Q&A: Can They Be Financially Independent in Five Years … By Breaking the Rules?

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29:20Welcome back. Our next question comes from Les.

29:27Hi, Paula and Joe. This is Les from Washington State. I was surprised to hear you say on a recent podcast that it would be crazy for someone to have more than 30 % of their portfolio in international equities. When you look at market capitalization, the international market is currently about 38%. And before the most recent bull market in the United States was up to 50%. The Vanguard Total World Stock Market Index has a higher capitalization and proportion of their stocks in internationals than the 20 % to 30 % that you and Joe suggested. Am I missing something? Currently, I have about 40 % of my portfolio in international index funds.

30:14Also, if you have time or for another podcast, could you talk about your thoughts on the small cap value premium? And if you do think it will continue in the future, what percentage should one consider allocating to this momentum factor? Thanks again. Oh my goodness, Les. Thank you so much for the question. And by the way, Paula, I hope it's not lost on anybody and it might be lost on a significant amount of the audience what Les is actually saying. There are so many people I'm seeing in online communities right now talking about, I don't do any international investing, and it's worked out great for me the last 10 years.

30:56And I feel like I've been the person going, do not give up on your diversification. This never ends well. You need to keep international investing in your portfolio. And I'll have some people, I'll call them know-it-alls, going, well, I've never invested international. I'm doing okay. Well, good for you. It just drives me crazy, the survivor bias. So what Les is actually saying is he wants more. I'm trying to get most people to 30%. And we said, it's crazy that somebody has, I don't remember what the number was, was it 50 or 60 % international? We're like, whoa, that's a big number. But Les, for you to question us on the, you should have even more international.

31:39You are a salmon, my friend. You are swimming so far upstream. I love you. We need more of that. Yeah, exactly. Less is zigging when everybody else is zagging. Everyone else is burned out on international. International's not performing. Everybody wants to concentrate in the US and less is a contrarian. I feel like it's like the end of the first decade of the 2000s. Everybody's like, large cap does nothing. I'm getting out of large cap. Right. But seriously, that was what it was like. 2015 was like the heyday of everybody piling into small cap. I mean, you really saw it. Our ability to do the wrong thing is just amazing as human beings.

32:20So Les, I love this question. So let me answer it for the Uber nerds out there that are thinking the same thing that Les is. And by the way, when I say Uber nerd, that is not at all put down. That is you're my kind of person. Yeah. We're Uber nerds. Yes. First of all, I wish I was more of a scientist and less of a practitioner, but what you're talking to right here is a practitioner. I think this would have been a great, if Paul, either you or I could talk to somebody like a Michael Kitzes or a Wade Bao, this is an even better question for them than it is for you or me. Michael was on last week's show.

32:49We talked about this on last week's show. But did you talk about international specifically? Yes, we did. We did. Well, there you go, Les. Joe, don't you listen to this podcast? Actually, in full disclosure, Joe and I are recording this prior to that episode airing. So I'm really giving Joe a hard time. Paula loves watching me sweat. But it was funny to see your face. Yes. Yeah. Funny for one of us. Sorry, Joe. That's all right. But I will say this. Two things. Never working with a major company like American Express and going in and looking at lots of different corporate benefit packages and 401k pie charts, did I ever, ever, ever see a number larger than 30 % even for the most aggressive people?

33:35I just never saw it. And by the way, and the proof for me is borne out if we want to get a little scientific. Long-time fans know what a fan I am of the efficient frontier and following the efficient frontier. If you follow the efficient frontier based on different timeframes, you have not seen an allocation of international stock that paid out on the efficient frontier, which means that while the market cap might be 38%, you never saw a return that matched the standard deviation enough, meaning risk level versus return that made sense enough to be more than 30%. Dr. Markowitz and the work that people have done on the efficient frontier shows that the juices hasn't been worth the squeeze.

34:20So historically, we haven't gotten the returns out of international over long periods of time. We have gotten the return enough to still justify 30%, those of you that have given up. And I think that there is a reversion of the mean coming. So Les, I like where you're going, but the data around the efficient frontier doesn't bear out that a 38 % or 40 % allocation has made sense historically. And until it does, we won't see the efficient frontier change because that's all based on what's happened in the past. We haven't seen that change. Beyond that, I'm going to get really nerdy now. If you look at a portfolio allocation of no constraints using modern portfolio theory and the efficient frontier, it will actually tell you based on recency that a much lower allocation to international makes sense, like 10 to 15.

35:11But that's all based on recency bias, which the efficient frontier will show if you show it over a small enough set of numbers, a more recent set of numbers. In fact, if you show it over a 10-year timeframe, obviously, it's going to show you 0 % international. Makes sense, which is what people have done and why they're all high-fiving themselves. So that's about as far as I can go on that. Right. Based on that data, the reasonable outer edges of the range are 10 % international allocation at the low end, 30 % international allocation at the high end with the more reasonable in between being somewhere around 15 to 20, 25%.

35:50Yeah. I use a 30 in my portfolio. And again, I don't start here. So, and this will get into the small cap value question, which I love as well, which we can dive into next, but I don't start here. I start with what do I need to do? What do I need to do? And then can I do it? So I set a target. I go to the efficient frontier on that target. I put in my constraints and then I work backward. And when I work backward, then I get my international, which gives me 20 large company international and 10 emerging markets international, which is, you know, Paula, if I was left to my own device, it's not the efficient frontier.

36:28I'd be like 90 % emerging markets just because I get so excited. Like, Talk to me about Southeast Asia. I'm a fan. But I got to temper my emotional attachment to that sector with reality, which is what the Efficient Frontier helps me do. And the Vanguard Total World Stock Market Index, I mean, yes, it has a higher proportion of that fund in internationals, but that fund itself inherently is supposed to be an international fund. Yeah. As Americans, as US-based investors, when we put that fund in our portfolio, we are putting that fund into our portfolio as part of an international allocation. Now, yes, there are some US stocks in there as well because it isn't ex-US as we talked about on an earlier episode, but it is intended to be a sliver of that international allocation.

37:16And that is why that fund is a great place to start out. Right. And Paula, the sister fund to that, the Vanguard Total Stock Market Index, also has some international exposure because a lot of these companies are international companies. General Electric, international company, the company I used to work for, American Express, international company. So you get some international exposure immediately just in that fund, which is why I like starting with that fund as well. The Vanguard Total Stock Market. Total Stock Market Index, yes. VTSAX. Yes. I like that better than a target date fund. I like it better than a robo to start off with.

37:55I think JL Collins nails it with buying the total stock market index. It also buys small companies and small company value. So let's explain what Les is talking about there before I lose everybody in this discussion. small cap value. For people that don't understand the word cap, which always has driven me crazy, if you're not a practitioner of this on a daily basis, just take out the word cap and put in the word company. So small companies value oriented. So there's two sides of this equation. There are growth companies and there are value companies. Growth companies are companies that investors are looking at and they may be way overvalued, but they're growing at such a pace that investors don't care.

38:43So these are companies that are super hot. They think they're in hot, sexy industries like AI, as an example. You're not going to find a small AI shop that is a value stock. Right. Because everybody and their sister is buying small company values looking for the next hot thing. And so they're going to be overvalued, but you're going to buy it anyway, because these companies, if they continue to perform are what we're relying on tomorrow. So that's the growth side of the equation. If I'm evaluating it based on growth, who's going to take over the world? Amazon has always been one of those companies, right?

39:17Very growth oriented. All those years where Amazon didn't make any money and value investors were driven crazy by this. Paul, remember this? Everybody's like, Amazon hasn't made a profit. What the hell are we doing? And the growth side was always like, nope, they're coming. Nope, they're growing. Nope, it's going to work out. Look at who won that battle. Amazon worked out. The value side of the equation is the opposite side of that, where we're looking for a discount. We're looking for a company that is undervalued, but unrightly so, where the pieces of the company are more than what investors say the sum of the parts are.

39:51So you take the parts and it's worth$100, but the stock price is$80. We got a deal there. This is an undervalued company. So small cap value are little tiny companies that have not been discovered yet by the mainstream. This is always, until the last few years, been the big winner out of all the asset classes. This has been the place where you won, you won, you won, you won. Now, the last few years, recency bias, you've lost, lost, lost, lost. However, what's really cool about this, Paula, we're seeing what Les is talking about with the international game where he's overvalued international. We've seen this already happen in small cap value.

40:33Small cap value the last few months has smoked it, has been amazing, has been on this huge run. So for all those people that were like, yeah, that whole small cap value thing, that didn't work for me. So I got out. Shame on you because you lost a ton of money by ditching your diversified approach. I like small cap value, but that roller coaster ride, as I even explained, these are small companies not yet discovered. This is going to be a hell of a roller coaster ride. So for that reason, I always kept my exposure to this area at a 10 % allocation to small cap, small company value stocks. Could it be 15?

41:15I could make an argument if you're really aggressive for 15. Would I go 20? I think you need to take some tums. I think you need to be ready for years where you're pulling your hair out going, what did I do to my portfolio? Because this is a mess. It'll come back, but you never know when like it is now. It's like, hey, yeah, we're here. But now the roller coaster ride up, we know maybe six months from now, maybe a year from now, maybe five years from now, is going to have a huge roller coaster ride down again. And so that's why we cap, I often cap it at 10 to 15%. But again, I don't start there less.

41:49I start with what do you need to do? And then does that rollercoaster ride hurt me or help me? Certainly if it's a long time rollercoaster ride, like you've got 30 years to use this money, I'm in. Maybe then I'm 15%. If I'm Christina and I'm wondering about my housing today, I think close to zero is a good number there. So Joe, for somebody like Christina, 60 years old, concerned about expenses today, not investing for the long-term, investing for today, what type of allocation do you think is appropriate? What is interesting about Christina is the discussion that we would have first around, is she going to turn this into an income stream, right?

42:31Currently, she hasn't turned it into an income stream. And we would then, based on when she's thinking about doing that, creating the allocations, she is going to need some money. If she's 60 today, she's going to need some money when she's 80. 80, 90. Yeah. So her having some money in small company value, even though it's going to roller coaster ride today, that roller coaster is going to be way up the hill 20 years from now. If history repeats itself, which of the economy is going to continue, it will. Having that doesn't bother me. In fact, I think it's actually a good move to have maybe 5 % of that money in that small cap value to give her the growth she needs to beat inflation over the long run.

43:10However, when I was a financial advisor, what I needed to do with Christina was caution her about what that roller coaster ride is going to look like. And it's much like the pilot that comes on the plane and tells you there's turbulence ahead. I would have to tell Christina, don't watch this fund. Right. I noticed sometimes my clients would look fun by fun. They go, this fund is awful. And I go, yeah, guess what? We're going to reallocate. We're going to put more in it. I wouldn't say it that way. I would say, well, the way it works is it goes up and down. We're going to put more money there. Well, okay, Joe, where are we going to take it from?

43:46We're going to take it from this. No, no, no. That's one that's doing good. Why am I going to take it out? Quote the one that's doing good. I'm going to take money out of that and put it in the one that's doing awful. That is contrarian investing. Harvest the winners, put it into the losers. And it smooths out your ride. Exactly. That's another reason why, going back to Christina, I would start with which one do you want to do? Or at least come up with, am I doing option A or option C? And then build that portfolio around what engine she's trying to drive. I love this question though, Paula. Right.

44:18How come you don't have more in international? I love you less. Exactly. That's the type of question in a current environment when so many people are looking at the recent performance of the US, which has smoked international. And everyone's saying, why not just go all US? I love the fact that Les is talking about making the contrarian move to go heavier into international. Oh, come on. Just say it. Les is thinking about more. It's true. Les is thinking about more. So thank you, Les, for the question. We're going to take one final break to hear from our sponsors. And when we return, we are going to hear from a couple that's thinking about breaking the rules of personal finance for the sake of reaching financial independence faster.

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46:22Welcome back. Our final question today comes from Luke. Hi, Paula and Joe. I love listening to the show and how you analyze listener questions. I like how you can answer the question and challenge the premise all in one response. My question came up after listening to episode 515, where Paula challenged the premise of how we think about retirement accounts. My wife and I are currently breaking some personal finance rules with a particular goal in mind, and I wonder what you think. For a bit of background, we are in our late 30s with a relatively high income. We are in a 35 % federal tax bracket and live in a state with a 5 % tax rate.

47:02We save$150 ,000 to$200 ,000 per year to various investment accounts with an aim to make work optional in five years or so. We are attempting to pay off a small portfolio of rental real estate, five doors, in the same time frame. We can't say for sure that we'll retire completely at that point, but I expect we will scale things back a bit. My question relates to the investment accounts we are using. My wife maxes out tax-deferred accounts in her business, I max out Roth 401k amounts with my employer, and we contribute everything else to after-tax accounts. I like the three-bucket strategy because it provides the most flexibility when we arrive that our work option will take, particularly because we are not certain what we will do.

47:49However, with our high tax rate in mind, I understand that it would be more optimal for my Roth contributions to go into a tax-deferred account with my employer instead. If we do, in fact, slow down, we could pursue Roth conversions at that time. What do you think? Paul, you know what I think? What is that? I think Luke likes to think of himself as a bad boy. I'm breaking all the rules. I'm naughty. and he's not. I don't think he is breaking the rules. I don't think he is. You think Luke is a rule follower. Well, I do. You know why? Because as you know, Paula, the thing that I like, I like breaking this rule, Luke.

48:28The rule that you're breaking is the rule that I like to break. So I don't think you're breaking any rules. You think it's not even a rule at all? Well, I do. But the rule that I like, we call the tax triangle. He calls it the three buckets. I call it the tax triangle. Same, same. Yeah, we don't know where tax rates are going to be in the future. And if we give that up, if we go, I don't know, I don't have any idea. Well, then especially, Luke, if you're making big money today, which congratulations, number one, on the great income and also number two, on having the foresight to shovel a lot of that money into savings.

49:04because, man, I know so many people that are making good money and they spend every dollar of it and the future is going to hurt, but not for you because you thought that way. But also giving away the fact that we don't know where tax rates are going to be in the future. You're taking with a part of it, the bird in the hand with the pre-tax. I'm going to accept the pre-tax today. I'm going to do Roth with some of the money to give myself flexibility in the future. And because of the fact that I'm going for this early financial independence, I'm giving myself the flexibility of non-qualified investing as well, where I don't have any chains put on me by any institution, the federal government or an insurance policy or an annuity or whatever it is.

49:48I'm just putting money in a spot where I can get it whenever the hell I want. He's doing what I think should be the rule more of us follow. So, Luke, even though I know you probably want to get a tattoo that says bad boy and I'm breaking all the rules, I think you're doing amazing. I love this. And if more people did this the way you did it, I would be super excited. I'd be way more excited than telling people to pump the brakes on so much money in pre-tax, you know, pump the brakes on everything has to have this optimized for today tax strategy. You know, I wonder if Luke talked to his accountant and that's why he thinks that he's making a wrong decision.

50:31Because no offense to the accountants out there, but my accountant has said the same thing. My accountant once physically winced. We were sitting next to each other. We were having a face-to-face meeting. He physically winced when I told him how much of my money I directed towards Roth accounts. And I will plant that flag in the soil. I will die on this hill. My take, my bias, however you want to call it, is extremely pro-Roth, very pro-Roth. Because you take that tax hit once, but you have all capital gains, all dividends, all growth, tax exempt for life. How can you pass that up? And particularly the younger you are, the better, because that means that money is just going to grow for decades and decades tax exempt.

51:24Here's the thing that people don't realize is that especially when you're young, to your point, I put money in that pre-tax position. I put money in a spot where I take the tax, the one-time tax break today. Every dollar that account makes from here on out, I'm sharing with the IRS. because the IRS is going to take a percentage of every dollar it gains. Or if I go the Roth route, I take the amount that I put in today and I give the government what they want from that. I get text on that. But every dollar it gains from here on out, I get to keep all of it. I'm not sharing it with anybody. Now, the more money you make today, the more I can make a case for maybe Maybe putting some of the pre-tax and taking the bird in the hand is fine.

52:11But yeah, I totally agree with Roth, Roth, Roth, non-qualified Roth, non-qualified Roth, non-qualified Roth. Yeah, Roth all day, every day. My bias is extremely pro-Roth unless you can make a solid case otherwise. And I understand, Luke, that you're in a very high tax bracket. You're a high income earner and you don't expect to be a high income earner in perpetuity. You and your spouse have a goal of taking your foot off of the gas pedal and scaling things back and reducing your income. And so I get that on Reddit or in the online forums, they'll say, hey, you've got a high income and high tax bracket today and you think that your tax bracket is going to be lower in the relatively near future.

53:01I get that's why the internet would tell you to tax defer today and then do the Roth conversions at the time that you scale back. I get that in theory. But what I have seen in practice over and over and over from the financial independence community is that even if you think that you're going to scale back, you often accidentally end up making more money than you expected. I mean, that storyline has played out again and again. People are like, yeah, I'm done. I'm tired. I don't like my job. Then they hand in their resignation and they have a big party about it and they celebrate the fact that they've quit this grinding corporate job and yay, isn't that so exciting?

53:50and for a month or two, they, I don't know, sleep in and play video games or play golf or whatever your thing is. But then there's this like project that they're sort of tinkering with and they don't really have big goals for it. It's just like a fun thing. And next thing you know, eight months later, it's making way more money than they ever expected. And they weren't even trying to do it. it just kind of happened. And I see that storyline play out over and over and over because the type of people who reach financial independence are necessarily, they self-select as the type of people who are curious, are driven, are intelligent, who have hobbies that give rise to making money.

54:38And it doesn't really feel like making money. It just feels like fun. But then the fun gets monetized and then that monetization just sort of takes off. I know I'm sounding glib about the money-making process, but honestly, I think one of the myths out there is that money is hard to make. I think in the age of the internet, I don't know what things were like pre-internet, but in the age of the internet, making money is a lot easier than most people are led to believe. I think that's true. It's just making more money in general. We often focus on the expense side of the equation and the income side of the equation is more resistance between our ears, but in every other way for most people is a lower barrier to entry, easier path to wealth, making more money, increasing your income.

55:28So often overlooked. Yeah. And we're taught that it's hard. We're taught that it's a struggle. We're taught that it's a grind and you need hustle culture and business is war and you've got to go and combat. I sleep when I die. Yeah, exactly. Like we're taught that it's treacherous, but it's actually a lot of fun. And yeah, you do to really take off. I mean, to be like ultra, ultra successful. Yeah, you do have to work a heck of a lot harder than everybody else. But that's only true if you want to be at the top, top, top of your game. If you want to be in a position that's maybe not top level, but still lucrative.

56:10You're sitting pretty, you're making great money, and you have a great life. It's actually not that hard. And I'm going to asterisk not that hard for the type of person who is intelligent and curious and who derives joy from following their curiosity. So Luke, I guess my answer is part of the reason that I bias towards Roth is because I assume that you're going to make more money than you think you will. I assume that even after you take your foot off the accelerator and decide that you're going to be intentional about slowing things down and you're going to accept a lower income in exchange for a lifestyle trade-off, I think you're accidentally going to make more money than you intended to.

56:58100 % agree. I think there is a second important piece to this. Like Luke said, we like talking about how you think. I think there is danger in accepting things as rules. I think when you question the rule and ask why did that become a rule? How is that a rule? Why is that a rule? I think you become more careful about which rules you accept as rules and which ones are not actually rules. I think that's important because how many times have you and I been in online forums and we've seen people with a whole set of assumptions that we question. I mean, daily, I see this, Paula, where I just want to jump in.

57:34I don't have the time, I don't have the energy, the inclination to go, we just need to go back to the beginning because you're looking at this in a way that just is not healthy. And it's because this particular person daily is accepting a bunch of rules that are not really rules. It goes back to questioning the premises. Is it premise I? Is it premise I? I think it's premises. C's. I'm messing with you. Just trying to get you back for Michael Kitz's. But Luke, great job. Yeah. Both Joe and I are on your side. We are very pro Roth. And we're pro Luke. Yeah, exactly. So congratulations on everything that you've built.

58:14Congratulations on getting to the point where you and your spouse have a high income and on being so responsible with it and investing it well and stewarding it wisely, working your way to financial independence. I think you've got some big, big things ahead, bigger than you realize. Joe, we've done it again. So fun. So, so, so fun. And thank you everyone for the great questions, the thoughtful questions. It makes it fun, Paula, for you and I, and I'm just grateful we get to help so many people do this. Absolutely. You all are the reason that we do this. So thank you to all of you for being part of this community.

58:55Joe, where can people find you if they'd like to hear more of you? Oh, on the Stacking Benjamin show, Monday, Wednesdays, Friday, we call it the greatest money show on earth because as Paula knows, because she's part of the circus, that's the Stacking Benjamin show. We are in the season of the Olympics, Paula. And last Friday, you were part of a fun episode with a woman who's a financial planner and the first American woman to win medals in both the winter and summer Olympics. Our good friend, Lauren Williams, joins us to talk last Friday about the opening ceremonies and winning the gold. How do you win the gold with your money?

59:35And you have ideas. Lauren has not only great ideas, but great insights. She tells us what it's like to be part of the opening ceremonies, to be part of the Olympic community. She also shows us her medals, which are in a place where you wouldn't believe. Yeah. And our partner CFP OG from our team also has ideas and you guys come up with some great ones. So it's a fun, light episode with a lot of laughs and a lot of insights into what goes on behind the scenes kind of at the Olympics from Lauren and taking these ideas of becoming an Olympic athlete, infusing them with how to become better at money.

1:00:08So that's last Friday on the Stacky Benjamin show. Yeah. And that was so much fun to record. Thank you so much for tuning in. If you enjoyed today's episode, please share it with a friend or family member. That's the most important thing you can do to spread the message of great financial health. Subscribe to our newsletter at affordanything.com slash newsletter, and make Make sure you're following us on Apple Podcasts, on Spotify, and on YouTube. On the first two on Apple Podcasts and Spotify, you can leave us up to a five-star review. On YouTube, please leave a comment, leave a thumbs up, follow our show, hit the notification bell.

1:00:44Those are all ways that you can support this show. And remember, you can chat with members of the community at affordanything.com slash community. All of it is absolutely no cost and available for you to help you in your personal finance and financial independence journeys. Thank you again for tuning in. My name is Paula Pant. I'm Joe Zolcihai. And I'll meet you in the next episode. She also shows us her medals, which are in a place where you wouldn't believe. Yeah. And Lauren is the first American woman to have medaled in both the summer and the winter Olympics. Oh, I didn't say that correctly?

1:01:22Oh, did I get that wrong? Wait, did you not say it? Did I? I thought I just said that. Did you just say that? I thought I did. Sorry, Joe. I zoned out. Is Joe talking again? No, no, no, no, no.