Michael Zhuang

The other day, I was driving by a street in my neighborhood and I saw a neighbor putting up a rental sign: “Tudor-style house for rent, 4,500 square feet, only $5,000 a month.”

I can’t help but do a quick calculation in my head to figure my neighbor’s rental return. His house is worth at least $2 million. With a $5,000 monthly rental, he will get $60,000 a year. After property tax which is 1 percent of appraised value, he will have $40,000 left.

He will likely need another $10,000 minimum for upkeep and repair, so he is left with $30,000. My neighbor is a neurologist, so I can guess with confidence that his combined federal and state marginal tax rate is north of 50 percent. After income tax (and an Obama Administration surtax on investment income,) $15,000 is all he will get from renting his $2 million Tudor-style house.

All in all, the $2 million house will yield a $15,000 economic benefit a year. That’s a return of less than 1 percent.

If he had invested the same amount of money in a Maryland municipal bond fund, he would get a 3.7 percent yield totally tax free … and hassle free.

I have known quite a few doctors who put a substantial portion of their wealth in real estate, none of them have more than 2 percent return, which barely keeps up with inflation.

In ascending scale of risk and return, he could have also invested in treasuries (2.5 percent), corporate bonds (5 percent to 7 percent), real estate investment trusts (8 percent to 9 percent), large cap stocks (10 percent), and small cap value stocks (13 percent), just to give a few examples. If that sounds too complicated than just buying a house, that’s an indication that you need a fee-only, conflict-free financial advisor.

Investment is a profession very different from medicine. I’ve never seen a professional investor refusing medical help; but I’ve seen many medical doctors refusing investment help. That’s how they earn the dubious distinction of worst wealth accumulator among high income professionals.

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Investment is a different profession than medicine, so please physicians, get help on getting the greatest returns, especially when it comes to real estate.

Real Estate Investment: How Not to Make Money Like a Doctor

Three years ago, I talked to a very accomplished physician in New York City, who, much to my surprise had all her money in cash.

I asked her why. Her answer: “The market is unpredictable, investing is too risky, it’s much safer to be in cash.”

If you share her sentiment, I want to make sure you understand a very important idea: market fluctuation is shallow risk, and cash is deep risk. Cash is much more risky than stock market fluctuation.

To explain further, let me first define what is deep risk and what is shallow risk.

 is the risk of loss that you will never recover;

Stock market fluctuation is the most typical shallow risk. In the U.S., there has not been a recession (bear market) that has not recovered. See my early article about 

During the Great Depression, even if you rode the market down to the bottom (nearly 85 percent loss,) if you had invested in high dividend stocks and reinvested the dividends, you would had recovered in three and a half years, based on 

During the recent “great recession,” if you had a balanced 50/50 portfolio, and you rebalanced religiously, you would had gotten back even 11 months after the market bottom. (This is the experience of my older clients who have a 50/50 portfolio.)

Compared to market fluctuation, if your money is all in cash, you can expect to lose 2 percent to 3 percent per year to inflation. In 10 years, that’s 20 percent to 30 percent; in 20 years, that’s 40 percent to 60 percent. This loss to inflation is something you will never recover!

Such is the deep risk of holding cash for your retirement.

Physicians, it is time to reevaluate holding cash for your retirement. Here’s why.

Cash or Stocks: Deep Risk vs. Shallow Risk for Physicians

I have a client who is a trained ENT physician. In addition to practicing otolaryngology, he also does facial plastic surgery and audiology treatment. He makes money from all three of his medical services. They complement each other and make this practice more financially solid.

Investing is all about taking risks. Some risk pays, and some risk doesn’t pay. It is very important for doctor investors to know what risk pays.

According to Nobel Laureate Eugene Fama, there are three major risks that pay. The "wages" from taking these risks are called risk premiums.

1. Equity risk premium: The "wage" from taking stock market risk over and above holding safe treasury bills.

2. Small cap risk premium: The "wage" from taking small company risk over and above big company risk.

3. Value risk premium: The "wage" from taking non-growing company risk over and above growing company risk.

Here are the three risk premiums from 2004 to 2013 (in percent):

Now let me make a few observations to help you understand the data.

Observation 1: The last column (RF) is the risk-free rate of return. It is achieved by holding short-term treasury bills. If you examine it carefully, risk free returns can be extremely low in some years, like 0.02 percent in 2013, but it is never negative. That’s why it is called a risk-free return.

Observation 2: The total risk-free return for the whole decade from 2004 to 2013 is 15.58 percent. This is basically the reward for time value of money, not for taking any risk.

Observation 3: The column "Equity" denotes equity market returns over and above risk-free returns. This is the additional return, or equity risk premium, investors earn from taking equity risk. Note that nine out of the last ten years, the equity risk premium was positive. The total equity risk premium for the whole decade was 84.75 percent.

Observation 4: The column "SmallCap" denotes small cap stock returns above large cap stock returns, or small cap premium. As you can see, small cap outperformed large cap seven out of the last ten years. The total small cap premium for the whole decade is 23.41 percent.

Observation 5: The column "Value" denotes value stock returns above growth stock returns, in other words value premium. Here you can see value stocks outperformed growth stocks six out of the last ten years. The total value premium for the whole decade was 14.44 percent.

Observation 6: Though over the long run, it pays to take equity risk, or small cap risk or value risk, in some years, you may lose money doing so. That’s why they are called 

So you see, a smart investor is not unlike my smart physician client, they would take all risk than pay and earn all risk premiums. In reality, however, I know many doctors who are not smart investors. Some of them are all in cash and they are missing out on all risk premiums, Some of them only invest in glamorous large cap stock like Apple and are missing out on small cap and value premiums.

Investing - much like the decisions in your medical career - is about sometime taking risks. But you also should know what risk pays and what risk does not.

Explaining Investment Risk Premiums to Physicians

I got a new physician client recently. The first step I took was to totally redo his portfolio. His old portfolio looked something like this.

Altogether there were 39 funds in his portfolio. I skipped over a bunch in the list above, but anybody who has read my blog for any period of time should be nearly shouting out what’s wrong with this portfolio.

Russell Kinnel, Morningstar's director of mutual fund research, published a study in August 2012 entitled, "

How Expense Ratios and Star Ratings Predict Success

." The results show that expense ratios are the better predictors. Quoting Kinnel: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. 

In every single time period and data point tested, low-cost funds beat high-cost funds.

So here are the funds I replaced his portfolio with:

VBTIX / 0.07 percent

I reduced his average fund expense from 1.1 percent to 0.24 percent, a saving of 0.86 percent a year. This is nothing to sneer at. Ten years from now, my client will be 8.6 percent wealthier and 20 years from now, 

he will be at least 17 percent wealthier just by cutting his investment costs. 

Talk to your advisor about investment expense.

A little change in a physician's portfolio, utilizing the predictive power of expense ratios, can make a big difference in his future wealth.