What should you invest in first?

My wife just got back (well, just before our Noosa trip) from a trip overseas to attend her nephew’s wedding; and, the young happily married couple decided to spend part of their honeymoon in Australia … so, they are staying with us right now!

This was an opportunity for me to interfere in their financial lives … naturally, I couldn’t resist

It’s also an opportunity for me to share my financial plan for our younger readers, whether single or married.

The plan is simple:

Step 1: Start working!

Step 2: Use your pre-work spending and living standards as a guide to ensure that you save at least 10% of your gross salary; preferably more.

Step 3: No matter what your Step 2 Income and Expenditure, save at least 50% of any future salary increase

Step 4: That includes any ‘found money’ such as: change found on the street; tax refund checks; small handouts/inheritences from friends/family (naturally, you will ‘up this’ to saving 95% of any LARGE handout/inheritence); etc.

It won’t take too long to actually have some money (perhaps for the first time in your life) to think about actually INVESTING.

So, what to invest in? Stocks; car parks; italian art; … ?

It’s simple: your own home!

It will probably be a small house or condo to start with … possibly with some ‘fixer upper’ potential …

But, what about the 20% Equity Rule and the 25% Income Rule, which will ensure that you can only afford to buy a shoe-box (literally) at this early stage of your financial life?

You forget them for your first home …

… and, replace them with these guidelines:

- Put as much equity into your house (by way of making a deposit) as you have savings (you’ll want to keep a little buffer against immediate expenses)

- Borrow as much as the mortgage payment that you can afford, which will be the amount per month that you are currently saving (of course, you’ll want to keep a little buffer against extra expenses).

When you (eventually) get tempted to ‘trade up’ to a bigger house, that’s when you apply the 20% Rule and the 25% Income Rule!

But, shouldn’t you invest in something else first? Perhaps you’re not even married yet and can happily rent for a while?

This is true: but, buy the condo anyway … then you can evaluate if your rent is so cheap that you should rent out the condo for a while before moving into it. Same applies if you move to another location: rent out the house/condo and rent for yourself elsewhere until you are ready to trade up (or across).

Why?

Let’s decide whether, over the course of your life, real-estate will go up in price or down in price? The answer for all of history has been UP (over a sufficiently long period).

Decide whether you will ever want to own your own residence? Again, the answer is YES for the overwhelming portion of humanity (and, even if you think not, I guarantee that your eventual spouse will have a very hard go at convincing you otherwise).

So, unless you have an overwhelming reason to believe that RE won’t go up in price for the next X month/years, then you are compounding your money at RE’s typical growth rate (6% … depending upon who you believe and where you live) TIMES the leverage that the bank is giving you LESS (your mortgage payment/costs – rent you would have otherwise paid).

Run the numbers; it’s a VERY good/safe rate of return

Be the bank!

My son asked why I don’t just plonk by money into a safety deposit box to tap into those wonderful gross margins that banks earn buy ‘buying’ your money at 3% and ‘selling’ it back to you (or to other people/businesses) at 7%.

That lead to a great discussion on P2P lending, which partially addressed the problem of risk for me: P2P offers filters to allow you to sort loans; ratings to allow you to evaluate loans; and FICO-based ’risk rated’ interest rates (circa 10%) to go along with all of this.

But, that doesn’t satisfy me …

And, it’s not because the banks have MUCH better systems to evaluate and manage loans and it’s their core business, it’s because I can do much better with my limited capital than P2P levels of interest.

Here’s two things to think about:

- Does P2P provide the annual compound growth rate that YOU need to reach your Number?

- Do you have the bank’s virtually UNLIMITED access to capital or is the amount that you can apply to P2P as a % of your Net Worth limited?

These points are critical: you have a limited amount of investment resource available to you and (probably!) a very large Number / soon Date to achieve using what you currently have as a springboard.

Now, let’s flip to the other side:

Banks dig into their ability to borrow (which IS the basis for their entire business, investment banking / asset management services aside) and lend to us for what?

Either to SPEND (on consumer items, if we are dumb) or to INVEST (in our homes, businesses, etc.) if we are smart.

So, let’s put those things together to create our own ‘bank’:

1. We have limited cash to ‘lend’ at our disposal, so we need to find a way to tap into vast amounts of borrowing power just like the banks.

2. Well, we don’t have the Regulations, Reputations, and Resources (e.g. access to the capital markets) that allow the banks to borrow (then lend) so much, but we do have something that allows us to achieve effectively the same huge jump in personal borrowing capacity: the spare equity in our houses.

[AJC: You knew there was a catch! If you don't have a house, have GFC'ed your equity out the window, or otherwise don't have enough equity built up yet, bookmark this post and take the rest of the day off ...]

3. If you DO have spare equity in your house, and can refi. to a fixed rate loan that locks in your borrowings circa 4% or so then you are probably now sitting on a relatively large sum of cash to lend, just like a bank (relatively speaking!).

4. So, you can either:

- Do, what the banks do and lend to somebody who needs the cash at a higher rate; e.g. P2P where you may get 10% for each 4% ‘unit’ that you supply … a VERY healthy 150% gross margin (plus, you have NO staff or overheads), OR

- Do, what I would recommend: cut out the middle-man and lend the money to yourself!

What would you do with that money that you have borrowed?

What any sensible investor would do with money that they borrow from the bank – depending upon their Number and their appetite for risk:

- Buy some investment real-estate,

- Buy stock [AJC: a friendly 'bank manager', no margin calls .... sweet],

- Start a business … it could even be a P2P lending business

That last one isn’t such a joke; I would be more tempted to invest IN a P2P business than I would be to lend VIA a P2P. Why?

It’s simple … the former gives me ho hum 10% returns (with some credit risk attached), whilst the latter gives me access to potentially, unlimited returns!

Are you worried about the risk of business failure?

Well, if the P2P site goes under, isn’t my risk of capital loss the same as if my cash was sitting in their investment accounts [AJC: which is one of the reasons why the SEC is VERY interested in regulating P2P, all of a sudden ... but, until they do ... ;) ]?

Call me … make it happen!

OK, so he wants you to buy five houses this year … and, he gives you the quick ‘hard sell’ at the end … but, the basic philosophy – to me – is sound:

- Houses are depressed in the USA, but so are interest rates,

- Unless the USA ‘double dips’ prices will begin to go up (when?)

- You can fix an incredibly low interest rate on your primary residence (can the bank rewrite the mortgage if you move?)

- You MAY be able to receive enough rent to cover most/all of the mortgage

- Who says you need to buy five houses (except for this Realtor!?) … just think about one for now

Do the numbers for your area/s of interest (price of house, monthly cost of mortgage, likely rental income, other expenses such as 6% – 9% property management etc.) … if you can even come close to breaking even, could you find a better return on your deposit plus the cumulative cost of any monthly shortfall (or gain of any monthly excess)?

Now, run the numbers again assuming that the US market stays flat for another 5 years before some sort of rebound … maybe it still makes sense?

Have you run the numbers? If so, what do you think?

A Vacation Question – Part II

But, what about the other financial question that my son asked while we were on vacation?

Well, we were walking along the beach and Bill, the shaved ice vendor, drove past with his little all terrain vehicle pulling his ‘shop’ behind only to stop a few yards up the beach to tempt my son – and, the many other children running along the sand and swimming in the warm surf.

Naturally, I  quickly became $3.50 poorer and my son had his paper cone filled with shaved ice with various color sweeteners poured over it (he chose ‘rainbow’ flavoring), which got us talking:

You see, it’s popular folk-lore that Bill, who has been selling his flavored shaved ice along the beach for 20 to 40 years, owns many of the apartments in the vacation rental buildings all around [AJC: check out the aerial shot in yesterday's post] … if true, then Bill is the poster-child for the Wealth Alchemist i.e. turning temporary cashflow into long-term assets.

It’s not hard to see that Bill turns over thousands of dollars a day, most of it costing him nothing (little staff, few overheads, little-to-no-cost-of-goods-sold), after all, how much can ice cost to make?!

Instead of spending all of that money, it’s not a great leap to assume that Bill saves up enough for a deposit to buy a property every now and then; we figure $1 million worth of property each year (with 20% initial equity).

Here is my son’s question:

“Would he pay cash for the properties, or would he just save up enough for a deposit and borrow the rest?”

Now, this is a seemingly simple – yet terribly interesting – question; one that we could labor over for many posts … instead, we’ll look at this another way, by asking:

“Does Bill need the property for income now or for its future value (hence, future income)?”

The answer is clear: Bill has plenty of income now, but what does he do if his income stops?

Presuming that he can’t rely on being able to sell his business (for example, the council could decide that they no longer want people peddling ice on their beaches), then Bill will probably want his properties to generate a replacement income “one day”.

So, which would do that better? When Bill moves into MM301, it’s likely that owning the properties outright and living off the rental treams that they throw off will be best …

… until then, Bill has to (in my opinion) work on the strategy that will produce the most properties by the time he wants to retire.

So, I had to explain the concept of leverage to my son:

SCENARIO A: If you purchase a property for $100k CASH and it doubles in 10 years, then you have $200k of property. Well done!

SCENARIO B: But, if you purchase TWO $100k properties, putting $50k deposit into each and borrowing $50k for each from the bank, then in 10 years (assuming they both double), you now have $400k of properties, of which you owe the bank $100k (assuming that you haven’t paid down any of the loan in the meantime), leaving you with $300k of property … a $100k improvement over Scenario A.

At least, that’s what the property spruikers would have you believe …

… because, they have conveniently forgotten that in Scenario A, you also have some rental income (after, say 25% costs) coming in, whereas in Scenario B that income would be largely offset by interest owed to the bank.

The question is, is that differential in income ‘worth’ $100k over 10 years?

Let’s assume that we can get a 5% return from our Scenario A property (after costs), giving us $5k a year initially (when the property is worth $100k), increasing over time to $10k a year (when the property increases to $200k in value). It doesn’t take a genius to figure that this comes to less than the extra $100k that Scenario B gives us (if you assume an average $7,500 per year rent for the 10 years, we are comparing $75k in rent for Scenario A to $100k in additional capital gain for Scenario B).

Now, add the benefits of:

- 80% gearing (i.e. only making a $20k down payment in our example), which should buy you 5 properties instead of Scenario B’s 2 properties (cost = $500k; worth in 10 years $1 mill., less $80k loan on each = $600k v $300k for Scenario B and $200k for Scenario A. Get it?),

- Increasing rents offsetting fixed interest rates (possibly producing some positive cashflow from each of our 5 properties as time passes),

- Tax deductibility of any excess of interest over income in the early years (a.k.a. negative gearing),

- And, any additional tax and depreciation benefits of 5 properties v only 2

… and, it’s just possibly a ‘no brainer’, even if that does make some of those scummy spruikers right

But, how does Bill pay his bills?

Well, that depends on how much excess of income the properties produce by the time Bill is ready (or has) to retire …

… if  insufficient to pay Bill’s bills, he can sell enough properties to pay off the bulk (or all) of the bank loans, thus forcing a positive cashflow situation (assuming the properties aren’t total dogs, which is highly unlikely in this well sought after tourist area, which boasts near 100% year-round occupancy) and that (after a reserve to cover costs of vacancy, property management, and repairs and maintenance) is his infltation-protected income for the rest of his life.

Then Bill can spend the rest of his days lazing on the beach … buying shaved ice from the next shmuck who chucked in his chance at earning a college degree for the life of a beach bum :)

Inspiration at the pump …

When your car runs out of gas, you go to the gas pump …

… when I run out of inspiration (as sometimes happens … not often, but sometimes) I go to the bloggers ‘gas pump’: Alltop.com, a compilation of articles from the best blogs on the web in almost any category that you would care to name.

I got excited when I saw the headline, there, of a CNNMoney article titled: Real estate in your retirement portfolio.

Excited, that is, until I read the first paragraph:

Question: How do REITs work? And is it prudent to have them in a diversified retirement portfolio?

This is the problem with the financial press in the USA: it’s directed to packaged financial products e.g. stocks, funds, REITS, and the list goes on … this is why average (and, 99% of  ’above average’) Americans will remain relatively poor.

It’s ironic then that the wealthiest Americans (and, I would suggest this to also be the case in all developed countries) made their money in business (including the business of investing) and keep their money in real-estate.

According to an otherwise (and, unfortunately) highly flawed book that I reviewed some time ago, the rich keep their money for generations ONLY if they split their assets roughly one-third in a business, one-third in paper (stocks, bonds, mutual funds, etc.) and one-third in real-estate (incl. their own home) … since I called this “the most dangerous idea in retirement planning that I have ever read” (and, you will have to read this post to find out why), I had better give you my much simpler formula:

As I transition into Making Money 301 [protecting my wealth], I would happily keep 95% of my net worth in real-estate (incl. no more than 20% in my own home; remember The 20% Rule?) … and, I am NOT talking about REITs here, I’m talking buy/hold income-producing real-estate.

It’s certainly not the only strategy, but it’s one of the simplest and, IMHO still the best :)

Are you a Money Hacker? I am!

Welcome MoneyHackers!

Here are three of my favorite posts to get you started; if you want to find out:

1. If $1 million will be enough to retire with, then click here, or

2. How much house you can afford, then click here, or

3. Why buying a new car is such a losing proposition, then click here.

Otherwise, please enjoy this article, then bookmark my home page (click here) and come back often …

____________________________________________________________________________________________

For those who don’t already know, I am a member of Money Hackers – a group of personal finance bloggers – and Lydia has just interviewed me; you can read the interview on the moneyhackers.net site by clicking here, or read the extract below:

What influenced you to start writing 7million7years?

I started out $30k in debt and made $7 million in 7 years, but the road was bumpy and I found that I had to learn most of the hard financial lessons myself. I started my blog so that others wouldn’t make the same mistakes that I did.

What encouraged you/where did you hear about becoming a 7 time millionaire in 7 years?

When I started out, I had two businesses which barely paid their own way, and I was in serious debt. But, I had no clear goal or reason to do any better. That all changed when I discovered my Life’s Purpose, which is to always be traveling physically, mentally and spiritually. I suddenly realized that I would need both a lot of free time and plenty of money to achieve what I really wanted in my life. In fact, I calculated that I needed $5 million in just a few short years. That epiphany started the amazing journey that took me from $30k in debt to $7 million in the bank in just 7 years.

What financial topic do you most enjoy blogging about?

My own financial journey and showing others how they can also free themselves from a life of work, debt, and drudgery by applying the same financial lessons that I learned. There are no scams or schemes needed to replicate what I achieved, if they just follow some good, old fashioned financial advice.

What crucial point have you learned through this experience of gaining 7 million?

Your money is there to support your life, yet most people act like it IS their life. No amount of money will ever be enough if you have no clear idea what you really need the money for. Find out what it is that you really want to do in with your life (and by when), then calculate how much passive income that you will need to get you there. Then come to my blog to find out how to safely build that income stream. But, once you have enough … STOP and smell the roses.

What 3-5 blogs are essential to understanding how to save money?

My blog isn’t really about frugal living and saving money, but more about accelerating your income through work, business, and investing. It’s also about protecting your wealth, through passive investment strategies (for example, using stock or real-estate). So, if my readers want to know more about saving than investing, then I recommend that they read:

1. JD Roth’s Get Rich Slowly

2. Steve’s Brip Blap

3. Pinyo’s Moolanomy

What is some financial advice you could give our readers?

Most people don’t really know how much house they can afford, so let me give your readers some very specific advice that will help them through every stage of their own financial journey: never have more than 20% of your Net Worth invested in your own house, and no more that 5% in all of the other ’stuff’ that you own (e.g. cars, furniture, computers, etc.). You can adjust the equity in your house by refinancing periodically (always lock in your interest rate when it is below 6% – 8%).

This means that you will always be investing at least 75% of your Net Worth, which is the only real chance that you have to get out of the financial rate race.

If you have your own blog, I’d like to hear how/why you started it … there’s plenty of space to share in the comment section, below …

I’m going to be a millionaire!

You don’t get to become a millionaire without style and confidence …

… you have to admit that this guy has at least a bit of both!

What’s wrong with this ad?

Aside from the obvious [AJC: Believing that you can turn $1k into nearly $6k in just 2 weeks is obviously stupid, right?] …

… there’s a basic reason why you are doomed to failure with FOREX (i.e. foreign exchange) trading activities. First, though, let me explain what FOREX is for those who don’t yet know:

The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business’s income is in U.S. dollars.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The foreign exchange market is unique because of … the extreme liquidity of the market [and] the variety of factors that affect exchange rates. As such, it has been referred to as the market closest to the ideal [i.e.] perfect competition.

My dire ‘doomed to failure’ prediction comes about because of that last sentence: FOREX “has been referred to as the market closest to the ideal [i.e.] perfect competition”.

Think about it: for every dollar, drachma, or rupee that you buy … somebody has to be on the other side selling. And, since you are ‘betting’ on the relative strength of one currency versus another, you are effectively betting opposing arguments.

You have the same points spread on the ball game, but you are betting on opposing teams … one winner, one loser.

Now, who do you suppose has better information? You, or the other guy?

Who do you suppose has better FOREX training and more experience? You or the other guy?

You are the amateur, the other guy is (probably) the professional who does this for a living …

Now, you can argue that people are trading currency because they are moving country, so the ‘relative strength’ argument doesn’t apply … or, that they are government agencies moving in and out of foreign positions for stability and political reasons … or, that they are corporates moving funds between various international subsidiaries …

Which all be true and yet another reason why you are gambling and they are expertly managing their portfolios.

The same double-sided coin argument applies to options trading … indeed, most other forms of trading: you bet one way and the person on the other end of the transaction has bet the other way. And, they probably know what they are doing …

… best case is that they are equally naive as you

One winner, one loser.

So, that means that 50% of the traders out there must be winning and the other 50% losing?

Well, the stats – somewhat surprisingly – tell a different story; cast your mind back a few weeks, where taloudellinenriippumattomuus  mentioned a Taiwanese study that found that (after costs) only 0.16% (or 1.6 per thousand) of traders [AJC: in this specific case, Day Traders, but I doubt whether FOREX or stock option traders fare much better] actually made a profit!

I’m sure that plenty of our readers have made – and lost – relative fortunes trading; if so, I’d love to read your comments …

I want to sell my business …

A week or two ago, a reader – who shall remain nameless as they are currently in negotiations – asked for some advice on selling their business:

I have a software company with a new proprietary software technology.  The company is considered for buyout due to the new technology (currently there are no revenues and no debt). The projected total revenues over the next three years is $1.55m (First year: $0.15m, 2nd year $0.4m & Third year: $1m) and total over six years is $4.55m (with 4th, 5th, 6th years at $1m each). What is the right valuation for this company if the company were to be acquired now.

This is a common request that I receive and I always have a soft spot for entrepreneurs, having been down this path a number of times, and I will give you some guidelines in a future post …

… but, in this case Mr X (as I will refer to him) has NO business to sell right now, so the usual formulas simply won’t work!

Why no business?

Well, as Mr X admits, the company has “no revenues” right now: no revenues, no business … no business, no business valuation.

But, Mr X does have a new proprietary software technology; apparently, one that at least one major company wants to acquire.

So, the first step is to recognize that we are selling a product (the “proprietary” rights to a new software technology), but we first need to find out what it would cost to duplicate the technology.

Mr X says: “4-6 months with 2 people on the job”

That puts a ‘lowball price’ on the software of $20k to $100k depending upon whether it is developed onshore or offshore.

Now, that’s assuming that it can be duplicated, but Mr X assures me that it cannot:

All major companies in this area have been trying to figure out an equivalent technology for the last 5-6 years or so, but with no success.

Given that Mr X’s software can’t be copied (6+ years development effort, with NO guarantee of success), then his company is worth whatever he can negotiate

Since he wanted a better estimate of potential selling price than that, I told him that it’s time to look at potential revenue, which Mr X projects over the next three years as: $1.55m (First year: $0.15m, 2nd year $0.4m & 3rd year: $1m).

If the company generates < $1 mill per year over the next three years, then I think that Mr X would be struggling to get $500k – $1 mill. for it …

… if he is offered less – and, he probably will be as the market is quite small for any major corporate (at the numbers provided above) then, if it were my software, I would be tempted to go ahead and get those revenues for myself then sell in 18 months to 3 years time.

Here’s my reasoning:

1. Development effort on Mr X’s side is tiny, but he feels strongly that his technology can’t be easily copied,

2. Mr X has a market that he feels can generate revenues of, say $1.5m+ over three years (discounted to today’s value), which are relatively small numbers for any substantive corporation.

In fact, if Mr X is offered more that that $500k to $1 mill. that I suggested, it will probably be as a result of a combination of how badly one of these companies wants (needs?) his technology and how big THEY think the market will be for them.

That’s why the next step, if Mr X hasn’t already done so, is to assess what revenues the purchaser believes they can make over the same period (better marketing/sales than Mr X?); better yet, what profitability.

If he doesn’t already have a good feel for these numbers, then he will need to try and get close to somebody on the inside of the company and carefully ask them …

… after all, the price that you set should always be as close to whatever the company that you are hoping to sell to can make, minus a fair margin for their trouble. Anything less, and you are being a little too generous

How to invest 101?

This video is way too basic for my readers [AJC: if it isn't, please stop reading now! ] …

… BUT, it’s a great video to show to the children in your family.

Let me know what you think?