Stop Buying Stocks, Pay Down Your Mortgage aka Why High Earners Should Quit the Stock Market
The poll threw up some interesting results and some people got the point I was trying to make.
(C'mon, greater than 10% is an ego response)
I could argue that as of today, only 2.6% of respondents guessed correctly. But the right answer is as always, "It Depends".
This is less a poll about returns and more about capital allocation. It is a bit of a test for how we think about deploying cash in relation to income, tax and net outcomes.
Frame of Reference
Many of those who are managing capital today only started their careers post-GFC. I too was at Uni during the GFC and traded stocks frequently before I got the slap-down that was 2008. Truly a costly education.
For me and many others, our careers have been dominated by falling rates and QE, inevitably our anchoring bias for rates is a cash rate of 3% or lower. Unless you travelled outside Australia to developing countries on a regular basis, no one has truly experienced what inflationary pressures are actually like in a very long time. The implications for allocating capital is gigantic.
Money is costly.
What is the right answer?
It is easy enough to talk about this on an institutional basis or in terms of allocating a pool of capital to investments. But what really matters is how you and I think about capital allocation on an individual level. We all just want to get ahead and get richer – allocating capital on the behalf of others in one form or another is exactly that, but your PnL probably matters more to you I think?
I get that we want to talk big numbers in finance but seriously, if you cannot answer basic questions that serve your own financial needs then what is the point?
So, let's forget about how we allocate capital for others and think about allocating capital for yourself. If you are reading this, you are likely highly educated, have a good knowledge of financial markets, likely own your home with a mortgage against it. Your marginal tax rate is likely 32.5% or higher. I know a fair few who read this here get taxed at 45% for every incremental dollar they earn.
RBA cash rates are in decline, now down to 3.85%. You can get a cash savings rate of over 4% today at banks with various hurdles and conditions. And 12-month term deposit rates max out around 4.25% too.
So, the answer for return with 100% certainty is less than 5%? …Maybe. Maybe not.
I do not this this is the case for the average Australian with a mortgage against their home.
(Note - If you are a retiree, wealthy, don't own your own home, etc, this really doesn't apply to you)
What is your home loan rate today?
There is a wide range of interest rates for home loans, and it is hard for me to pull a number out of the air. But let's make it easy for this discussion. Very simply I am going to assume banks will earn 190bps of Net Interest Margin over the RBA cash rate (Note 1), therefore I am simply going to extrapolate:
Therefore, Average Loan Interest is <3.85%+1.8%> = 5.75%.
Please note that this is for Owner Occupied, Principal and Interest mortgages. NOT investment loans or interest only or margin loans. Purely the mortgage on a principal place of residence. The roof over your head.
Back to my original question in the poll "If you had to invest $200k today, what return do you think you can achieve with 100% certainty over the next 12 months?"
I am simply asking where you will allocate that $200k to the most efficient use where you can maximise the return with a high level of certainty. (Nothing is ever certain, not even interest rates!)
The table above shows what pre-tax investment return you need to achieve at the very minimum at the various tax rates to make it worthwhile investing instead of paying down your mortgage.
At the current rate (I am assuming 5.75% today as highlighted above), you need to achieve a minimum pre-tax return of:
- 8.52% if you earn between $45k-$120k per annum
- 9.13% if you earn between 120k-180k per annum
- 10.45% if you earn more than $180k per annum
10.45%!!!
For anyone at the highest marginal tax rate, I can make the argument here that you need to generate a "risk-free" return of greater than $21,000 on the $200,000 available to deploy in any investment before it makes financial sense to do so.
Once again, I want to frame this in everyone's perspective of managing their finances. It is not easy to generate a "risk-free" return great than 10% per annum. In fact, I'd even go as far as saying it is difficult.
Cost of Capital and Equity Risk Premia
How do we think about cost of capital when making new investments in this lens?
From what I've clearly shown above, does that mean we need a 10% hurdle for any new investments? …Maybe. (How does that private credit fund look now?)
From my perspective and ignoring the craziness that was the falling-rate environment of the last decade or 3, allocating capital to risk does deserve to earn a premium over the risk-free rate. Simple stuff really.
There is plenty of data and research available on equity risk premium (ERP) that I am not going to bother with here, but ERP is commonly taken to be circa 5.50% above the risk-free rate of return.
With a cash rate of 3.85% and as a taxpayer at the highest marginal tax bracket, the required return is 10.5% (pre-tax rF) + 5.50% (ERP) = 16%.
I think that makes sense, why should you be getting out of bed for anything less than 16% for taking on equity risk in todays environment?²
This has implications for equity markets and allocating capital if you are trying to pay off your mortgage. Desired equity returns are perhaps different for those who are wealthier and don't have the added stresses of mortgages and debt but the surely you would think that there is some consistency between various groups of individuals as taxes are always certain.
A Tidal Force
The rising tide that was structurally falling interest rates have abated for now (peace dividend + China exporting deflation) and one might need to be a bit smarter about allocating capital these days.
Money is costly and it is hard to continue underwriting pre-tax equity returns at the historical returns of the ASX200.
So where does capital get allocated in the future? Should we be seeing a major deleveraging event across markets? Maybe, but I don't think so as simply not enough people are aware of what I've covered here or are aware of the mechanics of it all.
Most finance-y folk or for that matter anyone really only ever think about returns from a pre-tax perspective. And finance-y folk all want to talk about big deals but most people reading this aren't the big money makers and you're all reading this from you $2-3m 3 to 4-bed home in the burbs. But the reality is if you want to get ahead you REALLY need to think about long-term capital allocation.