I have no financial or other relationship with the good doctor, and as far as I know, The Physician Philosopher has no relation to the physician known as The Happy Philosopher. They just both happen to be happy philosophizing physician bloggers.
Today, TPP is talking about how carrying student loans should change the way you approach asset allocation in your portfolio of investments. Take it away, TPP!
Growing up in a house where credit card debt was as common as a Florida rain in the summer, debt had been normalized for me. I didn’t have a healthy fear of debt. It was a necessary evil. I remember signing my first master promissory note in medical school stating that I’d be okay with paying down my debt, and thinking how awesome it was I was getting “free” money.
My future self now hates how little I did to prevent the amount of debt I accumulated back then, but I simply didn’t know better at the time. However, debt is a reality for most people graduating from medical school (or dental school or law school or any advanced degree program) these days. Today we will discuss how student loans fit into our overall diversified portfolio and how we should view this pile of money we owe to someone else.
A Diversified Portfolio
On many financial websites, you’ll often hear the term “diversified portfolio”. The idea behind this is that you are invested in a wide array of assets, which will help protect you from the turbulence of the market. This can occur in two major ways. I’ll discuss each and how student loans fit in.
Stock / Bond Ratio
The idea here is that you should have a good mix of stocks and bonds. For example, some people propose an 80/20 model, which means you are investing in 80% stocks / 20% bonds. Many argue that as you transition closer to retirement you should have a higher proportion of bonds. The premise is that while bonds provide historically lower yields, they are also more stable (less volatile) and provide relatively guaranteed returns, unlike stocks. Stocks have the potential for greater rewards, but with that potential comes much greater volatility. Having a good mix provides diversification.
Given that I am a young attending (32 years young as of this writing) and have a long horizon prior to my retirement, my Stock/Bond Ratio is 1. I have discussed my portfolio before, but essentially I am 100% stocks via various low-cost index funds. Many financially minded people will (wrongly) tell you that being 100% stocks shows two things:
1) “You have obviously not had your first major correction yet. We will see if you are 100% stocks after that!” This is a ridiculous line of reasoning. I am actually hoping for a Bear market for the next five years so that I can buy all of my mutual fund investments while they are at a discounted price.
The market always corrects back. You simply need the mental fortitude to stick to the plan. And if it doesn’t correct, we are all up the creek. Not just me.
2) “You don’t understand how it works. Bonds provide you stability during the times when the market corrects.” I agree that bonds are a form of protection and stability in a down market. When stocks dip, bonds can sometimes rise. However, this is not the only way to protect against fluctuation as we will discuss here in a moment.
The other way to diversify is to make sure your asset allocation places your invested stocks into multiple parts of the market. For instance, I have 55% large caps in my 403B at work while I have a smaller portion in international index funds (~5-10%).
Student Loans, The New Bond
Unfortunately, debt is a necessary evil for most of us who have obtained an advanced degree. To put a positive spin on my debt, I like to think of student loans as another source of diversification for my portfolio known as Student Loan Bonds. [In case you are curious, I am not the only one who thinks of student loans as bonds].
It is a completely different (negative) asset class. As I pay down my debt, I am increasing my net worth. Therefore, Student Loan Bonds are certainly an investment that will provide more wealth. How exactly do Student Loan Bonds fit into the diversification mentioned above? Glad you asked.
The reason that I think of student loans as Student Loan Bonds is because I have an interest rate on my student loans (~3.6% most months) that is just about as “Guaranteed” as any bond you will find, no matter how high the rating. I have a 10-year variable rate with intentions to pay off my debt ($180,000 at end of fellowship) two years after graduating from fellowship.
During my first year as an attending, I am set to invest $75,000 (in all stocks) and to pay off about $80,000 in debt. So, despite looking at the TPP Portfolio, which holds 100% stocks, my stock to bond ratio is actually upside down. I have 48% in stocks and 52% in Student Loan Bonds.
Having any investments in bonds at this point seems redundant to me until my debt is paid off. I get the guaranteed rate and protection I desire through my Student Loan Bonds. Two years after graduation when my student loans are gone, I will likely transition to a 90/10 stock to bond ratio until I am 40.
Surely, you can appreciate that student loans are an entirely different animal. They don’t fit into any of the definitions I’ve mentioned before (large cap, mid cap, small cap, international, REITS, etc). Therefore, paying money towards my debt is actually a type of asset allocation diversification.
If you think that bonds provide a sure and steady rate of return, I promise you your student loans likely provide the same. For example, as of today, the Vanguard Total Bond Market Index Fund has ranged from 1.91% returns over the past five years to 3.84% over the past ten years. Your (refinanced) student loans are likely right in the middle of those targets, and if you haven’t refinanced and are sitting at >6% interest, then this isn’t even a conversation. You should be hammering away at your debt.
Take Home Point
If you are asking the question of whether you should invest more aggressively or pay down debt, I encourage you to do both aggressively. Student loans can serve as a form of diversification and produce the guaranteed market stabilization that you seek from bonds. Investing in bonds while you have a substantial amount of debt, particularly early in your career, could prove redundant.
What do you think? Can student loans perform similarly to bonds in your portfolio? Do you see a need/space for bonds in your portfolio if you are aggressively paying down debt?
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[PoF: While I appreciate TPP’s perspective, and I would guess many young physicians with a long investing horizon would choose to approach asset allocation in a similar manner, I’ll play the devil’s advocate and offer a different perspective.
By putting $75,000 towards stocks and $80,000 towards student loans, TPP looks at that as a stock / bond ratio of 48 / 52. But, do you recall when he referred to those student loans as a negative asset? He’s right! He’s not holding bonds, he’s holding negative bonds.
By paying down those bonds, it’s fair to say he is investing, but certainly not invested at a 48 / 52 ratio. I don’t know his current portfolio or student loan balances, but let’s say he’s got $110,000 invested in stocks and $100,000 remaining on his student loans. Leaving out other assets for the sake of simplicity, he’s got a net worth of $10,000 and $100,000 is invested in stocks. That’s like a 1,000% stock allocation. A 10% drop in the value of the stock market (like we had last month) would wipe out his entire net worth!
Now, I’m not arguing that he should invest in 100% bonds until his loans are eliminated, but it’s best to differentiate between the current asset allocation of your portfolio versus how you’re allocating your ongoing investments.
The same could be said for holding a mortgage. Jonathan Clements makes this very point in How to Think About Money. Someone with a paid off house and 100% stock allocation is actually invested less aggressively than someone with an equal stock and bond mix and a mortgage balance that exceeds the bond balance.
Food for thought.
This thought exercise, though, only further validates TPP’s aggressive loan payoff strategy. Eliminating a negative bond (student loan, mortgage, or other personal debt) gives you a lower-risk portfolio as a whole.
To learn more than you care to know about student loan repayment, refinancing, forgiveness, and more, take a look at my student loan resource page. For those of you not pursuing Public Service Loan Forgiveness, I’ve negotiated excellent cash back bonuses through eight top refinancing companies; their current rates are listed here, as well.]
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I’m 100% debt-free now, but I’ll be honest – I never adjusted my asset allocation based on my debts. I might think about it a little differently if I was carrying significant debt today, though. Based on what you’ve read today, how do you view your asset allocation?