I’m going to make a fortune, effective immediately!

Screen Shot 2013-03-22 at 9.21.59 PMAs catchy as the title is of today’s post, it has very little (but not, nothing) to do with the image on the left …

… which image simply serves to illustrate my preferred – or, should I say ‘accepted’ – approach to investing.

But, wait, you say!

Surely, the quadrant to the bottom-right (where the combination of profit and risk is optimized) is the most efficient?

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So, why would I want my arrow to hit the target in ‘no mans land’?!

Well, that’s the exact question that I threw to my readers in my last post

There were a lot of amazing comments (and, you should go back and read them all), but Dustin wins a signed copy of my book for his comment, which summarizes my views nicely:

there are significant gains to be made with a moderate increase to your risk … however the long term of the investment should moderate that for the endgame result. Technically it is a less “efficient” investment, but only statisticians care about that, not real world investors.

And, JD earns an ‘honorable mention’ (and, also wins a signed copy of my book) for his comment, which adds a crucial caveat to my views:

I worry less about potential losses for incremental investments. I may be biased since I am young enough to earn it back (I’m in my late 20s)

Whilst I would argue (as would Warren Graham who provided the source chart and much valuable commentary to my original post), that learning about the efficient frontier is valuable to investors, not just statisticians, Dustin has hit the nail on the head by focussing on the “endgame result” …

… for me, your overall investment objective drives everything.

The aim, in my opinion, isn’t to find the optimal investment where ‘optimal’ is defined as sitting on some curve, it’s to find the investment from the limited range typically available to you in the real world that delivers the result that you need.

If you’ve been following this blog for a while, you’ll realize that – in order to pin down that ‘result that you need’ – I advocate a Top Down Approach To Investing:

This means, knowing how much money you need; when you need it; and, using those answers to derive your required annual compound growth rate.

It’s this growth rate, as indicated by the horizontal line on the chart below (the positioning of this line will be different for everybody) that should dictate what investment choices you go after:

Screen Shot 2013-03-22 at 9.41.46 PM

Each of these investment choices (and, in my experience, there will be very few to choose from, since you need access, education, and aptitude in each type of investment in order to proceed) will bring with them their own risk profile …

… and, you will be amazingly lucky, if one of those choices (e.g. as represented by the black squares on the chart above) happen to fall on the intersection of the horizontal line and the ‘efficient frontier’ curve.

If not, and if you want to achieve your Number by your chosen Date [AJC: you do, don’t you?], you will go ahead and make that investment, anyway, even if it doesn’t fit neatly in the quadrant on the bottom-right of the image at the top of this post.

Because, as JD says, even if your investment fails, hopefully, you will still be “young enough to earn it back”.

We get one opportunity to live our Life’s Purpose; we get many opportunities to make investments to help us get there, but only if we have the mettle to choose the ones that have the potential to meet your minimum required annual compound growth rate.

To me, the investment choices that can help us reach our Number are the most effective of investments …

… they just may not be the most efficient 😉

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Surfing the efficient frontier …

Screen Shot 2013-03-22 at 9.21.31 PMOne of my Finnish blogging friends shared this interesting graphic on one of their most recent posts …

The implication is clear:

The best investments …

… in fact, the ideal investment is one that maximizes profit at the lowest possible risk.

Whilst that is ideal, the real world – at least in my opinion – doesn’t work that way.

Why?

– You may not understand the investments that maximize profit at the lowest possible risk

– You may not have access to the investments that maximize profit at the lowest possible risk

In fact, the operative word here is ‘you’ …

… unless you are professional investor, who has access to – and understands fully – all of the investment choices available, you will not be able to surf the ‘efficient frontier’:

Screen Shot 2013-03-22 at 9.41.46 PM

Because of access and education you may only be able to select from a few investments that, if you are lucky and choose well, approximate the efficient frontier, as represented by the four dots in the chart, below:

Screen Shot 2013-03-22 at 9.43.26 PM

In this case, you have lucked out!

Two of your investments have hit the efficient curve smack on, and one is optimal (i.e. best combination of risk/reward), whilst the other will suit the most risk-averse amongst you, as it is efficient, yet carries the least risk (of course, it also produces the lowest return of all the ‘efficient’ choices available to you).

Screen Shot 2013-03-22 at 9.21.59 PMMaths aside, here (diagram to the left) is where I like to position my investments …

… and, where I think most (but not all) of you should like to position yours, as well.

It’s not optimal (higher reward, more risk); probably not even efficient; but, ideal … at least, for my (our?) purposes!

Any idea why?

Why do you think I actually like to assume more risk?

I’ll do a follow up post; in the meantime, I’d like to hear what you think my reasoning will be?

I might even send a signed copy of my book to the person with the best (not necessarily correct) answer 🙂

Tin Stacker or Kite Flyer? Which one are you?

money kiteI fly kites and I stack tins. But, I mainly fly kites. And, it’s all because I understand the true value of money.

Do you? Let’s find out …

The money that you save has a value today and a value in the future.

Aside from money that you save as a short-term buffer against emergencies, or to pay for a trip or other expense coming up soon, the real value of money that you save today is the value that it can provide tomorrow.

But, the ‘tomorrow’ that I am talking about is the one that comes on the day that you decide to begin Life After Work. Some call this retirement; others call it semi-retirement; I call it early retirement … but, that’s really up to you.

So, a dollar today is exactly that: One Today Dollar.

But, in the future, two things happen to that dollar:

1. Inflation erodes it – robbing it of roughly half its value every 20 years, and

2. Investment returns grows it – increasing it according to the annual compound growth rate of that asset class.

With inflation pulling one way (down), you need to find an investment that moves the value of your savings the other way (up); how fast you need to move depends on (a) how much money you need (your Number) and (b) when you need it (your Date).

So, how fast do different types of investments grow?

Well, according to Michael Masterson in his book Seven Years To Seven Figures:

Screen Shot 2013-03-09 at 6.48.05 PM

[AJC: The greater the returns – that is, the lower down the table – the more ‘actively’ this table assumes you will manage the asset e.g. you may only be able to achieve 15% returns on stocks if you follow a system such as Rule #1 Investing. And, without active management – e.g. rehab’ing, flipping; leveraging; etc. – real-estate may only keep pace with inflation]

That’s why the Future Value of $1 could be $100, in just 10 years, if you invest it in a business.

But, that same $1 could be worth only $1.45 in 10 years, if left in CD’s. Now, that’s before inflation …

If inflation runs at its historical average of 4% $1 is only worth $1 in 10 years, 20 years, or 40 years!

So, when Brooke says:

create the proper mindset. then its time to move on to more advanced lessons.

I whole-heartedly agree.

EXCEPT that the “proper mindset” that she – and most others – talk about is saving, paying off debt, saving, living frugally, and … saving.

Which is great, if you value every Today Dollar exactly the same as a Future Dollar.

But, I don’t.

And, neither should you … and, here’s why:

The very first thing that you should do when you are thinking about saving is think about:

How many Future Dollars do you need, when you stop work / retire?

I’m guessing that Number’s at least 20 to 40 times your current expenses, doubled for every 20 years that you are prepared to wait.

[AJC: Ironically, the less you are willing to risk to grow each Future Dollar now, the higher the multiple that you will need e.g. if you are content to keep your savings in mutual funds, then you will need closer to 40 times your current expenses, doubled for every 20 years that you are prepared to wait. If you are prepared to actively invest in some mixture of stocks, real-estate, and/or businesses, then you may only need 20 times]

How much is that for you?

I’m guessing it’s much more that you previously thought.

Now, what has any of this got to do with either flying kites or stacking tins?!

700-00074906Well, when you save, is it going to be so that you can line each Today Dollar that you collect by saving into a nice Today Dollar Tin with all of the others that you get, until you have enough to oil, salt and close … putting it away, with all the other tins that you collect in your working life until – in 20 or 40 years time – you pull all of those tins out of the Tin Storage Bank, dust them off, and find …

… exactly as many Future Dollars as you had Today Dollars, no more no less, and not enough?

Or, will you take each Today Dollar, and when you have enough, make a Future Dollar Kite (it can be a Business Kite, Real-Estate Kite, or possibly a Stock Kite) and let it soar?

And, if it crashes – when it crashes, because of storms and, well, kite-flying whilst you are learning is risky – will you then take a few more of your Today Dollars and make another, and another …

… until one flies, with each Today Dollar used in making it becoming 100 Future Dollars?

[AJC: Most likely, you will also be putting aside a few Today Dollar Tins of your own, for a rainy day – since it need not take many to make a few Kites, and you may as well save something whilst you are at it]

Tin Stacker or Kite Flyer? Which one you choose is up to you …

But, I must warn you – even though most of you are tin-stackers by nature, therefore, should not be surprised when your Future Dollar stock is well short of what I would consider a ‘nice retirement’ – I write solely for the kite-flyers out there!

 

The myth of the millionaire next door …

weep warning

This post will make you cry.

But, it is a post that I have to write.

It’s one that I have been putting off … and, off … and, off.

Why?

Because, I am going to tear apart one last (well, until the next) tenant of finance …

… one that even I have not dared touch until now.

But, I have finally decided to bite the bullet, because there has been a whole generation weaned on an aspiration that, in itself, is a lie.

Yes, I am talking about:

[shock]

The Myth of The Millionaire Next Door.

[horror]

In case you are too young to remember, The Millionaire Next Door is the title of a 1996 best seller by Thomas Stanley and William D. Danko that was touted at the time as revolutionary but, to me, produced a totally mundane and obvious conclusion:

Most of the millionaire households that they profiled did not have the extravagant lifestyles that most people would assume. This finding is backed up by surveys indicating how little these millionaire households have spent on such things as cars, watches, suits, and other luxury products/services. Most importantly, the book gives a list of reasons for why these people managed to accumulate so much wealth (the top one being that “They live below their means”).

[sigh]

The perception after this book was released, becoming an instant – and enduring – best-seller, is that the typical American millionaire is actually your neighbor, the small business owner who has been working for 20+ years on his business, investing (and, reinvesting) its profits rather than spending on lifestyle and luxuries.

In other words, somebody who slips under your radar; somebody you probably ignore; for good reason …

It’s all fine and dandy: like all “spend less than you earn and save, save, save”-driven strategies you, too, will no doubt become a millionaire by the time that you retire, but there are two problems:

1. What about inflation? Start now and, if you take 20 years to become a millionaire, you are really still only half of one in today’s dollars, and

2. Who says that you can wait 20 years?

I certainly couldn’t.

That’s why I call this type of ‘Millionaire Next Door’ business – an ATM business – little more than ‘a job with benefits’ …

… if you really do want to have one of these businesses, then here’s what you need to do:

Do NOT spend the spare business cashflow on personal lifestyle building (homes, cars, vacations, etc.); instead, use that cashflow to fund an aggressive investment portfolio, outside of your business: one that will one day grow to replace your personal income i.e. the amount of money that you DO take from the business to live off.

When the day comes that this passive income surpasses your personal business income, you become free.

However, this freedom does not come simply from saving and investing passively – otherwise, you are simply following the advice given in the Millionaire Next Door and you, too, will slave for the next 20+ years to get there.

Rather, this true financial freedom comes from investing your business profits aggressively and actively, with a mixture of your money and borrowed money, in things such as direct stocks (no funds for you!), and real-estate.

In this fashion, you may still need to work your business for 20 years before you shut it down, but at least you will retire a real millionaire (or better) in today’s dollars.

Far better, instead of starting a lifestyle business that relies on YOU being the front man (e.g. lawn-mowing round; accountancy practice; design studio; etc.), or a business that is tied to a single location (such as a car-wash; a restaurant; a corner shop) …

… start a business that can scale like McDonalds, invest aggressively, and you (too) may be able to do it in 7 😉