Category: how to

It’s time for the mailbag again.  Thank you to everyone who reads the blog, and a special thank you to those who have emailed me questions.  I enjoy seeing the questions my readers have and doing my best to answer them.  If you have any questions about investing, please send them to me in a comment or email and I’ll be happy to include them in a future mailbag.

So without further adieu, here are actual questions from actual readers:

 

How do you allocate your investable funds across taxable and tax-deferred accounts?

–Aaron from Ft Wayne, IN

First, remember that tax-deferred accounts tie up your money for quite a while—until  you’re in your 50s at least.  So you have a longer time horizon, and the investments that best match a longer time horizon are stocks.

Also, tax-deferred accounts are most valuable earlier in your investing career (because you defer the taxes for longer).  If you’re a younger investor then you should definitely have most, if not all, of your money in stocks just because of asset allocation.  So those two conspire to tell you that stocks are probably the best bet for tax deferred accounts.

If you do decide to have bonds as a part of your portfolio then those probably make more sense to be in your taxable account just because that’s the money you want to be able to access if you need it in a hurry.  Unfortunately, the tax treatment won’t be great because bonds tend to have higher yields than stocks so you will be taxed on those.

A final thought—if your entire portfolio is mostly stocks (as is the case with the Fox family), you can get a little creative with which stocks you put in taxable accounts and which in tax-deferred accounts.  The logic is you would want to put the higher-yield stocks in a tax deferred account because you want to delay when you pay those taxes.  For the Fox family, most of our money is in a US stock mutual fund (VTSAX) which has a dividend yield of about 1.8%, and an International stock mutual fund (VTIAX) which has a yield of 2.7%.  All other things being equal, we should have our international mutual fund in the tax-deferred accounts because of the higher dividend.  The tax savings aren’t going to change the world, but I would bet that over the course of an investing career, it would add up to maybe $10,000.

 

How to invest short term in a zero interest rate environment? (i.e. we’re buying a house within a year or two but not for certain yet – how to invest the down payment until then?)

— Noah from Chicago

There’s never a free lunch, so if you’re looking for a higher return you need to be willing to take on more risk.  If your time horizon is a year or two, I think you would be pretty safe with a short-term bond fund (like VSGBX).  In the past few years the return has been about 1.5% which isn’t very good.  But the chances of you losing your initial investment are pretty low.  So you have some upside with pretty limited downside.

If you’re a little braver, maybe you go to a bond fund with longer maturities (VBMFX).  The return the past few years has been in the 4% range so that’s quite a bit better, but of course there’s a greater chance that you might lose some of your investment.

Having said that, there’s a double challenge with investing in bonds right now.  First, current yields are super low (as you mentioned) so you aren’t making a lot on them.  Second, eventually interests will rise and when they do, that will lower the prices of your bonds.  So it’s tough to say.  However, those two factors have been in place for at least 5 years, and long-term bonds have yielded 4% over that time, so who knows.

I would definitely not recommend stocks.  Everyone says that the market is overvalued (but who knows really).  However, stocks in general can take a 10% dive in the blink of an eye, and if you need that money in the next couple years to buy a house, I just don’t think it’s worth the risk.

Good luck and happy home hunting.

 

What about bitcoins? Any room for them in the portfolio?

–John

Bitcoins have definitely captured the imagination of the financial markets.  Let’s break this question down into two parts:

Investing in foreign currencies as a strategy—Since bitcoins are really just a different currency, let’s look at this broadly.  When Foxy Lady and I started investing in commodities, we also thought about investing in foreign currencies as well (I’m glad we didn’t because then we would have another investing disaster on our hands).

Similar to commodities, investing in foreign currencies isn’t generating value the way investing in a company does.  With currency trading, you’re just betting that the euro or franc or yuan will do better than the dollar.  Notice I used the word “bet” instead of “invest”.  When you trade commodities, it’s a zero-sum game so if you make money that means someone else on the other side of that trade loses money.  That’s just a game that I don’t feel qualified to play.

Also, if you are broadly diversified, you have exposure to foreign currencies with all the stocks you own since many of those companies are doing business in those different countries.  So if they do appreciate against the dollar, then you have those benefits.  That’s how I “invest” in foreign currencies.

All that said, if you have some special circumstance where you do business in a foreign country (or own a property there, or have some other connection) it might make sense to invest in foreign currencies as a hedge, but that’s really a different animal.

Bitcoins in particular—I think bitcoins are a super-cool innovation, and I like reading about the crazy moves they make.  I also think that something like bitcoin will have a real place in our world in the coming years.

A lot of people don’t realize that money and currency has evolved tremendously over time.  Obviously it started with precious metal coins, and those gave way to paper money backed by precious metals.  In the United States, it wasn’t until the 1860s that there was a uniform national currency; before that individual banks could circulate their own notes.  Then in the 1930s the US went off the gold standard so paper money became a fiat currency.  In the 1950s credit cards opened up a world of virtual money which has grown to the point where today I would guess 99% of your transactions are cashless.  My point is: Money is constantly evolving.

So I do believe that in the future something like bitcoin might really gain traction.  However, I doubt it will specifically be bitcoin.  Just like social media (Facebook wasn’t the first) or MP3 players (iPods weren’t the first), I think there will be a few false starts before something really takes hold.

I like to think I’m pretty savvy with this stuff, and I don’t completely understand how bitcoins work or how I would open an account.  And it seems every six months or so there is a news story about how the bitcoin infrastructure is breaking down (here and here and here).  I would recommend you just grind out strong returns using tried and true methods of investing in stocks.  You won’t have the chance to 10x your money the way you could with bitcoin, but you won’t risk ending up with nothing either.  If you’re a gambler at heart then put a little money in bitcoin, but just be honest with yourself—you aren’t investing, you’re gambling.

 

How do you feel about the use of 529s?

–Aaron from  Ft Wayne, IN

OMG!  A second Aaron from Ft Wayne?  No, it’s the same guy, just with a second question.

Absolutely, if you have kids and plan on paying for some or all of their education, 529s are a no-brainer.  A 529 takes after-tax dollars and then any gains you have are tax free.  In that way, they act similar to a Roth IRA, and you know how I feel about IRAs.  Over the course of your child’s childhood, that tax benefit could easily reach into the tens of thousands of dollars, so that’s pretty serious money.

Of course, the negative is that if your child doesn’t use the money (doesn’t go to college, gets scholarships, etc.) then you’ll be hit with penalties.  That said, the rules are pretty flexible so if your kid doesn’t use the money almost any other family member (cousins, grandchildren, brothers, sisters, even you or your wife) can use the money for educational purposes.

I totally believe in 529s.  Actually, I started the ones for Lil’ Fox and Mini Fox when there were still swimming around in Foxy Lady’s belly.

 

Thanks for the questions and please, keep them coming.

“Don’t look for the needle in the haystack. Just buy the haystack!” –John Bogel, founder of Vanguard Mutual Funds

In honor of my beautiful wife, Foxy Lady, I am using a picture of Nature Made Vitamin C.  Nature Made makes far and away the best vitamins in the world.  They are the only vitamins I use and the only ones I trust for Lil’ Fox and Mini Fox.  Did I mention that Foxy Lady works for Nature Made?

But what gives?  What does vitamin C have to do with investing or diversification?  There’s no question vitamin C is good for you, really good for you.  If you don’t have enough you’ll get scurvy or some other awful disease.  But you only need a little bit, about 90 milligrams or so—as much as is in an orange.  Anything more than that and you just have vitamin C-fortified pee (keeping it classy).

In a lot of ways diversifying your investments is like taking vitamin C: It’s a really important thing to do.  It’s not very hard to do.  Once you get to a certain point, diversifying more (or taking more vitamin C) doesn’t really help.

 

Broad is best

In the Elite Eight tournament we talked about diversification.  There are two ways you can look at diversification: It can be a risk-reducing strategy where you limit the volatility of your portfolio by not being too heavily invested in a single stock, industry, country etc.  We’ll call that the “too many eggs in one basket” approach.  The other way is thinking that you don’t know which stocks will do well so pick a bunch of them to increase the chances of having a winner (hence the quote at the beginning of this post).  We’ll call that the “casting a wide net” approach.  But they’re really two sides of the same coin.

As I said, diversification isn’t that hard.  Mathematically, you could be completely diversified with 20 or so well-picked stocks.  Of course, you would have to pick those stocks really well, so that seems like a lot of work.  But the good people at Vanguard and Fidelity and all the mutual fund companies have made diversification super-duper easy by offer broad mutual funds that consist of hundreds of stocks.  Problem solved.

But not really.  Take a look at almost every mutual fund.  An S&P 500 index invests in large US companies, but what about smaller companies or international companies?  This year is a really good example—the S&P 500 is up about 3% while international stocks are up about 13% or so.  You also have sector specific mutual funds like Vanguard’s Energy fund (VGENX) which invests in energy-related companies, but what about consumer goods or healthcare or insurance or the hundred other industries?  You have geographically-specific funds like Vanguard’s Pacific Stock Market fund (VPADX) but what about Europe, the Americas and the Emerging markets?  You get my point.

If you pick any mutual fund other than a total US mutual fund (like VTSMX) and a total international mutual fund (like VGTSX), both of which I own incidentally, you’re almost by definition leaving something out.  Maybe that’s your intention—that you think larger companies will do better, or emerging markets will do better, or high dividend stocks will do better, and on and on.  As you know from my total buy in of A Random Walk Down Wall Street, I don’t think I have that skill.  So I just want to own a little slice of everything.

By owning the broadest mutual funds out there (investing in the largest number of stocks) I kind of achieve those two goals of diversification: I own so many small slices of different companies that if one goes bad I hardly feel it, but at the same time I have my finger in everything so if any particular sector does well I participate in that a little bit.

 

All your eggs in one mutual fund

However, some raised a concern from my three ingredients post that if 38% of my portfolio is in only one mutual fund, should that be a concern?  Shouldn’t I diversify to other broad US mutual funds?  This is where I think the vitamin C analogy comes in.  Once you’re in a mutual fund, investing in another mutual fund (with the same objectives) really doesn’t “diversify you more”.  You’re at the point where you’re already diversified, so diversifying more is like taking more vitamin C after you’ve already hit your daily allowance—a waste of effort that really doesn’t benefit you.

That said, given that 99% of the Fox family’s money is in Vanguard, I suppose maybe there is a risk that if something happened to Vanguard, then we’d be in trouble.  Should I split my investments up and put some money in Fidelity as well?  I don’t think so.  First, I think Vanguard is a very reputable company so I don’t think any shenanigans are going on (like what happened with Bernie Madoff).  Second, and more important, the system is set up so even if Vanguard went bankrupt, my investments are still safe.  Remember that I’m not investing in Vanguard, I’m investing in companies like Coca-Cola and Proctor & Gamble and Ford.  Vanguard just facilitates those transactions.

I’m not an expert so maybe one of my readers who works in the industry can opine, but if Vanguard went to hell, all my money and the millions of other investors in Vanguard (including President Obama) is protected in a manner that Vanguard can’t touch it.  With all the things to worry about in this world, Vanguard or Fidelity or the other reputable firms out there going fleecing my money is not one of them.

 

So through it all, you want to make sure you’re diversified.  Of course, you already knew that.  If you invest in mutual funds, that’s probably one of the main reasons you do so.  But make sure you know how diversified you are.  Investing in bunch of large US companies (S&P 500) is definitely diversified in one sense, but not diversified in the “casting a wide net” sense.  That said, once you cast that wide net, don’t feel that you need to cast a second net.

 

How do you look at diversification?  Please leave a comment and let me know how you approach it.

“Less is more” –Robert Browning

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 so far in 2015 it has been our worst performer.  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	38%
International stock fund	VTIAX	22%
Bond fund	VBMFX	1%
REIT fund	VGSLX	12%
Commodities	DJP	8%
Medtronic stock	MDT	9%
Other		12%

 

I already mentioned the REIT and commodities investments.  The Medtronic stock is because I work at Medtronic and there is a really generous program which allows employees to purchase Medtronic stock at a discount, so I take advantage of that.  Also, we get a portion of our bonus in Medtronic stock.  All that said, there was a time when Medtronic stock was about 15% of our portfolio so I have been selling shares and reinvesting the proceeds in the US and International stock mutual funds.

The “Other” is composed mostly of Lady Fox’s and my 401k accounts.  Since you only have limited choices with those, we couldn’t pick precisely the VTSAX or VTIAX, but we chose the ones that are closest to that.

 

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?

“Little pink houses for you and me”  —  John Cougar Mellencamp

 

The decision to rent your home or buy your home is one of the biggies.  For those who buy, their house is often times their single largest investment.  For those who rent, that is usually the largest single monthly expenditure.  Obviously this is an extremely important financial decision in most peoples’ lives.

Yet as important it is financially, this decision tends to get steeped in emotional issues.  Homebuying is a bit of a rite of passage—when you buy a home you’re buying into the American dream, you have arrived, you’re investing in your community, etc.  There is some merit in those ideas, but they’re mostly just dripping with emotional sentiment.  After all, why can’t you invest in your community if you are renting?

For this post, I want to look at the choice from a purely financial perspective.  And what better way to do that than break it down Dr Jack style?  Just to put a little meat on the analytical bone, let’s assume we have a home that we could buy for $400,000 or we could rent for $2000 (I did a quick search on Zillow in a few different markets and this seemed reasonable).

 

UP-FRONT COSTS:  When you rent, you have to give a deposit which is typically something like one month of rent, so that’s $2000.  Not a big deal in the grand scheme of things.  When you buy, your down payment is in the range of 20% (or maybe even higher since the 2008 financial crisis—the Fox family had to put 25% down on our house).  That would mean $80,000 if you’re buying.

At first glance that may not seem like a big deal because it’s still your money, it just happens to be “invested” (did you notice how I used quotes there?) in your home.  However, when your $80,000 is tied up in your house you can’t invest it (no quotes there) in the stock market.  Since the stock market historically returns about 6% that means you’re passing up $4800 per year on average.  Over an investing career that ends up being a TON of money.

Advantage: Bid advantage to RENTING

 

MONTHLY PAYMENT:  The most common knock I hear on renting is “every month you pay rent, you’re throwing that money away.”  I hate that comment, and part of this post is to show how little sense that makes.  Obviously when you are renting, your monthly payment is your rent, $2000 in this example.

When you buy, your monthly payment is your mortgage (here we aren’t going to include insurance and taxes, that will come later).  If you have a typical 30-year mortgage, let’s say at 4% interest, your payment is going to be about $1530 per month.  That’s quite a bit less than you’re paying in rent, so obviously that’s an advantage for buying, but then there’s another little bit of good news.  That $1530 you’re paying is mostly interest, but a small amount is going towards paying down your loan.  In a way that can be seen as you “saving” money.  In this example the amount going towards you’re loan would be about $200 per month.  So that’s pretty nice.

Of course, that means that about $1300 per month is going to interest.  So when people say that you’re throwing away your rent, can’t you say the same thing for the interest on your mortgage?  Either way, this is definitely an advantage to buying.

Advantage: BUYING

 

OTHER COSTS:  With renting, once you pay that rent check, you’re pretty much done.  With buying you have a lot of other expenses that nickel-and-dime you to death.  Property taxes have to be paid (let’s say 1% of the property value so that’s $333 per month).  If you live in a condo complex or an association you might have monthly dues that could range from pretty minor to a significant chunk of money (when the Foxes lived in a condo in downtown Chicago, our monthly association fees were $900 per month—ouch!!!).  Those can definitely add up, so that’s a nice advantage to renting.

Advantage: RENTING

 

TAX ADVANTAGES:  The government has voted with its wallet that homeownership is a good thing, and they show this by providing HUGE tax advantages to homeowners that aren’t available to renters.  Typically, your mortgage interest and your property taxes are tax deductible.  As we know, being smart with taxes is one of the best ways to really turbo boost your portfolio, so this is a big deal.  In our example, if you assume a 35% tax bracket, the tax deduction equates to about $580 per month.  If you’re renting you don’t get any of that.

Advantage: Big advantage to BUYING

 

INFLATION:  Once you buy your house your biggest cost, your mortgage, is going to stay put.  We’ve talked about inflation before, and the enormous impact that even a little inflation can have on expenses after many years, so this seems pretty awesome that you don’t need to worry about it for your biggest expense.

With rent “that’s where they get you”.  Rents almost always go up.  Often there are laws that put a cap on how much they can go up, 2% seems a number I’ve heard before, so that provides some relief, but even that 2% can be a big deal.  If today your rent is $2000, in 10 years it would be $2440, in 20 years it would be $2970, and in 50 years it would be $5390.  That sucks, especially when compared to buying where your mortgage payment will always stay the same.

Advantage: Big advantage to BUYING

 

SELF-DETERMINATION:  A neighbor was renting a few houses down from us.  The family loved the house, loved the neighborhood, loved the neighbors (of course they did).  But one day the landlord called her and said she wasn’t renewing the lease because she (the landlord) was moving into the house.  That family that was renting was FORCED to move even though they didn’t want to.  That sucks.

When you rent, you’re definitely at the whim of your landlord.  If you buy, you are in control of your own destiny, baby.  Get drunk off that power.

Advantage: BUYING

 

UPKEEP:  One of the super-nice things about renting is that you don’t need to worry about when things break down.  If there is a problem with the toilet, call the landlord.  Water damage from the really bad storm, call the landlord.  Fridge on the fritz, whatever—call the landlord.   In general this is an awesome advantage.  This is even better if you’re not a very handy person.

If you own a home, whenever anything goes wrong you need to fix it yourself (hence my “handy” comment) or worse you have to pay someone to fix it for you.  There’s no perfect estimate, but a generally accepted rule is you should plan on spending 1% of the home’s value on maintenance.  In our example that would be about $4000 per year.

Advantage:  RENTING

 

NICENESS:  As an owner, if you want to make your place nicer you absolutely can.  If you want a pool, build it; hardwood floors, install them; custom closets, wallpaper, nice landscaping, and on and on.  As a renter there’s a reluctance to do it because in some sense you’re paying to make someone else’s property nicer.  If you rent there for years and years, maybe that’s not a huge deal, but that “self-determination” issue rears its ugly head.

I don’t have statistics on this, but I bet that most renters would love to make their place nicer, but just don’t because there is some deep attitude that you don’t do that when you rent.  I totally get it and understand it, but it sucks that this keeps you from making your place as nice as it would otherwise be.

Advantage: BUYING

 

WORST-CASE SCENARIO:  I’m not talking about your hot-water heater going bad or having to replace the roof (those we captured in “Upkeep”).  Here I’m talking about real worst case scenarios like a natural disaster (in California earthquakes aren’t covered by most homeowners insurance policies; you can get earthquake insurance which is really expensive, so most don’t get it), or the neighborhood really turns bad, or termites or black mold infestations happen inside the walls.  Let your imagination run with this for a second and you can really think of some nasty stuff.

As a renter, you can pick up and leave the nightmare behind.  Just go somewhere else and start paying someone else rent, and problem solved.  Not so if you own the home.  Your single largest investment is at risk.  Sucks to be you.

By its nature, the worst-case scenario isn’t very likely, but still it could happen.  This is one of the things that keeps me up at night as a homeowner.

Advantage: RENTING

 

ASSET ALLOCATION:  A mortgage is a “forced savings” program in a way.  Every month you’re making a mortgage payment and part of that goes towards your equity that you can use as you get older (reverse mortgages, cash-out refinances) or pass on to your heirs.  After 30 years your house will probably be paid off and you’ll have a tidy little sum of cash to supplement your portfolio.  Also, because home values tend to be much steadier than stocks, in a way this investment might seem like a bond.

We saw how crazy important asset allocation is, so if you have a lot of home equity, that might make you feel more comfortable to put a bigger portion of your portfolio into stocks which historically have a higher return.  This is a bit of a tricky one, but there’s definitely some level of advantage there.

Advantage: BUYING

 

REALTOR COSTS:  There will come a time when you are ready to leave your current home and move somewhere else.  If you’re renting this is easy (but not super-easy).  Usually, you’ll wait for your lease to expire and then head on down the road.  If you need to move right away and your lease isn’t up for a while, that can create a bit of a challenge of breaking you’re lease.  That could be as easy as paying a penalty of a month’s rent, or your landlord could play hardball and hold you to your lease until the end.  So this can be a pain, but more in the “moderate” zone.

When you own a home and have to sell it, that is a monumental undertaking.  Getting a home ready for sale, listing it, showing it, and ultimately closing the sale can take months from beginning to end.  Also, it’s not cheap.  While realtor fees vary, they average about 6% of the home’s value.  In our little example that would be $24,000.  That is a lot of money.  If you’ve been in the house for 30 years, that will amortize to less than $1000 per year, but if you’ve only been living there a few years that could be thousands of dollars per year that you need to tack on the to “Buy” expense column.

Advantage: Big advantage to RENTING

 

PRICE APPRECIATION:  We saved the best for last, kind of.  When you own your home, you get to take advantage of any price increases that your home experiences.  Of course, if your home goes down in value, you suffer those loses too.  However, like stocks, homes have historically increased in value over time, with notable exceptions like when home values crashed in 2008.

That’s great news, right?  No question.  However, it’s not as good as most people think.  You hear all sorts of crazy stories about people making a killing off their house, but those tend to be anecdotes rather than the rule.  The numbers are hard to come by but I think the most definitive and well-respected data, the Case-Shiller index (developed by my BFF Robert Schiller) shows that prices for existing homes have only increased 0.5% over the past 40 years after you account for inflation.

THAT’S CRAZY.  That goes against everything we hear.  How can that be?  Well his index controls for things like home sizes getting bigger, houses getting nicer features, etc.  So it really tries to do an apple-to-apples comparison of what you can expect will happen to your home.  So home prices do tend upward, but just not at anywhere near the pace that we’ve come to believe.

Advantage: BUYING

 

	Buy	Rent
Investment return on down payment	$400
Interest/rent	$1,333	$2,000
Property taxes	$333
Tax advantage	-$583
Maintenance	$333
Realtor fees (5 years)	$400
TOTAL	$2,217	$2,000

 

 

If you put it all together Buying “wins” it 7-5.  But the math shows that Renting comes out slightly ahead on a monthly expense basis.  Ahhhh, this is why the decision is so complex.  Hopefully you saw my point that buying isn’t the unambiguously better option.

If you look at the numbers, it really breaks down to two major factors—realtor costs and price appreciation.  The longer you’re in your home, the more years you can spread that 6% realty fee over.  So if you’re planning on moving after a few years, that becomes a major disadvantage to buying.  Your home appreciating in the icing on the cake that can really make the whole difference.  However, the Case-Schiller index showed that prices don’t rise nearly as fast as everyone seems to think (hence, I didn’t even include it in the expense comparison).

It’s a tough call, so I’ll leave you with this.  The Fox family owns our home, and it has turned out to be the best investment we’ve ever made.  We bought in 2010 when the housing market in Southern California had been thoroughly thrashed by the 2008 crisis.  In the past 5 years our home has rebounded, more than doubling in value.  We would have missed all that had we rented, but if I’m honest with myself, it was just really lucky timing.  Sometimes it’s better to be lucky that good.

 

Do you rent or do you own?  What do you think?

I started writing this blog because I wanted to share my own experiences with investing, including how to navigate the complex world of investing on your own.  I am a firm believer in DIY financial management.  That is what worked for me, and I believe all people can get really great results doing it on their own.  That said, many readers ask about using a broker or investment adviser or financial planner.  Here’s my take.

Quick disclosure: I am an investment adviser.  I passed my Series 65 and work with a small number of friends, helping them with their finances.

 

Are financial professionals worth it?

As with any purchase you make, you need to evaluate a investment adviser on the basis of how much she costs, and how much value you get in return.  On the surface I would say “no, it probably isn’t worth it,” however there are definitely some factors which may reverse that decision.

First, let’s look at how much investment advisers cost.  The rates range widely.  Plus there isn’t a lot of transparency in the marketplace so it’s not always easy to know what the going rate is.  My experience says that 1-2% is typical.  This can come in many forms—typically brokers get paid fees from the mutual funds they suggest for you or from the transaction costs for trades.  Advisers tend to charge a percentage of your portfolio.  We know that 1% coupons are really valuable, so those fees are a lot.  Over an investing career they can add up to hundreds of thousands of dollars.  That’s a pretty big deal.

Of course, if you’re getting a lot of value from your investment adviser, maybe it’s worth it.  One of the main missions of this blog is to show you how you can invest successfully on your own, and I think most people can do that without having to hire a professional.  Sure you have to make decisions on asset allocation, which accounts to use, what investments to make; but those aren’t really all that complex.  Also, thanks to the efficient market lessons from A Random Walk Down Wall Street we know that you’re as good a stock picker as anyone.

So my general feeling is that investment professionals aren’t worth the money; a motivated investor can do just as well on their own and pocket the fees.  Wait, what???  You said “motivated”.  As it turns out, a lot of people, despite their best intentions, aren’t able to put their financial plan in motion.  If you’re one of those people, and if an investment adviser can help motivate you to do the right things, then I do think they are more than worth it.

In this way, investment advisers are a lot like personal trainers.  Most of us know that exercise is good for us, and most of us know how to run on the treadmill and lift weights properly (or you can find out by watching a 3-minute video on Youtube).  But if a trainer can motivate you to actually hit the treadmill and the weights, they’re definitely worth the money, right?  How much is your physical health worth to you?  Same thing with finances.  If you know what you should be doing, but for one of a million reasons you never end up actually doing it, maybe you should get an investment adviser to help you out.

Nearly every post I’ve done shows that there is a ton of value out there if you invest properly, taking into account things like time horizon, taxes, etc.  But if you don’t do anything, you’re losing ALL that value.  If an investment adviser helps you in ways you won’t or can’t, then you’ll probably end up ahead of the game, even after you take his fees into account.

 

How would you pick a financial professional?

So let’s say you’ve decided that an investment adviser makes sense for you.  How do you pick a good one?  This is one of the biggest challenges, and in my opinion one of the reasons a lot of people don’t get investment advisers: They don’t know a good one they can trust.  The problem is there are a ton of them and the quality varies greatly.  Sadly, there are a lot of unskilled people in the industry who don’t know what they’re doing.  Even worse, there are some real shysters who might take your money, either overtly steal it or use other schemes to siphon away your money and put it in their pockets.  It’s a legitimate concern.

First, you need to find someone you can trust.  Ideally, this would come from a personal reference.  Today you also have things like yelp.com or Angie’s List that gives ratings.  Additionally, there are government agencies like FINRA.org that track these people so you can look them up to see how long they have been around and any complaints that have been files against them, etc.  These are okay, but for my money, nothing beats a personal reference from someone you trust.  Of course, it’s not always easy to have those conversations with friends: “So Mary, who is helping you with your money, and can I talk to them?”

Second, you need to find someone who is good.  Of course, knowing this isn’t always easy.  Using that same personal trainer analogy, you probably wouldn’t hire an obese trainer.  You’d want someone who is ripped, someone who has shown they have been successful at physical fitness themselves (like my totally buff friends Christel and Tobias).

 

Similarly, you want a rich investment adviser.  You want someone who has been successful creating wealth for themselves.  But this is where the challenge comes in: if the investment adviser is wealthy then why is he working with you?  Seriously.  You have a lot of young kids who are doing this (let’s say less than 30).  I’m sure there are some good ones, but I’m not trusting my family’s financial wellbeing to someone without a lot of experience.  You also have a lot of people who just aren’t that good.  If someone has been an investment adviser for 10 or 20 years and they aren’t a multi-millionaire, how good can they really be?  I’m not trying to be mean, but shouldn’t that be more than enough time to accumulate some serious wealth?

 

Questions to ask:

If you do decide to go with a investment adviser, make sure you ask a lot, A LOT, of questions.  Beyond your doctor or minister/rabbi, this person will probably have the biggest impact on your wellbeing.  Take the time to make sure you find a good one.

How long have you been doing this?  This is an area where experience definitely matters.  In particular, you want her to have lived through a few bear markets.  At a minimum she should have been doing advising people since 2008 and even better if she’s been doing it since 2001.

What did you do during 2001 and 2008?  Investing is a lot easier when things are going well.  You prove your mettle during the tough times.  Figure out how he handled himself when everyone thought the world was coming to an end.

What are you paid?  This should be answered in excruciating detail.  Does he get paid by you (how is the amount determined, when is it paid), by others like mutual fund companies (how much, how do you make sure you serve my interests ahead of theirs)?

What is your personal financial situation?  No point sugar-coating it.  Find what his financial situation is like.  As mentioned above, if he isn’t pretty well off, how good is he really?  Also, the relationship you have with him needs to be based on trust because you’re going to be sharing everything with him.  If he isn’t willing to reciprocate in some way, that might tell you something.

How will you ensure you serve my best interests?  This is a biggie.  Ideally you want her to have a fiduciary relationship which is a legal standard where she serves your interests ahead of anyone else’s, including her own.  No matter how this turns out, you’re going to need to trust this person, but you should get a sense of how she will ensure that you are #1.

What is your investing strategy?  Obviously, there are a lot of nuisances to this, especially as he customizes it to your specific situation.  But he should definitely have an approach and a philosophy that he can articulate clearly and understandably.

What type of power will you have over my money?  Will she be able to make trades and move money between accounts with your express permission, on her own, or not at all?  This is a tricky one because maybe you want to offload these activities completely, so her having a ton of control may be okay.  No matter, you should definitely understand this completely.

How will you take into account other assets that you won’t manage?  Most situations will have him managing an account like your IRA or brokerage account but not others like your 401k, mortgage, pension, etc.  Most times, he’s only paid on the accounts he manages, but to do his job well he’ll need to take into consideration those other accounts as well.

 

Those are what I came up with off the top of my head.  At the end of the day, if you do go with an investment adviser make sure you find someone who has demonstrated they have the skills to build your wealth.  Just as importantly, make sure you find someone who you can trust completely.

 

“Never a borrower . . . be”—Hamlet by William Shakespeare

People generally think of debt as a bad thing, and for good reason.  Debt can devastate national economies at it is currently doing to Greece and has done to countless others (Russia—1998, Argentina—2005, Mexico—1982, to name a very few).  At a personal level, it can hamper individuals with a burden that takes years to relieve, if they ever are able to pay it off.  Many people offer the sage advice to avoid debt as much as possible: “take on as little debt as you can, and if you have to borrow money for something then pay it off as soon as you can.”

In recent years the issue of debt has become raw meat for rabid politicians.  The explosion of college debt, the predatory lending practices on mortgages leading up to the sub-prime crisis, credit card debt in a world where credit card marketing is ubiquitous—all those are real issues that can affect anyone.  And the difference between getting this one right or wrong can lead to tens or even hundreds of thousands of dollars.

Quick note: This is an investing blog, not a personal spending blog, so I don’t want to get too much into the question of “should you incur debt?”  There are hundreds of blogs out there already that do that much better than I (my personal favorite is www.mrmoneymustache.com).  This post is going to be focused on looking at debt from an investment perspective.

 

Good debt and bad debt

Some people think of debt as either good or bad, like it is the good cholesterol or bad cholesterol you see on your annual blood test.  I think that glosses over some of the most important points.  Instead I look at debt solely by how expensive it is.  What is its interest rate?  Basically, if you can invest your excess cash at a higher return than the interest rate on your debt, then you should invest; if you can’t, then you should pay off your debt.  That seems pretty reasonable, right?  Based on that, the higher the interest rate on your debt, the more quickly you should pay that off.

If you make a list of common debts and associated interest rates, you get a bit of a hierarchy that looks something like this:

Debt type	Typical interest rate
Credit card	20%
Car loan	8%
Student loan	5%
Mortgage	4%

 

Obviously those are just examples, and they can vary a lot, but that’s a good starting point.  When you think about paying off debt, basically you’re getting a “guaranteed return” on your investment of the interest rate you were paying.  Right now, US bonds tend to have an average return in the 4-5% range; that certainly isn’t guaranteed, but that gives you a sense of what a “safe investment” can yield.  Stocks tend to have an average return in the 6-8% range, but sometimes it’s much higher and other times it’s much lower.

Now think about paying off debt.  Let’s say you own money on a loan that has 10% interest, and you have $1000 that you could either invest in stocks or use to pay off your loan.  If you invested it, let’s say you bought stocks; on average you would get 6-8% but that could really vary from year to year.  On the other hand, if you put the $1000 towards that loan, you would be guaranteeing yourself a 10% return because you wouldn’t be charged interest on that money.  This seems like a no-brainer, right?  A 10% sure-thing is much, MUCH better than investing in the stock market.  So this is the approach we’re going to use when we look at debt.

 

Credit card debt is pretty universally terrible for one’s personal finances.  The interest rates are usurious and there is no investment that can come close to the double-digit interest rates on most cards.  Some cards offer low introductory rates which change the calculations, but those are temporary.  As a general rule, paying off all your credit card debt should be the highest priority.

Auto loans throw in an added complication.  Some auto loans are on the high side, let’s say anything over 5%.  If you pay those off, you’re getting a guaranteed 5% return which is better than any other “guaranteed” return, so that makes sense.  This is the case with many new car loans and nearly all used car loans.  However, some car companies offer “below-market” interest rates auto loans to induce you to buy.  Last year, the Fox family bought a new Honda Fit, and we were offered a 0.9% interest rate to finance the car for 5 years.  If you compare 0.9% to what we could expect on average with stocks or bonds, we’re much better off taking the loan and investing the money we would have used to buy the car outright.

Also, you can think of a subsidized loan as something of value that the car company is offering.  If you don’t use it, you’re passing up that value.  However, if you do use it, even if you have the money to pay off the car in full, the value of that “subsidy” might be worth a few thousand dollars.  The Fox family has very little debt, but we do have an auto loan.  We had the money to buy the car outright, but we’ve taken advantage of the really low interest rate because we’re getting more by investing that money in the market.

Student loans get a little more complicated because the interest on them is tax deductible, and that’s an important consideration.  So for example, if your student loan is at 5% (current rate for new Stafford loans) while your marginal tax rate is 40%, you’re effectively paying only 3% (5% *(1-40%)).  Obviously the decision to pay off your loan right away or invest that money is significantly impacted by that difference.  You’d probably want to pay off a 5% loan right away, but a 3% loan might be low enough to make it worthwhile to invest the money.  There is a lot of gray area here, but I would generally choose to invest the money and just make the regular loan payments.

Mortgage is usually the biggest loan people have (as we covered here).  Similar to student loans, interest on mortgages is usually tax deductible, so really lowers your effective rate.  Also, mortgages tend to be subsidized by the government, so they often have interest rates that are lower than any other type of loan.  30-year fixed loans are currently at about 3.7% which is super low.  Add on the tax-deductibility benefit and your effective rate can drop as low as 2%.  If you’re paying 2% on a loan that will last decades, the math and historical averages definitely say that you should pay off the loan over time and invest any excess cash.

Of course, you can take this to the extreme and get an I/O loan (an “interest only” loan where your payment is only interest and your principal never goes down).  Some people do the calculations above and decide “if a little is good a lot is better”.  Mathematically, I think they’re right.  However, the Fox family doesn’t do this, less because of logical reasons (the logic says pay off as little as you can), but more because of emotional reasons.  I like the idea that over time I am paying off the loan and when our tails turn from red to gray, our house will be paid off.

 

Obviously there are a lot of considerations when it comes to what to do with debt.  Pretty universally everyone agrees that credit card debt and most auto loans are way too expensive and should be paid off as soon as possible.  However, as you move down the spectrum to student loans and definitely home mortgages, it becomes more complicated.

Some people have the attitude that a healthy portfolio has no debt, and you should focus on debt reduction before starting investments.  They set goals for themselves to be mortgage free ASAP.  That’s a noble goal, and one I totally get.  If you don’t have debt you feel more secure, you own your stuff outright, etc.  Those are very valid emotional responses, but the math says that’s the wrong thing to do.  I take the middle ground on this—the only debt we have is a subsidized car loan and a mortgage.

The car loan is pretty small, so let’s not even count that.  For the mortgage (currently we owe about $500k) we could have paid it off over the past 5 years by scrapping together every penny we had and pretty much saved nothing (including not doing things like our 401k—yikes!!!).  Today we wouldn’t have a mortgage which would be nice, but we wouldn’t have been able to take advantage of a pretty nice bull run the last five years.  Taking all that money and investing it has probably netted us a $400k profit.  That’s almost double what we would have had otherwise.

Of course, the past five years have been a really good time to be an investor, plus interest rates have been at historic lows, so that makes a perfect storm for it being to your advantage to invest rather than pay off your mortgage.  But remember that it’s a numbers game, and over the long term stocks return more than what you’re paying with today’s interest rates.