Welcome to another edition of The Mueller Report!
This week I’ll share some thoughts on investing. It’s a big topic and I still have a lot to learn. But perhaps some of the general principles and ideas here will be helpful to you.
This should go without saying but in our litigious day and age I need to add the caveat that I am not your financial adviser, and I am not suggesting you make any particular investment or that you will achieve any particular rate of return should you try some of the ideas I am about to share.
Principle Number One: Spend less than you make.
The larger the positive difference between how much money you make and how much money you spend, the more capital you will have to invest. Conversely, spending more than you make eats up your capital and eventually leads to indebtedness.
Principle Number Two: Following principle number one alone will not make you wealthy
Suppose you earn an average of $85,000 per year over your lifetime. If you spend an average of $75,000 over those years (following principle one), you’ll accumulate some savings. Suppose you work for forty years. You’ll have saved up $400,000 by the end of your career. That may seem like a lot but it’s actually not. A quick rule of thumb when planning your retirement is that you can live sustainably on about 4% of your accumulated savings – so in this case about $16,000 a year or about 21.3% of your previous level of living. Sure, social security may improve this total….If it’s still around!
Let’s say you’re not happy with that outcome and you would like to have a higher standard of living when you retire – so you work hard to cut $5,000 of spending out of your annual budget (that’s about $400 per month) and spend an average of $70,000 per year. After working forty years you have now saved up: $600,000. That’s definitely better than $400,000, but you’re still looking at a living standard of about $24,000 per year after you retire (again, excluding social security).
So, how much would you have to save up to maintain your same level of income when you retire? $75,000/.04 = $1,875,000. That’s more than triple the $600,000. To save that much over 40 years of work at an average salary of $85,000, you would need to save $46,875 annually ($1,875,000/40), which means saving over half of your salary every year (you would have to spend under $40,000/year on average).
If you aren’t saving during retirement things look slightly better:
While you are working: Save $40K per year, spend $35k per year. Retire with $800,000 saved.
While you are retired: Spend $32k (4% of your savings) per year sustainably
Simply saving money and sticking it in a checking (or savings) account, or putting it under your mattress, is not a good way to become wealthy. You have to do something productive with it.
Principle Number Three: Acquire assets and streams of income.
Everyone has limited time and energy. You cannot simply increase the number of hours you work indefinitely to increase your wages. You cannot simply increase your skills/experience level indefinitely to increase your wages. The only way to create significant wealth is by acquiring or building assets that generate income independent from how much time, effort, or energy you have.
Consider the “best case” scenario for maximizing your wages and your working time. An extremely effective lawyer might be able to average $500/hour during their career. If they work 60 hours every week, they can earn about $1,500,000 in a year. That’s a good chunk of change but you’re working ten hours six days a week year-round to get it. Furthermore, you don’t get a big chunk of it because you pay income taxes (high ones at that level of income). So you will really be making about $1,000,000 post-tax. After doing this for 40 years, your after-tax earnings will be about $40,000,000.
That’s the most someone can earn in their lifetime billing hourly and working 60-hour work weeks nonstop. And if you manage to save 40% of your post-tax earnings each year (spending $600k per year and saving $400k per year), you’ll end up with $16,000,000 which can support a lifestyle of about $640,000. Not bad but for most of us not realistic. Cut our hours by a 1/3 and our wages by a ¼ (so only $125/hour), and the picture looks a bit different:
Savings at the end of 40 years = $1,333,333; Retire with income of $53,333. Cut our wages again by half ($62.50/hour) and you’re looking at savings of $666,666 and sustainable income of $26,666. Now that’s just unfortunate!
Principle Number Four: Set things on autopilot
One of the most important approaches to building wealth is to automate as much as possible. This has several advantages. First, you don’t have to spend lots of time obsessing over how much your saving, how your investments are performing, etc. It will give you both more time and more peace of mind. Second, your lifestyle begins to revolve around good financial choices. There are many ways to set autopilot for building wealth. Here are a few:
Set regular autopayments for retirement accounts (employer 401k, especially if there is a match, IRA, Roth-IRA, etc.)
Set regular payments to a brokerage or savings account to build up capital for other investments
Buy a house (or two or three). Your mortgage payments every month automatically reduce your indebtedness, which increases your equity (wealth) in the house. This happens inexorably as long as you make the payments.
Principle Number Five: Leverage is not only about debt
You’re probably familiar with Dave Ramsey and the idea of not using debt (except to buy the house you live in). For some people, Ramsey’s approach is excellent. But there are also many ways of using debt (which is other people’s money) to increase your returns. This also comes with risk, though, and should be used cautiously and with significant counsel and research.
But there is another form of leverage to consider, especially if you want to be more aggressive about building wealth, and that is leveraging the use of your assets. I particularly recommend this for younger people who don’t have children yet (though it can certainly be done with children too!). Do you rent your room, apartment, or house out on Airbnb when you are not there? Do you have an extra room in your apartment/house you could rent? Or a basement?
What about vehicles? Do you have a vehicle or two that you use occasionally that you could rent out?
I encourage my students and young alumni to think hard about buying a house as soon as they can, not only because it sets up the autopilot building of wealth mentioned above, but because if they do their research and find a house where they can have roommates or a house with a secondary unit, they can create a stream (or streams) of income that can partially or fully cover the cost of the house.
Suppose you buy a house and your monthly PIMI (mortgage payment) is $1800. If you can have three roommates each paying $600/month, you’re essentially living there rent free -though of course you are on the hook for repairs, maintenance, miscellaneous costs, etc. But not only are you spending much less of your personal income each month, you are also increasing your wealth each month as the debt on your house gets smaller.
These are just a few basic ideas and strategies for building wealth. One of the most important questions you need to ask, though, is what your goals and priorities are. Is there a target net wort at retirement you want to hit? Are you trying to grow your wealth at a certain percent each year? Do you like investing and want to spend a lot of time doing it or would you rather limit how much time you spend thinking about money?
How you answer these questions will shape the kinds of strategies and decisions you make. The worst thing to do, though, is not to think about building wealth at all and hope that somehow things will be alright in 20 or 30 years. The power of compounding favors the young and those who take initiative. The longer you put off making plans and developing strategies, the fewer options you will have.
Thoughts on Options Trading
I wish I could say my options strategy has somehow made my portfolio immune to the market downturn we are experiencing but it isn’t (yet). I’ve been thinking about why that is and how to continue improving on my trading strategies. What follows is meant purely for educational purposes and does not constitute investment advice.
You could say the last nine months are a kind of stress test of my strategy. It has been one of the most volatile times in history for stock prices and we went from new highs to a bear market over that period. That makes measuring performance and success difficult – especially as the value of one’s portfolio can move 5% or more any given month!
Performance Metrics
Five of the stocks I’ve been trading options are currently profitable (meaning that the premiums I received plus realized and unrealized gains or losses on the shares are positive).
Seven of the stocks I’ve been trading options on currently have a net loss, almost entirely because of unrealized losses (i. e. I bought shares of these stocks at a price higher than its current market price).
More importantly, my overall return (including unrealized losses) is about how much the NASDAQ is down for the year (~-28%). As I mentioned in a previous newsletter though, my two largest losses were departures from my initial strategy of investing in companies that I thought had sound financials and were likely undervalued. If you take out those two losses, my performance since I started trading last fall (near the peak of the stock market), is around -5% which is better than the S & P 500 performance over the same period.
Obviously hindsight is 20/20 and who wouldn’t outperform the market if they removed their worst mistakes?
Insights
My strategy for trading options is not a get rich quick strategy – which means that it takes time for the investment to build. Part of why my performance now is crummy is because I’ve taken really large unrealized losses in a couple particular stocks while making small gains each month on option premiums.
There is a tax problem to my strategy – namely that all the premiums I receive are taxable as short-term capital gains and my unrealized losses are not taxable. Normally you want the reverse. You don’t want to pay taxes on your gains and you want any losses to be realized to reduce your tax liability. I don’t have a clever answer for how to improve the tax implications yet – though my current plan is to sell off the shares with the highest basis/loss near the end of the year to offset my gains.
I’ve been talking with a friend who also trades options and he (and others) has emphasized the importance of having a clear plan and criteria for trading. The plan is particularly important to prevent impulse trades that are often reckless.
I have shifted my thinking a little on my goal for options trading. Instead of simply collecting premiums and holding/selling shares as they move above or below my initial strike price, I would like to collect smaller premiums and try to capture appreciation (someday!) of the shares I have rather than just selling them again at the price I initially paid for them.
Options Trading Plan
Goals
Develop reliable cashflow through financial assets
Take responsible amounts of risk – don’t be greedy or impulsive; don’t bet the farm
Learn about financial instruments and markets
Invest for value, rather than simple speculation
Rules, Principles, Strategy
Aim for 12% annualized return (or better) on selling calls
Aim for 24% annualized return (or better) on selling puts
Sell purchased call/put options when they rise 25% or more
Adjust distance from strike price with length of option
>5% for 1 week
>10% for 4 weeks
>15% for 2 months
>20% for 4 months
>40% for 8 months
Exercised Option Characteristics
I analyzed my options that were exercised and, not surprisingly, they closely relate to how much risk/reward went into the option.
For example, over half of my options that were exercised (20 different contracts) involved the premium I received having over a 50% annualized return. Meaning that the premium was quite high for however many weeks the contract was.
Part of why those premiums were so high was because people thought there was a significant chance of them being exercised. 45% of my exercised options had a strike price less than 2% away from the market price at the time I sold the option. Now some of that is recklessness or impulsiveness, but there are a handful of times where I sold an option with a strike price so close to the market prices because I was interested in buying or selling the stock outright but decided to get a premium too.
And 58% of my exercised options had strike prices less than 4% from the market price. Needless to say, you can see how I’ve written out my guidelines to preclude writing options whose strike price is less than 5% away from the current market price. And the distance I aim for between strike and market price increases with the duration of the option.
I am still working on getting a better handle of what kinds of metrics and statistics I should be tracking - I’ll share more later in the summer.
That’s all for this week - have a happy 4th of July!