Check out the recent Redfin article we were featured in:
As mortgage rates sit at decade record highs, it’s no surprise to see and hear countless ads on social media and the radio that one “should refinance their mortgage” before rates go higher. Even during periods of decreasing rates, one “should refinance their mortgage” to take advantage of lower rates. It’s obvious to us that mortgage companies want borrowers to consider refinancing their mortgages regardless of where rates are. We aren’t faulting them, but in our fiduciary opinion, one “should refinance their mortgage” only when it is in their best interests.
How to determine when one should refinance their mortgage
It’s important to understand how interest rates work within mortgages and their impact on the amortization schedule. With the help of an example, we can illustrate the effects of mortgaging your home. Let’s assume you are purchasing a $450,000 home, 20% down, at 4.75% annual interest over 30 years. This results in a $360,000 mortgage with a Principal and Interest payment of $1,877.93 per month.
The amortization schedule shows that $1,425 of the payment will apply to interest while $452.93 towards the principal of the loan. Each successive monthly payment will decrease the interest portion and increase the principal portion. The interest is front-loaded to the earlier years of the mortgage. And then vice versa towards the later years. It’s important to understand this because it can help determine when one should refinance their mortgage. And here’s why. If you pay this mortgage as agreed, then you will have paid $316,054.95 in interest over the life of your loan. That’s a lot of money not going in your pocket!
Why is this so important? Because each time one refinances their mortgage, it resets the amortization schedule. This can be a good or bad thing depending on how the numbers play out.
Holding all else equal, either refinancing from a 30 to a 15 year, refinancing to a lower interest rate, and/or adding additional payments usually have the effect of reducing total interest paid over the life of the loan.
On the other hand, holding all else equal, resetting from a 30 year to a new 30 year, using home equity to pay off consumer debt, or allowing forbearance programs to continue, usually have the effect of increasing the total interest paid.
There are, of course, exceptions to the above
We hear ads consistently tout the benefits of refinancing to pay off credit cards, student loans, and car loans. Because mortgage companies don’t have a fiduciary responsibility, they rarely must determine if that is in your best interests. It’s up to you to determine if it makes the most sense in your specific situation. Using equity to refinance credit cards, for example, won’t allow the mortgage interest on that portion of the loan to be deductible. It will also increase your balance owed and spread your payments over the life of the loan.
“But it’s at a lower rate!” That may be true; but behavioral finance can cause further problems if you don’t address why the balance of the credit card grew over time. If this is left unresolved, one risks allowing the credit card balance to continue to grow.
All credit card debt isn’t bad debt. It’s a great way of building credit that allows one to borrow at the best rates when used responsibly. Our job as advisors is to provide advice that is sometimes hard to swallow. But, that allows clients to better position themselves towards accomplishing their most important financial goals. It’s not always easy, but tiny adjustments now can have immense changes years later.
In the end, one must compare the total interest and costs paid over the current mortgage versus the new mortgage. This may include additional comparisons of consumer debt balances and total interest over the life of those loans plus the opportunity costs of these choices. You need to answer: does refinancing this debt put me in a better financial position when it’s paid back?
Navigating this challenging financial life is no casual walk in the park. The good news is that you don’t have to travel alone. We help clients of all backgrounds make challenging decisions like deciding when they should refinance their mortgage. If you’re tired of the confusion of doing it alone or if you have existing advisors that just aren’t cutting it, consider getting in touch today. We’re fiduciaries first, which means we’ll provide the advice that is in your best interests, not in the interests of us or the mortgage company’s bottom line.
 Ignoring property taxes and homeowner’s insurance premiums
In striving for better performance, I often like to take a step back from the daily headlines to get a macro view of where we are and how far we’ve come year-to-date. As we enter the month of May, let’s check the pulse of the broad market indices as of 4.29.22 (source):
Dow Jones Industrial Average: -8.73
S&P 500: -12.92%
MSCI EAFE: -12.00%
MSCI Emerging Markets: -12.15%
US Aggregate Bond Index: -9.50%
As a quick and simple refresher, the Dow is comprised of 30, mainly value oriented stocks. The S&P 500 is 505 of large cap companies with an overweight towards growth stocks. The NASDAQ is mainly growth oriented stocks while the MSCI EAFE tracks international developed stocks and the MSCI Emerging Markets tracks emerging market stocks. Lastly, the US Aggregate Bond Index tracks the performance of the total US bond market.
Notice that the year-to-date performance is negative across the board, including fixed income. The only asset class that is positive in nominal terms is cash. However, due to inflation, the real return on cash is negative as well. By “real return,” I’m referring to the purchasing power of a $1, which no longer buys the same amount of goods and services it did at the beginning of the year and can be expressed as the nominal rate minus the inflation rate.
With signs of the year-over-year growth rate of inflation possibly peaking, a Federal Reserve on a continued path towards tightening economic conditions, persistent supply chain challenges, and what is turning into a prolonged war between Russia and the Ukraine, where is an investor to turn for better performance?
Before we answer that…
In my opinion, there’s two ways to look at the notion of better performance. The first is obvious: the return must have a plus sign in front of it. You essentially end with more money than you started with. The second way is less obvious. The return is better than a benchmark return even if it still has a negative sign in front of the number. Think of the latter way as a negative result but less negative than it would be had you invested differently. It goes without saying that we naturally prefer to have positive real returns. But in some short-term periods, that won’t be the case.
Here’s a current example of better performance in two negative returning asset classes (again, as of 4.29.22):
S&P 500 Growth Index: -20.00%
S&P 500 Value Index: -5.02%
In this example, the S&P 500 Value Index is outperforming its growth counterpart by +14.98% year-to-date. In the fourth pillar of our Investment Philosophy, we actively choose to structure evidence-based portfolios for our clients by overweighting certain asset classes. One component of this is choosing to hold higher weights in value stocks over growth stocks. This strategy is performing well in the current environment even if it’s still negative, albeit, less negative than it would be if we didn’t have conviction in our investment philosophy.
This takes us back to the question at hand, where does an investor turn for better performance during these times?
We believe there’s several ways to answer this question and it depends on your individual circumstances.
First, visit the strategy you’ve implemented and try not to sell for the sake of avoiding losses; analyze and understand why you own what you own first. We’re overweight value stocks while slightly underweight international and emerging market stocks. We also favor quality and cash-flow rich companies within the portfolio. It’s important to note that this doesn’t mean avoiding growth stocks altogether since there can be pockets of better performance within that asset class as well.
Second, as interest rates rise, bond durations should remain on the shorter end of the curve. This won’t prevent negative returns for bonds, but it should dampen the impact to bond prices as interest rates rise. Floating rate bonds can also be attractive depending on individual risk tolerance and capacity.
Third, defensive sectors like consumer staples, utilities, and commodities can be attractive tactical additions to a portfolio. In our opinion, these areas can complement an existing, well-diversified portfolio but shouldn’t be the largest weights in it.
Fourth, be methodical (purposeful) in allocating new cash to investments and during rebalancing periods. Just as we do each day for client portfolios, we look for long-term value and opportunities in where we allocate cash. This approach can also manifest itself through dollar cost averaging like participants do with each payroll deferral into their employer sponsored retirement plans.
There’s no doubt that economic challenges lay ahead. We cannot predict what tomorrow will bring but we also aren’t blind to the potential risks in front of us. We don’t believe anyone can accurately—and consistently—outguess the direction of markets. For this reason, we believe constructing evidence-based portfolios that align with your tolerance and capacity for risk, your financial goals, and preferences is a better means to a positive investment experience.
We aren’t the type of firm that markets on doom-n-gloom predictions. Rather, we work with clients to identify what doom-n-gloom may look like specific to their lifestyle. No two clients are alike. We then build and manage portfolios that we believe match certain characteristics so that our clients can tolerate what the world brings their way. If the past several months have been challenging for you, get in touch with us. We’d love to show you how we help clients to see if we’re the right fit for each other.
Image Credit: Marco Verch Professional Photographer
In a world with constant information overload, sometimes it’s best to take a step back from financial news feeds to focus on core topics that drive home the fundamental components and experiences of being a long-term investor. I don’t need to explain to anyone that it isn’t easy being an investor. However, I believe it’s much harder to be a trader.
Allow me to explain.
A trader tends to rely on short-term, one-off theme-based events to drive their portfolio allocation decisions. They rely on timing the market with the goal of outguessing, and thus outperforming, a benchmark.
An investor tends to view those same events as statistical data and routine (standard) deviations. I, and many others, simply call it noise. An investor typically doesn’t allow this short-term “noise” to drive portfolio allocation decisions. Naturally, I’m making some generalizations since not all traders and investors fall into these categories.
Trading requires constant attention with an ability to guess accurately and consistently over time. Volumes of academic research exist to counter the belief that someone can accomplish this profitably. Trading and market timing strategies must be correct more than just once. An example of this would be selling at the depths of the COVID slump during March of 2020 with the goal of preventing further losses. But when does one buy back in…weeks or months later when things seem better? The 2nd worst performing day of 2020, March 12th, was immediately followed by the 2nd best performing day of 2020 (source). Think about that for a moment…by the time the trades settled the next day, one would have missed the rebound. Missing just a few of the best performing days, days that typically occur shortly after the worst performing ones, can significantly impact portfolio performance and value (source).
Investing is an opposite strategy because it relies on the belief that current market prices reflect all available information and expectations of the future. By that definition, it means that it is impossible to outguess the direction of the markets. Our Investment Philosophy is based on these beliefs. As advisors to our clients, we strive to not let the daily noise of markets impact how we design, implement, and rebalance their portfolio(s). It is the reason why our clients remained invested during March of 2020 and the various market corrections we experienced before then and since (i.e. January 2022).
Because we believe there’s no accurate way to guess which way the markets are going to go, we rely on decades of academic evidence to guide portfolio design. This belief, combined with individual investment and financial goals, time horizon, and appetite for risk, make up the toolkit we use in our daily approach to managing our clients’ investments and the advice we give.
Does this mean we ignore current events? Absolutely not. There are fundamental shifts that occur over time that help guide certain parts of the portfolio. One example of this is how our expectation of future interest rates impact the types of fixed income securities we recommend. During periods when rates are expected to rise (the current view), we strive to stay on the shorter end of the yield curve to lessen the impact of declining bond values while seeking unique areas of the fixed income market with positive correlation to rising rates.
We know last month was challenging for investors. The S&P 500 lost -5.47% of its value during January alone. With that in mind, was it challenging being an investor during 2021 when the same index gained 28.68% (source)? Obviously, no. But as investors, we must take the good with the bad since we rely on our commitments to an investment philosophy to smooth out the short-term noise.
The future is always uncertain. Many potential events are currently shaping the investing landscape. Yesterday’s 7.5% CPI (inflation) reading was a negative surprise, but one that makes sense given the Omicron surge of late December and January. The markets are digesting this number to price in what they believe the reaction from the Federal Reserve will be in March and the remainder of the year. Will the Fed increase rates by 0.25% or 0.50% and how many times this year? Will quantitative easing turn into quantitative tightening? If so, when? Does Russia invade Ukraine? Is there another COVID variant lurking around the corner? These are some of the uncertainties we face right now.
While I don’t know the answers above, I do know that markets are resilient and always forward looking. I know that corporations have an unwavering ability to flex in response to current events with the goal of increasing shareholder value. And I know that the future remains bright, albeit, challenging at times. The one constant lesson that investors know is that conviction matters: “time in the markets is better than timing the markets.” – old adage.
If you’re the type of investor who is seeking a partner to help you through the next few chapters of your life, consider getting in touch with us today. We’d love to learn more about you and how we may be able to team up.
Investors are flooded with information, options, and little guidance when choosing what investment vehicles to put in their investment accounts. During and post-Pandemic, many of these options became household names as some investors worked from home and became quasi-day traders in their free time. The rise of popular MEME stocks via Reddit and access to free trading platforms, like Robinhood, resulted in the rapid rise of certain stocks, more interest in SPACs and IPOs as investors looked for the next best thing, in my opinion. However, an understanding of SPACs, IPOs, and Direct Listings would serve investors well before they allocate their hard-earned dollars. Many of our clients’ portfolios include the mutual funds and exchange-traded funds managed by Dimensional Fund Advisors. For that reason, we thought it would make sense to get their take on SPACs, IPOs, and Direct Listings. Here’s their approach:
Investors have long recognized that the reasons why companies elect to go public include access to greater fundraising opportunities, improved liquidity for investors, and/or a lower cost of capital. More recently, however, investors have considered the implications related to how companies go public. Historically, the most common path to enter public markets was through an initial public offering (IPO), and while IPO activity remains vibrant, entryways such as direct listings and special purpose acquisition companies (SPACs) have drawn fresh attention. Consequently, investors have been forced to evaluate what, if any, impact these roads less traveled may have on investment decisions. We examine IPOs, SPACs, and direct listings and show that, although each route is characterized by unique terrain, regardless of the path to public markets, the end result is a new public company trading in competitive and liquid equity markets.
In a traditional IPO, the company issuing new equity hires an investment bank to provide underwriting and advisory services for the offering. The investment bank helps pitch the company to potential investors, commonly via what’s known as a roadshow, in an effort to introduce the company to investors, drum up demand for the shares, and subsequently formulate an initial offering size and price that reflect investor interest. Investors awarded an allocation purchase shares through a primary market transaction, following which the shares are listed on an exchange and available to trade.
IPOs represent the most familiar portal to public markets, and while activity levels can vary with market conditions, they remain a popular thoroughfare. Our research highlights a few IPO features that can impact aftermarket pricing, such as underwriter pricing support and shareholder lockup agreements. At Dimensional, we avoid purchasing IPOs for up to one year to alleviate the potential impact of such post-offering activities.
SPACs are a modern version of a “blank check” company designed to use cash raised in an IPO to merge with or acquire an operating company. When the target is a private company, the transaction works like a reverse merger, allowing the private firm to enter the public market. While the vehicle has been around for decades, SPAC activity rose to new heights in 2020 and continued to outpace historical levels through the first quarter of 2021. For example, Exhibit 1 shows that SPACs raised over $150 billion in total capital across more than 500 SPAC IPOs during the 15-month period ending in March 2021. To put those figures in context, the recent SPAC activity levels exceeded those of concurrent common stock IPOs in both volume and proceeds, as well as the aggregate SPAC totals over the preceding 10-year period.
The current fad has placed SPACs under the spotlight, but the use of blank check companies as a path to public markets has also been in vogue at various times in the past. Therefore, it is important that investors understand the vehicle’s mechanics and the associated price discovery process, regardless of whether current activity levels are sustainable. First, unlike a traditional offering where issuers hold discretion over the use of funds, the money raised in a SPAC IPO is held in a trust until a target company is identified and a subsequent business combination, or the de-SPAC transaction, occurs. Following shareholder approval of the transaction, the SPAC operators can access the capital to help fund the acquisition or merger. If no deal occurs within a specified period, typically two years, the SPAC is liquidated and the cash held in the trust is returned to shareholders.
Another common SPAC feature allows investors to redeem their shares in exchange for the initial offering price plus interest prior to the completion of the proposed de-SPAC transaction, effectively serving as a backstop for the share valuation. As a result, SPACs typically trade near their IPO price until a deal is announced. Once a deal is completed, SPAC shareholders’ ownership in the shell company is swapped for a stake in the new public operating company, and the shares trade subject to the same pricing mechanisms in effect for the broader public equity marketplace. At Dimensional, SPACs are not eligible for purchase in our portfolios until the SPAC combines with an operating company and the stock represents equity in an operating business. Consistent with our approach to investing in traditional IPOs, we also require the expiration of any price support activities and lockup agreements before the new public entity is eligible for purchase.
Another avenue used to enter public markets is a direct listing, in which a private company lists its equity shares directly on an exchange without conducting an underwritten offering. Recent modifications to the eligibility requirements by both the NYSE and NASDAQ served to expand access to the direct listing corridor. This notably allowed for a few well-publicized new listings, like Spotify and Slack, though there have only been a handful of direct listings in total in recent years. However, the direct listing process continues to evolve, and new innovations, such as the ability to raise capital via a direct listing, have emerged that may attract additional entrants. Therefore, it is important that investors be cognizant of the direct listing process and the relevant pricing mechanisms to allow for informed decision making.
Before shares are made available to trade on a public exchange, the direct listing company and its financial advisor work together to establish the initial reference price based on a recent private-market transaction or an independent valuation. The reference price is then used in an auction process coordinated by a designated market maker on the first day of trading, similar to the way each stock opens for daily trading. Prior to December 2020, direct listings were not permitted to raise capital and the initial liquidity was provided exclusively by early investors and employees. As a result, lockup provisions have not been common, but that may change if firms leverage the direct listing process to raise new capital.
Choosing the Optimal Path
Private companies must evaluate and choose their desired path depending on their targeted objectives and constraints. Companies may choose to go public via a traditional IPO to allow investment banks to pitch the company to a diverse set of potential investors, while other companies may choose to merge with a SPAC to expedite the listing process or because the company believes the SPAC operators provide an additional source of value to the company. Alternatively, companies that don’t want or need underwriter services may choose a direct listing to cut down on the costs associated with going public. Exhibit 2 summarizes the key path characteristics that companies may use to differentiate between the available options.
Implications for Investors
The paths to public markets have come into focus of late due to increased activity in nontraditional entryways, such as SPACs and direct listings. No matter the vehicle chosen to navigate the transit, once a company enters the public marketplace, it becomes subject to the same interactions between the supply and demand for securities that shape equity prices each day. We remain sensitive to the relevant price discovery process associated with IPOs, SPACs, and direct listings, and account for characteristics such as lockup agreements in our eligibility guidelines. However, beyond those considerations, we can apply our systematic process to extract information about expected returns for new listings just as we would for any other publicly listed security. Hence, investors can take solace in the fact that, whether a company takes the road less traveled or follows the beaten path, we can rely on the drivers of expected returns—size, relative price, and profitability—to point the way forward. Interested in pursuing an investment strategy backed by decades of academic research? Get in touch today.
- Article written and published with permission by Dimensional Fund Advisors with edits by Coastal Wealth Advisors, LLC.