Pareto's Principle Revised …

There is a common thread running through the Personal Finance blogosphere that goes something like this:

80% of people live beyond their means, but the 20% who live within their means & save diligently will be A.OK

Then I come along and run a whole series of posts seemingly debunking various financial ‘truisms’, such as the old ‘save you way to wealth via your 401k’ chestnut and many people no longer know what to think!

Heidi summed up the mixed feelings out there nicely in a comment to one of my many recent 401k posts:

Very interesting. Goes against the grain of all of the personal finance blogs I frequent. I do have to agree with Lee, though, that at the very least [their 401k’s] gets people saving. I know way too many 40 year olds who haven’t even started and are too strapped for cash living their keeping-up-with-the-joneses lifestyle.

To me, this is not an all or nothing situation … you can save via your 401k (if you like) but, at the same time still do other things to set yourself financially free.

I was struggling to find a way to illustrate this when I came across this post in the Simple Dollar; Trent says:

In a visual way, my spending used to look something like this over time (with green representing spending and blue representing income):

graph 1

… and now it looks something like this:

graph 2

Aha!

At least, this represented an ‘aha moment’ to me …

… you see, Heidi is concerned about the 80% of people who follow Trent’s old pattern: they spend what they earn and then some.

We all know what to expect from their financial future: disaster!

So Trent’s blog, and most other personal finance blogs are aimed at the 19% of other people who see the folly in that pattern of living and concentrate on frugality (and, saving the difference) to turn their financial lives around. They try and follow Trent’s second chart.

But, now we have a mathematical problem … our Pareto’s Principle (a.k.a. The 80/20 Rule) only adds up to 99%:

– We have the 80% who are financial deadbeats and don’t bother reading personal finance books or blogs, let alone implement any of the simple methods to keep themselves out of the poorhouse

– The we have the 19% who do read the PF books/blogs and practice at least some of what they preach

What about the ‘missing’ 1%?

They are the ones who realize that as well-meaning as the common financial wisdom is, it can never actually make them all that much better off than their ‘poorer’ cousins … saving alone will not make them rich (or even wealthy)!

So here is how Trent’s chart for the 1% who do want to become truly financially free needs to look:

It’s a simple three step process:

1. Start implementing some sound Making Money 101 techniques to get your ‘green line’ of spending in order (most PF Blogs stop there), then

2. Start implementing some sound Making Money 201 techniques to get your ‘blue line’ of income (job/investments/business) pumping (but, don’t make the mistake of letting your ‘green line’ follow; instead invest the difference between the two lines wisely), then

3. When you retire (early!) and your ‘blue line’ disappears altogether, use sound Making Money 301principles to make sure that you can still safely maintain your desired ‘green line’ spending level … then, relax and drink plenty of pina coladas whilst lying in your hammock.

So, Heidi, we aren’t really saying that the other PF blogs (and their devotees) are wrong … we’re just asking a simple question:

Once you have your saving ‘house’ in order, why stop there? 😉

The 401k revisited …

I’ve written a series of posts about 401k’s with the intention of encouraging each and every one of you to assess why you are choosing to ‘invest’ in your 401k over-and-above any other investment choice.

I received a comment from Timmers that I wanted to address here because he raises some interesting points … I will break up his comment into the relevant pieces:

As a person who invests in both 401k and Roth IRA as well as residential real estate …

Let’s stop it right there and understand that we are talking about three totally different things here:

1. 401k is not an ‘investment’ as I have previously defined it … it is a limited, tax-efficient savings strategy with benefits (e.g. employer match). Limited because the underlying investments are usually (not always) costly and relatively inefficient ‘products’ packaged for the employer by their 401k provider.

2. A ROTH IRA is not an ‘investment’ … it is a tax-advantaged vehicle in which it may be possible to make investments. Interestingly, you can usually use one to invest in a wide variety of means including: funds, stocks, real-estate.

3. Residential real-estate may be a good or bad investments, depending upon where, when and how you buy … coming off the top of the ‘bubble-and-bust cycle’, I doubt whether I need to explain this further, here. However, it is important to realize that residential real-estate is not the only form of real-estate investment available to you.

Anyhow, on with Timmers’ comment:

… I have to also add one other Major argument for real estate as a retirement strategy. That is, if investing right and long-term, real estate is much more of a sustainable investment. That is, if you have held it long enough to pay down the mortgage, you simply can live off of the rental income. After drawing out the rental income for one year—guess what? It hasn’t gone down in price but usually up—at least maintaining parity with inflation if not more (sometime much more if you invest right). AND…(the best yet)….you still have the same amount of money available to you as the year before plus a little more (if you haver raised the rent).

This is a masterful strategy of the Making Money 301 kind i.e. something that you want to consider when you have already made your pile of money and are considering (a) how to keep your principle (‘nest egg’) safe and (b) have a safe amount that you can withdraw to live off every year without worrying about inflation OR your money running out.

However, paying off the principle as a Making Money 201 strategy (i.e. building your ‘nest egg’) may not be wise as you then need to think about what you are going to do with the excess cash that the property is spinning off … you will need to invest elsewhere anyway.

That is, the simple difference between real-estate as a wealth-building activity and a wealth-sustaining activity is how much equity you allow yourself to have in each property that you own:

i) Wealth-building: more properties, with less equity in each.

ii) Wealth-preserving: fewer properties, with more equity in each.

Finally, Timmers switches back to 401k’s:

The problem with 401K investments is that unless you have enough to live off of the dividends (out of the question for the vast majority of people), you are drawing down your investment every year. It is not sustainable like real estate. Granted, you must maintain your residences, which is an ongoing cost, but a smart investor always plans for the major repairs/renovations and has money set aside for the smaller ones. To be honest, I am so tired of the constant 24/7 blather of the stock market investment complex that has its tentacles in every media outlet. They want to keep spinning a song that hasn’t produced for most mainstream investors the past ten years (but has for their jobs and income). I am grateful for AJC’s contrarian and no-nonsense approach to most of their blather.

To this, I can only say ‘thanks’ and add some recent comments from the Tycoon Report:

If this market were a horse, I think we would have shot it already to spare it further misery … we have to readjust our perspective of the US equity markets. This is not a buy and hold the S&P 500/DOW 30 market, and it probably won’t be so again until about 2015 – 2018. This is a sector driven market brought about by a slowdown in profit growth and driven by spiraling commodity costs. Index investors get crushed in markets such as these …

If you are a diversify-and-save-via-your-401k kind of ‘investor’, this Kind of makes you sick, doesn’t it?

Good Luck!

It's not what you earn that counts …

I wrote a post a short while ago assessing whether the rich should invest in Index Funds.

I received a few interesting comments, including this one from a reader named Mike, that I thought I should share with you all:

Would you do a post that considers the lifetime earnings of different people? Reason being I read an article that high school graduates earn an average lifetime earnings (from 25 to 64) of $1.2 Million. For people with a college degree this goes up to $2 million, with a Masters it’s up to $2.5 million and a PhD brings in $2.9 million. For people with professional degrees (doctors & lawyers I presume) the number goes up further to $4.4 million. Still not bad, an average of $100K per year for the latter category. For the purpose of this article I’m assuming that all earnings are reconciled to net present values.

So you’ve managed to earn $7 million in 7 years… that’s really impressive and nearly twice that of a doctor’s lifetime earnings. What have you earned throughout your life?

For me I’ve earned $2 Million in my life to date. More than half of this has come in the last 3 years. I’m 35 now and have been working since I was 23. I figure between now and age 65 I should be able to earn a total of about $8 million more with an medium / optimistic case. I will pursue investments but realize high risk brings high reward but potentially devastating losses. For example I’ve taken a large position ($110,000) in a Chinese stock with what I believe to be very strong fundamentals and have researched this company for the last 4 months in detail. In the last 3 weeks the stock is down 30% from where I bought in…! So I don’t put everything into high risk investments for that reason.

I think starting a business has elements of this… if your business crashed you would have lost it all I guess?

Firstly, here is the official government report that I believe Mike is referring to:

http://usgovinfo.about.com/gi/dynamic/offsite.htm?site=http://www.census.gov/prod/2002pubs/p23%2D210.pdf

However, I am totally unconcerned with income or lifetime earning potential … I believe that there is very little correlation between what a person earns today – or over their lifetime – and, how wealthy that they are …

… you see, it’s not what passes through your hands, but what sticks that counts!

I remember reading the book that passes for a ‘bible’ amongst the personal finance community: The Millionaire Next Door (because, to a casual reader, it appears to equate ‘frugality’ with ‘wealth’, which of course is only a small part of the story) and was struck by the story of two doctors:

Both were on super-high incomes, yet one doctor was ‘rich’ and the other ‘poor’ …

… one had saved/invested a good proportion of his ridiculously high earnings, but the other had lived the ‘high life’ and was in debt.

Same income … vastly different outcome.

So, when Mike asks:

So you’ve managed to earn $7 million in 7 years… that’s really impressive and nearly twice that of a doctor’s lifetime earnings. What have you earned throughout your life?

… I say: I didn’t ‘earn’ $7 million in 7 years in the traditional sense; plenty of corporate CEO’s, super-high-flying attorneys, and some medical specialists earn more that that in 7 years (some in 1 year).

In fact, at the time my ‘take home’ and total combined business incomes were less than many professionals earn, and certainly nowhere near the stratospheric heights that I just mentioned …

… no, I ‘earned’ the $7 million by investing my far more modest earnings and my Net Worth grew faster than my earnings ever could.

Keeping the ‘two doctors’ story in mind, do you now see why I don’t care what my lifetime income was? If not, consider Mike’s closing question:

I think starting a business has elements of this… if your business crashed you would have lost it all I guess?

The answer to this question is the key to Making Money 301 (keeping your wealth) and explains why income is so unimportant from a wealth perspective:

For the ‘poor doctor’, when his income stops so does his (financial life); if he loses his ability to earn his ‘paycheck’ through some disaster (he certainly doesn’t have the luxury of retiring, yet) he is just on broke!

But, it’s possible that our ‘rich doctor’ may be O.K. albeit at a lower standard of living … at the very least, he is debt free. At best, he has some passive investments to help sustain him and his family … probably not enough to sustain his current lifestyle, though.

In my case, I ploughed as much income into investments as possible and waived all ‘pay increases’ (I could have ‘paid’ myself a higher proportion of my business profits, but chose not to) …

… in fact, my wife kept working, as she earned more than I took home.

In doing so, we put ourselves in a position where it would not matter if the businesses crashed … we would not have lost it all. In fact, the bulk of the $7 million in 7 years was in passive real-estate … selling the businesses just two years later was the ‘cream on top’.

The Making Money 301 ideal is this:

Earn money, plough 100% of it into investments, live off the income of these investments as though you were already retired … increase your spending only as the portfolio income increases.

Simple and self-sustainable … of course, for most people, the ideal is not achievable, which is why you start with ploughing 10% of you income into investments, and build from there …

BTW: Visit this week’s Carnival of Personal Finance; we have an article published there ,,,

The lament of the middle-class millionaire ….

I must confess that I understand EXACTLY what this ‘poor woman’ is saying …

http://www.cnbc.com/id/15840232?video=768292103

Ryan (who is one of the Final 15 in my 7 Millionaires … In Training! ‘grand experiment’) sent the link to me saying:

About 6 months ago I did a similar exercise to determine how much I would need to “retire” and live the kind of life I wanted to (travel, philanthropy, golf, bigger house,activities, etc.). Although it seemed like a stretch to even write down, I settled on $10 million in 10 years. After watching a show on cnbc, in particular this clip, http://www.cnbc.com/id/15840232?video=768292103 , I think it’s time to revise my estimate!!! And to think that a couple of years ago I thought if you had a million dollars you could do anything you wanted.

The exercise that Ryan is referring to is the culmination of a series of posts on http://7m7y.com designed for one purpose and one purpose only: to help you find your Number.

This video – I believe – helps explain why I think that your Number should be couched in terms of required living expenses rather than some nebulous lump sum (such as $1 million; $5 million; $10 million; etc.) … although I also show you how to calculate the ‘lump sum’ that you will need.

But, Ryan doesn’t need more than $10 Million (a.k.a. $500,000 per year … indexed for inflation) to live a life that simply involves “travel, philanthropy, golf, bigger house,activities, etc.”; he just needs to realize that on $500k per year:

1. He will not be able to afford ownership (fractional or full) of multiple houses, jets, yachts and the like (although one used Ferrari isn’t out of the question), and

2. He will NOT be rich … rather ‘comfortably off’ – at least, according to Felix Dennis the rather quirky (and exceedingly rich) British/American magazine publisher.

… it’s a tough life 😉

Should you lend money to others to buy real-estate?

A member of Networth IQ asks:

I’m debating on loaning a friend around 30k that I will dervire from a HELOC on my primary residence. I will recieve a flat 16% interest over the 6 months of the loan, and an extra 3% per month for every month if it’s not paid within 6 months. This moeny will be used for remodeling expenses on his investment property. We are in the process of creating a promisory Note and mortgage note for the loan.

Now, I know this is risky for a few different reasons but I don’t know how else I could generate $4,800 over 6 months for an investment of 30k.

Is there any glaring reason not to move forward with this loan?

D’ah, yeah!

Don’t go into business with relatives or friends … and, don’t lend money to them – which is pretty much the same thing, anyway …

… unless they are collateral damage and you are prepared to foreclose on them or sue them at the drop of a hat.

But, for the sake of this post, let’s put aside the “friends” issue and focus on the underlying ‘investment opportunity’ laid out in the question:

This goes to a debate that I was having on another topic about Trust Deeds

[AJC: worth reading just for the entertainment value … you get to see how closed minded and rude some people can be when encountering contrarian thinking] just scroll back to see it)

… my contention is – all other things being equal – is that if you are going to take the risk, why not take the upside as well?

We don’t know the outcome of the remodelling of the investment property. For example, is this ‘friend’ going going to remodel then flip? Or hold?

Let’s take these two scenarios one by one:

Rehab/Flip

You have to ask yourself what the chance of success is in the current market?

Because, if you lend the money and the flip is not successful, how do you get paid back without suing/foreclosing? And, you presumably stand behind the bank, so what chance do you have of getting your money back, if you do foreclose?

If you are going to take this risk, you may as well be in the full-hog and hold equity in the deal to get the full upside, as well.

On the other hand, if the flip is successful, you have taken a major risk for limited upside: if the property can be sold to (a) pay you back your principle, and (b) pay you the interest owed to you, and (c) give the ‘friend’ their required profit, why don’t you just take a split of equity in the deal instead of (as well as?) the interest.

In fact, I would be asking for a split of the profit or equity in a rehab/flip deal, with a minimum payout of the interest component that I would have expected … a kind of cake-and-eat-it approach. Friend or no friend … take it or leave it offer.

Buy/Hold

There are only two ways that I see this as a likely scenario:

1. The Rehab/Flip scenario didn’t work, so the investor/friend team are forced to hold on to the property (foreclosure being the ugly alternative, as discussed above), or

2. The friend intends to approach the bank (or another one) to refinance on the new post-rehab, presumably improved, valuation and use some of the proceeds to pay out investor out … in the current market, a lot of if’s and but’s in there!

The safest approach for both parties in this scenario is to borrow the unimproved value from the bank, add in the $30k from the HELOC as ‘equity’ and hold the property together under some agreed equity split. Paying HELOC interest the whole time doesn’t make sense, so the partnership agreement should spell out the requirement to at least try and refinance every so often.

The advantage: the property increases in value over a sufficiently long hold period (in the current market, who knows how long ‘sufficient’ will be … which is why buy/hold, at least as a backup option to flipping, is so attractive) and you get the negotiated % of the upside.

So, in both cases, by lending the money, you take on significant risks associated with the underlying investment, without access to the underlying capital returns. Why do it?

One final note: by using a HELOC to invest in this new property you are gearing to the max.

This, of course, is a good thing ifyou are (a) certain to flip at a profit, or (b) able to hold and cover the costs of the HELOC long term (or refinance out of it) … pretty big if’s, if you ask me 😛

Is this what a transition to Money 201 should look like?

I received a message from Ethele, a fellow Networth IQ member.

I love this question because it is a chance for me to review all the basics of the 7million7year Philosophy – so new reader, or ‘old hand’, I encourage you to really study this post and all the links that I have included!

Ethele asks:

I was wondering if you can give me some feedback on my plans for moving from Money 101 to Money 201.  At worst, I figure I’ll learn I was silly to ask 🙂  I’m still in the early 101 stages, but want to build a good plan for moving to 201 so I am ready to take advantage of opportunities as they arise.

Our situation:  I only recently got out of debt and bought a house.  Due to the expensive area we live in where the bubble bursting hasn’t been felt very strongly, we spent $370,000 on our home.  We got a 0% down loan, and are paying PMI.  Our NetWorth is currently growing by $1.7K / month, mostly from my J.O.B. I am 25, married to a stay-at-home-parent, with two kids.  Seeking an additional income from my husband isn’t a sensible move right now (he’s anti-J.O.B., has low earning potential, and is not very ambitious), but I am hoping to get him involved in our Money 201 strategy when we get there (and after the kids start kindegarten).

My current plan for getting through 101 is:
1.  Build a small 2 month emergency cushion (by 2009) and invest 6% income into a 401(k) to get the employer match (6 months)
2.  Pre-pay on our mortgage until we have 20% equity in our home (about 4.5 years with current rates of extra income – but will probably be accelerated by raises and bonuses).
3.  Refinance our home, get rid of PMI, lower our payments.
4.  Grow our cushion so we have 6 months expenses (should take about 6 months or less) and can take risks.  Maybe have this additional cushion money do some light work, but nothing too risky.
5.  Start investing our extra income (I’m still fuzzy on how – index funds?  Risk just means we might stay in 101 a little longer – or less long, if we get lucky) and grow until we can invest in a Money 201 strategy – leaning towards rehab / flipping or a rental property, so probably 20% down plus a little more to invest somewhere besides real estate.  This will probably take another three years or so.

Is this what a transition to Money 201 should look like?

Firstly, I responded to Ethele to let her know that I can’t give direct/personal financial advice: (a) it’s not legal – I am not a licensed financial adviser, more importantly (b) how could I possibly have enough information from just one e-mail to know enough about Ethele’s capabilities, hopes, desires, and true financial status to make any reasonable recommendations?

But, I can make some general observations that may assist us all:

Making Money 101 is the basic stage of getting your personal financial house in order … it is the ‘meat and potatoes’ of almost all personal finance blogs that I have read, so why would I bother to even talk about it here?

I agree!

If your plan is to work your entire life; save only via your 401k and buy (then pay down) your own home aiming to retire on $1 – $2 Million when you are 65 then you need read no further.

However, I feel that my audience wants more … they have a ‘big dream’ … they want it now (well, soon’ish) … and it requires fuel – lots of it (money!) – and lots of free time, to boot!

If that’s you, Ethele, then we DO need to revisit Making Money 101 in this blog, because we need to explode some of the myths that will hold you back from your goal of being rich … even before we get to Making Money 201.

Myths like: building a cash emergency fund; paying down our mortgage; diversifying through Index Funds.

So, Ethele, if you are planning to Get Rich Slowly, this isn’t the blog for you … and your plan looks excellent!

However, if you are planning on getting rich(er) quick(er) then you are still on the right track, with a few somewhat controversial tweaks that you may want to consider:

1. Do the math on the 401k + employer match against what you can achieve elsewhere. I have no problem with any answer that you come up with.

2. By all means keep a couple of months of expenses in the bank, but can you find something better to do with 6 months worth of expenses than having it just sit in CD’s: Can you pay down consumer debt? Can you put down a deposit on an investment property? Can you finance renovations to increase rent on something you already own?

3. Can you find a better investment than a diversified Index Fund (by all means use this option over bonds / Mutual Funds, if that’s all that’s available to you inside your 401k)? Maybe Rule # 1 Investing by Pete Town will get you interested in the stock market, or you can consider some of the real-estate options mentioned in #2., above?

4. Does your house fit into the 20% Rule? This is not a measure of % equity that you hold in your own home, rather a measure to ensure that you are always investing at least 75% of your net Worth (as measured by Networth IQ), allowing 5% for other purchases (cars, furniture, etc.).

By doing this, you are indeed transitioning to Making Money 201 … are you sure you need to – and are mentally ready to – make that transition?

So, for all the Etheles out there, food for thought?

More on the debt-free fallacy …

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

__________________________

Recently, I wrote a post that (I hope!) exploded the popular view peddled by the Ramsey/Orman/Frugal crowd: that you should pay down all debt, including your home loan. You will need to read that post to see why it’s such a bad idea.

As expected, the post generated a lot of reader comment, much centered on the theme that owning your own home outright is (a) better than doing nothing (true, but eating pizza every day is also – marginally – better than eating nothing) and (b) a great emotional ‘cushion’.

Money Monk summarized it perhaps most succinctly:

I think it all depends on a person risk tolerance. Some people just love the security of a paid for home. I just think either way is OK. I just would not suggest someone scraping by just to pay off their mortgage. Forcing themselves to live frugally

Either way is definitely not OK:

Sure, either way is better than NO way …

…. but, one way is clearly better than the other way!

The ‘catch 22′ here is that the very thing that these people THINK will make them secure (e.g. paying off their home loan) actually makes them much less so, in the long-term.

That doesn’t mean that you shouldn’t make emotionally-self-satisfying decisions … for example, owning your own home is not always a smart FINANCIAL decision, yet it’s one that I actively encourage people to make for exactly the EMOTIONAL reasons that Money Monk (and others) stated:

http://7million7years.com/2008/01/28/should-you-rent-or-buy/

But, that does NOT mean that you should own the property outright …

… there is far more REAL SECURITY in knowing that you will retire with enough to live off than there is in the FALSE SECURITY of having ‘just’ $1 Mill net worth in, say, 20 years (usually wrapped up in your home ownership):

http://7million7years.com/2008/02/28/is-your-home-an-asset-a-simple-question-with-a-not-so-simple-answer/

But, I’m not out to change EVERYBODY’s view … only SOME people’s: those who want to become Rich(er) Quick(er) ;)

Retirement Planning Made Easy!

Meg, a reader, asks:

My goal has long been to reach $1MM (net worth, not assets) by age 30 – which is under 6 years away for me. I’ve been working actively towards the goal for over a year now, so if I reach it it will have been $1MM in 7yrs. Not nearly as impressive as 7MM in 7 yrs, but that’s if I do it the most conservative way possible with minimal risk and leverage. If all goes according to that plan (which primarily involves utilizing real estate leverage) I will reach $2MM by 35 and then more than double it again by 40…of course that’s almost 2 decades away. Maybe I should look into ramping up my plan with some risk!

[AJC: My response …]

Meg,

Sounds great!

Now, I suggest that you work backwards:

How much income do you need (forget inflation for now, just use today’s dollars) and by when (figure costs of family, college, travel, etc.) … no more work for you OR hubby from then on!

OK, then double that amount for every 20 years until The Date (that accounts for 4% inflation) … and, multiply by 20 (if you want to be really conservtive, multiply by anything up to 40) to get The Number – that’s your Net Worth target (assuming that you also obey the 20% Rule).

Now, do you need to ramp up your plan with some risk, or not?!

Retirement Planning Made Easy! )

Good Luck!

AJC.

Why 99.999% of businesses fail …

This short (less than 2 minute) poorly made commercial for “Dan’s” product or service (or whatever it is that he is offering) is delivered by a ‘talking’ toy car.

Aside from that, he gives a great summary of what it takes to have a business rather than a glorified job. On that basis alone, it’s worth the effort to try and watch without snickering.