A Lightly Comedic Primer on Personal Finance for Law Professors (Michael Simkovic)

Many graduates of elite law schools work in large corporate law firms either initially or after a clerkship.  This requires law graduates to work closely with businesspeople, accountants, bankers, and other financial professionals.  Those who have expertise in finance or accounting are at an advantage.  Those who do not, but wish to succeed, quickly get up to speed.  Given this reality, surprisingly few law professors are financially sophisticated.  Some of them make suboptimal decisions, which over the course of a lifetime can cause them to end up hundreds of thousands or even millions of dollars poorer than they otherwise could have been. 

This article, which is intended for educational and entertainment purposes only, and not as individualized financial advice, may be of interest.  If you want individualized advice, talk to a licensed financial advisor who you pay in such a way that your incentives are well aligned. 

The goal of personal finance is to achieve the highest rate of return possible, on an after-tax, after-fee, after-inflation basis, without taking unacceptably high risks.  The higher the rate of return on investment, the less the investor needs to save now and the more the investor can consume later.  A “return” in this context, means the growth in the value of the investors’ assets or net-worth, both from asset price increases over time and from distributions of cash such as dividends, interest or rental income, which are often reinvested. 

Investments typically involve a trade-off between risk and return.  On average, over the long term, investments that are riskier—such as equities and real estate—offer a higher rate of return than investments that are safer, such as savings accounts, CDs, treasuries and highly rated corporate or municipal bonds. 

Investors can also arguably achieve a “free lunch”—reducing risk without sacrificing average returns much—through diversification within a risky asset class.  The easiest and simplest way to do this is to purchase a low-cost equity indexed mutual fund which tracks a broadly diversified portfolio of U.S. publicly traded firms, such as the S&P500, the Russell indexes, or the Wilshire 5000.  Within these broad indexes, when some stocks go down, others will go up, making overall returns smoother and less volatile.

Trigger Warning: Nerdy Jokes Appear after this Point.

Some investments, however, are over the long run, what is in technical finance jargon referred to as “what the heck were you thinking?” investments.  They carry both high risks and poor long-term returns.  These include, for example, commodities (gold; oil), cryptocurrencies, or your cousin’s idea to open a fine-dining restaurant in Patchogue.

There is considerable debate about the benefits of international diversification.  Historically, U.S. companies have produced higher returns than those in other countries, likely due in part to a system of corporate governance and securities regulation that is oriented towards protecting investors and promoting shareholder wealth maximization, as well as to a broader political and legal system that is very hospitable towards business and investors.  Many European stock indexes have performed reasonably well after accounting for the higher rates of dividends and lower rates of automatic reinvestment.  Asian indexes, especially those in Japan, have generally performed poorly—in spite of the fact that Japan has many world-beating companies that produce fantastic products—likely because of differences in business norms and legal systems which tend to favor priorities other than maximizing shareholder profits.  Emerging markets are—in my view—not appropriate for many unsophisticated index investors.

A broadly diversified portfolio of U.S. equities has historically produced better unlevered long-term returns than almost any other asset class.

U.S. equities, especially those in the S&P 500 index, are also generally highly liquid, meaning it is inexpensive to buy and sell them and we have a very good sense of what they are worth because of frequent market transactions.  This means that even an unsophisticated investor can typically get good returns buying into an index fund at random at market prices.

There is substantial debate about whether it is advisable to try to “time” the market by buying fewer equities when the stock market seems to be relatively expensive, or whether the opportunity cost of this strategy makes it self-defeating. 

Those who are interested in these issues might wish to start by reading Robert Shiller’s books and papers on the CAPE index and on the Excess Cape Yield as well as work by Wharton Professor Jeremy Siegel, starting with the latest edition of Stocks for the Long Run.  The work of Jack Bogle, and the Bogleheads blog and forum, is also helpful.

The finance literature tends to be skeptical of actively managed mutual funds, often finding that they rarely do well enough to justify their higher fees and higher tax liability for their investors.  It is also difficult to reliably and consistently identify the mutual funds that will perform well in the future.

Equity returns can be further amplified through the use of modest amounts of leverage.  Too much leverage will dramatically increase risks and increase the chances of the portfolio being wiped out.  Beginners may be better off avoiding the use of leverage at all.  Leverage here means borrowed money or something similar.  For example, when you buy a house with 20 percent down and borrow 80 percent of the purchase price, you are using leverage. (Such a high level of leverage would be very risky with stocks).  An excellent treatment of leveraged investing in equities appears in Yale professors Ian Ayres and Barry Nalebuffs’ book, Lifecycle Investing, based on their article, Diversification Across Time.

There is substantial debate about whether hedge funds and private equity funds on average produce high enough risk-adjusted returns to justify their risks and fees and associated tax liability.  There is also considerable debate about whether it is possible to pick only the “good funds.”  Most Law Professors won’t have the ability to invest in these assets, so I will skip this debate and assume that only equities, real estate, and fixed income are on the table.

Real estate is not a terrible investment, but it has historically on average performed worse than the U.S. stock market, is less diversified, and is much less liquid. 

Between the costs of showing a house, leaving it on the market, and paying a real estate broker, a house might cost 7 to 10 percent of its value to sell.  In contrast, S&P500 index ETFs typically have bid ask spreads that are much less than one-half of one-percent of the value and can be sold within seconds at the push of a button.  Mutual funds can typically be liquidated essentially for free within one business-trading day. 

Real estate is also subject to property taxes and requires active management—that is, it takes up the investor’s time and energy and it requires that cash be put into it.

And whereas most people can only buy one or two houses in one or two geographies, most people can get exposure to hundreds or even thousands of different companies with index funds that will only charge them a few one-hundredths of a percent per year.

Moreover, a primary residence is not a pure investment.  It is a mix of consumption and investment because an owner living in it is consuming much of the return—the rental income they would have earned if they had rented the house out to someone else.

Real estate is typically only justifiable as an investment because of tax advantages, the ready availability of oodles of leverage, or because of superior knowledge or complimentary skills (for example for someone who works in construction or a trade or is a real estate broker) that allow for better than average returns.  There might be some benefits of increased diversification if real estate is added to a mostly equity portfolio.  But real estate is so expensive in large cities, relative to law professor pay, that it is difficult to own it directly without overdoing it.

For many law professors, real estate will not be as good an investment as a modestly leveraged portfolio of equities.  Think of your house as money you are spending to enjoy life, not as an investment. 

Fixed income investments—cash, bank accounts, CDs, bonds, loans— carry returns that are often poor over the long term.  They are also often bad for tax reasons.  See Stocks for the Long Run by Jeremy Siegel.

The reason to hold fixed income investments is to reduce risks in the short run.  The stock market can drop a lot very suddenly—as much as 60 percent a year within the last 15 years, and as much as 90 percent from peak to trough going back to the 1929 to 1930s crash.  If a drop of that size would create problems for an investor, the investor needs to have a reserve of cash or other safe assets just in case.

In recent years, the stock market has recovered quickly, typically overtaking fixed income investments within 10 years of a crash, often within 5 years.  However, during the great crash in the late 1920s and early 1930s, it took roughly 23 years for the stock market to overtake the bond market, assuming the investor only bought in in one lump sum at the start of the worst possible year.

The stock market can also in theory go to zero, as it did in Russia and China after their communist revolutions, or in Germany after the devastation of WWII.  Very bad things could also happen in the United States or other economically linked regions, which could make equity returns bad in the future. 

Tenured law professors are generally in a unique position to take greater risks with their portfolios than the average investors, because tenured professors have unusually high levels of job security and because their incomes typically don’t go up and down very much with the stock market.

In my conversations with tenured law professors at elite institutions who teach business law subjects, most of them keep between 90 and 100 percent of their investable assets in a diversified portfolio of equities, and some of them use modest amounts of leverage.

I’ve experimented with leverage.  It can be scary.  But the math and the data suggests that using a little leverage (but not too much) can be much better over the long run than using none at all.  How much leverage should someone use?  See Ayres and Nalebuff.

Leverage can also be very attractive for tax reasons.  For more details, see the work of Ed McCaffery, who coined the brilliant phrase “Buy, Borrow, Die.”

Another excellent strategy for minimizing taxes and increasing after-tax returns is tax loss harvesting.  If you don’t know what that means or how to do it, talk to the members of your faculty who teach tax or corporate finance. 

If you don’t have at least three tenured faculty who teach tax, hire a dozen of them immediately.  Promote the one with the straightest teeth who smiles at puppies and small children to be your next Dean.  Elevate the one with the most resplendent sartorial style and well-defined calf muscles to be your Associate Dean for Spreadsheets for the Betterment of Mankind and Pre-finals Pilates.  Recite four “Hail Marys”, five “Our Fathers”, fast from sun-up to sun-down, feed lightly seasoned breadcrumbs to a duck, a duck, and goose, and write on a chalkboard 50 times, “There is no basis like tax basis.” 

But please don’t poach Ed McCaffery.  We need him at USC.  Find your own tax genius who can charm the nut off a salty pistachio.  I’m warning you, Search Committees, if you so much as look at Ed’s CV funny, I will report you to our Title 26 office.

End of Trigger Warning.

I repeat, this is not personalized advice.  It is only for general education and entertainment. It may not be appropriate for your situation.  If you do something risky and you lose money, that’s on you, capisce?