information but we strive to be decisive and step forward.

We’ve deepened our relationship with Optum and Charles Schwab on the HSA and investment management sides. HSAs are more than hedging future healthcare costs and current tax savings2to capture out-of-pocket tax savings without one you must reach healthcare expenses of at least 7.5% of AGI in, which few do, while you can reduce your taxable income by up to $3,650 by contributing to one..  Modest chunks of money, invested periodically can work wonders in setting up our future selves to offset healthcare costs in retirement. We’ve positioned the portfolio accordingly. One may have low costs now but the human depreciation curve steepens quite a bit after 60. Our tools help plan for it, help job switchers assess their core health insurance package, and negotiate off of that. Thousands of dollars are often at stake since some packages are Yugos and some Teslas. This is a truly unique service with which we will continue to help many people. 

While not all of our investors have sizable portfolios, the benefits of HSA tools and concentrated portfolios apply to any investment amount. It’s often that small, incremental changes provide massive benefits with one caveat–time. The difference in future expected value changes dramatically when you combine consistent periodic contributions (dollar-cost averaging), compound interest, and patience.

We’re excited to continue investing alongside you.




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The Savings Industrial Complex

In 1961 President Dwight Eisenhower gave his famous farewell address, warning about the military-industrial complex and the proclivity of monied groups to wield their interests to promote war. There exists other [fill in the blank] industrial complexes, where excess is promoted in the name of public good but a net sink to the public as a whole we see this in many forms. Medical, Universities, Prison, Food, Savings.

In investing and savings there are bars that are too high of a standard. The P90X1A famously intense exercise program from 10-15 yrs ago. of finance is often too much of a hurdle for most people290 days of hellish workouts to transform your body–drop out rates were high. “Save 20% and max out all your tax-advantaged accounts” is the equivalent. Most don’t max out their 401ks. The typical contribution is 6-10%3Vanguard’s 2021 Study: How America Saves. At a $60,000 per year salary, that’s less than 20% of your way to maxing out your 401k. Save as much as you can or parish is a model for many. The investment industry, 401k managers, employers, and others don’t want people to leave or start businesses; they want the slow trickle of passively invested money, with basis points taken off the top, with guilt about not being ready, not prepared enough, and a pittance paid to holders of cash accounts. Guilt and inadequacy are not the best motivators. Just 3-4 days of modest physical activity and sensible eating are enough. 

You don’t need P90X intensity or its investing parallel intensity to win or feel good about yourself. Savings and investing, of course, are a good thing; rainy days come and compound interest’s miracles are real, but baby steps count for a lot. Modest amounts saved, and savings and investing outside a 401k work too. IRAs exist. So do HSAs. We don’t always need the velvet handcuffs of employer solutions to guide us or to scare us into thinking we won’t have enough to retire. 

Fidelity and others use $300,000 as the number needed for healthcare costs in retirement for a couple. One problem: It’s too large for people to digest; it’s also a future value number, like saying your $500,000 home will cost you $1.2M with interest. That’s unfair since it includes future dollars which will have depreciated. It’s more effective to say at 65 you need $500 per month for premiums and out-of-pocket costs. Consumers can think in this annuitized way, we meet you where you are…doing something is enough. The savings industrial complex also discourages you from investing your health savings. Firms make more money on the yield spread when it sits in cash. Only 5% invest HSA balances, the rest earn a typical 10 basis points, or 1/10 of 1%, watching passively as inflation erases purchasing power. 

Subtle, small, and continuous contributions can hedge healthcare out-of-pocket costs in retirement. $200 per month goes a long way. Our analysis based on a proprietary model of 3 years of continuous claims data show how modest costs are. Costs for a 45-year old male with $25,000 saved in an HSA, and a modest 5% real investment gain per year, amount to a pot of $133,000. Enough to take distributions from without touching the principle. You could do it for much less than the $300,000 sticker shot. We frame it as $200 per month now, not $150,000 per person at 65.

Enough nuts can be squirreled away even without “only drinking coffee at home” type behaviors, or even large deposits. But the investing part and its compounding are a big part.  

We work with clients with larger balance HSAs, retirement accounts, and other assets, to invest methodically, over time, alongside us, with the same allocation. We buy pieces of businesses (not tickers) and we wait. We’d love to help you more rationally invest.

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Man walks carefully on a path of small rocks in the middle of the sea. He looks focused and moves in the right direction. Concept of success and avoiding problems on the way of a journey or career path. 
Note: The man is a 3D-render with face scan. Model release attached.

Portfolio Rebalancing Pitfalls

Virtually every managed account uses rebalancing to ensure that your investment portfolio sticks to a certain asset allocation. This is useful but can come at the expense of selling off your winners.

How does this happen? Let’s say your financial advisor or investment manager decides to have you 65% in equities, 25% in bonds, and the rest in money markets and cash. This is a simple allocation.

What happens if your equity holdings do really well? More specifically, what happens if your Apple stock pushed your equity allocation from 65% to 75% or 80%? Your money manager will use a portfolio rebalancing tool which will get alerted that your portfolio allocation needs to be adjusted. Naturally, you’ll sell off some of your well performing Apple stock and repurchase more bonds.

What you’re really doing here is trading a higher performing stock for a lower performing bond for the sake of asset allocation—all in the name of mitigating “portfolio risk”. You cut down your winners, algorithmically, with little regard for the fundamentals.

Asset allocation is a great way of diversifying risk while investing across different markets and asset types. It allows you to choose where to invest your money, how much, and when to sell.

The selling part is where portfolio rebalancing and asset allocation can stifle returns. So often, we’ll miss out on the continued growth of our well performing investments. 

So how do we keep our winners and avoid selling for the sake of selling? Portfolio rebalancing tools are built to allow certain tolerances for when asset allocations go beyond or below those thresholds. Instead of automatically selling or buying  to reallocate we should be mindful of how individual investments within our portfolio are doing. We can choose to manually adjust our portfolio, instead of having our portfolio rebalancing tool automatically sell for us. We can use the asset allocations as guidelines instead of hard and fast rules.

If we’re paying attention, we won’t automatically do any of this. Cruise control is convenient and comfortable but it also means we’ll miss the important details along the journey. With a concentrated portfolio this becomes even more critical, where passive investing and rebalancing is often driven by autopilot and imperfect cameras and sensors.


The Goldilocks of Diversification

When Goldilocks was roaming through the forest she was hungry and came across three bowls of porridge. The first one she tried was too hot. The second one she tried was too cold. The third one was just right.

When we look at our investment portfolio of businesses, how many is too many, how many is too few, and how many is just right?

A few things to consider.

The main goal of diversification is to limit our downside. This is largely measured by reducing unsystematic risk, or firm-specific risk. The next question you might ask is, how many stocks do I need in my portfolio to sufficiently reduce unsystematic risk? Virtually every investor wants to create higher returns while lowering the risk of any individual investment.

The benefits of concentrated portfolio returns can be demonstrated in a simple math exercise.

Consider two portfolios. The first is constructed of 100 public equities equally weighted across sectors, industries and geographies. If one stock in this portfolio loses 10%, the portfolio only goes down 1/10th of 1 percent(10 basis points). The upside is similar.

But…if the portfolio only has 10 stocks and one loses 10%, the portfolio goes down 1%. Similarly, the portfolio return increases by the same if the stock goes up 1%. This is all simple math as the return is proportionate in both cases to the size of the portfolio.

This only gets exciting or worthwhile when we look at finding 10 baggers (10x stock returns).

The likelihood of finding 10 baggers is rare—and much has been written about this. If we’re lucky to get one in our portfolio of 100 stocks, we only get a 9% return.

But….if our portfolio of 10 stocks gets a 10 bagger, we net a return of 90%!

For this reason, Andrew Carnegie once mentioned “Put all your eggs in one basket—and then watch that basket!”

The following well-publicized graph shows that with a portfolio of 12-15 public equities, we get 90% of the benefit of diversification. In other words, if we continue to add more stocks to our portfolio, we’re not significantly reducing portfolio risk(standard deviation).

Of course, we can’t just measure portfolio risk by standard deviation. That’s a blog post for another day!

When we think of limiting downside and managing risk we often forget to associate the time horizon. It’s easy to get scared over a month or even during a year or longer when markets can be volatile. Keeping this in perspective with long-term returns will help us remember the market always has volatility and swings.

Some might say, “12-15 stocks is way too concentrated for me.” Fair but remember to keep this in perspective. When we bought a home, did we check the market value a month later? When you got married, were you worried about your spouse leaving a week later? Most of us have one current employer. We are already concentrated in many facets of our life. We try to control risk as we make these decisions and it should be no different with investing.

What makes us afraid of “putting all our eggs in one basket”? Our fear of losing. This is explained by loss aversion or negativity bias. We naturally are more afraid to lose money than the opportunity to make an equal gain.

Warren Buffett is famous for saying “Diversification may preserve wealth but concentration builds wealth”.

What’s important here is not overly diversifying so that our winners get diluted by underachievers.

Photo credit: First Round Review


The Alchemy of Health Savings Accounts

Alchemy is for more than quacks. Even Isaac Newton dabbled in it. But it means more than turning lead into gold1one definition is to transform something in a mysterious way. Rory Sutherland wrote a great book of the same name on a type of alchemy–how marketing can create magic. 1+1 can equal 3. The marketing alchemist is unlike a physicist or economist; small changes can lead to big results.

In health insurance there’s a way to create alchemy.

The health savings account (HSA) is a bit of legislation that passed in 2003 and became law in 2004 that allows you the best of both worlds of tax sheltering and the slickest retirement investment product2the IRS allows contributions of $3,600/year if you’re under 55 and $4,600 if over. To qualify for an HSA you have to have a deductible of at least $1,400; without the HSA channel, you’d only be able to deductible medical expenses after reaching 7.5% of your adjusted gross income–a high bar for the great majority of people. The account is portable so it stays with your when you leave a job. It’s shielded from tax on contributions, investment growth, and when you take money out to pay for healthcare now or for your creaky knee at 65. Given the $150,000 price tag that Fidelity estimates a senior will spend in retirement on out-of-pocket health costs, we all need that.

However, the typical behaviour doesn’t say health savings but health spending. Yet close to 95% of the 31m folks who have an HSA don’t invest any of the balance. Balances are spent or sit dormant, earning a negative return after inflation, leakage that amounts to billions of dollars lost each year.

HSA alchemy is low due to information asymmetry3including employers who provide insurance know more than us and control the cards, inertia (it’s easy to stay on auto-pilot), and lack of investing choices (HSA companies make the most money when you park it in cash and don’t have much of an incentive to promote the most rational behavior).

Part of effecting changes is visualization. We visualize our future selves, fit, happy, rich in whatever way you define it, often through a distorted lens or in a way that says too much work. I’ll pass.

Nuggets of savings and investing add up. Alchemy builds then snowballs. Take the case of Zach Friedman.

Zach, age 40 is enrolled in a typical healthcare plan with a $1,500 deductible.

– His likely annual out-of-pocket costs are $200 to $800, approximately $400 on average based on his age, gender, and plan selection.

– Current HSA balance of $20,000 sits idle in cash, earning a negative real return.

With $200/month in HSA contributions, and a 5% real return on his invested balance, he could have $192,000 dollars by the time he is eligible for Medicare. More than enough to offset premiums and copays. His alchemy journey of savings from a high deductible plan, invested with an adequate return, is visualized below.

A path forward connects health and wealth in the big dollar decisions, in the coverage you choose, in understanding how modest out-of-pocket costs are for most, and in providing piece of mind. We have tools to know how much your coverage is worth if you’re employed, to model your costs, and to more rationally invest your HSA balance. Rainy days will come. A little financial alchemy helps. 

Disclosures: none

Photo by Artem Maltsev on Unsplash  

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