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Making Sense with Ed Butowsky
Hosted by 35-year investment manager, Ed Butowsky, "Making Sense" is designed for delving deep into understanding investing in episodes less than 30 minutes.
To learn more about Chapwood Investments, you can visit us at our website (www.chapwoodinvestments.com).
Making Sense with Ed Butowsky
The Elephant in the Room: Your Real Rate of Return
In this thought-provoking episode, we dive deep into the world of the uncommon discussion of the truth behind your investments to uncover the truth about the "Real Rate of Return." Join us as we explore the critical factors that can significantly impact your investment gains, often left unaddressed by financial advisors.
First, we tackle the three issues at play: inflation (cost of living increase), taxes, and management fees. Learn why inflation and taxes can lead to silent wealth erosion and how they can eat away at your hard-earned money if not factored into your investment strategy.
And then there are those elusive management fees. How much are you really paying for professional investment advice, and are those fees justified? We break down the different types of fees, so you can make an informed decision about the cost of financial guidance.
Are financial advisors truly transparent about these critical aspects of investing, or are there hidden agendas? Tune in to explore these vital questions and gain insights into how you can ensure your financial advisor is working in your best interest.
Join us on this eye-opening journey to uncover the "Real Rate of Return" and take control of your financial future. Don't miss this episode; your financial well-being may depend on it!
As always, if you have questions, please direct them to info@chapwoodinvestments.com. Have a great week!
The Making Sense podcast is recorded by Chaplain Investments Managing Partner, ed Butowski and Jordan McFarland. If you have any questions, please email them to info at chaplaininvestmentscom.
Speaker 2:Okay, everyone. Well, welcome back to the Making Sense with Ed Butowski podcast. I am Jordan McFarland. We're lucky to be joined by Ed today. Ed, how are we doing today?
Speaker 3:Doing well. Thanks for doing this again. I appreciate it.
Speaker 2:Absolutely. Yeah, we got good feedback from last week, so excited to discuss real rate of return today. Today we've labeled this real rate of return. How honest are your advisors with clients? We'll touch on that in a second, but, as always, we have to start with a trivia question. Ed Listen, you just got back from Houston. So anyone who knows anything about Houston knows NASA knows related to space. So the question I've chosen today is the Johnson Space Center is located in Houston. Who was the first person to set foot on the moon? In which Apollo mission did he lead?
Speaker 3:It was Neil Armstrong, okay, and it was Apollo mission 11.
Speaker 2:Wow, I didn't think I'd just pull across and you weren't going to get it. You did.
Speaker 3:They have a good amount. I'm a space dirt yeah.
Speaker 2:Me too, I love space. Okay, we're two for two. Well, kind of diving into today's topic, real rate of return. So before I ask you for your definition of real rate of return, I'm kind of going to share a story of how I came into it, and it was when I was at another firm and easy plug for the book here, wealth Miss Management. I read this book, I think, when I was about two years into the career and I was reading it and you kept talking about real rate of return and I was like of course this makes obvious sense, like why would someone not do this? And then I thought of you know the practice that we had going, and I was like I don't know if we've ever used this when discussing this with people. So this is an uncommon topic for some reason with advisors. But before I ask you that, why don't you give us just a kind of a definition of what real rate of return is?
Speaker 3:Sure, and it's a really important subject, because most advisors, as you perfectly stated, do not talk about real rate of return and real stands for after your cost of living increase, or some people call it the CPI, after taxes and after management fees, what is your rate? What is your real rate of return? And a lot of people in our industry try to camouflage exactly that CPI number because they try to have that number be as low as possible to support maybe some of their measly returns. And then, after taxes, you know, a lot of taxes take away quite a bit of the return, especially if they're short term capital gain taxes. So, and then management fees are kind of like the cherry on top if things are not looking really positive.
Speaker 3:That sometimes you got to focus in on. Are you being charged one, one and a quarter percent to have your funds being managed? So your real rate of return is what you really have as purchasing power, and that's what we're doing this for. Is the purchasing power increase or the purchasing power to be secured and be locked in? That's what real rate of return is.
Speaker 2:Yeah, and I think that's what really grabbed my attention when I first heard the definition was it's just very lack of a better term, just realistic. And I'm from Illinois, from a blue collar area, so whenever you would tell someone something, they'd just say, okay, great, what do you really mean? And that's really the essence of what your investment plan is all about. Well, great, this is what it says on paper. What does it actually mean for me? So, to break that down from what you just said, you said cost of living increase, you said taxes and you said fees. So let's go one by one on those. I know here in Dallas we have a significant cost of living increase per year, but why don't you talk to us a little bit about cost of living increase?
Speaker 3:Well, your cost of living increase is something that, in fact, I had a conversation with my son yesterday about how much more things cost today than when I was his age and he's 25, as you know you're probably right around your 26. I got him beat, baby, yeah, but. But we were talking about how much money and it costs just to live and the CPI does not properly evaluate or reflect what your cost of living increase is. So that's why I went and created the Chapwood index, which is an index that monitors how much things go up per city, because each city has a different Cost of living.
Speaker 3:Increase is not the cost of living you know what the cost of living is, but it's the increase that gets you.
Speaker 3:So if you were, you know, making, you know $50,000 a year and you the next year, you needed 55,000. Just to stay even, you need to make 10% more and and that's before Taxes, that's just your cost of living increase. And the government has done a masterful job since 1983 manipulating that number to make that number lower so they don't have to pay out as much in entitlement programs and cost of living increases on social security and so on. But the negative unintended consequences are in the private sector. A lot of people look to see if you know what. What their cost of living increase is based on the CPI and the CPI Reflects a much lower number, so it doesn't allow you to maintain the same cost of living or same quality of life that you did the year before, and I think people in our industry Don't are just not very honest with their clients about this and most people know that the CPI is not, you know, 3% or 4%. They know it's significantly higher than that and that's why I went and I really focus on real rate of return.
Speaker 2:Yeah, I think anything in the three to four range is is just outrageous. I mean, if you look at the cost of housing I know we had the the topic of housing last week you look at colleges, I mean some of these in the past don't even call it. You know, five years call it one to two years have increasingly gone up at a alarming rate. So I mean I did, you know I'm sure the our listeners are thinking of their own things right now that they like to purchase, and Small things like protein bars, I've even noticed have gone up just an incredible amount.
Speaker 3:Yeah, I did. I did a Analysis that if you got a bagel every single morning and if it went up 15 cents, just, you know, one year after, you know the next, you're, you're looking at, you know a Significant, you know a number of dollars, even though it's just 15 cents, you know every single morning you take 15 cents times, you know 365, you know you're you're looking at, you know Quite a bit of increase in what you're able to have in your bank and what you're able to invest, and that's just 15 cent increase.
Speaker 2:And I think the principle is it's your bagel, yes, but that's a barometer of what's going on overall. So if your bagel is increasing, that means you know something else is increasing. That means your coffee's ain't like everything is increasing at the same time and that's, you know, Kind of nickel and diming it sounds like, but when we look at the housing market, when we look at, you know, grander purchases, this is also the case in that area as well. Yep, absolutely Okay. So then, the second thing that we talked about was taxes. So obviously, there's not a lot of things that people can do about taxes, and I will say we have a very important webinar coming up Well, depending on when this is released, important webinar coming up with Scott Hodge next week that will go into taxes and and what's coming up in 2024 with the new administration. So whether you can make that live or whether you can watch the replay, I think that'll be a significant use of your time. But just talk to us a little bit about taxes and how that plays into the investment plan. I.
Speaker 3:Well, anytime, you should never let the tax tail wag. The investment dog is how they say it. But with capital gain taxes at 20% and ordinary income taxes up at 39%, you have to pay attention to when you bought something and when you're willing to sell it. On dividends, those are just ordinary income and there's nothing you can do about that. But when it comes to your taxes on capital gains, you really have to look at when you bought something and know that if you can turn it into long-term capital gains, you should.
Speaker 3:But if something isn't worth holding on to and if you have a substantial gain on it, like NVIDIA, right now, everyone has a substantial gain in NVIDIA and now the question is when do you sell it? A lot of people have significant gains. You might want to wait and make sure that a year has taken place so you can procure the capital gain. So that's a huge thing right now, and when you're looking at 20% versus 39.5%, that's nothing to sneeze at. So you have to be very knowledgeable about it. But, as you stated, there's nothing you can really do about that other than be aware. And if you have to get out of something, then you just get out of it. You want to adjust for the tax gain Right and just for clarity's sake.
Speaker 2:So when Ed is talking about short-term and long-term cap gains tax, anything over 12 months will be long-term and for long-term tax rates that can be 0, 15, and 20%. Typically, 20% will be your most likely that you'll. It just all depends on your income taxation, however that's working for you. And then short-term tax they're always going to do your marginal tax rate, which is just as high as they can. The government wants as much as they can for me pulling that out before 12 months.
Speaker 3:And there is something to be said about the Roth IRA. A lot of people want to know should they convert to the Roth IRA. There's very complicated calculations but I've yet to really see converting to a Roth IRA making a lot of sense. We've played this out for a lot of clients, but if anybody wants us to look at that, that's when you pay your taxes today and you would pay ordinary income tax today, but then when you pull the money out years later, you don't pay any income tax, but it takes quite a while to regrow that money to offset what you paid in taxes. So I've yet to really see a good calculation on when it makes sense to convert from a tax-deferred vehicle to a Roth IRA.
Speaker 2:I think a comparison of retirement accounts might make for a good future episode also, but let's hit on the last one. So fees and this is normally where you would think that's how we make our money. So this is where we'd get squeamish and uncomfortable. But I love talking about fees because I think it's an important discussion. I think it's something that advisors don't talk about enough, and I feel like, knowing the history of how fees have worked, it's come to a good place. So let me give you a two-part question there. First part just talk to me about fees overall, and then I would love, since you've been in the industry for 35 years, if you could talk to me about where we've come from in terms of commissions and fees and things of that nature.
Speaker 3:Yeah, well, when I first got into business back in 87, all we ever made were commissions, and so if you bought 1,000 shares of a stock, we got paid, let's say, $250. And so that's where the term churning came from, because a lot of people were buying and selling and buying and selling and just creating commissionable business. Now almost everything are management fees. So you have a certain amount of money under management and there's really no commissions that are charged anymore. Almost across the board, especially on the RIA side, the registered investment advisor side, on the broker dealer side, there are commissions that are charged, but so the fees are pretty well known to somebody.
Speaker 3:So if you take, let's say, a 10% rate of return, then you subtract out your cost of living increase, then you subtract out taxes. Both of those are kind of known. What your taxes are going to be and what your cost of living increases is something debatable, but you should figure that that's probably around 7% to 8%. But then your management fees are something that you absolutely know. And if you have $1 million or more, you should be looking at around 75 basis points, and if you have $1 million or less, you're looking at about 1%. And that includes all transaction costs, all reporting everything that you get from your advisor. So that's how you finish out the real rate of return equation.
Speaker 2:Yeah, and I was actually reading a report from an advisor. He's a popular advisor, I'll mention his name, obviously, but he was talking about 1.5% was his standard fee and anything regardless of amount. 1% was his fee, even if it was for $20 million, and I personally thought that was outrageous because I know that it's similar to a doctor. Obviously, you don't necessarily pay someone for the minutes that you spend with them. You pay them for the expertise they've built up over their career, over their study and everything along those lines. But I just think that fees are one of those things that's kind of an avoided topic when it shouldn't be.
Speaker 3:No, I mean because at some point you're going to have that discussion. I had that discussion with a client actually just yesterday, who's been a client of mine for 15 years, and she asked what she was being charged and I told her and she wasn't surprised, because we're very, very good about how we charge clients and I've told you many times, jordan, I hate the discussion about what am I worth. I'd rather just come in with a low number, but that's a number that everybody should know. You should know what your cost of living increases, you should know what your taxes are, you should know what your real rate of return is, and that's something that advisors have to do a better job of explaining to their clients.
Speaker 2:OK, so now we have a good definition of what real rate of return is. Now let's talk about how we can find that. So again, back to just being practical. We know what it is. Now we need to know how to find it, and this is a great chance to talk about chip score. This is a great chance to talk about all of our calculators that are able to find this. Walk us through some of the ways that we use the chip score, all the calculators that we have and how people can use those.
Speaker 3:Yeah. So on our website we have investment forensics, which is a dropdown, and we have something there called the chip score, and the chip store stands for Chapwood Investment Portfolio Score, and it's a very simple way to score your portfolio and it also highlights what your real rate of return is. So you're able to go in, put in your holdings and it will spit out for you a score for the Chapwood Investment Portfolio Score, and if it's below 40, that means you need to get some help right away. But in addition to getting the score, it highlights what your real rate of return is, and you'll be shocked at how many people have a negative real rate of return, which blows people away to think that they have a portfolio that their advisor gave them, but the goal or the summary of it historically has been a negative real rate of return, which nobody thinks about. You might be getting an 8% rate of return, but after subtracting out your cost of living, increase, taxes and management fees, you're losing purchasing power, and that's incredible that somebody would allow that to happen.
Speaker 3:So what I try to do with my calculators is highlight exactly what you need to make in order to not lose purchasing power, which brings me to Chapvest, which allows you to go through, and it's completely anonymous and you're able to go through a very detailed process to express exactly what you have in your portfolio, what you need in your portfolio and what. Basically, if you have what you need and if not, then we make a recommendation for you on what you should have. So it's a very simple process. Not a lot of people go to it. I'd like to make it a little bit more intuitive, but I don't want to get rid of the details that I believe are necessary for it to be effective. A lot of people think it should be a lot more simple, but I have some videos on there that help people understand exactly how to use it. So you just go to chapwoodinvestmentscom and go to Investment Forensics, go to Chapvest or go to the chip score, and both of those will help you understand what your real rate of return is.
Speaker 2:Yeah, and I'm always happy to do this for people. So I think I've done over 10 for people in the last month alone. So I know numbers aren't always people's favorite thing. I mean, I was watching a video, ed, on a 4% withdrawal rate in a debate between two guys last night in my living room and my wife almost slapped me because of how boring it was. So I know that this is not everyone's favorite topic.
Speaker 2:And let me kind of address the elephant in the room. A lot of times people have advisors who they play golf with, who they live down the street from, and I know some people. This is going to go in one ear out there almost, out the other ear almost, and if the very most of this just helps you have a better conversation with your advisors. We've done our job, frankly. But, ed, just talk to me about that. I don't want to call a conflict of interest Some people. If I had a best friend, I would want him to invest with me right. Talk to me about kind of that elephant in the room, though, of matching this with an advisor that's a friend of yours.
Speaker 3:Well, I have a lot of clients who are friends of mine, but I believe people should challenge even their best friend with asking them many different questions. One of them is my favorite catch-22 question, which is if you had a rate of return of 10%, what should your standard deviation be? Everyone should ask their current advisor that question. The answer is eight or lower. The reason it's a catch-22 is because if they answer the question correctly, then you can look at your existing portfolio and find out what your standard deviation is.
Speaker 3:If they don't know the answer to it, then you should remain friends with that person, but you should switch from that person, because they obviously don't know about risk and they don't know how to measure risk. Measuring risk is something that people will look you in the eye and say oh yeah, I'm taking good care of you. Yeah, yeah, don't worry about the market, don't worry about this or that, and they don't even know how to measure risk, let alone know how to manage it. As much as we have friends, you want to make sure that people are doing the correct job. Don't be afraid to challenge that person, because everything we're talking about right now is very, very real and everybody needs to follow suit and understand exactly what we're talking about when it comes to real rate of return.
Speaker 2:And you said something there, the word risk, and stop me if I'm wrong. I feel like if a listener or if one of our clients had to give one reason why they come to us a lot of times it's just risk. They're worried about how much money do they have for retirement? Are they going to pass away before they have enough money and things of that nature. So that would definitely be a topic worth exploring in the future. But I know we've got about five minutes left here, so let's dive into the Q&A section. So a listener asks I sure would like to hear about what high and higher net worth people can do in a high and hyperinflation market. And this comes from a gentleman that both you and I know excellent lawyer, great background, very smart guy. So I hope you've got a great answer for him, ed.
Speaker 3:Well, I mean, one of the things is you want to be invested in investments whose income or dividends go up as interest rates go higher. Normally during a hyperinflationary period, real estate does very well. So you might look at certain REITs, but the dividends on REITs get hurt as interest rates go higher. So real estate values might go higher in a hyperinflationary period, but the dividends that get paid out don't go higher. So right now REITs are a really tough place to put money. But there's business development companies, senior rate floating notes whose incomes go up as interest rates rise.
Speaker 3:But also you want to have as much as you can. You want to have companies that have really good cash flow and that don't have a lot of debt because, as their debt continues to soar, the amount of money that they pay out if they have to refinance or reissue those bonds at a higher level. So if they're paying 4% now and those bonds come due and they have to reissue them at 8% or 9%, that's a big drag on the earnings of that company. So high inflation usually real estate would do well. Utilities are absolutely not the place to be during high interest rates, but at some point utilities are going to be very attractive because they've been squashed so far this year. So I think we're getting to a point now where it's time to start looking at utilities and REITs.
Speaker 2:Yeah, one of the interest rates start going up. I know these companies are looking at their dividends like man. I don't know if we can keep affording those, but we got time for one more. So an anonymous listener asks in last week's YouTube video so they're referring to the housing sort of like the discrepancy going on in the housing market. They said you talked about housing prices, I have they gone up so sharply and are we at risk for another housing crash?
Speaker 3:Yeah, Well, the housing prices had a little bit of a move up in July, but at some point, with higher loan rates, the values of these are going to come lower. So you really have two different things working. You have inflationary pressures which are pushing interest rates higher, but it's also in some ways pushing real estate prices higher. I truly believe that we are going to have a real recession in the housing market. But if you start to see the 30-year mortgage rate top out at around 7.5, then we're going to start to see people going out and trying to buy up these properties. But I haven't seen a huge decline in real estate prices. Even here in the Dallas area I haven't seen a huge decline, especially in the 200 to $400,000 range. Those houses have stayed pretty steady. But I'm not the best to talk about where housing is going to go. I just know that I'm happy with my 3.5% mortgage and I'm not moving.
Speaker 2:Okay, so that means I can move in with you. Sounds good. So that'll do it for today's show folks On spot. If you want a copy of this book, first person to email me just say send me that thing. I will send it to you for watching today. I only have one on me right now, so that's just for one listener. But again, thank you so much for tuning in.
Speaker 2:Last message I just want to leave you with is to really take application from this. It's always great to listen to podcasts and learn and gain knowledge, but if you don't actually apply it, then you basically just wasted 30 minutes. So really just want to encourage you to take this to heart and if you want me to find your chip score, if you want me to run your portfolio through any of our calculators, we'll be more than happy to do so. I think I did seven last week, so we'd be happy to add yours to the list this week. But, as always, we're so grateful for your viewership. Your support means a ton to us. And, Ed, why don't you close us out here?
Speaker 3:Well, as you say, jordan, I'm sitting here listening and you do a great job and I really appreciate you doing this. And, again, we put these calculators up there because, after 35 years of being in this business, I really believe it's important to have, as you said, the ability to learn and understand exactly if what you have is what you need, and that's what we do this for.
Speaker 2:So thank you Right on, All right guys. Well, thank you for listening and we'll see you next week on the Making Sense podcast.
Speaker 1:Thanks, the Making Sense podcast is recorded by Chopwood Investments managing partner Ed Butowski and Jordan McFarland. If you have any questions, please email them to info at chopwoodinvestmentcom. This podcast contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this podcast will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
