Not too long ago, there are talks that the markets have been hard-carry by the largest capitalized companies in the United States.

The worrying thing is whether this is healthy or not. I think over the years, Dimensional Fund Advisers have a few good research piece on this. (Read my comprehensive introduction to Dimensional Fund Advisers here)

The largest holdings of the MSCI World index is currently Apple, Microsoft, Amazon, Facebook and Alphabet. Together they make up 13.5% of the index. This is not too concentrated.

However, if we peep at the S&P 500, these 5 make up 22% of the index.

These index are market capitalization weighted, which means as certain companies get stronger, their share price perform better, they get bigger, their returns drive the returns more.

Some companies stay on top for a long time:

1. AT&T was the largest two for six straight decades beginning in 1930
2. General Motors and General Electric was in the top 10 at the start of multiple decades
3. IBM and Exxon was the main stays for some time

Here is a clearer view:

Prior to the 1980s, the larger companies were more dominant than today.

There is always another story to tell: There were a lot of dominant companies in the past. They dominate for decades. And now they are gone.

I am not saying that Apple, Microsoft, Amazon, Facebook, and Alphabet will falter. They have strong moats. They could stay for 3 decades and your investments in them would do well.

However, the lesson here is that its not that unsurprising for them to falter.

How Poor Would Your Performance bet if You Missed out on the Top Performers?

The FAANG stocks are represented by Facebook, Amazon, Apple, Netflix and Google. For the past decades, if you have invested in them you would have done really well.

But how would the US broad market do without these FAANG Stocks?

Surprisingly, if you exclude the FAANG stocks, the performance over the past decade have been rather respectible.

But the top performers are important if you missed out on them.

Dimensional did a study of global stock market performance from 1994 to 2018. They want to see the performance if you missed out on the top 10% performers for each year and if you missed out on the top 25% performers for each year.

1. If you buy a widely diversified basket of global stocks and hold them from 1994 to 2018, you will earn 7.2% a year
2. If you missed out on the top 10% performers each year, your returns drop from 7.2% to 2.9% a year
3. But if you missed out on the top 25% of performers each year, your returns drop to an atrocious -5.1%

Research from Eugene Fama and Kenneth French in 2006 provides evidence that these market premiums were driven in large part by a subset of stocks migrating across the market.

• Research shows that there is no reliable way to predict the top-performing stocks
• If we look at the top 10% performers each year since 1994, on average less than 20% of these top performers were ranked in the top 10% in the following year <– this means that top performers keep shifting

If You Want to Outperform do You Concentrate or Diversify?

My answer would be to concnetrate. But it seems the data show otherwise.

Dimensional did a study on the impact of diversification on the probability of outperforming the market benchmark. In this case, they are using the MSCI All Country World Index (which you can invest with the VWRA listed on the London Stock Exchange).

They are not doing with active funds but suppose you want to be like Buffett or some value manager and want to look in the large cap stock space and focus on stocks that have lower market capitalization, lower relative price and higher profitability.

They want to see what is the probability of outperforming if you concentrate on different levels.

The table shows that your chances of doing better is higher if you are more diversified. This seem to mesh with what Joel Greenblatt talked about. Joel stated that there are people who would use the screen he recommend and pick certain stocks from the screen that they have a higher affinity towards.

His observation is that they tend to do more poorly then if they just buy the whole basket.

These seem consistent with that theory.

To continue with that research, Dimensional’s strategy in this research would beat the MSCI All Country World Index likely due to the value premium and the high profitability premium.

In this chart above, it showed that if you remain very concentrated, you might not generate excess return above the MSCI ACWI.

Together with the “missing out on the top 25% performers of the year” research, the subtle conclusion is that for these kind of factor strategy, you better act dumb and buy all.

Your Performance If You Continue to Hold the Largest US Stocks

We started this article buy questioning if the performance is driven by the largest stocks in the index. And it seems the conclusion there is that this is not all that special.

When they examined the ability for the 10 largest US stocks to generate excess returns after they became the largest, they realize that as you held them longer, the performance have been poorer.

I think this coincide with why people think the “Dogs of the Dow” is a good strategy. The larger stocks tend to be more expensive and if you buy them, you are paying more for lower expected returns.

At this time, it might seem very befuddling, but that is the data since 1926 (and that includes that 1920s when the value premium also didn’t show up)

Conclusion

We started this article wondering if this tech domination is all that unique and from the past history, it is not uncommon to find the index dominated by large stocks. What is unique about this time is that the top stocks are tech-driven.

If I wish to be very clear, Apple is a consumer company, Facebook and Google are advertising companies and Amazon is a retailer. If we view things through that lens, I think it is pretty OK.

Eventually, tech is just an enabler.

In the 1980s, the tech back then was electronics and in the 1880s, there were a lot of new tech such as the formation of the telephone company AT&T in 1885.

There is a fear that if you missed out on the FAANG stocks, it will affect your performance. The research shows that it is not missing out on the FAANG stocks that we should fear but missing out on the top 25% performers of the year.

We often spit at diversifcation because it is a sign of a lack of conviction in your investments. For the financial planners, it is a way to sell to your clients who have blow up some investments far too many times.

But for a lot of us, diversification is also about capturing the returns of the top performers.

It is true that if you diversify, the poor performers will pull you down. But a poor stock can at most go down to 0%. A good stock can go above 100%. If you own 10 stocks and 8 of them end up as duds but 2 of them became 10,000% winners, then that portfolio will do well.

But if you only have 10 stocks, that might not be enough to capture that 10,000% winner because that 10,000% stock is so rare that you got to own more than 10 stocks.

For those who wish to grow their wealth at a very fast pace, they always encourage concentration. This is true. But you are still speculating that your 2 or 5 or 10 stocks will work out very well, much better than the index returns.

If your 2, 5, 10 stocks are duds, your capital may get impaired, you incur opportunity costs when measured against the market returns. It works if you have the edge, but if you do not have…. good luck to you.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

If you have a sum of money in your CPF Ordinary Account (OA), is it better to pay a greater down-payment or to take a larger loan and delay repaying your CPF Ordinary Account?

A reader of mine asked me this question and my answer to him is that based on my past research (you can read Should we repay more of our 2.6% HDB loan to save 0.1%?) it should be better to drag out the loan.

I think the general idea is that if you have more lump-sum in your CPF OA as early as possible, it allows your CPF OA to compound over time. But there are a lot of things I cannot explain why this is the case.

The question today is more clear cut because instead of choosing to consistently repay $XXX a month more towards your mortgage, we are deciding whether or not to contribute more money to downpayment or not to.

I can tell you the answer is that it is mathematically better to take a larger mortgage loan versus making a greater downpayment.

Now, let us look at why this is so.

The Opportunity Costs of Using or Not Using More of Your CPF OA to Pay for Your Home.

This the problem brought in front of me:

1. You can take a $400,000 home loan at 1.3% a year in interest rate, and have $200,000 in your CPF OA earning 2.5% a year currently
2. You can reduce your home loan to $200,000 but you would have zero in your CPF OA

The pivot amount would be the $200,000 that you have in your CPF OA. In the past, CPF would force you to use all your OA to downpay for the home. What I understand is that this is no longer the case.

The way for you to think about is: What is the max loan that you could take?

Then, how much is in my CPF OA and how much do I want to keep in my OA.

If you choose to take a larger mortgage:

1. You would pay more interest over 25/30 years. In theory, the interest that you pay is not fixed. At the start of your loan, you will pay more interest (due to the size of your loan). As your loan becomes smaller the interest is reduced.
2. You would have money in your CPF OA to compound at 2.5% a year.

If you look at this math, intuitive this is a no-contest. We should do this since you would earn in excess of 1.2% if we take 2.5% minus 1.3%.

If you make a larger downpayment:

1. You pay less interest over 25/30 years
2. You will missed out on the 2.5% a year compounding in your CPF OA

So there is a 2.5% a year opportunity cost and your “return” is saving money on the 1.3% a year interest payment.

Net-net you will lose out on 1.2%.

We should always choose taking a large mortgage loan in this case. However, what if interest rate is closer to 2.5%?

What if you are taking a 2.6% a year mortgage loan? Let us see whether we can explore this.

Before we move on, do take note that the decision point is on the amount in your CPF OA that you need to make decision on, not the entire home loan.

Comparing the “Returns” Profile Between the Two Mortgage Financial Decisions

What we can do is to compare the internal rate of return for the two decisions.

Whoever has the higher internal rate of return is mathematically the better decision.

The internal rate of return (XIRR) needs to be computed between two streams of cash flow.

The XIRR, in very layman speak, is the “compounded interest rate per year” that you can earn based on this decision that you take. If we have an XIRR of 2%, you can interpret that this irregular stream of cash inflows and outflows will generate 2% a year compounded.

With this XIRR you can compare to other investments. For example, compare this to putting your money in an endowment plan earning an XIRR of 2.5%.

In this case we can compare the XIRR between both our decisions.

The first stream of cash flow is to not pay more downpayment but to take a larger mortgage. The cash flow would look like this:

1. Year 1: Putting $200,000 in CPF OA – Outflow
2. Year 2: Interest expense – Outflow
3. Year 3: Interest expense – Outflow
4. Last Year:
   • Get back your $200k principal from CPF OA – Inflow
   • Interest expense – Outflow
   • Accumulated interest earned from CPF OA over the years from the $200k in OA – Inflow

The second stream of cash flow is to contirbute more to downpayment and have less in your CPF OA:

1. Year 1: Paying away $200,000 more to downpayment – Outflow
2. Year 2: Interest expense that you saved by down-paying more – Inflow
3. Year 3: Interest expense that you saved by down-paying more – Inflow
4. Last Year:
   • Accumulating $200k in home equity after completely paying off the home – Inflow
   • Interest expense that you saved by down-paying more – Inflow
   • The opportunity cost of the accumulated interest we could earn from CPF OA over the years from the $200k in OA – Outflow

I decided to plot these two internal rates of return (XIRR) on a chart. The idea is to see how the returns change as time passes.

The return graph shows that the return profile of not paying off early is positive while making a greater downpayment is negative.

This more or less is inline with our guess.

Note: to be fair if you down pay more, at each point on the chart, you cannot get back the $200,000 principal (which I am assuming). The reality is that you would build up the equity of your home over time and only in the 300th month do you get $200,000. But let us assume here that even after 1 month, you could get back all your $200,000 equity.

The XIRR at the 300th month if you delay paying a greater down payment is 1.97%. It first dropped from 3.78% to 2.4% to 1.4% in the end of second year before going up.

This has more to do with the irregular nature of the interest payment (larger at the start and smaller at the end)

The XIRR at the 300th month if you use the $200,000 to downpay more is -6.3%. This is pretty crazy. I think the losses were that much because the opportunity was that great.

To give you an idea, after 25 years, the compound interest earned on that $200,000 was $173,000. The total interest expense paid was $35,000.

The conclusion at this point, just don’t increase the downpayment.

Would it be More Sensible to Increase Housing Loan Down Payment if Interest Rate is Higher?

This is a good question to ask.

The most obvious one will be to see if the decision changes if the interst rate is not 1.30% but higher.

Let us take a look.

• Don’t down pay more XIRR: 1.67%
• Down pay more XIRR: -5.42

The results start to narrow.

When you take HDB Loan and incur an Interest Rate of 2.6%

Intuitively, at 2.6% interest, the expense is greater than the CPF OA interest of 2.5% a year.

This may tilt the scale in favor of putting more into down payment.

• Don’t down pay more XIRR: 1.41%
• Down pay more XIRR: -4.63

Looks like it is still worth it after 25 years (300 months)!

But notice that at the start in the first six to twelve months, the XIRR return got very closed.

But even at this point, the total interest expense you will pay is $71,000 versus $173,000 in interest earned from the $200,000 in CPF OA.

Interest Rate of 4% – In Some Situation, it May Make sense to Contribute More Down Payment instead of Dragging Out the Loan

• Don’t down pay more XIRR: 0.79%
• Down pay more XIRR: -2.66

Ok! Now we are starting to see the blue line overlapping the red line. This indicates that in a certain duration, it may make more sense to minimize the loans you take.

The cross over point is about 15 years or 180 months. However, if your loan is 25 years, it would still make sense to not put omre to downpay your home.

• Total interest income: $173,000
• Total interest expense: $114,000

The Interest Rate Which would make more downpayment more worth it: 5.8% a year

If you really want to know at what mortgage interest it will take to make the more downpayment option more attractive, you need to take it to a whopping 5.8%.

• Don’t down pay more XIRR: -0.01%
• Down pay more XIRR: 0.02

• Total interest income: $173,000
• Total interest expense: $173,893

Right at the start, the XIRR for the decision not to downpay more starts working against you.

However, the money in your CPF OA gradually earns more such that you reached the break even point.

What is the Logic Behind This?

I think what worked for not committing more CPF OA to downpayment is similar to why mathematically, you should do lump sum investing than dollar cost averging.

When your returns and interest expense are both certain and you do not expect any volatility, by having more money at the start allows greater compounding effect than if you invest a little by little overtime.

When you choose to contribute more to downpayment, the interest you saved is on the amount of loan left.

As time passes, the amount of loan goes down, so the interest expense saved goes down.

In contrast, your CPF OA earns interest, and as time passes, the interest earns more interest. The power of compounding is very strong.

What May I Have Omitted from my Analysis?

Whenever the math is so befuddling crazy, I start wondering if my model is incorrect.

In this case, I do have a hunch my math is wrong.

If you commit to more downpayment for your home, you also have $200,000 more equity in your home at the start.

This means that if your home value goes up, and you sell off the property, you earn more.

That earns should be factored into my XIRR but I did not.

However, that is an area that is very subjective. How much should I put as the growth rate of the property?

Do I need to do a sensitivity analysis on different property growth rate?

I think if we factor in that equity property growth, I got a sneaky feeling the point where one decision tilt over would be earlier.

This will depend on the growth rate we expect for that property.

What if we are Evaluating Cash instead of CPF OA?

You can just replace the 2.5% return with the growth rate of cash, which is rather low. But if you are an investor, you may be able to earn more than 2.5%.

Your mileage (long term return) will differ based on your sequence of equity return.

Conclusion

The first time I did that analysis of whether it is better to put in more of my income to pay off loans earlier, I got a headache thinking about it.

This time it is more simpler but I think the issue is the same. There are some opportunity costs that is pretty hard to measure.

Some readers might prefer to have a peace of mind when you pay off your loans earlier.

However, I think that you do not have to pay off the loan. As long as you have enough liquidity to last for 3 years of mortgage payments, it may be more than adequate for you to ride out a tough situation.

In the worse scenario, just take the amount that originally was meant to down pay more and pay off a large chunk of it.

Right now, this plan makes more sense because the CPF OA earns 2.5% which is almost 50% more than the interest you can get from bank loan.

The CPF OA is interesting unlike cash in that, you cannot do much with it other than accumulate for retirement, put in investment or pay off your mortgage. With rates low and if you have return options, the decision may be more clear.

If you have another perspective to this problem, do let me know in the comments.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works