Thomas Young: Today we're going to talk about hedging strategies in a volatile market. We're joined by Rocket Dollar CTO Rick Dude, who before Rocket Dollar started and ran a company called Quant Advisor, which was one of the early roboadvisors. He had a lot to do with trading in the markets for his clients and saw ups and downs.
I think when you started it, it was mostly up, but you have to be prepared for the eventual downturn.This is why I have you on the show today because I want to talk to you a little bit about that and a little bit about hedging and how you would prepare for a downturn.
It's appropriate that we're recording this today because it is August 8th and even if this doesn't air for a few weeks, we've had a volatile few days, about a week now, that it's been kind of up and down. We had FED cut rates, not as much as some would have liked and some wouldn't have liked it at all. It's been a crazy week. Thanks for being here, Rick.
Rick Dude: Yeah, yeah. Happy to be here and happy to talk about volatility of your portfolio and how to manage that.
Thomas Young: Regardless of where this money's held, whether it's cash or in a retirement account like Rocket Dollar or just the regular stocks, bonds, mutual funds, retirement account, I'm imagining that the strategies are pretty similar as to what you would do.
Rick Dude: Yeah, yeah, absolutely. I think the standard disclaimer that just because something happened in the past doesn't dictate that you're going to see it again in the future, but I think it's important to recognize that the market does work in cycles.
The most important tool that every person has in their tool belt to combat volatility is what's called dollar cost averaging. It's a really simple concept. It's just really a financial math concept similar to compound interest where basically you put some amount of money into your portfolio on a regular basis and you buy the same amount of investment with that amount of money over time.
The idea is that when the investment becomes cheaper, you're buying more of it and then when the investment becomes expensive, you're buying less of it. Dollar cost averaging works in your favor because then over time your average cost will be lower than had you bought the same amount of the investment with variable amounts of money depending on the cost of the investment. Everybody has this tool available to them.
The reason why managing risks in a retirement account lends itself to a dollar cost averaging and therefore risk management is because the very nature of how money ends up in a retirement account is through regular contributions. The IRS also encourages this by basically setting the tax breaks on contributions on annual cycles. Each year you get a fresh new contribution limit that you can put money against that will give you a tax break.
No matter what your investment is if you're committed to regular contributions to a retirement account and you're committed to regular investments of somewhat equal amounts then dollar cost averaging will work in your favor. A lot of people, a level below that, you start getting into investment selection, volatility of the investments that you select. That's another I would say piece to the puzzle but dollar cost averaging is always the foundation of volatility management.
Thomas Young: Interesting. I thought you were going to say something like buy gold and hold that and something complicated. It's a pretty simple term, pretty simple concept, that you make the contribution and then maybe ... This might be an interesting, so would you advocate for regular ... Let's say you're not participating in an employer plan where every time you get a paycheck, a part of it gets deducted into your 401k. Let's say you're a solopreneur and you're making this money. Would you advocate monthly, quarterly, or yearly contributions? If this is a strategy that we're employing.
Rick Dude: Yeah. I think that obviously you could go to the extreme of it and average in every day. There's an element of your sanity and how much maintenance you want and similar to like diet and exercise, it's only as good as how much you stick to it.
I think quarterly is doable for most people. If you're a solopreneur or a self-employed individual, you should already be used to paying quarterlies to the tax man. If you incorporate contributions on a quarterly basis, that's a good cadence. Perhaps you say, "10 days at the end of each quarter I'm going to make myself a 401k contributions and I'm going to pay my quarterly taxes" or however you want to set it up.
Some people like to do monthly and I think if you've got automated tools in place so that you don't have to think about it then that's good but quarterly is sufficient. A lot of studies show that when you get more granular than quarterly, the benefits begin to fall off unless the asset class is just extremely volatile. Whether you do quarterly or monthly, you're not going to see a huge change in your return with averaging.
Thomas Young: Yeah, that makes sense. Let's say that you want to buy an individual stock and you have maybe $10,000 that you want to put into the stock because that's ... Now, would you go out and buy employee a dollar cost averaging strategy in buying that stock or do you ... How does that work? How do you think about that?
Rick Dude: You can certainly do that and you can average in from all kinds of strategies so you can average in for your entire portfolio, you can average in on individual names, you can average in on individual investments.
This is my theory and opinion about it. Unless you're going after something that just inherently is going to be extremely volatile, most things tend to correlate. The markets run in cycles. The economy runs in cycles. To say it a different way, if one bank is doing well, likely all the banks are doing well. If one chip company is doing well, likely all the chip companies are doing.
While we sit here in Austin, rising tide rises all boats. We have a lot of startup companies that are doing well. Is some of that because they're good ideas? Sure. But a lot of that has to do with the community and the culture and the money that's coming in and that the market is hot right now and people are buying the economy is doing well.
I think averaging matters more in averaging across your asset class or averaging across your portfolio rather than getting hung up on averaging on specific investments.
Like I mentioned before, the ability to maintain the strategy is very important and it's my feeling that if you're so focused on trying to average in on specific positions that can become a little bit of a maintenance nightmare. It's more about just when you're making your investments to make those on a regular cadence.
If you're a real estate guy, that might be like if you have a million dollars and you're going to do real estate maybe don't buy five properties at once. Maybe buy one property and then the way a quarter in and buy another property. Or if you are a startup guy and you want to make investments in startups and small businesses then then maybe don't make all your investments all at the same time.
This kind of feels contrary to what it might seem like, "Oh, I need to get my money in the market and I need to get the returns started" but let's remember that we're not talking about a savings accounts we're talking about investments that their underlying value will go up and we'll go down. To hedge that risk you want to average in.
We can talk a little bit about fixed income opportunities, which work differently and that would be what I would say you want to probably go all in all at once rather than averaging in because of the nature of how they work.
Thomas Young: Okay. Interesting. Let's say you make an investment and you've reached kind of your limit, right? Where you want to take some money out. Would you employ the same sort of strategy when you're selling, for example, individual securities or would you sell all at once?
Rick Dude: Funny thing about the math. The benefits that you get with dollar cost averaging, and by the way I didn't mention but the more volatility you have, the more effective dollar averaging is. In a low vol product like fixed income, dollar cost averaging doesn't help hardly at all.
When you're pulling money out the more volatility you have, the more violent it is as you average out. The more loss you take as you average out. Then the question becomes, well, then what do you do? How do you pull your money out?
I think that a time when you're divesting that would be a time that you would want to pick a time where you would totally divest. Then the question is, well, when is that?
What a lot of people do, and this is why target date funds have become popular, a lot of people gradually adjust their risk exposure to lower volatility investments over time as they get closer to the time where they're going to begin pulling money out.
The idea behind that is that you are gradually shifting into lower volatility things and so then when you're ready to begin to make withdrawals then the withdrawal is less impactful because you have lower volatility. Something to keep in mind.
What does that mean for alternatives? Well, what that might mean is that earlier in your alternative investing career you might take more bets on things that have higher volatility and potential more reward. Then as you get farther into your career you might take bets that are more cashflow focused, that do not have as much of a penalty with volatility when averaging out.
Thomas Young: Interesting. Yeah, that makes sense. Now let's go to the other extreme, right? Where we're in a very serious market downturn, people aren't contributing because maybe they can't or it's just not good. What sort of hedging or what sort of strategies would you employ in a scenario where you're not making regular contributions or you're not adding funds to our portfolio, but you really need to shift that portfolio around or kind of that situation where it's just bad?
Rick Dude: Sure, well, this is again kind of going back to where planning was important. If the market is not going your way and you are in need of the money then the assumption would be that you would have some foresight to know that this was a possibility and therefore you should already be in lower volatility and income producing things, at which point the income should already be coming out and if you need to liquidate the asset you won't have a huge penalty with the volatility about that.
But that being said, if that's not an option and you've got to take the money out then try to pick an opportunity that the market is at lower volatility, it seems to have flattened out, and most importantly try to limit as much as possible how much you need to pull.
The worst thing that you can do in a dropping market is totally go to cash because it's tough to pick a bottom. The advice is to just try to ride it out. If you weren't able to hedge ahead of time then try to ride it out.
The best application of a head strategy is proper prevention and the prevention is to have some foresight into the cash needs and then to get into lower volatility investments, things that are income producing, ahead of time before the market has totally given up the ghost.
Thomas Young: Yeah, it's kind of like when you get sick it's kind of hard to cure yourself when you're already sick, but it's easier to prevent yourself from getting sick in the first place.
Rick Dude: That's right. That's right. That's why many people use financial planners. Oftentimes the best benefit that a financial planner can do is give you a third party look at your holistic financial situation, practice some intellectual honesty about your cash needs, and the older that you get, the more important that it is that that appropriate planning has occurred.
I think that's why we see a lot of Rocket Dollar customers as they get closer to retirement tend to gravitate towards income producing real estate. The reasoning being that they're not tied to the value of the asset, particularly if they've bought the asset without leverage, so they've bought it with cash from their IRA or whatnot. The income will continue to be there and that will insulate them from the inherent volatility in the market.
Thomas Young: Yeah, that makes sense. I's a good point that as people get ... Kind of when you're starting out, you're looking at a lot of growth in the equity of the investment. Then as you get older it's more about maintaining a lifestyle or paying bills or whatever. You're really looking for that portfolio to provide you income, which is pretty standard and real estate is one of the things that people are really interested because as long as you have a tenant in that apartment, you've got cash coming in every month, which is super important.
Going back a little bit, when you talk about ways to get exposure in low volatility products, like what specifically are you talking about?
Rick Dude: Traditionally fixed income products, things like bonds, are what people turn to. Savings accounts are another thing. One thing we see getting popular as some of these higher yield savings accounts coming from companies like Betterment and Wealthfront. These are looking at 2%, 2.5%.
One startup company that I really like is Worthy Bonds. They offer 5% coupons using a tried and true investment model of making asset-backed investments into small businesses. Typically, that's an area of exposure that only larger financiers have exposure to and they're making the underwriting decisions. In this case they're democratizing that all the way down to a minimum investment of $10. That's pretty cool.
Outside of that, you've got a number of bond funds that get exposure to bonds via ETFs. Those are very popular. Then I think we mentioned earlier income producing real estate. These are properties that are ready to rent, that will throw off some amount of cash on a monthly basis.
The trick here is that you want to have things that are throwing off income where the underlying value is not dictating on a monthly or a quarterly basis the cashflow. That insulates you from volatility because it allows you to hold the asset and to benefit from the stream of income.
If interest rates get better than you can probably look at T-bills and some government products and then, of course, the CD rates will get better and whatnot but just look for things that are generating income rather than equity-focused investments that the upside is dependent on the underlying value of the asset growing.
Thomas Young: Yeah, that makes a lot of sense. I think that's why maybe real estate is even more attractive than, for example, a dividend fund because the dividends are tied to performance while rental income is tied to the lease agreement that you have with a tenant and that can only change once a year or unless you ... You know.
Rick Dude: A lot of dividend funds really suffered in 2008 when many Fortune 500 companies hit a cash crunch and they were unable to pay their dividends. You have to be careful with dividend producing equities because at the end of the day it's still an equity. The value is at the end of the day the underlying value of the business and there is no intrinsic agreement that the asset must produce income. Unlike a fixed income product where you've got higher preferential treatment on liquidation and the fixed income product contractually must create the income on a monthly basis or annual basis depending on how it's structured.
Thomas Young: In your opinion or you personally, when are you playing ... You're 33 now. When you think about your own life and your portfolio, when do you start the shift from equities to cash flow?
Rick Dude: I think that for me, personally, I always have some exposure to fixed income. Just from a psychological perspective, I think it's important to understand that this money is producing income and it's more liquid than the other money. I think that everybody should have tiers. You know, as they talk about you should have an emergency fund and then you should have a retirement account I think that everybody should have a portion of their portfolio that's hedging against volatility.
Does that mean that you will not participate as strongly in bull markets? Sure, but it also means that when bear markets occur that you've got a bit of a backstop and your portfolio will come out looking a little bit better.
I get also very excited about the different opportunities for low-vol income producing investments and I think in a lot of ways they're more important, the foundation of those are more important to the economy, than the equity market just because it's a well worn path. The lending rates are set by government with the prime rate and, ultimately, it encourages savings rather than your longer term bets, which often pan out but require the investor to take a considerably larger amount of risk.
Thomas Young: Yeah, and patience.
Rick Dude: And patience. That's right.
Thomas Young: Yeah. Maybe getting nearer towards the end is there anything else that you want to talk about that you want people to know? Maybe during turbulence like we've had in the last couple of weeks or just if and when this bull market sort of peters out what should we be thinking? What should we be prepared for in our portfolios in general, not just our retirement?
Don't underestimate the power of tax savings in an investment. If I've got $100,000 that I want to put to the market and I put that to the market with a taxable account and the market comes down 8% I've now gotten $92,000.
If I put that same $100,000 in a tax advantaged account and then the market comes down 8% I'm still at break even or better considering that my effective tax rate was $100,000 or was 8% because I basically saved on taxes what I ate with the market volatility.
As you're thinking about these things don't just think about the investment of what's the upside and what's the income coming out of the investment itself? But tax planning is a foundational strategy for all investments and should always be considered as part of the investment. Many times it's more important than the investment selection.
Thomas Young: Yeah. What your saying that tax avoidance is ...
Rick Dude: Tax evasion is a felony. Tax avoidance is the American way.
Thomas Young: I remember the first time you said that when we were in your office and I just about died laughing. That was funny and also very true. We spend more time at Rocket Dollar talking about taxes than we do about investments a lot of times.
Our team is encouraged to moonlight as freelancers and have self-employed income so that we personally can take advantage of these solo 401k accounts. We talk a lot about that. It's an interesting part of the conversation that's not always as heavily considered as the investments themselves. It's certainly not as fun or interesting to talk about taxes and tax savings but it is, like you said, potentially as powerful.
Rick Dude: For a lot of people it's the difference between being rich and not being rich after 30, 40 years of working and investing.