Taking a Stand Against Conventional Wisdom

Make no mistake, how you invest matters. But advice on investing is often based on conventional wisdom and using the past to try to predict the future, something that has virtually no chance of happening. Wall Street portfolios exhibit massive home bias. Most portfolios look nothing like the process that was outlined in Chapter 5. Most portfolios have over 80 percent of their assets in U.S. stocks and bonds—an allocation to two assets that are trading at or near absolute and relative all-time high prices. It is my opinion that this is a process that is virtually guaranteed to lead to massive amounts of wealth destruction.

If my two $100,000 charitable bets did not adequately make the point, let me try one more way. The average bear market is a 30-percent correction.¹ I do not need to know when the next bear market will take place. I simply need to know that if one happens anytime in the next five years there is a high probability of below average and potentially negative returns in U.S. stocks over that five-year period. Let's look at an extreme example and imagine stocks go up 50 percent between 2016 and 2020, making a bull market run that goes from 700 to 3,000. This would imply we are in the second-longest and second-biggest bull market ever, and then if what follows that run is an average bear market of a 30-percent correction, U.S. stocks would be flat for the next five years.

Keep in mind, the last two runs of similar size were the 1990s, which ended in the tech wreck, and one in the 1920s, that ended in the Great Depression.² The process the lemmings follow is virtually guaranteed to deliver returns that will disappoint and destroy value.

I am not saying investors should not own U.S. equities or that they shouldn't own cash or bonds. I am saying that I believe that if your portfolio is only composed of these assets you may have a difficult time capturing a spread for the next decade.

Conventional wisdom is not only wrong with respect to investing, it is really wrong with respect to debt.

You have been told debt is bad. You have been told paying off your mortgage is good. I believe it is a lie. I have found no mathematical basis to these claims.

The single biggest determining factor in your rate of return and in being on track for retirement is your debt, debt structure, and the choices you make with respect to debt. Do not underestimate the power of building up assets early and paying down debt later.

If you believe that you can capture a spread, at any level, over your after-tax cost of debt, on average and over a time period of more than five years, debt does not destroy value but, rather, adds considerable value to the accumulation of wealth. The greater the spread and the longer the time period, the greater the value of debt.

Let's look one last time at Brandon and Teresa. Without drastically changing their savings rate, they cannot hit their retirement goals through the conventional approach. It isn't possible without unreasonable assumptions.

If they had a return of 7 percent, their retirement portfolio would only grow to about $318,000.

If their returns were 10 percent, it would only grow to $429,000.

In fact, they would need a return of 14 percent to equal the net worth of $850,000.

In the L.I.F.E. path, they achieved $850,000 with a return of 4 percent.³

What is more likely, your ability to consistently get a 4-percent rate of return or a 14-percent rate of return?

It is virtually impossible for me to express how little returns matter relative to the decisions you make with respect to debt.

And if you believe you can accomplish higher returns, then you believe you can capture a spread—and you should believe in debt.

If you believe returns will be low, then you need to capture a spread to have any chance of hitting your objective.

If you believe that no asset class on this planet can capture a spread over a 30-year period relative to generational low interest rates, then you need a high savings rate, perhaps upwards of 50 percent and potentially pushing toward 100 percent. Unless you like that idea, you have to take risk. And faced with risk you should take the least risky, highest probability path to accomplishing your goals. To me, this is accomplished by embracing strategic debt—throughout your life—accompanied with perhaps slightly lower but slightly more consistent returns.

You—and your advisors—should not manage one half of your balance sheet. It is not possible to do a good job if you do not use all of the tools that are at your disposal. Debt is a tool that is to be managed carefully. You would not have a doctor operate without a scalpel. You would not build a house without a hammer. Failure to look at your financial picture in a connected, holistic way is gross negligence.

You have the right to be mad at conventional wisdom. In fact, you should be outraged. Partial advice is bad advice. The future of wealth management is interconnected holistic advice. Comprehensive plans that look at how your assets and liabilities work together. Advisors that manage only half of the balance sheet, assets, are by definition managing one half of the picture. As my friend Duncan MacPherson says, “Without debt, there is no balance to a balance sheet.”

Shoot for more conservative, more consistent returns with some debt rather than volatile, inconsistent returns with no debt. I can't say it enough: The single biggest determining factor in your overall rate of return is your debt ratio and your debt structure. But you have to be thoughtful, balanced, strategic, and comprehensive, or everything can go wrong.

So what does a balanced approach look like? In my opinion: If your net worth is less than 20 times your gross income and you want to retire, you have to carefully consider the potential risks and benefits associated with the value of debt in building wealth. To me, the benefits are compelling relative to the risks.

Here are some key takeaway thoughts:

Oppressive Debt:

• Get rid of it.
• Your number one goal is to eliminate oppressive debt and break the paycheck-to-paycheck cycle as quickly as possible.
• Be sure you aren't saving yourself into oppressive debt by putting money into your retirement plan while racking up charges on your credit card.
• Build up liquidity. Have money in your checking account so you have reserves and can ride out the storms.

Home Ownership:

• Too many people buy houses too early in their life.
• The risk and lack of liquidity is not worth it.
• Renting is not wasting money. It is about risk management, flexibility, and using other people's money so you can build up yours.
• There is considerable value to renting until: You have no oppressive debt and a net worth of at least 50 percent of your annual income and closer to two times your annual income, or you know you will be in that home for at least five years.

Borrowing:

• Try to keep your borrowing costs as close to inflation or inflation + 2 percent. If they get above inflation + 4 percent, it will be hard to capture a spread.
• Avoid 15-year mortgages unless you have the cash flow to be on a 15-year mortgage and save at a rate of at least 15 percent. A low savings rate combined with a 15-year mortgage virtually guarantees you will not be on track for retirement.
• Interest-only mortgages are not bad, if you stay within the guidelines outlined and save at a rate of 15 percent.
• 30-year mortgages might be good, but generally only if you plan to be in that specific property for more than seven years.

Capturing a Spread:

• A small spread of even 2 percent adds up to a lot of money over a lifetime.
• A spread of 4 percent could be the difference between being able to retire and not.
• A spread of 6 percent is a significant and material spread over a lifetime, but may not be worth the risk.
• I know I will not capture a spread every minute, hour, day, week, year or even every three-year period of time. I would like to capture a spread over most five-year periods of time. Properly positioned, I think there is a high possibility of capturing a spread over a 10-, 20-, 30-, and 50-year period of time.

Risk:

• The larger the spread you are targeting, the more risk you are taking on with your investment strategy.
• I would rather capture a smaller spread more consistently on a larger base of assets. It's a marathon, not a sprint.
• Over time, risk is equally important to return.
• A lot of risk isn't worth it early in life, and you can't afford it later in life.

Although conventional wisdom will tell you debt is bad, my advice is that debt is a powerful tool that can materially add value to your financial picture. It is one of the best ways to express a view with respect to currencies and interest rates. It is one of the best low-correlated assets in a portfolio.

The right debt, with the right balance, has a place in virtually everybody's life. Slow and steady wins the race. Consider taking your risk through a balanced amount of debt rather than through asset allocation. Tune out the news and market forecasts: Nobody knows what will happen in the future.

The 2015 Nobel Prize in Economics went to Angus Deaton. In discussing his award, the Economist magazine said: “As well as his specific contributions to our understanding of the world, Mr. Deaton offers three lessons to aspiring economists. First, the theory should tally with the data—but if not, then do not despair. Puzzles and inconsistencies help to prompt innovation. Second, the average is rarely good enough. It is only by understanding differences between people that we can understand the whole. Finally, measurement matters. In the words of Mr. Deaton, “Progress cannot be coherently discussed without definitions and supporting evidence.”⁴

I would suggest we apply the same framework to The Value of Debt in Building Wealth.

• The theory must tie with the data. But if not, then do not despair. Puzzles and inconsistencies help to prompt innovation.
• Average is rarely good enough. It is by understanding differences that we can understand the whole.
• Measurement matters. Progress cannot be coherently discussed without definitions and supporting evidence.

While Mr. Deaton's work has been called “a triumph for evidence-based economics,” it is my hope that this book is a small step forward for an evidence-based approach to the value of debt in building wealth.⁵

Lastly, never forget the importance of behavioral economics. This growing field is perhaps the most important. Simply ask yourself, “Will I honestly have the discipline to implement the plan?” If the answer is no, then make no mistake, debt will most likely destroy value throughout your life. This plan requires discipline and requires you to be rational and thoughtful. I believe in your ability to implement the glide path through L.I.F.E. we've outlined and examined together. I believe in you.⁶

Endnotes