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:

Screen Shot 2013-01-29 at 2.38.40 PM

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.


Transitioning to retirement …

withdrawal1You’re hard at work, trying to to reach Your Number, and you’ve cranked up your Perpetual Money Machine to make sure that you get there …

… now, there’s not much to do except work the plan.

So, let’s fast-forward a few years and think about what happens when you finally reach Your Number.

If you recall, you calculated your Number simply by:

Taking your Required Annual Living Expenses (which you adjusted for inflation) x 20.

Now, where did this Rule of 20 come from?

It is simply the same as withdrawing 5% from your Number each year.

Picture your Number as a pile of cash that you made by saving, investing, or even selling your real-estate and/or business portfolio, and now it is sitting safely in the bank as cash or CD’s, earning bank interest each year. The question is, how much can you safely withdraw each year to live off (like paying yourself a wage) so that you never run out of money?

When you are busy ‘working’ (be that on a job, in a business, or on your actively-managed investment portfolio) you will dream of nothing but having that pile of cash that equals Your Number just sitting there.

But, when you have that pile – hopefully, very large pile – of cash you will suddenly realize:

1. You have to pay taxes on the interest,

2. You have to beat inflation,

3. You have to spend some of your capital to live,

4. You have to survive market downturns.

You have to hope this money lasts as long as you do!

… all of a sudden, you have to be VERY protective of Your Number.

When you are working, you fear losing your job. When you start to invest, you fear losing some or all of your investments. When you start or buy a business, you fear closing down. The reality is that you can recover from any/all of these scenarios given a little extra time and work. But, if you lose Your Number, you have lost everything … and, the longer it takes to lose it, the less time/chance you have of recovering it.

So, a key question becomes: what is a SAFE percentage of Your Number to withdraw each year? Usually, a great place to start is by looking at what ‘the experts’ recommend …

Unfortunately, there is support out there for just about any annual % of Your Number (i.e. your retirement nest egg) that you may choose to spend, for example:

7% – Not so long ago, the financial services industry proposed spending as much as 7% of your portfolio each year in retirement.

6% – More recently, Paul Graangard wrote two books proposing a combined bond-laddering and stocks strategy that, he suggested, supported a spending rate as high as 6.6% of your portfolio each year.

5% – Investment funds routinely allow spending of 5% of the portion of their investment portfolios dedicated to simply keeping up with inflation. Indeed, my Rule of 20 appears to support this withdrawal rate, too.

4% – A large number of studies – probably, the most famous of which is the so-called Trinity Study – advocate spending up to 4% of your initial portfolio (ideally, 50% stocks and 50% bonds, rebalanced each year), which provides somewhere between a 90% and 100% certainty that your money will last at least 35 years.

3% –  A whole slew of new retirement planning tools (generally using a Monte Carlo approach to modelling tens, hundreds, or even thousands of potential economic scenarios) have been released over the last 4 or 5 years by the financial services industry, purporting to analyse hundreds of alternative economic scenarios to try and model what would happen to your retirement portfolio (i.e. simulating changes in interest rates, market booms and busts, etc.) to find the ideal ’safe’ withdrawal rate. A lot of these advocate very low withdrawal rates, typically in the 2.5% – 3.5% range.

2% – Some even advocate a totally ‘risk-free’ approach to retirement savings by investing close to 100% of your retirement portfolio in inflation-protected bonds (e.g. US Government Inflation-Protected Bonds – TIPS; Municipal Inflation-Protected Bonds – iMUNIs); historically, these have provided less than 2% return, after inflation but with total protection of your starting capital.

So, which is right?



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!


Why cookie-cutter personal finance does not work

Marie (speaker, blogger, investor) agrees with my simple plan for wealth creation:

I have to go with your 2 step plan. All my years in PF it seem to work best than the cookie cutter approach.

The ‘cookie cutter’ approach that Marie refers to are the approaches that I was talking about in my provocatively titled guest post at Budgets Are $exy: “Why Most Personal Finance Blogs Are B.S.“, and includes: paying off all debt; maintaining an emergency fund; frugality and expense-cutting; paying yourself first via max’ing out your 401k; and, so on.

[AJC: To be fair, I was asked to write something ‘feisty’ so you should head on over and read the article (and the comments) now …]

To prove any personal finance strategy you need to have an objective against which you must measure the outcome.

To me, that goal must be: financial freedom.

But, what does ‘financial freedom’ mean?

That depends entirely on you …

If your goal is to simply replace your income, say, within 20 years, and you can train yourself – through frugality – to live on a lower income than your peers then it is possible to save your way to wealth (simply defined as financial freedom, or having enough passive income to replace your then-current income from employment).

For example, MB writes about her 12 year plan to replacing her and her husband’s dual working income:

After a couple years of full-time work I started to wonder, how can anyone possibly tolerate doing this for 40 whole years?!

[Now] our number is somewhere in the $1-2M range depending on how many kids we end up having (if any). But, then again, we are saving >50% of our salaries.

By ‘training’ themselves to live on only 50% of their salaries – or 1/4 to a 1/2 less than their peers – MB and her husband accomplish two purposes:

1. They save a lot more than most people,

2. They live on a lot less than most people

So … they need a much smaller Number than most people and they’ll be able to reach that number much, much sooner than most people.

According to my calculations, if you start off earning, say, a combined $50k p.a. and are prepared to live off just $25k of that (assuming your combined salaries increase by 3% per year, and you get a very hefty 8% after-tax return on your savings) you will be able to retire on a combined $40k passive income in not the 12 years that MB is hoping for, but a still-healthy 17 years time.

The catch is that just 4% inflation would mean that you really have the earning power of a little less than $25k p.a. today.

In other words, to actually make this cookie cutter personal finance plan work, you need to be debt-free and be able to live on just half your current annual income for your whole life.

Is this you?

If not, I recommend that you spend a little time with an online retirement savings calculator and work out what income you would need in today’s dollars (i.e. assume you retire today) …

… then, leave a comment and – in my next post – I’ll explain what that means and what you need to do to get there.



You can be a millionaire in your lifetime …

Australia’s (now the world’s) richest woman is worth $25b or so …

… and, she says that you can be a millionaire:

There is no monopoly on becoming a millionaire.

If you’re jealous of those with more money, don’t just sit there and complain. Do something to make more money yourself – spend less time drinking or smoking and socialising and more time working. Become one of those people who work hard, invest and build and at the same time create employment and opportunities for others.

Of course, Gina Rinehart inherited one of the world’s biggest iron ore deposits …

… you and I have to find our own lump of wealth 😉

But, I agree with her sentiment: increase your income (“spend … more time working”) and put your money to work for you (“invest and build”).

If you do, getting to a million will be a snap:

If you start off earning $25,000 and work for 40 years (earning around $80k in your last pre-retirement year), and save just 10% of your annual salary (earning 8% on your money), you will have exactly $1,000,000.

Of course, you will be used to living on $72k p.a. ($80k less 10% for savings) by then, and $1m will ‘safely’ give you only half of that to live off … oh, and you can halve that twice again to allow for inflation, so you will really be retiring on the equivalent of $10k a year, today.

But, that’s not the point; the point is that you can be a millionaire in your lifetime …

Of course, getting to $7 million in your lifetime (let alone in 7 years) still won’t be a piece of cake!

But, that’s where this blog comes in 🙂

An interview with AJC …

I’ve created a new Facebook Group called 7million7years

Feel free to join! It’s where all of us can ask and answer questions about personal finance … ask anything you like, and see who responds; sometimes, I’ll weigh in, as well!


Here’s an interview that I did a while back for the nice folks at Spectrem Group (a research company specializing in the ultra high net worth market). It was quite ironic that they asked me to do this interview, because I called their book the most dangerous idea in retirement planning that I have ever read!

Still, for new readers, this interview is a great overview of who I am and why I write this blog (as well as what you can expect, if you choose to stick with me):


What is your financial goal? Adrian J. Cartwood (a nom de plume) had one: $5 million in five years. He didn’t quite make it. But he did make $7 million in seven years and he writes about it in his blog of the same name. His is the sort of self-directed, out-of-debt story that makes for lively posts. Cartwood lives in Australia and he communicated via email with Millionaire Corner about his hard-earned success. What inspired you to start your blog?

Adrian J. Cartwood: I inherited a failing family business, and I was $30K in debt. During this time, in 1998, I found what I like to call my “Life’s Purpose,” or “Life after Work”. Others call this retirement, but who wants to wait until they’re 65 to start living their passion? So, I calculated my “number,” that is how much I would need in the bank to stop working in five years instead of 20 or 40. That number was a very scary $5 million.


Five million dollars in five years seems like an impossible target, especially when you’re starting $30k behind the 8-ball, so I started reading every single personal finance book that I could get my hands on. What I quickly realized is that they are mostly written by people who became rich because they wrote a book about how to get rich. Needless to say they were mostly full of rubbish. So, I found another one of my passions! It was, and remains, to be the first true multi-millionaire to write about personal finance, hence the blog.


MC: When did you launch your blog? How many visitors does it get?

AC: Three years ago. I don’t do any advertising, marketing, or promotion for my blog at all. I’m not even sure how you found me! Yet, in the time that I’ve been writing it, I’ve somehow built a dedicated audience in the thousands who seem to read it every day. I hope to never disappoint them.


MC: For whom is your blog intended?

AC: This is an excellent question because I often get comments from new readers who say “Well, my 401k is company matched, so it’s a great investment.” Sure it is, but it won’t make them rich. So my blog is specifically targeted to people like me who want to stop full-time work to pursue their passion, be it writing a novel, traveling, researching great wines, volunteering, whatever. The kicker is, when they calculate their own “number”- how much they will need in passive investments to support them, it’s inevitably something like $2 million in 6 years. If you run their starting position (say $100,000) through any simple online compound growth rate calculator, as I encourage my readers to do, they quickly see that they need to achieve a 65% compound growth on their investments. Given that their 401k can’t achieve more than 8% over 40 years, it’s clear that they need somebody to teach them how to become rich. That narrows down my readership to those who have done the same kind of self-reflection that I did seven years ago and realize that they actually need to become rich.


MC: What do most hope your readers get out of it?

AC: I hope that my new readers realize that they should evaluate their lives and see if what they are currently doing is going to truly satisfy them. If so, don’t change anything. But, for those who need more out of life, I hope that they walk away with the tools to evaluate what they truly want to do with their lives, how much money they will need (and by when), and the real personal financial steps that they need to take to bridge the gap … quickly. It’s not about getting rich quick. But it is about getting richer, quicker.


MC: For those unfamiliar with your blog, what are some representative posts?


I like this one, because it encourages you to start thinking externally rather than internally, which is the first step to financial freedom:

This one shows that where you invest your money is more important than how much you put aside each week or month:


MC:  Did you grow up in a financially literate household? Did your parents discuss money matters with you?

AC: I grew up in a poor household. The rest of my family grew up in a rich one. The trouble was it was the same house! You see, my father lived beyond his means, but I was the only other male in the family, so he only confided his true financial situation in me. Therefore I grew up paying for all of my own clothes, cars, and so on. The rest of my family still lives on handouts from richer relatives.


That knowledge taught me financial responsibility, but it didn’t teach me how to make money. That came from my $7 million/7 year journey. Naturally, I taught my own children about money. My son is a natural entrepreneur, my daughter is more social, but both know how to save and how to spend responsibly.


MC: What books or financial pundits, if any, influenced you/

AC: Rich Dad, Poor Dad by Robert Kiyosaki and The E-Myth Revisited by Michael Gerber. The first is about money and the second about business.


MC: How did you get started in investing?

AC: My very first investment was an apartment that I bought soon after college because a friend of mine was buying one in the same block. I knew nothing other than to copy him. I sold it a couple of years later to pay for a trip overseas. It’s safe to say that was not the start of my financial journey. When my financial wake-up call arrived seven years ago, I made my first real real-estate investment. Like most people, I knew that I wanted to invest in real-estate but I had no idea how.


One day I was driving around my neighborhood and saw a ‘For Sale’ sign on a condo in an older block of 12. There was an auction just about to start.  I figured that not many people would know about it because the sign was by an out-of-town agent, so I stopped to check it out.


My next problem was that I had literally no idea of how much to pay. But, I saw a young guy in a tradesman’s outfit measuring doors and windows and so on. I guessed that he was planning to buy it for himself, fix it up and flip it. I decided to bid against him and pay $1 more. I figured that if he was looking to take a quick profit that he would be operating on a tight budget, and that I could then afford to pay just that little bit more to buy and hold.


And, that’s what happened. I found myself as the winning bidder for a property that I had never been in before. I had to call my wife (who was not pleased) to rush over with my checkbook. We still own that condo today and it has been a star performer.
MC: What are some of the defining lessons you learned when you first started out?

AC: You can’t save your way to wealth. Running some simple numbers through that online calculator quickly showed me that my 401(k) would never be able to fund my retirement even if I waited until 65. Investment returns from mutual funds are simply too low and fees are too high, not to mention inflation eats up half of everything every 20 years. I realized that I would need to create my own perpetual money machine by taking as much income as I could put aside and invest it in assets that I could borrow against (so that I could buy more), but still had enough income to cover the costs of owning those assets. Real-estate (and, to a lesser extent a small portfolio of hand-picked stocks) could fit the bill. I also learned that starting a business is the best way to increase income. More income means more investments and more investments means more real wealth.


MC: What are some of the most common mistakes investors make?

AC: The most common and costly mistake is confusing good and bad debt with cheap and expensive debt. Because so many people have trapped themselves into bad credit card debt, which they should pay off as quickly as possible because it’s just so expensive, they have been lead to believe by so many financial pundits that they should pay off all of their debt, including their mortgages. For most people, this is actually a mistake.


Instead they should pay off expensive debt (such as credit cards, and auto loans) as quickly as possible. But, as soon as their remaining loans are at a lower rate than the cost of an investment loan (such as you might get to buy an investment property), why pay it off just to take out a bigger, more expensive investment loan?


The second mistake is thinking that your house is an investment: it’s not. The chances are that you will never be able to sell that house, even when you retire. Retirees plan on selling their big houses but they rarely move into a small, two bedroom condo. They realize that they either don’t want to move, or they want to stay close to their children, or move into an expensive retirement community. That and the moving costs (plus, are you going to move old furniture into a nice, new condo?) mean that they pocket a lot less than they thought. Suddenly, there’s a huge hole in their retirement budget.


MC: What is the most common question you are asked?

AC: Mostly, people ask me how I became rich. I tell them on my blog because it’s something that anybody can do.


That’s the interview! What did you think?

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.

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 …


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?