Should You Pay Off Your Mortgage or Hold Stocks?

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The previous article, “When should you own your Home?” (Hanoch, December 2007) provides guidelines for determining if you can afford owning a home. The next step is to determine the size of mortgage you should take.

After putting a down payment that the lender required, you may be left with extra money. You have to decide whether to use it to pay off some of the mortgage or put it in an alternative investment. This article discusses the option of investing the excess in the stock market.

You may view this option as: (1) paying off the mortgage no faster than the required pace or (2) borrowing to invest – both statements are correct. Whatever your perspective, having a large loan combined with stock investments has led many to lose their homes and declare bankruptcies. This is the result of counting on the stock investment to grow enough to help pay the interest on the loan, while in reality the investment can decline in value for many years. When combined with a loss of job for an extended period, the results can be devastating.

You should be very careful, and review important requirements for considering this idea:

  1. Conservative stock investing: Diversification, No stock picking, No market timing. Most investors (including professional money managers) underperform the S&P 500 (10.5% in the long run), due to concentration in certain stocks or asset classes, stock picking and/or trying to avoid decline periods. In many cases, they underperform their mortgage rates, resulting in high risk combined with negative returns.

    In order to limit the decline periods of your portfolio, you have to diversify it globally, and include large and small stocks. You should avoid trying to predict which stocks will go up or when the portfolio will go up. Stay diversified using passive investments like index funds and hold onto them for the long run. This is true for any stock investor, but an absolute must when you have a mortgage to pay – you should not gamble with borrowed money.

    Note that stock diversification reduces risks without reducing returns. You cannot use bonds or any other low return investment for risk reduction, because it will reduce your overall returns, significantly increasing the risk of underperforming your mortgage rate in the long run.

    To be clear, you should have some money in bonds or money market, to carry you through recessions, but not as part of a long-term investment.

  2. Be prepared for a very bad combination of events: Make sure that you can handle many things going wrong at once, including no less than the following:
    1. Extended loss of your ongoing sources of income: Losing your job or clients from your business for a long period, during a severe recession.
    2. Extended decline of your stock portfolio: A decline of your stock portfolio, longer than all declines in recent decades (for Long-Term Component: nearly 3-years; for the S&P 500: 6 years; with stock picking or market timing: 10 or more years).
    3. Rising interest rates: A significant increase in the interest on your variable-rate mortgage. As mentioned in the previous article, you should be prepared for a prime rate of no less than 8%-9%. Alternatively, stick with fixed rate mortgages.
    4. Real estate recession: A very long real estate recession. Property values have declined for a full 10 years before recovering their peak value, as recently as the 90’s in many places. Be prepared for even longer declines. This means that you will not be able to refinance your loan to get a higher mortgage, lower interest rate, or fix the rate on the loan.
    5. Unexpected costs: A large combination of the following occurring at once: All home expenses not covered by your insurance, like home damage from earthquakes, floods or ongoing repairs like a roof replacement. All deductibles for insurance, including homeowner’s, health, car, etc. Car repairs and replacements. Uncovered medical expenses, including long-term care (or consider long-term care insurance).

    Make sure you can handle the above events occurring at once, as unlikely as it may seem to you. You should be able to handle the events in two ways:

    1. Financially : Make sure you can handle your ongoing living expenses when a combination of the events above occurs.
    2. Emotionally : Make sure you are unshakably confident about your stock investments, so you will never even consider selling your investments at a decline unless you have no other financial choice. If you stick to the conservative investment approach presented above, you have a good reason for being confident.

If the requirements above seem too harsh, you might be getting yourself into trouble. When borrowing to invest you choose to take certain risks in hopes for increased long-term returns. If you are not prepared for everything that can go wrong on the way, you might end up with much lower returns and even face bankruptcy. This would be very unfortunate since you chose to take the risks – you were not forced into the situation.

A Tradeoff . Note that there is a clear tradeoff between paying off a mortgage and continuing to carry it while investing the excess in a stock portfolio. The following table summarizes it:

Option Short-Term Security Long-Term Security
Pay off mortgage Higher Short-Term Security: lower mortgage payments Lower Long-Term Security: forgone growth of stocks beyond interest on mortgage
Invest in stock market Lower Short-Term Security: higher mortgage payments Higher Long-Term Security: extra stock growth minus mortgage interest

Example 1a. John has $4,000,000 in savings and qualifies to purchase a $1,000,000 home with 100% mortgage based on his assets. He is retired, and has only social security income.

He requested that his broker balance his current financial security with future growth, since he is 65 and wants to prepare for the possibility of a long life. His money is invested as follows: 60% in selected high quality Large US stocks and 40% in Bonds.

Low Potential Returns : Since his stock investments are concentrated in Large US stocks, his risk level is very high. This is exaggerated by the stocks being actively selected. The bonds reduce the volatility of his portfolio, but also reduce the long-term returns. He pays high fees for an actively managed portfolio (could be 2%-4% or more). Based on this information, we can expect his long-term returns to be 5%-8% at best. Since this is just about what he would pay on mortgage interest, there is no potential long-term gain on holding a mortgage.

Conclusion : Given the low potential returns, despite his high financial means, he should buy the house with cash (no mortgage).

Example 1b. See example 1a + John realizes that his actively managed, concentrated investments, are too risky for him. He decides to diversify them globally, and eliminate the risks and costs of active stock selection by focusing on index funds. Whenever a severe decline is expected, he can shift some of his investments to more conservative places like the virtually risk-free government bonds.

His long-term portfolio returns are 12%, while he qualifies for a 30 year fixed mortgage at 7%. He also learns that he can conservatively withdraw 4% annually without a real risk to the long-term viability of his investments.

High Potential Returns : Since this long-term return is significantly higher than the interest rate he might pay on a mortgage, he has the potential for significant gains by not paying off his mortgage. Specifically, on a $1,000,000 mortgage, he can make (12% – 7%) x $1,000,000 = $50,000 per year to supplement his social security income.

Low Financial Risk : His $4,000,000 savings can supply him with $160,000 income per year (at a conservative 4% withdrawal rate), enough to cover his full mortgage payments, property taxes, repairs and other living expenses.

High Investment Risk : When stating that he is open to shifting some of his investments to bonds when a decline is expected, he intends to engage in market timing. He would change his investment strategy based on predictions of future returns. When wrong, he would miss out on growth periods, and reach lower lows during declines with higher overall risk.

Conclusion : Despite his excellent financial situation and globally diversified indexed investment, he chose to incur the risk of timing the market. In this case, he should still buy the house with cash.

Example 1c . See example 1b + John understand the risks of any type of market timing. He decides to have a written investment plan and to stick to it at all times. Knowing that he might not be strong enough at times of financial turmoil and severe recessions, he uses the services of an investment advisor that specializes in disciplined investing.

High Potential Returns : See example 1b.

Low Financial Risk : See example 1b.

Low Investment Risk : By holding globally diversified investments during all recessions, and sticking to the plan with a low withdrawal rate, he is likely to recover future severe recessions.

Conclusion : With the combination of high potential returns, low risks and discipline, John should maximize his mortgage loan and enjoy extra potential income of $100,000 per year.

Example 2 . Mary is 45 years old and works as the CEO of a public company. She has a private jet, 3 houses, a large yacht and clothes designed by top designers that are updated regularly to meet with recent trends. She tends to spend her $2,000,000 income (including salary and bonuses).

She is about to buy a $2,000,000 house and is committed to disciplined investing in a globally diversified portfolio, avoiding stock selection or market timing.

High Potential Returns : See example 1b, resulting in $200,000 extra potential growth.

High Financial Risk : Mary has very high fixed costs for maintaining her private jet, 3 homes, yacht and designer clothes. Being a CEO, she can lose her job for many reasons well beyond her control, leaving her with very large fixed expenses and no income or liquid assets to cover them. After liquidating some of her assets, she might be miserable getting used to a much lower standard of living.

Low Investment Risk : See example 1c.

Conclusion : Despite the high potential returns and high income, Mary is already under great financial risk. She should avoid new mortgages, and consider significantly scaling back her spending until she has substantial savings to carry her through severe recessions without being so dependent on her job.

Example 3 . Lisa is a 70 year old retired high school teacher, with pension payments to cover her expenses. She is currently renting, and would like to buy a $200,000 house. She has savings of $400,000 and can qualify for a 100% mortgage at 7% fixed interest. She is a disciplined investor, working with a written plan and committed to a globally diversified portfolio of index funds, held through all market cycles. Given her limited assets, she carries long-term care insurance, and other insurances to protect her from all common risks.

High Potential Returns : See example 1b, resulting in $20,000 extra growth.

Low Financial Risk : Lisa has guaranteed pension payments to cover her expenses. Her $400,000 savings can supply her with $16,000 income per year (at a conservative 4% withdrawal rate), enough to cover her full mortgage payments, property taxes and repairs.

Low Investment Risk : See example 1c.

Conclusion : Lisa has low income and low assets for a retiree. But her expenses and house cost are also low. In fact low enough to allow her to take a 100% mortgage, enjoying an extra long-term growth of $20,000, to increase her financial security over the years and leave a larger inheritance to her children.

Disclaimer about the examples : Note that the examples demonstrate the ideas of this article, and do not represent a full analysis of each of the cases. A full analysis with a clear written plan should precede any of these investments.

Summary

Most people would do best if they paid off their mortgage as quickly as possible, other than maintaining reserves for recessions. This is true for many reasons, including: concentrated investments, risks of active stock selection or market timing, panic during recessions, and most importantly not having enough assets to carry them through severe recessions without a job.

If you are one of the rare people with iron discipline, investing responsibly and with enough assets to carry you through recessions, you can grow your financial security substantially by carrying a large mortgage and investing the proceeds, regardless of your age. When done right, your risk level should be lower than an investor with 60% Large US Stocks, 40% Bonds and no mortgage.

Due to the complexity of this activity, it is recommended to hire an investment advisor that has experience with the task and is very comfortable with it.

Disclosures Including Backtested Performance Data

When should you own your Home?

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The previous article “Why should you own your Home?” (Hanoch, Oct. 2007), described many benefits of homeownership. Despite the long list of benefits, not everyone should own their own home as soon as they can afford the down payment.

Let’s say you found a property that you like and it passed a thorough inspection with no major findings. Here are some financial risks and potential problems to look for:

  1. A need to move again. A need to move has several risks:
    1. Selling and buying a house involves very high expenses, and you might not be able to afford them right as you need to move.
    2. Even if you can afford the costs, a move after a few years makes the homeownership much less appealing financially.
    3. If the home value declined, or you paid less than the interest on the loan while you owned the home, you might end up owing more than you own. You will have to come up with money out of pocket to sell your home!
  2. Being unable to make the mortgage payments, resulting in a default on your loan and losing your home and/or declaring bankruptcy. This can happen for many reasons. Here are some of the main ones:
    1. You lost your job and cannot find another one quickly enough.
    2. Your mortgage has a variable interest rate (ARM) and interest rates have gone up.
    3. The ‘teaser rate’ period on your mortgage ended, and now the payments are much higher.
    4. You took a mortgage that allows you to pay only part of the interest on the loan (e.g., Option ARM) for some time. The period ended and your payment jumped significantly.
  3. Major repairs come up. Over the years, every home needs to be repaired and kept up. Some repairs can be very expensive and put you at financial risk if you don’t have large reserves prepared for them.

When should you own your home? Considering all the risks mentioned above, there are certain conditions to reduce the financial risks of owning a home:

  1. Long Stay. You are likely to stay in the house for a good number of years.
    1. Any stay under 3-5 years will make the transaction costs very significant. A 6% transaction cost (just realtor fee, not counting other costs) spread over 3 years comes out to 2% per year!
    2. Since real estate recessions tend to be very long, any stay shorter than 10 years can result in a selling price lower than the purchase price (just looking at the recent 1990’s recession). In that case, you might have to add money to sell your home.

    Alternatively, if you need to move after a few years, you are willing to do one of the following:

    1. Rent out the house and rent a house in a new location for several years. I would not recommend taking this approach unless you are ready for extra work and risks related to renting out a house.
    2. Rent out the house and buy a house in a new location. In addition to the extra work related to renting out a house, this option requires significantly higher financial means to own both properties. A future article will discuss this option in more detail.

    If you are not sure you are going to stay in one place for long, consider renting. You can always buy a house a year later, after you ‘tested’ the area for a while. You can even look for a place for rent with an option to buy (sometimes called: lease-option or rent-to-own).

  2. Money to cover move-in expenses. You have money to cover the down payment, closing costs and moving expenses. You also have money for repairs, furniture and anything else you might need as you move in.
  3. Ongoing cash reserves. After paying for the costs mentioned above, you still have cash reserves to cover the mortgage payments. Make sure to consider the payment:
    1. After the expiration of any ‘teaser rate’ period.
    2. Based on the full interest amount, in case you initially pay partial interest for an Option ARM. To be conservative, you may want to consider the full amortization (principal + interest).
    3. For variable interest rate, based on an index rate higher than the long-term average. For example, for loans based on the prime rate, I would consider a prime rate of about 8%, maybe even 9% to be conservative. This is based on the following historic averages of the prime rate:
      Period Average Rate
      1929-2006 5.83%
      1970-2006 8.73%
      1990-2006 7.25%

    In addition, remember that there could be spikes in this rate (18.9% average in 1981).

  4. Money for property taxes. The property tax bill is typically about 1.25%, but can be much higher in certain cases. Make sure to check!
  5. Money for repairs. Plan on 1% or more of the house value per year. If that sounds high, think about the following relatively infrequent but expensive items: new roof, repairs related to flooding, repainting (interior and exterior), kitchen and bathroom remodel, and many more.

It is much safer to buy a cheap home. Note that the financial risks of homeownership are much smaller for cheaper homes. With a cheap home, more job options can provide income that is adequate to afford the home. If you want to live in an expensive home, you might do best by waiting until you have substantial savings, and in the meantime choosing between buying a cheaper home or renting the more expensive home. A future article will discuss the price of a home you may consider depending on your savings.

Disclosures Including Backtested Performance Data

Why should you own your Home?

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There are many benefits to owning the home you live in, when compared to renting. Let’s review them:

Psychological pleasure of home ownership . Owning a home has a psychological benefit beyond the financial considerations listed below. You own a substantial physical asset, and this asset is also a place for you to stay.

Freedom to remodel . You have the freedom to modify your home to your liking without a landlord to report to. Money you spend on remodeling may partly increase your home value. This may have some financial value if you borrow the increased value and put it in other profitable investments, or if you ever downsize to a cheaper home.

An automatic savings plan . When buying your home, you commit to save systematically for many years. You commit in advance, and have a huge incentive to keep your commitment – you do not want to lose your home! This is a very important benefit, especially if you have trouble with disciplined saving. The savings include your principal payments, if you pay off the principal over time. Note that this is not a benefit until and unless you make principal payments.

It may turn into an investment . Your home can turn into an investment if you borrow part of its increased value to invest in a place that grows faster than the interest on the loan. A simpler, less common option is that you sell it to buy a cheaper home and enjoy the growth of the home value.

Forced discipline in investing . Typically, you should not sell long-term investments whenever they decline in value – if anything, you should invest more. Unfortunately, most people have the opposite instinct when investing in the stock market. This risk is reduced when you use your home as an investment, for several reasons:

  1. You cannot easily find your home value frequently. By not seeing the decline as it happens, you are less susceptible to an irrational panic.
  2. You also use your home for living, not just as an investment. If you sell it, you will have to start renting another place, something not desirable after you became accustomed to homeownership.
  3. Selling and buying real estate is a fairly long, expensive and time consuming process. You are not likely to choose to do it frequently.

A source of funds in tough times . If you haven’t borrowed the full value of your home, you can establish a home equity line of credit on the unborrowed portion of your home, to provide you with money for use in tough times.

Tax benefits . Interest on your mortgage is tax deductible up to a limit. Since the IRS sees your home as an investment, you get a tax deduction.

Own a potentially appreciating asset with limited cash outlay . Since real estate is considered a relatively stable investment, banks are eager to lend most people large amounts of money to own their home. This lets you own an asset that typically appreciates in the long run without having most of its value in cash.

High leverage possible . Large loans let you own an investment with very high leverage. Under the following conditions, you can make significantly higher gains than the actual growth of the home value:

  1. You are ready to live in it for a long time.
  2. You are very confident you can make the payments, even if many things go wrong.
  3. The home value appreciation plus the saved rent is higher than the expenses, including: interest on your mortgage and property tax minus the tax savings on the two, plus repairs.

In certain cases, when structuring your finances right, you can even outperform diversified stock investments.

Summary

As you can see, there are many benefits to owning a home. Despite this list of benefits, you should not rush to buy your first home as soon as the bank will lend you the money you need. There are many conditions for making it a smart financial move. The next article will present the main ones. Future articles will elaborate on some of the benefits of homeownership.

Disclosures Including Backtested Performance Data

Should you Leverage your Stock Investments?

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[Updated February, 2011]

How does stock leverage work? It is very simple: you open a margin brokerage account. This type of account lets you borrow from your broker to fund part of your investment. Your investment serves as the collateral, just like your home serves as the collateral for a mortgage loan.

Since stock values tend to be very volatile there are strict rules to limit the losses to your broker (set by the Federal Reserve, the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE) and individual brokers). Specifically, you are required to provide at least 50% of the security value when you purchase it, and keep having your investment be at least 25% of it on an ongoing basis. Individual brokers may have more stringent requirements and may change them without prior notice.

If your investment value declines and you don’t own enough of your investment your broker may sell some or all of the investment to bring your ownership to the required percentage. The following example demonstrates the financial impact.

Example . You have $500,000 and would like to leverage your investment using your broker’s money. You can invest up to $1,000,000, making your ownership 50% of the investment, and the broker finances the other 50%. From now on, you own the investment minus the loan value of $500,000. This amount is required to always be at least 25% of the investment value. The indented text below presents math calculations of the effect of these rules. You can skip it, if you don’t care for the details.

If we denote your investment value by X, we can express the requirement as follows:

X – $500,000 > 0.25 X

Let’s solve the inequality:

0.75 X > $500,000

X > $666,667

If your investment declines by more than 33% (($1,000,000 – $666,667) / $1,000,000), you should expect the broker to sell some of your investment to bring the ratio to the level required.

As shown above, the requirement of owning at least 25% of the investment is deceiving. In practice, a decline of 33% or more will result in the broker selling some of your investment to cover the excess loan.

Moreover, if your investment goes down to $500,000, you own nothing ($500,000 investment value minus $500,000 loan), your full investment will be sold and the proceeds will be taken by your broker. You will lose your entire investment.

Should you Leverage your Stock Investments? Like any other investment decision, answering this question requires an analysis of the risks and rewards.

Risks . As presented in the previous article “How does Leverage Work?” (Hanoch, June 2007), borrowing to invest can significantly increase the risks of your investments.

  1. Severe decline : In the example above, if your investment declines by 50% or more, you lose your entire investment. Since the most conservative stock investments (globally diversified, no stock selection, no market timing) tend to decline by 50%+ in the worst recessions, borrowing 50% of the investment is too aggressive, making bankruptcy a real possibility. You can decrease this risk by borrowing a much lower percentage. There is no way to predict the worst future decline, but since that decline could make you go bankrupt, I would choose a very conservative measure in the range of 5%-20% (withstanding an 80%-95% decline).
  2. Change in broker rules : Your broker may change its rules without any prior notice and require much higher ownership of your investments up to 100% (all lending to you is cancelled). Unfortunately for you, a change in rules is most likely to happen during a severe recession, when your broker is most concerned about a default on your loan.
  3. Loss of income : Without leveraging you can use your stock portfolio to supply you with a certain level of income, even during recessions. The amount depends on the specific portfolio, especially how diversified it is. For Long-Term Component, a reasonable withdrawal rate is 4%, growing with inflation. Once you leverage your investment, you may not have the money for withdrawals during recessions. If you depend on any portion of your portfolio for living expenses, you should not consider leveraging.

Rewards . Let’s see what your potential reward is if you borrow 20% of your investment – the most I could contemplate borrowing even while being overly aggressive.

  • 2% potential gains : You may be able to achieve investment gains of about 10% above margin rates (say 15% returns for a globally diversified stock investment, with 5% margin interest). This can increase your returns by 10% additional gain on 20% of your investment, or 2% (10% x 20%) additional return on your total investment. This is probably not worth the risk, however remote, of bankruptcy, due to a margin call at the bottom of a major decline.

Summary

Since we cannot know how deep a stock portfolio may decline temporarily and how brokers might decide to change their lending rules during recessions, any margin borrowing imposes some risk of bankruptcy. In addition, you eliminate the ability to use the portfolio for income at all times. With the potential benefit being limited to about 2% increased gains, I conclude that it is not worth borrowing using your stock investments as collateral, even if you are looking for very aggressive ways for making money.

Disclosures Including Backtested Performance Data

How does Leverage Work?

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Leverage is a powerful tool that can be used to magnify the returns on your investments. Understanding the financial results of leverage requires some mathematical calculations. If the calculations presented below are not interesting to you, feel free to skip them and focus on the results.

How does leverage work? A mechanical lever can help you lift large objects with less force. In investing, you can spend a certain amount of money and borrow additional money, to buy a larger investment and enjoy the appreciation of the full investment (minus the interest paid on the loan). If the investment goes up in value more than the interest on the loan, you make extra money. If the investment goes up in value less than the interest on the loan, you make less money, or even lose some. In both cases, leverage magnifies the change in the investment returns relative to the interest rate paid.

Let’s review how this works with the most common use of leverage: buying real estate. A common case involves putting a 20% down payment on a piece of property and borrowing 80% of the property value. Note that the financial analysis of real estate investing is significantly more complicated, but this article reviews the concept of leverage alone. Your actual returns of real estate are likely to be very different than shown below because of the other expenses and income from the property.

The following table shows the gain or loss from the investment assuming a 7% interest-only loan. (If the loan involves paying the principal, the effect of the leverage declines over time.)

The return is calculated as follows:

Down payment = the amount you put down to buy your investment
Growth = the percentage growth of the property value
Borrowed = the borrowed amount
Interest rate = the interest rate on the borrowed money

Investment Return =
    [Down payment x growth + borrowed x (growth – interest rate)] / down payment =
    Growth + (borrowed / down payment) x (growth – interest rate) =
    Growth + (80% / 20%) x (growth – 7%) =
    Growth + 4 x (growth – 7%)

Property Growth Investment Return Calculation
20% 72% 20% + 4 x (20% – 7%)
14% 42% 14% + 4 x (14% – 7%)
10% 22% 10% + 4 x (10% – 7%)
7% 7% 7% + 4 x (7% – 7%)
4% -8% 4% + 4 x (4% – 7%)
0% -28% 0% + 4 x (0% – 7%)
-20% -128% -20% + 4 x (-20% – 7%)

Note the following:

  • Every 1% of growth above the interest rate of 7% increases the investment return by 4%.
  • Every 1% of growth below the interest rate of 7% decreases the investment return by 4%.

The benefit : If the property value grows at a rate higher than 7%, the return on your investment becomes significantly higher. This is exactly how homeowners and real estate investors made large gains in recent years up until the recent real estate recession.

The risks : If the property value (plus income minus expenses) grows at a rate lower than 7%, the return on your investment becomes significantly lower. Note the following:

  1. The investment return can be negative even when the property value goes up! For example, when the property value grows by 4%, your return is -8%.
  2. If the property value stays the same, you are at a significant loss. In our example, the return is -28% (0% growth minus 7% interest rate magnified by 4, the leverage multiplier).
  3. With leverage, you can lose more than you invested! In our example, if the property value declines by 20% you lose your full investment and more, for a total return of -128%. You lose your entire investment and need to come up with additional money to cover the interest on the loan.
  4. The length of the investment period also magnifies the returns. For example, if you held a property for 10 years in which its value stayed the same (as happened with real estate in the 90’s), your loss is multiplied by the number of years. In our example, you would lose 28% in one year, resulting in returns of -280% over 10 years. Note again that in practice the numbers are different, because of additional expenses and income from the property.

Summary

Leverage, or borrowing to invest, is a very powerful tool. It can make you rich or send you to bankruptcy. Because of this tremendous power, you would be smart to shy away from leverage in most cases. You should consider using it in rare cases, when even if everything goes wrong you still expect to handle the situation without facing financial hardship. Future articles will analyze certain uses of leverage.

Disclosures Including Backtested Performance Data

What is Your Opportunity Cost?

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You can pay for a service in one of two ways – which would you choose?

  1. $100 per year forever
  2. $2,000 once

Answer: It depends on your opportunity cost. What is opportunity cost?

Opportunity Cost: The cost of an alternative that must be forgone in order to pursue a certain action.

Before you struggle to understand the sentence above, let’s continue with our example. If you pay $2,000 immediately, you forgo the opportunity to invest $2,000 and enjoy its growth (minus the $100 annual service fee).

The decision depends on the potential growth of the $2,000. Specifically, if you can gain at least $100 per year, or 5% (=$100/$2,000), you would be better off paying $100 forever, pocketing the extra growth.

Note a few important factors:

  1. Consider the taxes on the growth of the money. More specifically, consider the taxes on selling $100 of the gains per year. If the gains are taxed at the long-term capital gains rate of 20% (the rate after 2010), you need to make $120 or 6% on your investment, to break even.
  2. There could be an additional small tax component: the tax on capital gains distributions – internal sales within the mutual funds. This is usually harder to quantify and is relatively small (but not negligible).
  3. If the $100 fee for the service may go up, your investment would have to make up for the growth in the fee. This would depend on the service contract.
  4. When considering paying $100 per year forever, you should check what the word “forever” means. It usually does not really mean forever. It could mean the shorter of the life of the service receiver and the service providing company.
    An extreme example of a surprisingly short period is TiVo service. A few years ago, you could have chosen to pay a monthly fee for TiVo or a one time fee for the life of the TiVo player. Since TiVo players can stop functioning or the owner might want to upgrade to a new model, e.g., a larger hard drive or high definition quality, the life could be as short as 3-5 years.
    The shorter the service period, the more beneficial it is to pay the periodic fee as opposed to paying the large amount upfront.
  5. If you choose to make the periodic payments and invest the money instead, the investments may fluctuate in value. If they are a part of a large long-term investment, it is not a big problem – over your lifetime the performance of your investments may not be extremely far from their long-term average. If the service term is short and the money is invested specifically to generate the income for the service fee, there is a real risk that the investment will experience severe declines right when you need the money. Please take this risk into account.

Fortunately, in many cases there is a clear preference for one over the other.

Example . If you invest in a diversified stock portfolio, you may reach an average of 8%+, creating a preference for the ongoing payments in the example above, after factoring investment taxes.

Buying with a periodic payment plan . Let’s say you are looking to buy a car. In this case, the basic decision can be simplified. Usually the interest implied by the payment plan is stated in the contract. If the interest is lower than the after-tax growth of your investments, you may choose to make the payments and incur the interest.

One word of caution: you need to make sure that you put the money in the more profitable investment. Otherwise, it is pure borrowing with no alternative gains to show for it.

Mortgage . A similar approach applies to mortgages. If the gains on your investments are higher than the mortgage rate, you might choose not to pay off the mortgage too quickly. Since taking the mortgage while having stock investments is considered borrowing to invest, the mortgage is tax-deductible (even above $1M – please consult with your tax advisor). Therefore, you may not need to consider the tax impact on your investments.

Note that this decision is very serious because the amounts tend to be very high. Therefore, you should do such a thing only if you have plenty of extra money to let you go through recessions without a problem. In addition, if there is any risk that you will panic and sell your investment during a recession, don’t even think about taking a mortgage to invest. In general, this approach can be extremely risky if you don’t have a very clear understanding about what you are doing and don’t have plenty of extra money. In addition to having plenty of extra money and being very savvy, you need to make sure to invest conservatively by being globally diversified into many companies and avoiding any stock picking or market timing. I do not recommend this approach without the help of an investment advisor that specializes in such decisions and provides constant handholding throughout all recessions.

Repairs . You may have a leaky roof and you are not sure whether to repair it or replace it. The replacement cost is an immediate outlay, while the repair cost is a smaller payment that can prolong the life of the roof for some period. This may be tougher to decide because you cannot know how long the roof can last after the repair. In addition, the replacement has the benefit of peace of mind and pleasure of a new roof.

Whatever your considerations are, the potential gains of the money kept invested instead of spent on the new roof is a factor that is important to consider.

Summary

If you invest in a globally diversified portfolio with no stock picking and you are strong enough and financially stable to hold on to your investments throughout recessions, you can buy certain things in payments instead of an immediate outlay of the full cost. Contact your investment advisor to find out the long-term performance of your investments, take off a few percentage points for the investment risk and taxes and you can get an estimate of your opportunity cost. Purchases you can make at a lower interest than your opportunity cost may be worth their interest cost.

By making a few calculations and having a conservative investment plan, you have a recipe for making good money through simple financial decisions.

Disclosures Including Backtested Performance Data

What would you do after a Steep Decline?

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Close your eyes and imagine the following future. Over the next 2 weeks, your portfolio declines by 20%. You read the news trying to understand what caused such a rapid decline. There is no forecast for a recovery in the foreseeable future. This is what you learn:

  1. Millions of Americans took mortgages that require only minimal payments in the first few years, and now they cannot afford to make the full payment. They defaulted on the payments and lost their homes. Some lost their investment homes and some lost their primary residence.
  2. As a result, the market was flooded with homes for sale and the real estate market crashed.
  3. Homeowners who were able to keep their home have a lot less equity in their home, if any. They cannot take more loans, and they have no money for discretionary spending.
  4. As a result, the whole economy is heading into a recession.

As you are debating about how to deal with the situation, the decline is going on uninterrupted. A year passes, and the portfolio is down 50%. You go back to the news to assess the situation, and it looks worse:

  1. We are officially in the midst of a recession. Corporate profits are low, unemployment is up.
  2. The tension with Iran is increasing. There is a real fear of war.

You hold onto your investments, checking the news daily, hoping for a solution to come, but things get worse. Your portfolio just reached a 60% decline! The explanation:

  1. The world is consuming a lot more energy, while the tensions with major oil exporting countries are only increasing. There is a rapid increase in oil prices. The price per barrel just crossed $150 (up from $60), resulting in a collapse of economies all over the world.

You see in the front page of the investment magazines: “We are facing a New Reality”. “We have never seen anything like this before. A new reality requires a new way of thinking and planning.” People are rushing to rescue the rest of their money from the declining stock market.

What would you do? Before reading the answer, please try hard to envision this situation. Try to digest all the emotions, information, news and talks around you. How would or should you handle this situation? Would you sell your whole stock portfolio to stop this stress and the very real risk of further declines? Would you sell part of the portfolio? Is it smart to keep holding on to the portfolio as it is going straight down?

I should emphasize that this scenario is very possible. There is no reason to think that each of the things above could never happen. There is also no reason to believe that there will not be declines worse than we have seen in the past few decades. The big question is: Did your investment plan take into account such a possibility? Should you keep following it blindly?

 

Answer. As long as you have a well thought out plan, you can do the following:

  1. Avoid obsessing about the news in order to get investment solutions. Your well crafted plan should be the only answer to your investments. Listening to the news very frequently and reading investment magazines that track recent events will not do any good for your investments and is definitely not good for your health.
  2. Open your investment plan and read what it says. It should specify how to deal with recessions. Specifically, for QAM clients, it should specify a certain amount that you should keep in reserves for recessions. If you have more than the amount specified, and don’t intend to spend it soon, add it to the portfolio. If you have less and no source of income to replenish it, it’s fine. For any cash needs beyond your income, you should use the reserves, until the portfolio recovers. Once it recovers, you sell enough of it to replenish your cash reserves.

Why be Optimistic? Please refer to the article “Should you sell your declining stock?” (Hanoch, May 2005) for a detailed explanation for why globally diversified portfolios are always expected to recover.

There is no way to know for sure how long declines can continue despite the continued production of companies. The good news is that the longer or deeper the declines, the faster they are likely to reverse and the bigger and quicker the increases. The more the portfolio declined, the more it makes sense to hold on to it.

In addition, by holding a globally diversified portfolio that reflects whole economies all over the world and avoiding any type of stock selection or market timing, your portfolio declines are likely to be shorter than average.

Test yourself. Look at your investment plan. If you are thinking: “This is my investment plan for normal times, but there are always cases that we cannot anticipate and that require different thinking”, you are setting yourself up for failure. It is too late to plan when you are in the midst of a crisis. You are not only emotionally biased, but you may be in financial trouble if you did not keep enough money outside the stock market, before it declined .

For every $4,000 you take out at a 60% decline, you pay an additional $6,000 penalty (that’s 150%). Explanation: $10,000 declined to $4,000. When taking out $4,000 after the decline you paid a penalty of $6,000. You should keep enough cash in reserves for you to feel comfortable not withdrawing from your stock portfolio during the worst declines, unless there is no alternative. If you have any doubts, you are not keeping enough in reserves, or you do not understand your plan.

Peaceful Investing! Once you set the plan right, you will realize that there are no “New Realities” and there is no need to check the news or reassess your plan for a 5% or even 50% drop. You will not be caught by surprise with declines and will not panic when they happen. You will just accept them as a part of life and go on with your life. If you are lucky enough to have spare income during these declines, you can even make profits of 100% or more during the 2-3 years of recovery, by adding money to your portfolio in the midst of the declines.

Disclaimer: This article refers to globally diversified stock portfolios that stay unchanged (other than rebalancing to the target allocation) throughout all market conditions. The results are not likely to be true when using individual stock selection or market timing. In addition, this article refers to plans written by QAM – different investment plans are likely to require different actions.

Disclosures Including Backtested Performance Data

Who is on Your Side?

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Whether you are looking for someone to manage your life’s savings, or you already have someone, you want them to always have your interests in mind. You cannot afford to question the professional’s interests and you need to have full trust that the person is on your side.

If this foundation does not exist, you will not only lose sleep worrying that your money is in the wrong hands, you will also question every recommendation given to you. This is a practical concern, because you may decide not to follow the professional’s advice at the most critical times. If you do decide to follow the advice, you cannot be sure who the advice is helping more: you or your advisor. For example, if you have a losing investment, the decision about whether to hold onto the investment or sell it hoping for a better alternative can have a large impact on your finances. You cannot afford to question the advice given to you.

There are many titles for professionals providing investment advice. Two main ones include broker and investment advisor. Let’s review their obligation to you:

Broker: Brokers are legally required to offer suitable investments. This seems like a good requirement, but the law gives them significant freedom to:

  1. Not disclose fees.
  2. Not disclose conflicts of interest.
  3. Not get you the lowest cost trades and products.

Brokers can do your trades expensively in order to increase their employer’s revenue or their own income. They can (and often do) sell expensive mutual funds offered by their employer to their clients. These can cost you too much money and have poor returns. Your broker may even steer you towards expensive products that have well hidden fees, including individual bonds.

Brokers are compensated directly by their employers, not by you. As a result, they have in the first place their employer’s interest in mind when giving you advice. Many are good and intelligent people, but they may be pressured by their employer to sell you products that maximize the company’s revenue.

A common compensation arrangement requires that you pay a commission for transactions. This creates a potential for a conflict of interest that is difficult to resolve – the only way for such a broker to earn a living is to get your commissions, but it is usually in your best interest to minimize the number of transactions done in your account.

The Securities and Exchange Commission (SEC) requires that your broker provide you with the following written disclosure: “Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours.” Please consider the implications.

Investment Advisor: Registered Investment Advisors (RIAs) are legally obligated to act as fiduciaries. They have to provide objective financial advice and to put your interests before their interests. They are legally obligated to disclose their fees and any conflict of interest they may have. They also should get you the lowest cost trades, unless it is not in your best interest.

You may prefer to work with Independent Fee-Only Advisors – advisors that only charge a fee for service and report only to you. Specifically, they do not charge commissions for selling you products. This can help ensure that they make money when they make you money, not when they trade, ensuring that they get paid for helping you.

Registered Investment Advisors are obligated to provide the SEC (Securities and Exchange Commission) an annual update with information about their business. They file a form called “ADV” – a form that you should have seen before if you are working with an investment advisor. You are encouraged to review it.

There are many other titles out there. The following one is important to note:

Financial Advisor: A title commonly used by brokers, giving the impression that they are professionals who provide you with financial advice. Unfortunately, brokers and other salespersons are legally allowed to use this title, despite the fact that their first obligation is to their employer and not to you.

Wealth Manager, Private Client Specialist: There are many more titles in use. Whatever the title is, make sure to ask: “Do you have a legal obligation to act in my best interests?” Some of them do, some don’t – the titles don’t help answer this question.

Notes:

  1. Making sure that your advisor is legally obligated to be on your side is only the first step in the evaluation. There are many other conditions you should set before you let people advise you regarding your life’s savings. You should have a strong sense of trust and comfort with their knowledge. They should be upfront and open about all questions regarding their business, their investment principles and all possible costs to you. They should have time to talk to you and explain things in simple words. You should be very selective when dealing with such an important topic.
  2. This article is not intended to provide comprehensive advice regarding selection of advisors – it only touches on a few important issues.

To Summarize

You should ask all people that provide you with financial advice: “Do you have a legal obligation to act in my best interests?” If the answer is no, you should be very careful when following any of the person’s advice and consider hiring someone who is legally obligated to always be on your side.

Disclosures Including Backtested Performance Data

What Causes Momentum?

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What is Momentum? Momentum is the tendency of stock prices that went up recently to continue going up, and the tendency of stock prices that went down recently to continue going down.

How can you use Momentum to make money? You can look for stocks that increased in value recently, and invest in them with the expectation that they will keep increasing in value. Similarly, you can look for stocks that declined in value recently, and sell them short with the expectation that they will keep declining in value. This technique provides the potential of making money during up and down markets.

Why is there Momentum? Momentum exists because people tend to believe that what happened recently will be true in the future. They see a stock that went up significantly and view it as a good stock that is worth buying. Similarly, when people see a stock decline, they view it as a bad stock that is not worth buying. People imitate what others did before making momentum the “herd effect”.

A magnified effect. The longer stock prices increase without any change in direction, the more they become overvalued. The longer this happens, the more people get excited and continue the momentum. When this period becomes very long, the danger is magnified proportionally.

A great example is the increase in Large Growth US Stocks in the 90’s. Their price went up so far out of line with the value of the companies that a significant crash occurred in 2000 to correct it. Another example for the opposite direction is the decline from 2000 to 2002. The stock prices declined so much that by early 2003, a dramatic increase started to correct the decline.

Does Momentum work? Momentum works more often than not. Usually stocks keep going in the same direction they went recently. But this does not continue forever. Every run up or down in stock prices changes direction once in a while. In order to use the momentum effect beneficially, you have to accurately predict the turning points. Specifically, you need to sell the stock before it starts declining, or buy back (the reverse of short selling) the stock before it starts increasing in value. The latter is critical because the loss from a short sell can be unlimited!

Conclusion. Since it is very difficult to consistently predict the turning points of the market, it is very difficult to consistently outperform the stock market by counting on the momentum effect.

To Summarize

Our basic intuition and instincts are our biggest enemies in investing! By setting them aside and using cold logic, you can benefit from financial peace of mind at all times. It is best to create a portfolio and stick to the allocation at all times.

Disclosures Including Backtested Performance Data

Preparing for a Long Life

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[Updated February, 2011]

This article will help you answer the question: when can I retire? In order to retire you need sources of income to support you for the rest of your life. Part of your income needs can be covered using Social Security payments, pensions and any other lifetime guaranteed income you may have. The rest depends on periodic withdrawals from your investment portfolio.

For example, let’s say you need $100,000 gross income per year, social security provides you with $30,000 and you have pension payments of $30,000. Your portfolio should supply you with $100,000 – $30,000 – $30,000 = $40,000 per year.

If your portfolio can handle annual withdrawals of $40,000 without depleting, you may be able to retire. If your portfolio is worth $1,600,000, your portfolio should handle a withdrawal rate of: $40,000 / $1,600,000 = 2.5%.

If you have a portfolio that consistently tracks certain asset classes, your investment advisor may be able to determine a conservative withdrawal rate that should allow it to survive the withdrawals every year, including severe recessions, and never deplete. For example, this rate is 4% (growing with inflation) for the portfolio Long-Term Component by QAM. Note that this is a measure based on historic behavior and cannot be guaranteed. Therefore, it is important to choose a conservative percentage.

If you withdraw 4% of Long-Term Component annually, growing with inflation, your portfolio is likely to last forever. You may withdraw a larger percentage of the portfolio, if you want it to support you for the rest of your life and not have any of the principal left. For any given number of years you choose to support, your investment advisor can calculate the withdrawal rate allowed. Here are a few examples:

For a portfolio that can survive 4% annual withdrawals without depleting, what is the withdrawal rate that will deplete it over different time periods?
Life Expectancy Percentage Withdrawal Allowed
20 years 7.36%
25 years 6.4%
30 years 5.78%
40 years 5.05%
50 years 4.66%
100 years 4.08%
200 years 4.002%
Infinite 4%

Most planners prepare their clients for at least 30 years of retirement (e.g., ages 65 to 95). The total difference between the annual income available for 30 years of retirement and an infinite retirement is 23% (= 1 – 5%/6.51%). If you are preparing for a 30-year retirement, you can delay your retirement by less than 2 years (statistically) and be prepared for an infinite retirement.

This low added cost is a reason to always prepare for an infinite retirement.

There are 3 important benefits:

  1. As you grow older, instead of seeing your available money deplete, you can see it grow indefinitely. This can increase your financial peace of mind throughout your retirement.
  2. This is a conservative approach that provides an extra cushion in case there is an extreme recession that has never been seen before.
  3. Your heirs and/or your favorite charities can enjoy the full principal of your retirement savings.

Note that the analysis above was prepared for a specific portfolio, but the general results are the same regardless of the portfolio assumed. In reality, the referenced stock portfolio is likely to grow much faster than 4% per year (even in real terms), but you should keep the withdrawal rate at this level or lower because there may be very bad years in the beginning of the retirement period. A detailed analysis should be performed for the specific portfolio used.

To Summarize

Preparing for an infinite retirement is much cheaper than you might expect and can have huge rewards in terms of added peace of mind and the ability to provide a handsome heritage.

Disclosures Including Backtested Performance Data