A few years back I was talking to a finance instructor at the New York Institute of Finance who is a CFA (Chartered Financial Analyst) , he is the first person to explain this to me, and it is a topic that is not covered very frequently so I figured it was worth writing about.
The first thing we need to discuss is how much of your portfolio should be in fixed income, the old school rule of thumb is 100 minus your age should be in equities and the balance in fixed income, so a 20 year old would have 20% in fixed income, and a 60 year old should have 60%, with longer lifespans and better computer models a newer rule of thumb is 120 minus you age in equities, so a 20 year old would be 100% equities and no fixed income and 60 year old would be 40% fixed income. There are various other methodologies that are more complicated as well, I personally use the “Efficient Frontier” from “Efficient Market Theory” and find I am comfortable with a 25% fixed income allocation, that is the point on the curve where adding return is not worth the added risk and reducing risk reduces returns more then I would like, I am not suggesting this is the right mix for everyone it is my comfort zone.
For the example I am going to lay out I will use an equity bond mix of 75%/25%. If my portfolio is worth $500k and I use VTI which is the Vanguard Total Stock Market ETF which tracks the entire US stock market to represent the equity portion of my portfolio, and I am using AGG which is the iShares Core Total U.S. Bond Market ETF for the fixed income portion of this portfolio. The investor rents and does not own their home, so they have no home equity. We will invest this portfolio on 1/3/2011, VTI opened at $65.36 and AGG opened at $105.4, so we would have purchased roughly 5,737 shares of VTI and 1,185 shares of AGG. Over the course of 2011 VTI declared quarterly dividends that added up to $1.23 per share for a total income on our investment of roughly $7,056, and AGG declared monthly dividends that added up to $3.49 per share for a total income of roughly $4,136. On 1/3/2012 VTI opened at $65.41 and AGG opened at $110.20, so our portfolio is worth $517,036 (market price of the securities plus the income earned). The yield on the fixed income portion of our portfolio is 3.31% based on our purchase price. At the start of the new year we would reinvest all cash into the portfolio, yes it is more efficient to reinvest as we earn the dividends because the money is working for us and we get to dollar cost average the investments, however for the purposes of this post it is not important when they are reinvested simply that they are.
So let us assume we have the same amount of money to invest but we also own a home with a mortgage and we are not currently dependent on the our investment portfolios income to cover expenses (we are not retired yet). Our house is worth $300k and we put down 20% so we have a mortgage for $240k for 30 years at 3.5%, our monthly payment is $1,077.71 our mortgage also begins on 1/3/2011. Over the 1st 12 months the average principal payment on our mortgage is $383.83 or $4,605. Principal payments reduce our mortgage balance and therefore increase our home equity which is a direct increase to our net worth. So if we look at both our portfolio and our mortgage we can see that our fixed income assets increase our net worth by $4,136 through income and our mortgage increases our net worth by $4,605 in home equity. Now in either situation we are not looking at the appreciation or depreciation of the underlying asset, AGG did increase from $105.4 to $110.20 but it could have just as easily gone down in value of the 1 year period, our house could easily do the same increase or decrease in value, the income/payment stream is the only thing we are looking at right now and the mortgage is increasing our net worth by a few hundred more then our AGG investment.
As you can see the homeowner has a steady stream of a fixed income increasing their net worth every month and is now substantially overweight fixed income and can now allocate more of the investments to VTI rather then AGG. If we were to invest the entire $500k in VTI our investment portfolio would be worth $509,729 and we would have an additional $4,605 in home equity due to mortgage payments. In NY where I live real estate appreciated on average 1.3%, so our home appreciated $3,900 bringing our total increase home equity up to $8,505 if we add that to the $9,729 in our investment portfolio we get a total increase of $18,234 which is about $1k more then the non homeowner portfolio. In years where the stock market out performs using your mortgage as your fixed income investments will yield much higher returns and in years where the stock market is flat or down your mortgage provides roughly the same amount of downside protection.
Most people look at their mortgage as only a liability, and the interest you pay over the duration of the loan is a liability, but every month when you reduce your balance you are increasing your home equity and your net worth by a set amount and when you look at your financial picture overall you have to consider all of your assets not just the money you allocate towards investments.