The 6% Realtor Solution

Posted on May 3, 2008 by Adrian

Last days for ‘pre-applications’ to become one of my 7 millionaires … In Training! Click here to find out more …

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To get a Realtor or not to get a Realtor, that is the 6% question …

Joshua asked a question about a recent post:

I’m planning on buying a condo soon … fixing it up a bit and renting it out … but how would someone “educate themselves daily on the market”? I keep an eye on the 30 FMR and am impressed with rates right now but I’m wondering if there’s more to this education.

If you’ve been following this blog, you’ll probably also be thinking that now might be a great time to be buying some real-estate: a house, a rental house/condo, duplex/triplex/quadraplex, retail/commercial, office or industrial … the choices abound!

No matter what you are thinking of buying, once you have done some of your own homework and narrowed down (a) the type of real-estate you want, (b) the price range that you are interested in, and (c) the area/s that you are looking at …

… then find a Realtor who will send you ‘comps’ (i.e. comparable sales) on similar sales in the area from the Multiple Listing Service (MLS).

Also, ask the Realtor for information that will help you find how the market has changed over the past couple of years … do the same with rental ‘comps’.

Also, physically look at a number of similar properties in the area/s that you are interested in before choosing one.

Of course, you can get some (most) of this information from public (many free) databases … just Google ‘MLS’ for listings of properties of the type that you are interested in, and sites like rent.com for rental rates on apartments and houses. Sites like realtytrac and loopnet are great for commercial.

But, there are some big advantages of using a Realtor:

1. Qualification – these guys are trained (more so than a ‘standard’ real-estate agent … the ‘Realtor’ designation actually means something!) and if they have worked in the market for a while, they will know what you are looking for before you do.

2. The MLS listings that they can get you are far more detailed than the publicly available ones.

3. If they own and invest in the same types of properties in the same areas that you are interested in, they can be a great resource (AJC: this should be the first question that you ask … only deal with an Investor/Realtor who already invests in the same type of real-estate that you want to be investing in, and in the same or similar area/s).

4. They will represent you in the purchase and the other guy (i.e. the one selling the property) pays their fee – they typically split commissions with the selling agent.

So, the seller’s 6% commission pays you for a ‘free’ buyer’s agent … just choose the right one … OK?

The most dangerous idea in retirement planning that I have ever read!

Posted on May 2, 2008 by Adrian

Double Dose of 7million7years! Please check out my FIRST EVER Guest Post … it’s at BripBlap, a blog that should be on your DAILY READING list: http://www.bripblap.com/2008/guest-post-education-a-curse-or-a-cushion/

In a few weeks, I was planning an ‘expose’ of a book that I read , but just came across a related post by an innovative thinker who calls himself Gryffindor (presumably, named after one of the Hogwarts Houses in Harry Potter) so I can’t resist but to weigh in now …

And, I’m going in boots and all!

First, here is what Gryffindor had to say – which I actually like because it is innovative and a little controversial:

So if an investor has 2 million at the age of 55, what does the conventional wisdom say? He could invest it and with a safe withdrawal rate of 4% count on $80,000 a year. 2 million of savings – with that all you get is a 80k a year. No wonder most people are depressed about retirement.

Now what if the investor takes a million of his nest egg and buys [a] business? She gets $200k of cash flow a year that is growing at 3% to match inflation. She can also reinvest the additional earnings from the other $1 million. She also gets some additional tax benefits of owning the business and can have some productive part-time hobby / business and not just spend her time on the golf course. It sounds all good to me.

And, here is part of my response that I posted on his blog post:

This is such an important topic that I am going to post a response on my blog [which you are now reading!] … I would really like to set up some debate on this because it is a very useful – but, potentially highly dangerous – retirement strategy that really needs to be well thought through before anybody implements.

Rightly or wrongly, some people just see me as a guy who ‘got lucky lucky in business’ (AJC: most of my $7m7y Net Worth actually came from investments … my leter/additional Net Worth came from selling some businesses), so it might seem natural when I say that Gyffindor actually appears to be onto something that is one of the central ideas in a recent book called Get Rich, Stay Rich, Pass It On.

The principle is that rich people keep their money for generations ONLY if they split their assets roughly one-third in a business, one-third in paper (stocks, bonds, mutual funds, etc.) and one-third in real-estate (incl. their own home):

Then, you might be surprised when I say that this is “the most dangerous idea in retirement planning that I have read”!?

What the book is recommending, that I find so damn dangerous for retirees, is this:

The authors of Get Rich, Stay Rich, Pass It On suggest that you need to invest, and keep invested forever, 25% – 35% of your Total Household Assets into ‘continually innovative enterprise/s’:

What we mean here by a continually innovative enterprise is one that either offers a product or service that breaks new ground or changes a traditional product or service so much that it becomes virtually new.

Now, that is something that you do before you retire so that you can retire rich … you take risks, you innovate, then you sit back and reap the profits (or sell) …

… it is not something that you get into in order to preserve wealth, which is exactly what the authors suggest:

At the lowest level of personal involvement, you might invest in a limited partnership, private equity plan, or venture capital program in which the actual management of the enterprise – possibly even the choice of the enterprise to invest in – is beyond your reach and outside your control.

Put simply: this recommendation is crazy …

… in my opinion, it unfortunately totally discredits an otherwise fine book written by authors who are respected consultants who assess the wealth habits of America’s mega-rich for the financial planing industry.

to me it seems that they are confusing the Making Money 201 wealth-building practices that rely partially on risk-taking strategies that may include a business – or, at least look a lot like a business (e.g. rehabbing/flipping real-estate; trading stocks/options etc.) …

… with the Making Money 301 wealth-preserving (i.e. retirement) practices that move you away from risk towards passive income!

So, is there a place for owning a business in a wealth-preservation strategy?

Absolutely!

I think that I speak with some authority on this: I have owned, operated, and successfully sold a number of businesses across a number of countries, many of which I owned at the same time!

I was an active owner in some and am still a passive owner in others …

Now that I am retired before 50, I am giving one part of a business away to my partner, converting another part into a ‘licence annuity’ that I will keep, and I am also keeping one other operating business as a semi-passive entity.

This last one is interesting, as it appears to support the thesis in Gryffindor’s post and the book that I mentioned:

This business is still in another country … it’s a finance company that turns over $40,000,000 per year with a only staff of 4 and nets me a cool $250k per year with about an hour’s work a month from me … I control it (through various legal entities) 100%!

Even so, here is the fundamental truth:

There’s no such thing as a PASSIVE business – as long as you own a business, you:

1. Will lose sleep every so often until it is sold or closes down, and

2. You will NEVER be truly retired.

As long as you can accept this level of semi-retirement worry and activity (which may actually HELP to keep you young!) then the Gyffindor Strategy could work for you, BUT:

i) I could accept owning in retirement: Big Name Franchises; Self-storage facilities; Mobile-home parks; Car-Washes; Your own well-established business that you are now ‘winding back on’.

ii) I would be a lot more concerned about: auto-repair and other skill-based businesses OR ‘vanity businesses’ – you know, the types that celebrities like to own (e.g. restaurants, bars, etc.).

iii) You would need to set out to have the business/es that you select run without you from the very beginning.

If you like the idea of owning a business in ‘retirement’, here’s a hint:

This strategy could hold a lot more attraction for you if you can also own the real-estate that the business operates from!

Why?

A. It assures the rental stream,

B. It assures at least some capital growth,

C. It hedges your bets against business failure (particularly if you plow excess cash generated by the business into the mortgage),

D. It provides a partial exit stream i.e. sell or give the business to management or a buyer under the condition of a long-favorable lease with upward-only ratchet clauses (rents increase at least with inflation).

A final thought:

I mentioned that I will continue to own at least one business now that I am fully retired:

– I founded this business and have owned it since 1991 … it has successfully run without my direct involvement for more than 5 years.

– I tried to sell it anyway, but it was only worth 3 times annual Net Profit before Tax … for that I will keep it for three years and take my chances!

– If I do happen to find a buyer who will pay me 5 or 6 times annual Net Profit before Tax, I will sell it.

– I do not count this business’s income towards my retirement portfolio’s ‘safe withdrawal rate’ because anything can happen with a business at any time … rather, I use the profit to build my portfolio’s total value, and spend the passive income from that.

If I do eventually sell it, THEN I will increase my portfolio’s withdrawal rate because I will have converted the business into a passive investment (cash, stocks, or real-estate).

Phew! This is one of my longest posts … so, now it’s your turn to comment!

Who is the Devil's Advocate's "devil's advocate"?

Posted on May 1, 2008 by Adrian

Have you noticed whenever you have an idea that goes against the mainstream (as most of my good ideas seem to) that people always pop up to rain on your [idea] parade?

They often justify their negativity under the guise of that old cop out: “oh, I’m just playing the Devil’s Advocate” … meaning that you get to listen to their endless diatribe. If you’re unlucky, they just may succeed in having you ‘come to your senses’ [a.k.a. miss yet another opportunity].

My response usually is: “In that case, I’m the Devil’s Advocate’s Devil’s Advocate! ;)”

… which means, this time I get to explain why their [contra]-ideas are dumb, and they get to sit there and listen!

I particularly like to play Devil’s Advocate’s Devil’s Advocate with the typical Personal Finance mantras as published in so many PF books and blogs – and, we have already covered a few, with a whole lot more to come – because so many of them are so self-limiting.

I go the idea for this post from a PF blog that I like, Bargaineering, who has a whole section called Devil’s Advocate … I have reprinted a section from his latest roundup, and have included the links in case you want to review the actual articles [AJC: I haven’t had time to review them all, yet]:

I have a few good ideas in store for future articles but I wanted to do a little roundup, in part for myself to see all the topics we’ve covered, so that you could join in the rock throwing against mainstream ideas.

Don’t Invest in the Stock Market

Cancel Unused Credit Cards

It’s Okay To Ignore Your Problems

Ignore Personal Finance Experts

Don’t Have Kids

Buy More House Than You Need

Don’t Move From Job To Job

Get A Store-Branded Credit Card

You Don’t Need College to Succeed

Four Reasons You Should Get A PayDay Loan

Don’t Get Married

Buy That Home Warranty

Adjustable Rate Mortgages Are Awesome!

Pay Cash for Everything

Don’t Budget to the Penny

Invest In Your Company

Say No To Credit Card 0% Balance Transfer Arbitrage

Why Roth IRAs Are Bad

Lease A Car, Don’t Buy It

Don’t Just Buy Index Funds

Don’t Optimize Payroll Deductions

Rent Forever, Don’t Buy A Home

My view?

Great ideas – in fact, I made a fortune by FOLLOWING ideas # 4, 6, 13, 15, 16, 18, 20, 21.

Here’s how I look at it:

Follow conventional thinking and you’ll get conventional results.

Follow Unconventional Wisdom, and you just MIGHT get rich, too (but, don’t be stupid about it, because you will probably remain poor) … but, you need to throw in some ’special sauce’ as well [AJC: that’s what this blog is for].

Nothing wrong with following good advice … nothing wrong with ignoring it, either … I’ve made money both ways – just be sure you know WHY you are following/ignoring it!

Here are the Top 4 Personal Finance Myth’s that I will be doing my very best to destroy over the coming weeks:

1. ‘Bad Debt’ is to be avoided at all costs!

2. Your house is NOT an asset or Your house IS an asset!

3. Max. your 401.k and other Retirement Accounts

4. You can [and, must!] save your way to wealth

5. The Magic Number is $1 Million

… a whole plethora of ideas for us to explore!

But, first a word of caution:

If your target is just an amount like $1 Million to $2 Million in 15 – 30 years, then you do NOT need to read any further – this blog is NOT for you and you will get far more benefit for your time invested by reading here, here, and here, or probably ANY of the places listed here instead.

However, if you are going to join me on this exploration of Anarchic Personal Finance Ideas – and be the Devil’s Advocate’s Devil’s Advocate – then let me know which DUMB 😉 ideas that worked for you, so far …

Business for sale?

Posted on April 28, 2008 by Adrian

As you know, I’m a member of Networth IQ – and quite an active member, at that! I love reading and answering questions …

[AJC: you’ve probably already seen that from the detailed responses that I try and give commenters on my posts on this blog … try me, if you have a question … I just won’t give direct personal advice, because I am not a qualified professional, but I will give general advice if I think it will benefit all of our readers]

… and this unique site provides a great platform (as does Tickerhound, which provides a great Q&A forum on everything from stocks to real-estate).

For those of you who aren’t members of Networth IQ, here is an exerpt of a great question:

I found a business for sale that has generated the following free cash flows since 1998.

1998 – $3,426.0 Mil
1999 – $3,949.0 Mil
2000 – $4,917.0 Mil
2001 – $7,133.0 Mil
2002 – $6,077.0 Mil
2003 – $8,333.0 Mil
2004 – $8,956.0 Mil
2005 – $9,245.0 Mil
2006 – $11,582.0 Mil
2007 – $12,307.0 Mil

The current owners are asking $183.49 Bil, …. I don’t have $183.49 Bil, but they said that they would sell me a smaller portion of the business if I wanted … Should I buy?

I like this question on two levels:

1. It’s a neat reminder that when we buy stocks, we’re not just buying ‘bits of paper’ … we’re buying a small piece of a real, live business!

And,

2. It gives me an opportunity to show you the sorts of questions that I would ask – and the types of information that I would be looking at before buying into this – or any – business.

According to Warren Buffet (or sources who purport to know how he works) the intrinsic value of a business is in its discounted cashflow.

That is, a business is – or should be – a cash machine … what’s the reason for owning it, if not to get some cash out?

So, in the above example, we should be able to decide if the business is worth $183.49 Billion (not knowing the company in the above excerpt, I am assuming that this number represents the entire current market capitalization of the business) by discounting the cash-flows shown above …

… a quick look at the most recent cash-flow figure shows that it is currently producing $12 Bill. cash per year (probably growing, if history is any guide); that would mean about 15 years to get our money back … yuk.

Now you know why the stock market is generally a fool’s game … I would by far prefer to invest in my own business, or buy a private one at ‘only’ 3 to 5 years free cash-flow (better yet, Net Income), and grow it … then float it myself!

Or, at least sell it to a public company who can immediately ‘claim’ 15 times my Net Profit (hence, give me 7 to 12 times my Net Profit).

But, if we are going to play ‘the stock market’ game, what would we need to know before we can make an informed decision about ‘investing’ in this stock?

Hmmm …

As I pointed out, the free cash-flows on their own say nothing …

For example, I recently sold two similar businesses: one had been going for many years and generated ‘free cash flows’ [now that’s an oxymoron!] of $1 mill. and the other was less than 2 years old and had yet to make a dime.

Yet, I sold them both (separately) for about the same price! So, there must be more to the valuation of a business than Free Cash-flows, right? Absolutely!Let’s start with Return on Invested Capital:

I’d like to know what it has been for this company (and, the industry) over the past 5 years? I’d like to see an improving trend in excess of 15%, please.

Then, is the company growing?

Cash Flow is just one measure (but, what about operating cash-flow … have they made any strategic purchases / major capital expenditures /etc.), so what about the 10 years trends in: Earnings? Book Value? And, what about plain, old Sales?

I’d like to see a history of growth (min. 10%) in all of these …Now, how is there debt situation?

How long will it take them to cover their long-term liabilities from ‘Free Cash Flow’?

I’d like to see no more than 2 to 3 years.

Do the people who run the company own stock? Are they buying or selling?

Tell me about the company: do they have a ‘sustainable competitive advantage’ (what Warren Buffet calls a ‘Moat’ … but, that’s too much water for me!).

Do I believe this company will be around for the next 100 years … do I really want to buy THIS business in THIS industry?

Lastly, if I like the answers to all of the above (unlikely … so far I’ve only liked the answers to similar questions for 7 companies out of the 5,000+ that I can currently buy a ‘piece’ of) …

…. then how CHEAP can I get this thing!?

PS I made the ‘other’ category … waaaayyyyyy down at the bottom of the 150th Carnival of Personal Finance … whoo hoo!

Thinking of buying something on credit?

Posted on April 27, 2008 by Adrian

‘Need’ a plasma TV? Perhaps you ‘just’ need a new car?

There’s ALWAYS a way to find the money that you need WITHOUT putting yourself further in debt … just ask Mr Bean :

http://youtube.com/watch?v=42AHISKy2Kk

Mr Bean (a.k.a. Rowan Atkinson … played the priest in 4 Weddings and a Funeral) is not as well known in the US as he is overseas … he’s one of my favorite comedians and comedic actors.

Anyhow, I hope that you enjoyed this short clip for today’s installment of our Video on Sunday’s series as much as I did?!

AJC.

My $7 Million Dollar Journey …

Posted on April 25, 2008 by Adrian

I am a little shy, which is one of the reasons why I write semi-anonymously. It’s also so that I can share specific (and, highly personal) financial information, so that you can travel a similar road, if you are so inclined …

But, some of you want to know where I came from? How is it that I could amass such a large amount ($7 million) in such a short time (7 years)?

Fair questions.

So it is for YOU that I humbly outline my $7million7year journey …

… I count my 7 years as starting in 1998:

By then I had resurrected a defunct family business as a sole proprietorship (I was $30k in debt and living off $50k a year) and started a new one that had real potential but was draining all the cash from the first business (and then some … combined the businesses were losing about $5k a month).

We owned our own home (well, the bank owned most of it) but had zero other investments.

I was what you would call “broke … with prospects”.

1998

Since I had no idea how to fix the situation, I did what any self-respecting person would do: I lucked upon a book!

The book was called The E-Myth Revisited by Michael Gerber and I bought it to help me get out of the hole that I was in …

… not, the financial hole – I had NO idea that the book (or any book!) could help me with that – rather the personal hole (more like hell) that I was going through working in my businesses rather than on them.

[AJC: This will be the subject for another post, but I was the classic control-freak entrepreneur (I sure as hell didn’t feel like an ‘entreprenuer’ … I was just a guy seemingly out of his depth) trying to do EVERYTHING myself … therefore, achieving NOTHING]

No, the epiphany came when I did the very first exercise in that book (and, that’s why I suggest that EVERYBODY reads it … just for that chapter) and learned the most important lesson of my financial life:

My life wasn’t about my business (or my money) … my business was there to support my life.

You have NO idea how important that was to read … and, how scary it was when the book then went on to show me how to cost that life.

You see, I realized that for the life that I wanted … actually, needed … I had to be ‘wealthy’ [AJC: damn, why couldn’t I just ‘need’ to live on a kibbutz?!].

The problem was, I had no idea how to calculate wealthy.

Fortunately, soon after I happened to go to my first ever financial seminar, and the presenter told me two things (that I simply took on face value at the time) that changed my whole life’s financial outlook:

1. To live ‘wealthy’ (nice house, cars, schools, lots of travel … no work) you need at least $250,000 a year (1998 dollars) in passive income, and

2. You need to multily that number by 20 to determine the size of your nest egg.

There you have it … $5 million … my new (first!) goal … oh sh*t!

First, the problems:

i) My businesses were small / niche businesses with limited growth potential; I calculated that I would need almost 100% penetration of the largest business prospects available in order to achieve my new goal

ii) I had just LOST my second largest client, so now I was losing $300k a year!

iii) Year 2000 was approaching and my software was no longer supported nor was it Y2K compliant.

2000

I got over the last problem by rewriting my software, which gave me the opportunity to fully internet-enable it … this enabled me to totally change by business model, and we (accidentally) ended up with one of the world’s first complete eLogistics systems.

All of a sudden, the business that was losing money MADE money and we added new clients (thus getting over the second-last problem) and soon became profitable.

2001

However, as soon as we became profitable, I bought a building for over $1.25 million, on the advice of my accountant of all people … this was very scary because:

Business 1 + Business 2 + Building 1 = break-even again!

However, the businesses (now, both) started growing and soon became reasonably profitable … $10k – $20k a month by 2002 … I still only took $50k a year in salary.

Our Net Worth was now the equity we had built up in our home and office property, plus whatever residual value our businesses had; probably $1 mill. to $2 mill. In fact, an overseas listed company made us a $2 million offer for Business 2, but we rejected it (at that time) … so, our Net Worth could have been as high as $3 Million if we sold, or if somebody else would ever offer us the same.

When it comes to businesses, do you ever know your true Net Worth until you sell?

2003

We made it all the way to $7 million over the period of 2003 to 2005 simply by:

1. Repeating the process: generating profits in the business, and

2. Retaining as much of the businesses’ profits as required to maintain the businesses and grow, and

3. Ploughing as much as possible into real-estate, and

4. Keeping a lid on personal spending and maintaining zero-personal (i.e. consumer) debt other than the house [AJC: which, as I mentioned before, we eventually paid off … not that I would recommend this strategy any more … see an upcoming post for more on this].

But, we did pump as much as we could back into the business and bought a number of smaller, residential investment properties (one condo @ bought 2003 for $145k now worth about $300k, one quadruplex bought 2005 for $1 million now worth $1.75 million, and paid off our own home eventually sold for $800k, plus the office building recently sold for $2.5 million).

If you think about it, these are the EXACT SAME STEPS that every PF blogger writes about (debt free, save, reinvest) … I just multiplied the scale and was VERY CLEAR on my cashout $ and time.

But what about my opening comment:

I deliberately chose a provocative title for my blog … whilst partially true, I chose it … well … because it sounded good!

Why only “partially true”?

Well, I did make it to $7 million in the seven years between 1998 and 2005 – and, by then, my other assets probably had Net Equity of: Business # 1 ($2 million … $1.5 million in cash + whatever value the business could sell for); Home # 1 ($650k); Office ($1.25 million); Residential investments ($1 million).

So, that period sets the scene for our [more than] $7 million 7 year journey, made the good old fashioned way (grow an income stream or two, live frugally within reason, and invest, invest, invest) … and, provides many of the lessons that I had to learn the hard way, but you no longer need to.

But, ‘partially true’ because my journey has an unexpected (but, pleasantly surprising) postscript …

2006 – 2008

I had totally miscalculated the earning potential of my two existing businesses [AJC: actually, three, by then I had started a small training company with a partner, Business # 3]: post year-2000 reengineering, Business # 2 on its own was now capable of producing (and did) $1,000,000 a year net earnings (2006), almost all reinvested in some unexpected new ‘opportunities’:

You see, way back in 2002 I still didn’t know the potential of the new eLogistics-driven business model, yet I still had a $5 million bird to catch …

… so I had already put in train a parallel set of actions that saw me close a deal in 2004 to open two overseas offices (commencing in 2005) – both as ‘no money down’ joint ventures – unfortunately, there went my profits (yet again):

Business # 1 + Business # 2 + Business # 3 + Business # 4 + Business # 5 + Properties # 1 thru’ 4 = Break-Even again!

I was still only taking a $50k salary … my wife still had to work … don’t I EVER get to spend anything??!!

Finally, I sold something: Business # 2 in 2006 for more than 3 times what I was offered in 2002.

… and, the next 3 years sets the scene for an unbelieveable set of negotiations, opportunities, and manoueverings tied to Business # 4 and Business # 5 (which was the reason why we moved to the USA) selling both after only 2 years of operation, more than doubling our net worth again …

… and, funding properties # 4 ($2 mill … paid cash) and # 5 ($4mill. … churned #4 + paid cash) as well as now being able to fund my retirement at age 49.

I kept Business # 1 as well as Business # 5 (although, I soon plan to ‘gift’ my share in that one to my hard-working partner): they both run well and profitably in another country, with separate staff in separate locations, and without me … Michael Gerber taught me how – and why – to do that, too!

But, this period is not the subject of this blog:

Whilst entertaining – and, it might teach you a trick or two about negotiating (I sure as hell learned something!) and/or running a business ‘hands free’ – it hardly counts as Personal Finance, so I might just save the details of that story for ‘the one-day book’ 🙂

How much interest do you earn on one million dollars?

Posted on April 19, 2008 by Adrian

Welcome new readers!

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

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

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

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

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

____________________________________________________________________________________________

“How much interest do you earn on one million dollars?”

This was the question that Clint at Accumulating Money asked in a ‘classic’ post – I commented on it earlier this year and still receive click-through’s two or three months later. It must be a very popular question!

I’m not sure why, because it implies that people are happy to just have their life savings ‘sit’ in CD’s …

… but, here’s the answer to the “million dollar” question courtesty of Accumulating Money anyway:

So, to answer the question, how much interest do you earn on One Million Dollars (assuming a 4% interest rate, compounded monthly)?

One Day – $109.59

One Month – $3,333.33

One Year – $40,741.54

Five Years – $220,996.59

Ten Years – $490,832.68

Twenty Years – $1,222,582.09

I think this related question asked by Afroblanco at Ask Metafilter – repeated on Get Rich Slowly (which is where I picked it up) – really goes to show how The Savers (as opposed to The Investors) think:

“What’s the safest possible thing that I can do with my money?” :

I take bearishness to an extreme. Having witnessed the 2000 tech crash, I have no faith in the stock market or the US economy. I keep all of my money (USD) in a savings account. However, with the recent financial turmoil, I have a few questions:

Is it conceivable for the FDIC to fail?

If so, is there a place where I can put my money that will be safer than a savings account?

What’s the safest, most risk-free way for me to save money and not get killed by inflation and the tanking US dollar?

If there is a safe way for me to save money and not be punished by inflation and the depreciating dollar, is there a way that I can do this without having to stress out and micromanage my finances? I don’t want to be checking the finance page and making adjustments every day.

Even though I follow finance news, I’ve never done any investing or money management other than socking money away in my savings account. I’m a n00b, I admit it.

OK … I confess …. I am like our friend, Afroblanco … very risk-averse; yet I have become rich by understanding that it is actually safer to invest than not.

The GREATEST RISK that our friend can take is NOT TO INVEST … inflation will just eat up any bank deposit/CD strategy.

Take Accumulating Money’s example above:

One million dollars approximately doubles in 20 years … but, inflation will halve its buying power!

Think about it, if the average bank interest rate is 4% (pushing the value of your savings UP) and inflation averages 4% (pushing the buying power or value of your savings DOWN), what have you gained in 20 years?

Nothing …

Now, if you just push your savings into a low cost Index Fund that averages, say, an 8% return over the 20 years, then the same 4% inflation means that you should effectively DOUBLE the value (or ‘buying power’) of your million dollars over 20 years.

But, Afroblanco is even better off BUYING The Bank [i.e. investing in the Bank’s stock] than putting his money in The Bank. The risk of failure is about the same (if the bank fails you will lose the money that you have IN the bank’s vault as well as the money IN the bank’s stock), yet, as long as he has a long-term view (minimum 20 to 30 years), the former strategy will make him rich and the latter broke.

If the bank stock averages just 12% average growth over 20 years – as any well-picked Value Stock, can easily do – then Afroblanco won’t just double the buying power of his money ONCE, he will get to double it TWICE … that’s $4 million AFTER the effect of inflation (or, the $1 million grows to $10 million in ‘raw’ dollars).

What about risk? Aren’t bank deposits FDIC Insured?

[AJC: Well, yeah … up to a paltry $100k – of course, you could open up 4 bank accounts at 4 different banks … but, $400k is hardly what I hope my readers are aiming at!]

But, inflation is a much bigger risk: 100% certain to eat up your money … and, would the Federal Government (the same entity backing the FDIC) allow a Major US Retail Bank to fail?

I guess we’ll find out in the next few months!

If you don’t believe that’s likely, then isn’t your money just as safe in The Bank as it is in the bank?

[AJC: think about it 😉 ]

And, doesn’t The Bank’s stock at least meet the overall market returns which averaged 8% p.a. for the past 100 years … what have bank deposits averaged in that time? 3%? 5%?

The point here is not necessarily to buy stock in The Bank … rather it’s to think about Investing rather than Saving …

Before suggesting WHAT to invest in, we need to know HOW long is our friend is expecting his money to last? Assuming that our friend is a hands-off investor, here’s what I suggest as the lowest-risk strategies possible:

If less than 30 years, then TIPS are a an option – PROVIDED that he can live off the inflation-adjusted interest (unfortunately, very unlikely in the current low interest environment – but, in 5/10 years, who knows?).

If 30 years or more, then a low-cost Index Fund is ideal for a hands-off investor. There has been NO 30 year period since the recording of the stock market indices where the market has not produced a positive return well above inflation.

If he is more hands on and/or more knowledgeable, then I would recommend no more than 4 or 5 well-selected individual stocks and direct investment in real-estate, for any time period 10 years or greater.

Inflation forces us to invest … because of this, inflation is our friend!

… 7million7years doesn't even know how much is in his Retirement Accounts!

Posted on April 17, 2008 by Adrian

[continued from yesterday]

Now, I’m not particularly proud of this … but, it is true … I have no idea how much is in my retirement accounts; and, I didn’t even bother opening my own 401k account as CEO of my last company!

Why?

Yesterday, I wrote about the costs that can build up in the ‘food chain’ of the investing world, showing that merely accounting for the cost-differential between a typical mutual fund and a typical low-cost index fund can account for 20% of the performance of your entire investment portfolio after just 10 years.

I also, mentioned that I don’t like any of these products (even low-cost index funds, even though I will recommend them to lay-investors), primarily because of lack of control and too much diversification (who ever got rich from diversifying?!) …

So, the second part of this post will, hopefully, tell you why I don’t worry about 401k’s and Roth IRA’s as well as address a question that I recently received from a reader who asked:

Any suggestions on a strategy to use for retirement accounts if you earn beyond the limit for a 401k and Roth Ira? I have no company match for a 401k … get hit hard in taxes and have discovered that there is an income limit to a 401k and Roth IRA. Any suggestions?

Well my simple suggestion is: don’t …

The only time that I invest in a retirement account is when my accountant says:

“AJC, you have too much income flowing in, we had better plonk some into your [401k; Roth IRA, Superannuation Plan, whatever]”.

Yet, using a tax shelter is saving money, and as yesterday’s post showed, even a small difference in cost can add to a big difference in outcome … so, what do I really recommend and why?

If you still have plenty of working years left, I don’t recommend that anybody invests inside their company 401k except to get the ‘company match’ (who can argue with ‘free money’… yee hah!)

I also don’t recommend that anybody – who still has 10+ years of working/investing ‘life’ left – invests inside any tax-vehicles (such as a Roth IRA) etc. UNLESS they can:

(a) Choose their investments, and

(b) leverage those investments.

By choosing, I mean the whole gamut of what we want to be investing in: e.g. businesses, stocks, real-estate, and ???.

Now, in practice, these 401k/IRA’s are limited, so if you don’t intend to invest in some/all of these classes of investment or you have so little money to invest that you can ‘fit’ the whole or part of your intended, say, stock purchase strategy into one of these vehicles then, absolutely … knock yourself out!

Therefore, for most people, it’s still possible that a 401k or Roth IRA can provide an important place in their investing strategy … simply because the amount that they have to invest is so small …

… even so, they should go ahead only if it doesn’t limit the scope of their overall investing strategy, hence returns!

And, we should all know by now that primary importance of your investing strategy should be set on maximizing growth unless:

i) You are within a few years of retirement, when you no longer have time to take risks and recover from mistakes), or

ii) Have such a long-term, low-value outlook that simply saving in a 401k will do the trick (in which case, invest to the max.).

Just remember, this blog and my advice isn’t for everyone … it’s only for those who need to become rich …

… which usually means getting into investments that:

1. You understand and love, and

2. You can grow over time, and

3. You can leverage through borrowings.

If it doesn’t meet all three of these criteria, I simply don’t invest!

Direct investments in businesses and real-estate are the investment choices of the rich because of these three criteria… stocks to a lesser degree (you can only ‘margin borrow’ up to 100% of these, so the amount of ‘leverage’ that you can apply is lower than for, say, real-estate) … and, Managed Funds even less so (you can margin-borrow only on some of these, and only from limited sources).

For me, the limits that tax-effective vehicles place on me, and the maximums that I am allowed to invest in them, automatically reduce these typical ‘tax shelters’ to a very minor position in my portfolio … so minor, that I allow my accountant to manage them for me, totally.

Remember, though, that they only became a minor portion of my portfolio because I followed the advice that I am giving you here when I was still early into my working/investing career!

Now, I hope that (eventually) you, too, will have so much money OUTSIDE your 401K that whatever is INSIDE will be insignificant for you … in the meantime, at least invest for the full company match.

Pretty controversial? Let me know what you think?

Why 7million7years doesn't buy 'packaged' products …

Posted on April 16, 2008 by Adrian

I left a somewhat tongue-in-cheek footnote to a recent post on the differences between Index Funds and ETFs (if you didn’t read it, I favor the former over the latter for neophyte investors, and neither for serious investors):

Important Note: 7million7dollars does NOT currently invest in any Index Funds, Mutual Funds, or other “Packaged Investment Products” … apparently, he is just a (rich) product of the Stone Age

It seems to me that the wave of packaged products has increased over the past 20 years.

No longer do you tend to hear those stories of people like the reclusive and grumpy Old Man Miller who fell off a ladder and died leaving no heirs and a box of dusty old stock-certificates that now just happens to be worth $900,000 (not to mention a pile of gold just sitting under some lumber in the old wood-yard)!

It’s not just stocks … it seems that you can’t buy L’il Jon a toy without taking out your industrial grade laser to burn through 15 layers of impossible-to-open plastic ‘bubble’ packaging.

Think about the cost-differential between a typical consumer product at manufacture (the price it cost the guy who made it in: raw materials, labor, tooling, bulk packaging, and bulk shipping) and the eventual end consumer who buys it at retail: the price can inflate by 5 to 7 times … or even more.

The more hands, the more cost … simple.

Similarly, with ‘investment products’ …

… in my perhaps archaic way of looking at things, the further removed that I am from the investment, the less control I have, the more people who want to add cost (including their profit) into it, and less I like it.

That’s one of the reasons that businesses (my own) are my favorite form of investment … followed by direct investment in real-estate … followed by direct investments in company stock.

Now, if you do decide to invest in a fund, why would you choose a Low Cost Index Fund over the typical well-diversified Mutual Fund?

Unless, you can guarantee to find me a Mutual Fund that will outperform the market over the next 10 years (considering that 85% of fund managers don’t beat the market, that’s an easy bet for me to take), I would choose the lower cost option, simply because of cost.

If the Index Fund charged you only 0.25% of your total investment amount to enter the fund and another 0.25% a year to manage it for you, but the mutual fund charged you 1.0% and 1.0% [BTW: in this example, the Index Fund fees are too high and the Mutual Fund fees are too low] …

… over just 10 years (assuming an average 8% return for each), you would have paid the Index Fund just over $43,000 in fees … but, the Mutual Fund $157,000.

Why so much?

Because, you also need to factor in the foregone earnings on the amount that you could have had invested, if those fees weren’t there …

On the other hand, if you invested directly in some stocks and just managed to meet the market, with little to no fees (it costs just $7 to buy, say, $25,000 of stock using an on-line broker) …

… now you know why I don’t like packaged products!

I encourage you to run some numbers for yourself …

[To be Continued]

How to sort the rational wheat from the emotional chaff …

Posted on April 15, 2008 by Adrian

I published a post last week called 10 steps to whatever it is that you want … how to weigh up the cost of a lifestyle decision which outlined a basic Making Money 101 decision-making process to help you sort your way through a discretionary purchase decision (you know the type: “Hey, that 48″ plasma screen would look really great on that wall!”).

You see, I come from the school of Ambivalent Frugality – sometimes you should … sometimes you shouldn’t. After all, money was invented to trade for ‘stuff’, right?

We just have to trade it for the RIGHT stuff, only when we can AFFORD it; and, the 10 Steps were designed to help us do exactly that.

Now, I don’t normally do a follow-up post so quickly … after all, what will I have left to write about next month?! 🙂

[AJC: kind’a reminds me of the old joke: why shouldn’t you look out of your office window all morning? Because you’ll have nothing to do all afternoon!]

But, Diane had a great question attached to my original post that this post is designed to help her answer – and, I hope that it helps you, too!

Here’s part of Diane’s question:

Have a dilemma regarding is it a need or a want – I have a house now, student loans, bad debt and need to decrease everything. I have a rescue Old English Sheepdog I’ve had now over a year and a half. Always meant to get a [larger] fence up, even prior to getting him, but had different expenses and no savings to cover them (hence the debt climb) and have put off getting a fence up … under the 10 questions, it doesn’t qualify as something to change lifestyle, but … I think this is a need, but … it is a financial decision as well. It’s not putting food in our mouths, but it is providing shelter and protection for the family dog who is also protection for us (single mom household). Or is this too left-field?

Now, this is definitely not left field, but – at least on the surface- the 10 Questions seem more designed to answer “can I afford ‘stupid stuff'”-type questions than these really tricky emotional ones.

In my experience, when we get into emotional ‘need v want v life-changing’ questions, rational decision-making can fall flat on it’s head.

But, I have a simple solution …

… one that doesn’t need to involve attempting to answer (preferably, Qualified Shrink Assisted) a myriad of ‘soft’ questions like: “will the animal suffer if you don’t put the larger fence up?” and/or “will YOU suffer if you delay puttin the larger fence up?” and/or “did your parents emotionally ‘fence’ you in when you were young and are you projecting this onto your dog?” and so on [AJC: Sigmund would be SO proud of me].

Instead, I shortcut the whole process for Diane – and, I suggest that you give this a try next time you are trying to avoid answering the 10 Questions because you really need something that you probably can’t afford, too – by simply asking her to do the following:

Follow the 10 questions exactly as written … that’s what I put them there for!

Simple … isn’t it?

Now, Diane, if you followed this advice on Sunday when you left your comment, by now you would have made your own sane, rational decision. Right?

If as I suspect, given your financial position, it was against Poor Pooch then I have a question for you:

How do you really feel now, having made that really hard decision?

…… [Diane inserts emotional feeling of (a) relief having made the ‘right’ decision, or (b) pain having made what feels like a terrible, albeit financially correct decision, or (c) she’s emotionally dead] …..

Diane – and all of us – that is the only way to sort through an emotional need from a want:

Make the decision rationally, then see how you really feel …

… then, go with your feeling!

That’s what LIFE is all about … and, didn’t we just say that our money is to support our life?