Elite Eight: Mortgage versus Savings rate

Basketball hoop

 

After a thrilling contest between Index mutual funds and Free money yesterday, we are now pitting Mortgage against Savings rateAs always, I am not an expert on these matters.

bracket-game 2

 

Reasons for picking mortgage:

For most families, their Mortgage payment on their home is the single largest expenditure they have.  Also, due to its nature as a commodity, it’s also one of the easiest places to really save a lot of money pretty painlessly.  For a lot of products there’s a trade off between price and quality.  A BMW 325 owner could pay $20,000 less and drive a Honda Civic, but there is a trade-off, either real or perceived, between those two cars.  Sure you’re saving a lot of money, but you’re also getting not nearly as nice a car.

Mortgages are very different because money is a commodity, so there’s no difference.  If you get a Mortgage from Bank of America it acts pretty much identically as the Mortgage you get from Roundpoint (incidentally, the Fox family refinanced our mortgage—we used to be with BofA and now we’re with Roundpoint).  Money is money so here you want to go with whoever can give you the lowest rate (there are some features that might be important like prepayment penalties or ability to refinance within a certain period of time, but in my experience those are pretty rare).

Here we’ll use the Grizzly family as an example; they owe $400,000 on their home.  One of the easiest ways to save money on a mortgage is by refinancing when interest rates go down.  In the past few years, rates have been at historic lows and that means Mortgage interest rates have been similarly low.  Let’s say the Grizzlys got their mortgage 5 years ago with a rate of 6%, but now they can refinance at about 4%.  That alone would reduce the interest payments over the life of their mortgage about $175,000!!!  That’s an incredible amount of money for going through a process that takes maybe a month from beginning to end, and probably about 5 hours of work on your part.  As easy as this is, there are millions of homeowners out there who haven’t done this yet.

You can move a little up the difficulty spectrum and save even more.  Some Mortgages are sold with “points” which is basically prepaying interest; for example you might pay an extra $5000 when you get your loan and for that you would have an interest rate of 3.5% instead of 4.0%.  Points aren’t very well understood and because of that a lot of people tend to stay away, but if you are planning on staying in your house for a long time, they can be the best money you ever spent.  Using that above example, paying the $5000 to get the lower interest rate would net you a savings of about $35,000 over the life of the loan.

Kind of the opposite of points are adjustable rate mortgages (ARMs).  Instead of a 30-year fixed loan (the interest rate stays constant for the 30 year life of the loan) you could get a 5-year ARM where the interest rate is fixed for the first 5 years of the loan and then adjusts based on market conditions for the remaining 25 years.  The benefit of these is ARMs tend to be about 1% less than fixed rates, but the major concern is that rates could rise after the 5 years is up and that could increase the cost of your Mortgage.  In my opinion ARMs make sense if you don’t think you’ll be in your home for very long.

In fact the Fox family is anticipating moving in the next few years, so we refinanced from a 30-year fixed at 4.0% to a 5-year ARM at 2.75%.  Let’s say the Grizzly family did the same thing with their loan; that would equate to savings of about $15,000 for the first five years.  Of course, after that they would either need to move, refinance their Mortgage, or deal with the uncertainty of a floating rate Mortgage.

 

What it does?

Refinance Take out a new loan at a lower interest rate to decrease the amount of interest you pay
Buy points Pay more in closing costs to get a lower interest rate
ARM Get a lower interest rate that is fixed in the beginning but then becomes adjustable (usually after 5 years)

 

So all these seem to be pretty big numbers, especially since you aren’t really giving anything up to achieve them.  But they aren’t going to be quite that big because interest on mortgages is tax deductible, so saving $100,000 in interest on the life of your mortgage may only put you ahead $60,000 because of the tax deduction.  On the other side of the spectrum, you might end up with significantly more if you took those savings and invested them.  Either way, your Mortgage is a great way to pad your nestegg.

 

Reasons for picking savings rate:

Savings rate is probably the most fundamental element of investing.  You can’t really invest until you have saved some money to invest with (Gee Stocky, thanks for that tremendous insight into what we already know).  And certainly, the more you save, the more you can invest, and the larger your nestegg will become.  But how much can saving more really move the need?

savings rate

The impact can be pretty staggering.  Over a 38-year period, from 22 when most of us enter the workforce, until we turn 60 and hopefully retire, if you invest $100 per month (assume a 6% return) you will end up with about $175,000!!!  It’s not that $100 isn’t a lot of money (it definitely isn’t chump change), but that seems pretty incredible that such a modest amount every month can lead to such a large number at the end of the run.  Over those 38 years, you would have invested a total of about $47,000, and because of investing returns you would have ended up with about 4 times that amount.

And the math works so if you save $200 per month, you end up with about $350,000; $1000 per month, you end up with $1.75 million.  Ladies and gentleman, say “hello” to the power of compounding.

 

Who wins?

Mortgage gives it a good fight, but in the end Savings rate is able to generate numbers that are so much bigger.  Also, while refinancing at a lower rate is a pretty sure-fire way to save money with your Mortgage, the more complicated maneuvers like buying points or using an ARM do entail some risk which could cost you serious dollars if you move too early or too late.  On the other hand, there is really no way that saving more can hurt your nestegg.  In the end Savings rate crushes Mortgage 65-51.

I’ll do my usual week in review on Friday.  Then come back on Monday to see the final match of the first round, Starting early against Tax optimization.

 

bracket-game 3

Elite eight: Free money versus Index mutual funds

Basketball hoop

After a thrilling first day where we saw Asset allocation blow out Diversification, we are now on to day two where Free money will face off against Index mutual fundsAs always, I am not an expert on these matters.

 

bracket-game 1

Reasons for picking free money:

Free money is . . . well . . . FREE.  And obviously the more money you can contribute to your portfolio the closer you’ll be to retirement, the better you’ll be able to ride out stock market downturns, and the more financial flexibility you’ll have generally.  I’m not telling you anything you don’t already know.

In the US, by far the most common opportunity for Free money is the company match for your 401k.  Typically it looks something like they will match $0.50 for every dollar you contribute up to 6% of your pay.  And there are some companies that are even more generous; Medtronic has historically matched about $0.90 for every dollar up to 6% of your pay.  Do the simple math and your average 401k match comes in at about 3% ($0.50 * 6%).  Ever since I started working in 1999 I have always contributed at least enough to get the entire company match.

If you do a quick calculation (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), the value of that match is about $350,000.  That’s not what your whole 401k would be worth, that’s just the value of the match!!!  Not bad considering the median nestegg for a 60-year-old living in the US is about $140,000.

So who says no to this?  Sadly, about one-third of employees who have access to a 401k plan are “leaving money on the table” by not contributing up to the amount that their employer will match.  This is some really low hanging fruit that is going unpicked.  I get that there is only so much money to go around, but man, every dollar you’re putting in gets you another $0.50 of FREE MONEY.  That’s a guaranteed 50% return; there are a lot of investors who would give their first born for something like that (Foxy Lady just instructed me that I am not allowed to give away Lil’ Fox for a 50% return–damn).

 

Reasons for picking index mutual funds:

Index mutual funds are mutual funds that mimic an index like the S&P 500, Barclays Bond index, FTSE Global Cap, or the MSCI US REIT index.  That may sound confusing—the point is these mutual funds find an index already established in the market and do their best to copy it exactly.

Index fund advocates, and I count myself among them with probably about 95% of the Fox’s nestegg in Index mutual funds, believe that these funds actually perform better than actively-managed mutual funds (an actively managed fund is one where the mutual fund manager picks individual stocks or bonds that he or she believes will out-perform the general market).  I personally think the data here is mixed to slightly favorable for index mutual funds (mostly because of tax implications), but that is a pretty deep discussion probably for another blog post.  For this analysis, I’ll assume that actively managed mutual funds and index mutual funds return the same amount.

The undeniable advantage of Index mutual funds is their lower management fee.  Like all things, mutual funds charge a fee for their services; it is a percentage that the fund managers skim off the top to pay for managing the fund.  For actively managed funds that fee averages to about 1% with some higher and some lower.  This goes to paying for all the research done, salaries for the different teams, brochures and disclosures, travel to different conferences, etc., and it tends to be a pretty decent chunk of change.  For Index mutual funds, you really don’t need all that because all the team is doing is tracking a pre-existing index; because of this management fees tends to be fairly low—in the 0.05% to 0.2% range.

Remember The power of a single percentage?  We actually called out mutual fund management fees there as ripe for a 1% coupon.  Running the numbers using the same scenario we just used for Free money (assume you work from 22 to 60, with a salary that starts at $50,000 and rises to $100,000 over the years, with a 6% investment return), that 401k account using a index mutual fund with a fee of 0.2% would leave you with about $990,000.  An actively managed account with a fee of 1% would leave you with about $820,000.  That a difference of $170,000 in your 401k over the course of your investing career.

But that’s just for one account.  Index mutual funds can be used for pretty much all your investing accounts—401k, IRA, 529, brokerage.  Also, they can be used throughout for investing career, from the time you open your first account as a youngster all the way through the end when you shuffle off this mortal coil and leave some cash to your loved ones (more cash than you would otherwise because you were paying lower fees).

 

Who wins?

This turned out to be much closer than I anticipated.  At first I figured that Free money would win this going away, but Index mutual funds definitely came to play.  Free money has a power effect (about 3% of your salary on average), but that is generally limited only to 401k accounts, only to the first 6% of your compensation, and only while you are working.  Even with all those limitations, it makes an enormous difference over your investing lifetime.  Index mutual funds have a smaller impact but a much broader application.  You can use them on every account, with every dollar invested, for every year you’re investing.

In a game that came down to the absolute wire, I think Index mutual funds barely edges out Free money in a Bryce Drew-style miracle finish.  The final score, Index mutual funds 70, Free money 69.  Ultimately I think Index mutual funds and that lower management fee will save more of your money in every corner of your investing portfolio, and that will ultimately lead to a bigger impact on your nest egg.  I hope to see you tomorrow when your Mortgage takes on Savings rate.

bracket-game 2

Elite eight: Asset allocation versus Diversification

We’re ready to kick off the investing strategy tournament to determine which is the single best investing strategy if you could only pick one (which fortunately isn’t the case–you can pick all these).  As always, I am not an expert.  So without further ado, we’ll start with the contest between Asset allocation and Diversification.

bracket-begin

Reasons for picking Asset allocation:

Asset allocation is picking the right mix of stocks, bonds, and cash which maximize your investment returns while also limiting that chances that you hit a bad patch of time which cripples your portfolio beyond recovery.  The basis of the concept of asset allocation is the fact that as your expected investment returns increase, so does its volatility.

So for example, cash (or money market accounts) are the least volatile investments around where the chances of you losing money are nearly zero, but they also offer the smallest return at about 1-2%.  On the other end of the spectrum are stocks which historically have averaged about an 8% return, but where about one-third of the years you lost money.  Bonds are between those two, both in terms of returns and risk of losing money.

In my experience screwing up Asset allocation, especially among young investors, is one of the most common missteps.  The conventional wisdom is that you want to take more investing risk when you’re younger because you have more time to “recover” from any market downturns (as was the case with me in 2001 when I was just starting out).  That means that typically (and of course, each individual is different) younger people should allocate more to stocks than bonds or cash.  However, so often I talk to younger investors who have a significant chunk of their 401k in bonds or worse yet, cash.

Why is this so bad?  Well, over a period of decades, the investment horizon when you’re in your twenties or thirties, you end up leaving a lot of money on the table.  Using historic averages, if the 25-year-old you invested your 401k in stocks and your twin invested in bonds, when it comes time to hang up the spurs, it’s no contest—you’re so far ahead of your twin.  Remember that historically, stocks have returned about 8% while bonds have returned 5% and money markets (cash) have returned about 2%.  Just doing some really simple math, the historic difference between stocks and bonds has been about 3%–that adds up to huge differences over an investing career (remember from “The power of a single percentage” how big a difference 3% can make?).  Who knows if it will be like that in the future, but based on history that could lead to hundreds of thousands or even millions of dollars over time.

Of course, you probably read A Random Walk Down Wall Street, so maybe you’re saying, “but when you invest in stocks you’re only getting a higher return because you’re talking on more risk.”  There’s no such thing as a free lunch, and right you are.  That argument is exactly why Asset allocation is so important.  If you were 60 years old and getting ready for retirement, it probably wouldn’t be a good idea to risk losing a big chunk of your portfolio by investing the majority of your money in stocks.  But if you’re 20 or 30 years old, then you can invest in stocks to get the higher return knowing you’re at less risk of a catastrophic loss because you have three or so decades to ride out any storms.

 

Reasons for picking Diversification:

Diversification is the strategy of picking multiple investments so that you can reduce the volatility of your portfolio.  When some of your investments are down, others will be up.  This is really Investment 101 stuff, and I don’t think you’ll find many legitimate investors who would not say it’s a good thing.  But if you think about it, how much is Diversification really doing to help you achieve your financial goals?

The fact of the matter is that Diversification does not increase your investment returns, on average (“on average” is a critical phrase here).  If that’s true, then why does everyone make such a big deal about diversification?  Because by diversifying with several stocks you even out the highs and lows that would occur with a single stock.  As an example let’s look at investing in an S&P 500 index mutual fund which is considered highly diversified, and compare that to investing in a single stock.  Here I picked Catepillar because from 1980 to today, it and the S&P 500 had largely the same performance (they were both up about 1000% over those 34 years).

Over that time both investments had their ups and downs, but the difference was that Caterpillar’s ups were much higher and its downs much lower.  Since 1980 (34 years), the S&P 500 index had seven negative years with its worst year being 2008 when it was down 39%.  It also had 11 years where it had a return of 20% or better with its best year being 1995 when it was up 39%.

Now compare that to Caterpillar over the same time, remembering that over the entire 34 years they both had total returns fairly similar to each other.  Caterpillar had 15 years with negative returns, the worst being 2008 when it fell 55%.  On the other side, it had five years where returns were over 55% (16% better than the best year of the S&P 500 index), with the best year being in 2010 when it increased 90%.

So think about that.  If you decided not to diversify and put all your money in Caterpillar, you would have ended up in pretty much the same place as your twin who diversified with the S&P 500 index, but you would have had a much crazier ride.  2008 would have sucked for both of you, but much more so for you than your twin.  Also, almost half of your years would have been negative (15 out of 34 years) where it was only about 7 out of 34 years for your twin.  Of course, that would have been offset by some real “bumper crop” years (I had to get a farming analogy in) like 2010 when your portfolio would have almost doubled.  No one is complaining about a year like that, but it that a good thing?  How do you plan for something like that?  Pre-2010 you were probably figuring you’d have a moderate retirement, and then 2010 rolled around and life all the sudden got a lot sweeter.  Just look at the graph—far and away the most common annual return for the S&P 500 index was the 0-20% bucket; for Caterpillar the returns were all over the board and the most common was -20% to 0%–a loss!!!

SP500 v CAT chart

And of course, I picked Caterpillar because over the 34 years it was pretty close to the S&P 500.  Remember that if you picked a single stock randomly from a broad index like the S&P 500, you would expect the stock to do just as well as the index, because the index is just an average of a bunch of those stocks.  And it’s true that on average a single stock will do as well as an index, but what if I randomly picked United Airlines which went bankrupt just like many, many other companies do every year (there’s no real chance that the value of the S&P 500 would go down to zero in a similar way)?  Or if I picked Medtronic (one of the greatest companies ever) which outperformed the S&P 500 some 12x?

My personal preference with investing is that I want as much predictability as possible, and that is even tough to come by when you’re highly diversified; when you aren’t diversified, there’s no chance.  Maybe if you like those types of thrills that putting everything into a single stock brings, you may want to think about BASE jumping or free diving.

But assessing it honestly, Diversification does not lead to higher returns on average.  It just reduces the crazy swings up and down.

 

Who wins?

Asset allocation wins this one pretty easily, 86-59 (I just made that up to look like a basketball game score, but it seems about right).  Diversification definitely helps smooth things out, but Asset allocation can undeniably increase your returns which translates to real money.

bracket-game 1

So Asset allocation moves on to theFinal Four.  Make sure you come back tomorrow to see Free money take on Index mutual funds.

 

Elite Eight tournament for investing

Basketball hoop

March is here and that means so many good things—winter is giving way to spring, flowers are starting to bloom, and of course March Madness (the college basketball tournaments for those of you unfamiliar with the lingo) is starting.  Normally I would totally consume myself with 10+ hours of games a day on multiple TVs at the same time, and Foxy Lady would become a basketball widow for the next three weeks (and that still may happen).  But now that I’m doing this blog (plus Pitt didn’t make the tournament), I thought I would have a little fun and combine the two.

So here is my tournament-style contest to determine what is the single best strategy/approach out there to help you build your personal fortune.  I whittled it down to eight “teams” which will face off against each other until there is one champion.

 

Without further ado, here are the teams:

  • Asset allocation—investing your portfolio into different asset classes like cash, bonds, and stocks.
  • Diversification—buying different stocks or bonds to avoid “putting all your eggs in one basket”
  • Free money—taking advantage of free money from accounts like 401k’s or stock purchase plans
  • Index mutual funds—choosing mutual funds that invest in broad indices like the S&P 500 or the FTSE.
  • Mortgage—picking the best mortgage that gets you the house you want but pays the lowest amount.
  • Saving rate—simply put, how much you’re saving every month or every year.
  • Starting early—beginning putting money away at an early age
  • Tax optimization—using tax advantages like 401k’s, IRAs, 529s, and other accounts out there that let you eliminate or defer paying taxes.

bracket-begin

 

Every day for the next two weeks I’ll break down the “game” between two of these investing strategies and determine which one, taken in isolation, will have the more important impact on your nestegg.  But in this tournament there are no losers (I’m getting ready for when I start coaching Lil’ Fox’s little league), and certainly each of these principles is very, VERY important as you think about your investing strategy.

The idea of this tournament (other than having a little fun while the real players are putting the balls through the hoops) is to help finish the sentence: “if you only do one thing in investing make sure you . . .”  I’ve evaluated these strategies along a few criteria:

  • How large of an impact could doing this right have on your nestegg? Are we talking about a few thousand dollars over the years, or could this amount to the millions?
  • How commonly do people screw this up? Is this something that everyone is already doing (so thanks for telling us something we already know, Stocky), or is this something that most of us can probably benefit from?
  • How easy is it to do correctly? Is this low hanging fruit that we can achieve with just a couple hours of work, or is doing this right going to require a huge time commitment and possibly a PhD in multivariate statistics?

Put all those together, and I’ll try to pick which of the head-to-head strategies “wins” the game.  I hope you have as much fun reading these next few blog posts as I had writing them.  If you’re feeling particularly ambitious, go ahead and fill out your bracket and send it to me and we’ll see how well your picks line up with mine.

Inflation won’t be as bad as everyone thinks

wheelbarrow-of-cash

“Ocean waves will grind the greatest boulder into sand if given enough time”

Inflation, the general rise in prices over time, is a powerful and unrelenting force which is eroding the value of your money every year, every month, every day.  How powerful is inflation?  Look at this simple example with my neighbors, Mr and Mrs Grizzly.

If they want to spend $50,000 per year (in today’s dollars) in retirement they’ll need about $1.2 million on the day they retire (40 year retirement, 6% return, 3% inflation).  Every year in retirement they’ll spend a little more than $50,000 to buy what $50,000 buys today because of inflation.  However, if you crank the inflation knob up a notch from 3% to 4%, they’ll need $1.5 million.  Up to 5%, they’ll need $1.8 million.  What makes inflation so scary is that the impact is huge—a 2% increase requires your nest egg to be $600,000 larger—and it’s also completely out of your control.

In the US, inflation is tracked by the Bureau of Labor Statistics, a division of the Department of Labor, with a tool called the Consumer Price Index (CPI).  Basically (I know it’s much more complex, but for brevity’s sake) it looks at a general basket of goods that people buy and tracks how those prices change over time.  It’s meant to track EVERYTHING that consumers buy: food, housing, cars, airline tickets, medical expenses, entertainment, and on and on and on.  The US boasts an amazing record of tame inflation over the decades, but even then it’s been quite a roller coaster: in the early 1980s, according to the CPI, inflation was averaging about 12%, and it has averaged about 1.6% since 2009.

That just ruined Mr Grizzly’s day.  So he needs $1.2 million today to retire, but depending on inflation it could range from $1 million to $8 million if it got as high as it did in the early 1980s?!?!?!  No bueno.  How the heck is he supposed to plan for a range like that?

 

The unfortunate answer is: there really isn’t a good answer.  Inflation is going to do what it will do, and there isn’t a lot you can do about it as an investor.  The US government sets an inflation target at 2%, but reasonable people can debate how good Washington is at managing stuff like this.  When I do my planning for the Fox family, I personally use 3%.  But there is some good news—I actually think the CPI waaaaaaay over estimates inflation and that it is going to be on the lower side of historic averages, which is a good thing for those of us saving for retirement (as always, this is just my opinion and may turn out to be quite wrong, also with my projections I am not predicting the future).

The CPI is supposed to compare apples to apples, so basically what did you buy last year and how much would that cost if you bought the exact same stuff this year.  I think over the short-term the CPI works pretty well; I’d believe that prices in 2014 were about 2% higher than in 2013 (in line with the CPI’s figures).  But over longer periods of time, the CPI really fails because I think it does a really lousy job of dealing with major technological advances.  So when you look at 10 or 20 or 50 years, which happens to be the time horizon we’re looking at for retirement, I think the CPI really overestimates inflation.

If you go back to 1965 (I picked 50 years ago, because I figure I have 50 years to live, so that’s my time horizon), the CPI says prices have risen about 7.5 times.  So something that cost $100 in 1965 would cost about $750 today.  If you do the math, that equates to about 4.1% per year.  We saw the impact that the level of inflation has in the above examples (pretty major impact), yet let me tell you why I think the government is getting it wrong and there is some real relief.  This is going to be a long post (but I hope a valuable post), so get comfortable.

 

1965_Chevrolet_Impala

Cars

In 1965 you could get a new 4-door sedan like the Chevy Impala for about $3000.  Today you could get a new 4-door sedan like the Honda Civic for about $20,000.  If you do the math, that calculates to about 3.9% inflation per year, right around what the CPI says (I know, you’re saying: “Stocky, so far I’m not impressed.”)  But remember, the CPI is supposed to compare apples to apples; when you compare a 1965 Impala to a 2015 Civic, the Civic has a ton of advantages.

The Civic gets 35 miles to the gallon, while the Impala got about 12.  The Civic has incredible safety features like airbags, antilock brakes, backup camera, and on and on; the Impala has seat belts across your lap (they didn’t even have the shoulder ones).  The Civic has Bluetooth to connect to your MP3 player, while AM/FM was an option on the Impala.  A new Civic will probably last you 200,000 miles or more, but your Impala would be lucky to get to 100,000 (like “go-out-and-buy-a-lottery-ticket” lucky).

Put all that together and how much of that 3.9% annual price increase is due to inflation, and how much is due to the Civic just being a better car?  It’s not an easy question to answer, but I would think an awful lot of the price increase is because you’re getting a safer, more fuel-efficient, and more durable car . . . just a better car.

To look at it from a different angle, we know $3000 in 1965 would buy you a new Chevy Impala.  What would $3000 buy you in 2015?  A quick look at Autotrader.com shows that for $3000 you could get a 1998 Honda Civic with 150,000 miles.  Between those two choices, each of which is $3000, don’t you have to pick the Civic as the better car?  It’s safer, much more fuel efficient, has more convenient features (cruise control, automatic windows), and it will probably last longer.  All that says that inflation was actually a lot less than the 4.1% the CPI said or the 3.9% we calculated.

 

Rent

Housing is the biggest expense that people have, so how does that come into play?  In 1965 the average rent was about $90 per month while in 2011 it was around $870 which calculates to about 5.1%.  That’s higher than the CPI, but before we freak out about runaway inflation in the housing market, let’s do the apples-to-apples comparison.  In 1965 you were getting a place where you might have shared a bathroom with your neighbor and a phone too.  You had an icebox instead of a fridge (literally a cabinet that you kept cool with blocks of ice), and radiator heating.

Today you have granite countertops and stainless steel appliances, central air conditioning, and a fitness center downstairs if you’re lucky.  How much of that 5.1% increase is due to prices rising, and how much is due to you just getting a much, much nicer place with much better amenities?  Today, I’m sure if you tried hard enough you could get a total armpit of an apartment that was completely vintage 1965, and I bet you probably wouldn’t pay more than a few hundred bucks for it, showing that prices for apples-to-apples apartments haven’t risen near that 5.1% level.

 

Heart Stents

Healthcare

Ahhhh.  This is where you’re saying: “But what about healthcare?  Medical prices are spiraling out of control.  That’s where they get you.”  The Medical CPI shows that prices have increased an astounding 17 times since 1965—about 5.9% annually.  Mr Grizzly just had a minor aneurysm, which he knows is really going to cost him.  But before you despair, do the apples-to-apples comparison and realize that the quality of healthcare has gone up exponentially while costs it can be argued have come down.

Let’s say Grandpa Fox had a heart attack in 1965.  First, his chances of survival weren’t very good, but let’s assume he survives and gets coronary bypass surgery.  After two months of recovery he’s back at home living his normal life, but now with a sweet scar running all the way down his chest from the open-heart surgery.  That surgery back then would cost around $6000 (it’s hard to find exact numbers on this so I estimated; any reader who has better data please let me know) which is a drop in the bucket compared to the $100,000 price tag bypass surgery costs today.

Unfortunately, Grandpa Fox passed his lousy heart genes on to me.  However, instead of a heart attack hitting me out of the blue, my doctor discovers early on that I have high cholesterol and prescribes me Lipitor which costs about $300 per year, and that is even lower if you go generic.  My heart problems get taken care of for much less money, plus I didn’t have to go through a high-risk surgery and brutal recovery.

But maybe Lipitor doesn’t work, so after a while they find my coronary arteries are severely blocked and I get a stent (of course, I only use a Medtronic brand stent).  I have a non-invasive surgery where they insert the stent through a tiny incision in my hip, I go home that evening, and it all costs me about $20,000.  Like before I probably would have a much better outcome than Grandpa Fox, at about three times the cost which equates to about 2.4% inflation over the 50 years.

So while medical expenses have skyrocketed (and I totally agree they are out of control), if you look at the idea of taking someone with a heart problem and getting them back to health, prices have actually gone way down since 1965.  So much for aggressive inflation here; you could actually argue that there has been deflation.

 

Food

So let’s compare apples to apples, literally.  Apples in 1965 cost about 16¢ per pound while today they are about $1 per pound (at least in LA)—that equates to inflation of about 3.6% inflation.  But there is actually a difference between 1965 apples and 2015 apples.  Back then there was this weird concept of fresh fruits and vegetables being “in season.”  You could only buy apples certain times of the year which was around late summer and fall (I had no idea so I actually had to look this up, which kind of proves my point).  Today fresh fruits and vegetables are in season when your grocery store is open and you have money.  So again, you’re paying more but you’re also getting a better product as well—year round fresh fruits and vegetables.

 

And there are many product categories whose prices have fallen drastically (air travel, anything with electronics), and others that we used to be charged for but are now free (telecommunications, news articles).  The whole point of all this is that depending on how you look at it, inflation isn’t going to be nearly as high as the CPI says which is a huge help to savers.  That means your dollar will stretch further in retirement than you might otherwise think, and that you’ll need less to retire on.  Consider this my gift to you.

My optimism overfloweth

“The report of my death was an exaggeration.”  –Mark Twain

A couple weeks ago Robert Schiller published an article warning investors that the next couple decades are going to be tough ones for the stock market, and they should prepare themselves accordingly.  I read this and I have to say that I disagreed with him.  Professor Schiller won the Nobel prize in economics last year and is a world renowned professor at Yale; I was one of 100 students to graduate with honors from the University of Chicago’s MBA program in 2006.  It should be pretty obvious which of the two of us is just a little more credible.

The premise of Professor Schiller’s argument is that stocks are at all-time high valuations, and they have to come down.  Intellectually I agree with this, but I think he’s missing the mark in two major ways:

Robert_Shiller_-_World_Economic_Forum_Annual_Meeting_2012_(cropped)
Nobel laureate, Robert Schiller

 

Predicting major moves in the stock market is really, really hard

As we learned from A Random Walk Down Wall Street (I’m sure you all went out and read it after reading my incredible review, right?), it’s nearly impossible to predict when things will happen with the stock market.  In 2015 Professor Schiller is predicting we’re going to have a major correction/sustained period of flat stock prices.  Sure, he’s probably right that that will happen, but is it going to be in 2015, or in 2020 when stocks are 50% higher than they are today, or in 2030 when they are double what they are today?

I think this is where history is a good guide.  The 1980s were an awesome decade for the stock market* with returns averaging an astounding 14% per year.  As you can imagine, there were a ton of pundits saying the stock market rose too fast, valuations were too high, things just weren’t making sense–you had to get out of the stock market.  What happened?  The 1990s came along and outperformed the 1980; stocks returned 18% per year.  People didn’t realize that the computer revolution of the 80s was leading to the internet revolution of the 90s, and if you missed the 1990s investing boat because the 1980s had been so good, you were hating life.

Even look at the internet boom and the bubble that eventually burst in 2000.  In the 1990s year after year, the stock market was putting up tremendous gains.  I remember in about 1997 or 1998 the chorus of naysayers was deafening; they were predicting that valuations didn’t make sense, a bubble was building, and stocks were going to plummet.  It turned out they were right, but the plummet happened 4-5 years later.  In the meantime, the DJIA went from 6800 in 1997 to a peak of 11,200 in 2000.  Of course, the bubble burst, but the stock market only went down to 7600 (Sep 2002).  Sure the pundits were right .  . . sort of.  The bubble burst, but if you took their advice when they gave it, you would have missed out on a market that rose from 6800 to 7600 with a crazy ride in the middle.

The history of the stock market is littered with these examples; literally everyday you have some market expert saying the end is near, yet the market consistently proves them wrong.  Professor Schiller is much smarter than I am, and there probably will be a time they the stock market crashes or goes sideways for a long time.  But no one knows when that is (and I would think Professor Schiller would agree that he doesn’t know that either), and you might miss out on a great run in the meantime.

 

Innovation is always happening

Innovation is one of the main drivers of the stock market.  Companies innovate, figuring out new ways to do it better, faster, cheaper.  This leads to higher profits which lead to higher stock prices.  It was the electronics innovations of the 1950s that led to 160% increase in stocks in that decade, computing innovations of the 1980s; and internet innovations of the 1990s.  Sure you have off decades like the 1970s and 2000s, but those happen less often; even then innovation is still happening, but it’s just not translating to stock gains until later.  Is there any reason to believe that in the next 20 years we won’t have unimaginable innovations that will change our lives the way computers and the internet did?  I think those will happen and I think those will drive stocks higher.

google car

Eventually cars will drive themselves.  My neighbor just bought a Tesla and the thing can start itself, open the garage, pull out, and have the car all nice and toasty, so all Mr Grizzly has to do is get in and go.  There is no doubt in my mind that in a few years they’ll be driving themselves.  Can you imagine once that happens?  Auto accidents and drunk drivers will all but be eliminated.  Old people, blind people, pre-16 kids will have incredible mobility.  Traffic jams will fade away.  Commuters will have hundreds of hours of their life back each year.  And all this innovation will make some companies tremendous profits and their stocks will skyrocket.

Every year solar panels become more efficient and less expensive.  Soon they are going to be as common on roofs as DirecTV dishes.  Electricity bills will go down, carbon emissions will drop (also thanks to automated, electric cars from above).  The world will benefit and some companies are going to make a killing.  Amazing medical advances are happening every day; really smart people at Amazon.com are figuring out how drones are going to change the world; light bulbs are going to last 100 times longer and use 100 times less power; new methods are going to find more oil less expensively.

I’m going to be wrong on nearly all the details I listed above, but I truly believe that I am going to be right on the general message that the innovations we have in store for us are going to dazzle our minds.  And they’re going to make tons of money for the companies that do them, and tons of money for the investors who own those stocks.

 

So I respectfully think Professor Schiller is wrong.  Investing in stocks is a great investment now and will be a great investment for years to come.  In fact, I’m putting my money where my mouth is and have 95% of the Fox’s portfolio in stocks.  I would welcome Professor Schiller to respond—he’s always welcome to write a guest post 🙂 .  Of course if he does, I will become giddy as a school girl and ask that he pose with me for a picture and then autograph it.

 

*  I’ll be using the Dow Jones Industrial Average in these examples

How to invest a windfall

raining-money

We got this letter from a reader:

Stocky,

Sadly my father passed away, but he had a $200,000 life insurance policy.  My mom spent $60,000 as a down payment on a house and $40,000 for my sister’s medical school.  That leaves $100,000 left; I was thinking about going into business with a couple shady guys to start a liquor store, but my wife talked some sense into me.  So we decided to invest the money in an S&P500 index fund (VFINX). 

My question to you is, should we invest the $100,000 all at once or spread it out in smaller investments over a couple months?

Walter Y from Chicago, IL

 

I admit I may have made this letter up as a framing device, but Walter’s problem is a pretty common one.  Maybe it’s an insurance payout, a tax refund in April, a bonus check, or a bunch of cash you’ve accumulated in your checking account.  In fact, every July the Fox family faces this exact scenario when I get my bonus check.  Let me tell you my thoughts on the matter (which of course is not an expert opinion, and which looks at historical price movements but makes no prediction on future stock movements).

When I get my bonus, and what I would have suggested to Walter, is to take the big chunk of money and invest it in equal pieces over a couple months.  Vanguard and most places will let you set up an automatic investment, so in the words of Ron Popeil “you can set it and forget it.”  So let’s imagine for Walter he would invest $10,000 per week into his mutual fund for the next 10 weeks.   Why do I do it this way?  Because I’m a spaz.

If I invested all the money at once, I would be totally freaked out that I would buy at the wrong time—either I would buy the day after stocks went up 1% or I would buy the day before stocks dropped 1%.  Using Walter’s scenario of $100,000 to invest, that would mean I could “lose” $1000 by investing at the wrong time.  That would totally tie me up in knots and I would be looking at the stock market trying to find the exact right time to jump in, like a kid on the playground playing jump-rope.  Of course we know from A Random Walk Down Wall Street, that all that stuff is random so there’s no point trying to time it, but I’m not totally rational when dealing with that much money.

For the blog, I did a little analysis and found that 12% of the time stocks* lose at least 1% in a single day; if I bought the day before that happened, I’m out at least $1000.  On the other side, about 13% of the time stocks rise 1% or more in a day; if I bought the day after that I’d similarly be out $1000.

My fragile nerves just can’t take that so I want to “diversify” the timing of my purchases to even out those big ups and big downs.  This is a strategy called “dollar cost averaging”.  So as I said, initially I would have recommended to Walter that he take the cautious path, take his $100,000 and split it into $10,000 chunks, and invest those each week for the next 10 weeks.

 

windfall analysis 2

But then using the magic of spreadsheets and the internet, I decided to see what the actual data said.  I looked at every week for the market since 1950 and did a comparison of the two scenarios:

  1. Invest your entire chunk of money all at once
  2. Spread your investment evenly over 10 weeks (dollar cost averaging)

Wouldn’t you know that on average it’s better to invest your entire chunk at once?  I’ve been doing it wrong this whole time, so thank you Stocky Fox.  In fact it’s not even close—historically it has been better to do option #1 about 61% of the time.

The thinking is that historically, stocks have always gone up.  Sure there have been some rough patches, some of which can last a really long time, but the general trend is definitely upwards.  So if you wait to invest your money over a longer time period, you’re missing out on some of that upward trend.  I looked at every week since 1950 (if you were curious, there are about 3400 weeks) and on average you gain about 0.7% by going with option #1 instead of option #2.  0.7%!!!  Holy cow.  Remember that post on The power of a single percentage?  We just found a 1% coupon right there.

So Walter, my advice is to pick a day this week and invest it all in one fell swoop.  You might get hit with bad luck, but the odds are better that you’ll get hit with good luck to the tune of about 0.7% (which in your case is about $700).  On the day you do it, don’t even look at the stock market and have several tablets of Alka Seltzer on hand.

*For this analysis I am using the S&P 500 data going back to 1950.

The power of a single percentage

2014-02-18 (1 percent)

“How can something so small be so impressive?” –Belinda Heggen

1% doesn’t seem like a lot.  It’s the extra sales tax my city adds, hoping I don’t notice it.  It’s the maximum amount of gross stuff food companies can put in packaged food without having to tell us (I don’t know it that’s true or not).  But in investing 1%, while so easy to overlook, can make a huge difference.  Here we’re going to find out how we can get that 1% to help us.

Let’s go back to my neighbors, Mr and Mrs Grizzly.  Each year they will save $10,000, investing it in a stock index mutual fund with an expected annual return of 6%.  After 30 years, they expect to have $790,581 saved (good time for the disclaimer that I am not predicting future stock performance, just giving an example), a tidy little sum to help see them through their golden years.

However, Mrs Grizzly starts playing with her spreadsheet and changes the annual return from 6% to 7% just to see what happens.  She’s astounded to see that the $790,581 that she gets with a 6% return balloons to $944,608 if she assumes a 7% return; that increase in the annual return of 1% led to an increase in her nest egg of 19%.  Tempting fate she sees what happens with an 8% return: $1,132,832.  She’s a millionaire now.  Cranking the return up to 9% made her nest egg $1,363,075; just increasing her return 3% nearly doubles how much she and Mr Grizzly will have to retire on.  Ladies and gentlemen, welcome to the power of compound interest!!!

Percentage graphic

The point here is that a seemingly small 1% change in your investment return can make a huge difference over time.  By tailoring your investment strategies to collect as many “1% coupons” as possible, you can substantially increase, even double, the value of your nest egg.

So how do we get those higher returns?  Most people will default to higher stock returns: “It’s a no-brainer.  Instead of investing in the stocks and mutual funds that return 6%, let’s invest in the ones that return 7%.”  Unfortunately, after reading A Random Walk Down Wall Street we know this isn’t so easy.  For any given level of risk, our investment return is probably going to be what it will be.

Now that changing the actual investment return is out, what are our options?  Fortunately there are a lot of other things that affect our total return beyond just what our investments give us.  We’ll dive into each one of these with its own blog post, but a few to think about at a high level are:

  1. Mutual fund management fees: Each year mutual funds charge between 0.05% all the way up to 1.50% or more for management fees.  Going from high-cost mutual funds to low-cost funds can easily get us a 1% coupon.
  2. Financial planner fees: There are a lot of people out there who are more than willing to tell you how to invest your money for a small fee.  Except that fee doesn’t tend to be all that small: about 1-2% of your total assets.  Do-it-yourself investing can absolutely give you that 1% coupon, and the results you produce will probably be similar to those your investment adviser would.
  3. Being smart with taxes: You know Uncle Sam is going to take his cut.  However, you can delay when he takes his share with IRAs, 401k’s, etc.  This allows you to keep the money longer, and it allows to you be taxed on the money later in your life when you will probably be in a lower tax bracket.  Being smart with your taxes can easily get you a 1% coupon.
  4. Take the “free money” offered to you: Many of us work for companies that match 401k contributions.  Except they only give you the extra money if you invest in your 401k.  So at least putting in up the minimum amount of get the match can absolutely give you one or two 1% coupons.
  5. Proper asset allocation: We all know that some of your investments should be in higher return, riskier investments like stocks and some should be in lower return, less risky investments like bonds.  Properly assessing your portfolio to know how much you already have in less risky investments (especially things like pensions, Social Security, your home equity, etc.), can allow you to safely put more money in investments like stocks.  Over the long term, this could easily increase your return each year and get you a 1% coupon.
  6. Fully investing: So many people I talk to have $10,000 or $20,000 or $50,000 in their checking account that they’re “just waiting to figure out what to do with it.”  These are certainly Champagne problems, but they are also fertile ground to find 1% coupons.  Just taking that money and putting it in a bond fund instead of a checking or money market account could easily give that extra 1% or more; investing in a stock fund will provide even greater returns over the long run.

Those are just a few examples of how you can squeeze an extra 1% or more from your investment returns.  You’ll notice that none of those strategies include “outsmart Wall Street and pick the stocks that are going to do the best.”  I’m not that smart; I wish I was because then the Fox family would own its own island in the Caribbean next to Johnny Depp’s island.  These are all really simple strategies that anyone can do, and each of which takes less than a couple hours to set up, and can lead to hundreds of thousands of dollars over your investing lifetime.  The Fox family has benefited by these little strategies probably to the tune of 4-5% extra return each year over what seems typical among your average American investor, and that has equated to hundreds of thousands of dollars.

So here’s the bottom line:  As you read this blog, we’ll constantly be finding “extra 1% coupons” that you can redeem to increase your overall investment returns.  As Mrs Grizzly showed, even one of those can add $150k to your nest egg.  If you can gather two or three or even more, you can double your nest egg.

The tax man cometh

2015-02-13 image (grim reaper)

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends of their investments at about a 33% marginal tax rate (special thanks to my ChicagoBooth classmate, Rich, for correcting me on this).  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).