The myth of asset allocation …

pie 2There’s a Rule of Thumb that says that you should keep 100% – Your Current Age in stocks (and, the rest in bonds).

For example, if you are currently 27 years old, you should keep 27% of your current investments in bonds and the remainder (73%) in stocks e.g. an Index Fund that mirrors the S&P500.

There’s also a new school of thought that says the numbers should be ‘upped’ to 110% or even 120%, to ensure that you keep a larger percentage of your net worth in stocks at a young age, whilst you can still stand the volatility of the stock market (c’mon, you haven’t forgotten 2008 already?) and allow for a larger upside to help find your longer lifespan.

But, there’s a problem:

Let’s say that you want to retire at age 65, and you are currently 60; the original ‘rule’ says that you should still have 40% of your (hopefully, now considerable) net worth in stocks; the question is:

If you plan to retire in 5 years, what % of your net worth should you put in stocks?

Well, the answer is none.

5 years is too short an investment horizon to invest in stocks!

In fact, we’ve already established that the best place to keep your savings is in CD’s:

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Over 5 years, based on past performance, there’s simply too much chance that you will lose money on the stock portion of your portfolio.

But, that’s not the major problem that I have with this – or any – theory of asset allocation …

… my issue is that asset allocation theory only works in long timeframes (again, because we can’t afford risk of loss), say > 10 years, and probably greater than 20.

And 10 to 20 years didn’t work for me, because my plan was to make $7 million in 7 years.

To have any hope of emulating my outcome, you need to focus on three things:

1. Building up the largest ‘starting bank’ that you can,

2. Not spending more than you absolutely have to help build that starting capital in the shortest space of time possible, and

3. (this is the most critical of the three), investing to obtain the highest possible compound growth rate.

Sitting on a basket of stocks and bonds – no matter what the mix – probably won’t cut it.

Short time frames put a LOT of pressure on modern asset allocation and portfolio theories …

… way too much pressure, if you ask me.


The best place to keep your savings …

Screen Shot 2013-02-04 at 7.46.21 PM
Where do you keep your money if you want to buy a house in, say, 7 years?

If you keep it in the bank, you’ll find rates up around 5% if you can commit to a 5 year term.

Given that inflation is currently running around 1.7%, you’re heading for a very small gain.

That’s why many choose to put their money into mutual funds

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Despite the crash, returns from investing in a low-cost Index Fund (say, one that mirrors the S&P500) have been up to 28.6% for any 5 year period that you care to nominate in the past 85+ years.

Now, that’s certainly a lot better than CD’s (long-term bank deposits).

But, there’s a catch … and, it’s a big one!

Whilst’s CD’s virtually guarantee their admittedly paltry return, there’s no guarantees in the stock market …

… and, there has been at least one 5 year period where the S&P500 has lost 12.5%.

But, let’s look at the downside v the upside: that’s a potential 12.5% loss each year for the 5 years … compounded (meaning your savings will halve in a little less than 7 years) … but, you may gain up to 28.6% annual return (meaning you may double your savings every 2 years).

Compare that to the measly 5% return (before inflation) from CD’s and it seems like no contest, which is why many Americans are opting to use mutual funds as a mid-term savings vehicle, but …

It’s a huge mistake.

You see, it might be fine if you already had the deposit for the house saved up, and you were just setting it aside for 7 years. If so, and if this were me, I might very well elect to buy units in a low cost Index Fund rather than scraping by with a CD.

But, if I had the deposit already, I would more likely just go ahead and buy the house now, and rent it out if I wasn’t yet ready to live in it.

But, the reality is that most people need that 7 years to save for their deposit. And, that’s a whole different ballgame, because now you are putting aside a little every month and, over that 7 year period, slowly building up your deposit.

This means, your money is really only going to sit in your investment or savings account on average just for 3 years.

Now, your risk of loss is up to 27%, almost as much as your potential gain of up to 31%, and that means you are gambling, not saving.

This is one of very few cases that I have found where common financial wisdom is correct …

… the minimum period for committing your funds to the stock market should be 5 to 10 years, assuming you are not prepared to gamble with your starting capital.

And, if you are prepared to play the market, well, that’s a subject for a whole other post

So – and, unfortunately – the best place (indeed, the only sensible place) to keep your money safely parked for up to 7 years is in CD’s 🙁


Investing for dividends is like driving half a car …

half car 2Like this guy, you could probably drive in half a car (at least, if you were smart enough to first select the best half  i.e. the bit with the engine) …

… but why would you want to?

You could take your supplements purely for the extra vitamins, and you may even gain all extra the nutrition that you need …

… but, why wouldn’t you want to take one that has all the trace minerals that you need, as well?

You could probably invest in real-estate solely for the rental income …

… but, why wouldn’t you want to get some capital appreciation, as well?

If you feel the same way as me, why should investing in stocks be any different?!

That’s what I have to ask James @ Dinks Finance who says:

Dude, dividend stocks are not substandard investments. They may not yield as much as directly investing in your own business, but they can and do produce very respectable returns for many people.

Well, dude, you probably wouldn’t choose to regularly drive half a car; you probably wouldn’t choose to take half a supplement; so, why would you choose half an investment?

And, make no mistake: selecting an investment purely on the basis of its dividends is choosing half an investment.


Well, Matt Kranz of USA Today says:

The total return [of any stock] is a tally of the net gain, or loss, an investor received by owning a stock and receiving the dividend. When you add the change in value of the stock to the dividend, you calculate the investors’ total return.

To calculate total returns on a stock, Matt says:

Start by adding the value of the dividends to the stock price at the end of the period. Subtract from that sum the price of the stock at the start of the period and divide that difference by the price of the stock at the start of the period. Multiply by 100 to get the percentage.

Here’s an example. Say a stock started the year at $20 a share, paid $2 a share in dividends and ended the year at $25 a share. The total return would be:

(27 – 20) / 20 or 35% total return

Dividend investors usually then counter with an anecdote of great personal returns, like this one from Tim:

I don’t know what sort of return you require but I have invested in a number of dividend producing stocks over more than 20 years and at least for my purposes the returns have hardly been sub-standard. Investments in MO, PM and MCD to mention several have provided very nice returns over the years.

But, Tim, if you follow my advice and look for stocks on the basis of their Total Returns rather than just Dividends, then you still may have invested in MO, PM and MCD, but you would also have invested in both AAPL (Apple) and BRK (Warren Buffett’s Berkshire Hathaway).

Westwood (a registered investment advisor) explains why chasing high dividends is not always the best strategy:

Generally, the highest yielding stocks are there because investors question (by forcing the price lower and, thus, the yield higher) the long term prospects of the business, and/or whether the payout can continue.

Current day examples include Avon Products, with its high 5.0% yield.

While Avon may be a well-known business, the company carries a lot of debt, and many speculate the dividend will need to be cut to manage this large debt load.

Or, consider the 8.5% yield of Pitney Bowes.

While the absolute yield is attractive, the level of EPS (earnings per share) is flat with 1999 and the stock is at a 20-year low. Again, investors question the long term health of the postage meter market, and Pitney Bowes’ ability to fund its dividend going forward.

So, people who look specifically at stocks that produce dividends are looking at only half the story …

… that’s why I say that investing for dividends is, almost by definition, a sub-standard investment selection methodology:

You may happen to come across the best stocks in the country, but – if you invest in the best returning stocks, regardless of what combination of dividends and/or capital appreciation produces those returns – then you are sure to!

Why I don’t have a wealth manager …

madoffThere’s a debate going on at Quora (the question and answer site) about the cost of wealth managers:

What are the pros and cons of wealth managers vs passively investing in an index fund?

One of the issues is comparative fees:

– Index Funds typically charge 0.07% of funds under management.

– Wealth Managers typically charge 1.00% of assets under management.

So what do you get for the 14 times increase in fee?

Well, I wouldn’t know, because I wouldn’t go near a “wealth manager” with a barge pole …

… but, Scott Burns said it best:

40 years of investing has taught me that rented brains seldom help us build our nest eggs. Rented brains feel a deep spiritual need to build 20,000-square-foot log cabins in Jackson Hole with the return on our money.

It would be OK if that 14 times extra fee equated to extra returns, but the research shows that it really does only buy the wealth manager a good living – not us:

Eugene F. Fama and Kenneth R. French looked into this issue in their working paper titled, Luck versus Skill in the Cross Section of Mutual Fund Returns. Their study focused on U.S. equity mutual fund managers from 1984 to 2006. It’s no surprise that they found that in aggregate, actively-managed U.S. equity mutual funds performed below the market after costs. The big question they were trying answer was did the winning managers have skill or were they just lucky?

So, if you are prepared to read a few books and try a few things, then go ahead and try your own luck in the stock market … failing that, simply put your money into a low-cost index fund – a least, you’ll avoid the heavy management fees!

Where’s the emergency?

When you get pulled over by the police for speeding, they often ask: “Where’s the fire?”

And, when anyone tells me that they have 3 to 12 months living expenses sitting in a CD, I have to ask: “where’s the emergency?”

The assumption is that you will have unexpected expenses at some time in your financial life, and you will have to come up with a way to fund them without having to sell the kids or the dog … but, definitely not your boat!

So, the questions are: Do you need an emergency fund? If so, how much should it hold?

Today Forward presents an interesting way to look at how much to hold in your Emergency Fund:

According to the author:

If you have a full year’s worth of expenses set aside, only once every 33 years would an emergency come up that would wipe out these reserves.

Basically, you look at the chart to see how often you would tap out the fund according to how large the fund is (i.e. how many months of expenses do you have set aside as an ’emergency fund’?):

  • 0 months = 100%, guaranteed to have problems
  • 1 month = 70% chance (or every 17 months)
  • 2 months = 49% chance (or every 2 years)
  • 3 months = 31% chance (or every 3 years)
  • 6 months = 10% chance (or every 10 years)
  • 1 year = 3% chance (or every 33 years)

But, these are hypothetical numbers; what is the real-world chance of an emergency cropping up?

Well, the Pew Research Center set out to find out the answer to that exact question …

… and, it was 34%

Only one in three of the 2,000 families surveyed had a ‘financial emergency’ in the past year.

Combining that with the graph above, and it would seem that you would need about 3 months living expenses set aside.

However, I think it’s also important to answer one more question: how much will the average ’emergency’ cost?

Well, the Consumer Federation of America found the figure to be surprisingly low:

Households … typically report unexpected expenditures annually of only $2,000.

What are these unexpected (or ’emergency’) expenditures?

The Pew Research study found they typically fell into the following major categories (which add up to more than 34% because many families reported more than one category as having occurred in the same year):

Given that the chance of an ’emergency’ is so low (34% in any one year), and the reality is that most are affordable (~$2,000 in any one year), why carry an emergency fund at all?

Let’s take a closer look …

Let’s say that you earn $50,000 and pay 25% tax. Since you keep an emergency fund, let’s also assume that you save 20% of your take-home. That means that a 3 months living expenses ’emergency fund’ for you is around $7,500.

Since you’re going to need to keep it in a CD (earning just 1%) instead of investing it (8%+), you are giving up at least 7% interest (or, $525 in Year 1) compounded.

On the other hand, you have a 34% chance of having an ’emergency’, which will then cost you $2,000. Where will that money come from? Well your break-even point on that expense, if you had to borrow it, would be 26%.

So, borrow it on your credit card for all I care!

[AJC: Actually, I do care … the key is to have a plan to pay it off within 12 months; if you do, then a 0% card set aside for exactly that purpose would be ideal. Borrowing against your home via a HELOC would be OK, too, as would borrowing against your 401k. Sure you wouldn’t like to do any of these things, but you are dealing with the unexpected so a little short-term discomfort is probably OK]

Now, the reality is that if you were merely going to stick the $7,500 in an index fund, and earn an extra $500 or so, then I would say just go for the emergency fund … for your peace of mind.

But, why have it lying around earning next to nothing, when it could be the seed capital for your new business or the deposit on your first piece of investment real-estate?

Oh, and if you’re worried about the possibility of losing your job, well, don’t (unless you have GOOD reason to) …

… I’m not sure how different these numbers are in the USA, but if you live in the UK (according to MetLife) you have only a 6% chance of losing your job in any one year. And, when you do, you have a 30% chance of getting a job within the next 3 months, or close to 100% chance in the next 9 months.

Rather than putting your retirement at risk by setting aside too much money for an event that has only a small chance of occurring, realize that:

1. Your money is always better off working for you, and

2. While you are able to work, you can always borrow (and pay back) enough to recover from any financial catastrophe that the typical emergency fund is large enough to cover.

That’s why, at least in my mind, the best defense is always a good offense 🙂

How to become financially secure …

When I moved to the USA, I was surprised to see so many old people (old, in the sense that they seemed well over ‘retirement age’) working the checkouts at supermarkets.

I was told that it’s because they need the employer health benefits.

But, soon (if not already) it will simply be because they need the money.

Right now, according to Wells Fargo, 1 in 3 Americans between the ages of 25 and 75 believe that they will be working until they are 80 years old. Not because they want to, but because they believe they will need to.

And, they are correct.

Unless you can live on just 50% of your current paycheck, so that you can save at least 50% of your income for the next 17 years (or, save at least 25% of your income, if you’re happy relying on Social Security for the rest of your life), you will simply not be able to afford to retire.

And, there’s yet another problem with these ‘save your way to wealth’ strategies: they all assume that you’re actually happy living on your current after-savings income. Well, are you?

I didn’t think so 😉

That’s why I decided to fly in the face of commonly-accepted personal finance ‘wisdom’ and start blogging here …

I think that true personal financial planning starts with just two questions that you need to answer very, very honestly and carefully because they will set your whole Financial – indeed Life – Strategy from this point on:

1. How much income do you want when you begin life after work?

2. When do you want to begin life after work?

Together, these two answers will then direct you to everything else that you need to know:

How much do you need before you can retire?

This is called your Number, and is very easy to work out in two simple steps:

STEP 1 – Double your answer to the first question for every 20 years in your answer to the second question.

Let’s say that you decided that you want $25,000 a year income (in today’s dollars) in 30 years time. You would double that to account for the first 20 years ($50,000), and add another 50% for the next 10 years ($75,000).

This is simply to help you account for inflation …

If inflation averages just 4% for the next 30 years, you will need to earn $75,000 a year in retirement just to maintain the same spending power as $25,000 today!

[AJC: because everything will cost 3 times as much by 2032. Imagine: gas at $10.50 a gallon; $7.50 for a loaf of bread; etc.].

STEP 2 – Multiply by 20. Multiply your Step 1 answer by 20.

For example, if your inflated income goal was $75,000 p.a. in 30 years time, then your Number would be $1,500,000.

This is how much you would need to have saved up over 30 years, so that – in theory – you can retire on your own resources (for example, you would not need to rely on Social Security).

But, I’m guessing that even if you are earning $25,000 p.a. today, that this is not the amount you chose for Question 1.

I’m guessing that how much you really want to earn (i.e. the minimum amount that you feel would make you happy, healthy, and financially secure) is more … probably a lot more … than you are earning today.

Worse, you probably won’t want to wait 30 years to get there. I’m guessing that you want to stop needing to work (as opposed to having the financial flexibility to choose if/when you decide to work) sooner … probably a lot sooner.

[AJC: this is not true for everybody; there are plenty of people who enjoy what they’re doing so much that they cannot imagine doing anything else. This was me … until I did reach my Number and found out how much happier I could be choosing what I do – and don’t – want to work on each day.]

Plug your numbers into the above two steps and let me know (via the comments) what you come up with?

How will you get your Number?

To give you an example, I decided that my Number was $5 million and my Date (i.e. when I wanted to get there) was 5 years.

This was fairly simple to calculate: I decided that I needed $250,000 p.a. passive income (i.e. without needing to work). Since it was in just 5 years time, I didn’t bother adjusting for inflation (I could have added ~25%). Instead, I just multiplied by 20 … $5 million.

It’s pretty clear that I couldn’t save $5 million in just 5 years (after all, at that time I was still $30,000 in debt). And, it’s likely that you won’t be able to either.

[Hint: You would need to be able to save the entire amount of your desired income (Question 1.) each year for 17 years, earning at least 8% (after tax), in order to replace it in retirement.]

So, if you can’t save your way to wealth, what can you do?

It’s simple: you do two things:

1. Increase your income

There are lots of ways to do this: get a promotion; send your spouse back to work; get a second job; and so on. Necessity is the mother of invention … if you are really motivated, you will find a way.

However, my current favorite method is to start a part-time business. Why?

Well, it can grow in an unlimited fashion; it could even replace your primary income; it can create strong cashflow; if you pick the right kind of business, it can be started on your kitchen table.

My current favorite kind of part-time business is one that you can start online. Why?

Well, you don’t need much money and you probably don’t need any staff (at least, to begin). And, an online business can be so cheap to start that if you fail (and, let’s face it, you probably will) you can quickly and easily start another, and another, and …

2. Invest it all

It’s all well and good to increase your income and save as much of it (and, your current income) as possible. But, if inflation is running at just 2% (the last time I checked, it was 1.99%), and all you can get on your CD’s is 1% (Bankrate points to rates around 1.05%), then you’ve lost the ‘inflation race’ even before you’ve started.

It should be clear that it’s not enough to earn more, and save more …

… you also need to earn more on the money you save.

How much more?

Well, that’s when you need to plug some numbers into an online ‘savings goal’ calculator:

Here’s how to make it work; plug in:

(i) How much money are you starting with?

Do you have any money in your current savings that you can tap into: CD’s; index funds; 401k; emergency fund; etc.)? In my example, even though I started $30,000 in debt, I plugged in $1,000 as the calculator doesn’t work very well with negative numbers. I could just as easily have plugged in $0, but I chose $1,000.

(ii) How much can you put aside to invest each month?

This is your current rate of savings outside of your 401k + the entire income from your side business.

This is difficult, because the amount that you might generate in monthly income will probably change over time. There’s not much you can do about this (without finding a much more sophisticated calculator or spreadsheet), so I just chose an average of $10,000 a month (or $120,000 a year) as a nice, round-figure estimate of my expected savings (driven largely by the expected profits of my part-time business).

(iii) What is your Date?

This is how long you have until you need to begin tapping into your money. I chose 5 years.

(iv) What is your Number?

This is how large your investment account needs to grow. So, I plugged in my Number of  $5,000,000 and my Date of 5 years (as my end date).

Then, here’s where it gets fun: I started playing with Interest Rates to find the rough point where the calculator said that I could reach my goal (i.e. 70%). If I plugged in any figure less than 70% the calculator showed a message that said: “Oops. Your savings plan goes into the red.” … so, this was just trial and error to find the lowest number that didn’t produce this message. For me (in 5% increments) the answer came to an annual ‘interest rate’ of 70% .

That’s it!

How do I know that this works? Well, I have the benefit of hindsight 😉

But, that’s not the point: the point is to show you:

a) Not only do you need to save (a lot) more than you ever thought reasonable, but

b) You also may need to earn (a lot) more on your investments than is possible with CD’s (<1% annual return, after tax) or index funds (<8% annual return, after tax).

So, this leads us to the last piece of the puzzle:

What should you invest in?

Most people invest in whatever gives them the greatest possible return (they are the risk-takers), whatever their family/friends/advisers recommend (they are the followers), or whatever they understand (they are people of habit).

Instead, I want you to consider a totally new way to choose your investments: invest in whatever investment produces the lowest rate of return that you require with the minimum risk.

This usually means comparing the ‘interest rate’ that you came up with when using the online calculator against this table:

[Source: 7 Years To 7 Figures by Michael Masterson]

So, at a 70% required interest rate, I had no choice but to start my own business (just as well, because I was already in one); but, I supplemented by heavily investing in real-estate and some stocks.

On the other hand, you may be lucky enough (because your Number is small enough; your date long enough; and/or the amount you can save monthly is large enough) to require a much lower interest rate …

… if that’s the case, you may be able to stick with your CD or Index Fund investing strategy. But, the chances are that you will need to push the envelope … a lot.

I promised in my last post that I would close this three-part series with my “strategies for real financial security”.

In this post, I showed you that the Number that means financial security is different for everybody, but I also showed you a very quick way to find yours.

That’s the starting point.

Then I showed you what kind of investment strategies you would need to follow, if you want to have any real chance of reaching your Number.

Now, it’s up to you to begin putting in place your plans to get there, starting with learning how to invest in stocks, real-estate, and/or small business.

For my part, I decided to start writing this blog (and, now my book) to help those whose required growth rate / interest rate is at the higher end of the spectrum, simply because most other blogs focus on those at the lower end.

If your required growth rate is high, as I suspect it may be, you have a huge job ahead of you

… but, if you don’t make the effort now, go back and read these three posts and you’ll quickly realize that you’ll have an even bigger problem later.

So, keep reading, keep commenting, and keep e-mailing me with questions [ajc AT 7million7years DOT com],  and I’ll do my very best to help!


The biggest mistake in commercial real-estate …

You might pay too much for commercial real-estate, but it will probably still bring in a reasonable return.

You might forget to look into the taxes and take an extra few years for the ratchet clauses in your leases to catch up.

You might find that the tin roof leaks, but it should only cost you $’000’s to fix and time and tax deductions (and rental increases) will help to catch up on that.

No. The biggest mistake in commercial real-estate is the one that Tyler is about to make:

I’ve been thinking quite a bit about commercial real estate lately, but have been so discouraged with all of the vacant properties in my area (and I am a bit skittish about looking outside my area, as I don’t like buying something I’ve never seen in person). My residential properties, though, have been consistently producing income in both good times and bad.

With the vacancies, compressing cap rates, and the headaches of financing, maybe it’s just not the right time to jump into the commercial space.

Where’s the mistake?

After all, Tyler has identified a cyclical low point in the market … the sort of market that Warren Buffett salivates over:

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

But, Warren is talking about public markets.

These are the kind of markets that are driven by short-term investor sentiment i.e. the stock market.

When the market is ‘down’, it usually corrects to a long-term mean of an 11% pre-tax return [AJC: it remains to be seen what will happen with the current down market, but it’s only a matter of time – who knows how long – before it corrects].

So, then the market is fearful – and, stock prices drop – Warren jumps in, knowing full-well that (sooner or later) things will correct themselves and he’ll be sitting on windfall gains.

That accounts for 30% or 40% (my estimate) of his $40b fortune …

…. it’s the other part – the major part – of his fortune that holds the real lesson for Tyler:

You see, what most people don’t realize is that Warren Buffett is actually a business owner.

The main purpose of Berkshire Hathaway (Warren Buffett’s company) is to buy operating businesses. Here, he doesn’t look for short-term, contrarianism …. he simply looks for solid businesses that have been around for a long time already, and will be around for another 100 years.

And, he buys them, if he can get a discount to what he believes is fair market value. The bigger the discount, the more likely he is to buy.

[AJC: contrary to popular belief, Warren doesn’t just buy bargains … he creates them! For example, he bought Sees Candy for $30m when he thought it was only worth $25m at most. However, it was Warren and his team who turned it into a multi-billion dollar business, making it a bargain at any original purchase price]

And, Tyler, if residential real-estate is like speculating in stock (it is), then commercial real-estate is exactly like buying a business …

… and, what’s the biggest risk if you own a business?

It’s simply that you will lose customers!

No customers, no sales. No sales, no revenue. No revenue, no profit. No profit, and you go broke 🙁

It’s much the same with commercial real-estate:

Your biggest risk is the risk of vacancy.

It can take a long time to find a tenant in commercial real-estate: businesses simply do not expand, contract, or move as often as a family looking to, say, upsize their home.

And, that’s also the attraction: once you have a commercial tenant, they tend to stick around.

So, Tyler, even though bargains no doubt abound in your area, it looks like you, too, may struggle to find a tenant.

Either look farther afield, or stick to residential R/E until you see signs of improvement in vacancy rates for the specific type/s of commercial R/E that you are interested in.

Alternatively, find a tenant first (make friends with the rental realtors in your area) then buy a building to suit. Or, knock on the doors of all the businesses in your area and see who wants to upsize and find/buy the building for them.

Another strategy, when talking to the business owners in your area, is to find the ones who own their own buildings and see who wants to “sell and lease back” to free up some additional cash for their business.

Any way you look at it, for success in commercial real-estate, the tenant is king.

When to buy residential real-estate …

Prior to 2008 in the USA, and still in many other countries (including Australia), residential real-estate, along with managed funds, had become one of the most favored forms of personal investment …

… one could say the opiate of the masses, as evidenced by the huge rise and fall of residential real estate (and stock market) values across the USA in 2008 and beyond.

Jackie L, cleverly likens investing in real-estate to doing leveraged buyouts in the world of business:

Housing is generally a poor asset class. Housing’s like a leveraged buyout. You put in a little equity up front and fund the rest of the purchase with debt. The real value from housing comes when you sell the property or refinance because you’ve increased your proportion of equity ownership through mortgage payments.

The idea of creating leverage (by borrowing) in residential real-estate investments, though, isn’t so that you can pay it down (which would merely de-leverage yourself, so why do it?), it’s so that you can grab a larger chunk of upside.

You see, the promise of residential real-estate is alluring: You buy a $100k condo with $70k of the bank’s money and $30k of yours. In 10 years, the property doubles in value and you sell it for $200k, giving the bank back its $70k and pocketing $130k for yourself.

You haven’t just doubled your money in 10 years (still a healthy 7.2% compounded return), you’ve actually grown your $30k investment into $130k (in just 10 years), which is an astounding 16% compounded annual return.

If you could keep this up for another 20 years, you would have built up a $2.3m fortune.

No wonder so many people see the allure in investing in residential real-estate … which, of course, lead to the boom leading up to 2008.

The reality is a little different:

On closer examination, you begin to realize that most residential real-estate investments aren’t cash-flow positive for many years, so you have to keep pumping cash in, and there are ongoing costs: mortgage payments, vacancies, taxes, repairs and maintenance, and so on, that your rents simply can’t cover – at least not for many years.

Even so, if residential real-estate doubles in value every 10 years, it’s probably still a great long-term investment.

But, and here is the second catch, in the current market most real-estate has dropped in value. And, in most ‘normal’ markets (i.e. over the history of recorded real-estate transactions in the USA), real-estate only tends to grow with inflation … which means it doubles every 20 years rather than 10.

So, this means that you need to find residential real-estate that will grow at about twice the rate of the average piece of US real-estate, which has been doable (at least until recently) for many, many years, and will most likely be doable again in the future.

In fact, now may be a great time to find those long-term ‘bargains’.

But, the problem remains: residential real-estate is not an investment.

You are gambling short-term losses on long-term price appreciation, therefore, purchasing residential real-estate (other than to live in) is speculation.

[AJC: Commercial real-estate is another matter entirely, as its current value is determined by its current and future ability to earn an income, as I explained in this post]

Yet, I own residential real-estate, quite a lot of it … why?

Well, there are two compelling reasons why I own – and why you should own – residential real-estate:

1. To live in

I like security of tenure; that means that nobody can throw me out of my house. My house is even paid off, so I don’t have to worry about what the market does to its value, but this is a luxury that you can’t afford: you should have no more than 20% of your net worth tied up in the value of your house.

Once you have reached your Number, go ahead and pay off your house. Enjoy!

But, the real reason why you should own your own home is that, for most people, it will be the only way that you ever get off the batter’s plate when it comes to investing.

2. To protect yourself

A down-market, like now, is a great time to buy residential real-estate. When you are retired – and, can pay cash – is another time.

The reason is simple: once you realize that you are NOT going to speculate … you are NOT going to buy in the hope of a future increase in value … you are NOT going to sell, ever …

… then, you buy for one reason and one reason only:

For protected rents.

What do I mean by ‘protected rents’?

Well, residential real-estate tends not to produce the same returns as other classes of investments; that means $100k invested, for example, in commercial real-estate will produce a better rent, with fewer outgoings (costs), hence better overall returns.

However, in a ‘down market’ – worse still, depression – businesses go under leaving commercial offices, warehouses, factories, and shops vacant. And, the stock market tanks.

But, people still need somewhere to live …

So, good residential real-estate will always deliver some income. Not always great, but always some. That’s why a good chunk (but, not all) of my net worth sits in residential real-estate and, as you get closer to ‘retirement’, so should yours.

And, because residential real-estate tends to increase in value at least in line with inflation (given a reasonable time horizon), your capital is largely ‘inflation protected’, so your children should be equally happy 😉

How to retire in 7 years …

For our new readers, let me ask:

How would you like not one, but two ways to retire in just 7 years?

But, I warn you, retiring in 7 years is not easy … or, everybody would be doing it. However, I promise you that it can be done, either my way or Jacob’s way [AJC: Jacob is the author of the controversial book Early Retirement Extreme and the blog of the same name].

I would suggest that Jacob is an outlier in the Personal Finance community because of the aptly named ‘extreme’ portion of his book’s/blog’s title. On the other hand, my method to early retirement is just as extreme … just the other extreme.

In fact, I’ve said before that Jacob and I pretty much book-end the spectrum of personal finance advice.

So, let’s take a look the two methods and find out why each method, in its own unique way, is so extreme:

Method 1 – Early Retirement Extreme

In his excellent review of Jacob’s book, Invest It Wisely summarizes Jacob’s reasoning for retiring early: so that you can explore “renaissance man” aspects of your life.

That is, ‘retire early’ so that you can become less job-specialized and explore wider, more varied options than you would if you were still tied to earning an income full-time.

In order to do that, Jacob advises taking drastic cost-cutting measures e.g. downsizing your home; lowering the thermostat in the winter and raising it in the summer; taking cold showers; downscaling to 1 car or even no car at all, and so on.

Now, that’s extreme!

There has to be a reason and a benefit to this … and, there is:

The reason for the extreme (there’s that word again) austerity plan is so that you can … Save at least 75% of your income.

The benefit of saving that super-sized chunk of your pay packet is that you may be able to effectively retire in just 7 years if you do. Here’s how it works:

Let’s say that you currently earn $50,000 after tax and want to retire in 7 years. Jacob suggests that you should save 75% of your income, this means in the first year you live off just $12,500 and save the rest.

Now, if your salary increases with inflation (let’s say 3% p.a.), and you can invest the money that you save (starting with $37,500 in the first year and increasing each year with inflation) at an 8% after-tax return (by no means easy in the current market), then you should be able to replace your then-current salary after just 7 years with your passive income from your $300k nest-egg’s investments.

There are two catches:

1. Your salary in the 7th year (hence, your starting retirement salary) will be just $14,700 a year (representing a 5% withdrawal rate on your $300k of savings). Given that you started by living on just $12,500 and can retire in 7 years, you should be able to live like a king (or queen) on nearly $15,000 p.a. And, if you find that you can’t survive on $15k a year, well, you’re probably still young enough to enjoy your extended holiday, go back to work, and start again!

2. Our numbers are quite bullish: there’s no investment that you should put your money into for only 7 years that will return 8% after tax. In fact, you would be extremely lucky to return more than 2% after tax, and really should be just keeping your money in CD’s or bonds which currently return just ~1% before tax.

Also, a 5% withdrawal rate is hardly safe; you have to make this money last much longer than normal retirees, since you are retiring so early. A Monte Carlo analysis shows that withdrawing just 3% of your now-required $600,000 nest-egg is probably already stretching it. The good/bad news is that you can still retire in a still-not-too-shabby 11 years, on just under $20,000 per year …

… but (because of inflation), that’s only worth $14k a year in today’s dollars when you retire.

Method 2 – Early Retirement Super-Extreme

Super-extreme early retirement means, to me, retiring in 7 years with $7 million. This means retiring on $350k a year.

Why $350k?

Is it really needed, especially since Jacob has shown that it’s possible for a couple to live on $12,500 a year?!

Strictly speaking, no.

But, since you can retire with $350,000 a year to spend (because I did), I say … why not?!

With $350,000 a year, you can definitely live the relaxed, varied lifestyle that Jacob suggests we should aspire to … just at a slightly different level to his suggested $12,500 / year lifestyle.

Cars? Have 2 …. heck, have 3 and make them imported (with at least one exotic).

Vacations? Twice a year … travel business class and make at least one of them international 5-Star.

Upsize your home? Sure … and, pay off the mortgage with cash.

Raise the thermostat in the winter and lower it in the summer? Sure (as long as your ‘green conscience’ can stand it).

Take loooong hot showers? Absolutely [WARNING: see ‘green conscience’, above]!

… and, so on.

So, how does one do this?

Well, the key is this ‘specialization’ thing that Jacob says that we need to avoid long-term:

I agree, but for the next 7 years you absolutely must specialize in increasing your income, and increasing your savings appropriately. However, unlike the ‘extreme savers’, you never reduce your lifestyle … instead, you just don’t increase it as much as your income increases:

– Save 10% of your income starting right now (or, build up to it over the next few months, if you have started by saving less)

– Save 50% of all future salary increases; all additional income (from businesses, second jobs); and even more for unexpected windfalls (e.g. lottery winning, inheritances, tax refunds, etc.).

Instead of cutting costs – and, saving – which are inherently limited (even Jacob can’t save more than 75% of his income) – concentrate on increasing your income because the sky’s the limit: start a second job; start a part-time business; start an online, part-time business (call it Facebook and the rest is easy).

Most of all, start investing … actively, aggressively, wisely.

Simply follow my patented two-step wealth generation system (it used to be 4-steps, but I cut it in half … so, now you have no excuses) … voila!

$7 million in 7 years.

There you have it: two methods of retiring young.

Choose the one method that appeals to you the most and, from today forwards, read the creator’s writings carefully, and ignore anything that you read that contradicts their advice …

… because every other method will have you enslaved for the next 20 to 40 years, with absolutely no guarantee as to what your retirement years may bring.

And, don’t let anybody tell you otherwise 🙂

Living to 100 …

First of all, let me tell you that living to 100 is not a blessing.

My grandmother just passed away. She made it to 12 days past 100 years.

In fact, the 100 was like the finishing line to a marathon for her; in Australia, you get a letter from the Queen.

She also got a letter from the Prime Minister, the Governor General, and her local member of parliament …

… and, a little party at the old people’s home where she resided, complete with party hats and balloons. Hurrah!

My Grandmother lead almost the whole family unscathed through the holocaust (she ‘only’ lost one brother, where most others lost their entire families) and emmigrated to Australia almost penniless where she (and, my grandfather … but, mainly she) did what most immigrants do: work hard, invest wisely, and slowly rebuild their fortunes.

She may not have made $7 million in 7 years, but she certainly made that much in 30 or 40 years, starting with nothing. I can’t see why anybody would settle for $1 million after a lifetime of work?

So, what have I learned from my grandmother’s experiences?

1. Living to 100 is not all it’s cracked up to be.

My grandmother’s brain was amazing, right up to the end.

When she got her letters, she immediately recalled our Prime Minister’s name as being Julia Gillard.  And, just a few weeks before her 100th, she was still doing mental arithmetic (“if you were only 85, how much longer to 100? I asked. Within a couple of seconds, my grannie answered “15 years”).

But, her body was not so good: the legs went first, then the teeth, and so on … she often told me that living to 100 is not all that great.

2. If you lose it all, get up and do it all over again.

My grandmother lived like a queen before World War II. He husband (my grandfather) was a banker in the small town in Poland where they lived. They also owned the local movie theater. My granny hadn’t worked a day in her life and had maids and servants. My grandfather never drove a car (he could afford a driver).

The war, and the Nazis, changed all of that. Coming to Australia destitute, my grandmother decided to start a business making neckties. Not only did she not have any money with which to start a business, she had never sewed a necktie in her life.

Instead, she took a job at a tie factory to try and learn how it was done and (after convincing the owner that she could, in fact, sew ties) she convinced a couple of the seamstresses there to make some sample ties for her after hours. Using those samples, my granny went door to door (shop to shop) signing orders for those ties.

3. Don’t ever convince yourself that you can’t ‘cold call’

If my grandmother – who had never worked a day in her life before and was a female at a time when all salesmen were … well … men – managed to do it, then so can me or you!

Once she had enough orders, she paid those same seamstresses a ‘per tie’ rate (it’s called “piece work”) to fill the orders. She then delivered the ties and used the money earned to start the process all over again …

… eventually, she had been through this cycle enough times to open a small factory and hire those “piece workers” away from their other factory job, and they stayed with her until my granny retired (she gave the business to her loyal staff).

4. Invest today so that you can live tomorrow.

Most people would take the money that they are earning from their businesses and start paying themselves a decent salary. My Grandmother wasn’t most people: instead, she would invest the profits from their business into real-estate.

Contrary to popular belief, most business people don’t become rich from their businesses (remember, my granny simply gave hers away); they become rich from the investments that they make using their business’ income.

My grandmother was no exception: she bought real-estate.

Not only did she buy real-estate, she also developed her own down-town property. To give you an idea what that may be worth, when he was 93 – and, living in the old people’s home – my grandmother sold another down-town property on behalf of her 3 other partners who were all as old as her.

The realtor told her that the property was worth $11 million. She said “rubbish” and managed to hold out for a better offer, which eventually came in at $18 million. Not bad for a half-deaf, bed-ridden 93 year old.

The corollary to this is something that I learned from my grandfather (but was relayed to me by my grandmother after he passed away many years ago): at one stage, my grandmother felt that they could finally afford to buy a house. My grandfather said: “You can always buy a house from a business. But, you can never buy a business from a house”.

All in all, the value of the life lessons that I learned from my grandmother were immeasurable … but, the business lessons that I learned from her shaped who I am as an investor, and an entrepreneur.

No doubt, I wouldn’t have made $7 million in 7 years without them, and I can finally share the ultimate source of my inspiration here with you.