The Big Papa lives in the 11th Dimension!

It should be obvious by now, that I am no Einstein … but, we do share a couple of things in common, the least of which is that we both believe in the power of compounding: Einstein is alleged (there is some doubt whether this is even true) to have called it “”the greatest mathematical discovery of all time”, as well as “the greatest force in the universe”, and even “the 8th Wonder of the World”.

Whether that’s true or not, Einstein and I shared one other passion:

Albert Einstein spent the last 30 years of his life “in a fruitless quest for the fabled unified field theory” … this is the Mother of Theories, the one that ties all the other theories of physics (hence, the mechanics and origins of our Universe) together.

This is not directly my passion (I’ll come to that) but I have been dying to talk about this since I first saw a documentary that explained all of this … it just fascinated me, so I will bore you with it – with a weak promise of tying some sort of financial angle into it, just to reel you in to my own morbid fascination:

You see, the closest that modern physicists have come to tying up all the loose ends of science (e.g. what is the Big Bang? What came before it? How can a subatomic particle be in two places at once? etc.) was with the discovery of String Theory.

Once thought to be the Big Mama of science, it all came apart when the String Theorists all came to similar conclusions: these ‘strings’ could be mathematically ‘proved’ in 10 dimensions – therefore, the Universe is in 10 dimensions …

… the only problem was that there were 5 totally different sets of equations which all ‘proved’ the strings (albeit, differently) in 10 dimensions … 5 theories ain’t one theory; in fact, it’s almost as bad as none!

But, then a group of scientists working on proving gravitational waves discovered that their formulas worked well in 11 dimensions.

Aha! Now a group of ‘string theorists’ went ahead and re-worked the 5 lots of ‘string theories’ in 11 dimensions (instead of the original 10) and discovered that they were all the same theory!

The scientists who discovered this (while they were riding on a train to work, by the way!) described it as similar to standing at the base of a hill: depending upon which side of the hill you happen to be standing, the view could be very different … but, it’s only when you stand on top of the hill that you realize that you are looking at different aspects of the same landscape depending upon which direction you happen to be facing at the time.

Using this new insight, scientists are now working on solving the issue of ‘parallel universes’ (the theory says they exist); what happened to cause the Big Bang (it’s what results when two or more parallel universes collide: baby universes!); and, much, much more …

So, God lives in the 11th Dimension!

I promised a financial angle, but I can’t find one other than to share my passion:

Like Einstein, I believe that there is a Unified Theory, but of Personal Finance instead of physics.

I instinctively seem to ‘know’ this .. I have certainly profited from it … and, I have already written pieces of it (including a ‘schematic‘ of what it might ‘look’ like) …

… but, I don’t have it all well-articulated or nicely laid out, yet.

Yet, I believe that when we stand on top of that mountain, each of us will see that the various discussions on the sensible financial forums (e.g. blogs, books, etc.) – discounting the ‘get rich quick’ crackpots; various financial con artists; and the ‘one trick ponies’ (who luck on one way of making a little money, then proceed to create an information publishing empire from it) …

… are really just different aspects of the same sound financial framework.

If you look out at the “young and just getting started” vista, you will see one aspect; when you look at “work for 40 years then live quietly and comfortably” you will see another aspect; and, when you look in an entirely different direction you will see all of us in the “aim for a big Number and get there” group.

Same hill, same earth, but slightly different paths and different terrain to cross … same underlying ‘laws of finance’.

So, in encouraging me to keep writing this blog – and, in challenging, commenting, criticizing, supporting it – you are helping me to clarify in my own mind what this ‘unified financial theory’, if there really is one, might really look like.

When I can write the ‘equations’ out, you will be the first to know!

There, the ‘secret’ of why some rich, ‘retired’ guy is doing all of this – when he should be lying back in his hammock, drinking Pina Coladas – is finally out 🙂

The hidden 'tax' on your 401(k) …

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ANNOUNCEMENT: If you haven’t yet caught up with the latest on our 7 Millionaires … in Training! ‘grand experiment’, now’s the time! We have (finally) selected our 7 MITs and this post will bring you up to date with what they (and you) need to review if you really want to get rich. Click here for more …

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One of the main reasons that people provide for saving via their 401(k) rather than investing elsewhere is the tax benefit: the money that you (and, your employer via their ‘match’) put into your 401(k) is in ‘pre tax dollars’.

But, keep in mind that there is a hidden ‘tax’ on your 401(k) because of the types of investments that you are forced to choose from: mutual funds.

That hidden ‘tax’ is fees, which the Division of Investment Management in their December 2000 “Report on Mutual Fund Fees and Expenses says averages 1.88% (if you amortize the sales commissions over 5 years … if you commit to holding the fund for 10 years, without topping up or selling down, then the average fee drops to 1.52%).

These fees have been trending up (they averaged 1.79% in 1992), so may very well be higher now.

So what?

Well the report says:

The growth of the fund industry has been accompanied by a debate over the appropriate level of fund fees. The focus on fund fees is important because they can have a dramatic impact on an investor’s return. For example, a 1% increase in a fund’s annual expenses can reduce an investor’s ending account balance in that fund by 18% after twenty years.

Scott Burns in his latest book (Spend ’til the End) says:

While annual expenses of, say, 1.4% [as we now know, this is an underestimate] for a mutual fund may seem reasonable, paying them is equivalent to being hit with a tax that exceeds 35% – the highest marginal federal income tax rate.

While this last part of the statement is a bit, how shall we say, sensationalist (the ‘tax’ comes at the end, so you are still better off than paying tax on the ‘input’ … so, this is an argument against high -fee Mutual Funds, not 401k’s … you’ll have to go here for that!) the principle is correct ….

… as Scott goes on to point out:

This is not obvious. Wall Street tells us the cost is modest because common stocks can be expected to return an inflation-adjusted 9.1% a year, and 1.40 percent in fees is only 14.6 percent of this expected return. And, if our manager is worth what we pay her, she’ll make a higher return.

Well, that’s why we invest in Mutual Funds … to get the Fund Manager’s expertise!

But does it work? Not according to Scott:

The reality is different. First, most managers fail to beat their appointed benchmark. And they tend to trail it by an amount equal to their expenses. The greater the expenses, the greater the investors’ loss of return.

There you have it … solid reasons NOT to invest in most Mutual Funds, and – as Scott recommends in his book – “invest in equities only via Index Funds” …

… except that these aren’t going to work for you either!

Why?

Because you have to focus on RETURNS first and FEES and TAXES later!

The clue comes in the expected 9.1% return for ‘common stocks’ less any fees that you have to pay (even the paltry .10 to .20 percent that you will pay on some low-cost Index Funds).

Will this 9% Net Return (equivalent to a 11.25% – 12.15% net return, depending upon your tax bracket,  + employer match, which will tend towards an extra 1% – 3% annual return, IF you are investing via a 401k) get you to Your Number?

If so, then heed Scott’s advice and invest in Low-Cost Index Funds (preferably via a 401k or other tax-advantaged vehicle).

If not, then start looking for where else you can increase your income and/or investment returns (preferably via a tax-advantaged vehicle), or you simply won’t make it!

What is risk?

Jeff raises a great question about the nature of risk; he is talking specifically about real-estate investing when he says:

After reading a couple books, it looks like the majority of the return comes from leveraging your money and keeping your money leveraged over your holding period. Also, reinvesting your cash flows into another investment (instead of living off of them) adds additional compounded return over the long haul. These, however, dramatically increase risk…but, no risk, no reward.

Now, I need to make a point right here: I talk about real-estate (RE) investing a lot … and, I certainly made a lot of money in RE … so, it follows that I am in love with RE, right?

Actually, no.

I hate investing … I dislike real-estate … I abhor risk …

…. it’s just that I hate NOT investing even more. Seriously.

I have a lot of money sitting in the bank earning interest (an excellent rate, if I may say so myself); but all I can think of is that it’s not working fully for me … I am not anywhere near maximizing my return. Where’s the capital gains?

In the bank, there is none.

So, I am FORCED to look elsewhere to invest, and I inevitably end up back at real-estate. I do it because, for me, it represents the best risk/reward trade-off that I can find … IF I am certain that I can cover the cash flows if things go south for a while (repairs and maintenance, loss of tenancy, etc.).

Jeff is absolutely right about RE’s ability to get returns ” from leveraging your money and keeping your money leveraged over your holding period”.

But, back to Jeff’s questions about risk: when Jeff says that leverage = risk, he is technically correct but absolutely incorrect.

Let’s take a look at the technical nature of risk:

Case 1 – RE v CD

We compare the risk of investing our $100k into a $100k piece of real-estate (no borrowings, and for the sake of the discussion no closing costs) v. into a bank CD and we realize that the piece of real-estate and CD produce differing rates of return: according to common wisdom, slightly above inflation for the RE and about even with inflation for the CD.

But, the RE can burn down, lose a tenant, etc. etc. Of course, on the plus side, you can rehab the property cheaply and increase returns; choose better tenants; find a high-growth area; etc.

The CD is fully government-insured (hence the $100k limit for this exercise); and, you can look around for the best CD deal (from an insured bank!) in town.

Bottom line: Slightly different rates of return, markedly different risks.

Intuitively, we understand that there is a relationship between risk and return and the RE v CD example illustrates that in a way that we can all understand.

Case 2 – RE v RE

Let’s say that you decide that the better return from RE is worth the increased ‘risk’.

RE can be leveraged; so that must increase risk? Again, technically ‘yes’, but let’s look at it in practice:

0% leveraged RE v 100% leveraged RE:

If the ‘sub-prime crisis’ didn’t show the risk (not necessarily the folly) of ‘no money down’ RE deals, then we may as well stop the discussion right here, because we all know that fully-leveraging a property is much more risky than owning it outright (it’s why we pay down our home loans, right?)

But what about 0% leveraged RE v just 20% leveraged RE?

Does that seem a lot more risky to you? If not, what about 0% leverage v 40% leverage … and so on.

In other words, risk is also personal: once you decide to invest in an asset class – say, RE – there is no magical point at which leverage becomes ‘risky’ or ‘not risky’ (unless you were one of the people who thought that 20% leverage was ‘risky’).

The point here is to show that whilst there is indeed technical risk, it can be highly subjective and frankly far less important to your financial decision making than ‘absolute risk’ …

Absolute Risk

To put this in perspective, we all know that trying to jump over roofs between buildings is risky. Much more ‘technically’ risky than going through the fire doors, down the fire-stairs, into the street, then reversing these steps in the next building …

… but, if you are Jason Bourne and a CIA Operative is coming through the doorway behind you with a BIG GUN (did I mention that you were out of bullets?) to ‘take you out’, don’t you think that you just might suddenly ignore the ‘technical risk’ and jump across anyway (if you thought there was any reasonable chance that you might make it)?

Instead you might decide to try and surprise the armed assailant with a karate chop (what is the ‘technical risk’ of karate chop v armed assailant?) … in other words, you mostly ignore ‘technical risk’ because the ‘absolute risk’ of failure is too great.

Equally, financially-speaking, ‘absolute risk’ is the only risk that really matters; it simply asks:

What is the risk that [insert preferred method of investing here] won’t be enough for me to make my financial goals i.e. my Number /Date?

If putting your money in a bank CD that earns 4.5% gets you to your financial goals, then that’s probably what you will/should do.

But, if it won’t what do you do?

It all depends on how important your financial goal really is, doesn’t it?

How big does your business need to be?

I explained to Scott [AJC: not the same Scott who helped us build our Perpetual Money Machine, most of last week; this Scott is one of our 7 Millionaires … In Training!] that his “zero to $10 Million in10 years” financial rocket ship would need to be powered by a potent kind of fuel: one that can deliver a 67% compound annual growth rate …

… and, that kind of growth usually only comes from one place: starting your own business.

Yep … super-growth is the just reward for the entrepreneurial mind set.

But, most won’t even start because super-high growth means assuming more risk; and, many who do take this path fail miserably … or, miss their target completely.

Still, a $10 Mill. / 10 year target – or even a $7 mill. / 7years target – can probably only be achieved with your own business … one that you start yourself so that you can minimize capital (if you buy a business, you are paying precious capital to somebody else, and usually they are selling because the growth rate isn’t stellar).

But, how big does that business need to be?

Well, if you don’t have a target, most people are happy if their business can bring in a decent ‘salary’ …

… but, that’s not enough for you. Because now you have a Life’s Purpose and that needs a certain Number to ‘fuel’ it!

For anybody in business, or aspiring to be in business, here are the steps that will tell you how big your business needs to be:

1. Get a handle on your Life’s Purpose: I’ve already laid out a step-by-step process that will only take a few days to think through (but, will change the way you think about money).

2. Derive your Number / Date combo.: Understanding your Life’s Purpose will tell you are awful lot about how much money you need to generate (Your Number) and by when (Your Date).

3. Set the future sale price of your business: The chances are, your ‘nest egg’ (i.e. your Number) will only come from one place – from selling your business (you might decide to keep it, but let’s assume that the end goal is to sell it, for now). So, let’s assume that you have to sell your business for at least the amount of Your Number (you can subtract any houses or other assets that you are sure that you will have by then).

4. Set your end profit target: Most businesses sell for 3 to 5 times their earnings after tax; professional practices often sell for 0.75 to 1.5 times their annual billings/fees … just check with an accountant and reputable business broker how similar businesses in your area are typically valued (they will usually also tell you to value your inventory, if you carry any … you can probably ignore that for now).

So, it’s simple to work backwards from your Number (hence required business sale price) to see how big your business needs to be in terms of earnings (i.e. net profit) or fees/revenue. Just a rough calc. will be plenty to …

… scare the pants off you!

I’ve said before that understanding my Life’s Purpose was the most profound thing that I ever did … and, I was talking pure finances when I said that – not visualization, self-actualization, or any kind of pop-psychology mumbo jumbo!

You see, when I did this exercise in 1998, I had two small businesses that just managed to break-even (after paying me a nominal salary) after a number of years of operation.

When I suddenly realized that I had just 5 years to turn the loss-making two businesses combined that I already owned for better or (mainly) worse, into a $1.5 million per year net profit powerhouse, I immediately started to look at the businesses very differently …

… and, that’s what suddenly took me on a global hunt for expansion possibilities, resulting in joint ventures in three countries, including the USA, growing my portfolio from 2 loss-making businesses to 5 profitable businesses in less than the 5 years that I allowed myself.

It also sparked the search for an investment portfolio (centered largely on real-estate, at the time) that actually got me to my target even without needing to sell my businesses … that just became the cream on top 😉

There’s no way any of this would have occurred without the spur [AJC: more a kick up the … ] that truly understanding the financial implications of my Life’s Purpose gave me.

Now that you know how … go and do it, too!

How to bullet-proof your assets …

Surprisingly good advice from a somewhat unusual source (this guy is a self-proclaimed ‘internet marketing guru’ rather than an attorney, it seems) …

… he says 7 steps, but it’s actually three steps:

1. Separate your personal assets from your business assets – in fact, most of our personal assets are in my wife’s name, not mine.

2. Put your business assets in an LLC – actually, I use a combination of trusts and LLC’s, but this is where a good attorney and accountant comes in handy!

3. Separate your investments into separate LLC’s – I agree with this completely; I have more companies that I know what to do with, each houses just one business or investment (say, one property).

He also glosses over a ciritcal step, if you can swing it (I never did this … but, in hindsight, it’s a wonderful thing to do): separate your business into TWO companies – one holds the client contracts (hence, the revenues), and the other provides management services (hence the costs).

But, here’s the beautiful thing: the management company charges just enough (check with an attorney on how to do this right!) to keep the ‘fronting company’ (i.e. the one with the client contract) at roughly break-even … it’s the one that’s most likely to get sued by customers (those are the expensive law suits!) whereas the management company is the one most likely to get sued by employees.

For information on company protection and charging orders, check out these two links:

http://www.assetprotectionbook.com/charging_orders_intro.htm

http://www.assetprotectioncorp.com/chargingorderprotection.html

The bottom line: DON’T hold businesses or other active investments (e.g. real-estate) in (a) your own name, or (b) as ‘doing business as’ or (c) in the type of entity where the ‘general partners’ are held personally liable for the performance of the ‘business’.

How much to spend on a house – Part II

One of my earliest posts introduced the 20% Rule which is a guide to how much to spend on a house.

Naturally, it was one of my most popular posts.

The 20% Rule is simply this:

You should INVEST no more than 20% of your Net Worth into your house.

Strangely, nobody took me to task, because it doesn’t really tell you how much to spend on a house!

It merely tells you how much equity to have invested in your own home. It doesn’t tell you how much house you can actually afford to buy, because houses can be financed.

For your first home purchase, or any new home purchase, the 20% Rule effectively tells you how much deposit you can afford, because (at purchase, and subject to closing costs) your deposit generally represents your equity in the property.

And, the bank will then tell you how much you can afford to borrow …

… unfortunately, they won’t tell you how much you SHOULD borrow … only how much you CAN borrow.

Put your deposit + mortgage together, and there’s your house!

Michael Masterson, in his new book [AJC: the first 41 pages are excellent] makes it a rule to never spend more than 25% of his net (i.e. after tax) income on housing.

I agree … this is less than the 30% – 35% ‘rule’ that the banks normally apply (although, sometimes that will only allow 35% of your pre-tax income).

For your first home, the chances are that you will need to break the 20% Equity Rule and probably also the 2% Income rule … and, that’s OK.

I want you to buy your first home … it gets you onto a ‘wealth train’ that I want you to board.

When these rules – together – are helpful is:

1. When you are sitting on too much house: the 20% Equity Rule will ‘force’ you to pull out some of that equity and put it into another form of investment (maybe stocks, maybe another rental property, etc.) or

2. When you want to upgrade to too much house: You’ve outgrown your current home and want to buy a bigger one. Now that you are on the train, there is not so much ‘wealth creation’ pressure on you to buy a bigger/better house, only lifestyle (or spouse-style) pressure to upgrade.

So the combination of these two rules will tell you what you can afford:

1. The 20% Equity Rule will tell you the maximum deposit that you can put into the new home (i.e. up to 20% of your Net Worth … most of which is probably represented by the equity in your current house, anyway), and

2. The 25% Income Rule will tell you what mortgage payments you can afford to make (I am suggesting 30 year fixed interest) … use a simple online mortgage calculator (you may need to run a few trial-and-error iterations, as most aren’t designed to run ‘backwards’) to see what is the maximum size mortgage you can ‘afford’ where the monthly payments total no more than 25% of your annual net (after tax) income.

By the way, since keeping your old house and using its equity to help finance the new house (if you can find a bank to come to the party – which may be difficult for the next couple of years) doesn’t change your Net Worth, why don’t you try and keep your old house as a rental?

The Perpetual Money Machine begins to wind itself up!

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I’m about to find out if I can make money on-line … read the latest installment (just posted) here!

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Your Perpetual Money Machine begins to wind itself up (in the case of selecting RE as your ‘income capacitor’) simply when the property portfolio that we discussed on Wednesday becomes cashflow positive …

… this is a critical point in time, because now we can exponentially accelerate the size of our pool of capacitors!

Now, we can take our 15%++ (continually growing as our income stream continues to grow) and ADD the excess cash spun off by our profitable property portfolio (assuming that we selected real-estate, as our ‘income capacitor’ i.e. storage device for money) …

…. this ALL goes into: new properties!

Now, Scott is building a whole bank of financial ‘income capacitors’ …but, for what purpose?

Aah, until the point in time that the income from these ‘capacitors’ is enough to replace Scott’s income from his inventions and movie royalties!

If you have been following the process, this can happen surprisingly quickly (5 to 10 years) IF the income stream that Scott is seeding with is large enough to purchase large ($1 million+ each) commercial properties.

If residential (incl. larger multi-family) you can expect it to take a little longer, as these tend to start more cashflow-negative, or grow too slowly.

At this point in time – assuming that the income-replacement is sufficient to satisfy Scott ‘forever’ (if not, keep working/building a few more years) – we have our Perpetual Money Machine!

You see, the real-estate will continue to grow, even if you no longer continue to ‘seed it’ with more income … in fact, it will grow (on average) at least according to inflation, producing an income that also at least grows with inflation (even allowing for keeping 25% aside as a buffer against repairs/maintenance/vacancies/etc.).

Scott can spend that entire income with impunity, knowing that his capital is never at risk … just like cash in the bank, only better because the capital also grows (at least) with inflation …. provided that your outlook is long enough.

On the other hand, if Scott chose to put his money into Berkshire Hathaway stocks, instead of the real-estate portfolio that we discussed here, which have grown at 21% compound for the past 20+ years (although, not even Warren Buffett suggests that that rate of growth will continue), then Scott can simply sell down enough stock each year to fund the next year’s income.

Different tool, hopefully a similar result …

In either case, when Scott’s royalty income stops, his Perpetual Money Machine seamlessly and automatically takes over.

Nice for some 😉

PS The mechanical/electronic Perpetual Motion Machine is impossible in physics (although, quantum mechanics may provide a solution) … the one depicted in the image above was built in 1996 and resides in a vault in a Norwegian gallery: it once ran as long as 14-days in a row without stopping … hardly ‘perpetual’ but pretty, damn good!

Motion begets motion …

No, we are not talking about the effect of prune juice of the vital bits of our digestive system!

We are talking about beginning to wind up our Perpetual Money Machine (believe it or not, the above ‘prune bush-driven machine’ achieves both objectives!?) …

… the one that we are designing for Scott who is earning a great passive-seeming income (but, not really because it comes as royalties from various movies and inventions that Scott has created over time, not actually from cash in the bank or the equivalent).

Scott already understands this:

Have some in real estate, but not much. What is your take on the time it takes to start realizing a “substantial” income from real estate?

Longer than you think, Scott 🙂

The problem is that RE has a ‘lag’ time that is hard to estimate: you need to cover closing costs, rehab costs, tenancy costs just to ‘wind the property up’ … and, it’s possible (likely) that you will need to wait X years until inflationary forces push rents up higher than your (hopefully, fixed) mortgage costs (plus the costs of maintenance, vacancies, property taxes, etc.).

Of course, on the PLUS side you have depreciation allowances and tax benefits that can produce paper-profits, but these take very careful management to live off 😉

It’s why building a real-estate portfolio, while you can still seed it with income, is better than waiting until you can cash out (i.e. retire and cash out your 401k; sell your business; discount your annuity/royalty incomes by selling these) … you may find that you become ‘asset rich and cash poor’ for a while.

There has been many a successful business owner who has sold their business only to suddenly become ‘poor’ by putting all of their nest-egg into newly acquired RE  …

… but, that won’t be you, Scott, because you are building your Perpetual Money Machine while you still have increasing incomes.

In fact, this is the key!

You still keep ‘seeding’ your RE portfolio with the same/growing 15%++ of your income until you no longer need to cover the negative cash flows from the current ‘income capacitor’ (i.e. property/s) and have saved enough as a deposit (plus buffer for contingencies) for your next one/s.

You repeat this process until you have too many capacitors/properties to manage, in which case you trade up through a series of 1031 Exchanges until you have a manageable portfolio, and …
Final installment of this series of posts on Friday

How to build a Perpetual Money Machine!

Yesterday, we introduced Scott, one of the creators and stars of the success documentary, Pass It On.

Scott wanted to know if his royalty streams (he is also a prolific inventor who teaches others how to invent) meant that he was a multimillionaire.

I’ll leave you to read that post, but the answer, as you may have guessed, is “yes … but” with the ‘but’ being that he has to guarantee his future income by building his own Perpetual Money Machine!

Unlike the world of Newtonian physics, where it is impossible to build a Perpetual Motion Machine (most closely approximated by those desktop ‘toys’ with the liquids or magnets that seem to rotate and swing ALMOST ‘forever’), it is actually quite easy to build a Perpetual Money Machine:

This is ideal – and, quite necessary – for anybody who has an income stream that they want to guarantee …

… and, isn’t that everybody with a job, or in business?

Our Perpetual Money Machine needs two components:

1. An income ‘energy source’ – a source of cashflow to ‘seed’ the machine

2. An income ‘capacitor’ – a means to store/recycle the financial energy until an excess is created

This ‘money machine’ becomes ‘perpetual’ when enough cash begins to spin off to become it’s own energy source …

… but, it becomes useful when it (soon after) also begins to spin off excess cash that we can spend!

Fortunately, this is a lot easier to ‘build’ (at least, in principle) than it is to describe.

Let’s take a simple example:

Joe is working at his job; he earns a income – that’s his ‘energy source’: his weekly paycheck.

Instead of opting to spend all of his money, he decides to ‘seed’ (i.e. save 15% of his gross salary) his ‘capacitor’ (in this case his 401k) until he has amassed $2 million. This takes Joe 30 years.

Joe then retires, reinvesting his nest egg into various ‘safe’ investments (as recommended by his financial adviser) that return 10% every year (in this Utopian world, there are no variances from ‘average’) which is 5% above inflation (ditto for inflation) and Joe can safely spend 5% of a pie that keeps growing with inflation, well, pretty much forever.

Of course, Joe had to work for 30 years to achieve this result and we had to suspend the laws of ‘financial physics’ to make it work, so let’s build Scott a ‘real’ Perpetual Money Machine:

Scott has a current income from his royalties: this is his ‘energy source’ and we can trust Scott to continue to build this energy source even further, but he realizes that all energy sources eventually dissipate.

So, instead of spending all of it, Scott puts at least 15% of his income from his inventions/movies/etc. towards his first capacitor (where he temporarily stores it is of little consequence; a bank is ideal).

Why 15%?

Well, we assume that until now, Scott has been spending all of his income in the belief that he already had a ‘perpetual money machine’ … if not, then maybe Scott can begin with even more than 15% 🙂

As Scott increases his income, now realizing that it is not ‘perpetual’, he also diverts at least 50% of the additional income towards building his Perpetual Money Machine … he sacrifices a little bit of ‘current increased lifestyle’ for ‘guaranteed future lifestyle’.

When Scott has ‘enough’ (and, that is up to Scott to determine) he ‘seeds his income capacitor’ by purchasing an investment property: if Scott wants a series of ‘small capacitors’ he buys residential (houses, condos, up to quadraplexes); if he wants a ‘large capacitor’ he buys commercial (multi-unit apartment complexes, offices, strip shops, etc.).

My recommendation is that Scott uses the largest ‘capacitor’ that he can afford right now … he can always trade up later, if he wants to consolidate into fewer capacitors/properties.

Now, does it have to be real-estate?

Of course not, it just needs to be anything that you can buy/hold that produces an income: it can be divided-producing stocks; Berkshire Hathaway shares (no dividends, but we’ll deal with that later); etc. … but RE is ideal because it can be well-leveraged, eventually produces a mostly-reliable income, but is stable over a long holding period: very handy attributes for a ‘financial capacitor’.

Scott repeats the above process until a  magical point in time … when the Perpetual Money Machine starts to wind itself up!

To be continued … 😉

If it's not Passive, it's Active …

I received a great question/comment from an unusual source: Scott who is a prolific inventor, known actor (ever see Beethoven 2 and 3?), and movie industry ‘mover/shaker’:

I generate income through intellectual properties… Inventions, movie royalties and so on. I receive royalties every quarter (or so) from many sources, the total of which far exceeds the return on one million dollars in the bank. This is passive (royalty) money.

Irrespective of one’s actual money in the bank, is it safe to say that if one is realizing the income (passively) as if having the millions in the bank, that they are living the life of a millionaire?

Is it safe to assume that if someone were doing this for a living they’d be living as if having the million(s) in the bank?

Even though Scott seems comfortable in the continuity of the income streams (he has “many on the retail shelf and on T.V. with many more coming. It’s just what I do.”), I am not quite as comfortable.

As I said to Scott:

You need to look at the certainty and longevity of those royalties and incomes … unlike cash in the bank, your ‘Life of Riley’ lasts only as long as the income keeps coming in.

You see what Scott has is NOT passive income; it’s BUSINESS INCOME and business income is most assuredly not ‘passive’ … it’s ACTIVE.

‘Active’ implies risk …

Even though Scott can create a product, put a team around it, and set it free to generate ‘passive income’ via royalties, etc. it is not enough to say that Scott is as rich as, say, somebody with enough cash just sitting in the bank on CD’s generating the same income, merely from interest, as Scott earns from the fruits of his creativity.

The money in the bank will keep generating interest for ever … the capital NEVER changes (let’s forget inflation for now, which is the real risk for this ‘money in the bank’ strategy).

You see, each ‘product’ (be it a movie, an exercise bike, a kitchen gadget, or whatever) has a ‘life cycle’ – it will either make money from the get-go or flop … if it is a winner (and, it seems like Scott has the Midas Touch, here) it will sell for a period of weeks, months, years until eventually another product will take over and product sales will die … along with Scott’s royalties.

This may happen quickly or slowly, but it will happen!

Since Scott is great at what he does – and loves doing it – this isn’t a problem for Scott: he just goes ahead and creates the next product.

Financially, though, this means that Scott is like any other professional in private practice: once he does stop creating, either by choice or because of disaster, sooner or later the income will stop coming.

Now can you see the difference between the ‘passive income’ generated by a few million in the bank and a similar level of ‘active income’ generated by Scott’s creativity?

Great! So, what can Scott do?

Well, the same thing as anybody earning an income either through their own sweat/blood/tears or through a business:

Scott could try and estimate the future cash flows of each of his product streams and see how long they will take to die down/ disappear as if he never created another product as of today and basically tie his current life-style to the present value (smoothed) of that future income stream.

If disaster doesn’t strike, Scott can review each year and adjust his ‘smoothed’ income stream, accordingly … but, this doesn’t solve the fundamental problem, so Scott should also:

Build a Perpetual Money Machine …

To Be Continued … 😉