Declining Worth of Hedge Funds

Maybe it’s because of the high fees, persistent underperformance, or the recent spate of movies about the greed of Wall Street. Whatever the reason, investors are withdrawing money from hedge funds. Maybe some of them see the light at the opposite end of the spectrum, with low cost index tracking funds. Aside from Vanguard, the 800 lb gorilla, other brokerages are getting into the act as well, including my own Fidelity. Undoubtedly, they are responding to consumer demand. Those who have read my book on wealth know how much I emphasize the importance of tax-optimization and low fees are to returns. Maybe more people are naturally starting to realize this.

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Should You Dollar Cost Average?

It’s an interesting question. Let’s say you are an investor looking to start investing for the first time. Should you invested a large sum in bulk or purposefully trickle in a little bit every month?

First, we should recognize that not everyone has the luxury of doing this. Most of us in the accumulation phase of life have to invest alongside our biweekly paychecks. There’s no choice except to trickle in our money.

But what if you’re blessed with a sudden large windfall, say from an inheritance, a house sale, or lottery? Is there really an advantage to investing piecemeal or all at once?

Vanguard ran a study back in 2012 about this. By doing historical simulations on different strategies dating back to 1926, they found that lump sum investing outperformed dollar cost averaging in every country they studied over all time horizons, for all mixes of stocks and bonds.

The reason is that on average, the market goes up more than it goes down. Therefore, by maximizing time in the market by investing in a lump sum, we are able to enjoy the market’s rewards earlier. Delaying also means missing out on dividends as they are distributed. The only time that dollar cost averaging makes sense is if we time our investments to match a downturn, but if we knew there would be a downturn, why not delay 3-6 months when the market is lower and then invest lump sum? Dollar cost averaging makes no logical sense.

Vanguard though does note that even though it produces poorer returns, dollar cost averaging can be helpful in calming the nerves of some jittery investors because it reduces short-term volatility. That’s literally the only benefit it provides.

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Is Buying a Home Overrated?

Famed economist Alex Tabarrok certainly seems to think so. He cites a few reasons for why housing may not pay off as an investment:

  1. Significant concentration of wealth in a single asset
  2. Locking one in place geographically
  3. Sentimental attachment (preventing more rational choices regarding when and how much to sell)
  4. Historically appreciating less than the stock market

These are generally true, and I cite in my book all of these factors as caveats for any buyer to be aware of when considering a house. Indeed, a house is more than a place to live – it’s a complex investment at the same time, even after the mortgage has been paid. Choosing to buy poorly can lead to being underwater, unable to sell, and unable to move.

What Tabarrok neglects to mention is that the quirk of leverage allows us to dramatically increase our profit in the first few years. The government also subsidizes housing by making mortgage interest payments deductible from one’s taxes.

In terms of comparing housing to stocks purely in terms of financial payoff, let’s crunch the numbers with a bunch of assumptions. In general, a house rises slower but with less volatility and less significant drops in price as compared to stocks. So we can assume that our property value increases by 10% each year, while our rental yield is 6% of the total property price. Reserve 2% of the house value for expenses that arise (interest payment, property tax, advertising, maintenance). Here’s what it would look like, assuming a base $200,000 starting price and 20% down payment:

Year House Value Yearly Rent Yearly Expenses Total Equity % Equity Yield on Equity
1 $200,000 $12,000 $4,000 $40,000 20.0% 30.0%
2 $220,000 $13,200 $4,400 $56,000 25.5% 23.6%
3 $242,000 $14,520 $4,840 $73,600 30.4% 19.7%
4 $266,200 $15,972 $5,324 $92,960 34.9% 17.2%
5 $292,820 $17,569 $5,856 $114,256 39.0% 15.4%
6 $322,102 $19,326 $6,442 $137,682 42.7% 14.0%
7 $354,312 $21,259 $7,086 $163,450 46.1% 13.0%
8 $389,743 $23,385 $7,795 $191,795 49.2% 12.2%
9 $428,718 $25,723 $8,574 $222,974 52.0% 11.5%
10 $471,590 $28,295 $9,432 $257,272 54.6% 11.0%
11 $518,748 $31,125 $10,375 $294,999 56.9% 10.6%
12 $570,623 $34,237 $11,412 $336,499 59.0% 10.2%
13 $627,686 $37,661 $12,554 $382,149 60.9% 9.9%
14 $690,454 $41,427 $13,809 $432,363 62.6% 9.6%
15 $759,500 $45,570 $15,190 $487,600 64.2% 9.3%
16 $835,450 $50,127 $16,709 $548,360 65.6% 9.1%
17 $918,995 $55,140 $18,380 $615,196 66.9% 9.0%
18 $1,010,894 $60,654 $20,218 $688,715 68.1% 8.8%
19 $1,111,983 $66,719 $22,240 $769,587 69.2% 8.7%
20 $1,223,182 $73,391 $24,464 $858,545 70.2% 8.5%
21 $1,345,500 $80,730 $26,910 $956,400 71.1% 8.4%
22 $1,480,050 $88,803 $29,601 $1,064,040 71.9% 8.3%
23 $1,628,055 $97,683 $32,561 $1,182,444 72.6% 8.3%
24 $1,790,860 $107,452 $35,817 $1,312,688 73.3% 8.2%
25 $1,969,947 $118,197 $39,399 $1,455,957 73.9% 8.1%
26 $2,166,941 $130,016 $43,339 $1,613,553 74.5% 8.1%
27 $2,383,635 $143,018 $47,673 $1,786,908 75.0% 8.0%
28 $2,621,999 $157,320 $52,440 $1,977,599 75.4% 8.0%
29 $2,884,199 $173,052 $57,684 $2,187,359 75.8% 7.9%
30 $3,172,619 $190,357 $63,452 $2,418,095 76.2% 7.9%

 

Most of the data, if plotted, would look linear, as we’d expect given our fixed assumptions. However, I’d like to draw your attention to the last column – yield on equity – which is the annual rental income divided by our total equity. This is where leverage comes in and amplifies our gains. Normally a business generating $12,000 per year in gross yearly income (or $8,000 net) would cost more than $40,000 to buy, but we were able to finance it with a mortgage. As we plow our profits back into paying off the mortgage, we build our equity. This happens very rapidly in the first few years, and tapers off over time approaching the 6% yield, as our equity approaches 100%.

Visually, we can plot the exponential rise in equity in the first few years:

equity over time

This is why some house flippers sell the house after a few years, when the bulk of the equity accumulation has happened. They then take the profits and split that into buying 2-3 houses, starting the leverage process all over again from the beginning and benefiting from a 20-30% yearly increase in wealth into perpetuity. This rate just about doubles stocks’ average yearly gains.

Banking on leveraged gains like this can pay off handsomely, but it can backfire if prices drop rapidly. This is why this strategy can only be used on a (mostly) stable income generating asset like housing, where prices and rents rise slowly but surely.

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When Housing Becomes Unaffordable

A friend recently sent me an article detailing how Seattle has a major homeless problem (with the accompanying scourges of drug use, violence, and property crimes). It’s definitely sad to see. I’m intimately familiar with the growing 21th century phenomenon of unaffordable housing, having grown up in the SF Bay Area, which dealt with these issues decades before Seattle (and Portland). Realistically, I anticipate that the forces driving unaffordability will only get worse over time. Real estate in downtown cores of desirable cities, like Seattle, San Francisco, Vancouver, and London, is priced as an investment asset rather than a place for locals to live. There’s just no way middle class workers can compete with large pensions, hedge funds, sovereign wealth funds, and billionaire tycoons for property.

What can we do? Certainly economists have developed ways to combat homelessness through subsidies and affordable housing mandates. Others seek to curb foreign investment in housing or extract large taxes from absentee/nonresident homeowners. Those strategies will only go so far if we don’t address the fundamental issues of inequality. There’s simply too much wealth sloshing around looking for things to invest in. Nevertheless, I try to stay away from politics on this blog, instead preferring to approach things from an microeconomic perspective. As individuals, we’re unlikely to have much effect on changing things at a larger systems level, so all we can do is adapt, adjust, and try to survive.

How can we do that? Check out my book on wealth for tips on how to make enough money to buy that expensive house, how to structure the mortgage, as well as learn lifehacking tricks for how to compensate for expensive housing.

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Illustrating Why Not to Pick Stocks

If you’ve read my book on wealth, you know that I highly discourage trying to time the stock market or to cherrypick which stock to buy. In today’s stock market, we have another great example of why. The market overall has been wobbly, with a few stocks (Facebook, Google, Amazon) shooting into the stratosphere and the rest of the market essentially in recession-level pricing (especially the energy and industrial sectors). This is great if you have concentrated your wealth correctly in those few stocks that are doing well, but most people didn’t guess right and are instead dealing with huge portfolio losses.

Let’s illustrate this point with a simple example. Assume a stock market with four different stocks.

  • A has dropped by 20% in the past year
  • B has dropped by 25% in the past year
  • C has gained by 150% in the past year
  • D has dropped by 10% in the past year

Assuming that each stock is weighted equally in the market, this means that the entire stock market as a whole has increased by 23.75%, all on the back of stock C.

Now we have fifteen different people each with a different approach to the stock market, scattered on the spectrum between concentration and diversification. We also list their gains. For math/stats geeks, we are essentially enumerating all the possible combinations of choosing among four options.

  • Person 1 concentrates all wealth in stock A (-20%)
  • Person 2 concentrates all wealth in stock B (-25%)
  • Person 3 concentrates all wealth in stock C (+150%)
  • Person 4 concentrates all wealth in stock D (-10%)
  • Person 5 buys two stocks (A and B) (-22.5%)
  • Person 6 buys two stocks (A and C) (+65%)
  • Person 7 buys two stocks (A and D) (-15%)
  • Person 8 buys two stocks (B and C) (+62.5%)
  • Person 9 buys two stocks (B and D) (-17.5%)
  • Person 10 buys two stocks (C and D)  (+70%)
  • Person 11 buys three stocks (A, B, and C) (+35%)
  • Person 12 buys three stocks (A, B, and D) (-18.33%)
  • Person 13 buys three stocks (A, C, and D) (+40%)
  • Person 14 buys three stocks (B, C, and D) (+38.34%)
  • Person 15 is the closet indexer and buys all four stocks equally (+23.75%)

In short, the more stocks you buy, the closer you get to the index average and thus are more likely to get a positive return. The fewer stocks you buy, the greater the chances of scoring a home run hit, but with a greater chance of losing money as well. The effect is magnified even more when only 3/500 stocks in the S&P index are outperforming the index. This example illustrates the value of diversification. In a world where most of the gains come from a few stocks, and where most of the gains come on a few days, missing out on those days or those stocks can be catastrophic for the overall portfolio. This should serve as yet another point in why low-cost index funds, with their instant diversification, are the only correct way to invest in the market.

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Turbocharge Your Retirement with the “Backdoor” Roth

For those of you who have read my guide to wealth, you’ll remember that one of my points of emphasis is to save for retirement. Tax-deferred (traditional) and tax-free (Roth) 401k and IRA accounts allow us to minimize the taxes we pay in a legal manner. This allows our earnings to compound and grow faster than they would in a taxable brokerage account. Of the two, I like the Roth as it takes away all future tax headache as everything inside is tax exempt forever! It also has many advantages when drawing down (no required distributions) and as part of an estate package (automatic step up in basis).

Unfortunately, the government recognizes that the Roth IRA offers such good benefits that it has built in strict income eligibility thresholds. Singles making more than about $130,000, and married folks making more than about $190,000 can’t put anything into a Roth IRA. A Roth 401k remains a (great) option, but not all employers offer it.

For those who don’t qualify or are otherwise prohibited from contributing to a Roth IRA, we need to go in through the back door. Here are the step by step instructions:

  1. Open a traditional IRA
  2. Make a nondeductible (after-tax) contribution of $5,000 or $6,500 (depending on age), but don’t buy anything with the money yet
  3. Immediately convert the account into a Roth IRA
  4. Invest the money

Voila. Absolutely no difference in the end between this and a direct Roth IRA contribution. The back door approach exploits the loophole that tradition -> Roth IRA conversions don’t have the same income eligibility limits that Roth IRA contributions do. Now anyone without regard for income can take advantage of the great features of the Roth IRA.

Should you take advantage of this? The general rules of traditional vs Roth apply. If you plan on becoming wealthy in the future with the help of my book, you will have plenty of income-generating assets. Having as much of your wealth sheltered from tax in Roth IRAs helps to optimize your tax situation in that setting.

Keep in mind one big gotcha. If you have a large traditional IRA with a mix of deductible and nondeductible contributions, the “pro-rata” rule comes into effect. This means that you can’t just choose to convert only the nondeductible portion. If you have a $10,000 IRA with half of it as deductible (pre-tax) and the other half nondeductible (after-tax), a conversion of $5,000 will incur tax on $2,500. The best workaround is to keep the size of the IRA small and convert all of your contributions each year, or suck it up and convert the whole IRA.

Keep in mind that the pro-rata rule doesn’t apply to our 401k investments. This may be one situation where it’s advantageous to hold off on rolling over the 401k to an IRA when we change jobs.

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