Not Rich Yet | Managing higher incomes

Across my and my wife’s various investment accounts I recently instituted a new portfolio allocation.

The concept here was to be:

  • Well diversified across multiple asset classes (8)
  • Have a good representation of international stocks (20%)
  • Slightly more conservative approach by weighting bonds heavier than I have done in the past (30%)
  • Not invest in asset classes I currently consider overheated – delay that investment until prices come down: this means currently avoiding investing in gold, although I do want to invest in that once the gold price cools down

Source of inspiration for my approach was the book The Intelligent Asset Allocator by William Bernstein, one of the best books on the subject IMO.

As you will notice, we have all our account with Vanguard. I am a huge proponent of investing in indexes vs. mutual funds, and therefor prefer Vanguard to most all other providers.

And here is my portfolio:

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As you budget and plan for the the future, I would like to recommend several metrics for you to consider.

Maintaining liquidity

Cash / Monthly regular expenses

This tells you how many months you could survive a total loss of income; ideally this should be at least as long as it would take you to find a new job from scratch plus several months safety buffer, e.g. 6 months

Cash  / emergency expenses

Similar to the metric above, this is helpful if much of your expenses are discretionary or driven by your current occupation. For example, if you rely heavily on a nanny, you may be able to do with-out and avoid the expense if one of you loses their job.

Dialing-in your savings rate

Total annual savings (cash savings + retirement savings + debt principal retirement) / Gross annual income

This metrics tells you how much of our income you are effectively saving. See my post on  “How much should I save?” to understand what this does to your retirement outlook.

Managing your portfolio

Asset breakdown

While most people look at the breakdown of their investment portfolio, they often forget to include their other assets. The following breakdown allows you to avoid over-investing in one specific area:

  • % in liquid assets (cash and equivalents)
  • % in short-term investments (CDs and other assets that can converted into cash for a small fee or within 3 months)
  • % in real-estate
  • % in long-term and retirement investments

Overall financial health

Networth (Total assets less total debt)

Following the evolution of your networth is a healthy thing to observe. Watch it go up or down and understand why. Some people argue that you should exclude the value of your home here – I think either including or excluding your home is fine as long as you are consistent.

Networth less home equity/ annual expenses

This metric helps you gauge your readiness for retirement. Your retirement “nest egg” should be large enough to throw off a sustainable income stream. Common rules of thumb propose a 20x value here, but that assumes that your expense rate is sustainable in the future. This is likely not true since your healthcare costs and life-style creep will lead to higher expenses after retirement.

Networth less home equity / net income

Similar to the metric above, but it takes a more conservative approach by assuming you are attempting to replace your income instead of your expenses. A typical recommended value here is achieving a of value of 20x here.

What metrics do you use?

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Casino weekend

I spent the weekend at a casino. Gambling has never been my deal, but there was a family event and it was held at a casino.

Here are my observations:

  • The vast majority of people at the casino looked like they should be the last people to be gambling. They all looked very much like the people I saw the other day at the cable company office who had to pay their cable bills in cash because they couldn’t get a checking account. Not one person looked like the glamorous tux- or cocktail dress wearing youthful yet wealthy “players” displayed in the same casino’s adds.
  • I apparently don’t enjoy gambling. I get no kick from systematically losing money, I guess I’m not wired for it
  • Instead, if I had to gamble, I would much prefer to make some long-shot bets buying stock options – e.g. banking on the S&P 500 tanking or going through the roof. At least there it isn’t pure (just a lot ) of luck and the pay-off actually is worth my while.

How about you? Do you enjoy gambling? Why?

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I don’t – in fact, I have real trouble hiding my feeling like disgust, joy, worry, annoyance etc.

If I were to play poker (I don’t for this very reason) – you would be able to read my hand by looking at my face. I would have a huge grin with a good hand, anda look of concern with a bad one.

This prevents me from playing poker but also hurts me in face to face negotiations either professionally or when it comes to my personal affairs.

For example, if I want to play hardball with a vendor, plumber, cable company etc., I am much better suited to do this over the phone. Luckily for personal finances issues most such conversations happen over the phone anyway.

How about you – do you have a poker face? If yes, how do you use it?

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Yesterday the market took a major nose-dive – whether computer glitch, gremlins or human error was the cause isn’t quite clear yet.

Some of the trades that happened during that very scary nosedive were canceled after the fact. However, the vast majority were not. So if you owned shares in P&G and had a stop-loss order, you may have lost up to 37% of your investment.

What is a stop-loss order?

A classic stop-loss is a kind of insurance you can use with your stock investments. You can set a “panic” threshold so if the price of your stock drops below the threshold, your holding in that stock are sold at, theoretically preventing you from incurring even greater losses.  E.g. if you own Goldman Sachs shares, that trade for $150, you could set a stop-loss at $130. If the price drops beneath $130, your shares are sold. Traders often use stop-loss orders as a kind of insurance against a stock tanking in a big way while you are not paying attention.

However, a stop-loss order can also ruin your day.

It is important to understand how a stop-loss order works. A stop-loss order is a dormant order that is converted into a market order when a price threshold is met. This does NOT mean you are guaranteed that the stock will sell for your stop loss price. Instead, it well sell at the next best price. That may be your stop-loss price or a couple cents below it. It may however sell for far less than your stop-loss price. In the case of P&G, Apple, Sam Adams and a bunch of other stocks yesterday, the best next price may have been far below your stop-loss price. Sam Adams for example went from $56 to $0.01 in a heart-beat. If you were unlucky your converted stop-loss may have sold at the very trough of that decline. In the case of Sam Adams, the SEC decided to undo the trades, but for P&G and others, people weren’t as lucky.

What does this mean to me?

Stop-loss orders tend to do fine with high-volume stocks – there are enough trades happening so that prices evolve more smoothly, and that your sell price will be close enough to your stop-loss price. However in low-volume stocks prices tend to move in jerks they only move when bid and ask prices meet, so the risk that your sell price will be far below your stop-loss price is much higher.

So know that using stop-loss with random small stocks is risky.

Next, you could use a stop-limit order. This means that your stock sell order is triggered when a threshold is met – same as a stop-loss order – except you choose a limit price. This means that the stock is sold for a minimum price, typically your stop-price. This means the stock only sells if price is above the limit. If the price is in free fall, no-one will offer a price greater than the stop price that the price just rocketed past, and you end up not selling your shares – no-one offered you a price that met your limit.

So both stop-loss and stop-limit orders are helpful insurance policies, esp. for large stocks, but they are not fool proof and can end up hurting you bad if the market or your stock tanks.

Buyer beware!

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How much should I save?

One of the toughest questions you need to answer – regardless of your income – is how much of your income you should save?

5%? 10%? 50%? What is the right answer? If your “hard” expenses are close to your net income, you won’t have much choice in the matter, but if dialing your “fun” spending up or down moves your savings rate a lot, you should take a look at the graph below.

This is a simple analysis I ran to see how many years it would take assuming a fixed savings rate, inflation and investment return rate to build up a nest egg that exceeds 20 times of your annual net income adjusted for inflation. Why 20 times your net income? Well, that is a reasonable rule-of -thumb value for a retirement nest egg that has a good chance of not running out of steam before you do.

This graph shows that saving early and a lot is a good thing.

Under a moderately conservative scenario of 2% inflation and 8% pre-inflation investment return

  • Saving 10% of your net income per year will take you 44 years to save up that 20x income nest egg
  • Saving 40%, will take you 23 years
  • Saving 60% will take you 18 years
So if you can only save 10% of your income, you better start at 21 so that you hit the magic number by 65. But if you have an higher income, cranking up your savings from 40% to 60% by reigning in your expenses, would allow you to retire 5 years earlier.
What is the right answer? That depends on your goals and circumstances. But think about it carefully…

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Motivation for this blog

I have been an active reader and commenter on various personal finance blog for several years now.

However, I always felt that the topics discussed on those blogs typically missed the issues that my wife and I wrestle with given our somewhat higher-than-average incomes.

We aren’t interested in making our own laundry detergent or clipping coupons to save a few $ here and there, instead we want to move the needle in a much more meaningful way by optimizing the way we manage our income.

Lacking other useful sites to discuss these issues, I decided to start a blog to share what I have learned the hard way and explore new issues with you as they emerge.

I suspect this blog will appeal most to individuals with professional or entrepreneurial backgrounds (doctors, lawyers, bankers etc.), who make enough money to one day really regret mistakes they make now, but are too early on in their careers to have amassed a fortune that would justify the attention of private wealth managers and other professionals.

However, I hope the blog will also have a broader appeal than just the sweet-spot described above, and provide helpful insights for a broader population.

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Our story

In spring of 2009 my wife and I fulfilled a long-time dream of ours and bought a house. We decided to live close to down-town in one of the larger metro areas, so we had to pay a steep price of around $600,000, but since we both hold good jobs we were able to comfortably afford the house.

Through some persistence and stubbornness we were able to lower our annual mortgage payment by a whopping $5,600. How? We avoided the so-called jumbo spread.

Fannie, Freddie and the Jumbo Spread

When you get a mortgage in the US, the issuing bank will often sell you mortgage to Fannie Mae / Freddie Mac. Those companies are pseudo-owned by the US government, and their principal role is to lower mortgage rates by buying up mortgages from banks for decent prices.

The government however has regulated what kind of mortgages Fannie and Freddie may buy. Mortgages they may buy are called “conforming”. Currently in most locations, including our city the limit for such conforming loans is $417,000 – i.e. your mortgage may not exceed $417,000. If you mortgage is larger than that magic number it is called a “jumbo” loan. Jumbo loans cannot be bought by Fannie and Freddie, and are therefore not subsidized. This leads to jumbo loan interest rates being higher than interest rates for conforming loans, an effect often called the jumbo spread. In the past year, the jumbo spread has been around 1.8% to 0.6%, impacted heavily by the real estate crisis.

What this means is that just by getting a mortgage north of $417,000 you automatically pay a higher interest rate e.g. 6.6% instead of 6%.

The hack

In order to buy our house for $600,000 with 20% down, we had to get a total mortgage of $480,000 – clearly above the conforming limit. When I started calling mortgage brokers, they all insisted that I needed to get a jumbo loan for 1.5% above the conforming rate – so instead of paying 5%, they wanted to charge me 6.5%.

If found this very frustrating, and was sure there was a better way. So I did my research and came up with the idea of a 2nd mortgage and found a good mortgage broker that allowed me to get 2 mortgages. The 1st mortgage was for $417,000 – a nice 30-year fixed rate conforming loan for a low 5% interest rate. The 2nd mortgage was just to cover the remaining $63,000. In the end my mortgage broker was able to offer me several options including a HELOC for 4.75% and a 5/2 ARM for a similar rate. By accepting the small risk of the variable rate for the HELOC or ARM, I was able to fix the vast majority of my mortgage a very low rate – over 1.5% lower than the jumbo rate. In fact, simple math shows that I would make out better with the 2nd mortgage vs. the jumbo-loan as long as the HELOC or ARM rate stayed below ~15%, a rather unlikely situation.

The impact

By implementing this jumbo-avoidance “hack”, I was able to reduce my effective interest rate from 6.5% to a bit under 5%, saving over $5,600 on my mortgage payments annually. While the jumbo-spread has come down a bit in recent months, it is still quite substantial and could also peak again if the much-talked about second wave of foreclosures rocks the real estate market.

How to do this yourself

When to use:

  • If you are even just even a little comfortable putting in some extra effort and dealing with some financial math
  • Either for new purchase or refinance
  • If your total mortgage would exceed your local conforming loan limit,. Please look up you local conforming limit here.
  • If your jumbo-spread is substantial, e.g. >25%: ask your mortgage broker for side-by-side quotes of a full (jumbo) mortgage and a conforming mortgage (both with same points, fees etc) – to see what the difference is. National rates are tracked here.

What to do:

Call up your mortgage broker and say you don’t want a single jumbo loan but instead 2 loans, one conforming loan and a 2nd mortgage for the remainder

  • If your broker doesn’t know what you are talking about, or pretends that this doesn’t make sense, fire him/her  and find a new broker
    • Brokers are not created equally
    • Going to 2 loan approach is more work for them, but of huge value to you, so you should insist on this
    • There are knowledgeable and hard-working mortgage brokers out there who will go the extra mile to win your business
  • Choose which 2nd mortgage option you are comfortable with and go and save a lot of money!

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