fungible money

Money is Fungible

Mental Accounting, Fungibility of Money, and Asset Location

Fungible is a funky financial term. Money is Fungible.

Let’s inculcate fungible into your lexicon.

Fungible means interchangeable. Or substitutable. The meaning of fungibility is the same.

A dollar bill in D.C. is the same as a dollar bill anywhere else in the world. Indeed, $10 is worth two five-dollar bills, or ten one-dollar bills. Money is fungible.

Commodities are fungible. You can take sugar out of the little bowel and scoop it into your coffee. Since sugar is fungible, you refill it from the jumbo bag you got from any store. Gas is gas at the corner station or the kitty-corner to where you usually go. Commodities are fungible—that’s what makes them a commodity!

During retirement, money is fungible. If you sell equities from any account to provide income, you can buy equities in a different account and keep your asset allocation on target. Same with bonds.

Even if the market is down and you “sell low,” if you buy the equivalent “low” in a different account you haven’t really lost. Really. Because of fungible money.

Let’s dig in a little deeper to understand how money is fungible. And, let’s discuss how lack of understanding regarding fungibility may lead to mental accounting… and poor asset location.

Fungibility of Money in Retirement

So, how is money fungible in retirement? How can you withdrawal money from any account and keep your asset allocation spot-on?

Say it is time for you to take 4% of your retirement nest egg out to spend. You are under 59 and 1/2 and in order to avoid the 10% penalty on your qualified retirement accounts, you take money out of a brokerage account.

For convenience, say you have 50% of your money in a brokerage account—which is 100% equities—and 50% in an IRA. Your overall asset allocation is 80/20, so the stock/bond ratio in your IRA is 60/40. If you sell stocks your brokerage account, you need to sell bonds and buy stocks in your IRA to make your asset allocation 80/20 again.

The net effect due to the fungibility of money: you are selling both stocks and bond (at a 80/20 ratio!), as you sold stocks in your brokerage account, and at the same time you sold bonds to buy back the same stocks in your IRA. As money is fungible, you kept your overall asset allocation intact!

How does this work in up and down markets?

Selling in an Up Market

Here, say equities have been on a killer run and your asset allocation has drifted, such that it is now above the 80/20. Well, as you need to take a distribution anyway, you can just sell off equities in your brokerage account and be done with it. Re-balance in your IRA if needed.

Fungible Money in a Down Market

In a down market, on the other hand, won’t you be selling your equities low? (Never Sell Low) Yes, you will. But remember, you can turn around in your tax-deferred account and, without tax liabilities, re-balance there.

So, you sell stocks low, but in order to get back to your pre-determined asset allocation, you sell bonds (which have hopefully kept their value), and buy stocks which are low. In effect, you are not selling low, you are selling bonds!

Thus, as cash is fungible, it doesn’t matter in which account you keep your equities or bonds. That is true when you are thinking about asset allocation, but not asset location!

Asset Location and Fungible Money

Asset Location looks at the tax efficiency of your asset allocation. To keep things simple here, we will stick with just stocks and bonds.

In your brokerage account, you are forced to pay ordinary income taxes on short term capital gains and dividends. This is why you prefer equity index funds with low turnover (no short-term capital gains). Also in your brokerage account, bonds pay dividends which are taxed as ordinary income. So, bonds should probably should go in your tax-deferred account rather than your brokerage account.

Your other two account types are tax-sheltered (pre-tax and tax-free). What that means: you can buy and sell and have all the short or long terms gains you want, and you won’t pay taxes now.

Since money is fungible, asset location means you want your tax-efficient funds in your taxable brokerage account and your tax-inefficient funds in your tax-sheltered accounts. These are basic principles of asset location. If you need more help on the topic, visualize the 3-fund portfolio across your account types.

So, in summary, you have different types of funds in accounts with different tax treatments. Because money is fungible, it’s all good! Just swap out stocks and bonds—or re-balance—in the tax-deferred accounts where you can buy and sell without triggering ordinary income or capital gains.

Debt and Fungibility of Money

Because debt is money owed, it is also fungible. Debt is fungible!

Debt is also part of your asset allocation, and debt actually has a negative or inverse effect.

Say you owe $100k on the mortgage and have $100k in stocks and $100k in bonds. Well, because debt is like a negative bond your asset allocation is not 50/50, it is actually 100/0. That’s right, the negative $100k in debt wipes away your bonds and you are taking more risk than you might realize.

You are taking more risk because you are using leverage (borrowing money) in order to invest in stocks and bonds.

In retirement, not having a debt payment is the same as having more money to spend. Debt and cash are fungible. If you didn’t have that mortgage, you’d have more money at the end of the month. In addition, debt is leverage and inversely affects your asset allocation. Fun stuff!

Fungibility is Not Liquidity

Liquidity is not the same as fungibility.

Liquidity is the ability to turn an asset into cash. For instance, stocks are very liquid because they can be sold whenever the stock market is open in exchange for cash. Your home is not liquid because it could take month to sell in order to convert to cash.

Fungibility, on the other hand, has to do with substantially equivalent items which are equal when exchanged in time and space.

So, pure gold is fungible where diamonds are not, as they have different qualities (cut, clarity, color etc). Diamonds, however, are rather liquid, as they can be sold in exchange for cash. Same with gold. But remember, illiquidity does pay a premium and there is no reason not to have some illiquid investments in your portfolio.

Money is Fungible

Figure 1 (Money is Fungible even when it is made into little animals)

That’s enough on the fungibility of money. Let’s talk about the logistics and methods to tap your accounts during early retirement.

Money is Fungible and Mental Accounting

Here is the heuristic that causes all the problems with the fungibility of money.

Folks don’t think money is fungible. Households don’t treat money as fungible. They use mental accounting instead.

We are subject to mental accounting.

Mental accounting is an important concept in behavioral economics which is most associated with Thaler. It implies that people are disposed to think about an asset in regards to its relative value rather than its absolute value.

Say you have a diamond ring that has the same street value as your neighbor’s wedding ring. Are they the same to you?

Or a different example, why do folks spend more on a credit card than they do if they had to pay cash? Or gamble more aggressively with “house money” than with “their own” cash?

Cognitively, money is not fungible in our thought processes, as we attach a value to it and consider where it came from and what its intended use is.

This leads us to ignore opportunity costs. For instance, we hold stocks that have done poorly because loss is more painful than gain is pleasurable.

And we hold dearly to the sunk cost fallacy. Money doesn’t care if what you have left is a result of a bad decision in the past.

Let’s explore mental accounting by looking at bucket plans and dividend paying stocks.

Money is Fungible Meaning: Why Dividend Paying Stocks Don’t Make Sense

With dividend paying stocks, people think they can “live off the interest” and that is safer than a total return approach where you sell funds at capital gains rates when you need the income. Because you are actually paying ongoing taxes on the qualified dividends rather than choosing when to pay taxes, the dividend approach can actually be less efficient than the total return approach.

Money is Fungible Meaning: Why Bucket Plans Don’t Make Sense

With bucket plans, people use time segmentation to plan income. They have a cash bucket for “now,” bonds for “soon,” and stocks for “later.” Collapse it all down and it is just ONE asset allocation. And you still need to address the different asset allocations in different types of account to afford tax-efficient asset location!

Risk should be managed across the portfolio, not in a bucket.

Mental Accounting and Asset Location

Let’s return back to your brokerage account and your pre-tax accounts and see where mental accounting affects most folks.

Good tax-efficient asset location suggests that stock should be in your pre-tax accounts rather than in your brokerage account.

money is fungible meaning

Figure 2 (Money is Fungible but mental accounting leads to poor asset location)

Mental Accounting leads to poor asset location. Remember, cognitively we don’t believe that cash is fungible. We ascribe it meaning and purpose depending on where we got it and what we plan for it.

Above in figure 1, you can see the mental barrier between your account types. Here, you have bonds in both types of accounts.

If you, however, want to optimize taxes, however, you should have all tax-efficient stocks in your taxable account, and only hold tax-inefficient bonds in your tax-deferred accounts.

Don’t fear selling low because money is fungible. If you sell low from your brokerage account, you can always change the asset allocation in your tax-deferred account which nets out as just selling bonds.

Conclusion: Money is Fungible

Money does not come with a label. There are no tracker tags or collars with specific identification. Money is fungible.

Although it is common to bucket money, or to create separate accounts in our mind, you have one portfolio and one asset allocation. Creating buckets of money for separate purposes ignores the fact that money is fungible.

Implications are many: you don’t need an emergency fund, debt is like a negative bond, you don’t need all cash or bonds in account you access sooner than others.

But we don’t live in a rational world. I say if you have blind spots where you ignore the fungibility of money, that is fine. As long as you understand that money is fungible, and money doesn’t care where it came from or how you intend to use it.

You don’t have to be perfect, just good enough. As with fungibility and fungi: don’t eat poisonous mushrooms. Eat the edible ones.

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17 Comments

  1. Agree with much of what you wrote. However, due to tax implications of selling highly appreciated stocks in a taxable account money is not completely fungible.

    If a decision is made to reduce allocation from 80/20 to 60/40, it seems to make sense to sell stocks in a tax deferred account to reduce immediate capital gains

    • Yes, Fungibility ignores Tax-Optimization, which is going to be 3rd or 4th in this series of posts.

  2. Physicians have tendencies to have high mortgage debt. No one considers implication of negative bonds and not having that money to invest in stock market. Please address the issue next time. Thanks for great insights

  3. Excellent post Dave.

    Like the above commenter I too caution about tax implications in selling in a brokerage account if it has appreciated a lot.

    Really haven’t thought of treating debt as a negative bond so that is eye opening.

    Even though it may be a blind spot I will probably have cash equivalents of a couple of years at least when I retire so I don’t have to sell depressed assets if the market tanks early in retirment to avoid the sorr

  4. Great piece but I think that consideration should be given to placing all of one’s early retirement money in equities (money needed before age 59.5). One needs enough to sustain withdrawals over an extended down market. If one doesn’t have that, there is a risk of running out of equites to sell in taxable space for income needs. So, to mitigate this risk one might ensure they have twice the amount of projected living expenses in taxable to sustain early retirement should the market drop by 50% and stay there for an extended period of time.

  5. Great post, Dave. Appreciate your sharing of great info.

    Would you agree that if one is in the top tax tier that it would make sense to have National Municipal Bonds in our Brokerage Accounts? Would it be reasonable to consider putting all or most of our Bonds asset allocation into Municipal Bonds?

  6. “You can take sugar out of the little bowel and scoop it into your coffee”

    I am not a physician, but I do not recommend taking sugar out of your little bowel.

  7. As always a very useful and thought provoking article. Regarding “debt is like a negative bond” does the fact that a 30 year mortgage can be had for 2.7% now alter your calculations in any way? It seems to me that buying your primary residence for cash right now is like leaving money on the table.

    • The idea of a negative bond is that you are using leverage to increase the equity part of your portfolio by having debt. The interest rate is low, but so is the return on fixed income right now, so I think they cancel each other out!

  8. I missing something here: If you have a taxable account ALL STOCKS and need to sell , because you don’t have have any other source of money ( and not cash reserve or bucket) you are selling LOW, even though you can rebalance without tax consequences in a tax deferred/ tax free account. Only having municipal bonds allow you to sell from the taxable account, which is in fact one way of rebalancing the whole portfolio. Remember in retirement taxable account are supposed to go first. Any taxable brokerage account must have bonds(preferably municipal).

    • Luis, thanks for writing. Yes you are missing something! You don’t need munis to rebalance. Think about this: You have 100k in the brokerage account in stocks and 100k in an IRA in bonds. Your asset allocation is 50/50. You need 10k so you sell 10k of stocks. Then in your IRA, you sell 10k of bond and buy 10k of stocks. So -10k stocks plus -10k bonds plus 10k of stocks = -10k of bonds. In effect, you sold 10k of bonds to get 10k out of your brokerage account. Of course your asset allocation is 53/47 but if stocks tanked recently something like this would probably get you closer to your goal asset allocation. And of course we are not talking about after-tax equivalence here because that math is a pain in the butt. Does that help?

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