Afford Anything - Ask Paula: Investing, Rebalancing and Renovating

Episode Date: September 5, 2016

#41: Mollie, a listener, is making smart money moves. She's getting the maximum match on 403b contributions. She's saving for a downpayment on a home. Her husband opened a Roth IRA. What's next? After listening to the Jim Collins episode, Mollie wants to open a Vanguard account. How can she balance this with the rest of her saving and investing goals? Is she spreading herself too thin? Meanwhile, podcast listener Elizabeth is trying a little-known tactic to rebalance her portfolio. Traditional advice tells people to rebalance by selling their gains. But Elizabeth wants to let those gains ride. She'd prefer to rebalance by buying undervalued assets. Are their hidden dangers to her strategy? Finally, podcast listener Chris wants to remodel his basement. He's an aspiring Airbnb host who'd like to make extra cash by renting out part of his home. How much money should he spend on his basement remodel? Are there any good rules-of-thumb? I tackle these three questions in today's Ask Paula episode. Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. And that's true not just of your money, but also your time, energy, focus, attention, any limited resource in your life. So how are you going to spend these scarce resources to create the best life possible for you in the way that you define that? My name is Paula Pant, host of the Afford Anything podcast, the show that explores how to make smarter decisions and spend your money, time, and life more wisely. It's the first Monday of the month, which means it's time for Ask Paula, the episode in which I answer questions that you've submitted. Today's first question comes from Elizabeth. Hi, Paula. This is Elizabeth calling from Canada.

I've been investing in index funds for a couple of years now, and I have a question about rebalancing your portfolio. So how I rebalance my portfolio is I'm constantly investing more money in it every month or two. and then I have certain percentages that I'd like each index fund to be. And so I kind of balance it out that way and just buy more of whatever fund is lower. But whenever I read about rebalancing portfolios online, everyone seems to suggest selling whatever is high and buying more of what is low, which makes sense. But since I'm investing on a regular basis, I'm just trying to balance it out as I go along. Anyway, I'm not sure what the right way to do this is or what you think about portfolio rebalancing,

but I'm interested to hear what you have to say. Thanks. Love the show. Bye. Elizabeth, short answer? I think that's fine. But let me elaborate. First, I'm going to give some background for the sake of any other listener who isn't familiar with this topic. And then I'm going to elaborate on your specific question. So first, for listeners who aren't familiar with rebalancing, here's a bit of background. your investment portfolio, and I know that sounds like a fancy term, but if you've got a retirement account, you've got an investment portfolio.

That portfolio, according to most experts, should be split up between investments that have low correlation to each other. Now, correlation is the relationship between things that change together in tandem. For example, in a broad sense, there's a correlation between, and this is actually true, there is a documented correlation between making your bed in the morning and professional success. It's not a causal relationship. Making your bed doesn't cause you to be more successful in your career directly, but there is, at least according to some studies, a correlation between the two. Now, in the world of investing, correlation measures the degree to which the prices of two assets move together. So if one asset class goes up, then the other asset class also tends to go up. If one goes down, then the other also tends to go down.

Measuring the correlation between two asset classes, and by the way, when I talk about an asset class, I'm talking about just a category of different types of assets, like stocks, for example, equities, that's an asset class. Bonds, that's an asset class. Correlation is how much those different types of asset classes move together or don't. And in order to, you know, and in order to to measure the correlation between two asset classes, that's actually incredibly simple. All you do is compare the monthly returns of one asset class to another over the long term. And the good news is you personally don't have to do any of that work because a whole bunch of spreadsheet jockeys in offices already did that for you. So based on their research, we know that the U.S. stock market

and the U.S. bond market historically have relatively low correlation to each other, which means that when one rises, the other often tends to fall. In other words, historically, when stocks go up, bonds go down. When bonds go up, stocks go down. It's not perfect. It doesn't happen every time. But historically, over the long term, that's the pattern that we've seen. So given that information, many financial experts recommend holding both stocks and bonds in your investment portfolio.

So in your 401k, your Roth IRA, whatever it is that you have. And they recommend holding these in proportion to your risk tolerance and your timeline until retirement. Meaning if you've still got 30 years before you intend to retire, you can take on a little bit more risk. If you've got three years, you kind of want less risk because, you know, you got to start tap in that pretty soon. For example, let's say if you want to retire at the traditional age of 65 and if you have a medium risk tolerance, then hypothetically you might decide that your age minus 10 is the proportion that you want to keep in bonds with the rest in stocks. So in other words, if you're 35, then your age minus 10 is 25. So you would decide to put 25% of your portfolio in bonds and the other 75% of your portfolio. in stocks. I'm not saying that this is necessarily how you should diversify. I'm just giving this as an illustrative example. So that being said, let's say you're 35 years old. You put a quarter of your

portfolio into bonds. You put the other three quarters into stocks and a year passes. And during that year, the market moves. Stuff rises, stuff falls. And at that point, the traditional advice is to rebalance, which means that you sell the stuff that's high and you buy the stuff. that's low so that you can get back to that 2575 split, or in this case, I guess, since a year passed by if you want to get really picky about it, a 26% 74% split. Now, there are two benefits to rebalancing. The most talked about benefit, the one that people emphasize in the media, is that this gets you back to your desired allocation. This gets you back to that stock bond split that you wanted. The benefit that is typically not talked about, but that I think,

is incredibly powerful is that rebalancing forces you to sell your winners and lock in those gains. It also forces you to buy the losers, buy the stuff that's undervalued. In other words, rebalancing forces you to be a contrarian investor. It forces you to buy low, sell high. Psychologically, this is an incredibly difficult thing to force yourself to do. And so rebalancing makes this systematic. It kind of takes that emotion out of it. So that's the background that I want to establish.

And based on what I've just said, it sounds like what I'm talking about is leading me down a path that ends in me telling Elizabeth to rebalance her portfolio in a traditional way, selling high and locking in those gains. Because as you recall, here's how Elizabeth rebalances. How I rebalance my portfolio is I'm constantly investing more money in it every month or two. And then I have certain percentages that I'd like each index fund to be. And so I kind of balance it out that way and just buy more of whatever fund is lower. Elizabeth, your strategy, which is rebalancing by virtue of just buying more of what's cheap, that's totally fine. True, you're not selling the winners and locking in those gains,

but you are continuing to buy the losers. You're continuing to buy the undervalued asset. The reason that people sell the winners is to generate the cash that allows them to buy the losers. But you're generating that cash in other ways. You're generating that cash through your income. So you've got the money to buy those undervalued assets. Keep doing it. The thing that I will just note, though, is that mathematically there's a limited window in which you can do this.

Right now, you're contributing enough money to your portfolio, at least I assume that you are based on your question. You're contributing enough money to your portfolio such that making a monthly contribution puts you back to that ideal rebalance that you want to get. If those numbers work out, if the raw dollar amount that you're putting in gets you back to the percentage that you want to be at, awesome. eventually, that might not happen. Eventually, if you've got a million dollar portfolio, depending on how much you're contributing every month, you might not be able to put in enough money in January to get that million dollar portfolio back to where it needs to be.

But if the numbers work out, if the percentages work out, I think that's great because here's the thing. When you sell an asset, depending on, you know, if it's a traditional brokerage account versus a tax deferred one versus a tax-exempt one. You know, different types of accounts have different tax structures. But when you sell an asset, depending particularly on the type of account that you have, you incur taxes and fees.

And so by virtue of not selling, you don't incur those taxes. You don't incur those fees. That's great. Let your winners ride. Why pay short-term capital gains tax when you don't need to? Oh, and tip for any other listener? There are arguments as to how often you should rebalance. Some people say annually.

some people say quarterly, some people say twice a year. I will just plant the idea in your head that one of the benefits to rebalancing annually is that you don't incur short-term capital gains. Short-term capital gains tax is charged on assets that you hold for under a year. Long-term capital gains tax, which is cheaper, is charged on assets that you hold for one year or more. So I'm not going to tell you how often to rebalance, but I am. I'm going to plant the seed in your mind that rebalancing yearly puts you into the category of long-term capital gains tax rather than short-term. Now, again, this depends on what type of account

that you're using. Is it a Roth? Is it a traditional? Is it a brokerage? But I'm just planning that seed out there. It's something to think about. Thank you, Elizabeth, for that question. Our next question comes from Molly. Hey, Paula. I really enjoy your work, and I've learned a lot from you. I have a question about whether I'm putting my available money to invest to its best use. My husband and I don't make a ton of money, but we're content with our jobs and career paths. I don't see any major increases in income in the future, and we're definitely in the five figures. The bulk of our savings right now is going towards a house down payment. We've done the research, and we know that owning is cheaper than

renting in our area. After listening to your interview with Jim Collins, I've been reading his stock series, and I'm ready to start investing with $3,000 in the Vanguard Total Stock Market Fund, and work my way up to Admiral shares, but I have a fear that we'd be spreading out our money too much and limiting our growth since we don't have a ton to invest. We'd be able to put about 150 a month into the index fund and increase that as we can. I'm contributing to my 403B up to the max match. My husband has a new Roth IRA that we've been contributing about 250 a month to since the beginning of this year, and the plan is that when we're done saving for a house, we'll start maxing that out every year. There's also a 55,000 IRA from an old job. I know that it gives us a decent

makeup. I have no plan to add anything to it unless I was going to do a rollover in the future. Do you have any thoughts on how we're distributing our investment money? Would you do anything differently? Thank you. Awesome. Molly, you are doing a great job at managing your money, so congratulations. I love the fact that you have done the research on renting versus buying in your specific area. That is so important. I love that you've looked into that. You've asked the question and you have arrived at the informed decision that buying is better in the place where you live. That is so important. By the way, to any other listener who isn't sure if renting versus buying is better in your area, in the show notes, which you can access at podcast.offordainthing.com,

I'm going to link to an article that I wrote about this. And I'm also going to link to a calculator. It's on the New York Times website that is the single best rent versus buy calculator I have ever come across. Both of those are available in the show notes at podcast.offord anything.com. Molly, I love that you've done that. I love that you are contributing to your 403B up to the maximum match. I love now that you're looking at other investment opportunities. You're doing a great job. So to your question, which is that you want to open a Vanguard account, you can right now invest

3,000 into the Vanguard total stock market index fund, and you can contribute another 150 a month into that fund. That's what you can do. Your question is should you? Or, you know, should you do something else? I've got a few thoughts about this. Now, first, assuming that you and your husband have fully merged or fully combined finances, here's what comes to mind. You mentioned that your husband opened a Roth IRA and that he is currently contributing $250 per month and that your plan is to start maxing out that Roth IRA after the two of you have finished saving for a house. So first question that pops into mind, where is this Roth IRA housed? Is this at Vanguard? And the reason that I'm asking that is because I see a way for the two of you to combine these

goals. Assuming that you're under 50, the maximum that you can contribute to a Roth IRA is $5,500 per year. That divides out to $458 and 33 per month. So if you're currently contributing $250 a month, that means that in order to max out your Roth IRA, you would need to contribute an additional $208 per month more than you're currently doing now. If you've been planning to contribute 150 a month to a new Vanguard fund, then my question is, why not put that money towards the Roth IRA instead? Because that would accomplish a couple of things. Number one, you'd be pretty darn close to maxing out your Roth IRA.

You'd be $68 a month shy of maxing out your Roth IRA. And I'm guessing that if you're $68 a month shy of doing it, that might be the motivation to like get you to get that extra $68 bucks in there. So that's reason number one. Reason number two is that if that Roth IRA is housed at Vanguard, you could invest this money in the total stock market index fund, which you've indicated that you want to do.

It seems to me that that would accomplish both goals. And the Roth IRA holds a whole bunch of advantages. For example, as you probably know, the money that you put in there grows tax exempt, meaning that when you withdraw that money in retirement, you don't have to pay taxes on dividends or capital gains. And the other benefit is that if Armageddon strikes, if you are in a worst case scenario and you need access to money, you can withdraw your contributions penalty-free. In a 401k, that's not the case. You'd pay a penalty for trying to access that money.

But in a Roth IRA, you've already paid the taxes on the money that you're contributing in. And because you've done that, the law states that if you want to tap that initial contribution, that $5,500 a year, you can withdraw that money without paying any penalties or any taxes. Now, I'm not saying that you should. It's better to keep that money in there, but it's nice to know that in a worst-case scenario, when everything else falls apart, that's an option. So that's the first place I'd encourage you to check out if your goal is to have an account at Vanguard and start buying the Vanguard Total Market Index Fund. I would like to take a moment to thank our sponsor, FreshBooks. They are a super intuitive tool that makes creating and sending invoices extremely simple. Using FreshBooks, it takes about 30 seconds to create and send an invoice.

You can add your own logo and color scheme so that your invoice reflects your brand. and you can see whether or not your clients have even opened the invoice. FreshBooks will send automatic follow-up reminders to any clients who are late in sending their payments. And your clients can go ahead and pay you online, which can improve how quickly you get paid. Give them a try for free at freshbooks.com slash Paula. That's freshbooks.com slash p-a-u-l. And if they ask how you heard about them, mention this show. you can say Paula or you can say the Afford Anything podcast.

With that being said, let's listen to Chris's question. Hi, Paula. I enjoy the podcast. Have a slightly different angle on the how much should I spend on a rental property question. I'm a single guy. I own my home. Well, the bank owns most of it, but you know what I mean. My question is related to finishing the basement of my house in order to accommodate a roommate slash tenant or perhaps listed on Airbnb. Currently, the basement's partially finished. It has a full bath that has been recently updated. The rest of it would definitely need some work. So my question is,

if you have a good rule of thumb for how much you would spend on fixing up a basement in order to rent it out. Thanks, and I look forward to hearing your response. Chris, your question came at a perfect time. On my blog, Afford Anything, I recently wrote about renovating of my rental properties. We just did a $13,000 kitchen renovation. So this topic is very fresh on my mind because, you know, when we planned this kitchen renovation, we had to do a few back of the envelope calculations. Before I answer your question directly, I want to start by distinguishing something important. Your goal is to renovate your own personal residence. And that falls into a different thought category than renovating a rental property. Now, this might sound like semantics. This

might sound like some inconsequential distinction, but it's not. And within my answer, I want to explain why. First and foremost, when you buy a personal residence, you don't analyze that purchase in the way that a property investor would analyze a rental property. You don't calculate the cap rate. You don't calculate the net operating income. And that's fine. That's appropriate for the purchase of a personal residence. I didn't run those equations when I bought my own personal home, you know, the mindset of somebody buying their own house is different than an investor mindset. And that's totally fine. But the reason I want to point that out and emphasize that is because you're asking a question about the math behind something that is not a rental property.

You're asking about how to make a back of the envelope calculation for a personal residence that you're monetizing on the side. And this makes the math different. You're going to use a different set of equations. When you're figuring out how much money you want to put into a personal residence, you're going to use a different set of numbers than you would if you were looking at an investment property. First of all, the first question that I want you to ask yourself is, how long, realistically, do you want to rent out this basement? I know right now you feel really excited about the prospect of having a roommate or becoming an Airbnb host, but three years from now, are you going to be as excited? And if

you're not, are you going to think to yourself, oh, man, I've got to rent this thing out because I put all this money into it and I need to at least recoup my costs? Like, is that the thought that's going to be running through your mind? Essentially, what I'm saying is your personal preferences are going to play a role in you figuring out what that back of the envelope formula should be. That wouldn't be the case if this were an investment property, something that you didn't live in. But because you live there and the fact that you're renting it out will have a significant consequence on your lifestyle. The first and primary question that you want to lead with is how much of a commitment do I want to lock myself into? And I would recommend, and this is

going to sound extreme, I would recommend not locking yourself into more than at least one year to recoup the renovation costs. Now, I know that sounds totally extreme. And you're probably thinking like, well, one year, wait a minute, what are you talking about? There's hardly any way that I can recoup a renovation in one year. But again, I'm saying that because this is your own home. And the last thing that you want is to be forced to rent out the basement in your own home because you've locked yourself in. Now, let me pause there. Let's keep that concept in the back of your mind. And I'm going to switch gears. You'll see how this all ties together in the end. Last month, when I renovated one of my rental properties, one of the factors that I

considered is the fact that in this particular case, the general market could support a higher rent. So the particular property that I renovated recently was in worse condition than its surrounding neighborhood. So I knew that the primary factor that was putting a ceiling on my potential rent was the quality of the building itself. I also know that when I renovate a property, the rent goes up, but the operating overhead mostly stays the same. Now, operating overhead includes any expense associated with running the property, such as property taxes, insurance, management, maintenance, repairs, capital expenditures, all of that. The benefit of a renovation is that, for the most part, the rent increases, but the operating costs stay relatively constant.

And as we know from managing our own personal finances, when income goes up and expenses stay the same, we wind up with more money in our pocket, more money falls to the bottom of. line. So that was the perspective that I was coming from as an investor making a decision about how much money to put into a renovation on a rental property. Now, I'm going to say for the benefit of any other investors who are listening, in fairness, some operating expenses do climb higher post-renovation. For example, property management is typically charged as a percentage of the rent, like 9% or 10%. So when the rent increases, the property management fee increases proportionally. Likewise, after a renovation, it's common for your property tax assessment to go up.

So that's another bill to pay. But on the other hand, repair and maintenance bills tend to go down for the next several years because so many of your home's components are new. So roughly, and I want to emphasize this as back of the napkin, rough, rough math. Roughly, it's a wash. Roughly, your operating expenses stay the same. Your rent goes up. That means all of it falls to the bottom line or most of it falls to the bottom line.

And so last month, when I was deciding how much money to spend, well, really it was a few months ago when I was making the decision on how much we wanted to budget to renovate one of our rental properties, I first established a couple of foundational facts. You know, number one, I established a foundational fact that the local market in that particular neighborhood can support higher rent. So I established that renovating could lead to higher rent. And number two, given that most of this increased rent would roughly fall out of the bottom line, I knew that I could use the gross difference in rent, the gross increase as the number that I look at when I make that back of the napkin projection. And that really, those two factors combined with the fact that I chose to recoup the cost of the renovation within a maximum of five years led me to a budget of $15,000 for the renovation. So let me walk you through that so that you can see kind of what I was thinking, but then I want to emphasize how it's different when it's your own home. So in my case, because this was a rental property, my personal preferences are not on the table. They're not a factor to consider.

I don't have to worry about how Airbnb being a basement is going to affect my lifestyle because this property is located 2,000 miles away from where I live. So there was no personal downside to this renovation. For the most part, I am primarily buying surface-level finishes that will depreciate the minute I put them in. Now, in fairness, because this was a kitchen renovation, it's going to have a longer life cycle than a lot of other types of rentos. So the cabinets, the countertop, the flooring, that's all going to have a longer lifespan than five years. But if I were, let's say, putting in paint and carpet, I mean paint and carpet lasts five years. So if you don't recoup the cost of that investment within five years, well, guess what? The life cycle is going to expire before you've even recovered the cost.

So in my particular case, taking all of those factors together, I set a budget of $15,000 for the renovation. And I actually ended up spending $13,600. And the reason that I chose that is because I wanted to recoup the cost of the renovation within five years. And I believe, I reasonably believe, that this renovation could, increase my rent by about 400 per month. So that 400 per month, that equals around $4,800 per year. And we've advertised it at that price. We've gotten a lot of interest. And we've already collected one tenant application at that price. So this is a very reasonable metric for me to use for that particular property. But let's be conservative. Let's say that I only increase the rent by

$250 a month as a result of this renovation. That would yield an extra $3,000 per year. And so, So even in the reasonable worst-case scenario, even in a conservative scenario, I would still recoup the cost of that kitchen remodel within less than five years. That's why I chose the budget in which I did. But even though I used five years for my back-of-the-envelope calculation, I would encourage you not to use five years. I would say that for a personal property, that is too long of a time span. shrink it down to one year, two years max, because most of the upgrades that you're going to be putting in are going to be the type that rapidly depreciate. You're going to be putting in, I assume, paint and carpet rather than drywall and electrical. Assuming that that is correct, you need to recoup the costs of that and profit from that before that life cycle ends.

if you're going to turn your basement into an Airbnb rental space, you're also going to be spending part of that renovation money, buying nightstands and bed sheets. That stuff has a very short life cycle as well. So that's part of the reason that since it's your personal property, I would encourage you to set a shorter time limit. And the other reason, as I already said, is because of the impact that this is going to have on your personal life.

You want to give yourself the flexibility and the freedom to be able to say, you know what, I don't want to do this anymore. I've rented my basement out for a year. and I'm done. You want to be able to preserve that option. So long story short, Chris, to answer your question, I would encourage you to use a benchmark of approximately one year when you are making your back of the napkin calculation

as to how much money to put into renovating your basement. And to anybody else who's listening, who's an investor and who's thinking about how this applies to a rental property that you yourself do not live in, something that is purely an investment and not your personal residence, I'd say five years is a pretty good back of the napkin, rough rule of them. All right, well, Chris, thank you so much for asking that question. And thank you to all of you who are listening to this episode of Ask Paula. If you have a question, please go to afford anything.com slash voicemail to record your question so that I can

answer it in an upcoming episode. Again, that's afford anything.com slash voicemail. If you'd like to read today's show notes or if you'd like to check out some of our other episodes, go to podcast.orgadainthing.com where you can dig through the archives and look at some of our other episodes. If you like the show, please go to iTunes and leave us a review. In fact, I'd like to pause here and give a shout out to a few listeners who have recently left reviews. One recent review from Michael says, you can afford the download. and he says that Paula manages to make a boring subject, engaging in fun. Thank you so much, Michael. And he says that he likes that I bring in guests with different points of view. Thank you so much. I really appreciate it.

I'm also glad that I get some amazing guests on the show. We're going to be featuring Cal Newport in an upcoming episode as well as Gene Chatsky, and we're bringing J.D. Roth back onto the show. So that's what you've got to look forward to. Another recent review says that this podcast is great for date night. My husband and I are so close to financial freedom, we can taste it. Awesome. I love hearing that.

Thank you so much for that great review. I love it. And congratulations to you for being super close to financial freedom. Another recent review says that my voice is fun to listen to. I appreciate that. And another one says, this is not a podcast to casually listen to while driving to work in the morning, because it will hit your faceholes with truth.

And you need to be furiously taking notes. I'm flattered. Thank you so much to all of you. To those of you who enjoy the show, please go to iTunes, leave us a review. These are so helpful and they're incredibly instrumental in helping me land great guests who can come to the show and share their wisdom and stories and experience with all of you. So please head to iTunes, leave a review for the Afford Anything podcast. Be honest, be truthful, and know that I really appreciate it. These reviews are, instrumental. Thank you again to everyone who is listening to this show. I really appreciate the fact that you have chosen to spend this time with me and I will see you next week. Wow, Jay, at this point, you've been off the show for a really long time and somehow you're still on the blooper reel. No, I'm not. I think you are. So a couple of examples of... Yes. Uh, sorry. Go ahead. A couple of examples of some of this stuff... Keep going

Keep going