Category: how to

DIY oil changes and investing

Stocky 1 Comment

The Top 5 ways changing your own oil is like doing your own investments

Just the other day, I changed the oil in our 4Runner and our Honda.  It was the first time in my life I ever did that by myself instead of taking it to a dealership or one of those quick lube places.  First, I want to thank my new BFF Jesse Bearcat for helping me.

Second, as I was doing that and since, I have started to think how changing your own oil is a lot like doing your own investing.  In fact, a lot of the benefits of doing an oil change yourself are exactly the same as doing your investing yourself.

 

Here are my Top 5:

 

More conscientious:  No one cares more about you and your wellbeing than you.  Twice in my life I have had horror stories of the guy at the shop doing a crappy job and it leading to bad, bad results.  They were sloppy and forgot to connect a hose which led to my car breaking down and needing a tow.  Once I was driving on the road into the LINCOLN FREAKIN’ TUNNEL.

When I do the work on my own car, the car that hauls around my family, you can be sure that I check and double-check every screw and tube and everything.  Investing is the same.  Is someone else going to check the next day to make sure your fund transfer happened or that the change in your 401k allocation took?

 

Better materials/parts:  I buy name-brand oil and filters.  I don’t know if they are better than the discount stuff those quick-lube places use (normally I am a big fan of generics, but motor oil seems a little different).  It’s an open question.  At a quick lube place I never used synthetic oil because it was an extra $30 or so, and I’m too cheap for that.  When I do it myself, 5-quarts of oil costs about $3 more when you buy synthetic, so that’s a no-brainer.

Similarly with investing, when you do it yourself you can pick the best mutual funds at the lowest price.  I have spent a ton of time on why I think index funds with a low management fee are the best.  When you do it yourself, you can pick anything you want.  When someone else does it for you, your choices tend to be more limited.

 

Better use of your time:  This is a bit counter-intuitive, but it’s absolutely true.  When you change your own oil or do your own investing, you actually save a lot of time.  To change your own oil, you take 5 minutes to set everything up, 1 minute to unscrew the oil plug, and 1 minute to unscrew the oil filter.  Then you let the car drain for 10 minutes or so while you’re doing something else.  You can come back, screw the new oil filter on (30 seconds), screw the drain plug in (30 seconds), fill the oil and check the levels (5 minutes).

If you go to a place it might take you 10 minutes to drive there, 10 minutes waiting time, 20 minutes for them to do it while you’re stuck in the car.  Doing it yourself saves a lot of time.

Investing is the same way.  If you have your investment advisor do it all, you still need to meet him, drive to his office or schedule a call, etc.  You can do it on your own at night in your pajamas after the kids have gone to bed while the World Series is on in the back ground.  I know which one I would choose.

 

Look at other things:  As I have started doing my own oil changes, I am becoming more knowledgeable and look at other things about my car as well.  When I went to a place to get my oil changed, they always say I need extra stuff down, and I totally shut them down because I think they’re just trying to fleece me (good analogy to personal finance there).  However, there are other maintenance things you need to do to your car.

Changing the air filter is one of those.  The oil change place says I always need to do it, and I actually do it every once in a while.  Now that I change my own oil, I have the confidence to check that and it’s surprisingly easy.  I can do it in 2 minutes (plus get a good price on the filter from amazon.com which is maybe 80% less than what they charge me).

Investing is the same.  It’s easy for an “expert” to come at you and tell you all the things you need to do.  It’s natural to resist that a little, knowing a lot of it you don’t need to do, but some of it you probably should do.  As you get more knowledgeable, you’ll know what does make sense (probably an IRA) and what doesn’t (probably an annuity).  That can pay HUGE dividends (figuratively and literally).

 

Lower cost:  It costs $40-60 to change our oil at one of those quick lube places, plus a lot more if they did my air filter and other stuff.  It’s much higher at a dealership.  My all-in cost for an oil filter and 5-quarts of synthetic oil are probably about $20.

Those are decent numbers for a car, but you know how that translates to your personal finances.  If you do investing yourself, you can save a boatload in costs and fees that would line the pockets of investment advisors, mutual fund companies, and everyone in between.

 

You only need three investing ingredients

Stocky 2 Comments

“Less is more” –Robert Browning

o-TABASCO-SAUCE-HISTORY-facebook

The fine people at McIlhenny make Tabasco sauce, one of the most popular condiments in America.  Can you guess how many ingredients go into their sauce (you might have an idea from the title of this post)?  You guessed it, three: peppers, vinegar, and salt.  That’s it.  Nothing else.  Only those three.  In investing you can take a similar approach.  In a world where there are thousands of stocks to pick from, thousands of bonds, tens of thousands of mutual funds, how do you pick which ones to go with?

Let’s break this down one step at a time.  First we know from Asset Allocation that our portfolio needs some stocks and some bonds.  That’s at least two different investments—one for stocks and one for bonds.

Second, we know from Diversification that we should be . . . well, diversified.  There are a ton of mutual funds out there that can give us plenty of diversification with the stock market.  I personally like either the Total Stock Market Index from Vanguard (VTSMX) or the Spartan Total Market Index from Fidelity (FSTMX).  But wait, those are all (or very nearly all) US stocks.  To be really diversified don’t we need international stocks as well?  The answer is an unequivocal “YES”.  So let’s add a highly diversified international stock mutual fund like Vanguard’s Total International Stock Index (VGTSX) or Fidelity’s Spartan International Index Fund (FSIIX).

With a broad US stock mutual fund and an international mutual fund, you pretty much own a small sliver of every stock in the world.  Add to those two mutual funds a bond mutual fund like VTSMX or FBIDX, and you have your three ingredients, just like Tabasco sauce.

Can it really be that easy?  I say “yes” but let’s look at some of the objections you might have:

 

What about an international bond fund?

Fair point.  We have an international stock fund to give us diversification for our US stocks.  Shouldn’t we have an international bond fund for a similar purpose?  Maybe.

I don’t because bonds are such a small portion of my portfolio right now (less than 5%), mostly due to the stage of our lives that Foxy Lady and I are at.  So I don’t think it’s really worth the hassle.  When we get older and Asset Allocation dictates that a larger portion of our portfolio should be bonds, then having two bond funds might make a lot of sense from a diversification perspective.

 

Why not use a total world fund?

Vanguard does have a total world stock index fund (VTWSX) that combines both US and international equities.  You could imagine just having this one mutual fund for stocks instead of two (a US fund and an international fund).  That’s reasonable and knocks your ingredient list down to two.

Yet I choose not to do this because I am cheap.  The total world index fund as a management fee of 0.27%.  That’s low but the management fee is 0.17% for Vanguard’s US fund and 0.22% for their international fund.  Shame on you Vanguard!!!  Why are you charging more when you combine them.  It’s not a ton, but we know that even increasing your returns a small amount like 0.05% can still be thousands of dollars over the years.

 

Why not use a target date fund?

You could do a total one-stop shop using a target fund like Vanguard Target Retirement 2050 (VFIFX) or whichever year makes sense.  You get your US and international stocks and your US and international bonds all in a single mutual fund.  As I mentioned before, I’m not a huge fan of these because I think figuring out your asset allocation is a little more nuanced than just picking a year, but I’m a little OCD when it comes to this.  That might be the best choice for someone who is willing to trade a small amount of mutual fund performance for a lot of simplicity.

 

What about all the other investments out there?

Ahhhhh.  That’s the question we’ve been waiting for.  I am a firm advocate of efficient markets so I really don’t think I can successfully pick individual stocks or even stock sectors.  I’d rather just pick a really broad index mutual fund knowing that the winners and losers will balance each other out and over the long run I will do okay.

That said, beyond those basic three ingredients, the Foxes have invested in two other investments.  We have a commodity ETF (DJP) which has turned out to be the worst investment that we’ve ever made (which I chronicled here).  Also, we invested in a REIT index fund (VGSLX) when I thought that real estate would be a good investment.  From 2010 to 2014 this turned out to be the case and we did quite well with this, but since 2017 it has been mediocre to bad.  That just goes to show that trying to beat the market is a futile effort.

 

Does Stocky Fox eat his own cooking?

For the sake of full disclosure, I’ll tell you where our investments are.

Investment Ticker symbol % of portfolio
US stock fund VTSAX 51%
International stock fund VTIAX 36%
Bond fund VBMFX 1%
REIT fund VGSLX 7%
Commodities DJP 3%
Others 2%

 

I already mentioned the REIT and commodities investments.  The “Other” is composed mostly of Lady Fox’s 401k accounts, our money in Lending Club (which has been a total disaster which I’ll chronicle in a future post), and a couple other odds and ends.

 

So there you go.  With all the crazy things going on in the world, and all the things that need your attention, I think which investments to pick is an easy one.  With three fundamental building blocks—a US stock mutual fund, an international stock mutual fund, and a bond mutual fund—you can build a rock solid portfolio.

So which investments do you pick?

Invest in 401k before you payoff student debt

Stocky Leave a comment

“The longest journey begins with a single step” –Laozi (580 BCE)

Investing is a long-term game.  As that really smart Chinese philosopher said, that long-term game needs to start with your first move.  For most people, investing will start when they get their first “adult” job after college (you already know how I feel about college).

Some people start with a clean financial slate when they leave college, but many have student debt from all the loans they took for that degree.  That sets up an interesting question as they get their first paychecks: what to do with the money?  You can even make the question more precise and ask: should I use my savings to payoff my student loans or start investing?  Let’s dive right in

My niece Starty Fox just graduated with her engineering degree from State U.  She has $20,000 in student loans that has an interest rate of 4.45% (I think that’s the current rate for government backed student loans).  Because she listened to her wise uncle, she got an engineering degree which presents many job opportunities.  She took a good job paying $54,000 per year (luckily her salary is divisible by 12 so this post is a little easier to write).  Plus, they offer a 401k which matches her contributions up to 6% of her salary.

After she accounts for rent (her parents made it clear she could visit, but not live with them), her car payment, food, and other living expenses  she is able to save 10% of her income each month.  She makes $4,500 per month and has $450 left over at the end of each month (let’s ignore taxes for a second, but just a second).

So what should she do, payoff that nagging student debt as fast as she can or start investing in her company’s 401k?

 

A match lights the world on fire

Let’s say Starty has a neurosis about her debt.  She was raised never to have any debt (although maybe that’s not always the best idea—here and here), so she wants to pay it off as quickly as she can.

If she applied all $450 each month to her student loans, she would pay off that whole $20,000 in a little over 5 years.  There would be a couple things she wouldn’t like.  First, that $450 would be taxed (just like the rest of her income).  Let’s say her marginal tax rate is 20%, so that means the $450 she has set aside is really only $360 after she pays Uncle Sam.  Taxes are unavoidable, so while that’s a bummer for Starty, she accepts it as a fact of life (although maybe she shouldn’t—more on that in a second).

When it is all said and done, she will have paid everything off by the time she turns 27, which isn’t bad.  Through it all she would have paid about $2,300 in interest.  That interest is tax deductible, so it would only feel like about $1,840.  After everything is paid off, she can start investing in her 401k with a clear conscious.

Let’s take the other extreme, and assume that Starty watched Wall Street a lot with her adoring uncle when she was little.  She’s not too concerned about debt, especially when there are other good investment opportunities out there.  She pays her minimum payment on her loan ($150 per month before taxes, $120 after taxes) and then invests the rest in her 401k.

Obviously, the downside of this is it takes her a lot longer to pay off her loan; instead of being done by age 27, she’ll have the debt until she’s 40.  That sucks.  But she more than makes up for that with her 401k.  Every year she contributes $3,600 to her 401k.  When she does this she has three really big spoonfuls of awesomeness working for her:

  1. Tax free—her 401k contributions are pre-tax so just off the top she is saving $30 per month that would go to taxes if she used that money to pay off her loan. That’s enough to buy a new Lululemon outfit and splurge on extra spin classes each year (Foxy Lady just took over my computer for a second).  Sure, eventually she’ll have to pay that in taxes, but there are a lot of things she can do to minimize that when the time comes.
  2. Match—the big one is that Starty gets to take advantage of her company’s match. They match dollar-for-dollar up to 6% of her salary.  Since she’s contributing more than that, she takes complete advantage of the match, and that comes to $270 each month.
  3. Investment returns—obviously this is why we do invest money. On average Starty is going to earn a 6-8% return on her 401k.

If you put that all into the pot and mix it, you’d have a 27-year-old Starty who is debt-free but with nothing in her 401k, or you could have a 27-year-old with $41,000 in her 401k and still with $16,000 in student loans.  Obviously, the 401k option is much better. She has a net worth of $25,000 on her 27th birthday (versus $0 if she paid off her student loans first).

 

The cause of it all

Those numbers tell a pretty powerful story that from a mathematical point of view, paying off your student loan at the lowest level is best so long as you put that money into your 401k (and not spend it on stupid crap).  However, there are some fairly big assumptions there.

Match—obviously the match is a big part of it all.  Without the match the numbers don’t look nearly as good, but the 401k option still comes out ahead.  On her 27th birthday, she would have a net worth of $5,500, without the match.  Many people may complain that this example isn’t realistic because Starty’s 401k match is so generous, but without the match she still comes out to the good.  And we know a 401k without a match is basically like a traditional IRA which is available to everyone.

Liquidity—when Starty chooses to go all in on her 401k she’s losing a lot of financial flexibility.  At 27 she’ll still have $15,000 of debt that she’ll have to pay off plus she’ll have a lot of her money tied up in her 401k which is very hard to access.  If something happened at ages 22-27 she’d be in pretty much the same boat either way, but after age 27 she’d have a little more flexibility if she had killed the college debt.  This becomes a question very similar to the one we raised with the post on the emergency fund.  Personally, I would be willing to roll the dice for that extra $5-25k over five years, but risk aversion is different for all of us.

That’s all good, but fundamentally this boils down to Starty being able to borrow money at 4.45% (3.6% after taxes) and being able to invest it at a higher rate, 7% for argument’s sake.  Over a 20 year time horizon (about how long it takes her to pay off her student loan), stocks have historically done much better than that 4% hurdle.  For all these reasons, it does make a lot of sense—in Starty’s case thousands of dollars each year—to slowly pay off her college debt and put that money into her 401k.

Emergency fund

Stocky 2 Comments

As you might imagine, I talk to a lot of people about what they’re doing with their investments.  One of the things I hear a lot is, “I’d like to start investing, but before I do that, I need to build up my emergency fund.”  That sounds pretty prudent.  You don’t want to get caught in the lurch when life throws a curve ball at you.  Yet, I actually think this is a really bad move.  I freely admit that the Fox family does not have an emergency fund.  We have investments, and if the unforeseen happens that’s what we’ll use.

 

How likely is an emergency?

What are the types of things that you’d use an emergency fund for?  Almost by definition, an emergency is something that is unpredictable and somewhat rare.  If your 12-year-old Honda Civic is starting to die and you know in the next couple years you need to get a new one, that isn’t really an emergency as much as something you need to budget for (that was the exact circumstance of the Fox family a few years back).  If you’re having an “emergency” every year, either you’re the unluckiest of people, or probably  more likely you just have a lifestyle that needs to be budgeted a little differently.

When I think of things that you’d spend an emergency fund on it’s stuff like: your hot water heater gives out, you’re 7-year car gets totaled and insurance only gives you $6000 to get a new one, your son goes into the NICU for four days because of croup and your portion of the bill is $4000 (as happened with Lil’ Fox last year), or you are fired from your job.

As I was writing this post, I asked Foxy Lady if she could remember any emergencies that we have faced since we were married 7 years ago.  The hospital thing with Lil’ Fox was the only one we came up with.  There were smaller things like when we had to replace the dishwasher ($500) or fix the clothes dryer ($400), or fly back to Michigan for a funeral ($400), but the hospital thing was the only major one (I’m defining “major” as more than $1000).  So that means we have averaged one emergency every several years.  Once every several years—I don’t know if we’re more or less prone to emergencies than the general population, but that seems about right.

So be a little more cautious and use once every five years as an average—you have about a 20% chance in any given year of needing to tap into your emergency fund.  We’ll use that in a second.

 

How likely is it you’ll make money in the stock market?

Obviously we put a huge caveat on this, but we can look at historical performance to get a sense for how likely it is that you’ll make money or lose money if you invest your emergency fund in stocks.  Actually, we kind of did this in a post a while back.

Remember that historically, if you have a one-year investment time horizon, you make money with stocks about 70% of the time.  That is actually pretty good odds that investing your emergency fund in stocks would have you come out ahead, just looking at it for one year.  In fact, we can do the math, and the chances of you having an emergency in a given year and losing money in the market are about 6% (20% chance you’ll have an emergency x 30% chance you’ll lose money in the market that year).

But remember, emergencies don’t happen every year—they tend to be much less frequent than that.  For the Fox family, they happen on average once every five years.  Just for the fun of it I put a table together that estimated the chances of having an emergency if you assume in any given years there’s a 20% chance of having one.  Also, I looked at the historic data to see the probability that you would have lost money in the market over different time horizons.

Time horizon Chance of an emergency Chance of losing money in stock market* Chance of emergency and losing money
1 year 20% 28% 6%
2 years 36% 24% 9%
3 years 49% 18% 9%
5 years 67% 13% 9%
10 years 89% 3% 3%

 

As we mentioned above, there’s a 6% chance that in any given year you would need to tap your emergency fund when the market was down.  Looking at other time frames you get similar results.  Pretty much any time frame has a less than 10% chance of you needing that emergency money at a time that you would have lost money in the market*.  You need to decide if you’re willing to take that risk, but to me that seems like a no-brainer.  If I have a 90%+ chance of coming out ahead on something, I’m doing it.

You can see where I’m going with this.  First, emergencies don’t happen all that often (if they do, you probably need to come up with another name for them other than “emergency”).  Second, if you give yourself a few years in the stock market, the probability of losing money goes down a lot (of course, it never goes to zero).  That seems like a perfect combination for investing your emergency fund the same way you invest any of your other money.  $10,000 invested in stocks with an average return of 6% would give you about $13,300 after five years; keeping that same amount if your savings account at today’s interest rates would give you about $10,050.  Seriously, that’s ridiculous.

I get that many people look at that and say, “the whole point of an emergency fund is you never know when you’ll need it, so don’t put the money somewhere where you might lose it.”  That’s a very understandable concern, but it’s also where a lot of people are leaving a ton of money on the table.  Over the past 150 years, investing in stocks has a really good track record, and the more time you give it, the better that track record becomes.  You’ll never eliminate all the risk from investing, whether it’s your 401k or US bonds or the cash in your checking account, there will always be some type of risk.

It’s the successful investors who understand that risk and understand how to decrease the risk (expanding that time horizon to five years cuts in half the likelihood of losing money), that are able to get the most bang for their buck.  This is definitely one of those areas where you can get a 1% coupon.

 

The Fox family eats on our cooking on this one.  We don’t have an emergency fund.  When emergencies do happen like with Lil’ Fox, we pay for it out of our investments, absolutely believing that over our lifetimes there may be one or two instances where we lose money but there will be many, many more where we come out ahead.

 

Let me know what you think.  Do you have an emergency fund?  Do you think I’m crazy not to have one?

*I used the same methodology for this table that I did for my post “Will you lose money with stocks?”

Your house–the leveraged buyout

Stocky Leave a comment

Last week I did a post looking at if your house was a good investment or not.  A classmate named Karthee from ChicagoBooth made a really smart comment:

“Isnt the house purchase a Leveraged Buy out? You didn’t actually put in all the $785K, but took all the profits (1.15M – 785K) – so shouldn’t the return math be based on your down payment rather than the cost of the house (unless you paid for the house in full – which most people don’t)”

Before we dive into the issues, a quick thought: Karthee and I got our MBA together 10+ years ago.  He was a tremendously smart guy and has been very successful since we were at U of Chicago.  When I did my post looking at the value of college, I left out the value of personal relationships that you can develop with your classmates and the network you can build.  I did that deliberately because so many college grads are struggling to pay student debt and make ends meet.  A strong personal network that doesn’t translate into professional opportunities seems like a bit of a luxury.

That said, the people I met at ChicagoBooth are absolutely the smartest and most talented people I ever spent so much time with.  I don’t know if that alone was worth the cost of attendance, but as I get older and my professional career takes on a new look and feel, being connected to so many really amazing and scary smart people becomes the more dominant value I enjoy from my MBA experience.  You know, other than meeting my wife and the mother of my children there.

 

On to Karthee’s comment

I think he’s mostly right, but a little bit wrong.  Let’s talk about how he’s wrong first and then we’ll get to how he’s right.

His comment has less to do with the performance of the asset (did the house increase in price?) and more to do with how the purchase was financed.  Definitely in that he was right that we bought the house with a mortgage, paying a 25% down payment.  The house cost $785,000 and we had to “invest” $196,250 as the down payment.  Then every month we made a mortgage payment of $2,811, of which about $1,000 went to paying off our mortgage (the rest was interest).

He’s absolutely right that if you look at our investment as $196,250 and our gain as $365,000 that changes the numbers substantially.  But should you?  Maybe.  More on this when we talk about how he’s right.

If you just look at the assets’ performance—the house compared to the stock market—the house didn’t do as well.  In our particular case, our house increased about 46% over the five years we owned it; the stock market increased about 76% over the same time period (about 90% if you include dividends which you should).  The broader data shows that houses on average return about 0.4% annually while stocks have historically returned 8-10%.

 

How Karthee’s right

Should we consider how you finance an asset purchase when you make an investment choice?  Certainly, money is money.  Again, if we were doing apples to apples, you could put 25% down to get a house and compare that to if you bought stock on margin and leveraged it 3:1 (put $1 of your own and borrowed $3 to invest).  In that scenario you would have the same results that the stock market does better.

However, that’s a bit of a theoretical construct and Karthee’s point is much closer to reality.  Not many ordinary investors buy stock on margin; I certainly don’t.  About half to two-thirds of people borrow money when they buy a personal residence (I was shocked that it wasn’t higher).  So in that way, the default for home tends to be “leveraged” while that’s not the case for stocks.

Furthermore, interest rates when you borrow for a mortgage are much, much more favorable than if you bought stocks on margin.  Our mortgage is 2.2%; if I bought stocks on margin the rate would be about 6-9%.  Also, our mortgage is tax deductible which brings it down to an effective rate of about 1.5%.  I’m no tax expert so I don’t know if interest on margin purchases are tax deductible.  If not, that further supports Karthee’s point.

Certainly in a practical example of making the choice between buying a house and renting and then investing the money, reality is closer to Karthee’s point.  That said, most of the return comes from the decision on how you financed your house, not that you bought a house that increased in value.

We can put a little table together that figures this out.  The last row includes an adjusted CAGR which accounts for all the costs—realty fees, home improvements, plus the “value” we got from the house acting as a shelter.  We’ll also include the returns if we invested the money in the stock market and invested on margin (maxing out at 1:1 margin ratio at an 8% interest rate).

 

House paid with cash

House paid with mortgage

  

Buy stocks

Buy stocks on margin
Cost to house (2010)

$785,000

$785,000

$785,000

$500,000
Money “invested”

$785,000

$250,000

$785,000

$250,000
Sale price of house (2015)

$1,150,000

$1,150,000

$1,511,450

$595,375
Profit

$365,000

$365,000

$726,450

$345,375
Gross return

46%

146%

93%

138%
CAGR

8%

20%

14%

19%
Adjusted CAGR

9%

21%

 

This leads to some pretty insightful results.  To Karthee’s very correct point, when you look at your house as a leveraged-buyout, the profits are greatly magnified.  In our case, instead a 9% return assuming no mortgage, when you factor in our mortgage we would have a 21% return.  That’s enormous, and that’s really Karthee’s whole point.

You can compare that, as I did before to investing in the stock market.  The stock market had about a 14% return, so a house with a mortgage would have done much better.  However, if you leverage your investment in a similar way to how you did with your house, they end up about equal—the house is at 21% and stocks bought on margin have a return of about 19%.

19% and 21% are close, but the house is slightly ahead.  That speaks to some inherent advantages you get when borrowing money with a house.  For the stocks on margin, I assumed the most you could do is borrow at a 1:1 ratio (you could only borrow as much money as you were investing).  Keep in mind for a mortgage, we got a 3:1 ratio; we borrowed $3 for every $1 of cash we brought to the table.  Also, I assumed that when you borrow on margin you pay an 8% rate; that is much higher than the 2.2% rate we have on our mortgage.  Those two factors—ability to leverage at a 3:1 ratio and to borrow at such a low rate—give the house a great advantage.

So with all of this KARTHEE IS RIGHT.  If you consider a house as a leveraged investment, our housing experience did outperform the stock market.

 

What if we weren’t so lucky?

Our house appreciated at a particularly high rate, but most houses only increase at about 0.4% when you strip out all the home improvement and other stuff we talked about last week.  But to Karthee’s point, your house is a leveraged investment and we know that should increase the returns you experience as a home owner.

If we assume a very vanilla situation, if you put 20% down on your mortgage and the house appreciated 0.4% annually, the math would tell you that you would realize a 2% return per year due to the leverage you have on your house.  Obviously 2% is significantly lower than you could get in the stock market, on average.

Plus, that 2% number is a bit of a best case.  Over time, you’ll be paying off your mortgage so your investment will creep up over 20%, decreasing the impact of the leverage.  Also, as we mentioned last time, when you sell your house you’re likely going to have realty fees which basically act as a massive transaction fee which can really zap your profits.

 

We’re at 1500 words.  Karthee had a really great point that we should look at our house as a “leveraged” investment and that definitely enhances the positive returns if you house does increase in value (we didn’t touch the nightmare scenario of an underwater mortgage ☹).  In our case, the leverage put us ahead of what we could have done in the stock market, so that did make our house a good investment, I suppose.

However, the data shows that even with leverage houses tend to underperform the stock market pretty drastically.  As I said last time, that doesn’t mean you shouldn’t own a home.  We do.  There are a lot of great reasons beyond the investment angle to do so.  Let’s just be weary of thinking they are these great investments.

Teaching personal finance in schools

Stocky 2 Comments

If any teacher wants to convert their math problems to have a financial element, please email ([email protected]) and I will be happy to do it.  If you know any teachers, please share this with them.

Prepare for a rant.  However, I will include a solution at the end, so maybe that makes it a little easier to stomach.

As a loyal Stocky Fox reader you know succeeding with personal finance can be extremely beneficial (no kidding).  Also, personal finance is a skill learned just like any other skill.  It’s not really hard to learn the basics—asset allocation, tax optimization, long-term view—but you definitely need to know them.

 

Financial literacy is low among adults

There are a lot of challenges we face as a society.  We all have our own lists.  At or near the top of my list is financial literacy, or the lack thereof.  Not knowing this has a crippling impact on someone’s ability to achieve their life’s goals.

FINRA, which is the governing body for financial advisors (when I took my Series 65 it was administered by FINRA) has a handy little quiz you can use to test your financial literacy.  I have listed the questions at the end of this post if you want to take it.

There are five questions (plus a bonus question that is quite a bit harder) that have to do with finance, but really they are math questions dressed in financial clothing.  They fundamentally test addition, multiplication, and division.  We were all taught the mathematical skills needed to answer these by 5th grade.

Do you know what the average adult scores on this test?  3 of 5.  60% correct.  Knowing the answers to these questions will mean the difference of hundreds of thousands of dollars.  Knowing these answers will help keep people out of the nightmare death spiral of credit card debt that will limit their opportunities for their entire lives.  Knowing these answers can allow people on a moderate income to build generational wealth.

Yet people don’t know these.  What’s even worse is the problem is getting worse.  In 2009 people got at least 4 of the questions right 42% of the time; in 2015 that number dropped to 37%.  YIKES!!!

Reasonable people can debate, but I can’t think of a life skill that can have a more direct and enormous benefit on someone’s life, but which is lacking across such a wide swath of the population.

 

Status Quo

School got very real for us this year since ‘Lil Fox just started elementary school.  We love the school and his teacher (Mrs Sheppard-Jones) is awesome.

I have volunteered at his school the past three years, and several years before that at the local elementary school when we lived in Los Angeles.  I work on advanced math concepts with 3rd and 4th graders.  I am no expert, and certainly I am not as close to it as the dedicated teachers who do it all day every day, but I have been struck by how little personal finance (let’s say that’s anything with a “$”) comes into the math curriculums.

That’s not to say that it’s not there at all.  There are some math problems that involve money and finance, but I wonder if it’s enough.  Why doesn’t every single math problem incorporate finance.  Every.  Single.  Problem.

I’m not talking about hard core personal finance concepts; students are welcome to come to this blog for that ?.  If you have an addition problem like 3 + 5, why not make it $3 + $5?

Suzie has five apples, and she gives 3 to Steve.  How many apples does she have left? Could easily become Suzie has $5, and she buys a toy for $3.  How much money does she have left?

Byron has already filled 6 buckets with water.  If he can fill 2 buckets per minute, how long until he has 20 buckets filled?  That could just as well be: Byron has $6 saved.  If his weekly allowance is $2, how long until he can buy a $20 video game?

Obviously, each of those questions are identical, testing the exact same mathematical concepts.  The difference is for the second of each pair, there is a financial layer that also gets the student thinking about money, saving, investing, etc.  Those financial layers are going to pay major dividends, literally and figuratively, if the student retains them.

The questions on Suzie and Byron are real questions that I have seen given to students.  As important as counting apples is or filling buckets of water is, managing your finances is much more important.

Pretty much every math problem can be written as a math/financial problem, with the possible exceptions of some geometry and trigonometry concepts.  Even then, I think if you are creative enough you could pull it off.

 

The mother of all concepts

This is obviously up for debate, but I think that compound interest is probably the most important concept in personal finance.  If you are a borrower, it’s impact can be devastating.  If you are an investor, it’s impact can be liberating.  Thanks to this little jewel, I was able to quit my job in my mid-30s and live off our savings.

As powerful as it is, it’s a purely mathematical concept.  We’re first taught it as exponents like 34=?  It starts to look a little more like finance with something like 1.085=?  This isn’t a hard concept to learn.  Most scientific calculators have a specific button for this, so all you have to do is enter the numbers.   

My major complaint here is exponents tend to be taught in a very sterile environment, at least in my experience.  Sure, you can do all the mechanics of 53, 76, 28, 34.6, and on.  As a high schooler I remember doing pages of them.  I became a robot punching buttons on a calculator, producing answers that I wrote on my paper.

What if instead you had questions which involved $1 of debt at different interest rates for different lengths of time like 1.15, 1.0820, 1.210, 1.25, 1.0920?  You still pushed the exact same buttons, but now there is some upside.  Worst case is the student learns exactly what he would have anyway.

Best case is that a student notices that 1.0820 is surprisingly larger than 1.0720.  If she makes the link that a 7% interest rate over twenty years produces a much lower amount than an 8% interest rate over the same time frame, she’s learned a powerful concept.

Right now it would just be a seed, but eventually that seed will grow.  That exponent problem shows the difference between a 7% return and an 8% return over 20 years.  That’s the difference between using an index fund with a low management fee and an actively managed fund with a high fee.  That’s the difference of several hundred thousand dollars over her investing lifetime.  If that seed never grows, she’s no worse off than she was.  If it does, then when it’s time to pick her investments for her 401k, she will realize how big an impact one little percentage can have when compounded over time . . . well, you know how I feel about that.

This is real—we live in a world where millions of homeowners could refinance their mortgage at lower interest rates to save billions, but they don’t.  I guarantee you the biggest reason is that most people don’t realize how much money they could save by lowering their mortgage rate a measly 0.4%.  Why aren’t we teaching that very thing when we teach exponents?

 

I am ready to do my part

There’s nothing I like more than when people find a problem but not a solution.  It’s awesome to hear people bitch on Facebook about some difficult issue, and then implore other people to do more.

So we have this big problem and I am going to ask everyone other than me to do something about it.

JUST KIDDING.  For all the teachers, educators, parents, or anyone else out there who works with kids in math, I am here to help.  I’m being totally serious.  Email ([email protected]) me any questions you have in a regular format, and I will change them so they are finance-related math problems.

Financial literacy is a huge problem, but it also has a really easy and costless solution.  Incorporating math won’t take away from any other learning; it won’t consume time that right now is spent learning other skills.  The kids are already doing the math, let’s just put a financial watermark on all those math problems.

 

FINRA quiz

  1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, do you have more than $102, less than $102, or exactly $102?
  2. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?
  3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
  4. True or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.
  5. True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
  6. (BONUS) Suppose you owe $1,000 on a loan and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

Is your house a good investment?

Stocky 5 Comments

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For most Americans, their home is the largest purchase they will ever make in their lives, and it is their largest asset.  A lot of people call a person’s home their largest “investment”.  That begs the question: Is your home a good investment?

 

Definition of an investment

We need to remember what an investment is, particularly for this.  An investment is where you pay for something and then either get payments, like a dividend, or you are able to sell it at some point in the future for a profit.

For houses, you don’t really get a periodic payment.  That may be the case for rental properties which I’ve discussed here.  But for this post, let’s assume you use your home for your personal residence.  That means for the idea of an investment to work, you need to sell your home for more than you bought it.

Now that we have that out of the way, let’s figure this out.

Our story

A lot of times in personal finance, it’s better to be lucky that good.  Foxy Lady and I were very fortunate when we bought and sold our Los Angeles house.  It turned out to be an awesome investment (or so we have always thought, but let’s wait until the end of this post for a final verdict).

Shortly after we were married in 2010 we moved to LA.  That was pre-cubs but we knew we wanted to start a family, so we bought a cozy 3-bedroom house for the low, low price of $785,000.  What?!?!?  Los Angeles real estate is insane.

In 2015 I retired and we moved from LA to North Carolina.  As insane as housing prices were in 2010, they got even more insane in 2015.  We were able to sell our house for $1,150,000.

Wow!!!  That’s a heck of a profit.  Definitely that shows that in our case, our house was an awesome investment.  Not so fast.  Let’s look at the numbers and really figure out how good of an investment it was.

Our $785,000 investment grew $365,000, so that’s a 46% increase.  That seems like a really high return, but wait . . .

That was over 5 years, so on a compounded annual basis that’s about 8%.  Still, that’s a really good return, but wait . . .

We did a fair number of home improvements to our house.  When we bought the house there was a bit of water damage on one of the outside doors, so we replaced those plus a few of the windows.  Plus we decided to paint the outside because it has a hideous white color.  Also, we did a lot of landscaping work and had to fix the sprinklers.  Let’s say all that came to $20,000.

Later in 2014, Foxy Lady completely redid the kitchen and bathrooms.  It was one of her crowning achievements, and a bit of her died when we moved just a few months later.  That all cost about $40,000.  If you factor that in, then the return falls to 7%.  Most people will take 7% any day, but wait . . .

We were really lucky in that we sold our house as part of Foxy’s relocation package for her new company.  Normally, realtor fees are about 6% of the house’s selling price.  That would come to about $77,000.  Fortunately, we didn’t have to pay that, but under most circumstances we would have.  Had we factored that in the return falls to 5%, but wait . . .

Then there were other costs like property taxes (about $10,000 annually) and regular repairs like when we had to replace our dishwasher (let’s call that $3,000 each year).  If you factor that in, the return bottoms out at about 4%.  That is a far cry from the 46% we originally had in our head.

Maybe we’re being too pessimistic.  There’s some upside, right?  Sure there is.  It did act as shelter for us.  Let’s say it would have cost us $4,000 per month to rent a place like that.  In a way that acts like a bit of a dividend; owning that house gave us $4,000 of value each month.  That is a huge factor which has a major impact, raising our return from 4% to over 9%.

Plus, on the upside, selling your home has some nice tax advantages depending on the circumstances.  If you owned the house and used it as a personal residence for at least a couple years (to avoid flippers), then any profits on your house up to $500,000 ($250,000 if your single) are not taxed.  If you had profits for stocks those would be taxed like a capital gain whose rates are around 15-20%.  That is actually a pretty ENORMOUS advantage.  In our case, we had a profit of about $300,000 after you accounted for the home improvements we did; a 20% tax rate would have come to $60,000.  As it was, we didn’t pay any of that.

Looking to the data

We had our story, but I have this nagging feeling that we got fairly lucky with the house.  Imagine an investor whose only experience with stocks was buying in 2012.  They would have had a annual return of about 11%.  Hopefully they would have the perspective that that isn’t normal for most investors over most periods of time, and they just happened to have really lucky timing.

For housing it’s a bit tougher to figure that out.  In the stock market we have all sorts of data that bloggers (whose kids just went back to school, so they have more time on their hands) can parse a million ways.  Not the case with housing.

First, there’s just not that much data out there.  Second, the calculation becomes complex for all the reasons we discussed in our situation.  You have to control for things like home improvements, repairs, etc.

That said, my BFF Robert Schiller in all his smartness has the authoritative data on the subject.  Going back to 1950, the same year the S&P 500 started, housing prices have increased 0.4% annually.  That seems crazy low.  We know that houses are more expensive now than they were back then.  Did the Nobel Prize winner get it wrong?

No, he got it right.  That 0.4% is the increase if you hold everything else constant.  Since 1950 houses have gotten a lot bigger, made with better materials, with more features, and all that stuff.  Using some hard-core statistics, you can strip all that stuff out and find out how much the house on it’s own increased in value.  That number is 0.4% annually.

Just in case you were wondering, the S&P 500 has increased 11% annually since 1950.  BOOM!!!

During that same period of time that we owned the house, stocks were up over 12%.  Granted, that was during a decent market run, but that kind of makes it apples to apples comparing that to a really strong run for California real estate.  Just from a numbers perspective, it would have been better for us to rent and put all that money into the stock market than what we actually did.

Putting it all in perspective

9% seems like a huge return for our house (4% if you just count the house), given that I typically use 6-7% as my expected return for stocks.  That should be a vote in the “yes” column for the question: “Is your house a good investment?”

However, based on the data it seems like we had really, REALLY good timing.  If normally houses appreciate 0.4% when you strip out all the other stuff, then our experience where we got a 4% return seems like a major outlier.  Conversely, stocks had a return of 12% when they historically have a return of 11% or so.  We could debate which was MORE lucky, but I definitely think the appreciation of the house was a greater outlier.

What does it all mean?  Houses tend to appreciate about 0.4%, but if you include the value it provides as shelter while you hold it as an investment, maybe that bumps it up to 5% or so.  It also has favorable tax treatment so those are all really attractive.

However, stocks on average return about 8% per year.  So even with the tax benefit, ON AVERAGE (which is a crazy term in and of itself), houses aren’t that good of an investment compared to the stock market.  Even in our case, where we had an awesome run with our house, the stock market did better.

Does that mean that we should never buy a house, only renting and then using that money in the stock market?  No, I don’t think so.  There are really good reasons to buy a home beyond the investment angle.

In my opinion, the most important element is self-determination.  I weighed the pros and cons of home ownership here, and the one thing that transcends money is when you buy a home you control your future.  In that post I mentioned how our neighbors who were renting didn’t have their lease renewed and had to move.  Also, people who rent don’t tend to upgrade their house to make it as nice as they want.  Those are important considerations that, at least for us, tip the balance towards homeownership.  But what doesn’t make a very compelling argument is the fallacy that homes make great investments.

Investing let me get my new car for free

Stocky 5 Comments

A few years back our old Honda Civic went to heaven.  It had a terminal case of transmissionitis.

We bought a new Honda Fit which cost about $17,000.  However, when it was all said and done we got it for free.  This isn’t some scam or a crazy thing where we had to drive around with the sides painted as a billboard or anything like that.  This is how it worked:

In September of 2011 we bought our new car.  Our Civic had been struggling for a while so we had been saving money knowing that sooner or later we would need a new car.  Because of that we had the $17,000 in cash ready to purchase the car outright.

However, Honda offered a fairly generous financing program at 0.9% interest.  That’s a super low rate so it was very tempting.  There’s always the nagging idea that you shouldn’t borrow money if you don’t have to, but as low as it was we figured we had to consider it.

It was bit more complex, but for the sake of simplicity, let’s assume we had these two choices:

  1. Pay for the car in cash.
  2. Finance the car at 0.9% for 6 years and then invest the cash.

As you can guess from the tone of this post, we went with option 2.  Our plan was to finance the car, and then invest that $17,000 in a stock mutual fund (VTSMX).  Every month when a payment was due we could sell a few shares of the mutual fund.  At the end of 6 years we would either end up ahead, making this a really smart move, or behind making this a really dumb move.

 

Looking at the numbers

A 6-year loan for $17,000 at 0.9% interest requires a monthly payment of $243.  Back in September of 2011 the S&P 500 was at 1,131 (today it’s at 2,471).

Over the course of those 6 years, the market mostly went up, but it certainly had some rough moments.  2012 and 2013 were really good years for the stock market so I felt like I was a bit of a genius for doing this.  Then in 2015 stocks fell plus there were a few of those really crazy months like January 2016, when the market was in total freefall, and I felt like I was an idiot.  Stocks recovered in 2016 and then really took off after Trump’s election.

Needless to say, there were a lot of ups and down.  The smart thing would have been to just ignore the daily/weekly/monthly variations in the stock market and not get stressed, but that’s not in my character.  I did look at it every day, and I did get totally stressed out.

Foxy Lady and I stayed the course, and this month we sent our last check in to Honda.  Now we own that $17,000 car outright, the same way we would have had we paid cash for it 6 years ago.  However, the account we were using for all this still has about $16,400 of mutual funds in it.

That’s awesome.  We bought a $17,000 car, but we ended up with a car and $16,400!!!  In a way the car was very nearly free.  We started this process with $17,000 and no car.  We ended this process with $16,400 and a car.

 

Were we lucky or good?

Our story had a happy ending, which begs the question how likely does it turn out this way.  The six years from Sep-11 to Aug-17 were a good run for stocks but by no means the best.  Going back to 1950 when the S&P 500 started, you can see how things stack up.

There are a couple important points.  First, success isn’t guaranteed here.  You would lose money (have to pay more than your original $17,000) about 18% of the time.  We know that over the long-term stock almost always do well.  This is a bit trickier because when you start this, you invest all your money at one time, so you don’t benefit from dollar cost averaging.  Had you invested right before a huge market downturn (think late 1960s to early 1970s or Mar 2001 or Aug 2008) that would really be awful timing.  Still, you come out on top 82% of the time, so those are pretty good odds.

Second, our timing was pretty good, but certainly not the best.  We would have done better 13% of the time.  The absolute best timing would have been if we did this scenario starting in September 1994 and ending August 2000.  Basically, that timed the investment just before the internet boom of the 1990s kicked off, averaging about a 24% each year.  If you’re curious, with that timing you would have ended up with a car plus about $25,000.

We can’t be lucky all the time but you don’t really need to be either.  You can look at a more average performance, let’s say starting in September 2002 and ending in August 2008.  You would have ended up with a car and $8,000, so basically you got a new car at a 50% discount.

 

Take free stuff

The other really important piece to this is the really low interest rate we were charged.  0.9% is not a normal interest rate.  As we discussed here about debt, sometimes it’s a good thing to take on debt.  Honda gives their car buyers an artificially low interest rate as an inducement to try to increase sales.  It could just as easily be cash back or lowering the cost of the car.  As it is they decided to give a really low interest rate.

Some car buyers would need to finance their purchase no matter what, so that 0.9% was just a bluebird.  Others, like us, had the choice: do we pay in cash or finance.  Had we paid in cash, we would have basically been leaving this sweet perk from Honda on the table.

We can pretty easily see the impact of using a more normal interest rate on our experience.  At 0.9% we ended up with the car and $16,400.  However, if we use 5%, then we still come out ahead, but not as much.  Instead of $16,400 we ended with $13,000.  Actually, I was a bit surprised that the impact wasn’t greater, but that’s why you have spreadsheets, right?

When all is said and done, hopefully this illustrates the point that being smart with investing, and really understanding what is likely to happen based on history, can really be lucrative.  Obviously this will apply to things like your 401k and IRA, but it also applies in more unexpected places like buying a car.

Plumber Fox or Electrician Fox

Stocky 1 Comment

For the past two posts, you’ve heard me rail about college, fundamentally questioning whether the astronomical tuition costs are worth it (here and here).  The real test is what I do with ‘Lil and Mini Fox.  Here are my thoughts:

 

Saving in a 529

Currently we are saving $1,000 per month in a 529.  That will build to about $400,000 which will allow both cubs to attend a public college (like UNC-Chapel Hill) with a fair amount left over, both to attend a private college (like Duke) but we’ll need to come up with more money, or one to go to a public college and the other a private college and we’ll pretty much spend it all.

If you are planning on your child getting any education beyond high school, 529s are a no-brainer.  They act like a Roth IRA in that they invest after tax money, but then all the investment returns are tax free.  That can really add up to some significant tax savings.

 

The best or . . . something really good

Foxy Lady and I have been blessed to have good jobs that have allowed us to build a comfortable nestegg.  One of the things we want to do with that is afford our cubs the opportunities to help them succeed.

If either ‘Lil Fox or Mini Fox turns out to be super smart and super hard working and super ambitious and is able to leverage those to get into one of the very best colleges in the country, we want to make the financial considerations a non-issue.

However, “best colleges” is a tricky term.  If either got into Harvard or Stanford, they would go and Foxy Lady and I would come up with the money, no questions asked.  You can include U of Chicago (where Foxy and I got our MBAs), MIT, Duke, Penn, Princeton, and CalTech as similarly expensive schools that we would swallow hard but also pay to gladly send our cubs to.

Beyond that, it’s hard to think of private colleges that would justify the 3x money that a public school would cost.  That’s not to say there aren’t great private colleges that didn’t make my list of eight, but are they worth the extra cost?  I don’t think so.

 

Local public college, but only if . . .

We’re lucky that in North Carolina we have some really great public universities.  UNC-Chapel Hill is regularly rated as one of the very best.  As a North Carolina tax payer we get access to that fine institution at a substantial discount.  Also, NC State is very strong, especially in STEM.  ‘Lil and Mini could get world class educations there.

Yet, Dad’s going to put some strings on that.  If that’s the path they take they have to major in STEM, business, pre-law, pre-med, or some other area that can reliably offer jobs that justify the educational expense.  I was a finance major and that has paid off.  Foxy Lady was a marketing major and that paid off.

UNC is a great school and I have no reason to believe their drama and literature and sports science and art history and music and Asian studies and creative writing departments are great, being taught by dedicated professionals.  But none of those majors offer good-paying jobs to the average graduate.  The main point of my last post was looking at the significant expenses of college and making sure the job you get with that degree offsets those costs.  For all those majors and many, many more, it’s not even close.  I’m not about to spend a hundred grand so my cub can get a journalism degree then become a host at Applebees.

 

Trade college for a trade

This is the one I really get excited about.  If our cubs aren’t Harvard material and aren’t interested in STEM, pursuing the trades is something Foxy and I are really going to push.  Follow my logic:

Being a plumber or electrician has some great things going for it.  First they make really good money.  A plumber makes on average about $51,000.  Remember that an average college graduate makes about $60,000, so they’re pretty close.  Add in to that our discussion last post about “smart non-college kids” and if our cubs are smart enough and hard enough workers to average $60,000 as college graduates if they got that degree, they’ll definitely be able to make more than $51,000—probably fairly close to $60,000.  That makes the salary a wash.

Also, the cubs can hit the ground running right out of high school.  It takes about a couple years to get your license and a few years after that to become a master plumber.  But you’re still being paid during that time, not paying tuition during that time.  Big difference.  Plus, by the time they would have finished college and entered the workforce making about $33,000 they could be a master plumber earning substantially more than that.

When you choose your education, you want to get something that will be in demand.  It’s hard to say what the future will hold, but people will definitely continue to poop.  Joking aside (although I do believe they will), there are a lot of reasons to believe that plumbers and electricians will continue to be in demand.  First, those vocations currently skew older because that’s when the trades were taught more widely.  There are a lot of 50- and 60-year old plumbers and electricians.  It’s not a sexy job that kids today want to pursue, so those who actually do will make a killing.

Second, the world is changing in ways that will probably need that skillset.  Plumbing and electrical wires are constantly breaking down so that will always provide steady business.  Plus, changes are coming that play right into their hands.  Two years ago we installed solar panels on our roof, and you know who did a lot of that work?  California just went through a major drought which caused everyone to roll back their water usage; you know who installed those water-efficient showerheads and toilets?

 

An ace in the hole

You can tell I have an interest here.  So it’s probably not surprising that whenever a plumber or electrician comes to our house (and charges about $200 for 20 minutes of work—not bad) I ask a lot of questions.

One thing that often comes up is what success looks like for them.  Like everyone in any job, there are always those things that remain just out of their reach, but “man, if I could get that I’d have it made.”  For a lot of tradespeople, it’s being able to go out on their own.

There was one electrician I talked to a lot when we installed our solar panels.  He was about 35 and had been working for this company for about 8 years.  He said he made about $50,000 a year and he was happy with that but he knew he could do better.  He’d love to start his own business.  When I asked him what was stopping him, he rubbed his fingers together.  MONEY.

He just didn’t have the money saved up to go out on his own.  I asked more details and he said it came down to having a truck and all the necessary tools (there are a lot).  Once he had that, he could do his own thing, be his own boss, and keep everything he made instead of a portion going to his boss.

How much were we talking to get him set up like that?  Between $80,000 and $100,000.  That’s a lot of money, no question.  For this guy, as well as most Americans whether or not they have a college degree, that’s an unattainable sum.  That causes him to continue to work for someone else and not realize his full potential.

Do you know who does have $100,000?  A kid like ‘Lil or Mini, whose parents have saved more than that for their college education.  If ‘Lil Fox foregoes $100,000 (or $280,000 at a private college) of college costs, that money will be there and could be used for setting him up as an independent plumber.  That puts him at a huge advantage, and isn’t that what Foxy Lady and I want to do with the education money we have saved for our cubs?

You could easily imagine our conversation with him: “We have saved $200,000 for your college, and we know you would be successful there if you wanted to be.  Instead, become a plumber.  In two years you’ll be licensed and three years after that you’ll be a master plumber.  When that happens, as a ‘graduation gift’ we will get you the best work truck with the best tools, plus we’ll cover your business’s expenses for the first six months.”

 

Who knows how all this will pan out.  These are my ideas right now.  We have 13 years until ‘Lil Fox needs to make this decision, and a lot can change in that time.  Also, there’s the little thing of what he want to do.  But as of now, unless he gets accepted to Harvard or wants to become an engineer, I am really liking the plumber idea.

However, this post particularly the two before it really shed light on this enormously important decision and how all of us as loving parents can think about it a bit differently than we have been brainwashed to.

Making college pay off

Stocky 2 Comments

 

On Monday we asked the insane question: “Is college a waste of money?”  We came up with an insane answer: “A person would do much better financially saving that tuition money and not going to college.”

Such a bold conclusion deserves some intense scrutiny.  Let’s look at this more closely and see what the key drivers are.

 

Base case

Recall from the last post that Smarty goes to private school ($280,000 total).  Fasty works at a job making $36,000 per year straight out of high school and Smarty spends four years in college then makes $60,000 per year once she’s out of school.

Results—FASTY comes out ahead by $2.7 million (11% better than her sister).  This is where we were yesterday.  Now let’s start looking at our assumptions.

 

Scholarships

Of course, this is a big one.  Scholarships effectively bring down the cost of college, potentially to zero if you get a full-ride scholarship.  The larger scholarship Smarty gets, the more the race tilts in her favor.

 

Public college

Public college is a much more affordable option, at $100,000 instead of $280,000.  Except at the very top (Harvard, Stanford, Chicago) there’s no reason to believe that Smarty couldn’t get as good an education at a public school like University of North Carolina-Chapel Hill compared to an average private school like Wake Forest.

Results—This has a huge impact.  SMARTY comes out ahead by $680,000 (4%) if she goes to a public school.  It’s not an overwhelming advantage, but the decision between public and private school makes a huge difference.

 

Wage growth

We assumed that Fasty would make $36,000 her whole career and Smarty would make $60,000 her whole career.  Those are the average incomes for people, but in real life people’s wages start lower and grow higher.  There’s a lot of debate and controversy here about wage growth and if it goes to everyone or just those at the very top (here is a link that a grad school friend posted).

If you look at more detailed data, it shows that those with college degrees have wage growth 33% higher than those without degrees.  To account for this, let’s assume Fasty starts out at $22,000 and Smarty starts out at $33,000.  Then let’s assume that Fasty’s wages grow 2.0% each year while Smarty’s grow at 2.7%.

Results—This actually has a pretty low impact.  FASTY comes out ahead.  If you assume public college Fasty is $233k (2%) ahead which is pretty much a tie.  If you assume private college then Fasty is ahead $4.8 million (39%).

 

College major

Let’s cut to the chase.  This is where the real action happens.  What you study at college has the biggest impact on what you earn.  Starting salaries for STEM (science, technology, engineering, math) majors are 30-50% higher than those for liberal arts and teaching majors.

Also, the income growth is much higher.  STEM majors can expect their wages to grow about 50% faster than teaching and liberal arts majors.  In fact, teaching majors have wages that grow SLOWER than those people without a college degree.  So if Smarty went into teaching, she would make more than Fasty at first, but Fasty’s income would pass Smarty’s eventually.

Results—This actually has a profound impact, even when you assume public college.  With a STEM degree, SMARTY will come out $3.0 million (19%) ahead.  You can play with the numbers, but it’s really hard to find a realistic set of assumptions where Smarty doesn’t win with a STEM degree, with the possible exception of private college.  This is true for medical and business degrees as well, just not to the same degree (degree-degree, did you see what I just did there ??).

As good as things look for a STEM degree they look that dismal for a liberal arts, career-focused (journalism, public policy, recreation, industrial arts, agriculture, etc.), social sciences, or teaching degree.  FASTY will easily come out ahead to the tune of $3.2 million (33%) if Smarty gets a liberal arts or teaching degree.  This assume public college; if we assumed private college, that would be drastically worse for Smarty.

 

Master’s degree

By attending college Smarty will give herself an option that Fasty just won’t have: the ability to get a master’s degree.  This is the route I took, going to college and then after working a few years getting my MBA. In a way, this is really more of the same, and links very closely to the “College major” discussion.

Getting a graduate degree doubles down on your college decision.  If you pick a major which puts you ahead, typically getting a master’s degree in that same area will puts you further ahead.  Conversely, if you pick a major that puts you behind, getting a master’s degree will put you even further behind.

Results—If Smarty gets a STEM degree she’ll come out ahead.  If she gets her master’s, instead of being about $3.0 million ahead she’d be about $3.6 million ahead.  That’s a bit of upside but not too much.  Conversely, if she gets a liberal arts degree and then a master’s on top of that she’d go from being $3.2 million behind to $6.0 million behind.  Yikes!!!

 

Taxes

Taxes always suck, but they are going to hurt Smarty a lot more then they’ll hurt Fasty.  Smarty got her degree and got a higher paying job, and that means she’ll be paying a much higher tax rate than Fasty.  Fasty makes less money and that helps in two ways.  First, she pays a lower tax rate.  Second, because her income is low she doesn’t pay taxes on her investment income.

As Smarty makes more money which is really her whole strategy by going to college, that will help her win the race against her twin, but that will also mean she’ll pay higher taxes and that has a moderating effect.

Results—The very best outcome for Smarty was a STEM degree from a public college, and then her master’s.  That resulted in her coming out ahead by about $3.6 million.  If you add taxes to that, she only comes out ahead about $1 million.  That’s still a lot, but taxes are making something that was a total sure thing a bit more suspect.

Of course, if you consider taxes on all the less favorable scenarios for Smarty (private college, liberal arts degree, etc.) it takes a bad situation and makes it even worse.

 

Smart non-college kids

We’ve been making an assumption that I think is actually flawed, and has the potential to tip the scales in Fasty’s favor pretty drastically.  Remember, we assumed that Fasty and Smarty are identical in every way—equally smart and equally hard working.

In our society, smart and hard-working high school graduates typically go to college.  That’s just what they do because they’ve been told a million times that is what they should do.  It’s a bit of a circular argument.

When we look at the data for high-school graduates with no college, those are people who never went on to college.  Maybe they were late bloomers, maybe not ambitious, maybe just plain not smart.  Based on my argument above, very few (although some for sure) had the option to go to college and passed it by.

I say all this because what would happen if Fasty is smart enough and hard working enough to go to college but chooses not to?  There’s every reason to believe that she would do much better in her career and make much more money that the “average” high school degree person we’ve been talking about.

Imagine she gets an entry-level job at a factory.  She is punctual, hard-working, figures out better ways to do things; all those things would have helped her in college but now she is applying that to her non-college job.  That will set her apart from many of the other high-school graduates who didn’t have those qualities and abilities, probably one of the main reasons why they didn’t go to college.  Eventually her talents will be recognized and she’ll get more opportunities at higher wages.  Maybe it won’t be as fast as if she earned her degree, but it doesn’t have to be.  Remember, she also has $280,000 in her bank account.

Results—If Fasty’s salary is higher or can grow faster than the average for a high-school grad, then the calculations drastically shift towards Fasty.  Remember that Fasty won the race most of the time.  It was when Smarty got a STEM degree that things changed, and that’s because Smarty had a higher salary and faster income growth.  However, if Fasty’s hard work got her even a little bit higher salary and faster salary growth, she would close the gap.

 

Other considerations

College dropouts—This is the real killer.  How many kids start college but don’t finish.  They end up with the job prospects of Fasty but without the head start.

Fifth-year seniors—Increasingly college kids aren’t finishing their degree in four years.  That is a double whammy because it delays them making money for another year and they have to pay an extra year of tuition.

Living at home—There are a lot of ways to get the benefits of college without the full-blown college experience.  Living at home (and eating Mom’s cooking) is one that drastically cuts down the cost of attendance.

 

We’ve come along way.  After Monday’s post I was pretty pessimistic on college.  I don’t know if this post made that better or worse.

Definitely we learned that private college makes it near impossible to come out ahead financially.  More importantly, what you study makes or breaks the decision; STEM and healthcare and business will probably put you ahead while liberal arts and teaching and social sciences will doom you.  There’s other stuff too, but I think those are the two most important.

Come back on Monday when I tell you what Foxy Lady and I are planning on doing with ‘Lil Fox and Mini Fox.