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.

How to Make a Physician 17 Percent Wealthier

The fiscal cliff deal struck between Vice President Joe Biden and Senate minority leader Mitch McConnell is a good deal for physicians.

The biggest win of all is the Sustainable Growth Rate (SGR) mandated 30 percent cut in Medicare reimbursement will be put off for another year. Judging from politicians' propensity to kick the can down the road - as long as there is still a road - I come to the conclusion that physicians shouldn’t be worried about that any more. Once the negative economic impact is so huge, it almost guarantees the cut would not be carried out.

The second biggest win is that the cut off for a tax increase is $450,000 as opposed to $250,000 as President Obama first proposed. While many physicians are making $250,000 and above, far fewer are making $450,000 and above. For the few physicians who do earn that much, however, you will see your marginal tax rate on income above $450,000 increase to 39.6 percent. Your first $450,000 of income, though, is permanently set at the Bush-era income tax rates.

The third win is the tax increase for capital gains and dividends are far less than anticipated. Only families making $450,000 and above will see their capital gain and dividends tax rate go up to 20 percent. The president’s original proposal will have the dividend tax rate for top earners go up to 39.6 percent as well. This is going to be beneficial for physicians building long-term wealth.

For physicians who make between $250,000 and $450,000 you will still see higher taxes as the result of phasing out of itemized deduction and the 3.8 percent "Obamacare" surtax on investment incomes. For physicians who make less than $250,000, everything will stay pretty much the same.

A one-year delay in the proposed Medicare SGR payment cut is one of three wins of the fiscal cliff deal reached in Washington, D.C., for physicians.

Fiscal Cliff Deal: Mostly Good for Physicians

With President Barack Obama's re-election, there is now no doubt that the Bush Tax Cuts will expire as of January 1, 2013.

Why is there a sunset clause in President Bush’s tax cuts?

In 2001 and 2003, Congress passed, and President George W. Bush signed into law, significant tax reductions for nearly all taxpayers. These cuts included marginal rate reductions, the introduction of a new 10 percent tax bracket, an expansion of the child tax credit, and a variety of other provisions. Both bills were passed using a Senate procedure known as "reconciliation" - a tactic that lowers the threshold for cloture to a simple majority of Senators (as opposed to a 60-vote supermajority.)

This procedure, under the Congressional Budget Act, is not allowed for any bill which affects budget deficits beyond a 10-year window, so these tax cuts included a "sunset" provision which caused them to automatically expire at the end of 2010, in order to bypass that requirement.

The sunset of the Bush tax cuts were extended by President Obama twice to the end of 2012, largely because the economy was in the tank and could not take another tax hit.

The majority of physicians are married, high-income earners with investment assets. They will be hit particularly hard by this expiration. In particular:

• The 28 percent rate will go up to 31 percent.

• The 33 percent rate will go up to 36 percent.

• The 35 percent rate will go up to 39.5 percent.

• The tax rate for long-term capital gains will go back up to 20 percent.

• There will no longer be a “qualified dividend” category; the tax rate on all dividend incomes will be back up to the filer’s marginal tax rate.

Does President Obama have any alternative proposal?

Yes he does. To keep a long story short, his budget proposal is to keep the tax cuts for those earning less than $250,000 and let the tax cuts expire for those making $250,000 and more. Many doctors are making more than $250,000, so there will be no relief from the president's plan.

What can doctors do to limit the tax hit?

1. Explore the option of using a defined benefit plan to create a substantially larger tax deduction.

2. Explore the option of low-cost, non-commission variable annuities to shelter capital gains and investment incomes from taxation.

3. Use tax-efficient investment vehicles like low-turn over index funds to minimize capital gain realization.

The end of the Bush-era tax cuts is likely on the horizon. Here's what it means for physicians and how they can begin preparing today.