Newsletter December 6, 2020
This has been an extremely volatile year in the stock market. At the depths of the virus-driven market panic on March 23, the S&P 500 was down a gut-wrenching 32% for the year. Similarly, the Toronto stock index was down 35%! And many individual stocks fell by over 50%.
Those kind of declines were more than enough to scare almost all stock investors. In particular those who had invested the great majority of their funds in stocks and who had little cash or fixed income investments were hard pressed not to feel some panic.
Even the Vanguard Balanced Exchange Traded Fund Portfolio (VBAL) which is only 60% invested in stocks and which has global diversification was down fully 20% at the low point in March. Even most fixed income investments traded down significantly due to the fear.
Only cash, and cash equivalents held rock steady which is always the case by definition. And the strongest longer-term government bonds rose significantly in value as investors paid higher prices in a quest for safety.
But now, as the end of 2020 approaches, all is sunshine and roses in the stock market. The S&P 500 is now up 14.5% this year which, incredibly, is 69% higher than its low point. The Toronto stock index is up 2.7% year to date which puts it 57% above its March low. VBAL is up 7.3% for the year and sits 35% above its low point.
An ideal but unrealistic scenario for 2020 would have been to have sold stocks at the highs in January and so to have entered the panicky month of March with a very large allocation to cash and then bravely bought back into stocks as others panicked in March.
A more realistic scenario would have been to have been holding a balanced portfolio with a reasonable allocation to cash and fixed income and then to have done basically nothing. except ride the storm out. That strategy would have been stressful in March but has worked out well as the year draws to a close. It might also have allowed at least some buying near the lows simply due to rebalancing to keep the cash and equity percentages relatively constant. For example, the VBAL fund is automatically and frequently rebalanced on that basis.
The worst scenario would have been to have panicked and sold a significant portion of a portfolio near the lows in March and then to have “sat in cash”. That scenario has locked in the losses.
With the markets now at record highs it might be tempting to move to a sharply lower equity allocation and higher cash allocation. Or, others might be tempted to have a very heavy allocation to stocks to ride the current trend. Only one of those strategies will look wise in a year’s time. If 2020 has taught us nothing else it is that markets are unpredictable. History has shown time and again that markets rise over the longer term. A reasonable strategy for most investors is to have some balance in their portfolios and to stick with that allocation.
Long-term historical annual returns from stocks, bonds, cash and gold
I recently updated my article on the annual returns from the main asset classes of investment which are stocks, bonds and cash. I also included Gold although it is usually considered a more niche investment. The data covers 1926 through 2019. One thing to note, it is annual data and does hide some of the within-year volatility that we have just seen can occur.
I also updated an article on whether stocks are really riskier than bonds. They certainly are in the short term but arguably not in the long term.
This is Not Your Father’s Mortgage
HSBC Bank was in the news this week because it is offering a mortgage below 1% for Canadians. Their current offer is 0.99% for a 5 year variable rate mortgage! I’ll round that off and call it 1%.
A 1% mortgage rate is intriguing and got me thinking. At 1%, the interest on a one million dollar mortgage is just $10,000 per year or $833 per month.
I’m old enough to have paid over 10% on a mortgage. At 10%, a million dollar mortgage would have cost $100,000 per year in interest or $8,333 per month! But not coincidently, ordinary houses did not cost anything close to $1 million back then.
Don’t worry, I am not here to suggest that it’s easier to buy a house now because interest rates are so low. Home prices have vastly increased since the days of 10% or even 6% mortgage rates.
What I wanted to explore today, is the way in which mortgage math has been just about turned on its head.
In the “old days” with say a 10% interest rate most of the payment for quite a few years had to go to paying interest and the amount owing on the mortgage came down very slowly indeed. Amazingly, with a 25 year mortgage, it took over 19 years before the mortgage was half paid off. After 10 years the mortgage was only 16% paid off with 84% remaining. The good news however was that it was feasible to pay off the mortgage years early by making extra payments over and above the required payment. For example a $5,000 bonus cheque would knock a meaningful chunk off of a $100,000 mortgage.
Now, with a 1% mortgage most of the payment even in the first year goes to paying down the principal. For a 25 year mortgage at a 1% interest rate the amount paid off after 10 years is 37% and the mortgage is half paid off in a little over 13 years – which is not much longer than half of the full 25 year period. My figures are from Dominion Lending’s mortgage payment calculator web page.
It’s difficult to know how large of a mortgage families are taking out these days. But given that a single family home in, for example, Hamilton averages about $725,000 it’s probably fair to say that a $600,000 mortgage for a young two-income professional couple is not particularly unusual.
At a 1% interest rate the payment on that $600,000 mortgage would be $2,261 per month. At a 10% interest rate the same payment would support a far lower mortgage of $252,800. The table below compares these two mortgages. They are vastly different in that the 1% mortgage allows most of the payment to go to paying down the mortgage right from the start.
Mortgage Comparison Assuming the same Monthly Payment |
||
Interest Rate |
1% |
10% |
Starting Mortgage |
$600,000 |
$252,800 |
Monthly Payment for 25 years |
$2,261 |
2,261 |
Initial amount going to interest |
$499 |
$2,064 |
Initial percentage of payment going to interest |
22% |
91% |
Initial amount going to pay down principal |
$1,762 |
$197 |
Percent paid off after 1 year |
3.5% |
1.0% |
Amount owing after 10 years |
378,000 |
$212,871 |
Percent paid off after ten years |
37% |
16% |
In the days of 10% mortgages, most of the payment went to interest for many years. At 1% that’s not the case but the mortgages are now typically far larger.
Taking out and then paying down a mortgage can be thought of as “renting” the money from the bank and then paying it down over time.
In the days of 10% interest rates the “rent” was high and it was good advice to pay off the mortgage as quickly as possible. And given the far lower mortgage amounts in those days it was often feasible to pay it off early. Some over-time hours, a bonus or any kind of savings could fairly quickly make a noticeable dent in the amount owed.
With a 2% or certainly a 1% mortgage, the annual “rent” per dollar owed is vastly lower. But typically the mortgage starts out vastly higher. It’s now far harder to pay off today’s mortgages early. A typical bonus cheque or a savings of a couple hundred dollars per month simply will not make a noticeable dent in today’s mortgages.
And perhaps these mortgages should not typically be paid off early. The savings in interest at 1% or 2% may simply not be worth the effort. There may be far better uses for the cash than paying down these low-interest mortgages. There may even be good arguments that these mortgages should be paid off over an even longer period such as 35 years.
These are not your father’s mortgages (or those of your own younger days as the case may be) and the stern rules of your father’s generation about paying down debt may simply not be applicable.
Home buyers today are more or less trusting that home prices will rise or be stable or at worse will fall very little. They are also trusting that interest rates will remain low or at least not rise very much.
There are certainly risks and stresses in taking on these very large mortgages.
No one can guarantee the future but my guess is that with the existence of 1% or even 2% mortgages, house prices are not about to drop.
Taking on a huge mortgage like $600,000 is not a comfortable idea for me. But the math suggests that it may be reasonable to do so in order to buy a home – and also necessary. And the old adage that paying a mortgage builds equity has never been truer – as long as house prices hold their value that is.
END
Shawn Allen
InvestorsFriend Inc.
December 6, 2020 (with minor edits on December 8, 2020)