Micromanaging Your Portfolio: A Cautionary Tale

In a recent post I shared how my net worth has held up against five years of retirement funded entirely by portfolio withdrawals. The good news was that my liquid net worth had increased since I retired, and by a respectable 6.3% to boot. The bad news was that, after adjusting for inflation, it had gone down by 13.9%!

I noted that despite a protracted stretch of high inflation, I hadn’t given myself a raise. I changed my behavior instead, foregoing frivolities like frequent meals out, the latest outdoor gear and an expensive new car (I bought a used Subaru instead).

Ending on an upbeat note, I added that these adjustments hadn’t diminished my standard of living in a meaningful way. Without noticeable hardship, I had protected my portfolio from the ravages of inflation.

In today’s post I’ll take a deeper dive into the impact five years of withdrawals has had on my investment portfolio. I’ll do so by way of four insightful charts. These will reveal some troubling details; not least the damage caused by a couple of costly mental errors.

Related: Am I as Rich as I Think?

Tax Me Now Or Tax Me Later?

Like many preparing for—or already in—retirement, my savings are spread across three broad categories of tax treatment: Roth IRA (tax-free), Traditional IRA (tax-deferred) and bank and brokerage accounts (taxable).

There are different schools of thought concerning the best order to tap these in retirement. Conventional wisdom suggests depleting taxable accounts first. The idea is to allow tax-advantaged money to grow, while at the same time reduce interest and dividends in taxable accounts sooner than later.

A counterargument is that this approach sets you up for higher tax bills down the road, when you will be forced to take bigger withdrawals from Traditional 401(k)s and/or IRAs. This will happen either when you run out of taxable money, or you are forced to take RMDs. At that point, those bigger withdrawals will be taxed at the regular income tax rate.

A compromise would have you draw from taxable and tax-advantaged accounts simultaneously, thereby spreading the tax burden over the course of your retirement.

Having retired at 53, I chose the first strategy. This was something of a no-brainer. I couldn’t touch the tax-advantaged money prior to 59.5 anyway, at least not without paying a steep penalty. There are ways around this, but they are complicated and inflexible. In any case, having a taxable account rendered the point moot.

Related: The Benefits and Drawbacks of Taxable Accounts

My Taxable Portfolio

My taxable accounts consist of cash in checking, and traditional investments (i.e., ETFs and mutual funds) in a brokerage account.

The first functions as an operating account. Because it earns no interest, I transfer just enough there from brokerage monthly to cover the sum total of my current month’s expenses; things like my mortgage payment, credit card balances, utility bills, and the like.

Rat Poison?

I should mention that I also own Bitcoin (BTC), a digital asset Warren Buffett has famously likened to rat poison. Though BTC is technically a component of my taxable portfolio, I exclude it from this analysis because its volatility adds too much noise to the signal.

I should also mention that I do not own BTC for ideological, political or any other non-financial reasons. BTC is algorithmically-enforced scarcity, and its design permits the instantaneous and frictionless transfer of value. I use it as a hedge; a small bet against USD hegemony (color me paranoid).

Related: Should Bitcoin ETFs Change Your Investment Strategy?

The Bank of Mattress

I can’t know for sure at what point in the future I will run out of taxable money, but I can make a pretty good guess. How? By subtracting my monthly expenses until their sum total overtakes my taxable account balance.

The red line in the chart plots monthly subtractions from my taxable money, assuming that money had never been, and will never be, invested in income-generating assets like stocks, bonds or real estate. Think of this as cash I store in my mattress. (Why this is useful will become clear in the next chart.)

From March 2019 until September 2024 the line is bumpy. That’s because it reflects my actual spending which, as you might expect, varies from month to month.

After September 2024, the line starts to smooth out. From here it plots subtractions I expect to make in the future. I estimate these by taking the average of the previous 12 months’ subtractions. I exclude outliers in these forward estimates; like buying that used Subaru in September 2023 (you can see a marked step-down in the line here.)

At the mattress-money burn rate, the chart indicates I will have depleted its contents by August 2029. In fact it will likely be sooner than that given the probability a few more unexpected expenses will crop up along the way.

The Investment Premium

Of course I do not store my money in a mattress. Rather, I invest it in financial assets whose performance will (I hope) beat the mattress-money burn rate over time.

The blue line plots the actual balance of my taxable money, month over month, since March 2019. (Note that I’ve truncated the chart, such that it no longer extends to the date the mattress-money line reaches zero.)

The wilder gyrations in the blue line reflect the fact that my taxable portfolio tracks the performance of the assets it is invested in. Starting around February 2020, for example, the value of my taxable account dropped precipitously. This was a direct result of the pandemic stock market crash.

The blue line tells me that I am beating the mattress-money burn rate (so far, at least). For this I give myself a little pat on the back.

Diversification on Steroids

Following is the actual composition of my taxable portfolio in March 2019, the month and year of my retirement:

• Cash (8%)
• Energy Select SPDR Fund – XLE (8%)
• SPDR Gold Trust – GLD (7%)
• Vanguard European Stock Index Fund ETF – VGK (10%)
• Vanguard Financials Index Fund ETF – VFH (8%)
• Vanguard Global ex-US Real Estate Index Fund – VNQI (11%)
• Vanguard Real Estate Index Fund ETF – VNQ (8%)
• Vanguard Total Stock Market ETF (9%)
• Various Brokered CDs (29%)
• WisdomTree Chinese Yuan Strategy Fund – CYB (2%)

There is only one word I can think of to describe this portfolio—nuts! It reflects the flawed rationale that if diversification is good, more diversification must be better.

By definition, mutual funds and ETFs hold diversified portfolios of stocks, fixed-income, cash and/or other instruments. Indeed, built-in diversification is the main point of owning mutual funds and ETFs in the first place. Funds that track indexes, like the S&P 500, feature even broader diversification than the sector-specific funds that dominate my erstwhile taxable portfolio.

Diversifying the diversified just muddies the water. It exposes you to opaque costs and management fees, notably on actively-managed funds. Rules governing REITs—like VNQ and VNQI, for example—require them to pass the majority of their taxable gains to shareholders. The same is true of GLD (although for subtly different reasons).

All this amounts to more taxable income, and therefore needless drag on portfolio returns.

Simplification

Just over a year ago, I took the long-overdue step of simplifying my taxable portfolio. My brokerage account holdings now comprise just three ETFs and one mutual fund, allocated as follows:

• Vanguard Total Stock Market ETF – VTI (23%)
• Vanguard Total International Stock ETF – VXUS (26%)
• Vanguard Total Bond Market ETF – BND (26%)
• Vanguard Federal Money Market Investor Fund – VMFXX (25%)

To the chart I’ve added a new, gray line. Holding all other things equal, this line plots what the performance of my taxable portfolio would have been had I started retirement holding the simplified, 4-fund portfolio. (These returns assume monthly rebalancing to maintain equally-weighted fund allocations.) The upshot is that my taxable portfolio would be worth 8.6% more than it is today.

To what extent this difference can be attributed to tax and fee drag, I don’t know. I do know these were contributing factors, and likely not insignificant ones.

Related: 5 Reasons to Simplify Your Investment Portfolio

Fear Factor

While overdiversification, some of it in suboptimal investments, likely damaged the performance of my taxable portfolio in retirement, I made another mistake that proved far costlier.

The green line—what I call 4-Fund (Revised)—illustrates the effect of this mistake. (Recall the blue line represents the actual value of my taxable portfolio over time.)

Panic

In August 2020, when the S&P 500 index recovered from a 34% decline to its pre-pandemic peak, I bailed to cash. Except for GLD and brokered CDs, I sold all the mutual funds and ETFs in my taxable account.

Note that I did not sell at the bottom of the market—that would have been a far costlier mistake. Rather, I sold at the point the market recovered its pre-pandemic peak. Nevertheless, the effect this had on my taxable portfolio is so stark it jumps off the chart.

Had I a) started my retirement holding the 4-fund portfolio, and b) not cashed out in August 2020, the value of my taxable account would be represented by the green line, not the blue, in the chart.

It was not until September 2021 that I began to plow idle cash back into the market, eventually replicating more or less the composition of my pre-selloff portfolio.

Rationale

Why did I bail to cash? The short answer is I freaked out. I was a recent retiree who relied entirely on portfolio withdrawals for living expenses. In August 2020, the month I sold, the future was still very uncertain. For all I knew, the head-snapping recovery of Q2 2020 was the last death throe of a market teetering on total collapse.

But the ensuing four quarters were among the best in stock market history; the S&P 500 rose more than 30% during that period. Meanwhile, my sidelined cash languished.

Related: Put Your Money Fears in Perspective

Takeaways

What have I learned from this exercise? For one thing, trying to micromanage my investments is a bad idea. To correct this, I’ve massively simplified the composition of my taxable portfolio. Except for occasional rebalancing, I intend to leave it alone going forward.

Though not nearly as messy as was my taxable portfolio pre-simplification, my tax-advantaged portfolio also reflects a misguided tendency to over-diversify. I am currently in the process of simplifying it, too. Happily, I made no changes to my tax-advantaged portfolio in reaction to the pandemic crash.

By far the biggest lesson I take from this exercise, however, is one whose magnitude I did not fully comprehend until doing the research for this post; the one that is illustrated by the yawning gap between the green and blue lines in the last chart.

The lesson here is that, when the future is uncertain, and/or the markets volatile, I must resist allowing fear to drive my decision-making. Practically speaking, this means holding sufficient cash to buffer my portfolio against the occasional, and inevitable, market plunge.

* * *

* * *

[I’m David Champion. I retired from a career in software development in March 2019, just shy of my 53rd birthday. To position myself for 40+ years of worry-free retirement, I consumed all manner of early-retirement resources. Notable among these was CanIRetireYet, whose newsletters I have received in my inbox every Monday morning for the last ten years. CanIRetireYet is one of exactly two personal finance newsletters I subscribe to. Why? Because of the practical, no-nonsense advice I find here. I attribute my financial success in no small part to what I have learned from Darrow and Chris. In sharing some of my own observations on the early-retirement journey, I aim to maintain the high standard of value readers of CanIRetireYet have come to expect.]

* * *

Links on this site, like the Amazon, NewRetirement, Pralana, and Personal Capital links are also affiliate links. As an affiliate we earn from qualifying purchases. If you click on one of these links and buy from the affiliated company, then we receive some compensation. The income helps to keep this blog going. Affiliate links do not increase your cost, and we only use them for products or services that we’re familiar with and that we feel may deliver value to you. By contrast, we have limited control over most of the display ads on this site. Though we do attempt to block objectionable content. Buyer beware.