Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this month’s podcast takes a closer look into behavioral mistakes investors make that accompany both bull and bear markets. Included is an in-depth analysis on if Real Estate is a good investment and the polarizing effect it has on client advice. Plus, you won’t want to miss each of their monthly tips! Join us as we explore what academics have learned and improve your own investing strategies!
Time Stamps
[0:00] – What was it like in the early days of Creative Planning, particularly after multiple recessions, including 2008?
[4:27] – Behavioral Finance. What types of mistakes have academics identified that leads investors to do damage to themselves? How can you avoid them?
[11:20] – Real Estate Investments
[22:43] – Peter Mallouk Tip of the Month
[23:20] – Jonathan Clements Tip of the Month
Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, director of financial education at Creative Planning here in Overland Park, Kansas, and with me is Peter Mallouk, the president of the firm, and we are Down the Middle. Here we are for another podcast, Peter, and now it’s history time. So, we were talking before we sat down, started recording this about what it was like in the early days of Creative. You took over the firm in 2004. Along came this nice event, 2008, from peak to trough, the market fell 57% as measured by the S&P 500. What was it like at the firm at that point?
Peter Mallouk: The first 10 years of my career was fascinating, because you had the tech bubble, 9/11, and ’08, ’09. These are three of the worst bear markets in history, with bear markets at 20% drop or more. All of those were well over 40%, so you’re talking about three very severe ones in a very short period of time that still colors the thinking and the way that people invest today, particularly the 2008 one. In ’04 we were managing less than a hundred million dollars and it was very easy to talk to every client and get them through those first issues. But when you got to ’08, ’09, at the time it was big, it’s certainly not big today. We were managing about 500 million in assets. We had a few hundred clients, and I think the way we invested made a lot of sense for them.
I mean, basically our approach is we are needs based, so the money they need in the short run is never at the mercy of the market. And so, I didn’t have to call up anybody and say, “Hey, I need you to skip this month’s distribution or not spend this much,” or “Oh my goodness, the stocks are down whatever percent and so we’re going to have to change plans.” I never had to have that conversation, and so, I mean, that was the first very big positive. And back then, there were not a lot of people doing that approach to investing. The second thing we were doing, and I think ahead of a lot of folks is we were very index heavy. We were using ETFs at the time. I believe. We were the largest holder of Vanguard ETFs in the country, probably of any independent RIA.
And I remember, very vividly, when our representative there told us that me being surprised, but I looked and there’s only about a hundred firms that were 500 million or more, so it wasn’t that crazy, since that was heavily what we were in. And we were very aggressive at tax harvesting, which was something that, really, a lot of people weren’t doing back then. And we were able to sell off some bonds and buy stocks as the market was declining, that’s called opportunistic rebalancing. Instead of rebalancing at the end of a year or end of a quarter, or never rebalancing, we were doing it when the opportunity presented itself. Now that’s not brain surgery, but you fast forward to 2009, typical person has losses on their tax return but is now back to break even in their portfolio, even though the market itself doesn’t break even for several years, simply by rebalancing while the market’s down.
You might remember the beginning of ’09, the market, it bottomed around March 9th and that same month it was up about 30%. It recovered all of 2009’s losses just in three weeks. So, the market’s like a rubber band. When you pull it back, when things turn, it really springs forward. A lot of people think, “Oh, when I’m down 30% it will take five years of 6% to get back to where I was.” That’s not really how the market works. If it goes down fast, it can go up fast, and vice versa. It goes up fast, it can come down fast. And so that was really a coming out nationally for Creative Planning, when we really started to get a lot of national attention and grow from there.
And really the key was controlling the behavior of our clients. Making sure that they were educated, informed. That their investments match their needs in a way where they didn’t make a mistake going through that, because everyone goes to a cocktail party or a Christmas party, or whatever, and somebody says, “Oh, I’m not investing because I lost everything in the ’08 crisis,” or after 9/11, or the tech bubble. Well, if you’re a diversified investor, that’s literally impossible, right? I mean, the market recovered from each of those and went onto a new high. It’s the behavior of that person, that investor, or their advisor’s behavior, that really did them in.
Jonathan: So yeah, you say to an investor, “Do you have any reason to think that the stock market will not be higher 10 years from now?” And they’ll of course say, “Well, no. Almost certainly it’ll be higher.” And then you say, “So why are you worried about today?” It’s like, “Well, it’s scary,” for whatever reason. So that brings us to one of the topics we were going to discuss about today, which was behavioral finance. I mean, we know from the research there have been all kinds of behavioral mistakes that have been identified by academics which seem to influence a disproportionate number of investors and leads them to do terrible damage to their own financial health. And one of the ones, going back to ’08 and early ’09, is this tendency to extrapolate recent returns, this recency bias where whatever has happened most recently looms larger in our minds. And presumably back then you must have seen that among some clients who were like, “It’s going to zero!”
Peter: Right. Yes. No, I think that recency bias is extremely powerful, I mean, in personal life and when it comes to investing. I mean, this is why if you’re going in for an interview and you’re applying for a job a hundred other people are, you want to go as close to last as possible so that they remember who you are, they’re focused on what happened most recently. And when it comes to events, especially, it very much highlights things. If the market’s going up, we expect to continue to go up. If the market goes down, we expect it to continue to go down. If five things happen over five years, the one that happened most recently carries the most weight. And I think that the most recent bear market we had was cataclysmic, and so I think this is what people are fearing today, because it’s the one that they have most top of mind.
And it impacts their behavior in a sense that most people tend to be more conservative than they’re supposed to be. This year money markets went over 3 trillion dollars after averaging around 2 trillion, and people have been moving the cash while the market’s going up because they feel like we’re overdue for a bear market, and what’s a bear market? Oh, it’s what happened in ’08, ’09. Well, that’s not the typical bear market. Typical bear market’s a low 30 something percent drop, it’s very temporary. ’08, ’09 was 53% from top to bottom. It took many, many years to recover, but that wasn’t normal. That was one of the three worst bear markets in history, and one of the two worst in modern history. But that recency bias is very powerful. It’s causing people to be more conservative than they should probably be.
Jonathan: So, there’s recency bias, but then layered on top of that is another key finding from the behavioral finance research, which is loss aversion, this notion that we get far more pain from losses than pleasure from gains. One of the peculiar things about loss aversion is it can actually help during a bear market, because people become so reluctant to sell out of their loses that they actually hang tough. They may not be willing to rebalance, which is what they ought to do. They may not be willing to add more, which is what they should be willing to do, but they, for goodness’ sake, never going to ever sell until they get back to even.
Peter: Yeah, that’s exactly right. I think it actually can help in those situations because they feel like if the market’s going down and they sell, they now lock in that loss, their net worth doesn’t change that moment, right? They’re at the same place. And so that aversion to that keeps them in the market, which for many people helps them grow. Sometimes it works in a very negative way, though. Sometimes the market’s going down and people assume it’s going to continue to go down, and their loss aversion causes them to sell rather than participate in further losses. But it doesn’t feel as good to make a dollar as it hurts to lose a dollar, and that very powerful force of human nature can cause people to make some mistakes.
Jonathan: Yeah. I think for a lot of investors the real danger point was not so much in late 2008 and early 2009, it came in 2010, 2011 when they were back to even and like, “Okay, I finally made back my loss in my little mental account. I’m whole again and now I’m going to get out.” And I think the result was that a lot of people missed the rally that continued for many years after that because they got conservative too early.
Peter: That definitely true. And around that period, we had all the Greek debt crisis things, the market would go up and retreat. I mean, I think it went up and down through 10,000 points a dozen times, or several dozen times, it really struggled. And that was a big turnover area in the market, and you did see a lot of flight to cash trade in that period.
Jonathan: So, we have recency bias, takes us in both bull and bear markets, we have loss aversion, which obviously kicks in during bear markets. But then once you get along bull market, what you see is increasing self-confidence, right? People become more and more sure that they know what they’re doing, and I think we saw that through 2017 and into 2018 with the Fang stocks. That suddenly, “Oh yeah. I know what I’m doing, and big tech companies are the place to be, and that’s what I’m going to load up on.”
Peter: That’s right. And the narrative with that, whether it was the internet bubble or the cryptocurrency deal or the Fang stocks is, “Oh, everything’s different now and you just don’t understand how this works anymore, and this is the future and I’m going to load up.” But simple math says things can’t go up 50% a year, every year, that’s not going to happen. And anybody that knows anything about capitalism knows capitalism kills companies. I mean, it’s a great idea that a company gets built around, and eventually competitors attack that from different angles and take little segments of it until that company can’t grow at that same rate anymore. And that happens 100% of the time, right?
And everyone talked about Sears, “Oh, what a terrible story.” That was an amazing success story. I mean, it lasted a century. I mean, very, very few companies make it a century. And so, it’s a little microcosm. When GE dropped off the Dow, it became the last stock from the original Dow. I mean, no one would’ve ever dreamed back then that all of these companies would no longer be on the Dow. And so, the economy’s going to progress, but it’s different companies that will carry the torch. And just because you see something that seems like it’s gone on forever, five years is not forever. It will find a way to unwind itself eventually,
Jonathan: Which of course is the reason to diversify. There was the great study that came out of Arizona State University, I’m sure you saw it, Peter, where the finance professor looked at the results of the financial market over the last 90 years and found that the entire gain of the S&P 500 over and above treasury bills could be explained by just 4% of the stocks. And that half of the game could be explained, I think, by just 90 companies. And of course, this has this perverse effect, which is you see the big winners and you say, “Okay, I’ve got to own the big winners,” but the problem is if you go out and you pick just one stock, the odds are you’re going to end up with those 96% who underperform treasury bills.
Peter: That’s right. It’s not so obvious. I mean, one-year Southwest Airlines was the top performer in the S&P 500. It’s very hard in advance. Instead of looking for that needle in the haystack, you buy the haystack, the needles in there, and you’re going to have that stock that lifts those returns. Helps you along the way.
Jonathan: So, talking about behavioral finance, I mean, one area where people tend to behave very emotionally is real estate, right? For many of us, it’s our biggest investment, at least when we make it, hopefully one day our portfolios will be larger. And not only is it a big investment, but it’s a complex investment, right? Involves leverage, it involves thinking through both price appreciation and the fact that you get to live in the place. When you talk to people about real estate, how do you explain it?
Peter: Well, I think you have to divide it into several different categories. So, one, you have your primary residents. Some people are asking about second homes. Third, people are asking about buying it as an investment, private real estate, like buying a duplex and renting it out. And then there’s people that are in the business of real estate. I tell people real estate’s a nice diversifier, but I don’t expect it to do as well as the stock market. And this makes people absolutely hysterical, right? I mean, especially people in the real estate business.
So, let’s start with the primary residence. If you look at your net worth statement, there’s assets that bring money to you and assets that take money away from you. We tend to look at it as assets and liabilities. The house shows up in the asset column, so we think, “Oh, that’s a wonderful thing. I should buy more of that.” Well, it might be in the asset column, but it’s taking cash flow away from us, right? We have maintenance costs, taxes, insurance, and so on, not a great investment. We took all that money and put it in a S&P 500. Thirty years from now, when that mortgage is just paid off, we’d have more money in the S&P 500. That’s almost a certainty, and it would be by many times of a factor.
But we need a home to live in, right? And homes are not about the financial side, they’re about the emotional side. I have a nice home. I’m not living in a $10,000 hut, even though it would be better financially to do that, because I want a place to live and to be with my family, and I want to do what I want to do there. But I’m not buying that home on the idea this is a wonderful investment. For most Americans, it winds up being their biggest asset because it’s forced savings. You’re forced to pay that mortgage. You wake up 15 years or 30 years later, your house is paid off and you’re able to then downsize homes and then take that money and go live off it. That’s interesting for a lot of people.
Jonathan: Yeah. So, before you go on, let me just throw in a quick number here. So, if you look at real estate prices over the past 40 years, real estate prices over the past 40 years have increased one percentage point a year faster than inflation. Just one percentage point a year faster than inflation. And then if you take all the costs involved in real estate, the fact that you have to maintain your home, the homeowner’s insurance, the property taxes, and you subtract it from that price appreciation, the net result is that you’re probably only breaking even on your real estate, and you might even be underwater. And that doesn’t mean a home is a bad investment, because as you find out, you get to live in the place. That fact that you are able to rent your home to yourself, that you have this imputed rent, that is the huge return from owning real estate. If it’s your own home, the problem is you immediately consume it, so it’s not an investment.
Peter: And even with the home, it doesn’t even make sense to own a home, even from the rent perspective, unless you’re going to be there for maybe 10 years. But somebody who’s going to buy a home and sell it within five years, you’re going to have a commission to get in a commission to get out, you may as well rent. So, for somebody who’s going to be in it for a long period of time, it makes some sense, doesn’t compare to other investments, but you get that imputed rent if you’re a long-term resident.
Jonathan: Right. So that’s your primary residence. Now second homes, Peter.
Peter: Second home is a hundred percent emotional play. A lot of people are like, “Oh, but this worked out wonderfully.” I’m going to just use a personal example. So, our family would go to the Gulf of Mexico every year. My in-laws had a place there, my kids loved going there. We went every single year for seven or eight years. My in-law said, “Hey, you know what, Peter? This condo’s pretty crowded.” And I said, “You know what? You’re right. It is two bedroom and I’m bringing my family of five in there, and they love their daughter, and they probably like me okay, but they didn’t need all five of… And they were already sharing that with one of their other son’s families.
So, another condo came for sale there right in the middle of the ’08 crisis. And it was a 200 something thousand dollars condo, and we bought it. And it was at the bottom of the market. I mean, these same places have been selling for 50% more just a year earlier. And we’ve used it every year. We’ve gone several times a year for what’s been now a decade, and it’s gone up in value a hundred thousand dollars. You would think that is an amazing investment. Perfect time to get in, by luck, because my father-in-law was not timing his, “Hey, it’s time to get your own place,” to the stock market. It just happened to be down. And the real estate market at the same time obviously was suffering. And here we are, there’s been a recovery. And so, you think I would think that was an amazing investment, but I have those things you were talking about.
I’ve paid insurance and I’ve had the homeowner’s association dues, and I’ve paid my taxes. And that’s more than the money that it appreciated. So even though someone buying and selling thinks, “Oh, this is great.” They’re forgetting all of the costs they had along the way. In fact, it turns out I would’ve been better financially to go to the Ritz Carlton every year for a week in Florida from a financial perspective, but I don’t regret the decision because it was never a financial decision. It was an emotional decision. That place means something to the family. We know we want to go back to that same place all of the time.
But whenever a client asks me, “Is this a good financial thing to buy this cabin in Colorado or this condo in Florida or this place in California?” The answer’s almost certainly not. The reason to do this is because you are sure you want to go back to the same place all the time, and that tradition means something to you and your family. If you’re sure of that, then understand that you would be better off with other “investments”, but that’s not the primary reason we’re doing this. And that’s how I feel about second homes.
Jonathan: Okay. So, second homes. Now, rental properties.
Peter: Yep. Rental property’s a different story. Now we’ve finally moved to a category where things are bringing money to you, right? So instead of owning publicly traded real estate, you might buy a duplex. You rent it out. You’re willing to deal with the hassle of all of this. You’re willing to lease the place out. You’re willing to meet people there. You’re willing to change the carpet when it needs to be changed and call the plumber. Are you going to make some money doing that? Absolutely, you will. Especially if it’s a hundred thousand dollars duplex, you put $20,000 down. Well, if it appreciates over five years to be worth 120, you’ve doubled your $20,000 initial investment. So, the power of leverage confuses people. They inflate their returns, but really, it’s the power of leverage. We could take a stock portfolio and leverage it too, but that makes people much more uncomfortable. So, with that private real estate we’ve got more hassle, but we’ve got more of a reward. And I would expect to get a low double-digit rate of return from owning investment real estate.
Jonathan: I would just throw in three points here just on the rental real estate, because I’ve thought about this a lot. Never done it. One reason is none of my stocks ever called me up in the middle of the night and told me the toilet is broken. That is a risk with rental real estate. Two. It is a big undiversified bed. And three, it is indeed a leveraged bed. In fact, owning a piece of a single property with leverage, I would argue is riskier than having a diversified stock portfolio. And while people look at those leverage gains, your example, you put down $20,000 on a hundred thousand dollars property and it increases 200,000. It looks like your money has gone up sixfold, but remember, in many cases, the cost of leverage matches the benefits of leverage. So how much did you pay in mortgage interest over that period it took for the property’s price to double. You might well find that it’s pretty close in terms of those two numbers, and the leverage really didn’t make you a whole lot of money.
Peter: Well, the leverage works backwards. I mean, you put 20,000 in to buy a hundred thousand property and we have a real estate crisis and the real estate’s worth 80,000. The net worth of that’s gone down a hundred percent. So, it can go against you as well, for sure
Jonathan: Though you can’t always give into foreclosure, but not something we want to recommend.
Peter: And I think that this is where we are the risk reward continuum. So, we’ve got more household and you could say, “Well, I’m going to hire a property manager.” That’s going to dilute your return. Now I would never tell somebody to put all their eggs in one basket. If you’ve got a net worth and you want to get private real estate, do I think even unleveraged you will get a better return than the publicly traded real estate market? I do, but you’re going to deal with more hassle and less liquidity and things like that. So, it’s a risk reward decision that you have to make to go that step, but you could make a lot of money doing that. You can diversify yourself, let’s put it that way, doing that.
And then you’ve got the last step, which is being in the business. So, I have people go, “Oh, Peter, I hear you talk about real estate, and you’re crazy because I buy places and I remodel them and I…” Well, you’re not a real estate investor. You are in the real estate business. I mean, this is a totally different story. This is the difference between investing in McDonald’s or Panera, and opening up a sandwich shop, right? If you are buying a property and remodeling it, that’s not a real estate investment the way we’re talking about it, where you’re buying something that produces income and selling it. Even the IRS will say you’re in the business and they’ll tax you at a higher rate. So, it’s just a whole different world. And that world lives and dies by are you a good business operator?
It’s no different than somebody asking me, “Does it make sense to open a restaurant?” Well, it depends. If you’re a good restaurateur and you’re a good businessperson, you might be successful there. A lot of people aren’t. Same thing when you’re in the business of real estate. Of course, some developers and turnaround specialists are going to make a ton of money. That’s their day-to-day business. That’s a totally different deal.
Jonathan: So actually, just a quick pet peeve on this, which is remodeling. So, I can’t tell you how many homeowners I’ve met who said, “We spent a hundred thousand dollars. We put in this new kitchen, and we went to sell. Our house was worth $200,000 more.” And this is just delusional. Your house is worth $200,000 more because the property market went up over a time. In terms of that actual remodeling project, the statistics tell us that probably you will recoup less than 50% of the money you make, and that’s only if you sell soon after you did the remodeling project.
Peter: And that’s only some remodeling projects, even, where you even get that, right?
Jonathan: Right. So, there’s something called Remodeling Magazine, and they have a survey they do every year called the cost versus value survey. And you look at that, and the return on these home improvement projects is often sort of 50 to 90%, but that assumes you sell within a year. The longer you wait to sell, the worse your new kitchen is going to look and the less money you’re going to recoup. When you remodel your home, it is not an investment decision. It is a consumption decision, and you should only do it if the pleasure you receive is comparable with the dollars that you’re putting out.
Peter: I completely agree with that. I tell my clients that all the time, that eventually your house will regress to the neighborhood, which is why you see… Good or bad. You buy the cheapest house on the block, you’re going to benefit disproportionately, and that’s why I think you see that remodel effect diminish over time.
Jonathan: So anyway, wrapping up another podcast here, it’s time for your tip of the month, Peter.
Peter: All right. This tip of the month is really easy, and a lot of people don’t do it. But you can accelerate your contributions to your 401k. The key here is we don’t want to lose out on the match. So, you want to go the person in your HR department that handles this. Instead of giving a little bit of your paycheck throughout the year to max out your 401k, max it out as early as you can, but without losing the full match that the employer gives you. And what that does is allows your money to be in the market longer, and it benefits from compounding because of that. So, you’re investing the same dollars, but you get a better outcome.
Jonathan: And my tip for the month, Peter, is tell family stories to your kids that illustrate lessons about money. So, if you try to lecture your kids, and we’ve all tried to do this, it’s remarkably unsuccessful. They will not listen to you. But if you tell family stories that illustrate the values that you think are important, they will remember those stories. And so, for instance, when I was growing up, the story that my three siblings and I regularly heard was how my maternal grandfather blew the family fortune. He inherited the equivalent of millions of dollars, and throughout his life he dissipated that money on farming. It wasn’t wine, women, and songs. It was on farming. He ran one gentleman farm after another, when the capital was depleted, he would trade down to a smaller farm, free up more capital and then spend that. Eventually the farms got too small, and that was when he retired.
And we four siblings all heard that story, and one of the consequences is that even though we’re all remarkably different people, we were all super careful about money. If you want to teach your kids about money, tell them family stories that illustrate the lessons that you want to learn. For instance, if you had hard times in your twenties and you really struggled to get by, you lived in this shack, there were mice, you can dress up the stories. It’s okay to lie. There were a few cockroaches, whatever it is. Tell them the story so that they understand that when they get out into the workforce, they will need to be thrifty, and they will need to be careful about money. And it works.
Peter: That’s good advice.
Jonathan: All right, Peter. So, this is the end of our most recent podcast. Thanks for chatting with me. And this is John Clements, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only, and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed to be reliable but is not guaranteed.
