Peter answers listener questions in this Mailbag Episode.
Listen now and learn:
- Why housing is consumption and not an asset
- How to think about the ideal investment mix for retirement
- How to prioritize paying down student debt vs investing
Episode
Outline
Welcome to The Long Term Investor. I’ve been collecting questions from readers, listeners, and social media followers. I had originally planned to answer a question or two at the end of each episode, but it was feeling a bit forced, so instead I’m going to have the occasional mailbag episode.
This first mailbag episode is primarily a mix of questions that were asked in response to past episodes.
This question was in response to Episode 2: How I Invest My Money…Can you elaborate on “a house is a form of consumption?” I get the arguments that buying a home is not an investment. But, to me, consumption is spending $18 on a bottle of wine that quickly disappeared.
I really liked this episode, which was based off a really popular blog post I wrote, which I’ll link to in the show notes: https://peterlazaroff.com/how-i-invest-my-money/
I’m glad this person agrees with me that your primary home shouldn’t be viewed as an investment. It’s a place to live.
But in that same vein, I don’t really think of my house as an asset that I’ll ever tap. Sure, I’ll build up equity over time that I might theoretically use in retirement if I downsize, but I think it’s more likely that if I downsize someday, it will be to a smaller place with a higher cost per square foot.
That’s what I see happening with most of the people I work with “downsizing.”
So even though my house is on my balance sheet, I’m never planning to tap into the value of my home, so I mentally account for it more as consumption.
I think of it as a use asset – one that is used but has no productive monetary value. A car is a good example of a use asset, the assumption being you will always need a car.
I will always need a place to live.
The other thing is that owning a home costs a lot of money. I’m not just talking about property taxes or a mortgage. You decorate it. You repair it. You remodel it. But it’s just a place you live.
Now, I don’t list other use assets like our cars on our balance sheet, but I do keep the house on my balance sheet listed at the purchase price. Part of this is because there is a healthy sized liability hanging out on the other side of my balance sheet, but I guess I’d keep it on the balance sheet even once the mortgage is paid.
This one is also in response to the How I Invest My Money episode: Hypothetically speaking, if you inherited $1 Trillion, would you change the way you do things considering how you invest your own personal capital right now?
Because I basically only own a single mutual fund that is 100% equities and globally diversified, I’d have to think $1 trillion would change that equation, if for no other reason that I would want to pay far less than what that fund currently charges if I’m sticking $1 trillion in it.
While my existing plan is to go a 70/30 portfolio at age 50 (unless we are in the midst of a bear market), I probably wouldn’t need bonds if I had a trillion dollars.
I’d probably try to buy a MLB franchise, but I’d also be the type of owner that plows money into the organization with a greater desire for championships than profits, so I’m not sure how much of an investment that would really be.
I could also see myself making some private investments in things that interest me where I could also make some sort of personal contribution.
Whenever I have that classic, “if I won the lottery” conversation that everyone has from time to time, I’ve usually pictured it being something closer to $10M or $20M (apparently my dreams are boring), in which case I don’t think I would change my strategy. Again, I might go to the fund company managing my fund and perhaps have them do a SMA at a much lower fee, but I’d still stay 100% stocks and I’d probably scrap the plan to ever buy bonds.
This was a question was sent to me in response to Episode 8: Investing For Inflation…”As a long term investor who benefits from ‘compounding,’ how does one also integrate the negative impact of inflation on the net result? I suspect that the rate of compounding is correlated to a great degree with the rate of inflation, which negatively impacts the return from compounding. Can you explain that relationship and impact? I rarely see mention of inflation when reading about the “8th Wonder of the World” aka compounding.
Great question. You’re correct that most people (myself included) talk about compounding nominal returns, but it’s really real returns (nominal return minus inflation) that matters.
Inflation lowers your real return every year, so yes it does act as a drag on the compounding of your long-term purchasing power.
The most relevant place where we integrate the negative impact of inflation is in the capital market assumptions that drive our financial planning models.
In our planning models, we currently assume a long-term average real return of a 7% for global equities and 1% real return on global bonds, which is largely in line with long-term historical averages. You could easily make an argument that real returns will be lower over the next ten years as a result of lower expected stock/bond returns or higher inflation or some combination of both, but longer multi-decade real returns don’t deviate much from that long-term average.
I like using real returns in our planning models because it means there is one less thing to predict – in this case, I don’t need to forecast whether inflation will be higher or lower in the near term or over any periods for that matter. Instead, I only need to make an assumption about the premium stocks provide above inflation.
This question came in response to Episode 11: Where to Save For Retirement….You spend a lot of time talking up Health Savings Accounts (HSAs), but is it worth using a HSA if I might need to spend some of those dollars now?
It totally depends. If you’re in a HDHP, then you should definitely use your HSA to get the income deduction. But if you know that you need to use your HSA contributions for current medical expenses, then you probably shouldn’t be investing the funds.
As a rule of thumb, if you have money set aside for something in the next handful of years, that money should remain in cash to eliminate the risk of it being worth less than you need it to be, especially if the timing of the expense or goal isn’t flexible.
When I talk about using an HSA as a retirement savings vehicle, that’s really for people that can afford to leave their HSA contributions invested while paying for medical expenses entirely out of pocket.
The other thing is that some people shouldn’t opt for a HDHP plan just to get access to a HSA.
I think the equation is pretty simple for deciding whether or not a HDHP makes sense, but it might be easier to digest in written form, so I’ll be sure to put this in the show notes:
Choose HDHP if: [Expected Medical Expenses] < [Savings in Premiums + Employer Contributions + PPO Deductible]
But if your expenses are going to be greater than that, you should stick to a PPO plan and not worry about the HSA strategy.
You can get a decent estimate of your expected medical expenses using one of the calculators on your insurers website.
What’s the ideal mix for retirement?
I’ve gotten a lot of forms of this question, so I simply too the shortest version of it here.
There probably is an ideal investment mix for this reader and the others that effectively ask this question, but without knowing details of this person’s situation, it’s impossible to know. It would be like a doctor prescribing medicine without ever diagnosing the patient.
The way that we determine the ideal mix for someone’s retirement is by creating a Living Financial Roadmap that considers where you want to go and adapts to reflect your changing life situation and objectives.
I have a pretty good resource that I can link to in the show notes that walks through the inputs to come up with this ideal investment mix.
But something I can say at a high level about people entering retirement is that the biggest risk to any allocation and financial plan is something called sequence of return risk.
In the few years leading up to retirement and the few years immediately after retirement (assuming that’s the point at which you start drawing down from your portfolio), a bear market can dramatically lower your portfolio’s lifetime income generating ability.
If you are forced to take withdrawals early in retirement when your portfolio’s value is 20+% down, then the impact from those withdrawals will compound over the years, permanently impairing your portfolio to some extent.
For this reason, we typically recommend having 1-2 years of cash on hand at retirement so that you can spend from this bucket if there is a recession early in retirement while you allow your portfolio time to recover.
One last thing I’ll mention about an ideal retirement mix, is that the allocation you have on your retirement doesn’t necessarily need to remain static for the rest of your life. As you age and it becomes clear that you will outlive your assets, you can adjust the time horizon of the portfolio to reflect your heirs’ time horizon since they will ultimately be spending the money.
I noticed you lightly chimed in on Twitter about the CFA vs MBA, but I noticed you have a CFA and CFP. Why did you get those credentials and is one more valuable than the other?
So there was an article on Bloomberg shortly after the CFA Institute released the CFA pass rates, which fell to historic lows. The article makes a pretty pointed case that the CFA isn’t as good as an MBA.
I can’t say a lot about getting an MBA because I don’t have one, but the author also never got the second exam, so I felt like he was drawing some conclusions that weren’t necessarily universal truths.
It’s not a black and white issue – it totally depends on the person.
For listeners that aren’t familiar with the CFA designation, it stands for Chartered Financial Analyst.
When started the CFA Curriculum, I was an Investment Analyst, so the content was highly relevant to my job function. For those that aren’t familiar with the CFA Curriculum, it is a series of three exams that used to be given just once a year, but now I believe it’s given a few times a year (although you’ll have to fact check me on that).
The website says the average study time per exam is 300 hours and pass rates are fairly low. The May 2021 pass rate for the first exam was only 25%. The second exam was 40% and the third exam was 42%.
So if someone is considering the CFA exam, be ready to commit some serious time.
I feel like I completely disappeared from friends and family every year for 6 months. And while it could theoretically take just 3 years to pass all three exams, the pass rates suggest that most people don’t do so.
In fact, the CFA website says that only 20% that start complete all three exams.
In my role as Chief Investment Officer, the CFA comes in handy. I don’t know that I would have gotten where I am today without it.
That said, the CFP designation, which stands for Certified Financial Planner is far more useful for providing wealth management and financial planning advice.
Shortly after I finished the CFA Curriculum, I started working with clients as a lead advisor, so I sat for the CFP the following year, so it’s served me well over the year as well.
This person is asking if one designation is better than the other. In my opinion, the CFP is more valuable if your primary function is being a financial advisor. For me, the CFA has probably been more important given my role as Chief Investment Officer.
But I would agree with the Bloomberg article that there are probably too many people taking the CFA exams that shouldn’t be or at least have unrealistic expectations of what the designation will do for them.
Are there any best practices people should keep top of mind when beginning the refinancing process. Are there any checklist items that people shouldn’t forget to do?
I think the most important thing is to do the math to make sure refinancing is worth the cost.
There’s all sorts of costs involved: cost of appraisal, loan origination fees, recording fees, taxes, and so on. Some lenders require you to pay the fees up front, while others bake them into the loan in the form of a higher loan balance or higher interest rate.
There isn’t a right or wrong way to cover the fees, but you’ll definitely want to crunch some numbers to make sure the monthly savings will be worth the expense, especially if you’re not planning to stay in the home long-term.
There’s a pretty simple way to calculate a breakeven number that tells you how many months you need to stay in the home to make up the cost of refinancing:
Start by subtracting your expected monthly payment from what you currently pay — which is what you would save per month. Then add the total cost of the fees. Finally, divide that total by the monthly savings.
If, for example, your breakeven number is 18, it will take you 18 months before you’ve recouped your refinancing costs. Only after that 18-month period will you actually start realizing the savings.
A good rule of thumb to use to determine if a breakeven period is reasonable is to keep total costs divided by the monthly savings to 24 or less. It should take no more than two years for you to break–even on a refinancing.
If you aren’t planning on living in your home for at least as long as it takes to breakeven, then it would be better to keep the original loan rather than refinancing.
I recently turned 70 and read that my generation are the biggest targets of cybercrime. Are there steps I should be taking to protect myself?
While the best practices for keeping your accounts safe are always changing, they boil down to common sense and a healthy dose of suspicion when doing things online. There are a few best practices we share with clients that I can outline.
We can’t use this content for show notes because I haven’t edited from the original source: https://www.schwab.com/resource-center/insights/content/10-tips-keeping-your-accounts-secure
- Think before you click
One wrong click could drain a financial account, expose you to identify theft, or install malware on your device.
These so-called phishing scams successfully trick too many people into revealing highly sensitive information, including credit card information and passwords.
- If you get an email you’re not expecting, don’t click on any links or accept any offers.”
- If an offer seems too good to be true, it probably is…And no reputable company will reach out electronically to request sensitive personal information, so that’s another red flag.
A few ways you can confirm the legitimacy of the source, is:
- Double-check the email address, which can differ by just a single character from an account you know.
- Hover your cursor over any links—without clicking—which will reveal the underlying URL (that may or may not jibe with the one it’s purporting to be).
- Activate your email program’s spam filters, which have become adept at separating out suspicious and unsolicited emails.
- You can always call the company back at a known or publicly listed number rather than risk responding directly to a fraudster
Beyond email, be aware of other forms of attack—including fraudulent SMS texts (a.k.a. “smishing”), voice calls (“vishing”), and “spear phishing,” or the practice of mining social media posts for personal information to create more targeted and potentially convincing emails.
- Use Two-Factor Authentication Where You Can
- Be password smart
The first rule of passwords is: Never share passwords. And while most people know not to use simple passwords like “1234” or their birthday, they still don’t create nearly strong, hard-to-guess passwords that don’t use personal information.
I’m a huge fan of LastPass, which creates, stores, and even autofills unique passwords on all of my devices.
Password managers can create, store, and even autofill unique passwords for as many sites as you choose.
- Keep your devices up to date
Most desktop and mobile operating systems—as well as individual applications—offer periodic updates, which frequently include security patches as new vulnerabilities are discovered.
Failing to do so can be costly—as up to 143 million customers of one credit reporting agency learned the hard way in 2017 when their Social Security numbers, birthdates, and home addresses were exposed though a security hole for which a software patch had been issued months earlier.
And finally, when it comes time to discard old gear, don’t forget to restore the device to factory settings in order to securely remove all personal data. Wifi is another thing to think about.
- Fortify your home network
Don’t overlook the internet connection that powers your home. Newer routers—devices that stream data from your internet provider to your various devices—tend to have stronger encryption settings and offer automatic updates, which manufacturers may discontinue for older models.
Your router, too, should be secured with a strong password—as should internet-enabled doorbells, speakers, thermostats, and other smart devices, whose default passwords are often as simple as “password.”
- Protect yourself in public
Cyber criminals can easily set up a decoy Wi-Fi network containing the name of the airport, hotel, or restaurant from which you’re trying to connect. “Instead, tether your laptop or tablet to a ‘personal hotspot’—a feature of many smartphones,” Victoria says.
It’s one thing to use public Wi-Fi for innocuous tasks like checking sports scores—but avoid logging in to financial, shopping, and other sensitive accounts.
- Talk with your children …
While most children grow up with the internet, they may not be aware of its potential pitfalls or their own vulnerabilities to them. Start early—and be frank about the risks involved and your own experiences online.
Our 8 year old is starting to spend more time online with his iPad, so we are constantly reminding him not to tell anyone his name, the name of your school, or your home address, and never agreeing to meet anyone in person who you’ve only ever met online.
- Freeze Your Credit
You might also consider instituting a “credit freeze” for you and your family members with each of the three agencies, which can prevent new accounts that require a credit check from being opened in your name without your express permission.
I’m still paying off my student loans. What’s the bigger priority: paying off my loans in full or starting early on investing?
This question came in prior to the last episode, which was Episode 11: Where to Save For Retirement
I’ve actually written on this a few times before, most recently for The Wall Street Journal, so I’ll drop a link to the free version in the show notes: https://peterlazaroff.com/pay-off-student-loans-or-invest-heres-how-to-decide/
I’ll also link a recent interview I did with Money: https://money.com/pay-off-student-loans-or-invest/
Optimizing the amount of you use to invest versus pay down debt depends on the interest rate, term, and payment features of the loans. The optimal choice for you also depends on the savings vehicles available and the expected return on the investments you make into them.
Evaluating these variables can help you arrive at the optimal solution from a purely mathematical perspective.
However, the decision is based as much on your personality as it is the math – after all, we don’t live in a spreadsheet.
Some people prefer the idea of being debt-free. Others will prefer to optimize the return of their savings. Perhaps you might like the idea of doing a little bit of both.
With that in mind, here is my personal preference on how to prioritize paying down student debt versus investing.
- Contribute to your employer sponsored retirement plan up to the match.
- Create an emergency fund.
You can’t ignore the importance of having some money available for unexpected expenses, regardless of whether or not you have debt. In fact, allocating some portion of your excess savings to an emergency fund takes priority over any extra debt repayment or additional investing.
- Pay down private loans with the highest interest rates and least payment features.
If your interest rate is above 8%, then it probably makes sense to allocate your remaining savings towards extra principal payments on these costly loans. If your interest rate is between 6% and 8%, then perhaps allocating half of your excess monthly savings is enough before investing more.
At this stage, you want to hold off on prepaying your federal student loans. Private student loans typically charge a higher interest rate than federal student loans. The also tend to offer less payment features commonly found with federal student loans.
These benefits include payment and interest deferments while in school or returning to school, loan forgiveness for certain professions or public service work, income-based repayment plans, balance forgiveness at death, and situational loan payment forbearance.
Private student loans sometimes have a few of these features, but it’s rare they have all of them. The lack of payment flexibility and features also makes private loans a better candidate for consolidation and refinancing. (Federal student loans often lose their payment features when consolidated.)
- Make the maximum contribution to your employer sponsored retirement plan.
Employer-sponsored retirement plans are often the cheapest place to access a diversified set of investments for retirement. Employer sponsored retirement plans such as a 401(k) plan offer tax-deferred compound growth, so it’s worth taking advantage of this benefit to reduce your tax burden. Same is true of 403(b) and 457 plans.
- Pay off federal student loans with interest rates greater than 6%.
After maxing out your contributions to your employer-sponsored retirement account, then you can knock out your federal student loans charging at least 6% interest.
If you have a federal student loan with an interest rate below 6%, then simply make the minimum payments until the debt is repaid and allocate any excess cash flow to your other goals like investing for the future, building your emergency fund, or perhaps even buying a home. Lower interest rate federal student loans are not restrictively costly, especially when compared to the potential return in the stock market.
There’s one exception to this rule: if you work in a profession where your loans will be forgiven after a certain number of years, just make sure to follow the rules of the program to ensure your balances will be forgiven.
Should You Invest for Retirement or Pay Off Your Student Loans?
The above order of prioritizing savings largely ignores common emotions people feel with debt, but again, humans don’t live in spreadsheets. The psychological draw from being debt-free is hard for many to ignore.
It’s common for people with a relatively small amount of student loans to prioritize paying down that debt just to free themselves mentally from the obligation.
Others may prepay a loan more aggressively if they suddenly come into the financial resources to do so, and they want one less thing on their plate.
Some also feel a greater sense of control over their finances by being debt free. This is particularly true when a large debt is financially limiting. Paying it off early creates more control of their finances and optionality for their futures.
While there is no perfect answer, it’s important to remember the choice between paying down student debt or investing for the future doesn’t have to be a mutually exclusive decision. A mix of both is probably going to be the mathematically and emotionally optimal solution.
Resources
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About the Podcast
Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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