… another man’s poison!

To some people, it seems that I promote high-risk strategies. For example, long-time reader, Josh says:

I wondered over to your blog to see what’s new and after reading a few posts I realized why I don’t visit anymore, and it’s because your articles are drenched in pro-debt/leveraged strategies. This is something I don’t agree with and don’t practice. I do understand the mathematical ramifications of using debt to leverage yourself, it’s just something I plan to do without.

Firstly, what Josh is saying isn’t quite true …

… in fact, I don’t recommend debt to anybody. What I have said is that I don’t believe in the anti-debt lobby.

There’s nothing evil about debt per se, it’s if/how/when you apply it that counts.

For example, I have variously had:

a) a little debt: on my various buy/hold properties

b) a lot of debt: in my finance company (for a finance company, cash is like stock … you need as much of it on hand as possible)

c) no debt: all of my other businesses were ‘bootstrapped’ and self-funded

I should point out that Josh is a stock investor; he has made a small fortune (turned a couple of $k into one $m or so while still at college) buying pharmaceutical ‘penny stocks’ … I wonder how many people would consider that risky?

One man’s ‘sensible investment strategy’ is surely another man’s poison

Would you cash in your 401k to fund your new business venture?

There was a question on Quora that asked something along the lines of “what is the most overlooked factor in starting a business?”.

This applies equally to an online or offline business … and, I was surprised that none of the responses mentioned it:

Risk

.

In order to launch a business, you need to be able to overlook risk.

Even though risk can be managed, if you sat down to think about all the possible things that could go wrong with your proposed business, well, you would never start it.

So, I think you need to be able to overlook risk – and, move well out of your comfort zone (unless you are already into extreme sports and other forms of death wish!) – if you are to think about starting a business that consumes considerable time and/or money (no ‘hobby businesses’ here).

Hopefully, this now paves the way for a sensible discussion around a rather controversial Wisebread article sharing Darwin’s thoughts on How to Start a Business With Your 401(k).

Darwin’s view is that, rather than taking on expensive debt, it may be better to start your business by withdrawing all or part of your 401k using “a little known, but increasingly popular provision in the tax code referred to as the Rollover as Business Startup (ROBS). It allows someone to start up a new business venture with funds from an old 401(k) account without incurring the dreaded early withdrawal penalties meant to deter people from using their 401(k) accounts like piggy banks.”

A sensible – negative – response is offered by one reader:

To avoid going into debt is a pretty bad reason to raid your 401(k). If your business fails you can always declare bankruptcy – bankruptcy can’t touch most 401(k)’s – you’ll still have your retirement savings…roll it over into the business instead, have it fail…and you’ll have nothing.

And, I agree – to a point: your 401(k), although woefully inadequate for its intended purpose (i.e. ensuring your retirement) is useful as an insurance policy when all else in your financial life goes wrong.

Cashing in your insurance policies because you need money is the last thing that you should do!

But, this viewpoint ignores some basic realities:

1. Going into business, for a true entrepreneur (the type that can build a $7m7y business) is a “must do”.

Starting my own business was all I could think of for 4 years (yes, I was slow to act), and risking everything (career, etc.) was simply par for the course. I’m not saying this is ‘right’, just that it’s how an entrepreneur thinks.

2. Raising significant debt finance is almost impossible for a new business.

Sure, you can (and should) tap out your sources of traditional finance: refinancing your house (if you’re not already upside down on your mortgage); max’ing out your credit cards; trying for a personal loan (fat chance once the bank manager finds out what it’s for).

I do not think cost of the debt is an issue (if it’s available TAKE IT because it’s deductible and you’ll pay it off if your business is successful). I do think access to debt is … I think you’ll find it’s just not available; at least, not in the amounts required if your business requires access to substantial capital (e.g. for shop fit-outs, software builds, stock purchases, etc.)

3. Equity Capital can be equally difficult

The first place you should go for funds for your new venture is the 4 F’s: Founders (see above), Family, Friends … and, Fools. These days, Fools are very hard to find (they’ve already had their pockets emptied in the crash!) and Family and Friends are less likely to dig into their pockets than ever before.

So, that may leave your 401(k).

If that’s the only source of funds for your new venture, what will you do?

Help a reader …

I received this e-mail from Bristol:

I am in love with your debt cascade idea, I was stuck in an internal conflict about paying off debt or investing for years until now. I would like to apply your debt cascade to my financial situation and need your help.

I have an extra $2000.00 after minimum payments per month that I dont know what to do with.

StudentLoan $15000 @ %4.25
StudentLoan $15000 @ %3.75
StudentLoan $8000 @ %3.5
Mortgage $130000 @ %5

What amount would you put on these loans and what amount would you invest?

Help me help a reader; what advice would you give?

The False War On Debt …

There’s a war raging out there: it’s being fought by authors and bloggers everywhere.

But, is it the right war? Is it a just war? Or, are we just throwing ourselves, by the millions, into a hail of fire: exploding spending, rampant inflation, the death of social security?

Sure, as we sit in the relative safety of our trenches (at least, that’s what we tell ourselves, until a random mortar shell of job loss or unexpected expenses chooses to lob our way) this is not OUR future … it’s somebody else’s, or it’s too far away, or it just can’t happen …

The sad truth is that legions have jumped the wall before us and have been brutally cut down for lack of an adequate nest-egg; it’s sad to see them go over the dreaded wall of retirement (be it their time, or forced on them early) without an adequate safety net … when they do, it’s as though their grim fate had already been sealed.

Broke – or ‘just’ financially crippled – and unable (for financial reasons) to live life as they had hoped, they are a sad, sad lot.

You see, the war that they fought wasn’t – isn’t – a just war. It’s not even a war … well, it shouldn’t even be more than a skirmish.

It’s the War Against Debt!

When it comes to that war, I’m strictly a pacifist; isn’t it better to simply avoid BAD debt?

Of course, that doesn’t mean that we can’t … shouldn’t … defend ourselves.

Far from it: if we find that BAD debt has snuck through our defences, let’s keep an eye on it. And, if we find that it’s also EXPENSIVE debt, then let’s whip out the Big Guns and wipe it out. Quickly, surgically …

… but, let’s not commit Debt Genocide.

You see, unlike the well-intentioned, but largely Debt-McArthyist “ALL Debt Is Bad, So Let’s Wipe It Out” rabble out there, let’s first ask The Missing Question:

What will you do after your debt is paid off?

“Well, start investing of course!”

But, does that REALLY happen? Who better to ask than Money Reasons:

This past February 2010, I became totally debt free, but now what!

I thought that there would be a period where I would break even for a while, and then start to plow about $1,000 extra each month into investments!  So now that it’s seven months later and how much extra did I save or invest?  Not a single cent!

Hang on, the whole purpose of suiting up for battle – for going to war against debt – was so that you could start investing, right? What’s up with that, Money Reasons:

Well it’s been a matter of bad luck with equipment breaking down and needing replaced and spending too much for our past vacation to Hilton Head Island!

But it’s also been a subtle form of LifeStyle Inflation!  Thinking back now, I realize that when wants would arise, I would just go ahead and buy it.  Yeah, I thought about it a bit, but I knew that I had the cash.  Then when your car and lawn mower broke down, I had the cash too…

Money Reasons should have started investing well before all of his debt was paid off … he should have started investing as soon as his expensive debt was paid off and left his cheap debt on a regimen of minimum payments.

The problem with this war is that it’s an unjust war; as TraineeInvestor said: “Debt is a tool. Paying it off is simply choosing not to use the tool.”

Yes, becoming debt free is simply a tactic …

If you have to go and fight a war, don’t fight a war against debt …

… go and fight a war for investment

Pay off debt or invest?

I’m publishing a whole series of posts targeting Debt … it has very little to do with conventional financial wisdom on this critical subject. Here is the second post (I have another one coming up, soon) …

______________________________

Gen-X Finance is polling his readers as to whether they would prefer to pay down debt or save:

If you have both debt and a need to save money, how do you prioritize? Some people will pay off debt at all costs before saving a penny. Others will be fine getting by with minimum payments while dumping as much money into savings or investments as possible. While others try to do a little bit of both. That’s why the poll today asks how you view this subject.

You should go ahead and answer the poll.

Now, this is such an important decision – perhaps one of the MOST important mindset changes that you need to make if you want to follow in my $7 million in 7years footsteps – that, for my new readers, I will point you again to my trademark Cash Cascade™ system (don’t worry, it’s simple and free) that replaces the Debt Snowball, the Debt Avalanche and most of the other other debt repayment systems that you may have previously tried.

Here’s why it works:

People make the mistake of thinking that there is GOOD DEBT (typically, investment debt) and BAD DEBT (typically, consumer debt) … but, this is only true BEFORE YOU TAKE ON THE DEBT.

Once you are in debt, then there is only CHEAP DEBT and EXPENSIVE DEBT. Put simply, pay down your expensive debt, until only the single digit ones (on an after tax basis) are left, THEN start investing.

This goes against the ‘pay down all debt’ theories, but works both logically and practically. Try it … and, let me know how it’s working for you?

Becoming debt-free is a tactic …

My uncle had a wish: he wanted to stay healthy. He heard that eating apples is good for you (you know, ‘an apple a day keeps the doctor away …’), so he started eating apples.

If one apple is good, he thought, then two must be better. In fact, he started eating apples religiously. He got Vitamin A poisoning. He stopped eating apples.

There is such a thing as ‘too much of a good thing’

I sent out the tweet in the graphic at the top of this page because too many Twitterers/Bloggers – and their followers – eat too many apples.

Here’s what I mean …

If you’re healthy you get to run and run and run, just like a puppy does. Fun!

If you’re financially-free you get to do pretty much whatever your ‘freedom’ allows, and you no longer need to spend 8 hours a day (or more) at work for The Man. Whoohee!

But, being healthy and being financially-free are ‘wishes’ – something that you want. Just wanting something doesn’t mean that you’ll get it.

So, you eat an apple a day because a doctor told you it’s good for you … or you start paying off debt because a blogger told you that’s it’s good for your financial well-being.

But, the problem with these proscriptions is that there’s no prescription [AJC: yet another bad pun] … you need to be told exactly how much of a good thing is really a good thing, before you keep going and overdose!

You see, eating apples – as my uncle found – and paying down debt – as many blog-readers find out too late – can be good or bad for you, depending on how much you under- or over-do things. Eating apples and paying down debt are just tactics promising to help you get you to where you want to go.

With debt-reduction – as with apples – there’s an optimal point: it’s the point where it contributes most to your real goal.

If your wish is to become financially-free then your goal should be able to be expressed as a specific Number and a specific Date; you should apply debt reduction in such a way that it maximizes your chances of reaching that Number by that Date.

I have a hypothesis that the Number/Date bell-curve for my reader population – nay, the entire personal finance blogosphere’s readership – is well and truly centered where paying down debt only makes:

- absolute sense in the double-digits i.e. where most credit card, personal, and (many) auto loans sit today

- no sense (nonsense?) in the low-to-mid single digits i.e. roughly where home mortgage rates and student loans sit today

And, the remaining debts (say, between 5% and 10%), they can be paid off, if you have low financial aspirations but if you are aiming for $7 million in 7 years, I’m suggesting that these, too, need to be set aside for a while in favor of funding your latest startup and/or active investment.

Paying down debt IS investing …

Budgets Are Sexy [AJC: If J. Money really thinks so, I don't want to be invited to his Stag Night!] poses an important question: “Should you invest or pay down debt?”

And, he provides these guidelines to help you decide the answer:

Whenever you have any extra money in your pocket, make sure to take care of these financial priorities, in this order, before you do anything else:

1. Pay down any delinquent debts that could threaten your well-being or credit score, such as an overdue tax bill or legal judgment.
2. Accumulate a financial safety net. If you don’t have at least three to six month’s worth of your living expenses saved up in an accessible emergency fund, that’s the next place your extra money should go.
3. Pay down high-interest debt. If you have credit cards, lines of credit, or auto loans, with double-digit interest rates, attack those financial burdens next.

If you’ve accomplished the above and still have excess money left over each month, you’re in a great position. Maybe you have an extra $100 and are struggling with whether to invest it in your Roth IRA or to use it to pay down your mortgage, for example. The answer to the dilemma is simple: Determine which option is more profitable for you. To do that, you have to figure out your after-tax return for each choice.

I agree with the first bullet point: you must pay down any delinquent debts. You have to keep your head above financial water.

As to the rest, well, I think that we’re in danger of forgetting a critical point:

Paying down debt is investing!

You’re investing in your own ‘debt instruments’, where the risk is low (in fact, by paying down the debt, you’re IMPROVING your risk profile) and the return can be low / mediocre / high depending upon the AFTER TAX cost of the interest and any other fees and charges.

Your student loans and mortgage debts are probably LOW interest, hence LOW return investments.

Your car loan and credit card debts probably HIGH interest, hence HIGH return investments.

… and, you may have some personal loans or other debts that fall somewhere between the two.

So, I would modify BAS’s guidelines as follows:

1. Pay down any delinquent debts that could threaten your well-being or credit score, such as an overdue tax bill or legal judgment.
2. Put in place a financial safety net. Put a HELOC in place; make sure that you can tap into your retirement accounts, or keep some spare loan facilities in place in case a financial emergency arises.
3. Pay down high-interest debt. If you have credit cards, lines of credit, or auto loans, with high double-digit interest rates, you’re probably safe in attacking those financial burdens next.
4. Find investments that can outperform your remaining debts. If you have 1st mortgages, student loans or other loans with low single-digit interest rates, let them ride PROVIDED that you instead invest somewhere where AFTER TAX returns should be expected to outperform these remaining loans by a comfortable margin.

Once you’ve made the mental leap that paying down debt IS investing, you’re in a MUCH BETTER position to decide how best to use your money … particularly if you have optimistic financial goals

The problem with Henry …

Actually, it’s not the problem with Henry, it’s the problem with HENRY: High Earner Not Rich Yet.

Included in this group, a group that most workers mistakenly aspire to, are those doctors and ceo’s (at least those not in the Fortune 500) that I mentioned in yesterday’s post.

Now, this is only interesting because I can now answer the question posed on Twitter [AJC: you can glance across to the right to conveniently find a link to my Twitter account].

Dianne Kennedy (CPA), I think erroneously, links HENRY’s to taxes then lifestyle, but (as my article some time back about doctors also said), I think it boils down to three non-tax (even though taxes hurt!) issues:

1. As your income grows so does your spending … then some!

2. Keeping up with YOUR Jones (i.e. other high-flying corporate executives and professionals) is VERY expensive

3. You can’t sell a salary package (like I can sell a business, some shares, or a property or two) when you decide to retire

[AJC: You need both a big 401(k) - see reasons 1. and 2. why this doesn't happen - and a huge golden parachute, which may / may not happen to compensate for reason 3.]

If HENRY’s want to become rich, they have only two choices:

- Get lucky, or

- Invest a very large % of their annual earnings

Let’s assume that a HENRY – conveniently named Henry who happens to be ceo of a medium-sized business – is earning $290,000 and has already managed to save $1 million – our consummate Frugal Investor – and has arranged things so that he can continue to save a very hefty 35% of his salary (this is all pre-tax).

After 22 years, Henry will have saved just enough (in Rule of 20 terms) to replace his $290,000 ceo’s salary … by then, inflation adjusted to $661k per year, assuming that he wants to maintain his lifestyle [AJC: more importantly, assuming that he can - and wants to - 'ceo' for 22 more years ... if he 'only' starts with $500k in savings, he'll need to work for at least 26 more years].

Seems easy, but human nature [read: urge to spend it up] is what it is …

I should know: I was ceo of my own business, employing over a hundred people across 3 countries (USA, Australia, and New Zealand).

I paid myself $250k per year, and had cars, cell phones, laptops, and health insurance all paid for by my company – I reinvested all the remaining profits in these businesses.

I had a $1.65 million house in the ‘burbs, paid for by cash (s0, no mortage), and two children in school (one private, one public). We traveled domestically and/or internationally once or twice a year as a family, ate at ‘normal’ restaurants (and, the occasional top-tier eatery).

I can’t see how I could have saved 1/3 of my salary … I couldn’t even save 10%

Of course, I could have saved 10% if I really tried, but my point is that it’s very hard to save 30% of even a high salary, unless you gear yourself up to do it from the very beginning.

[AJC: Look, it's not my job to tell what should happen as you get richer, but the reality of what will happen and how to do better ... when you get to $250k you will bring with you exactly the same spending and saving habits as you have today, if not worse. Moral: start MM101 today!]

In other words, don’t divert all of your creative energy into playing Corporate Lotto (i.e. chasing a higher salary) if you want to get rich – or, even to reach a more humble goal, such as becoming debt free (a dumb goal, IMHO).

First – and, as soon as possible – learn how to get rich (or debt free, or …) by taking action right now, with whatever you can bring to the table.

If your salary happens to improve along the way, all the better … but, don’t rely on it!

When is cheap debt expensive?

Dave Ramsey says to use Gazelle Intensity to pay down all debt, before even thinking about investing. Yet, would he consider running his (rather large) business without an overdraft, or leased cars, equipment, and/or furniture?

I doubt it … he needs to preserve his capital, and put it to better use by growing his business investment (more stock; better marketing; more staff; more training; etc.; etc.)

So, why should personal finance be any different?!

But, Dave Ramsey would argue to pay off all debt, whether it is ‘good’ (e.g. produces income) or ‘bad’ (e.g. credit card loans for consumer goods, like that LCD TV that you just bought).

If you are a regular reader of this blog, by now you will know that my view differs markedly; I say:

Once the debt is incurred, it is no longer ‘good’ or ‘bad’ … it becomes either ‘cheap’ or ‘expensive’.

And, as I mentioned in a previous post …

You should only pay off your ‘expensive’ debt!

What makes a debt ‘cheap’ or ‘expensive’? What is the yardstick interest rate? 2%? 5%? 11%? 19%?

Any, all, or none of the above. You see, it’s relative:

- Debt only becomes ‘cheap’ when you have something that produces a better after-tax return [AJC: probably, a MUCH better return to account for the fact that paying off the debt is a GUARANTEED return].

- Otherwise, by default, all debt becomes ‘expensive’ and you should do as Dave Ramsey suggests.

Fortunately, finding suitable investments to offset the need to pay off relatively low-cost debts such as student loans and home mortgages is as easy as finding some great value stocks, a cashflow positive real-estate investment or three, or a small business to buy or begin …

… provided that these are things that you are:

1. Passionate about,

2. Educated in, and

3. Convinced are needed in order to achieve your Required Annual Compound Growth Rate to reach your Number.

I recommend that – if you are pursuing a Large Number / Soon Date - you must pursue your investments with Cheetah Focus … a great example is provided by Eric [AJC: emphasis added]:

I graduated college 2008 from the University of Texas. worked at an oil and gas company in Houston named Flour Daniels. they had massive lay offs in 2009. I worked for a year and managed to save well over 50% of my pay. I reinvested it all into the stock market. I set up a regular investment account and a Roth IRA.

To date my Reg. Stock account is up 30%+ and my Roth IRA is up over 60%. and I still have another month to increase my yearly gains for it

I have had no prior experience with investing/trading. I played safer stocks/ETFs .. Bought on dips and sold when it would pop.

Oh and I also took out a loan from Citi bank.. who sent me a 10,000 loan offer in the mail with a 2% interest for the life of the loan. LOL.. I had to take it. I threw that into stocks also.

Any how my point is. If i had focused on paying off my $28,000 college debt I would have missed all of last year gains. I just made it a goal to beat my debt interest. and I did!

Currently I have enough money to pay off all my debt. but of course i’m not going to do it. I took out 2K from my portfolio to invest in an online woman’s clothing site. We have great style at affordable prices. we are not making huge profits.. but we are selling and that is encouraging.

Did you notice in the image (above) why the gazelle has such intensity?

It’s because the cheetah is coming up fast and furious on his tail ;)

Is he really a clever dude?

[Disclaimer: Artist's rendering of AJC ... any resemblance to other bloggers living or dead is purely coincidental]

Have you noticed that I don’t have a category for debt on this blog?

[AJC: you can click on any of the keyword/categories in the orange header-banner above to see a list of blog posts focusing on that subject]

It’s not because we don’t talk about debt, as we clearly do …

…. it’s because, to me, creating or paying off debt is just the same as investing (after adjusting for tax: a dollar saved in interest, is the same as a dollar earned in interest or investment income, right?).

That’s why I was genuinely interested in finding out what was going through fellow-blogger Clever Dude’s mind when he loudly proclaimed:

We’re Free of Consumer Debt!!!!!!

As of today, we have paid off all $113,000 of our student loans, auto loans and credit card debt.

We are debt free!!!

My fellow blogger is right to be proud of his achievement … but, does that make it the right investment choice?

Check it out:

He paid off $113k … now, this is no small achievement, some people don’t even save that in their entire lifetime! Still I couldn’t resist asking Clever Dude for some details:

The rate on the student loans was 6.25%. The 2nd mortgage is 7.875%. First was 5.25%.

I chose to pay off the student loan because it was more manageable and I could get it off the books faster than the 2nd mortgage. Mathematically, the 2nd mortgage makes more sense until you factor in the tax deduction which brings them down to about equal.

I also wanted to know a little about his current net worth (after the mammoth debt-payoff feat) – nosey, aren’t I?! Anyhow, Clever Dude was happy to share:

Don’t mind the math as I rounded:

Cash: 17%
Investments: 37%
Home Equity: 6%
Autos: 17%
Personal Property: 12% (if I could sell it all right now)
Whole Life Insurance: 5% (yep, I got it, it’s expensive, but I’m not giving it up!)

So, Clever Dude has ‘invested’:

-> $113k in loans returning (by avoiding having to pay) around 6.25% after tax

-> 17% of his net worth in cash returning (I’m guessing here) 2%?

-> 6% of his net worth in his home returning some unknowable amount in future (potential) capital gains

-> 5% of his net worth in insurance ‘investments’ of dubious value after (often) exorbitant fees

-> 29% in (presumably) depreciating ‘assets’ such as autos and personal property

Now that he is debt-free, what  will drive Clever Dude’s investment strategy from here on in? He says:

Investing and savings are next up in our planning. Honestly, we’ve spent so much time just thinking about debt, we haven’t spent much time on the future. Now is the time.

Now, I’m not here to pick holes in Clever Dude’s investment strategy as he had a strategy and moved mountains to achieve it – not to mention, that we know so little about Cleve Dude’s true financial situation that we are in no position to advise / criticize …

…. but, I do want to use this example to show why following a blind – and, in my mind totally arbitrary – investment goal such as “reducing debt” is not always the best idea:

Clever Dude has only 37% of his net worth in investments right now (OK, he is working on his Master’s Degree, so he has had other things on his mind) and has limited the bulk of his net worth’s returns to only 2% to 6% (or so) by almost-totally focusing on paying debt.

Why?

So, that he can start “investing and saving”!

Now, does that make sense to you?