Myths On Money

The Word on the Street

There is a prevailing notion in our society that it is possible to get extraordinary returns out of the stock market by following a particular investment strategy, buying certain sectors of the market, finding stocks with certain characteristics, or in hiring a sharp-dressed, smooth talking account manager.

The Truth

While I do not deny that it certainly should be possible to “beat the market”, the simple fact is that, based on historical stock market and mutual fund data, very few account managers or mutual funds have managed to beat the market for more than a few years at a time.

In this post…

It’s in the Pudding

One of my current favorite finance books is called A Random Walk Down Wall Street, by Dr. Burton G. Malkiel. Dr. Malkiel updates this amazing book every few years with the latest information available in the financial world, and the book is currently in it’s 36th year of publication! The reason that I mention this book here is because one of Dr. Malkiel’s major points is that very few, if any, active investors and fund managers actually beat the market for more than a few consecutive years.

Mutual fund companies have strong motivations to make their funds look really good, so they have a tendency to use a little creativity when it comes to the statistics they report in regards to their funds. A prime tweaking technique involves elimination of underperforming funds from their portfolio of offerings. By closing a “loser” fund, the poor returns it was providing are removed from the pool of statistics used to measure the average return of the funds the company offers.

If you want a prime example of a particular strategy working for a short period of time, then failing, look no further than the dot com boom. For a number of years, the investing mantra was “invest in dot coms, and you can’t go wrong!” Well, history has proven that that strategy was not a long-term success, and most of the fortunes created by that strategy were also lost by that strategy.

Critics of Dr. Malkiel’s premise often will cite the success of a few private investors as proof that high returns can be earned. They cite the success of Peter Lynch (who had excellent returns on his Magellan Fund for a number of years), and Warren Buffett, whose very name is synonymous with investing prowess. But, the reality is, that though there may be a few who can in fact beat the market, they are vastly offset by the numbers of those who not only can’t, but haven’t matched the market. How many successful investors have you ever heard of? One? Two? A dozen? A hundred? A hundred sounds like a lot, but at this very moment there are more than 9000 mutual funds currently available, and many thousands more that have already been closed. The media focuses on the very exceptional few, and tends to ignore the immense mass of investors who have not managed to outperform the market.

Buffett and I

Many of you who frequent the blog know my preferred investment strategy. I am a believer in efficient markets, which basically means that I, like Dr. Malkiel, don’t think you can expect to beat the market. So, if you can’t beat ‘em, join ‘em, right? I think the best approach is to simply purchase an exchange traded fund (commonly referred to as an ETF), or a mutual fund that tracks one of the major indices of the economy. Examples of such indices include the S&P 500, NASDAQ, Dow Jones Industrial Average, Russell 2000, etc. These funds have very low expenses because they are not actively managed, and do not trade stocks around very often. As a result, you manage to efficiently invest your money in the entire market. One great benefit of index investing is that you automatically get access to a phenomenal degree of diversification, which lowers the total risk of your investment.

In a recent interview with PBS’s Nightly Business Report, investing legend Warren Buffett had the following to say in regards to the complexity of the investment world:

You should always stick to what you know. I say the “know-nothing investor” and there’s nothing wrong with being a “know-nothing investor.” I spend 60 hours a week, thinking about investments and most people have got jobs and other things to do. They can buy index funds. And they’re not going to do better then an index fund if they go around and trust some guy who’s promising them very high returns. If you buy a cross section of American business and you don’t buy it during a period when everybody is all enthused about stock, you’re going to do fine over 10 or 20 years. If you buy something with the idea that you’re going to do fine over 10 months, you may or may not. I do not know what stock is going be up 10 months from now, and I never will.
Warren Buffett

If you want to try to play roulette with your money, then go ahead and try to find the >1% of fund managers who will beat the market for more than a few years. For me, I am going to stick with the market, and almost guarantee that I will outperform 99% of all money managers.

The Word on the Street:

I still struggle to convince people that paying rent is not a purely wasteful practice. I have already done several posts on this topic.

The Truth:

Paying rent can be cheaper than getting a mortgage, and the difference in the cost can be invested to your ultimate gain. While I support the idea that most people would benefit from buying a home, I want to emphasize that no one should rush to buy simply because they don’t want to “waste” their money paying rent.

• A Quick Distinction
• A Waste?
• A New Perspective
• Real Estate As An Investment

A Quick Distinction

First off, I want to make a quick point of clarification. Renting an apartment can be much cheaper than taking out a mortgage, but renting a full house may or may not be cheaper. Personally, I think renting a home is not a very good decision, and should only be approached under special circumstances or at necessity. Because of the square footage you are renting, the cost to you to rent a home cannot be much less than paying a mortgage, so if you are going to be paying that much, you may as well get some equity out of it.

That said, if your rent is less than what you would pay for a mortgage, then renting is a viable option that ought to be considered.

A Waste?

So, is paying rent a waste? People often ask, “I paid all this rent, and what did I get out of it? Nothing!” But is that really true? Do renters truly get nothing from their rent payments? To answer, let’s look at a similar situation.

Suppose your family pays $200/month for groceries. At the end of the grocery run, is your net worth increased? Nope. Your net worth has decreased because you now have less money in your checking account. So buying groceries is a waste, right? Please say no. For your money, you got food, and food is necessary to life, so you could argue that buying groceries is a fantastic investment ($200 invested and you get back a month of life for your family, how can you measure THAT return?)

So it is with rent. You may not be getting any DOLLARS back, but the need for shelter is as vital as the need for food. So, for your rent, you are purchasing shelter. So it’s not a complete waste, just as buying groceries is not a complete waste. It is simply a necessary purchase.

A New Perspective

In a very real way, you can think of your mortgage payment as consisting of two parts: one part covers the cost of providing shelter, the second part is an investment in real estate. The interest that you pay every month is exactly like paying rent, with only one significant difference (to be discussed later). The principal portion of your payment is exactly like depositing money into an investment, again with only one significant difference (also discussed later). So, if your interest is just like rent, and your principal is just like an investment, then why not pay rent and make an investment? In the end, the result would be very close to the same.

Examine the chart below for an illustration of what I mean:

Notice the amount of interest paid versus the amount of rent paid. In the earler months of the mortgage, the interest is higher, leaving less to invest. But, over time, the interest expense decreases, thus freeing up more of your money to be invested in your home as equity. This is the fundamental difference between rent expense and interest expense. notice that it takes almost 7 years (83 months) for the interest expense to become less than the rent expense. So, for 7 years, you are “wasting” more money on interest than you would have on rent. After that point, the situation reverses. This is one reason why it is so important to keep a mortgage long-term; you need the late years to make up for the high expense of the early years.

So, if a portion of your mortgage is going towards an investment, what investment is it? It is your home. You are putting money into your home as equity. Simply put, you are investing in real estate.

Real Estate As An Investment

From EzineArticles.com:

Have the historical returns on Real Estate Investment measured up to the confidence it has received?

The answer is a cautious yes. Between 1926 and 1996, the annual average rate of return on Real Estate was 11.1%. During the same period the rate of inflation was around 3%. So, it was obviously a better investment to buy Real Estate than to bury cash in jars in your backyard. However, the rate of return for small stocks checked in a bit higher at around 12% while the Dow Jones Industrial Average was a bit lower at 10%. These figures would suggest that Real Estate investments were right there at a par with Stock Market Investments.

So, you can see that real estate investments enjoy similar returns to the stock market, so either investment would be a good choice. However, there are some differences between them. Perhaps most important is that real estate investments are not as easily converted into cash; this convertability is calledliquidity. If you have a large store of home equity, the only ways to access that is to sell the house or to take out a home equity loan (which would cost interest and thus reduce your net gain on the home). On the other hand, stocks (and bonds for that matter) are generally quite easy to convert into cash. The downside with stocks is that they experience a much higher degree of volatility in the short term. So they may be temporarily low in value when you have to cash them in. Both investments carry risk. The type risk each carries varies. Both investment types carry expenses. Again, the type and magnitude of these expenses can vary.

The important point to carry away is that both renting and home ownership present the opportunity to provide shelter, and that they both have room in them for you to save your investment in some kind of investment vehicle. Bear in mind also that the rent vs buy decision is not a decision that you make only once. At some point, renting may be better for you, but that may change next year or the year after. The key factor in the rent or buy decision is your time frame. If you are going to live in a place short-term, then renting is likely the better choice. If you are settling in for many years of living, then home ownership is likely the better choice.

P.S. Thanks to my Facebook Group for the inspiration for this post! Anyone is welcome to join.

Question:

My bank is currently offering a 3 month CD that pays a 4% APR. Does that mean if I buy a $5,000 CD, it will pay me $200 after 3 months?

Answer:

• Short Answer
• APY Defined
• Other Rates
• Using Rates

Short Answer

The CD will not pay you $200. It will pay you $50.16.

APR Defined

APR is an abbreviation that stands for Annual Percentage Rate. The key point to emphasize is ANNUAL. This is the rate of return for a given investment spread over a year. Since this particular CD is only open for 3 months, we have to convert the annual rate. We will convert it to a monthly rate, and then add up the interest earned over 3 months. To convert an annual rate to a monthly rate, simply divide it by twelve. This means that 4% APR is the same as a 1/3% monthly rate. 1/3% of $5,000 is $16.66 each month, and for three months that gives us a total interest earned of $50.

Other Rates

Anyone notice something strange here? In the short answer, I said that the CD would pay $50.16, but in the previous section we figured it would pay only $50. What’s the difference? The difference comes from the power of compound interest.

The calculation of $50 in the APR section was a calculation of SIMPLE interest earned, but our CD pays COMPOUND interest. What’s the difference? See, in the first month, the CD will earn $16.66. This means that starting month 2, our CD has a value of $5,016.66. 1/3% of $5,016.66 is $16.72. The interest earned went up because the interest from the first period also earned interest. In the third month, our CD is worth $5,033.38. 1/3% of $5,033.38 is $16.78. So after our interest has earned interest, we are left with $5,050.16. Pretty cool, huh?

But what if there were an easier way to calculate the effect of compound interest? Sure, $.16 is not a large amount to be off, but what if you were calculating your mortgage, or your retirement? The effect of compound interest is much stronger over longer periods of time. Fortunately, there is usually a very easy way to determine the exact effect of compounding. This is done through the use of effective rates. An effective rate is a rate that factors in the effect of compounding to allow you an easy way to figure your exact return from an investment. There are many types of rates, from nominal to real to effective, from yields to rates, and it can be very confusing to determine which number you should be most concerned with. Well fear not. Below is a quick list of the most common terms you will find used in the financial world to describe interest rates:

APR

The annual percentage rate is the interest rate that is used to calculate the payment on a loan or an investment. This number is based on simple interest, and does not include the effects of compounding interest. Therefore, it can be used to give only an estimate of interest earned/paid.
APY

The annual percentage yield is the annual rate that factors in the effects of compounding on your interest earned/paid. It is used to calculate the precise amount interest on an investment or loan. If you want to know exactly what your investment will pay, use the APY as your interest rate. In the case of the above example, you could use the APY of the CD (which the bank probably provides) instead of the APR and calculate the interest the same as we did in the “APR Defined” section. This would providde you the precise interest earning of the CD. APY is more frequently used for interest that you

EAR

You will usually see this one on the same page as the APR for a loan, credit card, etc. You may have noticed that the EAR is always higher than the APR. This is because the EAR is the effective annual rate, and it takes into account the effect of compounding interest, fees, charges, and time. This is the rate you should use when comparing two loans. And remember that the EAR is the true cost of the loan, not the APR. The APR understates the true cost of the loan.

Is everyone thoroughly confused? Well, don’t stress about all these terms too much. You don’t have to memorize all these terms and what they mean and how to calculate them. What you need to be focused on is just one thing: Effective rates tell you the true cost of a debt, and APY tells you the true gains of an investment. When looking at a loan, look for the effective rate. It will probably be listed simply as the EAR. A CD or savings account may or may not tell you the APY, but you can at least use the APR to get a close estimate of your investment gains. If you are fortunate enough to be given the APY of the account, then use that instead of the APR to get a much more accurate picture of exactly how much interest you will earn.

A Shocking Discovery

I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.

How Could They Miss?

If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.

So What Is Happening?

Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).

With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.

The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!

Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!

This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.