A main take-away offered by the creator is that Baby Boomers control a whopping 50% of the total wealth in the US while other generations lag far behind. And, it’s true. As a generation, Boomers are extremely wealthy at this point in their journey.
The other implication is that those much maligned Millennials are so busy staring at their iPhones and buying avocado toast that they’re missing opportunities to build real wealth. Look at how pitifully small their generational net worth line is compared to the Boomers.
But, are they really so far behind? It turns out that age matters quite a lot in the race to build wealth. The youngest Boomers are 60. The oldest are 78. If you are a Millennial born in 1981, you’re turning 43 this year. If you were born in 1996, you turn 28 this year. We shouldn’t compare the assets of a 65 year old to the assets of a 25 year old.
So what if we took the exact same data but started all the generations at the same time and looked to see how well they did accumulating net worth during their lifetimes. The plot would look something like this.
Remember, this is the same data, but it’s put onto the same axis such that each generation starts the race at the same time. Now, it doesn’t look like the Boomers are the clear winners of the race. Both the Gen X’ers and the Millennials have appear to have accumulated higher net worths by the same “generational age.”
I admit, the data set is incomplete. The Distribution of Financial Assets data set only goes back so far. So, we’re doing a bit of mental extrapolation during both the Baby Boomers and Silent Generations’ respective youth.
Another criticism could be that based on my (admittedly quick) read through of the DFA description, there is not an inflation adjustment applied to this dataset. 1986 dollars are not the same as 2024 dollars.
If you want to make an inference about how much or when Gen X or the Millennials will achieve a certain wealth level, it would require a lot of extrapolation using exponential growth. For now, I’ll leave that as an exercise for the reader. But, I like the idea of the footrace being less clear cut in favor of the Boomers.
A few of my excuses might become blog posts in the future.
We’re finishing up a road trip to Florida, and I have actual time to write. (yes, we drove from Maryland…see why I like $5/gal gas). One daughter is sound asleep. The other recently learned how to braid and is braiding everything in sight. At least it’s a quiet activity….
I’m reflecting on our whirlwind trip. Ok, I was scrolling through Mint and seeing just how much our whirlwind trip cost us. Instead of sweating the dollars, I realized this is exactlywhy we have worked hard, saved, and invested for years! And that’s what prompted me to put quill to parchment again.
For the record, we rented a mini mansion with two other families and filled it with laughter and joyfully squealing kiddos, lazed away a couple of afternoons bobbing around the resort river, completely throttled two Orlando area theme parks, and visited with family.
If this were Instagram, that would be the only perfectly coiffed image you would get.
But we weren’t quite so polished when our over-tired two year old raced off, red shoes a blur, through the packed theme park restaurant dodging patrons better then Rogue 5. Our first warning that something was amiss came from a staff member yelling, “we got a runner!”
Nor was I ecstatic when my little ones both turned up their noses at the tepid, slightly sulphury Florida tap water I had filled their reusable bottles with. I gritted my teeth and shelled out $8(!) for two nicely chilled plastic bottles of filtered water. But I totally poured the purchased water into their reusable bottles first…
So much of the personal finance space is full of tactics for how to get a certain number of dollars in some accounts. And, we’re not going to neglect our financial journey either. But sometimes, we miss out on the real purpose behind all that working, saving, and investing.
Yes, we’re exhausted from the trip. Yes, our wallets are lighter. Yes, we had plenty of aggravating moments. But our hearts are full.
I’m currently driving across a chunk of the United States with my family in our minivan. The van has a 20+ gallon tank. I put ~14 gallons into it. At $5.49/gal, I dropped just under $70 to fill it.
Ouch.
There has to be a better option than spending a day and a half stuck in a tin can. Then again maybe some perspective is in order.
We needed to be back home with family for about 10 days. We had about 3-4 weeks to plan our trip. The nature of our visit wasn’t something that could be done virtually or simply forgone. Typically, we default to piling into our minivan and hauling across the country. This time, I thought it would be interesting to look at some alternatives to see what the time vs. money tradeoff looks like.
Our Baseline
Our trip is about 900 miles one way. Our van gets about 25 miles per gallon on the trip. A little more in the flat states. A little less in the hilly ones. 1800 miles / 25 miles per gallon means round trip we’re buying about 72 gallons of gas.
All of our fill ups have been less than $5.49/gallon, but let’s use that as our worst case. For gas alone, we’re talking about $400 of gas.
We’re pretty good about taking care of our vehicles. Therefore, I’m comfortable saying we’ll get 100,000 miles of life out of this car. 1,800 /100,000 is just under 2%. Let’s pretend it’s straight depreciation of the vehicle purchase price (~$20,000) relative to mileage. That works out to about $360 of depreciation for this trip.
With 900 miles of road to cover, we either leave in the middle of the night and do 16 grueling hours all at once or we split the trip into two days. During the early parts of the COVID-19 pandemic, we did the former. We didn’t stop for anything except to fill the gas tank and empty our bladders. It was not fun. Now, we’re a bit more willing to make a stop midway, so we’ll say 16 hours of driving + 8 hours at a motel for a total of 24 hours one way. Adding the hotel costs $140 to the round trip price.
Total cost: $900
Total time: 48 hours
Intangibles: we travel with our dog, a cooler full of healthier snacks and have little contact with others (especially important for a 2 yr old still ineligible for COVID-19 vaccination).
Flying Commercial
Instead of 13 hours of road time (it’s actually closer to 15 with young kids), we could have taken a short flight. If we catch a nonstop flight, our door to door travel is 30 mins to the airport, 1.5 hours at the airport to clear security, a 2 hour flight, 30 mins to get bags and rental car, and then 2 hours to drive to our destination. 6.5 hours total (assuming everything goes smoothly) one way. Not bad relative to the drive time in the van.
Given that we had a relatively short time to book airfare, the cheapest flights I c0uld find are about $215 per person one way. With four humans, our flight cost is 4 x $430 = $1720.
Of course, we have to do something with the dog. No, we’re not going to ship her in the cargo bay. So, it’s either boarding at a kennel for something like $55/day or at home care for closer to $80/day. Our trip was 10 days. Yikes, we’re at somewhere between $550 and $800 just for the dog. Let’s go with $550 to be conservative.
Next, we need a rental car and two car seats when we get where we are going. That’ll be $850 for a full-size car for 10 days.
Total cost: $3120
Total time: 12 hours round trip
Intangibles: way less travel time with a potentially cranky toddler, more COVID-19 exposure, more people to annoy inside of an airplane with a cranky toddler.
Train
We’ve been on plenty of trains in Japan and Europe. Before kids and COVID, we took the train into and around Washington DC. But, as much as the notion of a train excites me, I don’t usually think about it as a serious method of transportation in the United States. For this exercise, here’s the numbers:
Amtrak quoted me $227 one way and $159 return. At $386 per person round trip, taking a train is actually cheaper than the prices I saw for flights. Total travel fare would be $1,544.
We still need to take care of the dog and rent a car upon arrival. $1,544 + $550 + $850 = a total cost of $2,944.
We need 30 mins to get from home to the train station. The train ride is slated to be about 24 hours with 2 train transfers. Again, we need 30 mins for getting from the train and into a rental car. Then, it’s 2 hours to get to where we are going. Total time is about 27 hours one way or 54 hours total.
Intangibles: less rigamarole to get to/from the train than an airport, someone else drives the train, moving sleepy kids between trains at odd hours.
Private Flight
I’ve never looked into this before, but why not? We’re almost A-list! It turns out that anyone can rent a private jet. For around $15,000 (give or take a few thousand bucks), we could get our own private plane to whisk us across the country. By the way pets are allowed on domestic private planes…guess we can bring our dog with us (and save big bucks on that costly kennel fee)!
Because the private flights leave from the General Aviation part of an airport, there is far less time required to go from the car to the airplane. And let’s be honest, if we could throw down $15,000 for a plane ride, we can afford a driver to get us to the General Aviation terminal. No $8/day long term parking for us! So the time works out to 30 mins to the airplane, a 2 hour flight, 30 mins to get bags and rental car, and then 2 hours to drive to our destination. 5 hours total (assuming everything goes smoothly) one way.
Total cost: $30,000
Total time: 10 hours
Wrap Up
Here’s a scatter plot showing each of these different options to visually represent the trade off between dollars and hours.
The gist is this: we all make trade-offs about how to spend our time and/or our money. If I absolutely needed to be with my family that same day, spending $15,000 for a private flight is truly an option. Fortunately, I’ve never been forced into that position. Instead, I’m optimistic about how much time I have left on this Earth, so we traded time for dollars. $900 (even with crazy high gas prices) is way cheaper than the nearest alternative.
Besides, who says that two days jammed into a car with your family can’t be memorable and maybe even fun? One of my favorite moments from this road trip: I read about a quarter of Little House On The Prairie to my daughters while my partner drove. At the end, our 6-year old was still entranced. Our 2-year old just looked up at me with a big toothy grin and said, “More cookies, please!”
The S &P 500 closed down 20% from its peak of 4800+ over the past 5 months. Financial headlines trumpet words like “crash” “bear market”, “extreme fear”, and “volatility“. Red is the predominant color on financial news service websites. Is it time to panic sell all your equities? Should you go all in on the US Stock market?
First: Don’t Panic
OK, take a deep breath. Don’t panic. 20% drops actually happen rather regularly. The current drop happened over a period of about six months. `Here’s an image showing the distribution of S & P 500 price changes for 6 month intervals.
Histogram of 6 month market returns
The light red dashed line is at -10% or “correction” territory. The dark red dotted line represents -20% or the threshold for a “bear market.” Look how much of the distribution remains to the left of both of these lines. Neither event is uncommon. In the histogram, I also highlighted the 0% line in solid blue. Take heart doom and gloom fans: most of the distribution is to the right of that solid blue line. That means that most of the time, the market has a positive return.
Let’s look at the same data differently so we can more easily quantify how often to expect a -10% correction and a -20% bear to occur within a 6 month window. Corrections happen about 10% of the time. That 20% bear market line happens about 3% of the time. There’s a reason why people smarter than me have said that over time, “it always goes up .”
Cumulative distribution of 6 month market returns
Second: The Market Isn’t That Cheap Yet
Believe it or not, we’re not at bargain basement prices yet either based on two widely accepted measures of aggregate market value.
1) the “Buffet indicator“, which looks at a country’s total stock market’s price relative to the economic output of that country. Economic output is usually measured as Gross Domestic Product. Here’s a detailed discussion if you want some real gory stuff. While the current market conditions have improved from late 2021/ early 2022, valuations are still relatively high.
2) the Cyclically Adjusted Price to Earnings ratio (CAPE) or Shiller PE is another measure of long term value. It too is still high by historical standards despite recent sell-off. As of this writing, the Shiller PE is above 30 against a long term average of about 17.
Of course, I don’t have a crystal ball that sees into the future. However, based on measurements like these that show some good predictive power with long term stock market returns, it might make sense to make a measured response.
How to Respond to a Market Downturn
With a 20% drop, your asset allocation is likely out of balance. you can think of the market on sale and consider this an opportunity to re-balance. Sell some bonds and buy some stocks to bring your asset allocation ratio back to your goal.
Continue investing regularly or dollar cost averaging. Stay the course and try to avoid any drastic action. You’re investing for the long haul. As we’ve seen above, dips happen regularly.
If you have low enough expenses, consider investing some extra funds while prices have reduced. I would be cautious of going all in at this time though.
Stay diversified. It’s tempting to think we’re able to pick individual winners. For most investors who aren’t spending their free time reading prospectuses our scouring the headlines for information about a company, buy the entire market (or at least a big chunk of it) and ride the tide.
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
We’re kicking off a new, multi-part series here. We’re going to be looking at several different investment strategies using Monte Carlo Simulation techniques. Our goals with this series are to:
Demystify the Monte Carlo simulation technique.
Objectively evaluate the performance of different strategies against each other.
Learn.
I’m going to drop in our disclaimer right here just to make sure there is no confusion:
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
What Is A Monte Carlo Simulation?
Monte Carlo simulations attempt to show how a system responds through the use of repeated, random sampling of a model of that system. In observing how the system responds to a range of inputs, we can make better decisions in real life. We would like to see if we can learn about how well different investment strategies performed so we can make decisions about what to do in the future. Check out wikipedia and investopedia for some more detail on Monte Carlo Simulations.
While this post/series is not a comprehensive overview of the topic, a brief introduction is useful. Remember the “Normal” distribution from your first statistics class? If not that’s OK. My first statistics class was traumatic too. It represents a range of values/probabilities that we’re likely to see in many systems. Here is a distribution that represents the US Stock Market’s annual returns:
1000 samples of annual US stock market returns from a distribution with mean of TBD and standard deviation of TBD.
For Monte Carlo Simulation, the distribution is at the heart of everything. It is our representation of the system. The underlying distribution tells us how often we expect to see a given result. Finally, it is also fundamentally based on assuming that the general shape of the past can give us clues to how the future will look. How?
We iteratively and randomly sample points from the distribution. In our case, this provides a hypothetical sequence of returns for that asset class. If we’re simulating a 30 year retirement, we need 30 points from each asset. We’re using a distribution rather than actual historical sequences like cFireSIM. Therefore, we can simulate an infinite number of sequences. Let me be clear: that’s not a knock against cFireSIM. It’s actually one of my favorite tools and an inspiration for a lot of our work here.
What does a Monte Carlo Simulation Look Like?
Next, let’s look deeper at the first 5 points sampled from this type of distribution. We will illustrate how we can start to build up a sequence of returns. Remember, these 5 points are randomly drawn from the same distribution. Think of them as the first 5 years of a single “run” representing one potential retirement reality. Below, each panel shows a new point being randomly generated from the underlying distribution and added to the prior sequence.
Five successively chosen points from an underlying distribution.
Next, we can extend the sequence to 30 points (or any number) to represent a single retirement “run.” The next plot shows three such runs. Remember, we drew 3 sequences of 40 points from the same underlying distribution. And, the underlying distribution represents the annual performance of the US stock market. Therefore, you can think of this as three potential retirement experiences.
Three simulated “runs” of randomly generated sequences of returns.
When you make thousands of such multi-decade “runs”, you start to see the range of potential outcomes from this portfolio over time. And, that’s the foundation of our Monte Carlo simulation. We iteratively sample from the historical return data. We then simulate thousands of 20 year, 30 year, or 40 year (or more for those in the FIRE community) return sequences. Finally, let’s put the whole thing together and illustrate our 3 runs from above against a fuller population of simulation data.
In this plot, we simulated 1000 runs and then took the 10th to 90th percentile of those runs within a given year. We’re essentially eliminating some of the less likely returns from the summary. This reduced population forms the grey band in the graph. Overlaid on top of that are the three runs from above. Notice how many individual points are well outside of the grey bands. That’s important: any individual run can have some pretty extreme values (March of 2020, anyone?), but when you look at expected values they’re frequently less extreme. Are those extremes possible? Yes! But, they’re also less likely to occur.
Three 30 year simulated runs highlighted against the 10th -90th percentiles (grey band) of a 1000 run Monte Carlo Simulation
If you had two distributions, one that represents the annual performance of the US stock market, and another that represents the annual performance of the US bond market, you could start to build a model of their respective performance over time. From there, we can start to compare how well different portfolios perform…but we’ll dig into that another time. For now, let’s look at one caveat of many simulations: the shape of the underlying distribution(s).
Pitfalls of the Normal Distribution
In many systems, the normal distribution is a good fit for the underlying data. Stock market performance is not one of them. Here’s a great discussion on the topic. The key phrase is, “fat tails”. Over time, people observed that the stock market sees big movements more frequently than the normal distribution would suggest. This results in errors: differences in the model relative to historical performance. We would like our models to be as right as possible. I need to pause for the obligatory quote from legendary statistician and 20th century Renaissance Man, George Box:
“Essentially all models are wrong, but some are useful.”
George Box
Of course, we would like the models to be as right as possible, especially if we’re going to use them.
Metalogs – An Answer to the Normality Problem
Meta what?
“Metalogs”
They’re flexible distributions that more accurately reflect the underlying data than many of the classic distributions we’re used to (e.g., the Normal). Check them out here. They were invented by Tom Keelin who could be the 21st century’s Renaissance Man. By making distributions that can generate continuous samples from the underlying source data, Tom enabled us to reduce the bias in our original models. He helped us to fatten up our models’ tails when working with stock market return data (and his invention can be useful for modelling in any discipline. Have I sung his praises enough yet?).
Here’s a picture to help illustrate the differences between the actual data and two simulations. We can make 1802 annual return data points from Dr. Shiller’s dataset, called “Actuals” going forward. First, I calculated the mean/standard deviation of the Actuals and used those statistics to generate 1802 simulated returns using the Normal distribution. Then, I fit a Metalog to the original data (a 13-term metalog had the lowest standard error) and simulated 1802 more annual returns using a Metalog based on the actual data. Here’s a Box Plot (yes, the same George Box) showing how the three distributions compare.
Visually, you can see the Actual Returns and Metalog Simulation both have longer whiskers and more outliers than the Normal Simulation.
Wrap Up
That will do it for this first introduction to the topic of portfolio evaluation. It’s a fascinating problem. Inevitably, we will make mistakes along the way. I’m excited to dig into this topic and learn more about it. Hopefully, you have a better understanding of how we’re approaching this idea of portfolio evaluation. In subsequent posts, I will lay out some sample scenarios and start simulating!
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
A worldwide recession. All time market highs. A global contagion. All time market highs. A foreign invasion. Are all time market highs in our future? The stock market is a wild ride. Stocks are a highly volatile asset class. They always has been. They likely always will be. So, how should one invest for volatility? How do you get to financial independence as quickly as possible while minimizing any missteps along the way?
My favorite investing strategy for volatile times (which is all the time) is pretty simple: subtract your age in years from 100. The result is the % of your portfolio you should keep in a total stock market index fund (like VTSAX). The balance (your age) should be in a total bond fund (like VBTLX).
It makes taking action (or remaining inactive) amidst volatility really simple. Is the market at all time highs? Sell some stocks and buy some bonds to rebalance and lock in your gains. Is the market crumbling around you? Sell some bonds and buy some stocks while they’re at a discount. Aim to keep your percentages within about 5% of their targets.
Selling At A Bottom Can Delay Financial Independence
One of the worst things an investor can do is sell at the bottom of a market correction/crash when emotions are high. Doing so can significantly delay the time to financial independence. Making an ill-timed sale turns a paper loss into a real one. Now, you need a correspondingly bigger increase to make up for the loss. Instead, invest for volatility so you never feel the emotional pressure to sell low.
Your Portfolio Adjusts For Risk As You Age
As you age, your portfolio will get more conservative. That’s not a bad thing, especially as you close in on needing to draw from the portfolio. But, the portion in stocks will still grow significantly, helping to ward off the insidious effects of inflation. And, this approach recognizes that human behavior, has a real effect on a portfolio’s performance.
A Variation
For more aggressive or risk tolerant investors, consider subtracting your age from 110 or even 120. You’re still investing for volatility! You’ll simply end up with a higher percentage of the portfolio in stocks (and likely a wilder ride). But, over the long haul, you can expect a higher total portfolio value because more of the portfolio is invested in growth assets (stocks).
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
My girls will have awesome 21st birthday parties if they want them. Or, they will have startup capital, weddings, house down payments, or gap years. How, you ask? Some modest investments, time, and dependent capital gains harvesting.
Investing In Your Child’s Financial Future
When my oldest daughter was born, her uncle Dan gave her a gift of $100 with the following instructions:
New Baby-
Tell your Dad to open an investment account for you (if he hasn’t already) and put this cash into the account. When you turn 21, you can have a big party with all your friends!
Uncle Dan
Any time she received money from other family members, we bought more of Vanguard’s total stock index ETF, VTI. Turns out infants don’t really need much more than diapers and onesies. So, we asked family members for any gifts during her first few years to be cash too. I also split up my 529 contributions so that every paycheck I put a bit more into this account instead of the 529.
Over time, we just kept adding more shares. Once her account crossed $3,000, we converted it to Vanguard’s total stock index fund, VTSAX and set it to auto purchase a little bit each pay check.
It has been a very positive 5 years during her investment career. I looked at my records and plotted the historical growth of her UTMA account. Being a nerd, I also extrapolated 3 scenarios into the future:
At the low end, we’re just contributing $300/yr and the account grows at a rather paltry 3%.
The nominal scenario has us contributing about $850/yr with the account growing at 5%.
In the high scenario, we’re adding $1700/yr and it all grows at 7%.
Three potential growth scenarios for a child investor
It’s a proud papa moment when my almost 6 year old is able to peer into her young adult years and have between 25-95k in capital at her disposal. Thank you, Uncle Dan!
Now for the fun part: Dependent Capital Gains Harvesting
As the market moves up and to the right, I periodically sell VTSAX and buy something similar like Vanguard’s S&P500 index fund, VFIAX. This is a taxable event. We sold shares for a profit, and my daughter, our dependent, owes capital gains taxes on her earnings from the sale. Note: to keep things simple, I’m assuming no other types of income (no dividends, no interest, no earned income).
For minors in 2023, the IRS taxes capital gains on up to $2200 of unearned income per year at 0%. My oldest daughter is almost 6. This is her only source of income. While she is our dependent, as long as she doesn’t profit more than $2200/yr, she owes nothing on the gains for that year.
Once she is no longer our dependent, she will be eligible to pay “filing single” capital gains taxes. Let’s pretend that we’ll flip that switch when she turns 18. That may not reflect reality, but it’s an example. In 2023, for individuals filing singly, the IRS capital gains tax rate on up to $40,400 of taxable income is 0%. Let’s take the low balance scenario and see what her cost basis looks like at 21. Remember, we’re making some assumptions here:
Selling enough shares each year until she turns 18 to lock in $2200 of capital gains with 0$ of taxes owed
After she turns 18, selling enough shares each year until she turns 18 to lock in $40,400 of capital gains with 0$ of taxes owed. OK, this may not be as realistic, but it should illustrate the point
A Deeper Look At The Scenarios
Using capital gains harvesting for a dependent while she has $0 of other income, by the time she reaches 21, the entire balance of her after tax account will already have had the capital gains taxes paid…at 0%!
Low balance scenario where we contribution ~$300/yr & it grows at 3%. See how quickly the basis catches up to the balance (the purple line is right at the orange line by the time she is 7). That’s the power of harvesting capital gains for your dependents.
By making these taxable transactions periodically and harvesting her capital gains, she will incrementally increase the cost basis of her investments. As her new cost basis increases, she has a lower potential tax burden in the future. The next two scenarios are a little more aggressive, but also show the power of this approach. Here’s the nominal scenario (contribute about $850/yr; grow at 7%/yr) resulting in around $50,000 of investments with little to no tax obligation at age 21:
In this scenario, the growth is high enough that she needs one year of filing single to fully catch back up. The net result is that by 21, she has a big asset with little to no tax obligation.
Finally, the high growth scenario is truly exciting. Yes, we’re contributing $1700/yr, which could be a pretty high burden for some folks. And, the funds are growing at 9% year after year. That’s high, but not unreasonable, I hope.
There it is: nearly $100,000 of assets with ~$0 of tax obligations against them. How cool is that?
By age 21, she has nearly $100,000 of investments, again with nearly $0 in tax obligation. Have a crazy cool 21st birthday? OK! Pay off a big chunk of student loans? OK! Down payment for a house? OK! Seed capital for a business? OK! It’s enough that she can do almost anything…but she cannot do nothing.
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.
A 50% decline is bigger than a 50% gain if it happens first. Let’s take a quick look at Sequence of Returns risk.
Your investment portfolio is represented by a pie, raspberry if you like.
Yes, that is a full pie.
Pretend that you have worked hard for 15 years, saving 54% of your income and are ready to embrace your financial independence. The day after you step into your new life, the market crashes 50%, wiping out half of your portfolio’s value. Think of your portfolio looking like half a pie now. Ouch.
One half of the pie. It was either “lost” due to declining portfolio value or after eating.
In our simple example, it is a volatile market. The very next day, the market soars 50%!
You’re back to where you started, right?
Nope.
You’re only at 75% of your original balance. A 50% gain after a 50% loss is only a 25% gain on the original amount.
Take away half the pie and then add half back. You don’t get the full pie.
If you needed to buy groceries or pay your mortgage (or make any withdrawal from your portfolio) while the market was down, you have even less left.
This simple example illustrates sequence of return risk where a decline in the portfolio happens shortly after someone starts to draw from it (e.g., in early retirement or FI years).
How to mitigate sequence of return risk:
Manage your asset allocation. Keep some bonds, cash, & stocks in your portfolio, especially if you’re planning to draw from it soon. In this way, you won’t have to sell stocks when they’re down in order to eat.
Continue to generate some income so required portfolio withdrawals can be reduced. If you keep working or pick up some extra work, that income can be used for living expenses instead of selling assets at a loss during an early down turn.
Should I refinance my current mortgage? Banks/mortgage companies want you to refinance your loans because they will make more money from you. Sure, they may advertise lower rates, lower payments and show pictures of smiling people having fun. Make no mistake: unless you do the math, odds are they will take more of your money.
With interest rates still low by historic standards, lots of folks have been refinancing to lock in lower payments. Add a booming housing market to the mix, and people are refinancing and withdrawing additional equity from their homes in droves. It seems like we get solicitations weekly from our own lender.
By the way, we’ve made this mistake too. Twice! Please learn from our missteps so you don’t have to make the same mistake.
Buying a House Is Like Buying a Car
Let’s start with an analogy. You are at the car dealership shopping for a different, used Camry. You have $2,000 in cash and want to stick to a 20% down payment. Therefore, your budget is $10,000. If you put down 20%, you need to borrow $8,000 to complete the purchase. For a 3 year auto loan at 3.69%, your monthly payment is $235.09.
Then the sales person says, “you know, I can get you into a new Camry for the same monthly payment.” Your ears perk up. New car smell for the same monthly payment? Maintenance free miles at the same price? Tell me more about how I could get more swagger for the same dollars.
You can’t, of course. Let’s see how this trick works.
For starters, take the first scenario and multiply the monthly payment of $235.09 times 12 for an annual total of $2821.08. Then multiply that times the 3 years you will have the loan. Your $10,000 car actually costs $10,463.25. The 463.25 is the interest you will pay over the life of the loan. That’s what financing will cost you. What could you do with that extra money if you just bought with cash?
Now let’s look at how our crafty dealer can get you more car for the same monthly payment. We’ll keep the interest rate the same, but we’ll push out the loan duration to 7 years. Let’s see how much we can borrow while keeping the payment no higher than $235.09. Looks like $17,375! Woo hoo! With your $2,000 in cash, you have a total of $19,375 to throw around. New car smell, here we come. The real costs of this upgrade are your indebtedness for an extra 4 years and a total of $2,367.03 in interest. Your $19,735 Camry actually costs you $21,742.03 over the life of the loan.
If you spend any time on “how much house can I afford?” websites, you’ll usually see that they focus on what your monthly payment will be. And, it works! According to an expert at Fannie Mae, 90+% of US home mortgages are 30 year loans.
Buying a House With a Loan Spends Your Future Earnings Today
Now, let’s scale it up. Houses usually cost more than cars. And, at least in the US, we accept 30 years as the typical amortization period. Once you sign on the lines, you have effectively pre-spent 30 years worth of income. (There’s a reason mortgage contains “mort” the french root word for death)
Why Banks Love New Mortgages (and especially mortgage refinancing)
I remember when we signed our first mortgage. We were pretty young. We knew this was not going to be our dream house, but it was our first house. Despite doing lots of homework, we never really had any one challenge our approach or suggest there might be another way (like house hacking). So, we went for a 30 year note to keep the payments low. The total interest we would pay over the life of the loan was almost double the principal. Let’s dig into how a mortgage is structured to better understand things from the bank’s view.
Let’s start with the concept of amortization. When you take out a loan, a lender gives you a sum of money. You agree to pay that sum back over time. The lender charges you interest as their price for the service of loaning you money. An amortization schedule is the sequence of payments over time where how you agree to repay the lender. By the way, amortization comes from old French/Latin. It means to “kill it off”. As in to destroy an asset that generates revenue. When you pay off your loan, you have killed one of the lender’s assets. Do you think they really want their assets killed off? (Hint: no!)
So you have a new letter in the main offering a mortgage refinance. Sounds interesting, right? Lenders love new mortgages because so much of a borrower’s payment goes towards interest. You need to look at an amortization schedule so you can see why. The amortization table shows the monthly payments for the life of the loan. It is your repayment plan. It also shows how much of each payment goes towards paying down principal and how much goes to interest. You can also see how much total principal and interest a borrower has paid.
Here’s a simple example. Let’s say a borrower took out a $200,000 mortgage. The duration is 30 years and the interest rate is fixed for the life of the loan at 4% per year. With these terms, each month, the borrower commits to pay $954.83. Because this is a 30 year loan, the full amortization table is 360 rows long. So, here’s a condensed summary showing every 36 months instead (with a couple extra highlight rows added).
Condensed amortization table showing when a hypothetical mortgage has greater than 50% repayment of principal and when cumulative principal exceeds cumulative interest
It Can Take Years Before You Pay More Principal Than Interest
A few observations from the table above:
Initially, almost 70% of the monthly payments are used to pay interest. Yes, you might be writing $1000 checks every month, but when you start, only $300 of that pays off the balance. $700 goes to your lender’s pocket.
It takes until the 154th payment (almost 13 years in) before 50% of the payment is applied to principal.
You have to wait until the 283rd payment (23 years!) before your cumulative principal payments outpace your cumulative interest payments.
Wait…what!?
No wonder bankers wear fancy suits! A new loan generates significantly more interest (potential profit) than an old loan. And, the longer the term (e.g., 30 years vs. 15 years), the more favorable the loan is for the lender.
Most People Do Not Pay Down The Full Balance Their Mortgages
Now that we understand why lenders have such a strong incentive to get you into a new loan, we can add another wrinkle. Mortgage companies/banks know you are unlikely to keep the loan to the end. According to the National Association of Realtors, the overall US “median duration of home ownership is 13 years.” And lots of folks complete a mortgage refinance even without moving. With rapid turnover on a 30 year mortgage, it can be difficult to build equity because so much of one’s payments go towards interest for so long.
That’s right. The 30 year fixed note that 96% of us sign up for is closed after 13 years. In our example above, that’s right about when each payment finally has 50% going towards principal. And a substantial number of folks close their mortgages before 13 years, meaning they accumulate even less cumulative principal payments than interest.
In addition, the lender gets the closing fees associated with originating the new loan (that’s the mortgage refinance). They get the most profitable period of time for the loan (where you gain the least equity and they gain the most interest). And then, as borrowers, we start their most profitable revenue stream all over again when we refinance or move. Who is winning here?
Now we know why banks sends so many refinance offers. It’s not really because they want to see us lower our monthly payments. What are the top selling points of these marketing campaigns? We can lower your rate. We can lower your monthly payments.
Now you understand why looking at just rate or monthly payments is a red herring. Unless your name is Jeff, Oprah, or Bill, you probably aren’t paying cash for your house. Or, maybe you want to take advantage of historically low mortgage rates. What are mere mortals to do?
Look at Your Potential Mortgage Refinance Like an Accountant
Run the numbers like an accountant.
Calculate time to be free of the debt.
Figure out how much less (or more) interest you will pay.
Bonus/Caveat: think about opportunity cost
First, run the numbers like an accountant: yes, you should consider your monthly payments. If you’re in a cash flow crunch (there is a pandemic on after all), freeing up several hundred dollars each month may be a huge relief. But understand that the short term relief comes with a long term cost. That’s why you need to look at more than just a lower rate/monthly payment.
Consider how much faster you can pay off the note. If you move from a 30 year to a 15 year note, depending on your original terms, you may get similar or smaller monthly payments and a shorter time horizon. For most people, eliminating the house payment eliminates the second biggest single line item in a family’s budget (hint: taxes are usually #1). And, anything that puts time back in your pocket aligns with our main life goal. “Time is the ultimate non-renewable resource”, after all.
Finally, look at how much less (or more) interest you will pay over the life of the new loan vs. your current note. If the change in interest rates is big enough, maybe you can justify refinancing into a new 30 year note. For us, we’re 10 years in, so it becomes really hard to make this criteria work because we’re mostly past the most expensive part of the mortgage now (smacks forehead).
Caveat/Bonus – Don’t Forget About Opportunity Cost
Don’t forget about opportunity cost. This is the counter example that could toss out all of the math and analysis we’ve talked about above — which is why it’s so important to mention.
The counter-example goes like this, “if you can do something else with the money that earns a higher rate of return for your risk tolerance, you could consider that instead.” This means, you might be able to refinance your mortgage into a 30 year loan at 3%, saving a few hundred dollars each month. If you can re-invest those dollars into something that returns more (e.g., a rental property earning 8%), you will have become the bank. You are now borrowing money at a low rate to invest it at a higher rate. And, that’s not a bad place to be.
Of course, there be dragons here too. The higher rate may come with more risk. And, this is why personal finance is … well… personal.
A Better Mortgage Refinance Calculator
One of the nice things about not trying to sell you mortgage products means we can tell it like it is. So we built a refinance calculator so you can compare two different mortgages to see if you can win on all 3 dimensions: monthly payments, time to freedom, and total interest paid to your lender.
Let’s walk through an example and then make the tool available. Consider our example from above: a $200,000 30 year mortgage at 4%. Let’s say the note started 1/1/2018. The borrower considers a couple refinancing scenarios.
Mortgage refinance to a new 30 year note at 3.25%
Mortgage refinance to a new 20 year note at 3.00%
Comparison of a 30 year note at 4% refinanced into a new 30 year note at 3.25%. Lower monthly payment and less interest over the life of the loan, but a longer time to pay it off.
In both cases, we’re holding the cost of refinancing fixed at 1.5% of the value of the new loan (although that is adjustable too). In the first scenario, the borrower has a lower monthly payment by about $228/mo. Because of the lower rate, they also save on interest over the life of the loan…not too bad. However, they’re pushing out the payoff date by almost 4 years. For some this is a great trade-off: more money in their pockets every month but slightly more time carrying debt.
Comparison of a 30 year note at 4% refinanced into a new 20 year note at 3.0%. Lower monthly payment and less interest over the life of the loan, but a longer time to pay it off.
On to scenario 2. What if the borrower chooses to go with a 20 year note at a slightly lower interest rate? They don’t get the same monthly savings…the new monthly payment is only $30/month less. However, they save over $60,000 over the life of the new loan. And, they are debt free 6 years earlier. That’s what I would look for in a refinance: accelerating my Speed to Freedom!
Coming soon! A mortgage refinance calculator upgrade that lets you have a shorter time horizon.
It’s now a tradition for bloggers to do year end write-ups and forward looks. This post certainly aims to pull together threads of a 2020 review and a 2021 look ahead. I’m also introducing a demonstration of exponential growth and a trade-off between two different modelling approaches. Let’s begin. while my general sentiment is to say, “Good riddance” to 2020, we’re super privileged to have escaped mostly intact (knocks on wood)…
Let’s start with what matters most:
Health
We’re healthy, all of us. We took as many precautions as we could to minimize our Covid19 risk throughout last year. We’re patiently waiting for our turn to get vaccinations and look forward to some semblance of normalcy. Our hearts go out to the millions of families who have lost loved ones and to the millions more whose lives have been upended.
We survived the in-hospital birth of our second child. We now have two healthy girls! After a significant scare with my wife’s health post-delivery, I have a healthy partner again. I am so grateful to have healthy girls in the house.
Next, as this is a website about the journey to financial independence, let’s talk money.
Wealth
I actually wasn’t planning to write a 2020 review/2021 forward look. But, then I stumbled onto a thread at boggleheads about the shape of folk’s net worth curves. I think this is a fascinating topic and worthy of exploration. As we’re still starting out the 2021 calendar year, I was inspired to reflect on several lessons from 2020 and look forward to 2021 and beyond.
Exponential Growth Is Real
The path for financial independence feels like a marathon. But, unlike a marathon, the first miles on your journey to financial independence are the hardest. We scrimped and saved to pack pennies into our accounts only to see minor or maybe modest gains year over year. It felt like financial independence was totally out of reach. But, through the steady inspiration and encouragement of the online personal finance community, we kept at it. We’re not there yet, but that exponential growth curve makes me do a double take every time I see it.
Here’s a plot of our net worth since I started tracking it in 2009.
Exponential fit of our net worth growing over time. How cool is that!?
While it doesn’t feel life altering yet (in part because we cannot touch most of our net worth), it sure looks like we’re on an exponential growth curve, even with our conservative asset allocation. Why do I think this: a little statistical concept called standard error.
Standard Error
I’m not going to delve deeply into stats here, but this concept is useful here and will be again in many of the other topics discussed. Standard Error is a measure of spread. It tells is how much distance is between a group of data and some statistic. In this case, we’re looking at how far the points are from the fitted line. When comparing different models, smaller standard error (less distance) means the fitted line is likely a better fit for this data.
Let’s try it. We see the fit and standard error for the exponential growth model. Here’s the same data with a linear fit. Just eyeballing it, you can see this line doesn’t match the data as well. Standard error calculates the distance from the fit line to each point. Models (lines) with better fit have smaller standard error.
Linear regression model fitted to our net worth growth over time. Not such a good model, but in this case, I’m OK with that.
Take a look at the exponential model again, especially at the most recent months. The most recent points are consistently above the fitted line. You could attribute this to our investing genius. Or, maybe irrational exuberance round 2. This model is not perfect either. We need to be very careful not to extrapolate too far into the future lest the difference between the model and reality becomes too big. I don’t think we’ll be 401(k) billionaires in 20 years!
Between the two models, it’s obvious that exponential growth is a better fit, both visually and using math. Now that we can measure our net worth growth and fit a decent model to it, let’s dig into why the shape of the curve looks the way it does. We’ll also discuss what we could be doing differently to change the shape.
Analysis: Why Our Net Worth Is At An All Time High Despite The Pandemic
Despite the worst health crisis in a century, our net worth is at a record high. Why?
We kept our jobs
We benefit from the booming equity market
We benefit from the booming real estate market
Our rental business has lower but still positive cash flow
We Kept Our Jobs
Let’s take each in turn, starting with our jobs. Like it or not, our jobs provide 90+% of the income into our lives. Therefore, as much as I grump about being a W-2 employee, these revenue streams are important! We both work hard to contribute as much value as possible to our employers in the hope that they will continue to provide gross income in exchange.
Call it fate or luck, both of us have continued to be gainfully employed throughout the pandemic (knock on wood!). This means our ability to save/invest/grow net worth continued throughout the pandemic. One of my favorite pod-casters has a whole series on why the number one task of any employee is: “Don’t lose your job.” Obviously, that can be easier said than done depending on the industry and ones’ specific circumstances. Regardless, the number one priority for each of us is to maintain our respective revenue streams.
We Benefit From The Booming Equity Market
While we’re not 401(k) millionaires (nor “Teslanaires”), we have consistently invested in a broad mix of index funds for the past ~20 years. (OK, OK, we do have some “dumpster fire money” in individual stocks). That said, we’ve largely maintained an asset ratio of 60% stocks and 40% bonds over this period. We re-balance when things get too far from that mix. I know: it’s boring. No options trading. No short selling. I couldn’t even tell you what a put or a take is. And, I don’t really care. What I do care about is the overall growth of the equities market, namely the S and P 500 and the total market indices. Their values have exploded relative to the values of our other asset classes (e.g., bonds, cash, and real estate).
If I am honest, over the past several years, stocks have been the main engine of our net worth’s exponential growth. We keep these other asset classes around for when the market inevitably turns. But, just like JL Collins says, “Toughen Up Cupcake.” Embrace the volatility that comes with exponential growth via the stock market.
We Benefit From The Booming Real Estate Market
Speaking of other asset types, real estate remains my favorite. I love the tangibility of it. I love the chance to provide meaningful value directly to other people. I love the way the government treats it when tax time rolls around. Thus far, we only have one rental unit, a nice 2 bed, 2 bath condo. We took this plunge back in 2015. While we’ve had one challenging tenant, for the most part, it’s been an awesome investment. We negotiated with our current tenant at the start of the pandemic: lower rent in exchange for an 18 month lease. It was a relief not worrying about filling an empty unit during the lockdown. Most importantly: we’ve been able to maintain positive cash flow throughout these crazy times.
And, guess what, due to the booming real estate market, the theoretical value of the property rose too. Of course, we’re not interested in selling any time soon. But, we do track the market value of the property as part of our net worth (discounted to an investor friendly price). Lately, our real estate has grown, maybe not with the same exponential growth that equities have, but I believe real estate will be a lot less volatile whenever the next downturn comes.
Our other real estate, our primary residence, also shows a decent lift in the market value. Again, we’re not planning to sell any time soon, but these increases do contribute to net worth growth. They also buffer our net worth during down turns. While real estate may not be negatively correlated with stocks, it tends to be less volatile. Unfortunately, our house (like everyone’s) is not really an asset. It consumes cash rather than contributes it.
Our Rental Business Has Lower But Still Positive Cash Flow
You cannot eat net worth.
This is an interesting realization. So many of us are taught to invest in stocks and bonds so that we can take advantage of their long term appreciation. The plan is to sell some of these appreciated assets during our retirement years. The hope is that we draw down our pile slowly enough to die before we run out of money. As long as you stick to certain assumptions, this works pretty well.
Let’s talk about tax deferred retirement accounts for a minute. If you want to draw from your retirement pile before retirement age, the government charges a fee of 10% Further, because you put tax advantaged dollars in, you will pay income taxes on the dollars you take out. No opportunity to pay the potentially lower taxes on dividends or capital gains.
The cash that a rental property generates (assuming it is not held in a tax advantaged account) is available for use immediately. And you don’t have to sell a bathroom from your rental property to get the income. (This is unlike stocks where, unless you are only spending the dividends, you have to sell part of your base.) That’s what rent is for. I can feed my family today using the positive cash flow from our rental. Or, I can reinvest it for the future. This flexibility is awesome.
When the pandemic hit, our tenant reached out to us looking to renew his lease with us. In exchange for an 18 month agreement, he asked for a 20% discount. He’s a great tenant, and there was a pandemic just starting! We wanted to keep him We did a little math and offered a 15% discount. We agreed and signed the new lease. I’ve never been happier to give a discount! So, while our business income is down, we avoided (for at least a while longer) a dreaded vacancy.
Resiliency
To me, all these things add up to the beginning of a resilient lifestyle. If one part of the system fails, the rest of the system can absorb the shock and we can continue onward. It helps that we have a pretty big gap between our total income and our total expenses, again part of a resilient system is avoiding overloads. For example, if I lose my job, between my wife’s job and our other income sources, we could continue to maintain a substantial portion of our current lifestyle. If we have a vacancy in our rental property, we can afford to cover the expenses using cash reserves and surplus income until we can get a new tenant. We have tried to set up our affairs such that some part (or parts) are always able to perform.
To see a master of multiple income streams and truly resilient financial setup, check out John C over at actionecon.
There will be ups and downs; there will be bumps in the road. The hope is that through good times and bad, we continue to stay the course: keep earning, saving, investing, and growing. When the pandemic hit and now, as things recover, our assets continue to grow… hopefully for decades to come.
Actions to Take in 2021
No one has a functional crystal ball, so I’m always leery of forecasting economic or market movements. Regardless of your circumstances, I think there are some fundamental ways to approach finances in 2021.
Grow your gap either by increasing your income or decreasing your expenses. This is a good action to take in almost any set of economic circumstances, market conditions or time of your life. Today is no different. The job market may be terrible or amazing; reducing expenses gives you more financial runway in case of a change in your employment. The market may be high or low. Having a bigger gap gives you the ability to invest that cash directly or save it for another opportunity.
Adjust your asset allocation. Whether 2020 was financially kind or terrible for you, it’s a good time to review your specific situation and adjust your mix for the coming year(s).
By some measures, the US stock markets are significantly over-valued. If your asset allocation percentage is out of balance, this might be a good time to rebalance. You can lock in your gains from the past 10 months of ear-popping highs. Be sure to balance prudence with the fear of missing out. No one knows how high (or how low) an asset class will go tomorrow.
Age adjustments. We turn 40 this year. We have 2 kids. Our risk profile looks way different now than it did 15 years ago. Back them, we could say go all-in on the stock market. Now, our asset base has grown, and our appetite for full risk has perhaps decreased a bit…or not. I’ll save a discussion of how we approach risk/allocation for another time. Regardless of what our asset allocation was for the past 10 years, we may need to have a different ratio for the next 10 years simply because our runway to needing to use our assets is a lot shorter. And, the same may be true for you. Think carefully about how much risk you are really willing to accept. My heart goes out to the family of this young investor who took his own life after (mistakenly) thinking he lost almost $750,000. I know our allocation is pretty conservative, but I sleep well at night. I hope you do too.
Pay down debt. For us, this would most likely be early payments on the note at our rental/primary residences. We’re not rolling the dice with Bitcoin. Instead, every extra dollar we pay towards our mortgages, comes with a guaranteed interest cost that we avoid paying. It’s like our own bond fund.
Keep plugging away; exponential growth is alive and well. With that, we wish you and your loved ones a prosperous 2021 and beyond.
