Engineering Portfolio Returns

Engineers are a special breed of investor—at least the engineers that I have seen in my career. These detail-oriented creatures show up at the office, armed with spreadsheets of cash flow, net worth and of course, portfolio allocation --- color pie charts at no extra charge! With all of their great knowledge of numbers and their organized minds, why do engineers need investment advice?

The answer to that question was revealed to me when “John,” a civil engineer, wanted to discuss his retirement accounts. I smiled as he unpacked what looked like a suitcase full of financial projections and balance sheets. After reviewing the numbers, I concurred with John’s belief that his goal of retiring in two years was indeed attainable. “That’s what I keep telling my wife, so I’m glad to hear it.”

I then pointed out that the only way that the 55-year old couple might run into a problem is if they incurred heavy losses in their portfolios at the wrong time, “so let’s take a look at how you are invested right now.” The first graph was an asset allocation pie chart that showed a fairly significant overweight in stocks. The total portfolio was 82% stocks, 12% bonds and 6% cash. That seemed a tad bit aggressive for a couple that wanted to retire in two years, but it wasn’t the biggest problem.

When I reviewed the holdings, I saw that of the total assets invested for retirement, 75% was in-the-money stock options of one company---the company for whom John worked! Of course John knew that this dangerous, but his problem was that his engineering brain was stuck in a loop. He kept trying to figure out how he could avoid taxes when he exercised and sold the position. And in the year that he has been trying to figure it out, the stock price has been rising, so it has not hurt him to drag his feet in the process.

While I think tax reduction is important for all investors, the risk that John was assuming so near to his desired retirement age seemed enormous. He said that when he thought about paying taxes, it felt like he was losing “40% of the gains”. I reminded him that at least 15-18% of the gains absolutely belonged to the federal and state governments. The remaining taxes due would be realized depending on the timing of the sale (whether the proceeds would be taxed at long or short-term rates). “The main question to consider is how you would feel if the stock went down and instead of paying 20 cents on the dollar in taxes, you would be eating 100 cents of every dollar as the stock dropped.”

John was stymied. He wanted to find a solution that would satisfy the need to diversify and to reduce taxes. Like so many others, he really wanted rewards without risk. Unfortunately in the emotional world of investing, this is usually impossible. No matter how hard we try, there is a tradeoff. Each individual must clearly understand and weigh both the risks and rewards involved in every investment decision to determine the most reasonable action necessary. Sometimes you can’t engineer the portfolio returns that you want, even when armed with information.