Holistic Finance:  Your Life as a Portfolio

Professor Matthew Spiegel

November 8, 2005

Breathe deeply.  Close your eyes.  Well, maybe not if you are going to actually read this!  Now think of your life as nothing but a stream of money. Your job, your house, your car, your savings, ahhh. . .  Pretty awful huh?  Perhaps, but if you want your investment portfolio to help you manage risk to the greatest extent possible you are going to have to start viewing your whole life as nothing but streams of money.

Your Life as a Portfolio

Most people think of their portfolio as their savings and retirement accounts.  But it is much more than that.  In fact, for most families their savings accounts for less than half of their wealth.  The largest component is typically employment income.  That is right; your career is part of your portfolio.

A person’s portfolio consists of every source of cash inflow and outflow.  Since your job is a source of cash inflow it is part of your portfolio. Because it is probably the primary source of cash inflow it is also a very important part of your portfolio. There are other important parts as well. Your mortgage is probably a large outflow, and you probably hope that the sale of your house will yield a large inflow.  The list goes on and on.

Portfolio management should have one and only one objective:  maximize the portfolio’s return for any given level of risk you are willing to bear.  If you are going to do that and do it well you need to account for all of your portfolio’s elements.

Some General Rules

1.  Never double down

The first rule is really simple and applies primarily to your employer’s stock.  Think about your income.  If the firm you work for does well what is likely to happen?  Your income will go up.  What if your firm does poorly?  Your income will go down.  In fact if things go badly enough you may be unemployed.  (Those in denial may consider how Enron’s employees would have answered.)  People that invest in their company’s stock are “doubling down.”  Unfortunately, they will likely find that a bad period for the firm not only reduces their personal income but also the value of their investments. This is very bad.  You want your portfolio to help you out in times of trouble, not add to your problems.  Unless your employer has a very generous plan by which you can acquire the firm’s stock at a discount stay away from it!  Even with a generous discount plan, you should sell your employer’s stock as soon as you can (at the end of the “vesting” period) and get into investments that will help you out if your firm goes south.

Not only should you stay away from your employer’s stock but you should also stay away from any stock in any firm associated with your employer’s industry.  If you work for a car company stay away from car companies, auto parts suppliers, and even tire manufacturers.  If you work for a high tech firm stay away from all high tech firms.  In fact, your goal should be to invest in firms that do well when yours may do poorly.  Often that is easier said than done since most stocks tend to rise and fall with the overall market.  But you can at least stay away from stocks issued by firms in your industry.  This will at least minimize the chance that a bad period for your firm is a bad period for your whole portfolio.

2.  All Money is Green

The government apparently does not understand this.  Fortunately you can use the government’s limited mental facilities to your advantage.

For various reasons the federal government has created any number of special savings plans each with its own tax treatment.  These include 401(k), 403(b), Keogh plans, 529 College Savings Plans, standard retirement plans and many others.  Each plan exists to encourage some particular group of investors to save for one congressionally designated socially desirable goal or another.  As a result the rules governing these plans are often quite complex.   It is not unusual to find that you can only employ a particular savings plan if belong to a certain group, and perhaps spend the money for a particular purpose at a particular time.  Having noted all of that if you are eligible to use one of these savings accounts you can often reap large tax savings (and thus investment gains) by readjusting your portfolio a bit.  For those that want to get to the bottom line and skip the details:  if you are eligible for a tax savings account you should at the very least redirect some of your current savings into it. 

The easiest way to see what is going on is via an example.  Suppose you have a child and you are saving for college via mutual fund investments.  Funds are required by law to pass along as a “distribution” the dividends and capital gains they realized during the year.  These distributions are considered income to the fund’s owners who then have to pay taxes on them.  Suppose your fund investment earns $1,000 this year and pays a distribution of $250. Further suppose the government taxes away just $50 of that distribution.  All of a sudden 5% of your return has disappeared.  Is that serious?  Most actively managed mutual funds have fees well below half that amount!  This means that even if a 529 Savings Plan has fees in excess of what your favorite fund charges the tax break may make give the Savings Plan the overall edge.  Another edge for the 529 Savings Plan is that when it comes time to spend the money, the government lets you withdraw it tax free as well!  Going back to our previous example consider what happens when you liquidate your holdings to actually pay for college.  In a regular savings account the $750 that you earned but were not yet taxed on will (generally) be taxed as a long term capital gain.  That means you will (if you are in a high enough tax bracket) lose another 15% of your profits to the government.

Fortunately, investing in a 529 Savings Plan (or other tax advantaged account) does not have to put even the slightest dent in you daily life, and can even leave you with additional funds to spend!  The easiest way to accomplish this is to simply take any funds you were going to put into a regular savings account for your child’s college education and transfer it into a 529 Savings Plan.  The same goes for all future savings.  If you had planned to put it into a regular account, put it into a 529 Savings Plan instead.  So long as you actually end up using the funds for your child’s college education you get all of the tax savings at no cost to you!  If you change your mind there are penalties.  So you should talk to an advisor before you invest in a 529 Savings Plan if you are at all uncertain about the money’s ultimate use.

What is happening with the 529 Savings Plan is that the government is saying, in effect, “Money in a 529 Savings Plan is red money and red money is not taxed.”  Fine, then you should take some ordinary green money that you were already saving and put it into a 529 Savings Plan.  That turns the money “red” and you get the tax savings. Fortunately, when you need the funds, it turns green again only now you have more of it!

Putting all of the special tax advantaged savings options together can make quite a difference to your ultimate wealth.  The best way to get started is to make a list of all of the tax advantaged accounts for which you are eligible.  Next take the funds you are already saving and parcel them among these accounts. The only caveat is that tax advantaged accounts typically have penalties if you take out the money prior to some date or use the funds “incorrectly.”  So, make sure you really are planning to save for the entire time period and will then spend the money as required.

If you think that you need help navigating your way through the various tax advantaged accounts you should contact us at www.alphainvestmentopportunities.com for help.

3.  Your House and Your Portfolio

How a home fits into your investment portfolio depends on whether you currently have one or want to buy one.  If you own one and if you are planning to invest in individual stocks you should avoid firms that are located in the same area as your house. The argument is similar to why you should avoid investing in your own employer.  If the local economy does badly it is likely that so will the firms in your area (their poor performance may even be the cause of your area’s woes).  When the local economy does badly so do area home prices.  You can avoid “doubling down” on the same risk by simply avoiding companies in your area.

If you want to buy a home how to adjust your portfolio becomes somewhat tricky.  Now you want your portfolio to help insure against a rise in local housing prices.  To do that you might actually consider adding in stocks from a few local firms.  If these firms do well so will the local economy. That in turn will raise housing prices. By allocating some of your portfolio to these firms you will insure that your ability to provide the necessary down payment will keep up with prices.  However, be very careful.  Do not put a very substantial fraction of your portfolio into stocks from local firms! Individual stocks are very volatile. It is possible that the firms you pick will do badly even if real estate does well.  To pull this off without actually incurring more risk you will need to know how the stocks from firms in your local area have done relative to the real estate market.  Most individuals will find that they need help from a really good advisor to pull this off.  If you are unsure about whether your advisor has the necessary tools to help you out then just forget about everything in this paragraph.  Instead, you are probably better off just putting your money into well diversified mutual funds. 

If despite the caveats given above you still want to use your portfolio to help hedge out the risk that local real estate prices will rise before you buy a house it is time to seek out a top notch advisor.  Fortunately, this problem makes it relatively easy to at least eliminate some of the under equipped advisors from the pool.  If your advisor does not know what a covariance is and how to calculate it then he or she cannot provide the advice you are seeking. Alternatively, you can just contact www.alphainvestmentopportunities.com for help on this as they do know what a covariance is.

4.  Rarely a Borrower and Lender Be

Do you have a savings account and credit card debt?  Many people do.  That is really too bad since they are basically throwing money away.  This was true of a friend of mine as well. 

Friend:  It has been a lot of work but I have managed to put away $2,000 in savings account!

Me:  That is great.  How did you manage to pay off that $10,000 credit card debt?

Friend:  Oh, the credit cards?  I still owe $10,000 on those. 

Me:  Maybe you should take the $2,000 you saved and reduce your credit card debt to $8,000.

Friend:  No, I think it is important to build up your savings.

My friend may like to pretend that he has one life in which he owes $10,000 on his credit cards and another with $2,000 in savings, but in reality he has just one life with both. Alas, having both is a bad idea. Suppose the credit card company charges interest at a rate of 1.5% per month, and the savings account pays 0.5% per month.  (If you are unsure of what these figures mean or how to translate them into annual rates see the article “Interest Rates and Compounding.”)  Each month my friend has the following cash flows:

If instead he eliminated his savings account and used the proceeds to pay off the credit cards he would have:

Basically, he would be twenty dollars per month better off.  The lesson is that if you are borrowing money at a high rate (credit card) and lending it at a lower rate (savings account) you should use the low rate funds to pay down or eliminate the high rate funds.  Some people worry that if they pay down their credit cards they will then just start charging on them again until they hit their limit.  If you are one of them then I have bad news for you: you need to cut up your credit cards and you need to do it as soon as possible.  Savings are integral to financial well being and you will be unable to save with large credit card balances draining your funds.

5.  Use the Tax Code

You want to buy a car and you need $20,000.  There are several options available to you:  (1) pay cash, (2) get a car loan, and (3) take out a home equity loan. What should you do?  Given these three options it is a near certainty that you should not take out a car loan.  The government in its infinitesimal wisdom has decided that the interest on a car loan is not tax deductible.  That means if the interest rate is 9% per year all of it comes directly out of your take home pay.  What about the home equity loan?  Currently, the government lets you borrow up to $100,000 via a second mortgage and deduct the interest.  Also, because people are loath to default on their homes second mortgage loans typically carry very low interest rates.   For this example suppose the bank charges 6% per year.  But wait!  The government lets you deduct the interest.  If you are in the 30% tax bracket that means the loan only costs you (1-.3)×.06 = 0.042 or 4.2% from your take home pay. The other 1.8% comes out of the government’s portion of your pre-tax pay check.  Sweet!  You get the car and the interest rate is less than half of what it would be with a regular car loan.

So, clearly you should take out the home equity loan and buy the car.  Not so fast, what about the “pay cash” option.  Remember lesson 4 above, “Rarely a Borrower and Lender Be?” It applies here too. Unfortunately, the outcome will depend largely on your circumstances so it pays to look at two typical cases:

Scenario 1:  You own a house and you have $20,000 in a savings account that pays 7% per year.

While the government does not allow you to deduct the interest you pay on most loans it does force you to pay taxes on interest you earn.  That means while the bank may pay you 7% on your savings account the government only lets you keep (1-.3)×.07 = .049 or 4.9%.  Since the home equity loan costs 4.2% you should use it to purchase the car.  In this example, the interest from your savings account can be used to pay off the second mortgage with 0.7% to spare for your personal use. 

Because the government taxes interest income and allows deductions for home mortgage expenses you can compare them on either a pre or after tax basis. Whichever source of funds has the lower rate one way will have the lower rate the way as well.

Scenario 2:  You do not own a house and you have $20,000 in a savings account that pays 7% a year.

In this case your choices are to either take out a car loan or draw down your savings.  As noted earlier, the car loan’s interest payments are not tax deductible.  That means your after tax cost on the loan is the same as the pre-tax cost, which in our example is 9%.  Since the after tax return on your savings is only 4.9% this is an easy call; draw down your savings to pay for the car.

Given the current tax code’s propensity to tax interest income there are few real life instances in which somebody with savings should take out any type of loan unless the interest on that loan is tax deductible.  The reason is that by reducing your savings you effectively get a tax deduction that you would otherwise lose.  You can see this by modifying our example somewhat.  Suppose you find out that the local car dealer will finance the cars it sells at a rate of 7% per year.  If you use the loan to purchase the car here is what your cash flows will be for the year:

On the other hand if you use your savings instead you pay nothing on the car loan (since you did not take it out), and you earn no interest on your savings (since you do not have any). Then best of all you pay no taxes because you earned no interest.  So you save $420 in taxes by simply switching from using a car loan to using your savings!  Not bad.  Notice that if the government treated interest income and interest expenses symmetrically (allowed or disallowed deductions for both) it would not matter how you paid for your purchase.  But the government does not treat all money the same. In this case it penalizes savings. If the government is going to tax you for saving then you should do as they apparently want you to do and pay for purchases with your savings rather than consumer loans.

© Matthew Spiegel