Motley Fool Answers October Mailbag: Allocation, Allocation, Allocation

It must be something in the air: For whatever reason, a lot of investors right now are looking more closely at their asset allocations, and wondering whether they need to adjust their portfolios. Should a person be heavier in small-cap stocks than large-cap stocks? What should you do when the same stocks you hold individually are also in your mutual funds? Are bond funds riskier than we think? And what should you do when one high-flying company grows enough to account for half of your portfolio's value? 

In this Motley Fool Answers episode, hosts Alison Southwick and Robert Brokamp pull those questions and others from the mailbag, and dole out their best advice with help from Buck Hartzell, director of investor learning and operations at The Motley Fool. 

A full transcript follows the video.

This video was recorded on Oct. 30, 2018.

Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.

Robert Brokamp: Hi, Alison!

Southwick: It's the October Mailbag, and this week we're going to answer your investing-related questions with the help of Buck Hartzell. Most of the questions, today, have to do with portfolio allocation, I noticed, so if those two words get you excited, boy, have we got a show for you. All that and more on this week's episode of Motley Fool Answers.

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Southwick: Hey, Buck! Thanks for joining us again!

Buck Hartzell: Thank you, Alison and Robert! Thank you for having me back again!

Brokamp: Always a pleasure!

Southwick: I also want to thank Austin, who is behind the glass today stepping in for Rick. Thanks, Austin, for filling in at the last minute! Rick learned that he is allergic to oysters.

Brokamp: What? Is that why he's home?

Southwick: Yeah!

Hartzell: That can't be good. Thanks for staying home, Rick!

Southwick: So future Rick, when you're listening to this, hope you're feeling better. Murr! So, should we just get into the questions?

Brokamp: Let's do it!

Southwick: Let's do it! The first question is from Alexander. "I'm 27 years old and hoping to retire somewhere between 65 and 67. How can I decide the right mix between large, mid, and small-cap equities? From what I see on the web, small caps have performed the best. Since I have many years until retirement, it seems to me that I can afford to take the risk and have more of my money in small caps. Yet, advisors and the resources I found online shy away from having a large percentage in small-cap companies. Also, my mother-in-law is about 11 years from being 67 and retiring. What's a smart mix for her?"

Brokamp: Well, Alexander, let's start with the outperformance of small-cap stocks. Those numbers often come from Ibbotson, which has numbers from 1926 to 2017. Over that period, small-cap stocks returned about 12.1% compared to large-cap stocks, which are 10.2%. So about a 2% difference.

The studies that found these, though, even though those numbers go back to the 1920s; it wasn't really until the 1970s that people began to pick up on this. Then small-cap investing became popular and then from like the early 1980s to the late 1990s small caps significantly underperformed large-cap stocks.

In fact, some people like Jeremy Siegel think that there is no outperformance of small-cap stocks. It's due to a couple of periods like the 1970s when small caps did particularly well. Not everyone agrees with that. If you look over the last, say, 15 years small caps have outperformed, but over the last five years, large caps have outperformed.

The main point is that we don't really know what the future will look like. For someone like you, I think it just makes sense to have an equal allocation to large, midcaps, and small caps, because we don't know what the future is going to look like.

One issue is that the smaller you get, the more volatile the stocks do become but because you're young, that's OK. If you're talking about [I think you said it was your mother-in-law], I think it makes more sense to lean toward large-cap stocks. They're less volatile, but more of those companies are more likely to be paying dividends, which I think makes sense. Dividend-paying stocks generally tend to be less volatile, but also once you're retired, it's nice to get that income.

Hartzell: And I would just say for anybody looking at small caps -- I don't know if we define that all the time for folks -- generally we look at stocks under $2 billion market cap and then things above $10 billion are generally large-cap stocks.

Brokamp: And he is right when you look at the typical target retirement fund. Morningstar does this report where they examine all the target retirement funds -- the recent ones. They looked at 49 series of funds, and they do find that generally speaking, those funds have about two-thirds of their allocation to large caps and only one-third to mid and small caps. I have to say I don't know exactly why they do that. I think it makes more sense to have a more evenly distributed portfolio allocation across all of those sizes.

Southwick: Did you offer up any percentages, or no?

Brokamp: Equal.

Southwick: But what about bonds, though?

Brokamp: We'll talk about bonds later.

Southwick: OK, well, sorry!

Brokamp: It's just looking at stocks.

Southwick: Everyone, stay tuned! We're going to talk about bonds later. But if you're looking at just the equity slice of your portfolio...

Brokamp: I think you can go one-third small, one-third mid, one-third large.

Southwick: The next question comes from Jim. "Now that Apple (AAPL 0.20%) is a trillion-dollar corporation, I started digging into how much of it I actually own. When I first started with The Motley Fool, I began building out my Roth IRA and Stock Advisor picks, which included Apple as one of my first Starter Stocks, but it's also the top holding in the index fund in my 401(k) and it's also in a couple of other mutual funds I own. Should I sell my small position in Apple that lives in my Roth to be able to reinvest those funds into another stock that has greater potential to grow? How many Apples is too many Apples?"

Hartzell: A good question, Jim! First of all, congratulations for actually looking. A lot of people who own mutual funds don't understand the concentrations of the funds and there's overlapping kinds of concentrations that can build up. Apple's an obvious one if you own ETFs or mutual funds. They're in just about everything because they're so big and so liquid.

I looked yesterday. Vanguard, if you own the S&P 500; about 4.19% of that mutual fund is in Apple. And then, of course, if you own it in your own portfolios as an individual stock, as well, you can easily get a big percentage that you didn't really know about. So good for checking. If you haven't checked, Morningstar has a cute, little tool. It's called Instant X-Ray or Portfolio X-Ray. Just google "Morningstar" and "X-Ray Tool." You can put in your mutual funds and your individual stocks, and then you can see the overlapping percentages of everything.

So whether you should sell it or not; the nice thing is you have this individual position in a Roth, so you don't have any tax consequences for selling it or not. I'd say that's an individual decision based on what percent you have in there. You didn't tell us that, Jim, but I'd say generally around 10% gets around the high side where you might feel a little bit uncomfortable having that much allocated to it. Like you said, there's no consequences to selling it, so that's fine.

Generally we tell people, though, if you like the company and how well they're performing, don't sell just for the sake of selling, but that 10% is a rough area where you might get uncomfortable.

Southwick: The next question comes from Michael. "I've read some convincing arguments, recently [including on Fool.com], that have suggested that the flood of investors' money going into passively managed funds has the potential to create an index bubble. This money is being unevenly distributed to the top-performing large-cap stocks," [oh, hey there, Apple]. "If those few companies were to falter, it would cause a cascading effect downstream to smaller companies. Do you see any truth in this assessment?"

Brokamp: It's a really interesting question! When you say the term "index bubble," that has different meanings for different people. What people are arguing is that indexing has done so well and become so popular that it won't do as well in the future, and that in the future actively managed funds will have an easier time of it.

I'm not sure if I agree with that or not. The long-term history shows it's very tough to beat an index fund. That said, what I think is more important [and it's more related to the previous question] is the more your portfolio is allocated to like an S&P 500 index fund, the more you are concentrating your portfolio in a handful of stocks. And particularly at this time, right now [more than 20% of] the S&P 500 is in technology stocks. The No. 1 holding is Apple and No. 2 is Microsoft. Google is in the top 10. You have a pretty big concentration in one sector.

So I think it makes more sense just to look at your index funds as part of your whole portfolio rather than just getting away from index funds just because they're index funds. I know Buck has an opinion about this, too, because we sit next to each other and we talk about index funds all the time, partially because we're both on the 401(k) committee and the Total Stock Market Index Fund is the biggest holding in our 401(k).

Hartzell: That's right and we used to have the S&P 500. We switched over to the Total Stock Market Index just because that does have exposure to smaller and midcap companies, so somebody who wants diverse exposure to the stock market should get all ranges. That's why we did that.

But I think it's a great question and I would say in addition to the indexing, there's something that we talk about quite a bit around here and that's "closet indexing." There are those professional money managers who are scared to deviate much from the performance in the index, so although they charge higher fees than what you get from an index fund, they tend to have a large overlap in the holdings of those index funds.

I think there's probably even more support for some of that momentum around those stocks, and one of the things that we get a little worried about around here sometimes is that there's largely a handful of stocks that are driving the performance of that index. And when you get too concentrated [this happened in the late 1990s], you had companies like GE and some of the large-cap [Home Depot was one of them and Lucent was a big driver]...

Brokamp: Cisco.

Hartzell: ... and Cisco was over a $500 billion company. When they make up a big proportion of this whole index, you get a little worried if something happens and they're all in that same sector. That gets back to your sector comment too, Bro. We worry not just about the index, but some of those people, and there's a lot of them because they've underperformed and finally they give in and go, "I can't underperform anymore, so I'm just going to add some of these stocks." There's a big follow-on, ripple effect from that indexing that's been going on.

Southwick: The next question comes from Ronald and he writes, "How and who established the traditional metrics that we use for valuation and why has that changed over time? Why are different industries and businesses being evaluated with different valuation metrics vs. other traditional metrics? For example, 20x forward earnings being cheap vs. expensive for different businesses and industries?"

Hartzell: Ronald, that's a little question, and it's pretty concise.

Southwick: The answer?

Hartzell: The answer is a big one!

Brokamp: [Laughs] So settle in, everybody.

Hartzell: See, I don't get in trouble. I'm just a guest here, so if you guys don't like the depth that we're going into in this answer, then you can tell them and they won't have me back again, which is fine.

Southwick: I'm going to get comfy.

Hartzell: But the short answer is some industries are inherently better than others, so that's the quick answer. Cereals, for instance. Cereal companies have earned 15% return on equity for a long period of time. They have competing products and that's just been a really good industry. There's other industries like airlines that typically -- they've done better recently -- that nobody earns great returns with the exception of maybe Southwest or one or two airlines. So some industries are particularly good and some are particularly bad, generally.

Now the longer answer, as to multiples and valuation of stocks, is a more complex thought, but I think it's important and it's pretty timely. It's understanding the relationship between inflation rates, interest rates, bond prices, and stock prices. We're going to take a little dive into that and hopefully it's useful to you.

Interest rates are driven a lot by inflation. The inflation rate [and I looked this up yesterday] is running about 2.3%. It's pretty low and it's been modest here for quite some time. So that's the inflation rate. And what happens when banks set interest rates for different loans and things like that, they're going to have to charge above the inflation rate or they lose money. So typically banks will charge about 3% premium to whatever inflation is. So if you see inflation is 2.3% you can expect that loans and stuff like that will be at about 5% or so.

That interest rate, in turn, influences bond rates. I looked at bond rates and we're at a weird time, here. We'll get back into this later. I looked at T-bills. 10 year T-bills are at about 3.14% right now, so on a $1,000 bond you would be getting $31 a year in interest and that's a 10-year. If you look at 30 years, you only get 3.4%, so there's not a huge premium for that extra 20 years. That's a little bit weird. We won't talk about the yield curve, but those are bond rates. They're not spectacular and they're certainly not a way to get rich right now at 3% for T-bills.

Then we look at stocks and multiples. Right now the S&P 500 is trading just below 18x earnings if you look at the S&P 500. Now, we compare those. Here's why it's important between stocks and bonds. Bonds are a replacement for stocks. They compete for money. So if you can get 6.5% guaranteed out of a bond, you assume more risk when you buy stocks, because if something goes bad [Sears shareholders out there], there's nothing left for the equity holders, but the bond holders precede them so they get preferential treatment. If you're going to take that risk for being an equity holder, you want to earn more than the bonds. As bond rates go up, then equities become less attractive.

So at 18x earnings, when we look at the S&P 500 multiple to compare those two, we need to convert it to an earnings yield. That's just the inverse. So if you have P/E of 10, one divided by 10 would be a 10% earnings yield. We have 17.98% which turns out to be a 5% earnings yield on the S&P 500.

Now here's the interesting thing. If you buy a bond, it doesn't change. You're going to get that coupon and that's what you get until it matures and it goes to the end.

Brokamp: That's what I call fixed income, because it's fixed.

Hartzell: Right, it's fixed. You get no growth. But when you invest in stocks, earnings generally grow. On average they grow about 7% a year if you look back historically. So what happens is investors typically will take a little bit less on the earnings yield for stocks than they will in comparison to bonds. Now here's the weird thing today we're getting at and why it's important.

We have a 5.6% earnings yield for the S&P 500 and we have 3% in bonds. That's weird. Usually it would be a discount, and the discount would be if you took the rate for stocks and grew it at 7% a year, usually it's about a three-year period there. So we would expect that stocks would be cheaper. Unfortunately they're not. You're getting more for stocks.

So what does this tell us, that 5.6%? It tells us we should be kind of leery of investing a whole lot of money right now in bonds. Some people, Warren Buffett and others, have talked about the big bond bubble and all of that, so as a result I would be pretty skeptical of putting a whole lot of money in bonds today. And most of the people that have to put it in [like insurers and those kinds of companies], are in very short yielding. They're in short-duration bonds. They're not going to buy that 30-year for 3.4% vs. a 10-year for 3.1%, and they're probably a much shorter maturity than that.

So in summary, here's what we know. Inflation impacts interest rates, interest rates impact bond rates, and bond prices impact stocks. So what happens when interest rates rise [and what we're seeing with the Fed right now is they're raising rates, and there's some signs that wages are growing that are traditional inflationary signs, so we'd expect them to keep rising] the current prices of bonds go down when rates go up. Because if you bought a bond a day ago at a 3% and now it's 4%, well, the old bond has to be repriced to be comparable to that 4%, so the price of it goes down.

Now if you hold it to maturity, that doesn't matter. You're going to get your payments, and that's why Bro tells people to ladder into bonds. Stocks, as well, when interest rates rise, the multiples generally go down. But when we look out right now -- and this is why it gets scary -- is people go, "Stocks look expensive to me from a historical standpoint." Well, you have to compare it to something. There has to be some relative comparison. And right now stocks in comparison to bonds look very attractive.

Southwick: So, hey, let's keep talking about bonds. The next question comes to us from Guy Over There. "If I understand the general suggestions around preparing for a goal like retirement or college, the idea is that the closer you get to needing the money, the more you should be moving it from stocks to bonds and cash. However, an article in The New York Times has scared the bejesus out of me.

"The article titled, The Big, Dangerous Bubble in Corporate Debt, by William Cohan, makes it sound like there are a lot of mutual funds that have riskier corporate debt than one might assume. So if I wanted to liquidate some of my shares out of these bond funds to pay for college in a couple of years, I run the risk that the bond prices, and thus my mutual fund values, might be depressed just as I need to sell. What's your take on this? Do we all have a lot more risk in our bond funds than we might think?" Dun dun duuuun!

Brokamp: Dun dun Duuuun! I'll just piggyback on what Buck said. Clearly there is more risk in the bond market these days when you have rising interest rates and we've seen that this year so far. For example, the aggregate bond index -- this index started in 1976 -- is on track to having its second worst year ever. And what does that mean? It's down 2.5%. So it's not a huge decline, but if you are saving for retirement, or if your retirement's coming up, or you have college coming up, you don't want to see your so-called safe money go down any kind of value.

He also raises a point in that there are some questions about the make-up of some bond funds, now in that they are getting riskier. For example, one stat that I read in a Business Insider article was that when you look at investment-grade bonds, those are rated BBB and above, and that's what most bond funds are. They're investment grade. But if you look at the aggregate bond index, 50% of those bonds are rated BBB, so basically right above junk as opposed to just 38% right before the Great Recession. So there is something to be said that the average bond fund is riskier these days, just because it ends up holding more bonds with lower ratings, so I think it's a valid point.

The bottom line for me is again to what Buck said. These days bonds are very unattractive. If you need to keep money out of the stock market, especially if you want to keep it very safe, I think cash is really the best way to go. And the good thing about that, nowadays, as we've said before on previous episodes, is that when the Fed hikes interest rates, you can almost see it immediately in a good savings account or in CD rates.

You have to look because a lot of banks and brokerages are still paying virtually nothing. Counting on everybody being lazy and not going out there and looking for better rates. But if you go out you will find you will be able to earn more than 2% -- almost 3% -- on your cash, and I think that's more attractive for money that you absolutely need to keep safe than a bond fund these days.

Hartzell: You've got to consider the risks and rewards, and I think right now you're not being paid a whole lot of reward for taking on that risk, so I would be in cash, too. I own no bonds, but even with college stuff and things, if you've saved $100,000 the upside is maybe you eke out an extra percent or so. That's $1,000. That's not going to make the difference on whether they go to college or not, so I wouldn't take the risk with money that I knew I needed in the next two or three years.

Brokamp: I'm not saying you shouldn't own bonds, by the way. If you have a long-term portfolio and you don't want to have all of your money in stocks, I think a diversified bond fund can still make sense. Just as long as you know the risks, I think over a span of five to 10 years, studies have shown that rates going up over the intermediate to longer term is actually good for a bond fund, because the new bonds that they buy have [higher] interest rates. So I think you can still earn more than cash over the long term but stick with cash if you want something that's absolutely safe.

Southwick: The next question comes from Harpreet. "I have a question about how stock prices of U.S. tech companies [especially the FANG stocks] might get impacted in the scenario of the U.S. dollar weakening and losing its reserve currency status. Do you think this is possible?"

Hartzell: The short answer is anything is possible, but I think you're probably worrying a little bit too much. For those of you out there with reserve currency questions, the US is the world's reserve currency, which means other governments keep a lot of our money. You may have some insights that I don't. We have people here in Washington who work in the Federal Reserve. I just don't see that changing. That's not anything that I ever lose sleep over at night.

We're a bottoms-up kind of investment shop here for how we look at investment companies and stocks to invest in. I put almost no thought into what's going to happen to Netflix (NFLX -0.48%) or Facebook if the U.S. dollar is not the world's reserve currency. I'm not worried about it. I don't even think about it that much and I don't think it's going to have that much bearing on any of those companies. If you like the companies and they're doing well hold them. Don't worry so much about the reserve currency.

Southwick: The next question comes from... Oh! It's another Allison, but this one has two Ls, and she's in Florida. "How much should I have in international stocks? I think the frequently accepted recommendation is about 30-40% of a portfolio or even up to 50%, but this week there was a long and heated thread on the Bogleheads" -- they're always heated on the Bogleheads Forum, aren't they -- "challenging this. The title of the thread was, 'It's not enough to mumble Stay the Course. Int'l investing has been a disaster!' Would you be able to comment on this?"

Brokamp: First of all let's start, because this was playing off the Bogleheads Forum, with what Jack Bogle says. I just recently heard an interview. The Bogleheads conference happened recently and he made some comments about international investing. He's one of those people that says it's not really necessary. When you look at the long-term returns of U.S. vs. international, there's no evidence that international outperforms U.S. over the long term. Plus the U.S. is a more stable country. We have a pretty good, highly regulated securities market, so you don't have to worry quite so much about fraud. Plus around 40% of the revenues from companies in the S&P 500 come from overseas ventures, so you're still getting some international diversification there.

So if you're going to go with Jack Bogle -- and it's hard to argue too much with Jack Bogle -- just stick with U.S. stocks. That said, when he was running Vanguard and he has since retired, they had international funds and they still have international funds. One of the reasons are there are time periods when international stocks outperform U.S. It happened in the 1980s. It happened in a good part of the 1970s. It happened in the first decade of the 2000s.

Jason Zweig in The Wall Street Journal wrote an article saying, "It's pretty tough, now, from a valuation standpoint, to ignore international stocks. They're about half the valuation of U.S. stocks." Of course, we've been saying this for years and international stocks still, other than in 2017, have underperformed U.S. stocks over the last five years or so.

I would say you have to be comfortable with the volatility of international stocks. I have about 20-25% of my 401(k) in international stocks, but you don't have to have it. One thing I will say is the way that was phrased on the Bogleheads is that international investing has been a disaster. It's not really been a disaster. Over the long term international stocks have underperformed U.S. stocks a little bit, but it really depends on what time period you're looking at.

Hartzell: And I would add if you're buying individual stocks there can be some extra trading costs from some of your brokerages when you buy international companies. I work mostly on Canadian operations, so I have ideas through all our services. I'd say that's an easy market because it's pretty familiar with us. It's right across the border. There's other ones where there's unique things in accounting that are a little bit different and more difficult to comprehend.

So I would say I don't think you need to, but if you have an interest and you want to find great companies, why would you not look everywhere for those? But you don't have to. You can do very well. Berkshire Hathaway (BRK.A -0.09%) (BRK.B -0.24%) and Warren Buffett have very little of their capital [in international stocks and] they're trying to buy more international companies and he's been trying for years. He's done pretty well with mostly sticking to the U.S. market.

Southwick: Speaking of Berkshire Hathaway and Buffett, our next question comes from Evandro who's in São Paulo, Brazil. "What will happen to Berkshire Hathaway stocks the day Buffett announces his retirement? He's 88, so it's possible it could happen soon. I have no issues with him continuing to lead the company, but for natural reasons we tend to think about his eventual retirement. It would be great to hear what you think."

Hartzell: It's a great question. I was at the Berkshire meeting this May and it's just amazing when you see him. You mentioned Warren Buffett up there at 88 and taking questions for six hours from 40,000-50,000 people. And Charlie Munger, his sidekick and vice chairman is 94.

Southwick: Wow! And still mentally sharp, right?

Hartzell: Amazing! Amazingly sharp and still eats about a box or two of peanut brittle and drinks Cherry Coke the whole time. So much for your doctor's orders of eating healthy and longevity. But the great thing about Berkshire -- and I've owned it for a long time -- is I remember reading this question on our discussion boards in the 1990s. "Buffet's 70-something years old."

Brokamp: I remember that, too!

Hartzell: Now we're getting it 20 years [later]. Here's what I would say. I would be surprised if Berkshire stock went up when Warren Buffett steps down. It's probably going to go down. But then, again, this is his baby. He's built this thing. There are some things that are very unique about Berkshire Hathaway.

First of all, they have a wonderful bench strength of managers and they have a decentralized organizational structure, so although they own 80-plus businesses, they're all run by their own entrepreneurs and great people, and Buffett has no real insight into those businesses. He understands what's going on -- he gets the numbers -- but they run those day-to-day. He does not. All he really does is capital allocation and management.

The capital allocation stuff, he's hired a couple of really good folks to do that. Todd Combs and Ted Weschler are helping out on that, and he's got same great people in the insurance operations with Ajit Jain. Greg Abel will take over some of the other operations for their management of oversight and the management duties of Berkshire. So he has great people, there, and my guess is if you're anticipating that the stock's going to get crushed, that's probably not going to happen. They have lots of capital, and I'm sure that the people who are taking over the reins from Warren will have free rein to buy back stock, at will, if it reaches a certain price.

I'm waiting for that day. It's probably not going to come. The day will come when he'll step aside, but the price probably won't be on sale as much as you think. I wouldn't worry so much about that.

Brokamp: I've also owned it for several years -- although I'm sure not as long as you --but like you, I don't have the same concerns. Buffett has shown an ability to invest in good businesses, and he has also shown the ability to invest in good people. Those people will still be there after he retires.

Hartzell: And they have $100 billion in cash. There's not many companies on Earth that have the balance sheet strength that Berkshire Hathaway has right now, and we know that they are willing to allocate it very quickly. I think he bought almost $40 billion of Apple in the last year or so. He'll put it to work when he finds ideas.

Brokamp: Another example of how you could possible own more Apple than you think you do.

Hartzell: Yes, through Berkshire. That's right.

Southwick: The next question comes from Morrell? Morel? I'm not quite sure how to pronounce it.

Brokamp: One of those.

Southwick: I'll pronounce it many ways. "My wife and I are 26 and 28 respectively. I just started a new job with what I feel is great pay and I'm trying to start good savings and investing habits. I'm getting aggravated because there are too many goals to hit." Are you ready?

Brokamp: Ready!

Southwick: "First goal: need three-to-six months' worth of income and savings for emergency fund, so a goal of $18,000. We currently have $10,000 saved. Need [10%] for down payment on a car; $4,500 for a $45,000 car. Need a 20% down payment for a house to avoid PMI; $40,000 for a $200,000 home. Continue savings for baby expenses. It seems that all my savings energy is going to amassing a minimum of $52,500 savings account just to meet the basics. How in the world will we ever be able to invest? My wife and I both contribute minimum to match amounts to our 401(k)s, but we are nowhere near maxing out those accounts much less a Roth IRA or brokerage account. I feel we are decent stewards of our money but it just seems like an impossible task to hit savings goals while investing at the same time. Any help would be amazing." Aw!

Brokamp: Such sympathy...

Southwick: Well, it's so much stress.

Brokamp: I know.

Southwick: You're doing great!

Brokamp: I'm sure you're doing great! First of all, you care about this and you're in your mid-20s, which is great sign. And it's certainly difficult to hit all these targets when you're just starting out and you're thinking of starting a family.

Here are my initial thoughts. You said three-to-six months of income in a saving-for- emergency fund. As I've mentioned in previous episodes, I don't think it's three-to-six months of income. It's about three months of must-pay expenses. You don't have a mortgage at this point. You don't have kids at this point. I think you can get by with a smaller emergency fund. You've already saved up $10,000. That's probably OK, especially if you feel like your jobs are pretty safe.

The $4,500 to put a down payment on a $45,000 car. I would say lower your car needs. I don't know what car you're looking at, but you can get a pretty good used car. Almost every car I've bought is a used car.

Southwick: We just bought a $16,000 new car and it's delightful. I don't care if it's a manual transmission. That's our best theft deterrent -- the fact that our car is a manual transmission.

Brokamp: Not to mention you can pop the clutch if the battery goes dead. Anyway, so I would say lower your sights in what kind of car you need.

Hartzell: The average new car now -- I did this quiz with my family last night -- is $36,000. That's the average price, and largely because they're not making little cars anymore, very much, and they've all gone to the more profitable SUVs, and that's driven up the average cost, but $45,000 is probably for a nice SUV.

Brokamp: And then a 20% down payment to avoid PMI. I understand how difficult that could be. If you're doing it for a $200,000 home I'm jealous because we live in the Washington, D.C. area and you could never find a home for that amount. I would say, especially with your first home, it's OK to put down less than 20%.

Southwick: We did the FHA loan. That was 4%.

Brokamp: And you can get out of PMI once you have built up 20% equity, so the combination of you making your payments and hopefully the home price increase means eventually you can get out of PMI, so you generally don't have to pay it forever. Just make sure you know what the terms are before you take on that loan.

Southwick: Also, you don't have to buy a house if you don't want to.

Brokamp: That's another big thing. We've talked about that. Home ownership is completely overrated. It's the biggest mistake my wife and I made that we've bought too many houses; partially because we bought the so-called starter home and didn't think down the line to how many kids we eventually would have. So if you're at a point where you're just starting this job and you're not sure whether you're going to like it or not, and you don't know how many kids you're going to have, you might want to wait on buying the house.

Hartzell: We see some house prices moderating. There's not a whole lot of inventory right now in most markets, and as more inventory comes on, it usually benefits the buyer, too. So patience, sometimes. I'll echo what Bro said. You're in your mid-20s. You're doing phenomenally well. Just prioritize things.

I would add one that Bro won't like, and we sit on the retirement committee here, but I remember we did it for our first house. We borrowed from our 401(k) to make our down payment for our first house. That's not your first option, but you guys are contributing to 401(k)s, so that is an option. And make sure that when you do buy that house that you want to be in that area for seven years, at least, because it's not something you want to do -- buy and sell houses. There's commissions that go along with those and usually around 6%, so it's much more expensive to buy and sell houses than it is stocks or anything else, so make sure that when you do buy, you make that commitment.

Southwick: Like the schools and those things. That's a big deal in our area.

Hartzell: Go visit that house and do the early morning commute and do the commute back at nighttime, as well. And one thing for those of you, since it's not a house show...

Southwick: Oh, I'm all houses all the time.

Hartzell: Oh, you're all houses. That's right.

Southwick: We're closing this Friday.

Hartzell: Alison is closing, but look for comparable rentals to your house, and generally you want to pay around 200x a comparable monthly rent. It will fluctuate, but around there is pretty good. In the peak bubble times of 2005-2007 around here, people were paying up to 400x monthly rents, and those people generally saw the value of their house decline by 30-40%. Then you're underwater and that's a bad situation to be in. So that's a good tip when you start to value what you should pay for a house.

Brokamp: And since this episode comes out right before Halloween, if you're going to have kids, it's a great time to drive around and see which neighbor has the most little kids walking around. Who's decorating the most for Halloween to get that vibe.

Southwick: That's true!

Brokamp: The final thing I'll say is if you can manage to save more money, the first place I'd put it is the Roth IRA because that money grows tax-free and as we've pointed out previously, the money you put into a Roth IRA you can take out tax and penalty-free if you need it. I wrote an article back when my kids were very young about us using a Roth IRA as an emergency fund. We put it in there. Hopefully we don't need to touch it, but if we did need to get it we could. We didn't need to, but we did look at that as our emergency fund and it worked out pretty well.

Southwick: So they could put that $10,000 that they currently have saved and shuffle it over to the Roth.

Hartzell: The contributions you can take out tax-free.

Brokamp: Right, not the earnings. And the limit per person is $5,500 for folks their age, although hopefully it's going to go up in 2019.

Southwick: The bottom line is you're doing great!

Brokamp: You're doing great!

Southwick: And you are investing! You're just investing in a lot of stuff!

Hartzell: That's right!

Southwick: The next question comes from Dr. YL. "My biggest holding is Netflix, which became 40-50% in my main portfolio. This is a taxable account. The recent pullback in the stock's price hurt this account substantially. Since I started investing, I've made nearly 200 buy orders and fewer than 10 sell orders. Overall I'm very happy with this Fool approach of buying, holding, and not selling; but, maybe it's time to stream some Netflix into other stocks."

Hartzell: Wow, I like that! First of all, congratulations!

Southwick: It's a nice problem to have!

Hartzell: We generally tell people to buy in thirds, which means whatever your full position is, you take one bite and one-third of that and then two more purchases, so you give yourself some time. You did it in 200s, so that's awesome, and he added to a great stock and he's made a lot of money. So first of all, congratulations for that!

We call it the "sleep well at night" test. Here's the thing. I think Netflix is doing very well. I'm not the expert analyst on covering it, but I think most of their potential is in the rest of the world, now, because they've gotten so much penetration, here, in the US. They've shown great progress in being an attractive offering around the world. That's great for Netflix.

But stocks are volatile from time to time, and if a 20-30% pullback in Netflix impacts your life, and it sounds like the recent pullback was less than that and maybe shook you a little bit, it's fine to sell some of that. I think it's in a taxable account, so you're going to have to pay some taxes, but there's worse things to do than pay taxes. Once in a while we've got to do that. I would say a 10% range I start to get a little bit uncomfortable, maybe. That's a personal thing. 40 and 50%; if you have a 20% drop in that, that hits your portfolio at 10%, it's a pretty big hit.

So I think you're wise to be thinking that maybe this is a little bit uncomfortable and you can take some out. Another great way to do this without paying taxes is if you're currently saving and adding money to your savings is to rebalance with new money by buying other things.

That way you don't have to sell your Netflix. You can just buy some of the other positions that you like and that percentage of your portfolio will naturally go down; unless, of course, the stock does wonderfully well. Those are two options. You can do both of them. Don't add any money to Netflix. You can just add money to other things and then if you feel like, you can sell it down a little bit.

Brokamp: Yes. The stock is down 20% since June. There have been times in Netflix's history where it's been down more than 70%.

Southwick: Qwikster.

Brokamp: Yes, so it's definitely a concern I would have. The tax consequences are unfortunate, or fortunate. It's always better to pay capital gains taxes than to take capital losses. But if you have made multiple purchases over your history of holding it, you can determine which shares you're selling, and choose the cost basis that is best for your situation.

To be quite honest, given that tax rates are pretty low [not knowing your particular situation], it might be a good time to take the big gain now if you expect to be in a higher tax bracket in the future or if you expect tax rates to go up in the future to find some way to pay for Social Security and Medicare and all that stuff. I'm not saying that you should necessarily choose the highest-basis shares. You might want to choose the lowest-basis shares and bite that bullet today. It depends on your tax situation, but basically you do have a little bit of control over that.

Hartzell: And to the extent that if you do sell some of that, you can look through your portfolio for some offsetting losses to cancel out some of those gains and balance them out. I don't know if you have that or not, but that's always a good thing to do at the end of every year, anyhow. Some tax-loss selling. You can buy them back in...

Brokamp: 30 days.

Hartzell: ... plus 30 days and do that if you want but, anyhow, that's something else to consider.

[...]

Southwick: That's it from those questions. Now it's time to move on to my favorite part of the mailbag episode...

Brokamp: Moving tips.

Southwick: No, I've gotten one moving tip, so far. That was it!

Hartzell: I've got one. Don't do it yourself!

Southwick: Yeah, that is a good one! That is a very good one! We are listening to that one. One person, so far, has sent one in, but I'm hoping more people will send in their moving, buying, and selling a house advice. There's only one person that sent one in. I'll share it later, and I've got some more advice from around The Fool. That's coming later.

My favorite part is where you guys send us postcards and talk about them. So first off -- Buck, you're going to be a little bit in the dark, here, but we're going to talk about how divisive our Financial Independence/ Retire Early episode was. On Twitter, [Harand] was intrigued and felt inspired by the episode, and Dylan, here at The Fool, he gave us extra gold for it.

Brokamp: He did.

Southwick: He said it was a great episode! However, a couple of people, or maybe more than a couple, had some concerns. Raj writes, "I've always found these type of self-help stories are misleading. Typically these folks publicize that they achieved their freedom beforehand, and now simply run the website to share knowledge out of the goodness of their heart, but it's misleading.

"More often than not, the fact is these folks can quit their jobs because of their online businesses. There's nothing wrong with that. It's just hard to take any of their stories credibly. Their advice generally makes sense. I would love it if you guys have guests on the show who are true FIs. Who have achieved their FI the Foolish way [financial independence] and now pursue their passions: travel, community services, arts, hobbies, education, going back to school, volunteering, etc., without running online businesses. It would be really interesting to hear those stories on how they achieved financial independence and how they handle their finances during pseudo-retirement."

Sam also wrote in and found some suggestions made by the guests about financial independence and self-reliance were more about getting public support and had concerns about that [relying on public support], such as getting subsidies for healthcare and sending your kids to community college for the first few years. Is that going to stunt their academic progress? I don't know if you have any thoughts.

Brokamp: When these guys were able to leave jobs that they didn't like to a life that they enjoy more, with more flexibility, because they found some way to save 50-70% of their income; to me that is the key lesson. At a time when the national savings rate is 6%, to look at people who were like, "I want to change my circumstances and I'm going to do it by saving a lot of money, ignoring the consumer culture, and creating a life that I like more," that's really, to me, the big story of these folks who want to retire in their 30s and 40s by doing the FIRE thing.

Southwick: For our more seasoned listeners and investors who've been with The Motley Fool for a long time, I think they already are frugal, and I think they're, "Yeah, I've already been there and done that. Now what I need to know is how can I really make more money by investing and how can I really be financially independent and stop making money, period, and just live off of what I've made." But I think for the younger listeners on the show, the idea of, "Oh, I can reject consumer culture," is probably quite eye-opening. I think it probably says more about maybe the stage of life that our listener is in...

Brokamp: Could be.

Southwick: ... and how they reacted to the episode.

Hartzell: I would add for running those businesses, this is what they love. They enjoy doing it and here's the real secret. This is not about journaling, but when you write about it and you teach other people, you learn a lot more about the subject yourself. You get comments from other people, so I'd say retirement means different things to different people, and I'd hope if you're in your 30s and 40s, it may mean you're working and you love working, but just doing something that you really like. And you're probably going to get a lot better at it, then, then doing other things. Certainly watching TV or whatever else.

Southwick: For the record, we always appreciate your feedback on episodes and when you disagree with us, that's really great and helpful to hear. I can't do anything about my voice -- but it's still helpful to hear from me -- nor can Bro. Sorry.

Hartzell: I can't either.

Southwick: This is what we've got. No, you've got a nice voice. I just want to say congrats to listener Jason, who got engaged and sent in a photo. He sent it in along with a question. We didn't get to your question, but I felt like we should say congrats on getting engaged.

Rick is going to be bummed that he's sick today because I'm mentioning [and I left it back on my desk], but our postcards. We got one. You have to imagine it. It's three parts of an alligator turned into three different postcards. It came from Clay in Saint Augustine. He addressed the head to Bro, the gut to me, and the tail to Rick, which I think seems exactly right.

Brokamp: How about the heart to you? You're the heart of the show!

Southwick: Thanks! The heart and the gut. Rich is like our own Uncle Matt from Fraggle Rock. He's so prolific with sending in the postcards. He sent us three postcards that his parents brought when they visited him in New Mexico, so all three are from his home town in Ohio. We have one of a leffel turbine, another of the courthouse, and a third of an old Methodist Mission church.

And [Tomoko] -- do you remember her? She came and visited The Fool and shared her story. She lives in Old Town?

Brokamp: Oh, yeah!

Southwick: She sent a card from Iaqluit, which is way up north in Canada. She says it's amazingly beautiful but cold. How cold you ask?

Brokamp: How cold?

Southwick: In October, on average, the high is negative one degree Fahrenheit.

Brokamp: Ow, wow! Why?

Southwick: I don't know what [Tomoko] is doing up there, but I appreciate her sending a postcard from a far-flung part of the world. So, I think that's it! Buck, thank you for joining us!

Hartzell: Thanks for having me! I appreciate it, Alison and Robert! It was fun!

Southwick: It's a joy! We try to have fun. The show, like I said, has been taped by Austin. It's still probably going to get edited nauseatingly by Rick Engdahl. Our email is [email protected]. For Robert Brokamp, I'm Alison Southwick. Stay Foolish everybody.