Monthly Archives: July 2008

One more time …

Posted on by
Reply

You can check out 7million7years and other great personal finance blogs at Money Talks … in the meantime, here is today’s post …

I’ve written a whole series of posts just focused on one thing: understanding whether you are in the BUSINESS of the stock market, or are you in some other profession/business just looking to save a little or invest a lot … and, have chosen the stock market as your vehicle (instead of, or as well as, real-estate, etc.)?

If you are in the BUSINESS of the stock market, and very few of us are (I’m not), then you treat it as a Making Money 201 BUSINESS i.e. to create income (either through dividends, profits on trades, or capital appreciation).

“You puts your money and you takes your chances”, as the old fair-ground spruiker once said.

If you are NOT in the BUSINESS of the market, then what should you do? Well, go back and read those posts, starting with this one …. they are designed to STOP you wasting your time chasing the impossible so that you can INVEST more time in the activities that will actually stand the best chance of making YOU money.

I received a couple of important comments from Moom to that post (and the one the day before):

I’m not sure there’s much difference between option 2 and being a speculator/trader. Most people aren’t going to beat the stock indices doing this on a risk adjusted basis. As I said yesterday, you’ve got to ask yourself: “do I have an “edge” that can beat the market” and if you do can it earn enough in above market returns to make your time invested worthwhile. If you only earn 1% above the market and only have $100,000 to invest it’s not worth spending much time on investing except in order to learn to be better.

It might make sense for someone with say $100-200k at least to invest to build a portfolio of just individual stocks they like. On the other hand ETFs/index funds in the US have very low management costs and so it might not make much sense unless they have an edge of some sort or just enjoy owning these different companies and their “stories”.

Another option is to select good managers. But that might be as tough for most people to determine as selecting good stocks.

My comments yesterday were that there are ways to earn equity like returns with lower volatility without trading (except rebalancing) or much in the way of security selection. You need to include lots of asset classes and use cheap leverage (mortgages and levered funds like SSO) where possible so that you can get an equity like return while including some stuff in your portfolio that earns less than equities (like bonds).

The point here is to understand which side of the fence that you lie; it’s a Binary Choice:

1. Dollar-cost-average into low-cost Index Funds over a 20+ year period, OR

2. Spend the time and effort to identify 4 to 5 undervalued companies that you understand, love, and believe have a strong reason for being able to stick around for, say, 100 years (try Coke … except it’s not undervalued) and buy those to hold for 20+ years or until the market ‘wakes up’ to their true value (I have nothing against you trading/in out of these stocks on the way up … equally, I have nothing against you just holding them).

The SAVER is looking for market returns over 20 years by dollar-cost-averaging into safe Index Funds: $100k becomes $400k+ (the reality is that they will be topping up regularly for an even bigger nest-egg circa $1 Mill.)

The INVESTOR is looking for circa DOUBLE market returns over 10 – years by investing in the stocks of a few well-chosen undervalued businesses: $100k becomes $1.4 Mill.!

To me, there are NO other [stock market-related] choices for the non-gambler (who is in the ‘business’ of trading/speculating a la Soros and a select few).

The 7million7years Binary Stock Strategy Selector 🙂 is designed to STOP you from wasting YOUR precious time and money chasing funds, managers, the market, etc …

… and, concentrate on building YOUR core skills (e.g. your profession; your business; your talents; etc.) and maximising YOUR return from THOSE.

This is not just me saying this; it’s Warren Buffett as well … but, we’re just two conservative rich guys (one ultra … Hint: his initials are WB … the other so/so) … what do we know 😉

But, here’s where I differ from Warren: IF your core skill is ‘speculating’ [AJC: and, this might be you, Moom?] … then, go for it … but, treat it as your BUSINESS …

…. and make sure you invest the proceeds in one of the other, safer ways available, just in case you ever get it wrong!

What's new in the vault?

Posted on by
2

For today’s entry in my Videos on Sundays series I thought that I would take a recent video from the archives ….

It was cut from my last ‘live feed’ taken from my hotel room in Sedona, Arizona … one of the most beautiful places on this planet: Sedona itself, not my hotel room! 🙂

If yuo want to see more, check out the archive of videos from my AJC [live] Feed Thursday night chat shows, the AJC Vault. Here is the key to unlock the vault …

The only emergency is the drain on your finances …

Posted on by
Reply

Do you have an Emergency Fund?

To me, an ’emergency’ is usually something like a problem with the house or car, losing/changing jobs, or a health problem. These are all real and can all take significant chunks of cash …

… but, if you can reasonably forecast their likelihood up front (i.e. you have a family member with a known or suspected ‘condition’; a crappy house/car/job; etc.), then they’re not ’emergencies’ – in my book, they are ‘time bombs’ – and you should be budgeting/saving a specific amount to cover the expected cost + a margin of safety, as best you can.

They are not ’emergencies’ for the sake of this post …

… they are the unfortunate realities of your life and you need to prepare for them properly – even if it has to come at the short-term ‘expense’ of your Investment Strategy.

No, what I am talking about is the ‘lucky majority’ who have good jobs, homes, cars, health – besides partying VERY hard to celebrate our good fortune – how much of an Emergency Fund should we have?

1 month? 3 months? 6 months? More?

OK, let’s bust the myth of keeping 3 to 6 months cash sitting in an Emergency Fund!

Never had one, don’t want one … and, if I was to keep one, it would have 2 years of income sitting in it (in a mixture of redeemable bonds, cash in various currencies, and gold coins/bullion) so that I could run and survive “when the [insert disaster of choice: Russians/Arabs/WWIII] come”.

So, does that mean that I don’t have cash?! Hell no … it’s just that it’s not for emergencies … it’s for investing. And, as I said, when I was still building my wealth, I never kept an emergency fund.

We did keep cash surplus for unexpected bills, etc. but never more than a month or two of income … at least, not for long … here’s why:

What happens if no emergencies crop up in the next 5 years?

If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $1,700.

If you had $10,000 sitting in an Index Fund you would have earned nearly $3,500.

 

What happens if no emergencies crop up in the next 10 years?

If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $4,200.

If you had $10,000 sitting in an Index Fund you would have earned nearly $10,000.

 

What happens if no emergencies crop up in the next 20 years?

If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $11,000.

If you had $10,000 sitting in an Index Fund you would have earned nearly $33,000.

Get the picture …. that’s a $22,000 ‘premium’ to cover a possible emergency!

It gets better ….

What if you had committed that $10,000 to a deposit on a $100,000 house? Over 20 years, it would have increased your Net Worth nearly $200,000 !

So, are you willing to pay a $200,000 premium for an insurance ‘insurance policy’ against an emergency?

But, what would I do if an emergency arises:

1. If it’s a ‘planned’ emergency of the kind that I mentioned before, I would borrow against the house, or sell down my stocks ahead of time and put the money aside well ahead of expected use.

2. If it’s an ‘unplanned emergency’ then I would already have taken a HELOC against my home – and, in the event of such an emergency, I would simply draw against it, and put in place a plan to pay it back.

Sure it will cost interest, but that’s the gamble that I took – even if it takes me 5 years to pay it back, the interest bill will pale against the increases that I made by investing those funds (and will continue to make, when I get the debt paid off and my feet back on the ground).

Warning Advanced Strategy: What do I do?

Well, I always pay cash for my houses, but then I take out as big of a HELOC as my wife and bank will allow me (usually more than 50% of the equity that I hold).

Then I draw down the full value of that HELOC and invest in individual stocks (an Index Fund is a fine alternative for the purposes of what we are discussing) … if I happen to need the money for an emergency, I sell off all or part of my investment and divert the HELOC borrowings to that use. So far, I haven’t had to. 

Loss on the stock? That’s market timing, which is why this is an ’emergency strategy’ only …

… the key is not to take a certain hit on your finances for the possible loss in an emergency. Equally, it means not sticking your head in the sand, and having a contingency plan in place i.e. a way to deal with emergencies if they do crop up.

But, Buffett doesn't use Stop Losses …

Posted on by
2

On my first Live Chat Show, in response to a viewer question, I discussed the theory of Stop Losses (I just posted on this, so I won’t go into the details here).

Andrew saw the show and asked:

Your webcast today prompted me to look up some more of Warren Buffet’s letters to shareholders and general advice, I wanted to get your take on something I came across that seemed potentially contrary to what you mentioned about your use of stop losses in your webcast today.

Warren said he believes that when you invest in a company you should be able to see it go down in value by as much as 50% and not sell off because you know that you already bought it at a steep value. I know this is potentially different than what you mentioned because you were talking about protecting gains, but if you have the time let me know what you think.

I’m amazed that my web-casts can prompt anybody to do anything! Well done, Andrew!

The way that I see it …

… there are two ways to invest: (a) buy and hold through thick and thin, (b) trade in/out on market swings.
 
Warren does (a) and I do (b) hence, Warren is (much, much, much) richer than me 😉
Warren’s method takes excellent understanding of the market fundamentals, a stock that provides strong underlying cash-flow, and a business model that will stand the test of time. It also takes an awful lot of faith …
Trading in/out seeks to avoid staying in a falling stock … those choosing this path, generally are trying to move with the ‘Big Boys’ (the institutional ‘insiders’ who might have caught wind of some negative news that may put a short-term dent in the company stock) or are trying to avoid getting caught up in a dog that looked like a show-pony.
(b) is also trying to time the market, and we know where that can go …
But, Warren and I agree on the underlying principle: we are both buying a stock that we believe is currently well-underpriced by the market, and one that we would be prepared to hold on to for a very long time.
 
I just trade in/out of the inevitable (and, hopefully, relatively small) up/down swings in what I hope is a generally upward trend … once the stock gets back to market price, I’m out’a there, Baby!
Who’s method works better over the long-term: Warren’s, without a doubt!
Remember, always go with the money 🙂

The Mighty 401k Fights Back!

Posted on by
7

A short while ago I wrote a post challenging the notion that you should automatically plonk your money in your 401k, because:

1. It’s ‘forced savings’

2. It’s pre-tax savings

3. You get free money from your employer!

Yesterday I wrote a follow-up saying acknowledging that these are all good things to have in an investment.

But, not the only things … in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

But, I expected to cop some flak, and here is some of it …

Traciatim said:

Historically real estate tracks inflation, not 6% annually. You’re also forgetting maintenance and property tax, water/sewage, heat, etc. When you want to retire you’re also forgetting the cost of selling the properties.

In fact, this is a really common theme amongst the detractors (there were a lot of positive comments, too) … but, who ever said that you should invest in ordinary residential real-estate in ordinary locations?

Also, those who ‘remembered’ the costs of these direct investments (which I did allow for) , we tend to forget the hidden management costs and fees of the funds that your 401k invests in (which I did not allow for).

Curt said:

If you wait three years, real estate ‘good deals’ will be everywhere and you won’t have to invest the time to find them. That will likely be a better time to move money back into real estate.

This is the mistake of trying to time the market; this affects both the 401k ‘option’ and the alternatives, and probably requires a whole post in itself … if you are interested in the real-estate option (and, it is just one of many non-401k options that you could take) and you can find something that ‘works’ now, go for it!

Paul said:

One major flaw in your analysis…and I’m sure I could find others if I look hard enough:

You’re not accurately accounting for taxes here at all. The contributions to the 401(k) Plan are on a pre-tax basis. If you’re saving money in a bank account to buy real estate, that’s on an after-tax basis. To save $5k in a 401(k) Plan, you have to earn $5k. To save $5k in a bank account, you’ll need to earn $6,667 assuming a 25% tax rate.

I didn’t even talk about the risk inherent in real estate versus a diversified portfolio, or how your analysis of the return on the employer match is a bit off.

While it is good to think in unconventional ways at times, you better make sure you are accurately looking at these scenarios before you risk your entire future on them. While it could pan out, it could also blow up in your face.

Wise words, Paul. Of all the criticisms of my post that I read, Paul’s is most valid: I did not do an after-tax treatment (although, I did mention Capital Gains Tax); it’s just too damn complicated to run the numbers for a post like this … and, doesn’t change the relative outcome.

In fact, why do you think so many wealthy people invest in businesses and real-estate? It’s partly FOR the tax breaks! How much tax do you think that they legitimately pay per dollar earned compared to you, even WITH your 401k?

And, it appears that Pinyo of Moolanomey actually reran the numbers:

AJC – Interesting post, but I have to agree with the naysayers. Your analysis in scenario 1 didn’t include mortgage and other expenses. In part 2 of scenario one where you actually account for expenses and deposit everything into CD, the true advantage is only $63,000 over 30 years and this is before tax — after tax it’s virtually wiped out.

Sorry, Pinyo, on this one we’ll have to agree to disagree … unless you want to share your numbers? Then, I’m happy to do [yet another] followup.

BTW: real-estate is not the only viable alternative to saving in your 401k; my arguments apply to any investment that has the following four characteristics: leverage, depreciation, other tax deduction/s, and inflation protection.

Guys, the critical difference is this one – hardly mentioned in the comments at all: Real-estate has an apparent risk … but, the 401k option has a hidden risk.

I think we all understand the apparent risks of alternate investments v the nice, safe 401k (if you were set to retire at the end of 2007 and you ‘forgot’ to shift the bulk of your funds to the bond market, you may have a slightly different view on this) …

I’ll leave you with one thought: when was the last time that you read this headline:

‘Multimillionaire thanks the tax system for favoring his 401k … says” “without it, I would not be sitting in my beach house in Maui sipping Pina Coladas today” ;)

The Hidden Risk of your 401k …

Posted on by
5

Recently I wrote a post that challenged the ‘Set It And Forget It 401k Brigade’ to at least rethink their strategy instead of just automatically maxing out their 401k …

… in doing so, I mentioned that there was a ‘hidden risk’ in your 401k.

Whilst the 401k proponents put forth all the wonderful, low risk arguments in favor of 401k’s (quoting long-term market averages of 12%+) they conveniently forget:

1. Fees: Figure around 0.5% – 1.5% in fees set by the funds that your 401k invests in and the fees associated with managing the 401k and the underlying funds (but, only the ones that your employer doesn’t pay). Most of these are conveniently hidden in your returns.

2. Market Dips: Did you know that while  the ‘market’ averages 12%+returns, you can only count on 8% as your 30 year return, 4% as your 20 year return, and 0% as your 10 year return from the market. My rule of thumb is: when planning your retirement, count on less … enjoy the possible upside when you are wrong!

3. Inflation: It takes time to get to the nest-egg that your 401k will give you … 20 – 40 years when you are starting out … so $1 Million just ain’t all that much money (now, let alone 20 – 40 years time!).

But, that’s not the hidden risk that I was talking about … it’s much, much more dangerous than those …

… the hidden risk of your 401k is that you may not get enough out of it to retire well.

Almost as bad, you may not care enough now to plan for what may happen then; after all, for you ‘retirement’ may be still 10 – 20 – 40 years away! Although, it need not be …

So, what do I mean?

As I said yesterday, the arguments that the 401k proponents put forth center around: it’s ‘forced savings’; it’s pre-tax savings; and, the possibility that you get free money from your employer!

All good things to have in an investment. But, not the only things …

… in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

Just remember this: there’s nothing holy about a 401k.

The purpose of your 401k investment is NOT to get a tax break, not to put aside 15% of your gross salary a month, and not to get any employer match … they are just (important) features …

Just like any other investment, your 401k’s purpose is to help you get you to Your Number so that you can live Your Dream!

Anything less is just settling for less. So, let’s consider the binary options here:

1. Your 401k will get you to your Number

You know your Number, right? And, you know when you need it?

If not, either read this and do this … or, you’ve just wasted a valuable 3.5 minutes beer drinking, relaxing time that would have had a far more beneficial effect on your life than what you have just read … or, will ever read … on this blog!

And, you know what your 401k can deliver by then, right? Not when your employer says that you retire, but by when you need The Number!

If you haven’t done the calculation yet, ask a Financial Adviser to help you (or follow along with our 7 Millionaires … In Training! at http://7m7y.com starting with this article) …

… you think knowing this might be just a tad important?

Now compare what your 401k is likely to be able to produce (now, I would not be using ‘average returns from the stock market’ for this life-critical calculation … I’d want a buffer … but, that’s really up to you and your bean-counter) with Your Number …

… if they are much the same, stick with your 401k (after all, it is ‘set it and forget it simple’). Then concentrate on keeping your job and, getting bigger and bigger pay-rises, because you’ll need ’em!

2. Your 401k will NOT get you to your Number

If your 401k will not get you to your Number, what choice do you have but to at least consider alternates, be they instead of –  or in addition to – your 401k savings plan …

… be they real-estate, stocks, 2nd/3rd/4th jobs, marrying into money, winning the lottery, businesses … 

…. be they whatever …?

Of course, you could just give up and settle for your lot in life; who am to tell you not to give up on your dreams?

I’ll leave that little job up to Frankie 😉