If you ask people why they want to be rich, the most common answer will be “so that I don’t have to worry about money any more” …

Think about it, no more money worries!

So, let me pop that little bubble for you:

MICRO

I went to the supermarket on Friday and duly handed over my credit card to the attendant who swiped it for me … only to find the TRANSACTION DECLINED.

What!? I thought that I put those days well past me? I called my wife who said that we must have max’ed out that card (it has a $17k credit limit!) that month and the scheduled payment hadn’t been processed yet, but didn’t I have another?

Well, I did have a ‘business’ credit card on me, as well, but that wasn’t the point … it appears that even rich people have credit card issues from time to time.

Not to worry, I just whipped out the old debit card and trotted off to the ATM, to find …. INSUFFICIENT FUNDS.

Now, I was confused … how could our bank account be empty? To be sure, it’s only a daily money needs account (not The Big One with all the zeros) but didn’t I just pop $15k in it, ‘to be safe’?!

Turns out that the debit card that I’ve been using is attached to an old bank account that we now just use to manage one of our properties … and, I’d unknowingly been using the wrong debit card and draining it with my day-to-day cash needs …. oops.

So, there I was shopping without any cash or credit cards; I solved the problem by rifling through the parking change sitting in my car (fortunately, there was about $50 or $60 just sitting in my center console) and even managed to lend $2 to a another ‘rich’ friend whom I happened to bump into the street as she was rifling through her purse for some cash to buy a loaf of bread from the bakery that I had just stepped out of.

Seems like she can afford a $3 house and $1 mill. renovations, but was equally ‘cash poor’ (on that particular day) as me …

… oh, the irony!

MACRO

Some people go through their wallets, handbags, coin jars, and various bank accounts adding up the bits and pieces to see if they have enough in the ‘kitty’ to buy that nice [insert discretionary item of choice: clothing; car accessory; concert ticket; etc.; etc.].

If my experience is anything to go by, it doesn’t stop when you become ‘rich’ … you see we suffer from budgeting problems, too.

It seems that a combination of market shifts and various stock market and housing market collapses and we have (relatively speaking) overspent on our house; not to mention, we haven’t yet sold our old house, and we have a complete ‘rehab’ of the newbie about to begin …

… and, herein lies the problem:

We provided our architect with a brief to draw up plans for renovations to fit a $450k renovation budget, which he assured us was not only possible but eminently achievable given the modest (if you can call adding a room, updating a kitchen, and refitting 7 bathrooms ‘modest’), mainly cosmetic, renovations that we had in mind

Well, when the quantity surveyor came in with an estimate of $890,000 for the renovations to the house – – this not including the costs to rehab the pool, tennis court, and redo the gardens etc. – I found myself doing what everybody else does:

In a panic I went through my “wallets, handbags, coin jars” – by way of checking all of the statements on my various bank accounts – adding up the ‘bits and pieces’ to see if we have enough in the ‘kitty’ to handle the cost blow out … thankfully, we do [AJC: you know, sometimes a mill. or two just seems to ‘slip through the cracks’, but when you add it all up, it’s still there after all … phew!].

So, if you need to find a reason to be rich, it had better be a very, very good one, because money ‘issues’ NEVER go away …

I’ll show this video [if clicking on the above embedded video doesn’t work, click this link instead] because (a) it is from the brilliant Derren Brown, the genius behind The System (that I ‘lifted’ for my own cruel experiment in spotting scams, a week or two ago) and (b) it shows that there is power behind the concept of advertising.

However, the problem is this: while ‘awareness advertising’ may indeed work (as I think this video, which I believe to be genuine, seems to prove) you need VERY DEEP POCKETS to make it work …. your message has to be in front of each person’s eyes multiple times, which takes money – a lot of it.

That’s why, for me, advertising is something best left to the McDonalds and Coca Cola’s of this world and the small guys, like you and I, are much better off with more direct forms of sales and marketing.

For example, I have used: e-mail newsletter campaigns (low cost and slightly effective),  referrals (free and fabulously effective), PR (which is totally free and reasonably effective), and educational courses (where I was actually paid to speak and that were completely effective) to deliver my message in a very cost-effective way … I am not aware of a single client who came to my businesses through any of the advertising campaigns that I allowed myself to be talked into (VERY rarely, I might add) over the years.

But, watch the video even if you are not in – or planning to be in – business … it’s a hoot 🙂

You can’t fully accept Charles Darwin’s Evolution Theory until you explain the Bombardier Beetle; equally, you can’t fully accept Larry Swedroe‘s support of Modern Portfolio Theory [MPT] until you explain Warren Buffett …

… having said that, perhaps I was little harsh when I suggested to my blogging-friend Pinyo that:

You might want to screen the advice from your ‘experts’ a little better …

But …

Larry Swedroe is a guest expert on Pinyo’s Blog, and Larry has published a number of books – including a highly-regarded one on the ‘workings of the stock market’ – so, I read the post with interest; it was a response to a reader question:

How can a person justify support of modern portfolio theory [MPT] when there is a Warren Buffett in this world?

Firstly, you already know my views on MPT and the so-called Efficient Market Hypothesis, which basically says that everybody has access to the same information (illegal trading based upon insider-information, as well as scamsters like Messieurs Ponzi and Madoff, aside) so, stocks must be priced correctly at all times.

Which doesn’t mean that you can’t buy ‘cheap stocks’ from time to time (e.g. now), but more that you can’t beat the market … nobody can, and if someone can, it’s either luck/randomness or can’t be predicted up front.

So, how do you ‘explain’ a Warren Buffett (or, the others)? Or, is this a case of the ‘exception proves the rule’?

First, it was no surprise to see Larry answer the question, in summary, as:

That is an easy question to deal with. First, with thousands or millions of investors we should expect some to outperform the market every year and some to do so for many years, randomly. The question is: Is there any more persistence of performance than would be randomly expected. The evidence from hundreds of academic studies is there is not.

Another answer to the question is that Warren Buffett is not the typical investor. He is not like a mutual fund manager. He often buys companies and then manages them. He provides them with economies of scale, lower cost of capital and the benefits of his managerial wisdom. And when he takes large positions in companies he often gets a board seat. So perhaps his great returns are more a result of his managerial skills than his investment skills, or some combination of both.

When I got this question a few years ago I went to do a simple check on the performance of Berkshire Hathaway for the prior ten year period and then compared it to the five major U.S. asset classes of large, small, small value, large value and real estate. During that period BRK had underperformed all but the asset class of large stocks (as represented by the S&P 500) and had underperformed an equally weighted (20% each) portfolio of the five that was rebalanced annually by several percent.

So we know that Buffett had delivered great returns in the past but we don’t know that he will in the future. In fact, during that ten year period BRK underperformed. So now what would you forecast regarding the future?

So, Larry answered the questions along the following lines:

1. Warren’s performance could be random – but, we already know that’s not the case, and I pointed Larry to the scientific study (http://7million7years.com/2009…..or-a-fool/) proving that Warren’s performance is no fluke, it’s simply only explainable by skill.

2. Warren often buys companies and actively manages them – this is true, for 78 of his investments, but not true for all of his stock holdings (in companies such as Coke, Kraft, etc.); he may – or may not – take board seats, but the reality is that he runs a hundred billion dollar company employing thousands of staff with only 19 people to apply all of his ‘managerial skills’; no, what Warren has is a system to effectively use excess cash from an already well-performing business to buy more (a perpetual money machine on steroids!).

3. Warren underperformed the market for 10 years – Warren agrees! He had too much cash and prices (as ‘perfectly and efficiently and modernly’ priced as surely as they must have been?!) were way too high … cash under-performs stock in a rising market. Let’s rerun that study over the next 20 years and see who wins?

4. We can’t use Warren’s past success to predict his future success – Oh yes we can; if Warren’s success is based upon skill, not luck, and the fundamentals of the market that have allowed that skill to succeed in the past are mostly true in the future, then of course Warren will be more successful in the future.

After some back and forth, Larry changed his ‘story’ somewhat:

I think we can agree on two key issues. Buffett’s record is almost certainly the result of skill. But the market’s have become much more efficient over time and the size of his assets under management make the challenge of beating the market now so much greater. Even Buffett himself has made this last point.

The other point is this. Likely we will see another Buffett 20 years from now, but there is no way to identify that person TODAY, we will only know who that person is ex post.

Now, it seems, Larry agrees that Warren isn’t a random aberration, he is skillful, but that will be less important as time goes on. Well, I agree – and, more importantly, Warren does also agree, to a point: Warren says that the smaller investor (around $1 Mill. to invest) should be able to beat him (hence the market) because Warren’s investments are getting too, d*mn big and he can’t move in/out of positions as quickly as he used to (well, more in than out as he is strictly ‘buy / hold’).

Larry, if Warren’s return via Berkshire Hathaway was 21%+ over the past 40 years, do you really think it will suddenly drop below 11%+ (or whatever the ‘market return’ happens to be) over then next 40? You may say “I don’t know …” (which is your point, I believe) …

… so, here is the kicker: if Warren felt that he could no longer beat the market, he would issue dividends!

Warren wouldn’t risk decreasing his shareholder returns by having them sit in cash or in BRK performing no better than the market – unless, he was expecting to be able to expend this vast ‘war chest’ on future ‘bargains’ – when he could just issue excess cash / profits as dividends and let the shareholders invest in a market-matching Index Fund, presumably at much lower overhead cost than Warren’s BRK can provide.

Therefore, Larry, I can confidently predict that Warren will beat the market (say, over the next 20 or 40 years), simply by ensuring that I invest with him until he changes his mind (on his dividend strategy) 😉

The point that Larry SHOULD be making is that this is not a common result … so, for the ‘average investor’, simply plonking all of the funds that you have earmarked for stock investing (e.g. in your 401k) into a simple, low-cost Index Fund – and, waiting 30+ years for Modern Portfolio Theory to run it’s ‘magic’ – will provide the best ‘bang for buck’ stock market performance that you need.

Ooops, I slipped up … I left some of our readers hanging …. did Ms Tomorrow Rodriguez win the $1 Million??!!

More after the break 🙂

First, I want to recap on the post; I wanted to know if you would take the Banker’s offer in this unique situation:

4 suitcases left: 3 of them contain ONE MILLION DOLLARS and 1 contains only $300!!

Ms Rodriguez – with the odds clearly stacked in her favor – has two choices:

1. Take the Banker’s Offer of $677,000

OR

2. Say “No Deal” and select just one more suitcase (then she will be presented with another offer)

Deal or No Deal?

The arguments ‘for / against’ basically fall into three distinct camps:

1. The Strictly Mathematical

The ‘math guys’ talk about a concept called ‘Expected Value’ (used a lot in gambling … which is what Deal / No Deal really is) that Wealthy Canadian does a great job of explaining … in the context of this post … here. Wealthy explained the Expected Value of this deal as:

The banker offered $677,000, a 9.7% ‘discounted’ offer. Lower than the expected value and therefore not a good deal.

Rick expands on this to explain why he would not take the Banker’s Offer:

If they offer 10% less than the expected value then going again is risking a loss of $77K to gain $323K with a 75% chance of success. I would definitely try again!

2. The Greedy Grabbers

These guys – and gals – want the $1 Million … that’s all there is to it! And, why not? It’s ‘free money’ after all … as explained by Josh – the Croupier’s Friend:

I would say no deal. The odds are in her favor, a situation which doesn’t happen a lot in life. Much like blackjack, when you have an eleven and dealer is showing a six, double down and wager as much as possible when the odds are in your favor. Take advantage of the situation while there is a situation to be taken advantage of.

3. The Life Changers

These people may – or may not – intuitively understand the math (i.e. the Banker always gives you a slightly cr*ppy offer to ‘keep you in the game’ … after all, who would watch if most shows didn’t go down to the wire?!) but, they understand that $677k – albeit not sounding quite as good as saying that you won $1 Million – is a sh*tload of money!

I think that this group’s mindset is best summarized by RRPF who said:

Seems pretty sensible to me … it’s all about the ‘utility’ of the money, as explained by Rick Francis (in justifying why he would take two more shots, but no more):

The utility of the additional money is NOT linear for me. Getting $450K would make huge changes in my life. However, I don’t think that the $1M would result in even twice as much of a difference. Because of that I would not be willing to risk the $450K and would take the sure thing.

So, what would I do?

Well, I would like to say that the utility of the money for me is such that I could keep pulling the trigger for the ‘fun’ and bragging rights of aiming for the full $1 Million, but I have to say that I agree with the one lone voice who voted …

… NOT SURE.

You see, we are not faced with million dollar decisions every day (OK, I’ve had a few in the past few years … even so …) so, psychologists will tell you that we have no idea how we will respond under that kind of pressure – c’mon, you’ve seen the war movies where the ‘hero type’ freezes under fire and the ‘wimp’ runs up to the bunker in the face of horrendous machine guy fire to throw a bag of grenades into the fox hole (it’s a shame that he usually gets killed in the process … hopefully he remembered to pull the pin, first?!).

So, it’s easy enough to guess what we are going to do, but any resemblance to what we actually will do is probably purely coincidental. That’s why we need systems … something that I covered in a previous post.

Oh, and yes, Tomorrow – who obviously didn’t ‘need’ the $677k – did go on to win the $1 Million … this IS America, after all 🙂

There is a ray of hope in a Personal Finance blogosphere that currently seems to be ruled by Ramsey Clones: Moolanomey says that you should NOT pay off your mortgage early:

I can now say for certain that I fully oppose the idea of paying off your mortgage early because there are several related factors that make this a bad idea.

Yay!

[AJC: I’ll leave you to read Pinyo’s excellent post to discover the ‘several related factors’ for yourself]

Look, if Pinyo’s post – or, my earlier posts – haven’t yet convinced you, let me draw it out for you:

We have two people, each sitting on a $150,000 house with a $100,000 mortgage remaining; they both have just signed up for a 25 year fixed rate mortgage … their payments are currently $585 at 5%. They both decide that they can afford to ‘invest’ an extra $100 a month.

Person A

This person puts the extra $100 a month into their mortgage, shaving off 6 years on the total time to pay back the loan, saving $20,000 in interest in the process.

Being a smart investor, and once the loan is fully paid off, this person then starts to put both the mortgage payments AND the extra $100 a month into an Index Fund and waits 25 years to cash out (hopefully, allowing enough time to get as close as possible to the 30 year 8% stock market return ‘guarantee’ that he’s heard so much about).

Person B

This person lets the mortgage ‘ride’ and instead invests the $100 ‘extra money’ a month straight into a low-cost Index Fund returning an average 8% over a 30 year period, adding the mortgage payment at the end of the 25 year period when the mortgage is paid off, then waiting the additional 19 years so that he finally cashes in his financial ‘chips’ on the same day as Person A.

The Result

At the end of (19 + 25) years or (25 + 19) years – depending upon which person you are 🙂 – you have an identical and fully-paid off house (so, the value of that is irrelevant in this comparison) and an Index Fund.

Let’s see how you fared with that Index Fund …

Now, we’re looking at a very simplified example, where the homes only cost $150,000 to begin with, and we’re only adding $100 a month … yet the difference between the two graphs represents a total additional return to Person B of nearly $100k by NOT putting the additional money into their mortgage.

In the ‘real world’ he would be even better off by:

1. Increasing his additional monthly investment in his Index Fund to at least match inflation,

2. Expecting better than the worst-case 30 year stock market returns that I have provided for here,

3. Reinvesting the ‘tax advantages’ of the larger remaining home mortgage.

Which camp do you sit in?