… and, loving it!

Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it's NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellers (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:

Enron

When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one

Martha

When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too

Warren

The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient Market Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%

Playing the Efficient Market Theorist for a fool …

I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it

Good deal or bad deal?

No, this is NOT another ‘Howie Mandel-style’ game show … I’m done with that series (aside from a couple of wrap-up posts, still to come)!

But, this will be my last reader Poll for a while, so I want you to sit down for 3 minutes and make a commercial decision with imperfect information:

[polldaddy poll=1327033]

Time for a fun ‘hypothetical’ … I’m not really asking you to invest with me [AJC: I want you to learn to invest with somebody far more capable: yourself!] …

I would like you, and a number of other people, to join me in a real estate project [remember: this is hypothetical].

It will be very low risk, because it’s a very well-established commercial strip-mall in a great area, pretty much fully rented with lots of good tenants with long leases left to run and for the last 10 years has produced a reasonable – perhaps not stellar, but certainly highly respectable – profit with very low maintenance costs, tenant turnover, etc., etc.

No catches, here, really … it will be a general partnership, I will be the managing partner and you can join the group of passive investors already committed.

So, let’s look at the deal a little:

Your share of the investment will cost $100,000 and for that you get 10% of the $1,000,000 project (incl. financing/closing costs) … it’s a very inexpensive strip mall

We expect reasonable capital appreciation over the life of the project (up to 10 years, although you can sell out anytime before then, and we will guarantee both a buyer and then-current market price for your share).

The property will return about $9,000 a year (net operating income per 10% share), but we think it’s best to keep aside some as a contingency against vacancies, maintenance, etc., etc.)

So, we will guarantee you (secured by the project itself) $7,500 income each year for at least the next 10 years indexed to 7.5% of the current value of the building (but, NO LESS than the $7,500 p.a. guarantee) v the $3,000 or 3% that a bank will currently give you, and which does not grow. Of course, you may have others ideas in mind for the money, but I hope you will invest with us … after all, here, your income is guaranteed!

In summary: an ultra-low-risk ‘bricks and mortar’ investment returning a MINIMUM 7.5% p.a. on your original investment (increasing in line with property value increase) … you will get your money back, just from the guaranteed distributions that the project will pay you, over 13 years and you STILL get 10% of any appreciation in the building!

Deal or no deal?

A little perspective …

For a bit of fun, I typed in an annual income of $220,000 into this handy little online calculator, and it shows that I’m the 107,565th richest person in the world … whoohoo!

Now, if I typed in my real annual income, I think that I could jump myself higher up that list … and, if I factored in that I get that money mainly passively, well ….

Reminds me of an interview that I saw with Guy Laliberté, founder of Cirque Du Soleil, who went from street performer (read homeless hustler) to sharing the same level of wealth as Oprah.

Now, that’s not the bit that blew me away; what did was that they were sharing something like 160th place on Forbes’ list of the richest people in the world: Oprah … Cirque Du Soleil Man … and, they ONLY get to be joint 160th (approx.) on the list??!!

Who are these other dudes between them and Bill Gates?!

So, it’s really good to be able to put things in perspective and realize that if you are earning almost ANY regular salary, you are in the Top 10% of the richest people on the planet:

The Global Rich List calculations are based on figures from the World Bank Development Research Group. To calculate the most accurate position for each individual we assume that the world’s total population is 6 billion¹ and the average worldwide annual income is $5,000².

Below is the yearly income in percentage for different income groups according to the World Bank’s figures³.

Percentage of world population Percentage of world income Yearly individual income Daily individual income Bottom 10 percent 0.8 $400 $1,10 Bottom 20 percent 2.0 $500 $1,37 Bottom 50 percent 8.5 $850 $2,33 Bottom 75 percent 22.3 $1,487 $4,07 Bottom 85 percent 37.1 $2,182 $5,98 Top 10 percent 50.8 $25,400 $69,59 Top 5 percent 33.7 $33,700 $92,33 Top 1 percent 9.5 $47,500 $130,14

The world’s distribution of money can also be displayed as the chart below.

¹ 2003 world population Data Sheet of the Population Reference Bureau.
² Steven Mosher, president of the population research institute, CNN, October 13, 1999.
³ Milanovic, Branco. “True World Income Distribution, 1988 and 1993: First calculations based on household surveys alone”, World Bank Development Research Group, November 2000, page 30.

So, realize that UNLESS YOU ARE PLANNING TO DEVOTE SERIOUS SLABS OF YOUR TIME AND MONEY TO WORTHY CAUSES this blog and everything we are doing here is about as useful as a blog on whittling … and, probably a darn site less so, because there’s nothing inherently of artistic merit in even the best-crafted bank account.

How much does it take to feel wealthy?

The answer is “about double”

But, that’s not really a tongue in cheek question / answer, it’s actually scientifically researched and verified fact …

… let me explain.

Most people want to become rich (when we strip away the houses, cars, vacations, sex, drugs, rock and roll [AJC: Boy, I must lead a great life!]) simply to feel secure … to stop having to worry about money.

So, the definition of ‘rich’ for most people is related to how much more money that they feel that they would need in order to stop feeling financially insecure. And, that always seems to be about twice what you currently have; take a look at this report by MSN Money (if anybody can find the base source, please send me the link … I hate to quote quotes).

• Those who earned less than $30,000 thought that a household income of $74,000 would qualify as rich.

• Those who made $30,000 to $50,000 said an income of $100,000 would be rich.

• And people in the top half [$50k - $100k+] of earners were more likely to say that an income of $200,000 earns you the right to the R[ich] word.

So, it seems that no matter what income level you are on, you need two (to perhaps three) times that in order to feel ‘rich’.

Perhaps, you feel that it would be different if we weren’t talking penny-ante incomes here, and jumped straight to millionaires and multi-millionaires? Surely, things would be different for them?

Well, not so … according to Robert frank, Author of Richistan, most of America’s Ultra-Wealthy still consider themselves as ‘middle class’ and would need “about twice what they already have in order to feel wealthy”.

So, this is just another reason why picking a random income or net worth $$$$ target and calling that ‘rich’ doesn’t cut the mustard … you’ll never be relaxed with your level of wealth, no matter how much you have.

No, what you need to do is:

1. Understand WHY you need the money: we call this Understanding Your Life’s Purpose

2. Understand HOW MUCH you would need so that you would be free to LIVE your Life’s Purpose: we call this Calculating Your Number

… and, when you finally reach your Number, not worrying about chasing more, because that’s about as sensible as a dog chasing it’s tail!

The definition of insanity …

“Insanity: doing the same thing over and over again and expecting different results.”  Albert Einstein

Thankfully, this blog isn’t for everybody … only those who want to get rich(er) quick(er) … I’ve proved that it can be done successfully, and I am conducting a ‘grand experiment’ at one of my other sites to prove that it’s not just luck and that others can do it, too.

But, the vast majority are still in the ‘work for 40 years and hope to have saved enough’ mindset … and they have worries of their own, as this recent Gallup Poll showed:

Of course, recent economic woes are probably ‘skewing’ this a little … but, think about it – most aren’t retiring tomorrow, or even in the next 10 years, so markets will have plenty of time to boom and bust again for them.

No, the problem is more endemic: most people simply don’t think that they will be able to retire happy or comfortably – and certainly not wealthy – despite the ‘formidable’ array of ‘retirement weapons’ at their disposal:

So, if the majority of people are using these tools and the majority of people believe that they won’t work for them …

Whatup?!

Surely, at some level, these people know that these tools – as I have been hammering home in this blog for some months now – simply won’t do the job?!

Let’s take a look:

1. 401k’s – High fees; low returns; lousy investment products on offer:

STRIKE 1 – I have never had a 401k and I have no idea what is even in any of my tax-advantaged / retirement accounts.

2. Social Security – An unfunded program; USA in the highest level of debt in history’ what’s the chances of Social Security being around in the same form when YOU retire?:

STRIKE 2 – When my social security statement arrives I chuck it in the trash without reading it, it’s irrelevant, it won’t be around when I retire, and I had this same line of thinking BEFORE I became rich.

3. Home Equity – Please! Where do you intend to live when you retire? By the time you buy and pay changeover costs etc. if you see any spare cash, it may be just about enough to pay off your remaining credit card debt:

STRIKE 3 – I live in my home equity, don’t you?

4. Pension Plan – Do you work for Ford/GM/Chrylser? Any airline? Just about any bank?:

STRIKE 4 [AJC: 4 strikes???!!! I'm an Aussie, what do I know from baseball?] Ditto to the above, in fact, I have never subscribed to an employer-sponsored pension plan, even where I have had the choice.

… need I go on?

The point is, if you know these tools aren’t going to work for you – as the majority of Americans surveyed by Gallup seem to – yet you keep using them – as the majority of Americans do – isn’t that the very definition of ‘insanity’?

Now, that’s a question that I would love to see the Gallup Survey for!?

Money Makes the World Go Around …

It’s sad, but true … it seems that money does make the world go around.

It’s what seems to drive people to make – lose then make – lose … and, so on … their money. It becomes an end rather than merely a means.

But, I have a slightly different view:

1. FIRST decide WHY you need the money … I call this Understanding Your Life’s Purpose

2. THEN decide HOW MUCH money you need in order to do whatever it is that you need the money for (and, by WHEN) … I call this Calculating Your Number

3. FINALLY, when you DO get to your Number, STOP and LIVE YOUR LIFE.

… the fallacy of dividend paying stocks!

When I’m not writing posts here, I’m hanging around the Share Your Number Community Site, talking to the other members.We launched this site in 2008, and in 2009 we are planning a major expansion so please join now … it’s FREE and easy!

Remember, helping others get to their Number is the best way to get to yours …

________________________

I have been itching to write this post for some time now, and yesterday’s post about investing in income-producing real-estate v speculating in (hopefully) appreciating RE should have provided the necessary comments/questions …

… but, it didn’t

However, Steve chose this particular day to finally complete his comment on a post that goes back 6 months … a comment that is right ‘on topic’ for me … and, is a question that all of us should be asking … so, thanks Steve!

Here’s what Steve had to say:

I don’t purport that he is write [sic] in his article but would really love to hear your views on [this] story…

http://seekingalpha.com/article/84850-investing-in-dividend-paying-companies?source=d_email

what i liked about it is the dividend paying stock situation. certainly i wouldn’t consider as an only avenue to wealth, but do you feel dividend paying stocks are a better choice than non dividend paying stocks?

The article promotes a method of investing that the author claims returns “a little over 8.68% annually … while not earth shattering by any means, compare[s] very favorably with the market’s performance over the same period. From July 1988 to now, the S&P 500 has advanced … around 7.86% annually.”

The ‘now’ is actually July 2008, so only reflects some of the recent stock market losses, but the principle is clear, at least according to the author: invest in dividend-paying stocks …

… and, this is certainly ONE (of many) Making Money 301 tactics that I recommend when you have made your Number and are trying to preserve your wealth. However, it is just that – a tactic – and, certainly not the best one there is.

Given this, and my strong recommendation that you invest in RE for income, you might be a little surprised to hear me say:

As a Making Money 101 or 201 strategy, seeking out dividend-paying stocks is almost irrelevent!

Why?

Well, let’s take a look:

Stocks return in TWO main ways, just like real-estate:

1. Capital Appreciation

2. Dividends

Capital Appreciation

Just like real-estate, the price of a stock tends to go up according to the profits of the company. When I say “just like real-estate”, I mean just like commercial real-estate … residential real-estate has other, less tangible drivers of future value. So commercial real-estate tends to rise in value as rents rise, and stocks tend to rise in value as the company’s profits rise.

Naturally, inflation is a key driver (forcing rents/profits up, hence the price of the real-estate/stock) but there are plenty of other ‘micro’ and ‘macro’ factors as well e.g. for real-estate it could be job growth, for companies it could be competitive pressures, etc.

This is what I would call the Investment Factor that tends to drive up the value of such investments, and you can generally be confident that prices will increase according to this factor – over the long-haul.

An equally important factor is ‘market demand’ for that type of investment, which is reflected in ‘capitalization rates’ for real-estate and ‘Price-Earning (PE) Ratios’ for stocks … this is essentially a measure of how long somebody who buys that investment is willing to wait to get their money back via future rents/profits.

This is what I would call the Speculation Factor that tends to drive up or down the value of such investments, and you can never be sure which way this will drive prices - over the short-haul.

Unfortunately, as recent market events in both real-estate and then stocks have very clearly shown – the Speculation Factor has a much greater effect on pricing than the Investment Factor … unless your time horizon is very long, indeed.

This is why it is much better to look for the underlying investment returns, unfortunately often mistakenly confused with …

Dividends

Because Real-estate produces rents – and, hopefully positive cashflow after mortgage and holding costs are taken into account (which, should be your main criteria for investing ), people often confuse dividends paid on stocks with returns on real-estate investments.

This is not the case:

Whereas real-estate returns are simply the rents that you receive less the costs (e.g. mortgage, repairs and maintenance, etc.), stock dividends do NOT directly reflect the profits of the underlying business.

Commercial real-estate usually provides an investment return set by a ‘free market’ (for things like competitive rents, competitive interest rates, etc.) …

… but, the dividends on most stocks are simply set by a board of directors according to whatever criteria makes sense to them at the time.

People who invest in dividend-paying stocks are confusing dividends with company profits … but they are NOT directly aligned: a company may make super profits and not pay a dividend at all (for example, Warren Buffett’s own Berkshire Hathaway has NEVER paid a dividend).

A company that makes NO profit may still choose to pay a dividend (perhaps from cash or even borrowings) … just to keep their shareholders happy (for example, in 2004 Regal Cinemas paid a $5 per share dividend; “to make the $718 million payout, Regal first had to borrow from its banks”).

Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T?

I’d love to hear your views …

___________________

You can also find us at the latest Money Hacks Carnival, hosted this week by Money Beagle …

Investing is a business …

There was a craze that hit Australia in the 90′s and America in the 2000′s … we know the result, but what was the cause?

It was the ‘negative gearing’ craze …

… people were promoting real-estate purchases on the basis that you take a loss now and make a (hopefully, huge) capital gain in the future.

The benefits that used to be promoted by the real-estate gurus are stated very nicely in this comment on Andee Sellman’s blog:

You have forgotten tax benefits which can be substantial. Also, the actual equity needed to purchase his investment could have been minimal compared to the purchase price. Most importantly, over time the tenant and the tax man pay for the majority of his investment.

Now, I would understand this comment if it were from 2005 or even 2006, but it is from only a couple of months ago …

… if we don’t learn from our mistakes, we are doomed to repeat them!

When real-estate is going up in price, it is easy to get caught in the trap of buying on the basis of future capital appreciation, and use tax deductions on the mortgage and depreciation benefits on the building and improvements to help ‘soften the blow’ as running costs were typically higher than the income (in some places, severely so … yet we still bought!).

Given the current market we all KNOW the problems this causes, but real-estate – and sentiments – cycle every 7 to 10 years, so WHEN you forget what happened in 2007 and 2008 during the next boom, pull up this blog and remember:

Treat your real-estate investment as a BUSINESS.

A real business is bought (or started) because it does (or soon will) produce profits and free cash-flow year in and year out, and then MAY be sold at a future date for a speculative gain. At least, that’s what happened to me …

… I can’t understand why we shouldn’t look at any other investment, including property, exactly the same way?

Can you?!

The perfect way to allocate your spending?

I saw this on Get Rich Slowly and wonder what you think of it?

Since I didn’t allocate my own spending this way ‘on the way up’, I can’t comment either way … but, maybe some of you can?

Here’s how it works:

You take your After Tax income and divide it into three categories:

1. Needs – These are you ‘must haves’ i.e. things that you can’t go without: rent/mortgage; car; electricity; basic food (the book provides a ‘rule of thumb’ for this); and, so on.

You allocate 50% of your after tax income to these needs; given that we already have the 25% Income Rule (spend no more than 25% of your after tax income on rent/mortgage) that leaves 25% on all the other ‘needs’.

2. Wants – According to the book, you should have fun – and, budget 30% of your after-tax income for it. I happen to be of the same mindset … what is money, if not for spending (except that you must do it in a way that allows you to live your Life’s Purpose by your desired Date). 

According to the book, ‘wants’ include additional food (i.e. lamb chops instead of dog food?), your cable TV and internet (these are definite needs for me, especially on my 100″ home theater screen … but, I can afford it!); trips and vacations; and, so on.

3. Savings – that leaves (or should leave) 20% of your after-tax income for your 401k investments and other savings/investment … since this is 5% to 10% more than most authors suggest, I commend it. Just remember, that even with 20% you’re not going to be able to save your way to wealth.

All in all, it seems like a pretty good savings plan to me … what improvements would you make?