LuckyInvestor has been busy building a kind of reference manual / index to our ‘grand experiment’ at 7m7y.com … take a look and let him know what you think (what is he missing? what’s in/out of place? suggestions?) … the only reason why I won’t directly support the site is that I am not sure where it is going and I cannot control if he eventually puts in advertising, which is against my principles for this program (but, he is welcome to) … so, any help that you can / want to give him … check this out: http://luckyinvestormn.blogspot.com/

Now, on with today’s post ….

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If you think you’re confused, then you really are confused!

This seems to be Ethel’s dilemma, one that we inadvertently uncovered when she wrote me an e-mail (on Networth IQ) asking for help on transitioning from Making Money 101 to Making Money 201.

After reading my answer to her original problem Ethel left a long – and critically important – comment, saying:

I’m glad that Ethel asked the question on NWiQ and gave me the opportunity to respond here, because she has summarized very neatly in this comment what I have obviously so far failed to make clear on this blog.

And, that is:

Retirement is not some nebulous date in 30 years when society ‘norms’ say that it’s time to stop working …

… it’s when you need to stop preparing to live and actually start living!

You ‘magic number’ is not merely a number ….

… it’s a DATE.

A date when you need to stop working (or, at least stop working as hard) to concentrate on LIVING your Life’s Purpose.

Rick asks:

What about time commitment? What is a realistic estimate of hrs/year needed to manage a single rental property?

Well, I can only tell you what we do: we only have one property that qualifies as a ‘single rental property’, one little condo in a complex of about 16 units that we do not own, near the beach …

…. and, while we live in the USA, that beach is in Melbourne, Australia!

Also, it’s my wife who manages this one, so I asked her:

It takes about 2 hours per year.

Now, we have another residential property that is a quadruplex; it’s also in Australia and my accountant takes care of that one while we are in the USA.

I checked and it takes him less than 2 hours per month … at least, that’s what he bills me for, so the whole thing probably also takes him about 2 hours per year!

The secret?

Simple: we always hire property managers and get them to take care of everything:

1. Finding tenants

2. Negotiating leases

3. Handling repairs and maintenance

4. Collecting the rents

5. Paying the bills

Doesn’t it cost money?

Sure. 6% – 9% of the rental income (plus usually the first month’s rent for any replacement tenancy after a tenant leaves).

Would it be cheaper doing it ourselves? Of course: we could ‘pay ourselves’ that 6% to 9%, but then:

1. We would eventually suffer burnout. It can be very stressful handling retail tenants.

2. We would be trading (our) time for money.

Trading time for money is exactly the wrong way of looking at it: time is a finite resource; money is an infinite resource, why trade the finite one for the infinite one?

In other words, they keep printing money, but nobody is giving away more time.

So, every time that I can find an opportunity to ‘buy’ time with my money that’s exactly what I will do.

It’s why I give my shirts to the dry cleaners; my mowing to the landscapers; and my property management to the experts. It’s why I outsource practically everything to do with my investments, too – except picking the investments themselves, or managing any issues to do with risk.

If I didn’t outsource my property management, I would eventually stop buying real-estate because every property that I bought would add to my workload, and who wants to do anything that makes you have to work harder? And, I would eventually get what Dave Lindahl calls “tenant burnout” …

So, I may lower my return on each property somewhat, but I reinvest the ‘saved time’ into purchasing more investments … the whole shebang is much greater than the parts.

Ryan asks:

I’d like your opinion on investment newsletters such as those offered by the guys over at Tycoon Research. Is it possible to use this in your money making 201 phase. At the moment I’m still in making money 101 but I can’t shake the idea of leveraging someone else’s knowledge to make you money. Of course, as with all things, you should know enough not to be taken for ride.

This is a really easy one!

Does Warren Buffet:

a. Write about his stock picks and earn a fixed fee for each one that he publishes?

b. Invest in his stock picks on behalf of his customers and take a 1% ‘cut’ on the money invested?

c. Invest in his stock picks on his behalf (and, on behalf of the other shareholders in his own company)?

Let’s see:

a. Might produce $100k – $1 million per year revenue, depending on how many subscribers you can get.

b. Might produce $1 million – $100 million per year revenue, depending upon how much money you can get under your management.

c. Well, how much did we say Warren Buffett is worth?

Newsletter publishers are on the bottom of the wealth totem-pole, so I would give their ideas about as much credence as I would give to anybody who makes their daily living by giving you information.

I would only take my information from somebody who has already made 10 times as I want to make from doing the exact thing that I want to do …

… so, if you can find a newsletter publisher who fits that criteria (and, I’m sure they’re out there, for the same reasons that I’m here), then go for it!

Otherwise, you’re going to have to learn how to do research (BTW: much of what I’ve seen in the Tycoon Report that you mention falls into the ‘how’ category … I read it!), then do it yourself …

If it’s stocks that you’re interested in, you could do worse than start by reading Rule # 1 Investing by Phil Town.

I wrote a piece about the 80/20 rule: how 80% of the people do nothing. I then broke the remaining 20% who do ‘something’ into two sub-groups:

– The 19% who save, pay down debt, etc.

– The 1% who will strive for – and perhaps reach – the top of the financial totem-pole.

And, I believe that the difference between all of these groups boils down to one thing: propensity to take action.

Josh‘s question sums it up quite nicely:

I guess you don’t want to be one of those people who contract “paralysis by analysis”. I’m thinking the key here is to just make a move, even though it may not be most perfect move?

Most people fail because they either take too much action or not enough!

Too much action can be a problem, for example, when you chase the market and switch investments a lot; as the Dalbar study found:

During the greatest bull market of all time from 1984 to December 2002 the study came up with an annualized return of 2.57% [for market timers, who move in/out of investments chasing better returns] compared to 12.22% for those who bought and held an S&P500 index fund.

But, how much did those who took NO action make?

0%

Clearly, taking some action is preferable to none … but, what of Josh’s second point: taking action even if “it may not be most perfect move”?

Life rarely presents us with a Final Choice Option …

…. when we take an action, we are usually free to take another! If you make a mistake, back-out as best you can and try something else.

I think of life in terms of a branching structure: at many stages – every day, hour, minute – we are standing at some sort of fork in the road and we have to take the left branch or the right. Somehow, we find a way to choose one:

a) If it seems to carry us to where we want to go. Fine. We stick with it (at least for a while).

b) If it seems to carry us away from where we want to go, we simply wait for the next branching opportunity and try something different.

For example, if an investment works we (should) stick with it. If not, we can always exit for a (hopefully) small’ish loss and try another … if we don’t the loss might increase and take us to zero (how about Enron?).

Of course, this is where it helps to have an overall destination in mind; it helps us understand what does represent the ‘right direction’ for each of us: sometimes, more than one branch appears to be sensible.

But, if you have a clear idea of your Life’s Purpose, all of a sudden only one of the branches may start to make more sense than another.

This helps to explain: where your Life’s Purpose goes, your finances will eventually and surely follow … either by direct route, or meandering, you will eventually find the road to what you deem to be success.

For those of you going into business – or are thinking of it (one day … when?), today’s installment of my Video on Sundays series is for you!

AJC.

Today, I have a treat for you …

… it will save you from going broke when you are on the cusp of success, so print this off and keep it somewhere safe!

It came about because of a great question from somebody who is (or should be) gearing up to move from Making Money 201 (increasing your income) to Making Money 301 (maintaining your wealth) …

… it comes from Donovan who asked this question by way of a comment on this post – appropriately about the ‘myth of income’:

My questions is, if my income is roughly $1,000,000 to $2,000,000 a year and I have no debt other than two small car loans. How much house can I afford?

I told Donovan “super-high-income can be a curse – not the blessing that the rest of the world imagines it to be”.

Now, tell me in your heart of hearts – if you are not already on a super-high income ($500k++) can you imagine what the problem/s might be?

Sure you can: too many girl/boy friends; too many cars and houses; cirrhosis of the liver 😉

On the serious side, these ‘excesses’ point to the real issue: living beyond our means is an even bigger problem for those on super-high-incomes than for those on ordinary incomes … really.

Here’s why …

You may be saving $200,000 (pre-tax) of your, say, $1,000,000 gross annual income … that’s 20% – a respectable percentage and huge dollar amount in anybody’s language.

But, that’s not the problem … it’s the $400k that you spend (after you pay Uncle Sam his ‘dues’) that is …

… the problem is this:

How ‘well off’ will you be when the income stops as it surely will (one day)?

If you don’t believe that this could be a problem: recall MC Hammer.

If not MC (who went from multi-millionaire to broke), then how about Elton John (nearly … he recovered financially) and many other sports stars who fell out of contract (or retired) or celebrities who time/circumstance took from A-List to C-List to …

Or how about the 4 out of 5 major lottery winners who are financially worse off 5 years after winning the lottery?

Here is the problem in a nutshell: living off your ENTIRE current income when it is likely (or even just possible) that it may not continue for ever.

If you are lucky enough to dramatically increase your income (and, if you follow my Making Money 201 strategies, you surely will), here is how you need to start thinking:

Income of any amount – and the more your earn, the more appropriate is what I am about to tell you – is the ‘fuel’ that builds your Investment Net Worth …

… your Investment Net Worth is like a (one day huge … if you follow the 7million7year strategy) battery that you are trickle-charging or fast-charging with your income.

The amount available to charge your battery is purely based upon what you DON’T spend from that income today.

For example, when I was earning $1,000,000+ from my businesses, I still took home a miserly $50,000 a year (plus cars, business trips, and other legal ‘perks’) and diverted the balance to ‘fast-charging’ my ‘battery’.

My battery consisted mainly of income-producing real-estate investments (plus some stocks).

What you can happily spend should tend towards what your battery can generate when it is unplugged from the mains (i.e. your income) …

That way, when your income stops, your battery can kick in like an Uninterruptible Money Supply, and you never need to take a decrease in your standard of living (a very difficult and humbling experience that I urge you to avoid).

I like the battery analogy, but I prefer a ‘perpetual motion’ battery which cannot exist in physics; but, here’s how it can work financially:

– You build up the charge in your battery as fast as your Income LESS Spending can make it happen. Can you see how you have two levers here: 1. Increase your Income, and 2. Spend less … also, a third lever 3. Increase your battery’s efficiency (i.e. increase your investment returns?

– Once your battery is fully charged (this is entirely up to what YOU consider to be ‘fully charged’) you can cut over to battery power … hopefully, this comes at a time and with an amount that suits you … if so, congratulations, you are retired!

– Just remember, that when you are on battery power, you have two forces that are serving to drain the battery (your retirement living expenses, and inflation) and only one force serving to keep it topped up (investment returns), so you need a MUCH LARGER BATTERY than you may, at first think.

So, when figuring how much of your $1,000,000 – $2,000,000 yearly income to spend, Donovan, think about this:

– Do you ever want to spend LESS in your life than you do now? You are a fool or a saint if you think you can.

– Multiply the amount that you WANT to spend per year NOW by 20 (or 40 if you are as conservative as me), and that is how much you must have in your battery if you were to retire TODAY on your current income.

– Double your battery size for every 20 years between NOW and when you DO want to retire (to allow for the trickle drain of just 4% inflation).

This simple three step process answers a very important question for our Super-High-Income (indeed, ANY income friends) …

… if the battery is too large for you to every conceive getting, simply lower your current spending wants until you come up with a number (and, a timeframe) that does seem to work. The good news is that as you lower your current spending, you can divert more to charging your battery!

How has this worked out for me?

Very well indeed, but you might be surprised to hear that I COULD live off much more than I do, but I also like the concept of keeping some of my battery power in reserve against unforeseen circumstances …

… after all, if you were relying on just battery ‘power’ for the rest of your life, wouldn’t you want to at least keep some in reserve? 🙂

Many of our readers are carrying ‘bad’ debt and are looking at ways to get rid of it as quickly as possible (surprisingly, this is not always a good thing) ….

There are two competing methods:

1. Dave Ramsey’s Debt Snowball, and

2. Flexo’s Debt Avalanche.

Actually, neither invented nor ‘own’ their method, they are each just the most recent promoters of their respective method that I could find with a quick Google search.

Followers of Dave Ramsey tout his method as the best because it encourages the smaller debts to be freed up first, hence putting larger and larger amounts towards each succeeding (and larger) debt. The psychological ‘boost’ of the early quick wins (by paying off the small debts first) are said by Dave’s fans to help ride the bigger waves (of the bigger debts) that will then confront you.

Flexo counters with cold mathematical logic:

If you have a certain amount of money available to pay off a portion of your debt each month, even if that certain amount changes, there is a mathematically correct way of paying off that debt. You can call this approach the Debt Avalanche. It is similar to Dave Ramsey’s popular “debt snowball” method, with one small but important detail: With the Debt Avalanche you will pay off your debt faster and pay less total interest to banks and lenders.

I think Flexo is technically right: the people that will give up because they don’t see a ‘quick win’ are probably financially doomed, anyway.

But, I disagree with Flexo in that, for most people the difference in time and cost is probably marginal in the whole scheme of their lives and if it serves to solve their problem (and, for them, the other method won’t) then for me utility wins. But, only if the avalanche won’t work for that person (and, I can’t for the life of me see why it wouldn’t, but whom am I to speak for everybody?) …

However, as far as either method goes – and, this is particularly suited to the method of ordering the debts by interest rate as in the Avalanche method – I would add an important ‘tweak’ here:

I would draw a line where the debt is lower than the cost of a current mortgage and at that point seriously think if I really do want to pay off that low cost debt or would I rather apply the cash towards an income producing investment and allow that older debt to run it’s course.

Student loans are a perfect example of this:

Why pay off a 2% loan in order to then incur a 6% mortgage on a real-estate purchase (assuming that’s what you intend to do next); just put the cash that you were planning to apply to the student loan into the RE and take a lesser mortgage.

Refinance when the student loan falls due (or interest rates increase, as some can ratchet up over time) and use the refinanced cash to pay it off (check out the likely refinance expenses right up front, though, to make sure that this will be cost-effective).

Complicated? Sure … Mathematically effective? Absolutely!

…

All [financial] work and no play makes Jack a dull boy …

… so, I thought that it would be ‘fun’ to share this quirky/interesting video (that I bookmarked way back in March) with you for my semi-regular ‘videos on Sundays’ series:

http://www.eightprinciples.com/

Enjoy … or, should I say, have fun?!

Yesterday’s post on the use of HELOC’s v. ‘standard’ mortgages brought up the concept of using the right tool for the right job.

Since this is a vital concept, I want to make one additional point, and I’ll do it in response to a comment that Moom left me on that original post:

Aren’t HELOC rates above 1st mortgage interest rates? Or if you have no first mortgage you can get a lower rate? Diane: At AJC’s level mortgage interest on owner occupied property is not tax deductible I think, while interest on investment loan is. Which might explain the HELOC strategy?

Moom is partially correct: at my level, tax detectability of the home loan portion is limited.

Having said that, since I am trading I may be able to offset the entire interest cost against my gains on the stocks anyway (a question for my accountant, I guess).

But, to be honest, I very rarely consider tax consequences or even cost differentials when making these kinds of decisions (unless major).

Read that again, because it goes against the concept of ‘millionaire as financial genius’ which is a mythical image that most of us erroneously carry.

Not only that, it serves to explain why the wrong people are rich!

So, I’ll repeat:

I very rarely consider tax consequences or even cost differentials when making these kinds of decisions (unless major).

This doesn’t make sense, does it? Because:

‘Rich people’ know every dollar that they have coming in and out, right?

‘Rich people’ ‘spreadsheet’ every decision that they make, right?

‘Rich people’ know the tax consequences of every decision that they make, right?

‘Rich people’ know ALL the alternatives – and, the costs thereof – and choose the lowest cost alternative every time, right?

‘Rich people’ are the smartest, most financially astute people around, right?

Wrong!

Some rich people know these things, but in my experience most don’t (at least not to the level that you might expect) …

… in fact, most rich people that I know are not the most financially astute people around. They just have the most financially astute people around them.

The financially astute people are in the supporting roles! They are the B-movie stars or ‘best supporting’ actors, not the guy carrying the ‘best actor’ Oscar …

Why?

Because ‘rich guys’ became rich by ACTING when more financially astute people would still be ANALYZING …

Because ‘rich guys’ became rich by focusing on INCOME when more astute people would still be focusing on EXPENSES.

For example, I create INCOME … I pay advisers to help me minimize EXPENSES:

– I pay an accountant to advise me on tax consequences.

– I work with a private banker to help me with finance products and interest rates.

– I work with a broker (rarely) if I need help to put together a new hedging strategy.

But, it is I who creates the new business concept; the new investment strategy; and, who makes the next real-estate purchase …

… and, it is the huge increase in INCOME that these decisions can make (and, have made) that have been far more important to the increase in my personal net worth than any cost/tax-based ‘adjustment’ that my accountant, banker, or broker could have made.

So, when Moom asks about interest rate differentials, and tax advantages, I have to say that I generally don’t even think of these – at first …

… I look primarily at UTILITY.

Which product do I think will best help me achieve the increase in INCOME that I am looking for?

9 out of 10 times I will go with that approach, even if my experience points in the direction that it will cost a little more in interest or may be slightly less tax-advantaged.

If I am not sure, or it seems like it may not be a close call, then a quick phone call to one of my panel of advisers will usually do the trick.

So, why did I choose the HELOC even though it costs a little more in interest (and, possibly more in tax, as well)?

Because, at the time, it seemed like the right thing to do. Simple!

I posted recently on using a HELOC as part of your emergency fund strategy and Diane noticed that I had mentioned my own use of a HELOC in an older post about my own home purchases.

Diane said:

I’m confused. You pay cash for the houses, then take a HELOC? If memory serves me, you never hold more than 20% of the house value, AND mortgages interest rates are usually lower than HELOC’s interest rates AND mortgage interest is also tax-deductible (at least to me)whereas the HELOCs may not be (seem not to be by what I’ve read). What am I getting wrong here? (and thanks for tackling this subject!)

This is a great question because it highlights how the rules of money ‘flip flop’ when you move to the next stage of wealth: from Making Money 101 to Making Money 201, then Making Money 201 to Making Money 301.

And, I have two quick comments to make on these transitions that I will expand on in future posts:

1. These are not necessarily hard/sudden transitions e.g. while you are still getting your financial house in order (Making Money 101) you can also start to increase your income (Making Money 201); before you fully retire, you may also be working on migrating your investments to help you preserve your wealth (Making Money 301).

2. The rules of money DO change during these transitions, which serves to explain why many people who do well with Making Money 101 falter at Making Money 201 (for example, they are unable to open themselves up to the idea of increasing debt after they just finished working so hard at eliminating their ‘old’ debt).

And, the HELOC is a great example of both …

In the post on Emergency Funds, I floated the idea of not taking a guaranteed loss (by parking 6 months cash in a CD, as most ‘experts’ recommend) to forestall a potential disaster. I suggested building up reserves for known/expected costs, and using a combination of insurance and HELOC’s for the true ‘unexpected’ emergencies.

This is a great Making Money 101 and Making Money 201 strategy as it provides more capital for investment, in the likely event that there will be NO serious emergency … of course, if you do have an emergency you may have a more difficult recovery if the cash isn’t already conveniently sitting in the bank.

Your choice, entirely.

But, as a Making Money 301 strategy? Well, I have enough cash on hand at all times to cover any emergency … or, opportunity. I don’t need a HELOC for that … and, when you retire, neither should you.

Why?

The rules ‘flip flop’: you no longer have the time to recover from an emergency (your investments by now are mostly set for passive/fixed income … not growth), but you also don’t need to be investing 100% of what you have available in order to live.

When calculating your Number, you ‘anticipated’ emergencies and have arranged your finances and investments to that you have excess cash on hand at all times.

So, why do I have a HELOC?

Well, this comes to the second post that I mentioned:

When you are still Making Money (101 or 201) you want at least 75% of your Net Worth in investments at all times … and, this still holds true when you are retired and concentrating on preserving your wealth (301) … just in different investments.

So the 20% Rule ensures that you don’t have more than 20% of your Net Worth invested in your own home at any point in time.

This means that if you want to buy a house that costs more than 20% of your Net Worth (as it will for most in Making Money 101 and 201) you will need to borrow … for this, I suggest locking in a fixed-rate mortgage for as long as the bank will give it to you.

But, it also means that your house may cost less than 20% of your Net Worth … think about it: if your Net Worth was $7 Million, you could spend $1.4 million cash on a house.

If you wanted to borrow, say, another lazy million from the bank, then you could spend $2.4 million on a house (provided that you can cover the mortgage payments).

It all depends on your lifestyle needs.

So, my current house fit within the 20% Rule for me, cash paid. So, no mortgage required …

But, as I mentioned in that post, I hate seeing so much ‘dead money’ tied up in a house … so why not do something with it?

Hence the HELOC of approx. 50% of the value of the house: I use it to invest in stocks; if the market is travelling badly, I can cash out these stocks, pay down the HELOC and have little to no costs. Tax is only a small issue at these levels … I am well over the IRS maximum no matter which way I go.

But, when the market appears ‘right’ again, I can immediately draw down the HELOC and invest. For this specific purpose, the flexibility of a HELOC far outweighs the interest-cost advantage of a standard mortgage.

Of course, a better use for the ‘spare equity’ in my house might be another real-estate investment; since these are (for me) invariably ‘buy/hold’ a HELOC is poor for that purpose and I will then switch out of it.

Different horses for different courses … thanks, Diane!