By Brad Thomason, CPA
A big part of the work that my team and I have done over the last 15 years is based on a simple premise. The world of investment assets is made up of more than just stocks and bonds, and the first alternative that most people think to look at when they start their wider exploration, is real estate. Investing in real estate is not as easy as buying stocks and bonds from a broker. The whole purpose for this part of our practice has been to remove (or absorb) many of the most common hassles, to make it easier and in turn more accessible.
When considering asset selection decisions, portfolio size plays a big role in matters related to diversification and the particular investments chosen for inclusion. Using a single model-portfolio and making simple, ratio-based adjustments for commas and zeroes is not an informed way to do this in the real world, at least not in personal finance situations. What’s right for one investor may not be even remotely right for another. In general, I have a reflexive aversion to just about any of the one-size-fits-all ideas bouncing around out there.
But today we’re going to talk about something which actually could realistically be part of a wide range of portfolios, including some that would be smaller than what you would normally see for a real estate allocation.
The set up is a single rental house that you sweat-equity your way into, along with a mortgage from your bank (and maybe just a little bit of cash or short-term borrowing for building materials, appliances, etc; which you’ll pay back within the first year or two from the rental income).
Most banks, even big ones, will do this deal; at least for a single property or two. If you try to go multiple units, you may start running into some headwind. But as long as you have decent credit and can demonstrate ability to make payments even if the house isn’t rented, they’ll usually say yes.
I’ll mention one more preparatory remark before we get into the specifics: We want to analyze this particular move in a unique way. Instead of looking at the investment performance itself, we want to look at how its presence affects the rate at which the other parts of your portfolio have to supply income after you retire.
Unless you have several million dollars and are already into your seventies, the odds are good that at some point you are going to have to start spending down your investment capital, even if right now your portfolio could generate enough each year to meet the income need. That’s just what happens as inflation does its thing over the years.
We refer to this situation – spending the annual return and dipping into the principal, as well - as a depletion model. Any time a depletion model is in play, the rate of depletion matters a lot for planning purposes; and disrupting that rate of depletion becomes very important. Enter our rental house.
I will now attempt to summarize the impact of taking this step within the broader context of a standard retirement income projection. That said, it’s a lot easier to understand if you can see all the numbers. It would create a mess to try to put all of that into a blog post, but we’ll be happy to send you the spreadsheet if you want to look at the details. Just pop us a note through the Contact tab and we’ll email it to you.
In the hypothetical we created, we gave a 65 year old $1,000,000; set the rate of return at 6%; set the initial, annual withdrawal at $60,000 (increasing by 2.5% each year for inflation); and sat back to see what would happen. Answer: twenty years later the balance was down to about $520K; and came to the point of full depletion near the end of year 26.
Then we made a single adjustment. For the second run of the numbers we added $2,500 a year. That was the net that was left from the rent payments on a $100,000 rental house (i.e. after paying for all of the operating expenses, and servicing the debt). That’s it. That’s the only difference. Just $2,500 a year.
Which probably doesn’t sound like a lot of money.
But it makes a bigger difference than you would think.
At the twenty year mark, instead of having $520K left in the portfolio, there was $610K. That’s right: 20 years of receiving $2,500 (i.e. a total of $50,000) made a $90K difference to the portfolio. Compounding returns are pretty cool, aren’t they? Plus, our retiree had also built up $57K worth of equity in the house. And that’s assuming zero appreciation from the day it was bought. Nor any increase to the rental rate.
Looking on down the track, this ultimately pushed the point of depletion out a couple more years (keep in mind that initial income of $60K a year climbs up to about $115K a year after that many years of inflation…), or age 93.
I think the implications here are pretty obvious, so I’ll point out that one scenario clearly looks better than the other, and leave the commentary right there. You will probably want to explore some variations on this theme (HINT: you don’t have to stop at one house…).
I like this exercise for several reasons. First, it highlights the importance of understanding the depletion dynamics, and how to disrupt them to postpone their ultimate effect. This concept also highlights the use of your full balance sheet: it not only utilizes assets as they are classically understood, but also pulls in credit worthiness and ability to inject labor to create capital. Both of which are important resources, with nearly endless applications. Finally, it demonstrates that surface-level analysis often fails to show what more complicated studies make clear: who would think $2,500 a year could have such a big impact down the stretch?
To finish where I started, this sort of play has applicability across a wide range of portfolio sizes. Even if you think you are going to have enough, this is a nice way to get some cushion. On the other end of the spectrum, this could be a powerful means to closing any shortfall gaps you may be expecting. People sometimes try to do that by amping up risk in pursuit of higher returns, often to disastrous effect. This is a more sober approach, and one that probably has better odds of actually working.
Herbert Hoover promised a chicken in every pot. I don’t know much about chickens, or whether he delivered on that promise. But I can recommend a nice 3/2 in an established neighborhood, if you’re interested.
By Brad Thomason, CPA
The Myers-Briggs personality test has been around for a long time and has been used in any number of settings to try to explain how people act, and why. Most likely you are at least familiar with it; if not there is no shortage of basic information just a Google search away.
The core idea behind the test, and the related body of research, is that people have certain tendencies which often form a sort of default way of behaving, but not everyone has the same tendencies. Consistent with many earlier systems of categorization, such as ones proposed by Aristotle, Hippocrates and other deep-thinkers down through the years, MB sorts everyone into four quadrants (and further sorts each quadrant into four smaller, more finely-drawn quadrants, to arrive at sixteen archetypal personality profiles). Which quadrant a person falls into provides insight as to preferences they most likely hold. It’s not a firm predictor of behavior from one decision to the next; but it is uncanny just how often people choose, frequently without even realizing it, to act according to the preferences suggested by the model.
So what does this have to do with investing? Sometimes investors do things that don’t really seem logical. I know that comes as a big surprise. When that happens, the obvious question is ‘why?’ Turns out, according to decades of research which has all come to basically identical conclusions, a lot of the time we do it without even realizing it. In this post I’ll highlight just one issue which would seem to be pretty inconsequential, but actually has big implications for how people select and manage the assets in their portfolios.
The degree to which a person has a tendency to be “one of the gang” affects how he/she makes some of the most important investment decisions out there.
If you have ever taken the MB test, you got the results back in the form of a four-letter personality type, where each letter represents one of two possibilities. If you haven’t, I’d encourage you to stop reading for a second and go take a quick online test so you’ll better understand what we’re talking about…
Welcome back. OK, two of the MB quadrants are considered to be focused more on Cooperation, and the other two are more focused on Utility (i.e. what works, in the mechanical, non-personal sense). This idea was advanced and developed by the researcher David Keirsey, whose landmark book Please Understand Me is seen by many as the ultimate expression of these principles, which were popularized earlier in 1900s by Myers and Briggs.
Those who have S and J as the second and fourth letter in their personality type, and those who have N and F as the second and third letter, are more prone to cooperation than SPs and NTs.
SJs cooperate because they have a greater tendency to respect formal authority, the value of tradition, and the need to be active in working to keep the machinery of society healthy. NFs are typically very focused on inter-personal relationships, don’t like conflict, and as such are often hesitant to rock the boat. So even though the rationale is quite different, the action step is the same: follow the crowd.
Here’s what economist Richard Thaler and policy expert Cass Sunstein had to say about that in their book, Nudge:
“sometimes it is rational to follow what others have done, but not always, and when investors travel in herds, they can get into serious trouble.”
In discussing the events and aftermath of the 2008 financial crisis, the economist Robert Shiller had this to say:
“… (the) most important single element (of a boom) is the social contagion of boom thinking, mediated by the common observation of rapidly-rising prices.”
In other words, if no one engaged in crowd-thinking or tribe-following, it would be much harder for asset booms to ever happen. But of course, that kind of behavior is common. So we have boom and bust cycles, from time to time.
In our own work, we have identified a pair of common, and potentially damaging outcomes that seem to be tied to an insistence (even an unconscious one) of going along with what everyone else is doing.
First, because the most common investment allocation in the US is between stocks and bonds, people assume that’s the best option available (despite ample objective evidence, that spans close to a generation at this point, that such is no longer the case), and don’t consider any asset classes outside of the main two.
Second, people get distracted by market behavior, especially when prices are rising, and forget that what’s most important is whether or not their capital is doing what it needs to do, in support of their own individual needs. In other words, whether the market is doing well or not is not nearly as important in personal finance as whether or not your capital is doing the job you need it to do. But because the crowd cares about what the market does, so do individuals who identify as being part of the crowd. Watching one often gets in the way of watching the other.
Hopefully you can see why either of these circumstances would be a cause for concern. And the point here is that some people seem to be more likely to get clipped by these tendencies than others. If your personality type falls into one of the two quadrants mentioned (SJ or NF), be aware of the vulnerability (though it should also be pointed out that folks in the other two quadrants can and do fall into this trap sometimes, too).
Despite the fact that I think there’s merit to the research, and have in fact seen exactly this kind of behavior more times than I can count (usually from people who would be expected to behave this way, based on their personality type…), I understand if you are skeptical. I get it. All of this sounds a little out there. You may not put much stock in psycho-babble, mumbo-jumbo. Which is fine.
But ask yourself this: If you have parts of your portfolio that aren’t doing what you need them to do, what’s keeping you from changing them? Are the reasons of a technical or objective nature? Or is it more a case of “just ‘cause?” If the latter, you may be in the grip of a cognitive bias against what most of your brain tells you is right; especially if you happen to fall into the two Myers-Briggs quadrants most closely associated with cooperative behavior.
When faced with a nagging feeling that something about your portfolio needs to change, you may be resisting what your logic is telling you because you don’t want to be seen as nontraditional, or one who bucks the norm. But it is probably fair to ask, who’s looking? And are these people going to kick in for your retirement if the tribal approach doesn’t go well?
So that being said, knowing where you may be vulnerable has value, in my opinion. And knowing why you are resisting the action that you feel compelled to take, may help you decide that the reason isn’t nearly as important as making the moves to get a portfolio that’s better suited to what you need it to do.
It’s a little embarrassing when we come to a moment of realization that the primary force keeping us from what we want or need to do, is ourselves. But better to be embarrassed for a minute, own up to it, then press ahead, than to ignore the possibility and never delve into the question of why. The good news: if you are the problem, you are in a pretty good position to change that.
By Brad Thomason, CPA
A $100,000 rental house can earn you $10,000 over the course of a year, plus provide you with some tax benefits.
A $100,000 stock portfolio can lose $10,000 in about three days, apparently.
Even if it recovers quickly, not a lot of fun to watch. And sometimes it doesn’t recover quickly.
What’s in your portfolio?
Older blogs (2015-2017)