This note in the Straight Talk series continues our original posting of six candid rules for individual investors. Today's analysis is inspired by Garth Brook's country classic "If tomorrow never comes." We focus today on housing, saving, inflation and risk.
Rule 7: Rent versus buy analysis in housing is a must
At one time, I was the only person in the world who had lost money owning a home in two countries, first in Los Angeles, which practically invented the housing bubble, and second in Tokyo, which perfected the bubble. For that reason, I've spent a lot of time thinking about the economics of renting versus buying. People all over the world think that buying one's own home is the American dream, the Indian dream, or the Chinese dream, and that's easy to understand from an emotional point of view. From a purely cold hearted financial point of view, it's not always obvious that one should buy a house even when it's possible to do so. Let's look at the facts. First of all, few people who are lucky enough to reach 85 years of age will still be living in their own home at that age, so for starters one should expect that if they're in a house at 85, they'll be selling it then. Second, even if one's in a house now, there are many surprises in life that can make it mandatory to sell it unexpectedly--divorce, a lost job, medical bills, etc. are the most common reasons. Third, the commissions on buying and then selling a house are astronomical in many countries, especially the United States. So consistent with part one in the Straight Talk series, a key mantra here is "don't trade houses like you'd trade a common stock." Ideally, one would make as few housing buys and sells as possible. Finally, the tax deductibility of mortgage interest in the U.S. and a few other countries has to be taken into account. Given all this, what should one do? First of all, lay out the mortgage interest and principal associated with buying the house. Include the fees associated with buying the house, including the real estate commissions. Carry the analysis forward until the day you have to sell the house or age 85, whichever comes first. Include the commission associated with selling the house when you finally move. Include property taxes and repair costs too. And, finally, include the tax savings from the mortgage interest deduction. Now, do the same projection of rental costs. Which has the cheaper net present value? Is it cheaper to rent or buy? And what combination of home price changes and rental cost changes are necessary to change one's conclusion? How likely is this to happen? Can you handle the increases and decreases in rent that might come if inflation gets out of hand?
In my case, the last time I did this analysis, the cost of owning the lovely place I live in was thousands of dollars a month more than the cost of renting it, and it would take 30 years of 8% annual home price inflation to "break even." With hindsight, that was a perfect predictor of how over inflated home prices had become in the U.S., and I avoided a 20-30% drop in home prices by renting.
What are some other obvious conclusions from this rule? If you are 81, don't buy a house--rent instead. If you are going to move in 2 or 3 years, renting will be cheaper in almost every circumstance. What if you and your spouse don't get along? Rent until you're sure you love each other. What if you work for a regional bank that's likely to be acquired? You should probably be renting unless your job is very secure even if your employer is bought by someone out of state. What if you work in financial services in New York? The value of any real estate you buy is going to be highly correlated with your bonus, and if you get fired, the odds are high that your home will have dropped in value. From a diversification point of view, it's probably better to rent from a doctor whose income isn't correlated with the markets!
Rule 8: If you buy a house, get a fixed rate mortgage
Unless your income goes up and down with interest rates, it's crazy to buy a house and then get an adjustable rate mortgage if you are lucky enough to live in a country where fixed rate mortgages are common. You can always refinance if rates drop, and you'll never run the risk of losing your home when interest rates rise. This is a corollary of the rule not to trade when you don't have to--taking on an adjustable rate mortgage is like saying "I want to run the risk of being forced to sell my home at the worst possible time," when everyone else that has a floating rate mortgage has to do the same thing. If you think you can predict interest rates, why not trade bond futures? It's cheaper to prove yourself wrong doing that than making your mortgage a "bond trade."
Rule 9: Save like you're going to live forever, because you might.
Let's say you have a 1% probability of living to age 100, and that an ideal life would be having $75,000 to spend in your hundredth year. Does that mean that the actuarial amount of money you need is 1% times $75,000=$750? If you're the insurance company, yes, but if you're you, the amount of money you need is $75,000! What if you live to 100 and you're left looking the investment proceeds from that $750 in the face? Do you tell yourself, "Rats, I beat the odds"? Actuarial tables can be very helpful in financial strategy, but this is one area where it's easy to outsmart oneself! Buying an annuity from an insurance company is one way to get around this problem because the insurance company is diversified. If you're handling your own investments, however, you are NOT diversified and that's an easy thing to forget.
Rule 10: Tomorrow does come: work backwards to determine how much you need to save and how to invest it
In the example under rule 9, to have $75,000 with certainty at age 100, what do you need to do? Assuming away inflation, we need a bond which pays principal and interest totaling $75,000 when you are 100 years old. You also need investments that pay $75,000 when you are 99. Some of the money you need at 99 will come from interest on the bond that matures when you are 100, so the additional bond you need to buy that matures when you are 99 will be a bond that pays less than $75,000 in principal and interest. By working backwards in this simple way, one can determine how much money one needs at retirement to lead the lifestyle one has in mind. All cash flow comes into play in this calculation, including pensions, social security, living expenses, and so on. This technique tells you how much you need to save using a "bonds only" strategy and assuming the bonds don't default. By doing this calculation carefully, taking inflation into account, serious individual investors will find the right savings and investment strategy. My firm often finds that investors, both retail and institutional, have overinvested in common stocks and real estate once all of the risks and correlations are taken carefully into account. Many investors ignore their future liabilities (food, living expenses, transportation expenses, and so on) in setting their investment strategy, which is one of the biggest risk management mistakes one can make.