Who’s Benefiting From Your Asset Allocation?
Canadian Capitalist is graciously hosting the third Canadian Tour of Personal Finance Blogs. There is no way I am passing up this opportunity to be mentioned in his blog. This will be my second participation to this tour. Enjoy!
Organizing your portfolio into neatly divided asset classes appears to be the sensible thing to do, but what if your financial advisor is offering you only a half-baked solution? Take my friend, Mel, for example. He and his wife walked in to a bank seeking an optimal way to invest a $10,000 windfall. The advisor had them fill out a Know Your Client form to learn their financial goals, risk tolerance, investment knowledge, time horizon and financial position. Based on his assessment, the advisor recommended a 70/30 split between equity and bond funds commanding a hefty 2% in management expense ratio (MER.)
What’s wrong with this picture? Like typical young couples, Mel and his wife still owe an approximate $200,000 worth of mortgage. Since homeowners pay mortgage interests with after-tax money, a 5% mortgage rate is costing Mel 7.14% of pre-tax income - assuming he’s in the 30% tax bracket. None of these bond funds could have guaranteed that rate, especially after MER. Why lend his money to a bond fund, only to borrow it back in his mortgage at a higher rate? He may as well pay down the mortgage instead of buying bonds.
The problem with the financial industry is that it’s not in their best interest if you pay down your mortgage. It’s a double-whammy for them:
- They stop collecting mortgage interests from you.
- They stop collecting MER on the bond fund.
A better solution – in my opinion – is to reduce the scope of your portfolio. Instead of investing $3,000 in bonds, pay that toward the mortgage. A dollar saved is a dollar earned. Paying down your mortgage is equivalent to earning 7.14% guaranteed. The net result is a reduced $7,000 portfolio invested 100% into equities. Sounds scary at first, but simply imagine the other $3,000 is invested in your mortgage. 7.14% guaranteed is a yield on steroid, that no one else can match.
Good analysis- what is particularly galling about a lot of bond mutual funds is that they hold bonds which the general public can buy direct and they charge fees!