Tulip Fever Movie: Love and Economic Bubbles

tulipIf you’ve read enough investing books, you know about the “Dutch Tulip Mania” of the 1600s (Wikipedia) and how it was considered one of the first documented economic bubbles. At one point, 12 acres of land were exchanged for a single tulip bulb.

I was catching up on my Bloomberg magazines and saw this: Finance Geeks Will Love This New Movie About the Tulip Bubble. The official trailer would indicate it’s mostly a romantic drama, but the article suggests that it weaves in the tulip mania, the “nature of money”, and what “love and money have in common”:

The critic reviews weren’t that great, so perhaps it will end up on Amazon Prime Video or Netflix soon enough.

I believe I first read about tulip mania in the Burton Malkiel classic A Random Walk down Wall Street as an example of the Greater Fool Theory, where you buy something for a high price not due to its intrinsic value, but solely because you think someone else will buy it from you for an even higher price. (Does this apply to iPhone X pre-orders?)

Savings I Bonds November 2017 Update: 0.1% Fixed, 2.48% Variable Interest Rate

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Update 11/1/17. The fixed rate will be 0.1% for I bonds issued from November 1, 2017 through April 30, 2018. The variable inflation-indexed rate for this 6-month period will be 2.48% (as was predicted). The total rate on any specific bond is the sum of the fixed and variable rates. See you again in mid-April 2018 for the next early prediction.

Original post 10/15/17:

Savings I Bonds are a unique, low-risk investment backed by the US Treasury that pay out a variable interest rate linked to inflation. You could own them as a replacement for cash reserves (they are liquid after 12 months) or bonds in your portfolio.

New inflation numbers were just announced at BLS.gov, which allows us to make an early prediction of the November 2017 savings bond rates a couple of weeks before the official announcement on the 1st. This also allows the opportunity to know exactly what a October 2017 savings bond purchase will yield over the next 12 months, instead of just 6 months.

New Inflation Rate Component
March 2017 CPI-U was 243.801. September 2017 CPI-U was 246.819, for a semi-annual increase of 1.24%. Using the official formula, the variable component of interest rate for the next 6 month cycle will be 2.48%. You add the fixed and variable rates to get the total interest rate. If you have an older savings bond, your fixed rate may be very different than one from recent years.

Purchase and Redemption Timing Reminders
You can’t redeem until 12 months have gone by, and any redemptions within 5 years incur an interest penalty of the last 3 months of interest. A known “trick” with I-Bonds is that if you buy at the end of the month, you’ll still get all the interest for the entire month as if you bought it in the beginning of the month. It’s best to give yourself a few business days of buffer time. If you miss the cutoff, your effective purchase date will be bumped into the next month.

Buying in October 2017
If you buy before the end of October, the fixed rate portion of I-Bonds will be 0.0%. You will be guaranteed the current variable interest rate of 1.96% for the next 6 months, for a total 0.00 + 1.96 = 1.96%. For the 6 months after that, the total rate will be 0.00 + 2.48 = 2.48%.

Let’s say we hold for the minimum of one year and pay the 3-month interest penalty. If you theoretically buy on October 31st, 2017 and sell on October 1, 2018, you’ll earn a ~1.76% annualized return for an 11-month holding period, for which the interest is also exempt from state income taxes. If you held for three months longer, you’d be looking at a ~1.91% annualized return for a 14-month holding period (assuming my math is correct). Compare with the current best bank interest rates.

Buying in November 2017
If you buy in November, you will get 2.48% plus an unknown fixed rate for the first 6 months. The fixed rate is likely to be zero or 0.1%. (Current real yield of 5-year TIPS is ~0.20%.) Every six months, your rate will adjust to the fixed rate plus a variable rate based on inflation. If inflation picks up, you’ll get a hiked rate earlier than versus buying in October.

If haven’t bought your limit for 2017 yet, I don’t feel strongly one way or the other. If you like the idea of locking in a rate of return for the next 12 months that is a bit better than current CD rates, buy in October. If you think inflation will go up soon, buy in November. Your November fixed rate might be also be bumped up a tiny bit to 0.1%.

Existing I-Bonds and Unique Features
If you have an existing I-Bond, the rates reset every 6 months depending on your purchase month. Your bond rate = your specific fixed rate + variable rate (minimum floor of 0%). Due to their annual purchase limits, you should still consider their unique advantages before redeeming them. These include ongoing tax deferral, exemption from state income taxes, and being a hedge against inflation (and even a bit of a hedge against deflation).

Over the years, I have accumulated a portfolio of I-Bonds with fixed rates varying from 0% to over 1%, and I consider it part of my inflation-linked bond allocation inside my long-term investment portfolio.

Annual Purchase Limits
The annual purchase limit is now $10,000 in online I-bonds per Social Security Number. For a couple, that’s $20,000 per year. Buy online at TreasuryDirect.gov, after making sure you’re okay with their security protocols and user-friendliness. You can also buy an additional $5,000 in paper bonds using your tax refund (see IRS Form 8888). If you have children, you may be able to buy additional savings bonds by using a minor’s Social Security Number.

For more background, see the rest of my posts on savings bonds.

[Image: 1946 Savings Bond poster from US Treasury – source]

Scare-Testing Your Risk Tolerance on Halloween

jackoIt’s Halloween as I finishing writing this, and soon little ghosts and ghouls will be lining up to score treats from my great-aunt. She’s lived through some amazing times. It’s really hard to predict how you will handle a scary situation until you are actually faced with it. The fear, the uncertainly, the doubt. Sometimes the best you can do is try to scare yourself and imagine your response.

Scary stories. Instead of a horror flick, I read all 240+ posts from an October 2008 Bogleheads thread where a 75-year-old retiree discussed whether or not to cash out some of his portfolio. What happened October 1st to October 8, 2008? The S&P 500 went down 25%. In a week.

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Even if you managed to keep it together then, March 2009 rolled around and you found yourself down over 55% from a little more than a year ago.

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Scary news articles. On Google Finance, if you look back at historical quotes, they will adjust the “News” box to include articles from that time period. Here’s a few I picked out:

Scary numbers. Here are historical S&P 500 drawdowns from user BlueEars.

1973 down 38% in 21 months (understated because of inflation)
1980 down 27% in 13 months
1990 down 19% in 3 months
2000 down 49% in 31 months (growth bubble, SP500 loaded with it)
2007 down 42% in 12 months to date

Lessons?

  • Know your own tendencies. We did live through 2008/2009, but it felt like a different time. We were barely 30 years old and both employed. We “lost” a six-figure balance but we didn’t need it immediately. We did not sell any stocks and kept up all our automated 401k and IRA contributions. The hardest part was rebalancing, because that required action. Lesson: I tend to freeze and do nothing.
  • Everyone is different. One poster had 33% cash, 33% bonds, 33% stocks and was still in a panic. Others wanted to increase their stock holdings to 90% or higher. Some bought in after the first major drop but then got nervous when it kept dropping.
  • Stocks can drop 50% very quickly. Whatever you have in stocks, imagine it cut in half. Are you okay with that? Are you sure? I think I would be more nervous today given our much larger portfolio size. Therefore, our current asset allocation is more conservative (66% stocks/34% bonds).
  • Cash helps keep you calm. If you don’t need the money for a long time, it’s easier to be detached. However, retirees tend to view investment loses in terms of “years of expenses”. If you usually take out $50,000 a year to cover spending, and then your portfolio drops by $500,000, that’s an entire decade of spending “lost”. Knowing that you already have at least 3-5 years of withdrawals in a safe money bucket can help.

If you are willing to read something longer, I recommend The Great Depression: A Diary. 2008/2009 was bad, but things could have been much worse. It’s easy to not appreciate safe assets when things are going well.

Book Review: A History of Gold in the United States

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Having been born after 1971, I have never lived in a time when the dollar was backed by gold. In an effort to learn more about the gold standard, I recently finished One Nation Under Gold: How One Precious Metal Has Dominated the American Imagination for Four Centuries by James Ledbetter. In other words, this is a history of gold in America. Here are my overall takeaways:

I always thought that the pre-1971 gold standard meant that for every dollar printed, there was a certain amount of gold set aside in a vault. This turns out to be false. A long time ago, gold coins actually circulated as currency. But the more modern version of a gold standard simply means the government agrees to sell gold bullion on demand at a fixed dollar price (ex. $35 for an ounce of gold).

Under the gold standard, countries rarely had enough gold in their vaults to cover if everyone decided to redeem their currency. As a result, countries including the United States were constantly worried about running out of gold and used various political tricks to prevent too many redemptions. If the fixed ratio was $35 an ounce and people could get the equivalent of $36 an ounce somewhere else, there would be a big spike in demand and the US would have to ship out tons of gold. If the vaults went empty, that could cause a financial crisis. The system was constantly under stress.

Every major currency has ended up being forced off the gold standard, usually in times of severe stress. Wars. International trade deficits. Economic depressions. In 1933, the US government was again running low on gold and so they devalued from $20.67/oz. to $35/oz (a devaluation of over 40%). In addition, they banned domestic individuals from owning gold from 1933-1974. (Hmmm… a gold standard where you couldn’t actually get gold…) In 1971, with both the Vietnam War and ongoing trade deficits, Nixon ended international convertibility of the US dollar to gold.

I’ve read that every fiat currency in history has eventually failed. Well, it’s also true that every gold standard in history has eventually failed. Just a thought that kept running through my head while reading this book. Gold-backed currency has its own set of problems.

Harry Browne: Wise investment mind or paid salesman for gold industry? You may have heard of Harry Browne as the creator the Permanent Portfolio: 25% stocks/25% cash/25% long-term bonds/25% gold. Well, this book mostly mentions Browne as a shady doomsday salesman for the gold industry. He wrote books that promoted a specific gold company (Pacific Coast Coin Exchange) and then got paid $100,000 (~$600,000 in 2017 dollars) by that company. That’s not all… The SEC shut down PCCE for having no actual gold in vaults and instead buying things like private jets with the money. Here is a 1974 NY Times article about the company.

The chance that the US goes back on a gold standard is very, very, very small. The gold standard did restrict governmental power, and some people like the sound of that. However, governments like having the ability to expand and contract the money supply to overcome stressful events like war and economic recessions. Will they wield that power wisely and effectively? Mistakes will be made, but I don’t see how they will voluntarily give up that flexibility. The question is not whether fiat currency is perfect, it is about which is better amongst imperfect options.

In the end, perhaps it is better that there is an open market for gold. Today, individuals can exchange gold for dollars and dollars for gold whenever they want. Gold ETFs let you buy gold with few clicks and lower transactional costs than physical gold. If you like market-cap weighting, consider a 1% gold portfolio.

I’m not a history buff in general, and perhaps that is why I found this book rather dry and hard to finish. There is no flowing narrative like a Michael Lewis book. However, I felt like I did learn some useful lessons and I’m glad I finished it.

Morningstar Star Ratings, Still Less Useful Than Expense Ratios

jeapordy_shadeFor investment nerds, the recent Wall Street Journal article The Morningstar Mirage was high drama. The subtitle got straight to the point:

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn’t.

Morningstar ratings mainly reflect past performance. However, something called “mean reversion” usually happens. If a fund has done well recently, it will have a high rating. But it usually doesn’t stick. The WSJ has a good visual:

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This quote is spot on: “Morningstar’s star ratings for funds are clearly used in the industry to imply that funds that performed well in the past will do so in the future.” Check out the fund flows into the Permanent Portfolio Fund when they were 5-star. Just a couple years later, chheck out the fund flows out when they drop to 1-star.

wsj_mstar2

Morningstar responded with Setting the Record Straight on Our Fund Ratings, which in my opinion just repeated the top graphic above. People think the left part will hold. Reality is the right part.

The Journal’s analysis found that most five-star funds perform somewhat better than lower-rated ones, yet on the average, five-star funds eventually turn into merely ordinary performers.

More importantly, something was conspicuously missing from this rebuttal…

Expense ratios are a more dependable predictor of performance. Source: Morningstar. Back in 2010, Russell Kinnell of M* had what the NY Times called “an act of radical and admirable transparency” in his article How Expense Ratios and Star Ratings Predict Success. Here’s my 2010 post about it.

If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. […] Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.

Smart investors know about this article. Morningstar executives choose not to mention it. Why would they? They charge fund companies $10,000 a pop to brag about their 5-star ratings in ads.

This is where my pragmatic side kicks in. I like Morningstar overall. I’m glad they exist. You just have to pick what you consume carefully.

  • Morningstar creates a lot of high-quality, free stuff for DIY investors. They have great free data, some nice tools, and many helpful articles from knowledgable authors. I link to them regularly. I talk about star ratings never.
  • People love star ratings systems. There’s a reason why you see stars on every Amazon product page. Most people don’t want to filter out everything themselves. They want the feeling that some fancy algorithm has hand-picked the best funds for them. They want easy.
  • Financial advisors love star ratings systems. If the financial advisor makes a pick and it goes bad, then whose fault is it? Not mine, I followed the rating system and followed the experts! Financial advisors are incentivized to stay close to the pack, as if they stick out in the wrong way, they will get fired. This is known as minimizing career risk.
  • This is not a perfect analogy, but Morningstar is kind of like Whole Foods. You could make some great food at decent prices using their raw ingredients and 365 product line. But 1/3rd of the store is prepared foods, and the most popular are stuff like pizza, sushi, mac & cheese, chicken nuggets, and chicken wings. Why do they sell these things? It is what the customer wants, and they are a for-profit corporation.

10 years from now, I predict that the system will be exactly the same. Morningstar wants to keep it, most clients want to keep it, and the financial advisors want to keep it. Morningstar stock plunged when the WSJ story broke, but recently bounced back up. I suspect people came to the same conclusion as I did.

Bottom line. The WSJ article reminds us of an important lesson. Morningstar “5-star ratings” are simply markers of past performance. Reversion to the mean usually happens. Consider long-term past performance as one factor amongst many, but don’t chase 5-star funds. Expense ratios are a better predictor of future returns than M* star ratings. If anything, simply avoid 1-star funds.

Early Retirement Income Update 2017 Q3: Do I Have Enough Yet?

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How do you know when you portfolio is enough to retire on? You have to figure out a withdrawal strategy first. This is a tricky question and full of worries about running out of money. You could take out a fixed amount (i.e. $50,000 a year). You could take out a fixed percentage (i.e. 4% a year). You can adjust for inflation. You can implement upper or lower guardrails.

Personally, I appreciate the behavioral reasons why living off income while keeping your ownership stake is desirable. The analogy I fall back on is owning a rental property. If you are reliably getting rent checks that increase with inflation, you can sit back calmly and ignore what the house might sell for on the open market.

I’ve also come to feel that dividend yield can be a quick-and-dirty way to adjust your withdrawal rate for valuation. For example, if the price of S&P 500 index goes up while the dividend payout stays the same, then wouldn’t it be prudent to simply spend the same amount? Check out the historical S&P 500 dividend yield via Multpl. Focus the last 20 years – the yield was highest in the 2008 crash and lowest in the 2000 tech bubble.

sp500dy_1710

Now check out the absolute dividend amount (inflation-adjusted), also via Multpl:

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Note that if you only buy “high-yield” stocks and “high-yield” bonds, that actually increases the chance that those yields will drop sooner or later. I am trying to reach some sort of balance where I spend the income on a “total return” portfolio.

Even the venerable Jack Bogle advocated something similar in his early books in investing. He suggested owning the Vanguard Value Index fund and spending only the dividends as way to fund retirement.

One simple way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar (linked below). Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a very close approximation of my most recent portfolio update. My current target asset allocation is 66% stocks and 34% bonds, and intend that to be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (Taken 10/23/17) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
25% 1.85% 0.46%
US Small Value
Vanguard Small-Cap Value ETF (VBR)
5% 1.81% 0.09%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
25% 2.57% 0.64%
Emerging Markets
Vanguard Emerging Markets ETF (VWO)
5% 2.34% 0.12%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 3.90% 0.23%
Intermediate-Term High Quality Bonds
Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX)
17% 2.81% 0.48%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
17% 2.99% 0.51%
Totals 100% 2.53%

If I had a $1,000,000 portfolio balance today, a 2.5% yield means that it would have generated $25,000 in interest and dividends over the last 12 months. (The muni bond interest in my portfolio is exempt from federal income taxes.) Some comparison numbers (taken 10/23/2017):

  • Vanguard LifeStrategy Moderate Growth Fund (VSMGX) is a low-cost, passive 60/40 fund that has a trailing 12-month yield of 2.06%.
  • Vanguard Wellington Fund is a low-cost active 65/35 fund that has a trailing 12-month yield of 2.48%.

These income yield numbers are significantly lower than the 4% withdrawal rate often quoted for 65-year-old retirees with 30-year spending horizons, and is even lower than the 3% withdrawal rate that I usually use as a rough benchmark. If I use 3%, my theoretical income would cover my projected annual expenses. If I used the actual numbers above, I am close but still short. Most people won’t want to use this number because it is a very small number. However, I like it for the following reasons:

  • Tracking dividends and interest income is less volatile and stressful than tracking market prices.
  • Dividend yields adjust roughly for stock market valuations (if prices are high, dividend yield is probably down).
  • Bond yields adjust roughly for interest rates (low interest rates now, probably low bond returns in future).
  • With 2/3rds of my portfolio in stocks, I have confidence that over time the income will increase with inflation.

I will admit that planning on spending only 2% is most likely too conservative. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years. But as an aspiring early retiree with hopefully 40+ years ahead of me, I like that this method adapts to the volatility of stock returns and the associated sequence of returns risk.

Early Retirement Portfolio Asset Allocation, 2017 Third Quarter Update

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Here is an update on my investment portfolio holdings after the third quarter 2017. This includes tax-deferred 401k/403b/IRAs and taxable brokerage holdings, but excludes things like our primary home, cash reserves, and a few other side investments. The purpose of this portfolio is to create enough income to cover our regular household expenses.

Target Asset Allocation. The overall goal is to include asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. I also try to imagine each asset class doing poorly for a long time, and only hold the ones where I think I can maintain faith.

Stocks Breakdown

  • 38% US Total Market
  • 7% US Small-Cap Value
  • 38% International Total Market
  • 7% Emerging Markets
  • 10% US Real Estate (REIT)

Bonds Breakdown

  • 50% High-quality, Intermediate-Term Bonds
  • 50% US Treasury Inflation-Protected Bonds

I have settled into a long-term target ratio is 67% stocks and 33% bonds (2:1 ratio) within our investment strategy of buy, hold, and rebalance. With a self-managed, simple portfolio of low-cost funds, we minimize management fees, commissions, and income taxes.

Actual Asset Allocation and Holdings

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Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard Small Value ETF (VBR)
Vanguard Emerging Markets ETF (VWO)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard Intermediate-Term Tax-Exempt Fund (VWITX, VWIUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
U.S. Savings Bonds (Series I)

Performance and commentary. According to Personal Capital, which aggregates all of my investment holdings across different accounts, my portfolio has gained 7.41% over the last 6 months since my last update. In the same time period, the S&P 500 has gained 9.21% (excluding dividends) and the US Aggregate bond index has gained 1.34%.

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Things are currently at 69% stocks/31% bonds. For the most part, I continue to invest new money on a monthly basis in order to try and maintain the target ratios. Once a quarter, I also reinvest any accumulated dividends and interest. I don’t use automatic dividend reinvestment. This way, I can usually avoid creating any taxable transactions unless markets are really volatile.

For both simplicity and cost reasons, I am no longer buying DES/DGS and will be phasing them out whenever there are tax-loss harvesting opportunities. New money is going into the more “vanilla” Vanguard versions: Vanguard Small Value ETF (VBR) and Vanguard Emerging Markets ETF (VWO).

I’m still somewhat underweight in TIPS and REITs mostly due to limited tax-deferred space as I don’t want to hold them in a taxable account. My taxable muni bonds are split roughly evenly between the three Vanguard muni funds with an average duration of 4.5 years. I may start switching back to US Treasuries if my income tax rate changes signficantly.

In a separate post, I will track dividend and interest income.

Housing Has Higher Long-Term Returns Than Stocks?

housemoneyI finally got around to reading an academic paper that looked a bit dry but had a great title: The Rate of Return on Everything, 1870–2015 [pdf] by Jorda, Knoll, Kuvshinov, Schularick, and Taylor. I wonder which of the authors came up with that.

One of the major findings that was residential housing – when you add up the returns from both price change and imputed rent – had a higher overall average return than stocks (equities). Not only did housing have higher returns, but it also had lower volatility (standard deviation). Here’s a chart that compares housing and equities:

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When the paper was released, places like the Financial Times discussed the paper’s conclusions but none of them addressed my two immediate questions.

Did they account for the maintenance and management costs of rental real estate? If you own a rental property, you may still have to pay for lawn maintenance, replacing roofs, HVAC units, interior and exterior painting, replacing carpets, and various other issues. To be fairly compared with equities, you should also account for property management costs. Here’s are excerpts that deal with maintenance and repairs:

To the best of the authors’ knowledge, this study is the first to present long-run returns on residential real estate. We combine the long-run house price series presented by Knoll, Schularick, and Steger (2016) with a novel dataset on rents from Knoll (2016). For most countries, the rent series rely on the rent components of the cost of living of consumer price indices as constructed by national statistical offices and combines them with information from other sources to create long-run series reaching back to the late 19th century.

A number of additional issues have to be considered when constructing returns on housing. First, any homeowner incurs costs for maintenance and repairs which lower the rental yield and thus the effective return on housing. We deal with this issue by the choice of the benchmark rent-price ratios. Specifically, in the Investment Property Database (IPD) the rental yields reflect net income (i.e., net of property management costs, ground rent, and other irrecoverable expenditure) received for residential real estate as percentage of the capital employed.

Did they account for the annual property taxes required on residential real estate? In many US states, the annual property tax bill can exceed 1% of the value of the house. Some are closer to 2% annually, and these are owner-occupied numbers. Rental properties may be higher. That’s on top of any potential capital gains you’d owe upon sale of the house, and any taxes you’d owe on rent received. Here’s are excerpts that deal with taxes:

Although the extent of real estate taxation varies widely across countries, real estate is taxed nearly everywhere in the developed world. International comparisons of housing taxation levels are, however, difficult since tax laws, tax rates, assessment rules vary over time and within countries. Typically, real estate is subject to four different kinds of taxes. First, in most countries, transfer taxes or stamp duties are levied when real estate is purchased. Second, in some cases capital gains from property sales are taxed. Often, the tax rates depend on the holding period. Third, income taxes typically also apply to rental income. Fourth, owners’ of real estate may be subject to property taxes and/or wealth taxes where the tax is based upon the (assessed) value of the property.
This section briefly describes the current property tax regimes by country and provides estimates of the tax impact on real estate returns.

With few exceptions, the tax impact on real estate returns can be considered to be less than 1 percentage point per annum.

This is an interesting paper that tries to cover a huge amount of stuff. Estimating the return of all businesses from all countries for the last 150 years? Estimating the return of all residential real estate from all countries for the last 150 years? They mix together a bunch of different datasets, so it’s hard to know exactly the quality level of each and how well they accounted for things like taxes and maintenance.

I’m not sure why they prefer to use arithmetic averages instead of geometric averages, but even if you shave off 1% for additional property taxes and another 1% because you don’t think they account for maintenance costs adequately, housing returns are still at least comparable to equity returns.

Here is the most recent update of the Case/Shiller home price index from Multpl, which tracks US housing prices on an inflation-adjusted basis:

shiller1890

Some people use this to argue that housing returns only keep up with inflation, but home prices ignore the value of rent. The fact that most housing purchases involve a mortgage loan does complicate things a bit.

Bottom line. An interesting paper that compares the long-term returns (last 150 years!) of residential housing and equities. In the long run, some may be surprised that residential housing returns at least matched equity returns, and housing returns had lower volatility. This is a reminder that you can also build wealth via residential real estate, taking into account that rent makes up half of the total return. Stocks are not the only game in town. (Just like with stocks, can is not the same as will.) New services like AirBNB provide an alternate path to monetize residential real estate.

TD Ameritrade Commission-Free ETF List – Changes Effective November 2017

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Updated. As of October 2017, TD Ameritrade notified their clients of the following changes to their commission-free ETF trading program. Here are the highlights from the e-mail:

  • Here is the old ETF list [pdf]. Through 11/20/17, they trade commission-free. Starting 11/21/2017, they will trade at standard commission rates ($6.95 online trades).
  • Here is the new ETF list [pdf]. These 296 ETFs can be traded commission-free immediately (as of 10/17/17).
  • ETFs held less than 30 days will be charged a short-term trading fee of $13.90, down from $19.99. This new fee will go into effect on November 21, 2017.
  • All new ETFs on the commission-free list cannot be used as collateral for a margin loan, nor can they be included in margin equity for 30 days after purchase.

What ETFs are being removed? Initially started in 2010, the “old” list of 100 ETFs was based on advice from Morningstar as to which 100 ETFs that would be most useful for long-term investors to build a ETF portfolio. In other words, these were popular buy-and-old ETFs for “Average Joe/Jane” customers. These ETFs were from the biggest providers (Vanguard and iShares) and had the highest assets, highest trading volume, and lowest expense ratios.

There are now zero ETFs from Vanguard. The most widely-held iShares ETF are also missing. Here are some notable removals:

  • Vanguard Total Stock Market ETF (VTI)
  • Vanguard FTSE All-World ex-US ETF (VEU)
  • Vanguard MSCI Emerging Markets ETF (VWO)
  • Vanguard REIT Index ETF (VNQ)
  • Vanguard Total Bond Market ETF (BND)
  • iShares Core S&P 500 (IVV)
  • iShares Core US Aggregate Bond (AGG)
  • iShares TIPS Bond (TIP)
  • iShares 1-3 Year Treasury Bond (SHY)
  • iShares 20+ Year Treasury Bond Fund (TLT)

Note: TD Ameritrade will still provide free dividend reinvestment on your existing ETF positions.

What ETFs are being added? The “new” list of 296 ETFs are mostly niche ETFs. Providers include AGFiQ QuantShares, First Trust Portfolios, iShares ETFs, J.P. Morgan Asset Management, PowerShares by Invesco, ProShares, State Street Global Advisors’ SPDR, and WisdomTree Investments. They cover a wide range of specific investment themes.

Unfortunately, this move also puts TD Ameritrade more firmly into the pack of brokerage with ETF/mutual fund “supermarkets” based on who will pay them for shelf placement:

TD Ameritrade receives remuneration from certain ETFs (exchange-traded funds) that participate in the commission-free ETF program for shareholder, administrative and/or other services, generally ranging from the equivalent of approximately 15% to 30% of the ETFs’ annual net operating expense ratio.

This is a common arrangement and you’ll see the same thing at Schwab and Fidelity, but in my opinion you end up a bigger list of less-attractive products. They also tend to have higher expense ratios. I’ve never even heard of these before:

  • First Trust Alternative Absolute Return Strategy ETF
  • iShares Fallen Angels USD Bond ETF
  • PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio
  • QuantShares US Market Neutral Anti-Beta Fund

To be fair, there are still some iShares Core ETFs (though not the broadest ones) and some SPDR ETFs that cover broad indexes (though with lower asset size and trading volume). There are maybe 15-20 ETFs that I could see as part of a low-cost, long-term portfolio. A few examples:

  • SPDR Dow Jones Total Market (SPTM)
  • SPDR S&P World ex-US (SPDW)
  • SPDR Lehman Aggregate Bond (SPAB)
  • iShares 0-5 Year TIPS Bond ETF (STIP)
  • iShares Core International Aggregate Bond ETF (IAGG)
  • iShares Core U.S. REIT ETF (USRT)
  • iShares Global REIT ETF (REET)

Here are two ETFs on the list that I have bought myself in the past:

  • WisdomTree Emerging Markets SmallCap Dividend Fund (DGS)
  • WisdomTree U.S. SmallCap Dividend Fund (DES)

Mostly, I just don’t like the fact that they changed it after many years. You might have built up a position with $0 trades, and now it costs $6.95 to buy more. You can try and switch to the closest approximate ETF, but what about next time they shake up the list? TD Ameritrade won “#1 for Long-Term Investing” in the Barron’s magazine 2017 rankings. I don’t know if long-term investors like to switch holdings every 7 years. Maybe the niche ETFs are a better draw for TDA’s target audience.

If you want to construct a low-cost, broadly-indexed ETF portfolio, I would compare with the offerings from Schwab, Vanguard, and Fidelity. None of those are an independent brokerage like TD Ameritrade, but they do offer commission-free trades on low-cost, broad ETFs. You could also look into the free trade offers from Bank of America ($50k+ in relationship assets) and Robinhood (trades done via app only).

Current New Account Promotions. TD Ameritrade will let you trade commission-free for 60 days + get up to $600 if you open a new individual, joint, or IRA account. The specific bonus depends on how much money you move over. Note that unlike some other offers, this one includes IRAs and thus rollover IRAs from 401k plans.

Bottom line. TD Ameritrade has shifted the nature of their commission-free ETF program. Overall, the widely-held, broad ETFs from Vanguard and iShares have been removed. In their place, many niche/sector ETFs and smaller, newer ETFs have been added. If you like specialized ETFs, check to see if it is on their newly-expanded list of 296 ETFs.

RealtyShares Update: My First Loan Default and Foreclosure Recovery (Ongoing)

realtyshareslogoHere’s an update on my debt investment at RealtyShares. The borrower stopped paying for unclear reasons, and as a result this is my first investment to go into foreclosure proceedings. I am still hopeful for a full recovery of my principal and accrued interested, but it will take a while to come to a resolution. I wanted to share some interim details for those interested.

rs_okeefe1

Initial investment details.

  • Property: 6-unit, 6,490 sf multifamily in Milwaukee, Wisconsin.
  • Interest rate: 9% APR.
  • Amount invested: $2,000.
  • Term: 12 months, with 6-month extension option.
  • Total loan amount is $168,000. Purchase price $220,000 (LTC 76%). Estimated after-repair value $260,000. Broker Opinion of Value $238,000.
  • Loan is secured by the property, in the first position. Personal guarantee from borrower.
  • Stated goal was to rehab, stabilize, and then either sell or refinance.

Subsequent summary of events.

  • January 2016. Funds committed. Loan closed.
  • July 2016 to May 2017. Sporadic payment history for over a year. They would be on-time for a while, then there’d be a late payment, then things would brought back current, etc.
  • May 2017. Borrower stated that the property was under contract for $225,000 with final walk-through completed and expected close within 30 days.
  • June 2017. Borrower stopped paying. I guess the sale fell through (or they lied). Foreclosure process initiated by RealtyShares.
  • September 2017. Judgment granted in Wisconsin court. By law, there will be 3-month redemption period where they borrower can still keep house if they pay foreclosure judgment plus interest, taxes, and costs. Expected scheduled sale date in December 2017.

Payment history. I invested $2,000 and have gotten paid $210.84 of interest before the payments completely stopped. That’s paid interest of 10.5% of principal with a rough estimate of 24 months elapsed from January 2016 to January 2018 (could be longer). My total return will depend on how much money the property will fetch upon sale.

What’s next? It was only a matter of time before I got a default. The question is how often that happens and the size of any losses. When it came to Prosper or LendingClub, the interest rates might be higher but when a loan was 60 days late you were pretty much done. As an unsecured loan, you had nothing to fall back on if the borrower broke their promise (besides hurting their credit score). Sending it to collections might get you pennies on the dollar.

However, this debt is backed by a hard asset, and RealtyShares has already started the foreclosure process. Within three months, either the borrower will have paid it off or the apartment complex will be put up for sale. I tried to research some recent comps in the area using the popular real estate websites like Zillow, but this is a somewhat unique property (6-plex). I don’t see any reason why it would sell for significantly less than the loan amount.

This is complete speculation, but I wonder if the borrower is still collecting rent from all these tenants even after they stopped making loan payments and even now during the foreclosure process. Just pocketing the rent… Is that allowed? Otherwise, the incoming rents should be higher than the mortgage payment, so why not keep paying on the loan? Curious.

Communications quality. I would grade the online updates from RealtyShares as acceptable/good. They are relatively detailed and consistent, providing me a look inside the foreclosure process. Here is a copy/paste of my most recent updates:

October 9, 2017 We have identified a real estate broker to sell the property. The broker spoke with the previous property manager who was at the property a couple of weeks ago and who may be available for property preservation. The broker is going to take a contractor to the property to try and get an accurate cost estimate to complete the renovation.

September 21, 2017 Judgment was granted at the hearing. We expect the filed judgment from the court in approximately one week and will process it upon receipt. We should be able to schedule the sale in late October and it will be held after the redemption period expires—sometime in December. As soon as we receive the filed judgment order from the court we will have the exact 3 month redemption date. Sale cannot be held until the redemption period has expired.

September 8, 2017 The partner has declined to go forward with the purchase of the property. On the foreclosure front, the judgement hearing is scheduled for September 18th. If the judgement is successful, there is a 6-month right of redemption period during which the property can not be sold. During this period we will identify a property preservation firm and a commercial broker to sell the property.

August 25, 2017 A minority partner has stepped forward and has asked for a week to visit the property with the idea of making a paydown in exchange for an extension. We have agreed to speak next week after his inspection.

August 22, 2017 Service has been completed on the foreclosure. The defendants were personally served with the summons and complaint on August 2, 2017. The statutory answering time will expire on August 22, 2017. The judgment hearing will be scheduled at that time.

June 29, 2017 Due to the borrower’s inability to stay current, we have decided to start the foreclosure process for payment default. The foreclosure will run parallel with the sales process, meaning if the sponsor can sell the property and pay us off before the foreclosure is complete we will stop the process, if not we will take over the property. Typically, foreclosures in Wisconsin take up to 12 months.

Bottom line. Well, I used to wonder what would happen in a foreclosure scenario, and now I get to find out. So far, I’m just waiting. There is no secondary market, so I can’t sell my share and invest it elsewhere. I must be patient, and hopefully I will earn an illiquidity premium as a result (i.e. higher returns). I will update again when there is more to report on the recovery process. If you are interested and are an accredited investor, you can sign-up for free and browse investments at RealtyShares before depositing any funds or making any investments.

I’ve also made investments in these other real-estate sites: PeerStreet, which offers $1,000 minimums and automated investing. Patch of Land, a debt investment backed by a single-family residential property in California. Fundrise eREIT, a basket of commercial property investments with an equity focus.

S&P 500 Total Return: Still Doubled From October 2007 to 2017

In early October 2007, the S&P 500 index hit just over 1,500 – an all-time high. You might have been concerned, or you might not have even noticed. Less than 2 years later, the financial crisis occurred and the S&P 500 dropped 50% down to 750 (March 2009). If you were a lump-sum investor, October 2007 would have been the worse month to invest in a rather long time. However, consider this chart via Bloomberg article:

bw_october2017

If you held on through the panic, you broke back even some time in mid-2012 if you include dividends (total return). Four years after hitting bottom, you were again hitting an all-time high. After that, basically all of 2013 was spent reaching new “all-time highs” over and over again. You might have gotten nervous again. Is it time for another drop?

Yet, if you continued to hold on until now (October 2017), even if you had the worst possible timing an pushed all your chips in on October 2007, you would have doubled your money. Over the last 10 years, even after both pushing your chips in at an all-time high and experiencing a 50% drop, you would still have earned over a 7% compounded return.

You could interpret this as pro-stocks, but my takeaway is instead that all-time highs don’t mean much. The price could drop by 50%. The price could go up 100%. We’ve seen that, and thus should be prepared for both. Instead of worrying, try considering either possibility and make a plan.

If stocks keep going up from here, I will ______. If stocks drop 50% from here, I will _______.

In my case, my portfolio could be described roughly as 67% stocks and 33% bonds. If all my stocks dropped 50% and my bonds held steady, then I would end up at 50% stocks and 50% bonds. After a 50% haircut, I would be shaken but hopefully remind myself that stock valuations would look a lot better as well. If I can get up the courage, then I will rebalance back to 67/33. If I turn out to be a scaredy-pants, simply staying at 50/50 should still keep me adequately exposed to any recovery.

Kelly Criterion and Your Fun Money Allocation

chipsDo you think you’re a below-average driver? I didn’t think so. In the same vein, Jason Zweig had a funny tweet the other day that hit home:

His linked article ends with this advice:

Put 90% of your money in low-cost index funds and lock yourself in by adding a fixed amount every month through an electronic transfer from your bank. […] Speculate with just the remaining 10%, and use a checklist of buying criteria to make sure you never buy a stock purely because it has been going up.

This coincided with me reading stuff about the Kelly Criterion, a mathematical formula used to determine the optimal size of a series of bets. Basically, the greater your “edge”, the greater your bet size should be. If you have zero edge, then you should bet nothing. If you have negative edge, you should theoretically bet against yourself (if only casinos allowed that).

Here’s an interesting example that involved a special coin where you have the advance knowledge that it has a 60% chance of heads and 40% chance of tails. In short, with this edge you should consistently bet 20% of your bankroll each time. That’s it! If the coin was 52.5% heads/47.5% tails, you should only bet 5% of your bankroll. Most people do not find this intuitive.

What’s your own edge? Consider that some folks think that only 5% of Active Investment Managers Will Add Value. This is where I insert a couple of Charlie Munger quotes:

I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans. And that’s just the way it is, I’m afraid. It’s nice that they keep an image of being constructive, sensible people when they’re really would-be faith healers. It keeps their self respect up.

Bottom line. In stock market investing, most of us lack an edge and thus should stick with index funds. But we all like to think we have some edge, so maybe a 5% or 10% fun money allocation is acceptable. Anything higher would be claiming to have some crazy, unreasonable edge. I would say it also depends on how aggressively your fun money is managed. Berkshire Hathaway stock is relatively low risk. Mine is invested in short-term loans backed by real estate with conservative loan-to-value ratios and a target return of 7%. The latest cryptocurrency promoted by celebrities on social media? Not low risk.