How to manage your life with just $19 Billion …

After the recent Facebook float, how did Mark Zuckerberg fair and – more to the point – how is he going to live?

According to the online business media:

The founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 billion payout. It’s a huge amount of money, even after taxes, but it doesn’t come close to his final stake, somewhere in the region of $US19 billion.

So, the answer to the “how is he going to live?” question is: very well, thankyou!

Instead, let’s take a look at a hypothetical Internet business owner whose company IPO’d for mere millions in value, instead of Zuckerberg’s billions:

Let’s say that our hypothetical founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 million payout. It’s a lot of money (let’s pretend that it’s after taxes), but it doesn’t come close to his remaining stake in his company, somewhere in the region of $US19 million.

How is our founder to live?

It would be tempting to say that he has $20 million, so a typical ‘safe withdrawal rate’ of 4% [AJC: which could be achieved through a combination of dividends and selling down small amounts of stock each year] would suggest that he has a massive $800k disposable income each year.

But, spending anywhere near $800k – even spending anything more than 25% of this amount p.a. – would be a huge mistake.

You see, the bulk of his money is in stock … and, risky stock at that: 5% of his net worth in cash and 95% in one relatively small, ‘hi tech’ company …

… and, we know what happens in tech: it can be boom/bust [AJC: remember MySpace, anyone?].

This is no different to an athlete trading off his contract, and spending money like it’s forever … except when it isn’t, which is why 78% of NFL players and 60% of NBA players are bankrupt within two years of leaving the game.

The second – less aggressive – temptation, then, would be to live off the dividends from the stock held …

…. let’s say that the company pays 2% dividends [AJC: which would not be unusual for a tech. company seeking to reinvest in itself, or acquire other companies, even though many - such as Apple - would pay zero dividends], which would deliver $400k per year.

But, again, what happens if the company stops paying dividends?

Instead, what our founder needs to do is realize that he is merely potentially very rich, but right now is a very valuable employee (and, controlling shareholder) of a company that is rewarding him with (a lot of) stock that may – or may not – one day convert to cash.

So, what our founder needs to do is count his blessings … I mean, assets:

1. He probably has a very healthy $400k+ annual salary, he should live off no more than 50% of this (indexed for inflation) and invest the rest.

2. He probably receives $400k in annual dividends; he should add 100% of these to his nest egg.

3. He has a starting nest egg of $1.1 million, which he should invest in ‘passive’ income-producing investments [AJC: real-estate is ideal for this]

As he starts to convert more stock to cash (i.e. through sale of small amounts of stock each year, as the law & his board may allow, and/or dividends) eventually, his nest-egg will grow to $4 million …

… which is his lifestyle break-even point i.e. the Rule of 20 says that your nest-egg should be 20 times your required annual living expense, which is currently $200k.

The good news is that anything converted to cash – hence, into passive investments – over $4,000,000 allows our founder to increase his annual living expense.

You’ll find that if you follow this system:

a) Sure, you’ll be living well below your ‘paper means’, but once you realize that your wealth is merely on paper, you’ll get over it, and

b) You’ll slowly-but-surely be transferring your ‘paper wealth’ into real wealth (i.e. passive investments), and

c) If you choose income-producing real-estate as your vehicle for holding your ‘real wealth’, you’ll pretty quickly find that you are able to support an even more quickly-increasing standard of living, no matter what happens to your tech company, and sooner than you may think.

This is how to bullet-proof your future …

… unless you’re Mark Zuckerberg, who can probably already survive on 4% p.a. of $1.1 billion

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How to ruin your return by paying off principal …

A while ago, I did a three-part ‘anatomy of a commercial real-estate deal’ …

Drew wanted to know:

You mentioned 63k income that you can spend, but I don’t see you including principle payments. Wouldn’t that cut into your cash flow?

You’ll need to go back and read the three-part article, but this question goes to the heart of whether to pay off your mortgage, and is somewhat the same argument whether you want to do this on an investment property or even your own home.

It boils down to return:

The building that I was looking at buying would have generated $255k in rents – $192k in expenses (including $130k bank interest) = $63k net ‘profit’ p.a.

Paying down principal doesn’t change that dramatically: it does lower my interest expense, which should increase my net profit, hence my return …

… in $$$ terms.

But, when you do the math, it can lower the % return  that I am getting on my money.

Aldo says:

Continuing with the comment from the previous reader, can you elaborate a bit more on why principal payments would not affect this deal? On the previous article you mentioned going for a 7yr financing or so, which will represent about 250-300k of additional capital you need to put each year. After the first year you would have invested 700 + principal (let’s say 250k) = 950k. The 63k you make then will become a 6.6% return on your own money… Then down to 5% the next year… And so on…

Aldo has forgotten to allow for the reduction in interest expense as my equity increases (and, the bank’s loan decreases), but he points to the % return on my overall investment decreasing …

… whereas, an investor should generally be looking to increase their % returns.

In simple terms: if I can buy a $100k property with 20% down (i.e. $20k), when I find (e.g. by saving) another $20k, am I financially better off:

1. Putting it into this property to pay it off quicker?

2. Putting it into my home mortgage to pay my home off quicker?

3. Putting it into another $100k property that I can buy with 20% down?

In order of decreasing return, it’s generally 3. then 2. then 1.

I know which I would rather do. How about you?

Poor little rich doctor …

A couple of weeks ago, I responded to a reader request from a young doctor who is on what can only be described as an OMG level of income:

I am a young physician (early 30s) making approximately 800k per year. After expenses and taxes, I am left with ~300k to save/invest.

Never mind the fact that he is losing approximately $500k a year in “expenses and taxes”, a $300k take home is still pretty good in anybody’s language!

There was plenty of well-considered reader debate and advice for the young doctor, including this highly-reasoned argument from traineeinvestor:

I’d suggest he continue to focus most of his energy on maintaining or growing his professional income. Time spent on side ventures and investments should be limited so that it does not interfere with the $800K professional income.

In terms of investments, given his time constraints, I’d go with a Boglehead approach, possibly supplemented with some geared cash flow positive real estate (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs).

I agree on both counts:

a) When you are earning a super-high level of salary, your primary goal should be to protect that source of income. It’s a river of money: you should do everything in your power to keep it flowing!

b) However, you shouldn’t just let the money flow into the taxman’s pocket, then into yours, and then out again by increasing your spending. Instead (and in keeping with our ‘river’ analogy) you should also build a downstream dam.

And, you should only open the sluice-gates to let off a much smaller amount than is going into the dam …

Why?

Because that’s the only way that the dam gets to fill up!

This way, when the river stops flowing (ideally, at a time of your choosing i.e. early retirement, but it could be forced upon you even earlier for a variety of reasons), you can keep the sluice gates open, knowing that there’s still enough water in the dam to keep the flow running for the rest of your life.

In other words: you don’t want the dam to run dry before you do

But, this is much harder to achieve than you may think, so here’s where I differ – but, only slightly – starting by reversing the order of traineeinvestor’s otherwise excellent investment strategy:

I’d go with a geared cash flow positive real estate approach (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs), possibly supplemented with some Boglehead-type investments.

The reasons are two-fold:

Firstly, I’m not accepting that 62.5% (i.e. $500k) of our doctor’s $800k earning capacity can simply be wiped off in ”expenses and taxes” …

… professionals are just sitting ducks when it comes to taxes.

But, by implementing a nicely geared (and, maybe even cashflow negative after depreciation allowances) real-estate strategy, there may be deductions that can legitimately increase his super-high professional’s take-home income, without falling afoul of the tax man.

This is a clear-cut case of where a professional’s advice can add huge value [AJC: not in asking "is real-estate a good investment for me" but in asking "is real-estate a good tax-advantaged but highly legitimate investment vehicle for me?"], and our doctor should not take another step without seeking such professional advice.

Secondly, he should go through every single expense with his accountant and see what he can reduce or better manage. Nobody can afford to burn $500k worth of dollar bills …

… not even a super-high-income doctor.

Secondly, real-estate (especially when prices are depressed) is just a great long-term investment.

With his $300k (and, hopefully much more once he implements some of his accountant’s tax and cost-management advice) cashflow plus any income that he receives from his tenants, the doctor can afford to leverage quite a large portfolio of such high-quality, long-term, income-producing investments.

And, it is this large portfolio that becomes his growing ‘dam’ of cash, trickling out at perhaps a $100k – $150k sustainable annual spending rate … one that he should be able to index with inflation and maintain for his whole life, whether he (one day, perhaps quite soon) chooses to work full-time, part-time, or not at all.

And, isn’t that the whole (financial) point of it all?

Why are professional athletes so horrible with money?

In 2009, Sports Illustrated observed:

78% of NFL players and 60% of NBA players are bankrupt within two years of leaving the game.

From this Get Rich Slowly concluded:

Many professional athletes are horrible with money.

Why does this occur?

Investopedia in a recent article stated the obvious:

Athletes have a unique problem that many other professions don’t: the earnings window is small. While the more traditional careers may allow a person to work 30 to 50 years, a professional athlete will work only a fraction of that time. This leaves the retired athlete with the job of managing what they have to last for the rest of their life with only a fraction of their old salary being earned.

Whilst I agree with GRS that many sports players are horrible with money, this is simply an undistributed middle fallacy of the type:

1. All students carry backpacks.
2. My grandfather carries a backpack.
3. Therefore, my grandfather is a student.

In other words, this problem is not isolated to athletes … they are just one class of people who have highly skewed earnings.

Others include anybody with what I call “Found Money”, which is my term for any one-off (or otherwise time-limited) sudden influx of cash. For example:

- Anybody who signs a major contract (athletes, musicians, actors, celebrities, even sales people or small business owners who “land that once in a lifetime deal”)

- Anybody who wins a substantial sum

- Anybody who inherits a substantial sum

… and, so on.

The Horrible Money Management Syndrome, that Get Rich Slowly incorrectly attributes to athletes, actually comes with the sudden influx of money i.e. it’s a problem with the source, not the recipient.

For example, there are lottery winners from all walks of life, yet the operators of the UK Lottery found that, on average, lottery winners had spent 44% of their winnings after just 2.5 years, which supports the anecdotal evidence that 80% will be entirely broke in just 5 years after winning a major lottery!

Whilst some sharp wits may observe that this is “because the qualifications for playing the lottery are being ignorant of the principles of mathematics” [AJC: for example, as one blogger recently observed, you are more likely to die from melting underwear than winning the lottery], my theory is that …

… you need to learn the lessons slowly on the way up, in order to stop yourself learning them the hard way on the way down.

In case any of you are planning to make a lot of money quite suddenly [AJC: even faster than $7 million in 7 years 'suddenly'], you would be wise to heed the lessons that I taught my children when they were still very young (and, follow to this day):

When they get money [AJC: Any money: an allowance, a gift, find it on the street, etc.] half goes into Spending and the other half into Savings.

So, too, does it go for you: anytime that you get any additional money [insert 'found money' methods of choice: you're a professional athlete; you win the lottery; you get a pay increase; a second job; loose change that you save out of your pockets; a gift; a manufacturer's cash rebate; tax refund check; etc.; etc.] you Spend half and you Save half.

At least, this is advice that will tide you over until I share my Found Money System with you …

… next time

How to become a wealthy doctor?

We all have this image of doctors. We believe that that they are all-knowing and well … rich.

But, is that really the case? Let’s check out what this young doctor (a new reader), David, has to say:

I am a young physician (early 30s) making approximately 800k per year. After expenses and taxes, I am left with ~300k to save/invest. However, I have been making ~40k for the majority of my working life and am completely overwhelmed as to how to handle this chunk of change (unfortunately I received no financial education in medical school…). Do you have any advice as to how and where I should allocate this money? I am worried about investing too much money in one source and would like to be fairly diversified.

You see, right here is where doctors go wrong!

Firstly, $120k – $250k net spending money p.a. [AJC: my estimate, depending on how the taxes and other expenses work out] is, indeed, quite a large “chunk of change” …

… especially when jumping from $40k starting salary.

So, the first mistake that most people in this situation make is to immediately increase their standard of living. Now, a conservative person won’t increase their living standard to $120k less 10% (because that’s what the books tell you that you should ‘pay yourself first’), but the chances are that they will raise their living standard quite dramatically.

The $40k quickly becomes $60k as they equip themselves with a new car and some extra furniture and a larger TV or two … then $85k as they move into a bigger apartment (with a view) … then $120k as they step into a more committed relationship and buy the house, school the kids, and so on.

In other words, the treadmill has a way of increasing its speed until you forget that you are supposed to be ‘rich’.

You see, David’s sudden increase in income comes under the heading of ‘found money’; I’ll post on it soon …

Would you take financial advice from this man?

Here’s an article about some guy who’s lost his house: http://www.consumerismcommentary.com/the-financial-planner-who-lost-his-house/

Sad, yes, you say … but, not to be rude, you also say … so have hundreds of thousands of others during this global financial crisis

But, if you look closely, you’ll see a small difference between this guy and the rest: this guy should have known better.

You see, he’s a financial advisor …

… and, not just any financial advisor, he’s a New York Times financial columnist/blogger!

What’s even more interesting is that he’s prepared to use his own tale of woe (as is Consumerism Commentary in his follow up piece to the original NYT article):

to explain how people continue to behave irrationally about money even when they know better. It’s a good indication of why a healthy approach to your finances requires much more than knowing, “spend less than you earn.” We’d like to think that building wealth is as simple as that, but if that were true, anyone who could do simple arithmetic would be financially secure over time.

Hello?!

Doesn’t anybody see what’s really wrong with this picture?

Consumerism Commentary tells us:

Carl Richards is one of today’s best writers focusing on personal finance

This is after Carl admitted to the world that he lost his house because he “behaved irrationally about money” …

If the BEST financial advisors can lose their houses … how have the average ones mismanaged their’s … and, how badly can the worst ones screw up your life?

And, would you have known about Carl’s screw-up if he didn’t come forward and tell us?

Who are you seeking financial advice from? And, how can you really be sure … ?

Make money when you buy!

There’s an old saying that you may have heard. It’s used particularly in relation to real-estate, but it can be applied to many forms of investment. It’s:

You make money when you buy, not sell.

One of my new readers asked me to explain what it means:

Could you expend on this statement a little or maybe you have some related blogs about this on your site? “…buy at the right price you make money when you BUY not when you sell.”

I don’t think I’ve ever written explicitly about this age-old investment adage, because it’s almost a tautologogy …

… after all, an investment is something that you should never need to sell!

To me, a true investment is something that generates ongoing income. So why would you ever sell it?

Any ‘asset’ that you buy, specifically to sell to (hopefully!) generate a profit, is in reality a SPECULATION, not a true investment.

Business makes these kinds of speculations all the time: buying trading stock (or labor) with the expectation [read: hope] of selling it at a sufficient price to generate a healthy profit.

Businesses take a calculated risk in doing so, hoping that the potential profits justify the risk, but …

… 90% of business owners are wrong!

They say that 9 out of 10 businesses fail within their first 5 to 10 years. They fail for lots of reasons, but one of the main ones is that these simply cannot make enough money when they sell due to competitive pressures, new products, outdated manufacturing techniques, low volumes, etc., etc.

As investors, we cannot afford to make the same mistake, otherwise we are just gamblers – gambling that: red will hit more times than black; we will roll a natural 7; AAPL stock will go long this month; Las Vegas house prices will continue to climb.

On the other hand, as true investors, we have to buy well, then hold on for the long run.

It is the income from our investments that makes us rich (by funding our dream lifestyle), not the amount that we could sell the investment for.

How about you? Are you an investor or gambler? Do you see the difference?

Installing an ATM in your business …

I met a small business owner a few weeks ago …

He was a smart young guy [AJC: aren't they all?] who was setting up his own Internet design studio, building Internet-based software projects for other business owners.

His business is essentially a professional service business, and my advice to him was pretty much the same as I give to all professional service business owners (consultants, accountants, attorneys, doctors, etc.):

Except in rare circumstances, you don’t have a business, you have a high-paying job … with perks!

[AJC: the perks are around the tax benefits that attribute to business owners but not to paid employees; ask an accountant for examples.]

Most of these kinds of businesses don’t scale very well i.e. they can’t grow very large; they rely on the owners’ personal exertion (sometimes called ‘partners’); and, either can’t be sold, or can only be sold for small multiples of annual profit or turnover.

In short: you can’t rely on selling these businesses to fund your retirement.

But, what they do generally provide is income …

Because they are professional services, the owners are able to sell their own labor – and, those of their employees – at high multiples, usually generating excellent recurring revenue.

And, because they often take years of hard work and relationship building over many, many clients they can be quite “bullet-proof” (if well managed) in terms of providing that income reliably.

This was certainly the case for the young guy that I met.

Even though his agency was still quite young/small, it was already generating a nice income and showing signs of growing well.

My advice for him was to grow his personal income very slowly (this is advice that I would give to any business owner), and to pull as much money out of the business as possible (this is not advice that I would give to other business owners) …

… my advice was to treat the business as his personal ATM

[AJC: but not to the detriment of the business, or his partners, employees, clients, backers, etc.]

But, my advice was not to spend that ATM-cash on personal lifestyle building (homes, cars, vacations, etc.), but on passive investments.

I recommended that he use that cashflow to fund an aggressive investment portfolio, outside of his business: one that would one day grow to replace his personal income as generated by the business.

When the day comes that his passive income surpasses his personal business income, he becomes free.

What would you advise?

How to increase sales …

If you’ve chosen ‘business’ as your primary vehicle to reach your own $7 million in 7years, then it’s best that you focus on increasing the amount of profit that you get to take home each day, week, month, and year.

To non-business readers this may sound like obvious advice, but you would be amazed at how many business owners focus on two numbers:

1. Sales Volume – usually expressed as “my business turned over $2.3 million last year”, and

2. Profit Margin – usually expressed as “my business makes 7% net profit, before tax”.

These may be key numbers for a large business – particularly if listed on a stock exchange, because the market punishes stocks that don’t grow their sales (sales $) fast enough, with comfortable margins (profit %) – however, for a small business …

… these are simply ‘vanity metrics’.

The only number that really counts is:

3. Net Profit After Tax - usually expressed as “Last year I took home from my business $738,000 in my pocket”

This is the number that you get to spend and / or invest (preferably the latter) each year, and the one number that you want to grow year-over-year.

So, when aspiring or new business owners ask me:

What is the best way to increase sales volume for a small business?

I say:

According to Jay Abraham (master marketer), there are only three ways to increase sales volume:

1. More customers (customer acquisition e.g. marketing, advertising, referrals),

2. Higher sales per customer (up-selling and cross-selling e.g. bundled offers),

3. More sales per customer (customer retention e.g. backend products)

You only need small improvements in each to make major improvements in your overall sales volume i.e. a 10% improvement in each area means a 33% increase in sales volume, overall.

An example strategy (for, say, an eCommerce site) that encompasses all three elements might be to:

1. Improve your Google search rankings and run some Adwords and FaceBook ad campaigns to bring in some new customers.

2. Create some bundled packages and add some special checkout offers to entice some of your customers to increase the size of their order.

3. Capture their e-mail addresses and send out special offers once every 6 weeks to encourage some repeat sales.

If you are very successful with your bundled, checkout, and e-mail discount offers, you might find that your % profit margin slips slightly, but that your overall sales volume increases significantly.

More importantly, the amount of net profit – i.e. cash that you get to take home in your pocket – goes up dramatically, meaning that you have a lot more cash available to invest in stocks and real-estate.

Then, it won’t be long before that $7 million in 7 years starts to look pretty achievable.

Before you can find the answer …

Yes. Before you can find the right answer, you need to know the right question.

So it is with personal finance: most pf bloggers will answer a whole variety of questions:

- How can I become debt free?

- How can I pay off my credit cards?

- How can I save for retirement?

- How can I be more frugal?

BUT, these are not the questions that you need to be asking … at least, not at first.

No, there are only TWO questions that you need to ask. The first is in two parts, and it simply asks:

a) How much money do I need to support the life that I truly want to live? And, b) when do I want to begin?

I have a hypothesis about the typical answer to these questions, but the truth is that for every human being on this planet there is a different answer:

For some, it may be that they are happy doing what they are doing today, and are happy to keep doing it until they drop. For, them personal finance begins with maintaining their current lifestyle (which probably revolves around maintaining their employment) and staying healthy.

It probably also means learning all the lessons about personal finance that the blogosphere has to share: living below your means, eliminating debt, cutting up your credit cards, paying off your home, setting aside an emergency fund …

My second question – which I’ll come to in a moment – is moot for these lucky, satisfied, job-secure, working-class few.

But, my hypothesis is that most people are not satisfied with their current lifestyle … that you are not satisfied with your current lifestyle … that you:

- Want more time with your family,

- Want to indulge your hobbies and interests,

- Want to travel more,

- Want to be more relaxed and healthier,

… and, the list goes on.

And, I’ll wager that the limiting factor for you, right now, is money.

But, I’ll also bet that with a little thinking, you could come up with a salary that if a rich uncle were to pay it to you, would allow you to stop working full-time (or, altogether) and fund your ideal lifestyle.

I’ll also take a stab that ‘salary’ would bear little resemblance to your current salary.

But, if you can take an educated guess at what that ‘salary’ would need to be, I can tell you what your Number is (the answer to the first half of my first question) simply by telling you to multiply that amount by 20.

Let’s now assume that you have no rich uncle and have to amass this amount yourself …

How long will you give yourself to reach your goal so that you can begin to live the life you really want to live before you are too old to enjoy it?

I gave myself just 5 years to reach my Number of $5 million; in the end, I made $7 million in 7 years, starting $30k in debt.

[AJC: keep in mind that the longer you allow to reach your Number, the larger it will need to be because of the effects of inflation. For example, whatever Number you come up with today, you will need to add 50% if you aim to reach it in 10 years, and you will need to double it if you are prepared to wait 20 years ... just to keep up with inflation.]

Which brings us to the second most important question in personal finance:

How am I going to get there?

For example, in order for me to reach a $5 million target in 5 years from a virtual standing start:

- I had to learn how to invest (I had no investments and no idea HOW to invest or WHAT to invest in)

- I had to turn my business around (it was breaking even, at best)

- I (more importantly, my family) had to sacrifice our existing life: we had to move overseas, my wife gave up her career, my children their friends, we all gave up our families for the 5 years we were away from home.

But, we all agreed that it would be worth it, because we had already answered the first question (both parts).

How about you?