Uncertainty vs Risks…

What is Risk?

The following are the definitions of risk according to the dictionary

  • A situation involving exposure to danger
  • The possibility that something unpleasant or unwelcome will happen
  • A person or thing regarded as a threat or a likely source of danger
  • A possibility of harm or damage against which something is or needs to be insured
  • A possibility of a loss…..ex financial loss

What is Uncertainty?

Many people, including me, have used risk and uncertainty interchangeably. But, if you did deeper, they are different. The dictionary definition of Uncertainty is:

  • The state of being uncertain
  • The state of a lack of certainty

Possible Outcomes and their odds of happening

Let us consider some math now. Consider all possible outcomes of an event like rolling two dice. Listed below are all possible outcomes:

  • (1,1)(1,2)(1,3)(1,4)(1,5)(1,6)
  • (2,1)(2,2)(2,3)(2,4)(2,5)(2,6)
  • (3,1)(3,2)(3,3)(3,4)(3,5)(3,6)
  • (4,1)(4,2)(4,3)(4,4)(4,5)(4,6)
  • (5,1)(5,2)(5,3)(5,4)(5,5)(5,6)
  • (6,1)(6,2)(6,3)(6,4)(6,5)(6,6)

Any time anybody in the world rolls a dice, the outcome *WILL* be one of the above 36 possibilities. In addition, we can also assign odds to each of each of the possible outcomes happening. For example,

  • The odds of getting a 2 is 1 out of 36 possibilities 
    • (1,1) is the only way
    • i.e. its PROBABILITY = 1/36 = .028 OR 2.8%
  • The odds of a getting a 7 is 6 out of 36 possibilities
    • (6,1), (5,2), (4,3), (3,4), (2,5), 1,6)
    • I.e. its PROBABILITY is 6/36 = .17 OR 17%

Uncertainty Redefined

There are two kinds of uncertainties (credit goes to Frank Knight, author)

  1. Type 1:  
    1. We know all the possible outcomes of an event in advance
    2. We may even know the probabilities of each of the outcomes i.e the odds of each outcome happening.
    3. This type of Uncertainty is called RISK.
    4. In the dice example above, we do not know that the possible outcome of a dice roll will be, but we know all the possibilities and their odds and we can plan/bet on them.
  2. Type 2
    1. We do *NOT* know the possible outcomes….let alone their probabilities.
    2. This type of Uncertainty is called GENUINE UNCERTAINTY

Risks and Genuine Uncertainty….Example 1

Two examples of genuine uncertainties that I have personally faced are

  1. 2008 recession
    1. Almost nobody even thought that such an outcome was possible for the US economy.
  2. Private companies
    1. I used to work for a private/startup company…we had identified all possible outcomes:
      1. Go ipo: low probability
      2. Get acquired by a bigger company: High probability since many senior management folks came from the bigger company which was supposed to acquire our company
      3. Competitor: very low probability…we were in a new area and had a super headstart
      4. Etc etc
    2. But a competing startup company came out of stealth mode…a company we did not know even existed. Even more surprisingly the bigger company acquired them *the next day*….and an inferior product to boost. And our company self-destructed….all in the space of 6 months. 
    3. This outcome was not identified and had no probability associated with it.

Risks and Genuine Uncertainty….Example 2

Let us take the example of an ordinary economic recession vs the super duper recession of 2008.

 

  • Ordinary Economic Recession

 

    • The possible outcomes (risks) of such an event can be
      • Possible job loss
        • Probability: 20%
        • Things to plan for:
          • An emergency fund lasting 6 months….done
          • Life insurance out of work…..done
          • Network with people and keep track of which companies are healthy and hiring
      • Possible portfolio loss
        • Probability: 80%
        • Things to plan for:
          • As long as there is no need to withdraw cash, keep investing and dollar cost average down. 
          • If already in retirement and drawing income or cash from portfolio, then keep a larger emergency fund to cover atleast 2-3 years of annual expenses in cash

 

  • 2008 super duper recession

 

    • I did not even dream of such a possibility….just like most of the world’s top economists 😐
      • My portfolio went down 40-50% and I had a conservative portfolio
      • I barely retained my job…but I knew many people who not only lost their jobs but could not get one for another 2 years, went through divorces, and many other hellish scenarios.
      • What if you are already in retirement and drawing money from the portfolio? Withdrawing money when the portfolio is down 30-60% is suicide 😦 

Should we plan for Genuine Uncertainties at all?

By now, we have understood the differences between Genuine Uncertainty and Risks. 

  • Risks can be anticipated because there are a set of possible outcomes. Since the outcomes are known, they can be mitigated by planning. Impact is reasonable.
  • Genuine Uncertainties cannot be predicted and hence there is no way to have a set of possible outcomes to plan for. Impact is very high.

If genuine uncertainties are so rare, then should we plan for it at all? In my personal experience, I have found that the genuine uncertainties are increasingly becoming frequent in the last two decades.

  • Finance:
    • In the last 2 decades, we have seen multiple instances of such unpredictable events in the financial world….2001 dot com bust, 2008 great recession, 2016 election night drop, etc
    • One impact example. I know people who were forced to go through home short sales and take a drastic cut to their standard of living: all cases were induced by job losses.
  • Health:
    • In my social circle, I have lost two people in an instant…heart attack and cancer…how do we deal with such unpredictable events in the personal world?
    • Work stress was the main cause in both. But one of them had reasonable savings and the family got taken care of. The other was a bit of a mess. 
  • Relationships:
    • A close friend got divorced…mainly (imo) due to the pressures induced by two unpredictable events in the finance world
    • A couple of families relocated out of this HCOL area…again due to pressures of the economy.

Going by what I am seeing in the last two decades, planning for Genuine Uncertainties is not an option anymore. WE HAVE TO PLAN FOR IT!

Possible Solutions for Genuine Uncertainties

We will talk about two solutions in a subsequent blog post.

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The Power of Investment Income

…through long term cap gains and dividends. If earning $73,800 per year (married filing jointly) or $36900 (filing single) and PAYING NO TAXES interests you, then please do read on for an interesting story. I will explain why lots of financial independence(FI) bloggers use investment income as a vehicle for their FI journey.

Many years ago, I remember Warren Buffett mentioning that he pays a lower tax rate that his secretary. I never really figured out what he meant until I started exploring financial independence myself and started investing in stocks myself. To understand his statement, one needs to understand some part of the income tax code….I know, not a popular topic, but knowing a little bit of the tax code can save you lots of money in taxes!! So, bear with me.

Types of Income

There are many types of income a person can earn. Some types are listed below:

  • From working for somebody
    • Salary
  • From owning stocks and bonds
    • Long and short term capital gains
    • Dividend Income
  • From owning real estate
    • Rental income
    • REIT funds income
  • From cash
    • Interest income from banks

Types of Income according to IRS

The tax man has a different notion of income. The tax man sets the amount of taxes based on the different notions of income. So, let us understand the types of income a tax man sees.

  • Ordinary Income
    • Salary
    • Short term capital gains (from selling stock owned less than a year)
    • REIT income
  • Ordinary Dividend Income
    • Owning non-qualified stocks that pay a dividend
  • Qualified Dividend Income
    • Owning qualified stocks that pay a dividend
  • Long term Capital Gains
    • from selling stock owned more than a year

The simple definition of Qualified dividends means income from corporations that meet a specific criterion like incorporated in the US or in a country that has a tax treaty with the US, stocks owned more than 60 days prior to the ex-dividend date, etc etc. There is a link at the bottom of this article for details. But, dividends from most US corporations are Qualified dividends.

Tax Filing Status

The tax man also specifies a filing status based on the different social definitions attached to a person.

  • Single
  • Head of Household
  • Married
    • filing jointly
    • filing separately
  • Qualifying Widow or Widower

IRS Tax Rates for the types of Income

Since the tax man sees income differently than you and me see it and different filing status, the tax rates are different for the different types of income. For 2014, let us consider the following table for two of the most common filing status types.

Tax Rates Single Married Filing Jointly / Qualifying Widow or Widower
Ordinary Income Long Term Capital Gains and Qualified Dividends Taxable Income over to Taxable Income over to
10% 0% $0 $9,075 $0 $18,150
15% 0% 9,075 36,900 18,150 73,800
25% 15% 36,900 89,350 73,800 148,850
28% 15% 89,350 186,350 148,850 226,850
33% 15% 186,350 405,100 226,850 405,100
35% 15% 405,100 406,750 405,100 457,600
39.6% 20% 406,750 457,600

The most important rows to consider are the rows in BLUE color. Two things stand out in the blue rows

  • 0% tax rate for
    • Long term capital gains
    • Qualified dividends
  • 0% tax rate until…
    • $73800 for married filing jointly
    • $36900 for single filers

What the above powerful statements tell us is that if *ALL* of your income comes from long term cap gains OR from qualified dividend, you will pay ZILCH to the tax man i.e. you get to keep what you earn!! How beautiful is that!

Back to Warren Buffet and his secretary…

You did not think I forgot about him did you 🙂 According to some news articles, Warren Buffet himself declares that he pays a 17.4 percent rate on taxable income. Note that he earns millions of dollars in income, but the first $73800 is tax free. His secretary apparently pays 8-9 points above him i.e. her average tax rate is atleast 25%. How is this possible? This is possible because of this:

  • Warren Buffett
    • most income is Investment income
    • Taxed at lower rates
    • First $73800 of investment income is tax free
  • His Secretary
    • most income is Salary income
    • Taxed at a much higher rate (from the table about, it is 25%)

Conclusion

Most financial independence bloggers, when they achieve financial independence and retire early, expect to get income from two sources

  • Stock investment
    • selling stocks and realizing long term capital gains
    • qualified dividend income
  • Rental income

If you are in the stocks category, like I am trying to be, aim for a good chunk of income from Investment income and get to keep all of the income until $73800 (married filing jointly) or $36900 (single filers).

It would be good to diversify the income streams and get some rental income as well. But, that is not my chosen path yet because of lack of hard $cash$.

Go Investment Income!!

Links

Bucket Approach to Retirement

There is a common question among those planning/approaching retirement and definitely among those already in retirement.

That question is:

  • How to withdraw money from the retirement funds?
  • How to invest the remaining money while in retirement?
  • How much to withdraw each year?
  • How to not not be too conservative and run out of money?

A recent article I read from Christine Benz (Morning Star, published around 2012) was very informative to me. I am enclosing a link to that article here.