How Much House Is Too Much?

I had dinner at my friend Alan’s house earlier this week. You could call it a mini-housewarming party. With a baby on the way, he and his wife decided to upgrade their house in anticipation. They’ve finally settled in, and I was their first non-family guest.

It might as well be a castle.

Four-car garage, swimming pool that resembles Hugh Hefner’s grotto, and a media room with better equipment than an actual movie theater… He cranked up the volume to show me what it could do. Three days later and my ears are still ringing.

It has a wine cellar, and a kitchen that would make a three-star Michelin chef jealous.

In the study, there is a secret door behind the bookshelf that leads to a hidden room, like something from a Batman movie.

There are houses. And there are houses. This one was the latter.

The Dream House

Now, you could argue that a house like that is nothing more than a vanity project; Alan would agree. He knows the entire project is ridiculous. No one needs a house like that.

But he’s done fantastically well in his career and could afford it. He made a 30% down payment in cash, and he’ll be reducing the mortgage further when his old house sells.

At his income level, he could pay down the remainder of the mortgage in two or three years without stretching his budget. This is a toy for him. He’s earned millions, and he can’t take it with him. So, he might as well have a little fun with it.

This raises larger questions for the rest of us: how much house is too much?

Before I answer that, we need to establish the first law of homeownership: Your house is not an asset.

I repeat: Your house is not an asset.

It generates no income for you, yet it generates plenty of expenses: taxes, insurance, utility bills, landscaping, the pool guy, the technician to fix your state-of-the-art home theater system when something goes wrong… These are expenses that can potentially bleed you dry.

Sure, your home equity has cash value. But you can’t extract it without selling or mortgaging your house.

Your house is an expense, and you should view it through that lens. Every dollar you tie up in your house is a dollar you can’t invest and use to grow your wealth.

To calculate how much house is appropriate for you, it’s probably easiest to back into the number.

Calculating the Cost of Your Home

Make a tally of your spending priorities — retirement savings, college savings, capital to start a business, day to day spending money, etc. — and subtract that from your household income. Give yourself a little wiggle room. You don’t want to be agonizing over a $4 purchase at Starbucks because you’ve made your budget unrealistically tight.

Once you’ve figured out how much you think you can afford as a monthly payment, knock off another 20%. You probably forgot a few expenses, and, again, you don’t want to be strapped for cash every month when the mortgage payment comes due.

If you have $10,000 per month left over, good for you! Go buy a mansion. You can afford it.

If you have $2,000 per month left over, then that’s your budget. End of story.

Trying to stretch it to buy a larger house is only going to cause you stress, and your home shouldn’t be a cause of stress. It should be a place you go to escape from stress.

As for the dollar price of the house you can afford, that’s going to depend on a couple factors, such as taxes and your area and mortgage rates. But if you know the size of the monthly payment you can afford, there are plenty of online calculators that can do the math for you and calculate the house price. As an example, you can check out NerdWallet’s calculator.

The point is, don’t buy more house than you can comfortably afford.

While I’d love to have a Hugh Hefner grotto like my buddy Alan — and I might very well buy one someday — I’m far more comfortable living more modestly and being able to max out my retirement accounts and spoil my kids.

The Next Ten Years

As we close out 2019, it’s time to look ahead to see what we can expect from the stock market over the next decade.

I want to be crystal clear here… there is no perfect, foolproof stock market indicator. No one knows with any degree of accuracy what the market will do over the following year.

If such an indicator did exist, it would become useless the minute it was discovered. Every trader in the world would start trying to front run it.

Any concept of the perfect indicator is fundamentally flawed because the stock market is not a machine. The market is nothing more than a collection of people buying and selling, and those people aren’t always rational. You can’t build a rational model to predict the behavior of irrational actors. You’d have better luck trying to predict the next popular hair style for teenagers or the next trendy Millennial buzzword or dating app.

But while there is no perfect indicator, there are a few that have a reasonably good track record of predicting stock returns over the next decade.

One of my favorites is the cyclically adjusted price-to-earnings ratio (CAPE) — also called the Shiller P/E ratio after Yale professor Robert Shiller.

An Indicator to Guide You

The CAPE takes an average of the past 10 years of company earnings and compares it to today’s prices. There’s nothing sacred about a 10-year average, and I’ve seen plenty of variants that use other timeframes. But 10 is a nice round number, and in any given 10-year period we’re likely to have seen a boom, a bust, and everything in between.

Using Shiller’s data, Barclay’s recently ran the numbers back to 1926 to see how the market performed over the following 10 years starting at various CAPE levels.

Not surprisingly, the more expensive the CAPE, the worse the returns were over the following 10 years. Any value investor would tell you the secret to market success is buying low and selling high.

The question is, of course, where are we today?

Where Are We Today?

The S&P 500 is trading at a CAPE of 29.4 at today’s prices, putting it in the most expensive bottom bracket.

If history is any guide — and, admittedly, we don’t have a lot of data points here as the market only got that expensive one other time in the late 1990s — we’re in for a rough decade.

The worst-case scenario has stocks falling 6.1% per year over the next decade, and the best case has stocks rising 5.8%. I think that’s a pretty reasonable range.

If we avoid a deep recession and the Fed somehow manages to pull a rabbit out of its hat and keep pumping money into the financial system without causing inflation, then it’s not unreasonable for us to hit the top end of the range.

But if the wheels come off — if investors lose faith in the Fed and the foundations crumble — the lower end of the range is also very realistic.

As the baseball-player-turned-philosopher-king Yogi Berra said, “It’s tough to make predictions, especially about the future.” Yet we’re going to do it anyway…

What’s to Come in 2020

I think the most likely outcome is something in the ballpark of 2-3% per year.

We’ll get some kind of recession and a maybe a mild bear market or two.

But Fed stimulus, low bond yields, and a dearth of opportunities anywhere else will keep the bottom from completely falling out.

Still, I don’t know about you… 2-3% per year isn’t going to work for me.

I need better returns than that.

Luckily, I don’t see that being a problem in Peak Income.

I target high-yielding investments with cash payouts of 5-10% and sometimes significantly more than that.

So, even if the stocks and funds I recommend see zero price appreciation (which would be very unlikely), the yield alone would make them attractive.

It Pays to Be Naughty

I read a headline this week that left me shaking my head in disapproval.

In a grandiose display of high-minded social responsibility, Japan’s Government Pension Investment Fund, the world’s largest pension plan, decided to ban the shares of the stocks it owns from being borrowed by short sellers. (In order bet against a stock by selling it short, a short seller must first borrow the shares from another investor.)

Apparently, the fund didn’t like the idea of shares it owned being used by hedge funds for supposedly nefarious ends. The horror!

Where do I even start in ripping apart that argument…

Money Is Lost

To start, the pension’s first priority is to the retirees whose money it manages. Allowing short sellers to borrow shares netted the fund around $300 million over the past three years. That’s money that will no longer be available to fund the retirement of elderly Japanese pensioners.

Arguably worse is the precedent it sets.

Short sellers may come across as dodgy characters at times, but their trading adds liquidity to the market. A healthy market needs both buyers and sellers. If other large pensions feel pressured to follow Japan’s lead and restrict shorting, market liquidity dries up and execution gets worse for all investors.

It’s another case of the road to hell being paved with good intentions.

But believe it or not, that’s actually not the worst case of do-gooding run amok I’ve come across this week.

Enough Is Enough…

Activist hedge fund TCI threw down the gauntlet and threatened boardroom proxy battles with any company that didn’t publish detailed reports on their carbon dioxide emissions.

In plain English, TCI threatened to fire the boards of directors of literally any company, anywhere in the world, that didn’t share their sense of urgency about global warming.

Now, I’m all for corporate responsibility. If you can quantify the damage that a company does to the environment, it only makes sense to make them pay. It’s not fair that a company can pad its profits while damaging the world we all have to live in.

It gets ridiculous when you look at some of the “polluters” TCI singled out.

At the top of the list was Moody’s.

Yes, Moody’s. The bond rating agency…

Moody’s isn’t an oil fracker or a coal plant. It’s a company that creates credit reports for bonds.

I’m struggling to comprehend how company full of white-collar analysts with spreadsheets is causing the polar icecaps to melt with excessive carbon dioxide emissions. It’s also my understanding that a money manager’s job was to make money, not engage in meaningless virtue signaling. But what do I know…

We all have our pet issues, and business shouldn’t be immoral. There’s a reason why some industries are illegal and others are strictly regulated. But high-mindedness can be taken to an extreme.

And when it is, it creates opportunities for those of us with a level head.

Profiting from the Politically Incorrect

In their 2007 white paper, The Price of Sin: The Effects of Social Norms on the Markets, Princeton Professor Harrison Hong and New York University professor Marcin Kacperczyk found that the taboos associated with investing in politically incorrect industries such as tobacco, alcohol, and gaming led these sectors to be priced as perpetual value stocks.

This perpetual discount means attractive pricing and dividend yields, which in turn meant market-beating returns for investors willing to be a little naughty.

In other words, by being socially responsible, you end up with lower returns. But by being a little less judgmental, you put yourself in a position to profit quite well.

Historically, socially-responsible investing tended to focus its disdain on tobacco.

Today, I’d argue that energy companies are viewed as the greater evil. And this has created fantastic opportunities for income investors like us.

Review: Return of the Active Manager

Active portfolio management is dead, killed by the superior performance of cheaper stock index funds.

Or is it?

In Return if the Active Manager, C. Thomas Howard and Jason Apollo Voss make the case that active management may actually be on the verge of a major comeback.

As recently as 2009, active mutual funds enjoyed a market share of over 75%, with passive index funds making up less than 25%. In 2018, active and passive funds reached parity, with each taking about 50%. It’s safe to assume that, once the numbers are tallied, passive funds will overtake active funds in 2019. Howard and Voss eventually expect the split the stabilize at roughly 70% passive index funds and 30% actively managed funds.

It’s not hard to understand why. As Howard and Voss explain it, the fund industry is structured to force active managers into being closet indexers, which is a battle they can’t win. They can’t beat the index if, in the authors’ words, “active managers are being asked, not just to beat the index, but to do so with the same securities, the same industry weightings, no tracking error, no style drift, the same volatility, with lower expenses,” etc.

The authors make a compelling case that Morningstar and its style boxes are to blame. While Morningstar intended for their style boxes to describe and evaluate funds after the fact, instead they became a straightjacket of investment constraints before the fact.

Because of the need to fit within a Morningstar style box, managers get forced into a game they can never win. The only way to beat an index is to do something fundamentally different, which means “style drift” or “tracking error.”  

As Howard and Voss explain it, the unintentional outcome was “the bland sameness in investment management strategies, leading to consistent underperformance of closet indexers…”

If the situation looks bleak for active management, the good news is that its destruction brings opportunities. As others, such as Mike Burry and Bill Ackman, have noted, indexing only works when there are active managers whose informed trading forces prices into a state of efficiency (or something close to it). If there are no more active managers, then passive investing stops working effectively.

As Howard and Voss explain, “As stocks are increasingly held by index funds, which simply respond to investor flows rather than fundamental  company information, stocks become increasingly mispriced… The implication is that as investors flee closet indexers and move their money into low-cost index funds, stock picking opportunities improve.” Hence the return of the active manager.

This brings Howard and Voss to the core of their argument. They see the future of active management being one in which Morningstar style boxes are irrelevant, as are all performance metrics that depend on the CAPM or the Efficient Market Hypothesis. Instead, active managers will focus on exploiting the stock picking opportunities created by excessive indexing.

This behavioral finance approach takes it as given that market prices are driven mainly by emotional crowds, and that investors are not rational. By understanding this – and by managing your own emotions – you can take advantage of market anomalies.

In evaluating active managers, Howard and Voss offer a few suggestions. First, look for managers that are pursuing a “narrowly defined strategy with consistently and conviction.” You’re looking for a specialist, not a generalist. Secondly, look for smaller managers with less than $1 billion in any single strategy. And finally, look for low correlations. Howard and Voss suggest looking for funds with R-squared values (a common measure of the degree to which a fund tracks an index) of below 0.80.

As active managers specializing in behavioral finance, Howard and Voss clearly have an interest in investors following their advice here. But their analysis is solid, and investors would be wise to take it seriously.

My compliments to the authors.  


I have a library. And you should have one, too.

I’m proud of the collection of books I’ve collected over the years. A good chunk of my library is dedicated to investing, economics, and other money-related topics. It is my job, after all.

But I also have an entire shelf of literature dedicated twentieth century Spain, and another dedicated to the rise and fall of the Ottoman Empire. I own just about every book Hemingway wrote. And I have a fantastic translation of Don Quixote. The particular edition I own is one that I’ve not found elsewhere since.

Why? You may ask…

Why not! The book is particularly interesting in its own right, and even more so since it’s something of a one-of-a-kind find. It was too good to pass up.

I have fiction, nonfiction, which includes biographies, how-to books, essays on various topics… And that’s just to skim the surface. When it comes to my books, I have it all. And I’ve actually read 95% of them. The remaining 5% I’ll get to soon enough.

In Good Company

I’m not the only voracious reader on the team.

Harry Dent has a formidable book collection spanning an impressive breadth of information.

Back when we were office mates, I remember watching Rodney Johnson get through three newspapers every morning before even touching his first cup of coffee… and then following that coffee with more reading.

I don’t know how many annual reports John Del Vecchio has read over the years. If I had to guess, I’d say that number is in the tens of thousands. It’s what makes him great at his job as a forensic accountant.

In short, we’re a bunch of nerds.

But we’re in good company.

Becoming the Best Version of Yourself

Warren Buffett is arguably the best investor of all time. I say “arguably” because he has his share of competition for the crown.

Much like professional basketball players, fans will always debate who the all-time great is.

Is Lebron James really as good as Michael Jordan in his day? It’s hard to say.

Likewise, it’s hard to say whether Buffett is greater that Jesse Livermore, Julian Robertson, or even a quant pioneer like Jim Simons.

But what is beyond debate is that all of these giants of finance reached the heights they did by continuously learning.

Todd Combs, one of Buffett’s lieutenants at Berkshire Hathaway, said that the best advice he ever got from his boss was to “read 500 pages per day.” Buffett apparently made that offhand comment while teaching a class at Columbia University, which Combs was attending at the time.

Combs took that lesson to heart and reportedly reads 500 to 1,000 pages every single day of his working life.

And Buffett practices what he preaches, too.

The Oracle of Omaha claims, even at his age today, to spend five or six hours every day reading.

What Should You Read?

The easy, one-word answer: everything. Read everything you can get your hands on.

Of course, that’s not possible. So, let’s be a bit more practical.

I suggest taking a cue from Rodney and start with a couple good financial newspapers. I prefer the Financial Times because it gives the best international coverage, but the Wall Street Journal and Investor’s Business Daily are both solid options as well.

It goes without saying that you’re not going to learn how to invest by reading a newspaper.

In fact, I know traders that make a living betting against mainstream media. But reading a good financial paper at least gets you that baseline of knowledge that you need in order for the additional research to make sense.

Read plenty of books, too. And not just the ones on investing. You can find tidbits of knowledge in history books or biographies, even novels. These books can spark an idea or help you to make a connection.

Every time I go to London, I make a pit stop by the bookstore of my old alma mater, the London School of Economics, and fill up a bag with books that I can’t find anywhere else. You don’t have to get that crazy, but make an effort to read books on a variety of different subjects. It’s training for your brain.

For a deeper education, read the quarterly or annual letters of large, influential investors like Buffett. He often goes into the nitty gritty details of why he bought or sold something. You’ll learn more about investing from reading 15 minutes of one of Buffett’s Berkshire Hathaway letters than you would from two years in an elite business school.

He’s something of a controversial figure, but I also get a lot of value out of reading Bill Ackman’s letters. For a fantastic understanding of the bond market, read everything that Jeff Gundlach has to say.

And, naturally, keep reading Sizemore Insights!

It’s my job to get you fresh content that you’re not likely to find anywhere else.