September heralds the dawn of a new school year for most American youth.
Adults, of course, can go back to school, too. In this episode of Motley Fool Answers, host Alison Southwick and advisor Robert Brokamp, a former teacher, don their academic robes. The two deliver money lessons on math, economics, English, and history. They also tackle a question on how to factor real estate investments into your portfolio and, of course, they throw in the usual dose of silliness expected with an Answers episode.
A transcript follows the podcast.
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This podcast was recorded on Sept. 13, 2016.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I am joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool, future doctor, and previous professor. A teacher.
Robert Brokamp: A teacher, yes. That's true.
Southwick: So summer is over and today we're taking you back to school. Professors Bro and Alison will deliver bite-sized money lessons in math, economics, English, and history?
Brokamp: Sure, it sounds good to me.
Southwick: We'll also answer your question about how to consider your real estate investments in your portfolio. All that, and more, on this week's episode of Motley Fool Answers.
Southwick: Time for answers, Answers. This one comes from Bruce. Now you told me to edit this down, and you left out some of the praise that Bruce had for you, but I stuck it back in.
Southwick: Bruce says: "Love the show. I listen every week and I have also read every word that Bro has written for Rule Your Retirement."
Brokamp: That is more than 12 years of issues, so good for you, Bruce.
Southwick: God bless you, Bruce. His question is: "I have a substantial amount of investable assets in income-producing rental real estate -- close to half, as I started investing in real estate at a very young age. I have been ignoring this in my allocations, but after thinking about it for a while, realized that is pretty dumb. What is your recommendation for considering these properties in my investment allocation and in creating a model portfolio?"
Brokamp: Well, Bruce, the question you would ask with any non-portfolio asset (including your human capital, which is your ability to earn a paycheck) is how it affects the risk profile of your overall household finances. So if you have rental properties, and they're cash flow positive, that adds diversification to your overall household portfolio, because you've got an asset that can increase in value and it's producing income.
Because it is adding this diversification, it lowers your overall risk profile (which means you can take more risk) in your investment portfolio. You might have more stocks that you otherwise would have.
You do have to look at the properties themselves. For example, just like stocks, you want to make sure you are diversified. If all your properties are in the same area serving the same sort of people, they're not quite as diversified as if you had properties in other locations. Maybe you have rental properties that are at the beach, or rental properties on a lake. You want to look at the location of the properties. Is that location economically diversified? Is it in a place like Detroit that was very reliant on the auto industry, or is it in a place like the Washington, D.C., area which has a diversified economy?
Then the other question people often bring up when it comes to real estate and their portfolio is, "I have a house. I have rental properties. Maybe I don't need to invest in things like real estate investment trusts," which is a good type of stock to have in a diversified portfolio.
But REITs are very different than rental properties and your house, because REIT investment companies (like hospitals, storage facilities, or office buildings) perform very differently than rental real estate or your own house. Just because you have rental property doesn't necessarily mean you should not have REITs. Overall, I think having real estate is a great idea and allows you to take more risk in your portfolio.
Brokamp: Ding ding ding ding ding! Settle down, class! Take your seats!
Southwick: Yes, that's right. Summer's over. School is in session, and so today we are taking you back to school. Get on the bus. We have four classes today. We were going to include a recess, but then we just couldn't come up with a good recess, so whatever.
Brokamp: So go out and play at some point in the middle of this podcast.
Southwick: Yes, just pause it and go play tag with some strangers or something. Bro, you used to be a teacher.
Brokamp: Yes, I used to be a teacher.
Southwick: Yes, you used to be a teacher. Tell me about that.
Brokamp: I actually was pre-med in college and had plans to go to med school, but I wanted to do some sort of volunteer work before I went to med school, so I joined something called the Teachers Service Corps for the Archdiocese in Washington, D.C., to teach in an inner city school in Washington. It ended up being in Georgetown. If you know the area, it's not really very inner city.
But I taught for five years. I taught sixth and seventh grade literature and religion. A little bit of science. A little bit of computers, here and there. And in the process of that, I got a master's in education along the way.
Southwick: I feel like you were born to be a teacher. You're so good at it. You're good at it!
Brokamp: Thank you. Thank you very much.
Southwick: We're actually going to split up the classes, today.
Brokamp: We are?
Southwick: That means I'm going to be teaching a couple, which...I don't know!
Brokamp: I think you'll do a fantastic job.
Southwick: I don't know about this. We know that my history of accuracy is in question. The first class -- first period -- is English. And that's me. I'm your teacher.
Brokamp: Yeah! All right. I'm seated. I'm listening. I've got my pen ready.
Southwick: You're seated and listening. So today for English class we're going to do etymology and we're going to look at the origin of the word "portfolio."
Brokamp: Really! OK. Go right ahead.
Southwick: So portfolio, in finance, means your collection of investments and financial assets. It comes from (probably not surprisingly) the idea of the suitcase — the portfolio suitcase. It comes from Italian as early as 1722 from the word portafoglio...
Southwick: ...porta meaning to carry and foglio from Latin, meaning sheet or leaf. It's literally a way to carry your sheets of paper.
Southwick: Now, it wasn't until the 1930s that the word portfolio started meaning the scope of responsibilities for a job. If you were in a government office, you would say, "Well, it's not part of your portfolio. It's not part of your job." It wasn't until the 1930s that people actually started using portfolio to mean a collection of securities, but it still wasn't widely used nor was the theory behind portfolio like it is today.
Brokamp: Oh, that's interesting.
Southwick: Well, just wait for it, because it's going to get more interesting.
Brokamp: Oh, it's getting even better.
Southwick: So back then (in the 1930s), when people created a portfolio, it was based on finding a good stock and buying it at the best price. I mean, that's not bad in theory, but the problem was this was in the 1930s and all of the information about a stock was based on gossip, whispers, hearsay...
Brokamp: That's exactly right.
Southwick: ...and a very slow ticker tape machine. According to Investopedia, at the time investing was perceived largely in the "form of gambling for people too wealthy or too haughty to show their faces at the track." (That's a quote from Investopedia.) Way to be cute, Investopedia.
The term really took off in finance due to a 25-year-old grad student -- maybe you've heard of him -- Harry Markowitz.
Brokamp: I got an email from him once, but keep going.
Southwick: You did? He's a Nobel Prize winner.
Brokamp: I know!
Southwick: Oh, my gosh.
Brokamp: I wrote an article about him when he turned 80. I sent it to him and he sent me an email back. It was kind of cool.
Southwick: Ohh! So you're probably going to know a lot about what I'm going to talk about from this point. Markowitz is dubbed the father of the "modern portfolio theory," also known as MPT. And even though he didn't have a background in finance, he was fascinated by the economics of uncertainty, which is basically the stock market when we're talking about the economics of uncertainty.
He thought it was cuckoo how nobody was worried about risk when it came to building a portfolio, and even in the 1950s, when he wrote his doctoral thesis, "Portfolio Selection," people only cared about buying a smattering of stocks that they thought were bargains.
So he thought what you should do (instead of just buying a bunch of random stocks, bonds, etc. that you thought were a great price) was to reduce your risk while seeing the same returns, and you do that by deliberately offsetting high-risk returns (like stocks) with low-risk, low-return investments (like bonds). Basically diversification.
Southwick: And now the words "diversified portfolio" pretty much go hand in hand.
Brokamp: Right. It's kind of crazy, because it's almost a given, nowadays, but back then it was this new concept and he won a Nobel Prize for coming up with the idea of diversification.
Southwick: He also proposed that once you knew your risk tolerance, you could just plug the right investments in. I don't know if you knew this, but his paper, "Portfolio Selection," didn't blow people out of the water immediately, mostly because four out of the 14 pages were text (only four). The other 10 were graphs and numerical doodles, which sounds whimsical, but it probably wasn't. It was probably a lot of sweeping equations. The way they described it on Investopedia I thought was adorable.
Eventually his dissertation took off, since we all know the word portfolio today, and the term skyrocketed in the late 1950s and 1960s. If you look it up on Google (you can look up trends in literature) and right after the late 1950s or early 1960s, the term for portfolio just skyrocketed. There you go. From suitcase (for carrying your papers in Italy) to porta folio. That doesn't sound like Italian. To porta folio...
Brokamp: That sounds great. That sounds awesome.
Southwick: ...to the modern portfolio theory, or MPT.
Brokamp: That's really interesting.
Southwick: Thanks! How'd I do, teacher?
Brokamp: You did a great job.
Southwick: Great. Now it's your turn.
Brokamp: I'm going to give you a score. Rate My Professor or Rate My Teacher -- which would have horrified me, by the way, if such a thing existed when I was a teacher.
Southwick: I'm sure you would have done well. Next class -- math.
Brokamp: Math. Well class, we're going to talk about three important financial ratios. One you've probably already heard of, and that is the P/E ratio. We all talk about it. You've probably heard of it. It's the most common way to measure a stock or the overall stock market, but I thought it would be good to explain it to make sure everyone understands how it's calculated. You first have to calculate a stock's earnings per share.
Southwick: Wait, teacher, teacher, teacher...
Brokamp: Yes, yes, yes, yes?
Southwick: Wait. Why do people use the P/E ratio again?
Brokamp: It is a measure of the stock market's or an individual stock's value.
Southwick: Value. Not its price...
Southwick: ...not its stock price.
Brokamp: Right. It is how much you are paying for a dollar of a company's earnings. So to do it you first have to take the company's earnings, (its profits)...divide it by the number of shares outstanding...and you get the earnings per share. Most P/E ratios look at the earnings per share for a company over the previous 12 months, and that gets divided into the market price.
Let's say you have a stock that has an earnings per share of $2. It's trading for $20 per share. $20 divided by $2 -- you have a P/E of 10. If that same stock were trading for $40, you then would divide 40 by 2. That's how it goes. You'd get a P/E of 20. That is basically a measure of how much you're paying for a dollar of earnings.
Now there are different P/E ratios that people talk about, so that's the trailing P/E. Some people look at the forward P/E and that is a projection of a company's EPS (earnings per share). Nowadays you hear the cyclically adjusted price-to-earnings ratio called the CAPE or the Shiller P/E, because Robert Shiller, the Noble Prize-winning economist popularized it. It averages out the previous decades of earnings and adjusts them for inflation.
But if you look at history, it's actually a decent indicator of what returns will be over the next 10 years. The CAPE, as it's known, is pretty high these days, so it indicates that future returns will be low. That's why people use the P/E ratio. They want to get an idea of whether they're getting a good value for a stock.
Southwick: Every time we talk about P/E ratio, I end up asking you a question like, "What's a good P/E ratio?" Then I always forget what your answer is. But you're a really good teacher. Just to let you know that you're doing great.
Brokamp: Thank you very much. Historically, the P/E of the overall stock market is around 16 to 17, so there you go. That's the first one.
Our second one is the "12 times salary retirement savings" ratio. That's a name I came up with in an article I wrote for Rule Your Retirement. I [reviewed] all kinds of studies that looked at how much someone should save before they retire. They were expressed as a multiple of your annual salary.
Southwick: At the time of retirement?
Brokamp: Right before. Basically it's an indication of when you can retire. And the consensus of the studies was that you should be shooting to have between 10 and 12 -- and 12 is better -- 12 times your annual salary before you retire. It assumes that you're going to be retiring in your 60s and that you're going to have about a 25 to 30 year retirement. So if your household income is $100,000, you should have about $1.2 million saved before you retire. It's just a good benchmark, because people are always curious about when they can retire, and it's a good thing to shoot for.
Now of course, it's a rule of thumb, and it depends on your other assets. If you have a pension, for example. If you have rental real estate. It also depends on your income. It turns out if you have lower income (like $75,000 per year) you may need only 10 [times]. If you are in a higher income (like $200,000 a year) you probably need something closer to 14 to replace your income.
That's because Social Security, the way it is designed, replaces a greater percentage of income for lower-income people. For higher-income folks, Social Security is going to replace less of your income. So the more money you earned over your lifetime, the more you have to have saved if you want to replace your income before you retire. That's No. 2.
And No. 3 is the housing cost ratio. It starts with how much lenders will lend you. They're going to look at your before-tax income and they're going to say, "We only want your housing expenses to be when the expenses (mortgage, insurance, and property taxes) equal 28% of your before-tax income." So you've got to shoot for that to get a loan. If the mortgage is going to take up more of your income than 28%, there are programs available to help you.
But I think it's a good guideline, regardless of whether or not you need to take out a mortgage, and it's also a good guideline if you're going to determine what rent you can afford, too, because when you look at your budget, your housing costs (whether it's a mortgage or rent) is going to be the biggest line item and it's going to determine how much you have left over to save. So I think it's a good idea to shoot for keeping all that to 28% to 30% of your expenses.
It does depend on your circumstances. I had a conversation, just today, with a colleague of ours who's thinking of buying a home. This person is married, but they don't have kids, and that figures into it. If you're not going to have kids, you're going to have a lot more money left over...
Southwick: You can get any house you want.
Brokamp: You can have five houses.
Southwick: You can each have a house everywhere.
Brokamp: Exactly. And they're not sure, but they're thinking of it. So you have to factor that into the situation, because once you have kids...
Southwick: You can't have nice things.
Brokamp: I don't know what the current number is, but the Department of Agriculture (yes, agriculture) estimates how much it costs to raise a kid to about age 17. It's something like $300,000, and that's not including college. So that would factor into this, but I still think trying to keep your housing expenses to 30% or less of your budget is a pretty good idea.
Southwick: There you go. Three ratios to know are the P/E ratio, the "12 times your salary" ratio... Is that what we're calling it?
Brokamp: Sure. It sounds good to me.
Southwick: And the housing cost ratio. Less than...
Brokamp: Twenty-eight percent of what lenders will use. But just as a guideline, 28-30% is good. Class dismissed.
Brokamp: Which class are we in now, teacher?
Southwick: It's time for history class.
Brokamp: Yeah! My favorite subject.
Southwick: Oh, I stole your favorite subject, because I called dibs on which subjects we get to do.
Brokamp: It's fine. I'm going to learn something. That's even better.
Southwick: Maybe. I know I couldn't teach you anything since you're best friends with Harry Markowitz. I think I am going to teach you something about the tulip mania, supposedly the very first speculative bubble. I think most people have heard of it, but just to recap.
The tulip mania of the 17th century. If had a big white board or chalkboard, this is what I would be writing down. The tulip, Robert, was like any other flower that came before. They were bright, and vibrant, and survived well in the low country. Why are you laughing at me?
Brokamp: You're doing a great job of teaching this with your demonstrative thing that no one else can see...
Southwick: Thank you. I'm using my hand.
Brokamp: ...unless they're watching the video.
Southwick: During the Dutch Golden Age, as Holland grew into a world power, the tulip also grew in popularity. Tulips eventually became the fourth most popular export after gin, herring, and cheese. Which sounds like a party. They make good cheese in Holland. I'll give them that. I don't know about the gin and the herring, but whatever.
So things got interesting around 1634 when the demand grew for bulbs, so much so (in other countries like France) that speculators were brought into the market. I actually don't have a good definition for a speculator. How would you define a speculator?
Brokamp: I would say it was somebody who was buying something only as an investment and is doing so, generally, as a short-term investment.
Southwick: Just turn it around. So eventually the Dutch created a futures market and bulbs stopped changing hands, altogether, but the contracts for the tulips kept moving around. The called it "windhandel" which literally meant a "wind trade." I thought that was kind of cool. Some futures contracts were being traded 10 times a day. Then the bubonic plague happened.
Southwick: Wah wah! And the market collapsed. Which is not surprising.
Brokamp: It's hard to diversify against plague risk.
Southwick: It is very hard, as we have learned. So fast forward 200 years, and the tulip mania was largely forgotten until a book was written by Charles Mackay. It was called Extraordinary Popular Delusions and the Madness of Crowds. That sounds like a pretty good book.
Brokamp: It's a good book.
Southwick: Have you read it?
Brokamp: I have read excerpts and it's generally considered one of the great books about risk management and the history of risk.
Southwick: Well, I've got some bad news for you.
Southwick: It took a closer look at tulip bubbles, and other bubbles, and in the book, Mackay talks about the tulip mania this way. "The population, even to its lowest dregs, embarked in the tulip trade. By 1635, the sales of 40 bulbs for 100,000 florins," (also known as Dutch guilders, by the way), "was recorded, and by way of comparison, a ton of butter cost about 100 florins."
Brokamp: A ton of butter?
Southwick: That's what he wrote. "A skilled laborer might earn 150 florins a year, and eight fat swine cost 240 florins." Everyone believed him until the 1980s, when people began to doubt that it really was all that big of a deal.
Southwick: Yes. In 2007, Anne Goldgar wrote Tulipmania and concluded that many of the stories around tulip mania, including what Charles Mackay wrote, probably weren't even true. For example, one story told how a sailor accidentally ate a tulip bulb that was worth more than what it would have cost to feed the whole crew for a month. Probably not true.
And she also found out that there weren't really that many people in involved in the speculative market of tulips. And while yes, the price of tulips did rise and fall significantly, maybe six people, she said, took a serious financial hit when the bottom fell out.
Southwick: Yes! So when it comes to bubbles, what's generally regarded as the godfather of them all, tulip mania, was actual more on par with Beanie Babies than, say, the housing bubble. But, thanks to the media and the book that Charles Mackay wrote, we all know about it and we all thought it was a big deal. So nothing changes.
Brokamp: So there was a bubble in the story of this bubble, and eventually it was popped.
Southwick: Yes, but it's like a different kind of bubble, I guess.
Southwick: Yeah. So your bubble has popped.
Brokamp: My bubble's been popped. Oh, my gosh.
Southwick: So that's your history lesson for today. The tulip mania of the 17th century -- and it's still held as the classic story of mania...
Brokamp: In your research, did you find out any... Now I don't know if it even mattered, or not, but when you mention the top exports (the herring and all that)...
Southwick: Herring, gin, and cheese...
Brokamp: But that's stuff that you can eat and consume, and I always wondered what the big deal was about tulips. There are plenty of beautiful flowers in the world. Why did the mania spread?
Southwick: You can't eat Beanie Babies, either.
Brokamp: That's true, but why wasn't there a rose bubble? What about the tulip caught everyone's imagination?
Southwick: Oh, I told you. Didn't you hear my sweeping ode? It is vibrant, and bright, and it survived well. Apparently tulips have such a beautiful and high saturation of color that was unlike anything other people had seen. And there was also this virus that made tulips a little bit more wacky and weird, and that was really prized, as well.
Southwick: I don't know. Why does anyone like anything?
Brokamp: That's a good question. I wonder how I ever got dates in high school.
Southwick: Oh. You were a tulip among men.
Brokamp: Thank you very much.
Southwick: All right, it is time for econ class. Hi, Dr. Bro.
Brokamp: Hi, everybody.
Southwick: Professor Bro, I should say. You're not a doctor, yet.
Brokamp: I realize it's after lunch, and everyone's tired, but try to pay attention. Anyways, here we go. So in economics class today, kids, we're going to discuss a couple of possible answers to the question of why Americans don't save a lot. As a nation, we actually have a pretty low savings rate, and if you look at some things like retirement-readiness indexes, we're way behind many developed countries. So why is that?
Well, there's one research paper that tried to address this last summer and is entitled, "The Role of Time Preferences and Exponential Growth Bias in Retirement Savings," of course. So let's break that down.
Southwick: Was this homework? Was I supposed to read this before class, because I did not?
Brokamp: So as you can guess by that spine-tingling title, there are two proposed explanations for the low savings rate. One is the present bias, and that is the tendency in evaluating a trade-off between two future options. So the people who are not saving just are not thinking far enough down the road.
Southwick: A bird in the hand is worth two in the bush.
Brokamp: Exactly. In fact, they did a test on this. They surveyed over 2,000 people and they asked some questions like, "What would you rather have? A hundred dollars now or $120 12 months from now? Would you rather have $120 a year from now or $140 two years from now?" The people who expressed more of an interest in getting the money now are the people who have the present bias. They really want the money now.
They also talked a little about procrastination. They asked people questions like, "You're going to get a tax refund in six months. Do you plan to invest it or not?" And the people who scored highest in having this present bias -- those who said, "Yeah, I'm going to do it," -- were least likely to actually do it.
The paper talked a little bit about procrastination's role in all this, and cited a study that found that the people who sign up on the last day possible for their healthcare plan during open enrollment save less for retirement and they stick with the default option. So there's a certain element of procrastination about all this.
The other factor they looked at was the exponential growth bias. Basically it is that people don't appreciate the benefit of compound growth. They underestimate how much saving and investing will pay off.
So when you think of simple interest (and they did this, by the way, by asking people math questions about compound growth) people were incentivized to get the answer right. They would get money if they got the answer right, and they were told they could use any means possible. They could use a calculator if they wanted to.
The people who tended to not get it correct (I think it was along the lines of 70% of the people didn't get it correct) also tended to have less money in retirement savings because they underestimate how much it will pay off in the future. And the flip side of that, too, is that they underappreciate how much debt can snowball, because compounding, when it comes to like a credit card bill is the same thing, except it's going in the other direction for you.
So when you put these two together, the researchers found that there is definitely a correlation between people who have present bias and people who underappreciate compound growth and retirement savings, and they figured if you could eliminate those two biases or these two problems, the nation's retirement savings would probably be about 12% higher. So it's not huge, but it's one or two possible explanations as to why we don't save enough.
Southwick: Mr. Bro? Mr. Bro?
Southwick: So you said that compared to other developed nations, we don't save as much, but I can't imagine that people in other nations have any less of these behavioral biases than we do. Would you, perhaps, think that because other countries have larger safety nets, retirement plans, and pension plans, that they are basically overcoming their population's bias by instituting these programs?
Brokamp: That is an interesting question...
Southwick: Thank you.
Brokamp: ...because it's not only a situation that we're behind developed countries now, but Americans, today, save much less than Americans of 30 or 40 years ago. I was reading an article by Derek Thompson of The Atlantic and I think I'm remembering this correctly. He said basically the savings rate of people in the bottom 10%, in terms of income, was 10%. They were saving 10% of their income back in the early 1980s. Now their savings rate is a negative 10%.
Brokamp: What happened? What changed? One theory is one that is probably more skewed toward Americans and that's more conspicuous consumption. People are more inclined to buy things and they correlated this with income inequality. When you see people who are living a certain lifestyle, you are more inclined to try to have that lifestyle, even if you cannot afford it.
Then another one of many possible explanations in Derek's article was the availability of cheap debt. Americans have become more comfortable with debt, particularly mortgage debt. As we have taken on more and more debt since the '80s, we've been able to save less and less money.
Southwick: So what's the good news?
Brokamp: The good news is...
Southwick: Is there good news?
Brokamp: Well, there is good news. The good news is No. 1 (getting to the appreciation of compound growth), even saving a little bit of money on a regular basis can pay off significantly over 10, 20, or 30 years. So having that appreciation is important. One of the studies cited in this study showed a correlation between numeracy (math skills) and retirement savings. The more you appreciate how money compounds, the more you'll be hopefully incentivized to save and it will pay off over the long term.
And then the other thing is to appreciate the fact that you may want to spend or have $100 today, but the fact is you're giving up a larger amount at some point in the future, and hopefully just being aware of that will encourage you to save more and spend less.
Southwick: That's it for the school day.
Brokamp: No homework?
Southwick: No homework.
Brokamp: Is it the weekend?
Southwick: It is the weekend. No homework.
Brokamp: All right. Go ahead and...
Southwick: Closing notes. If we had like a PA system, this would be like today's lunch is chicken nuggets and green beans. Alison would like to send a huge thank you to postcard senders. I'll stop doing that. We received one from Oahu. It didn't have a name on it, unless it was sent by the person who took the photograph, in which case, thanks Clark. [Shoots] sent one from my hometown of Boise. Jay got breakfast at The Friendly Toast in Portsmouth, New Hampshire, which probably included a 46-gallon mimosa, knowing New Hampshire like we do. Wink, wink. [Clint and Megan] sent one from Germany. Tim, who runs the trails around the U.S. National Whitewater Center. AJ from Talkeetna, Alaska and [Brian] from Guam.
So summer is over. I'm going to stop asking you to send postcards from your travels, but I will still squeal at Amy from the front desk every time she hands them to me should they continue to come in, so just know it will still give me great joy.
That's the show. Our email is [email protected] For Professor Brokamp, I'm teacher's assistant Alison Southwick. The show is edited pedagogically by Rick Engdahl. I did that in the wrong order. I did. All right, whatever. Stay Foolish, everybody.