The question of whether to buy or rent a home is of enormous economic significance for most families. Home equity represents the vast majority of American families’ net worth (see chart below). In a post in mid-2011, I discussed some of the major economic variables in the decision to buy a home. My conclusion was that buying a home made sense, but not because housing generates attractive long-term investment gains. The long-term data suggests houses have historically increased in value at a rate only slightly higher than inflation. The best arguments for owning a home, I argued, were historically-low interest rates, the mortgage interest tax deduction, and the inflation hedge provided by locking in your costs for shelter for the long-term. Since that time, housing prices and rents have risen dramatically. In the past week I read two thoughtful and interesting articles on the economics of owning a home that motivated me to revisit this topic for 2014.
In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income. The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic. These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.
The series of articles in Money kicks off with perspectives by Wade Pfau. Pfau’s introductory piece suggests a difficult future for American workers. A traditional rule-of-thumb in retirement planning is called the 4% rule. This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation. Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years. It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds. The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds. The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule. For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds. The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average. High P/E tends to predict lower future returns for stocks, and vice versa. For a detailed discussion of these relationships, see this paper. In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement. I also explored this topic in an article last year.
Income inequality is increasingly acknowledged as a key economic issue for the world. The topic is a major theme at Davos this year. Economic inequality is also an increasingly common topic in U.S. politics.
A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously. The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult. The numbers have not changed in three decades.
On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale. The richest 1% of Americans now own 25% of all of the wealth in the U.S. The share of national income accruing to the richest 1% has doubled since 1980. In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.
Why is this happening?
One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio. In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small. Over long periods of time, however, the ups and downs of the market tend to average out. The effect of those costs however is persistent and continuous.
There are a range of costs associated with investing in funds beyond the stated expense ratio. In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds. Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising. He has written similar pieces in the past. In this article, he provides updated numbers, backed up by a range of academic analysis. His summary of costs is provided in Table 1 of his article:
There are three types of expenses, in addition to the standard expense ratio. First are transaction costs, which are simply a fund’s trading costs. This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses. Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds. He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio. The second source of additional cost for active funds is cash drag. Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash. To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance. Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year. The final additional cost that Mr. Bogle includes is sales charges / fees. This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees. Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate.
When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year.
The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference. The ICI also reports that the most expensive funds can have much higher expense ratios. They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%.
Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year. This number is highly uncertain. The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%. A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%. Because of compounding, the long-term impact of these costs increases over time.
The average costs from Mr. Bogle’s article are not unreasonable. There are probably many investors paying this much or more. On the other hand, there are plenty of investors in active funds paying considerably less.
Where does all of this leave investors? First and foremost, it should be clear that costs matter a great deal. There will always be expenses associated with investing, but they vary widely. Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings. Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio.
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The Wall Street Journal recently published an article titled How You Can Survive a New Era in the Bond Market. The article suggests that investors adjust their bond allocations to tilt more towards high-yield (aka junk) bonds (both corporate and municipal) and global bonds, which tend to yield more than U.S. bonds. This advice resonates with an Op Ed by Burton Malkiel, famed author of A Random Walk Down Wall Street, at the end of 2013.
The case against bonds is straightforward. The best estimate for the expected future return from bonds is their current yield. If you hold a bond until maturity, your total return will be very close to the current yield. There are nuances to this rule. With high-yield bonds, you should expect a total return that is a bit less than the current yield due to the fact that some of these bonds will probably end in default. With bond funds, you don’t necessarily end up holding individual bonds until maturity, so the correspondence between current yield and expected return is a bit weaker. Nonetheless, with current yields as low as they are, bond investors should not expect attractive returns from most bond classes.
I have known Phil DeMuth for a number of years and I admire his common sense and views on many topics. Phil authored the recently-published book The Affluent Investor that fills a need in the crowded shelves of investment books. As a financial advisor to high-net-worth families, Phil brings valuable perspective to investors who have built substantial portfolios and seek to protect and grow their wealth effectively. Continue reading
Harvard Business School professor Michael Porter is a familiar name to almost anyone who has graduated from business school in the last twenty years or so. He recently gave an interview on CNBC in which he shares his analysis of the U.S. economy. Porter is best known for his work in competitive strategy, a field in which he is considered the preeminent expert, so his views of what ails the U.S. economy and how we can get back on track are of considerable interest. He has analyzed the forces that provide one country or region with relative competitive advantages vs. others and he applies this perspective in his commentary. Continue reading
Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related. Game theory is the study of how a rational person makes decisions in uncertain situations. As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome. Game theory focuses on how rational players can make the best decisions to maximize their satisfaction. Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker. Continue reading
Effective Actions in an Uncertain World: Part Five of Our Special Five Part Series
There are a number of factors that we need to predict in order to come up with saving and investing strategies for retirement. The values that we assign to these factors will have a huge impact on whether or not we will be able to meet our goals. First, there is the expected return that investors will make on their retirement savings. Second, there is the common estimate that people will need about 85% of their pre-retirement income to support them once they stop working. Finally, there is the potential impact of behavior on savings rates, investing, and spending. Continue reading