Where to Save?

After haranguing people to save yesterday, I naturally received queries about what one should put one's money in.  Fair warning: I am an inherently conservative investor who takes a rather brute force approach to savings--which is to say that I think that the amount of input is much more important than cleverness in one's investment allocations.

Indeed, having graduated from the University of Chicago, home of the efficient markets hypothesis, I am rather skeptical specially clever investment allocations are really possible.  We can argue about whether Warren Buffett's results are random chance or inherent genius, but here's one question we probably aren't going to argue about: neither you or I (or almost anyone else) is Warren Buffett.

This is especially pertinent for the retail investor, aka non-professionals.  Even if you think that it's possible to beat the market, doing so is a full time job.  You are not going to beat seasoned, well connected professionals on an amateur basis.  Thinking that you can do so is a symptom that you don't know enough to do so.

Ah, but what about strategic investments in your own industry?  Wouldn't you have an edge there?

Well, you might.  The problem is, you're violating one of the core tenets of sound investment, which is that your paycheck and your savings should not depend on the same place.  If you are a research chemist and you plow it all into biotech stocks because you know so much about the industry . . . well, first of all, if you're a research chemist, you should know how hard it is to predict clinical trial failures, which is what biotech investments are betting against.  More to the point, if pharma tanks, so will your investments . . . and this may happen just as you get a pink slip.  Bad strategy.

So where do I think the retail investor should put their money?  A walk through my favored asset classes, in (roughly) the order that I think they should be tackled:

1.  Bank or money market account: this is where your working capital (the amount of money you need to carry you through a month) should be, along with your 8-12 month emergency fund.  Yes, I know:  8-12 months of expenses is a good chunk of change, and you'd rather have it making money for you.  The problem is, this needs to be ready cash.  You may need those funds when the stock market happens to be down 16%, and then you're hosed.

Make sure that your money market account is FDIC insured, so that the Feds will make good any losses if the money market goes under, as happened to several funds in 2008.

2.  Certificates of Deposit:  sinking funds.  That's what we call the money we save for predictable large expenses: car repair and replacement, home maintenance and upgrades, vacations.  If you don't yet own a home, and want to buy one, this is a good place for your downpayment money to go.

Vary the term of the CD with the size of the expense.  You are unlikely to need to tap your kitchen renovation funds quickly, so a longer-term CD is fine.  But when you need a new boiler, you kind of have to have it right now.  Once you have an emergency fund, of course, you can float some of these expenses, and then replenish from the CDs . . . but still, a contingent repair fund should not be in a five year CD.

3.  Tax deferred savings plans:  When you invest pre-tax funds, it's like getting an automatic 20-45% return (depending on what percentage of your income is going to taxes).  If your employer does a 401(k) match, that gives you an even bigger boost.

Why tax deferred before, say, a Roth IRA?  I'm going to have to do a separate post on this, which should go up tomorrow.  Meanwhile, let's focus on what to put your tax deferred savings into.  I recommend four asset classes:

a.  Low fee S&P 500 index funds.  It's a broad enough index that you're getting solid diversification.  You will not ever outperform "the market".  But you won't really underperform it either.

b.  Low fee total-market index funds.  These follow very broad market indexes, such as the Wilshire 5000 (all the stocks on the AMEX, the NYSE, and NASDAQ).  You really can't underperform the market here, and it gives you somewhat more exposure to smaller stocks with higher growth potential.

c.  Low fee international equity funds.  You'll probably only have a choice of one or two of these in a typical 401(k).  They are inherently more idiosyncratic than US index funds, but they have higher growth potential, and they diversify your dependence on the US economy.  Look for lower fees and broad exposure to multiple markets.

d.  Bond funds.  As you creep past 45-50, you should start transferring some of your equity exposure into bonds.  They will not give you outsized returns, but they will protect your capital better than stocks. Again, bond funds are inherently idiosyncratic, and I am less comfortable offering dictates here except that you should keep in mind that the purpose of a bond fund is to preserve capital and lower the riskiness of your portfolio.  Stay away from emerging market debt (sovereign or corporate) and junk bonds.

With the exception of some legacy investments that I made when I was younger and less exposed to the EMH, my portfolio right now is roughly a third S&P, a third broad-market index, and a third international.  It doesn't do much, these days, but I don't worry much about it either.

4.  Paying off debt:  Always a great choice for savings.  Even after you adjust for the tax advantage, paying off your mortgage right now yields a guaranteed minimum of 2.5% (more if your interest rate is higher).  It also comes with a guarantee that you cannot be forced out of your home.  That's a lot more than any other low-risk investment is yielding right now.

And that's your lowest-rate debt!  Every other form of debt repayment has an even higher yield, absolutely 100% guaranteed.

5.  Tax free instruments:  into this category go tax-free munis and Roth IRAs/401(k)s.

There is nothing wrong with this; I have some Roths myself.  But remember that you are taking a bet that the government will never change the tax status of your investment.  That seems like a fairly risky bet given our government's revenue needs.  I suggest using these as part of a portfolio of various taxable and tax deferred investments, but not as your sole vehicle.

Note that rich people have bid up the value of tax-free munis so that they only make sense if you are in the top tax bracket.  And though it should go without saying, never buy tax-free munis in a tax-advantaged account like a 401(k) or an IRA; they don't yield as much as normal bonds, and you're not getting a tax benefit.

6.  Real estate:  I do not believe in investing in real estate before you have paid off debt and beefed up your 401(k).  I don't believe real estate is for everyone.  And I don't believe in making leveraged (aka mortgaged) real estate purchases.

However, real estate can be a great way to diversify your portfolio if you are careful about it. The stock market may be down, but your tenants will still be paying you some rent every month.

Here's how you are careful about it:

a.  Don't flip.  I shouldn't really need to explain this now, should I?  Buy for rental income, not capital gains.

b.  Don't invest in an excessively tenant-friendly jurisdiction  Whether or not you think these rules are a good thing, they are hell on the small investor.  In New York, DC, or San Francisco, a tenant can pretty easily stall eviction for 6-12 months, sometimes more.  If you're counting on that income, that's a big, big problem.  Big landlords can diversify to get a fairly steady cash flow.  You can't.

Most such cities have nearby towns with less restrictive rules governing evictions.  These are a much better place to look.

c.  Don't invest long-distance  You will have to hire a management company.  This is costly, and while there are some very good management companies out there, there are also some very bad ones.  It's going to be hard for you to tell which one you've got from another state.

d.  Budget for repairs In most jurisdictions, when you're a landlord, you're not allowed to let things slide.  You might decide you can live without AC in a balmy June, or stop using a broken bathroom fixture if money's tight.  You do not have the option of telling your tenants to do the same; if it was available at the time of the lease, you're legally bound to provide it. You will also need to budget for painting and normal wear and tear every time the apartment turns over.  A whole lot of small landlords get themselves in trouble when they don't have the money to make the repairs that are legally required.

e.  Budget for empty months  In a really tight, desirable city, you may never have to go even a week without a tenant, but in many locations, it can easily happen that you go several months before it's rented again.  You cannot be so dependent on the rental income--either to finance a mortgage, or your own consumption--that this sends you into a financial crisis.  This is one reason that I do not recommend investing with mortgages, and why I think that real estate should be an add-on to your portfolio, rather than its core.

f.  Do regular inspections  No matter how lovely your tenant is, they may be destroying your house without even knowing it--not changing air filters, attracting pests, letting leaks grow.  You have to do regular walkthroughs to see what they're getting up to.

g.  Use a lawyer to draw up a lease.  Yes, it costs money.  It costs even more money to download a form off of the internet that wasn't written for your specific jurisdiction's real estate laws, and then find out that half the clauses that you were counting on to protect you aren't even legal.

h.  Expect to manage it.  A solid real estate investment can earn you ten percent a year--but you have to work harder at it than you do leaving the money in the market.

i.  Watch the local market.  If the neighborhood is going downhill, sell before your rents decline.  On the upside, you'd be surprised at how many DC landlords are undercharging by hundreds of dollars a month simply because they keep renewing leases without realizing that they could be charging much more.  Every time I've left an apartment early, I've gotten my landlord at least an extra hundred or so from the new tenants.

j.  Check potential tenants thoroughly  Obviously get credit reports.  Check references.  Subscribe to those services where landlords report trouble with tenants.   A bad tenant--and they come in all shapes, sizes, and job descriptions--can cost you thousands more than the security deposit.  Do not assume that just because they are a fancy lawyer, they cannot also be bad people--or at least, bad tenants.  My old building had to spend a fortune evicting a lovely owner who was a senior VP at a major financial firm--and also, unfortunately, a hoarder whose refusal to take out the trash was causing a massive pest problem for the apartments around hers.  That was not predictible--but lots of problems are.  Lazy landlords get hurt.

k.  Require them to get renter's insurance  Renter's insurance is dirt cheap, and saves a lot of hard feelings if something goes wrong.  A shocking number of tenants believe that you are responsible if, say, a leak or a fire destroys their possessions.  A court will rule against them, but for all sorts of reasons, you do not want to be headed to court with your (possibly former) tenants.

l.  Don't view the security deposit as a sort of bonus.  I'm just throwing this in here because I think it's crap.  Provided that they've taken reasonably good care of the apartment, they should get their deposit back.  It's true that more often than not, they'll let you get away with keeping it.  But it's wrong, and if you've saved adequately, you shouldn't need (or want) to stoop to this sort of thing.  Moreover, being a good landlord pays dividends--the few I've had, I'm still singing the praises of, and I've helped two of them find last minute tenants.

m.  Know how many properties you can manage.  First of all, know your limits.  There are benefits to scale (you can have a handyman on retainer if you have enough apartments, and he'll probably give you a discount).  But there are also drawbacks--each apartment takes time.  And in some jurisdictions, adding units adds a lot of legal hassles--in DC, for example, small landlords (I believe under four units) are not subject to rent control, but large ones often are.  Understand the implications of buying more properties before you sign on the dotted line.

n.  Talk to other small landlords before you decide to become one.  My advice is compiled from a decade of reporting on (and reading about) personal finance.  But get local tips from landlords who know your area.  Most people like talking about their troubles, and you can learn a lot by listening to a litany of all the things that can go wrong.

o.  Landlording is a business  Don't buy a property you'd like to live in (or renovate one to that taste).  Understand what you can rent for, and how much you'll need to cover expenses like taxes, vacant months, and repairs.  Do not buy because you like a property; buy because it will offer you a reasonable return after expenses.

It's a simple portfolio, and it won't make you rich without working.  On the other hand, we should all be pretty sick of get-rich-quick schemes by now.