Playing the Efficient Market Theorist for a fool …

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I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it 😉

How not to be a dull boy …

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When I worked I was dull and when I retired I became insufferable … it’s official!

But, there is a way out: it’s called the Work/Life Balance and we all want it, but none of us really have any idea how to get it 🙂

Which brings me back to a conversation I had with a friend of mine after showing him our new house a few nights ago (extensive renovations will be underway, soon):

My friend, a doctor – an internist, family doctor, or general practitioner as he would variously be called depending on which country you are in – confided that he originally wanted to become a surgeon.

But, he stopped his studies – after many years of trying, failing, then retrying to make the ‘cut’ when his wife suggested that he draw a pie chart of how he was spending his time.

Here’s his chart:

all-work1

Typical working student; most of his day taken up with work, then study with very little left for sleep and virtually no R&R (rest and recreation: that’s where ‘family’ comes in) …

… she then asked him to draw a similar chart of how he would LIKE his typical day to look, and this is what he drew:

no-play

It doesn’t take a genius – or a budding surgeon – to realize that what he really wanted was a BALANCED LIFE: work, sleep, family.

My friend almost immediately gave up his surgery aspirations with absolutely NO REGRETS and now runs a successful suburban practice that gives him a life where he can help people, his family, and himself in almost equal quantities.

This leads me to think: why do we live the first pie chart, if not to get to the second? Perhaps, money is not really the object, after all …

… or, maybe you need to live the first for a defined period (your Date) in order to achieve a preset amount (your Number) so that you can live the life you really need (your Life’s Purpose)?

Now I better go and take some of my own advice … 😉 [AJC: Really, I just added this sentence: I have to go for a walk to the letterbox with my wife … whoo hoo!]

If you can manage risk, don't you deserve a better return?

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Diversification is an example of a risk management tool … I take exception with it because the financial services industry promotes diversification as an ‘end’ rather than as the simple ‘means to an end’ that it really is …

Andee talks about a way to turn the concept of ‘risk v return’ on it’s head! Here’s his comment:

On the question of diversification, do you think it has something to do with risk?

I was thinking about the old phrase of Risk and Return. i.e. the higher the risk the greater the return. This has been used in the past to steer people away from high return. How about taking the opposite view which is; If you can manage the risk better than anyone else then you deserve to get the high return.

However, there’s only a limited number of risks that you can manage well and this often leads to LESS diversification and sticking to your knitting.

One of our clients said to me that he knew everything that could go wrong in his business and therefore wanted to pull money out and diversify. My question of him was this: Why would you take money out of something where you know the risk and can manage it and put the money into something different where you don’t understand the risk and therefore can’t manage it!!

If you can manage the risk better than anyone else, do you then deserve to get the high return?

Not sure about ‘deserve’, but I agree: you have to pick the return that you NEED to get then manage the risks accordingly.

If you have no particular goal in mind … other than: work until you reach retirement age, then see what you have in your 401k and live accordingly … then, you probably need to at least diversify (a low-cost Index Fund should do the trick – I wouldn’t even bother rebalancing into bonds etc.) and WAIT (at least 20 years-to-40-years) …

… but, if you do have a Number – a financial goal that is clearly set in your mind, to be achieved by a certain date –  then you have to take Andee’s tack:

1. Choose your Number and Date

2. Compare that to your current Net Worth

3. Calculate your required Annual Compound Growth Rate (i.e. to take you from 2. to 1.)

4. Choose your required investment vehicle (i.e. to achieve 3. or better)

5. Mitigate the risks

Mitigating your risks means learning all there is to know about the investment vehicle/s that you chose (4.); also, choose the ‘least risky’ investment vehicle that can get you there, rather than choosing a ‘more risky’ investment that could have helped you ‘overshoot’ your Number.

What if there is no investment that you feel comfortable with that CAN get you to your Number?

Simple:

a) Lower your Number by a few million, or

b) Extend your Date by a few years, or

c) Do a mixture of both …

… in other words: opt out of your dreams!

A new way to look at your home …

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There is a new way to look at your home, and if you do it, you will never make a financial misstep again – at least when it comes to the biggest personal purchase that you are ever likely to take …

… but, I warn you: your wife may not like it 😛

You see, we tend to describe our homes as an ‘investment’ but the reality is far different: we buy emotionally and we justify rationally.

The truth is: we [most of us] want a home … then we want a bigger one … always, just a little/lot more than we can actually afford. And, to be totally truthful … I not only succumb to this line of thinking myself, I actually encourage you to do the same!

I subscribe to the old-fashioned notion that you should buy your own home – even if it means breaking my rules to get into the home in the first place – as a way of ‘forced savings’ …

… but, once you are in your first home, I then want you to rationally examine the true current resale value of your home, and the equity that you have in it (i.e. what the home is curently worth against what you currently owe), at least ONCE EACH YEAR, to ensure:

(a) that you don’t upgrade until you can afford the payments, and

(b) that you put any excess equity to work for you.

But, these rules are only ‘proxies’ for what you should be doing, if you could be trusted to manage your money rationally, instead of emotionally …

… if you could be trusted to treat your home – at, least from a financial aspect – as a house:

You should charge yourself rent!

This is the only way to ‘prove’ that your house is an investment. It lets you know two things:

Am I living beyond my means?

To find out, simply ask yourself these two questions:

(a) How much rent could you get on your house if you rented it out? Ask a Realtor or two … scour the listings in your local paper … look it up on rent.com … do this properly!

(b) What rent can you afford to pay, according to the 25% Income Rule?

If (a) is more than (b) then you have a problem … you are living beyond your means: either increase your means (e.g. get a second job; charge your children board; etc.) or decrease your living (e.g move out; rent out a room; etc.).

Am I investing wisely?

This one is easy; if you charge yourself rent, you can see if your property is positive cashflow or negative cashflow …

You have some ‘advantages’:

– You have a great tenant

– Your tenant has a great landlord

– You get to tax deduct your mortgage

– There’s no tax to pay on the ‘rental income’ … it’s all in your head, remember? 😉

To find out if you really are investing wisely, simply ask yourself these two questions:

(a) How much return on my money (i.e. equity currently in the house) could you get if you sold the house and reinvested the equity elsewhere?

(b) What rent would you have to pay (remember that you want to take the lower of your current rent or what the 25% Income Rule allows) if you lived elsewhere?

If (a) is more than (b) then you have a problem … you are investing badly: either sell your house or see if pulling out some equity and investing helps.

If the answers don’t please you, and you are unwilling to make the necessary changes, then the 20% Equity Rule and 25% Income Rule are still there to stop you from getting into too much financial trouble … make sure you obey them! 🙂

Good deal or bad deal?

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No, this is NOT another ‘Howie Mandel-style’ game show … I’m done with that series (aside from a couple of wrap-up posts, still to come)!

But, this will be my last reader Poll for a while, so I want you to sit down for 3 minutes and make a commercial decision with imperfect information:

Time for a fun ‘hypothetical’ … I’m not really asking you to invest with me [AJC: I want you to learn to invest with somebody far more capable: yourself!] …

I would like you, and a number of other people, to join me in a real estate project [remember: this is hypothetical].

It will be very low risk, because it’s a very well-established commercial strip-mall in a great area, pretty much fully rented with lots of good tenants with long leases left to run and for the last 10 years has produced a reasonable – perhaps not stellar, but certainly highly respectable – profit with very low maintenance costs, tenant turnover, etc., etc.

No catches, here, really … it will be a general partnership, I will be the managing partner and you can join the group of passive investors already committed.

So, let’s look at the deal a little:

Your share of the investment will cost $100,000 and for that you get 10% of the $1,000,000 project (incl. financing/closing costs) … it’s a very inexpensive strip mall 😉

We expect reasonable capital appreciation over the life of the project (up to 10 years, although you can sell out anytime before then, and we will guarantee both a buyer and then-current market price for your share).

The property will return about $9,000 a year (net operating income per 10% share), but we think it’s best to keep aside some as a contingency against vacancies, maintenance, etc., etc.)

So, we will guarantee you (secured by the project itself) $7,500 income each year for at least the next 10 years indexed to 7.5% of the current value of the building (but, NO LESS than the $7,500 p.a. guarantee) v the $3,000 or 3% that a bank will currently give you, and which does not grow. Of course, you may have others ideas in mind for the money, but I hope you will invest with us … after all, here, your income is guaranteed!

In summary: an ultra-low-risk ‘bricks and mortar’ investment returning a MINIMUM 7.5% p.a. on your original investment (increasing in line with property value increase) … you will get your money back, just from the guaranteed distributions that the project will pay you, over 13 years and you STILL get 10% of any appreciation in the building!

Deal or no deal?

How fast is frugality?

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save-v-invest

I love it when I read interesting posts on the personal finance blogs and other forums … take Mighty Bargain Hunter‘s view that frugality is the fastest way to a better bottom line:

It shouldn’t be the only way you’re improving your bottom line, but it does give results, fast.

For someone who already has their finances under good control, some money-saving activities are simply too little payback for too much time … [but] what about the people who aren’t as well off?  Maybe they’re making $40k or $50k, but have a lot less saved up than they probably should for their age.  This is the situation for which packing your lunch, buying generic, buying used, skipping Starbucks, and clipping coupons will help.

And it helps immediately.  The week you take lunch to work at $2 a day instead of hitting Subway at $5 a day, you’ve improved your bottom line by $15.  Boom.  Or brew your coffee in the morning instead of hitting Starbucks.  $10 per week.  Boom.  Instant gratification.

Building up income streams takes longer, especially the kind of income streams you want (passive ones) … higher income may be better in the long run, but that’s the long run.

Frugality is here and now.

Businesses have taken this view for a long time now … they call it cost-cutting 🙂

Usually a business that is spending its time cutting costs is a business that you should selling out of, not buying into …

… it’s current finances may begin to look great, but its future may be bloody awful (that’s why it’s busy cutting costs!).

On the other hand, a GREAT business invests in their future (sales and marketing, product development, R&D, production, etc.) while managing their costs.

So, let’s put it to the test: how fast is frugality?

Well, to find out, I put four scenarios into the Magic Excel Blender and here’s what it spat out:

Save: If you earned $100,000 a year and cut corners so that you could save 20% to stick in your mattress, at the end of 20 years, you’d have $400k stashed away.

Invest: If you only managed to save 10% a year and spent your time investing the proceeds wisely (@ 8% p.a.) you’d end up with $460k in (say) stocks.

Save + Invest: But, if you did the sensible thing and invested your savings instead of stashing it under your mattress (in other words, save 20% then invest it @ 8% … hardly rocket science), you’d end up with more than $920,000 after 20 years, and still have dividends each year to live off … a much better result for only a little extra work together with some belt-tightening.

MM101: However, if you did the really sensible thing, and built up your income (so that you can afford to reinvest the dividends), saved well (at least 20%, but only of your original level of income), and invested both the dividends and the savings wisely (@ 8% p.a.) after 20 years you’d have over $2.5 million.

Frugality may be quick (in that we can afford to pay a bill; pay down a pressing loan), but will never make us rich …

… that’s why we take a multi-faceted view to personal finance:

Making Money 101 – to ensure that our costs are under control and free up some cash to help us invest in MM201

Making Money 201 – to grow our income by investing what little cash we may have (to begin) wisely and maintaining sound MM101 ‘habits’ to ensure that we have ever-growing streams of investment income, keeping our growing personal ‘needs’ (read: expenses) in check, so that we can eventually reach our Number

Making Money 301 – to manage our Number (i.e. our nest-egg) so that it lasts as long as we do, while living the life that we have designed for ourselves, not the life that others have resigned us to.

The true cost of debt …

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Have you cast your vote yet?

Deal or No Deal … YOU DECIDE

Click here to vote!

_______________________________

In my post about debt, I said that it is not always correct to simply pay down old debt … in this post, you will see that it’s rarely ever correct.

First, let’s look at Jeff’s comments, which summarize the traditional view that it’s all about interest rate comparisons:

My opinion is to still compare your debt interest to prevailing debt rates (is it cheap money compared to what else is available?), how does inflation affect the rate (cheaper future dollars point again) and can I out perform the debt rates with the investment opportunity that is competing for this money.

Without the tax advantage, I’m more inclined to pay off the debt, i.e. lower tolerance for high debt interest.

I haven’t done any math on it…yet, but my gut feel is that 6% or higher on the debt and I’d be giving serious thought to paying off the loans.

This may be true, Jeff, if all else is equal …

… but in the ‘real world’ of investing, you will find that all else is rarely equal!

You see, I don’t look at interest rate and cost anywhere near as much as I look at utility – a concept that I introduced in this post: if I am serious about investing, I am struggling to find a scenario where putting my money INTO reducing leverage (by paying down existing loans) returns more than taking on new ‘good’ debt …

…. or, leaving old ‘bad’ debt in place, as long as it is cheap’ish and, much more importantly, available!

I’m sure that our resident real-estate experts (e.g. Shafer Financial) could point you to 1,000 examples where it is still viable to maintain debt of 8% – 15%+ as long as you could find cash-flow positive real-estate that appreciates at not much more than inflation.

It doesn’t even need to be real-estate, but it does depend on what you are prepared to invest into; e.g. assuming Michael Masterson’s numbers:

  • CD’s return 4%, so I would pay down the 6%+ debt
  • Index Funds return 8%, therefore, I would be inclined to keep the debt if it were very close to 6%; anything above and we would have a more difficult decision
  • Individual Stocks return 15%; I would buy the stocks (and, probably margin borrow into them as well), but that’s just me … Warren Buffett would say ‘never borrow to buy stocks’, so you have a ‘philosophical’ decision to make
  • Real-estate (together with stocks) returns 30%; @ 6% I would keep the loan (for as long as possible!) and buy the real-estate
  • Businesses return 50%+, so I would keep the loan in place (again) and use the ‘repayment money’ to help start up

Besides the obvious tax implications (e.g. CD’s and Index Funds – depending upon whether they are inside or outside a 401k – could become ‘line ball’ with paying off the 6%+ debt (IF it were pretty close to the 6% mark) …

BUT, you have highlighted a more important flaw in my argument: this table only looks at the use of the money; what if I could get a cheaper source of funds by paying down the old debt then acquiring new?

Great argument, in theory, but let’s see how it stacks up in the ‘real world’ … the simple question is: can we refinance or otherwise acquire cheap, new debt (thus allowing us to pay down the expensive, old debt) as Jeff suggests?

Let’s see:

CD’s: I don’t see any easy way to finance except with personal loans, credit cards, a refi or HELOC over our home, so I would say let the debt ride. But, the list above suggests that this would a recipe for losing money, anyway, because of the low returns.

Index Funds: possible to borrow on margin (i.e. finance) through a brokerage account (but, not in your 401k) but only to a max. of approx. 50% so you would still need to come up with the other 50% elsewhere.

Individual Stocks: same as with Index Funds (e.g. I am 100% financed in the US market through a combination of HELOC and margin loans).

Real-Estate: usually able to refinance, so I would agree with you to “compare your debt interest to prevailing debt rates”; other than right now, 6% is extraordinarily low historically … 8% – 10% would be closer to my refinance decision-point.

Small Businesses: very hard to finance except with personal loans and credit cards, so I would say let the debt ride if you were highly enthused and confident of success.

In other words, finance is simply not readily available on most investment choices available to us.

So, the questions that you need to answer – probably in this order, Jeff – are these:

1. Do I want to get rich(er) quick(er)?

2. If so, am I prepared to increase – or, at least maintain – leverage by borrowing for investments?

3. If so, am I prepared to make the mental leap of moving to the concept of ‘pools of debt’ and ‘pools of equity’ by not actually having the debt entirely on the asset that I am acquiring?

And, more importantly:

4. Is new debt available to make the investment/purchase (if so, is it cheaper than my current debt)?

5. Does the investment/asset that I am considering acquiring return more than my current (or new) debt?

If you don’t get past Question 1. then paying down debt is the only Making Money 101 strategy that you need to be concerned with … otherwise, I don’t really see this going half-way 😉

Deal or No Deal – Part 3 – Reader Poll

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Late last year, I asked you (a number of times … just like Howie Mandel) …

…. Deal or No Deal?!

What would you have done [AJC: if you haven’t yet ‘cast your vote’, please go back to this post and drop a comment]?

We know that Ms Tomorrow Rodriguez (sounds like a character out of a James Bond movie)  said “No Deal!” to the miserly Banker’s’ offer that only paid out 1-in-3 for a 50/50 chance …

… Vote 1 for the ‘math kings’!

But, look at the situation that she’s faced with right now (in the photo above):

4 suitcases left: 3 of them contain ONE MILLION DOLLARS and 1 contains only $300!!

Ms Rodriguez – with the odds clearly stacked in her favor – has two choices:

1. Take the Banker’s Offer of $677,000

OR

2. Say “No Deal” and select just one more suitcase (then she will be presented with another offer)

Deal or No Deal?

Let’s examine the options:

1. Take the $677k and run!

OK, the banker has offered $677,000 but there are 4 suitcases left of which three contain $1 Million and one is a (virtual) blank.

That smells like a 75% chance of $1 Million to me … ‘worth’ $750,000 (any maths whizzes out there to counter this?) … seems to me that the Banker is short-changing Tomorrow Rodriguez by $73,000 buckaroos!

2. Select just one more suitcase and see what happens next (after all, she can’t lose on the next turn)

Well, here is the problem … unlike any of the lead-up turns, this time there is only ONE non-million case left; so, there are actually two possible outcomes here:

i) Tomorrow selects the one suitcase containing the blank (i.e. $300) which means that she automatically wins (there are only 3 suitcases left … since each would then have to contain $1 Mill. she can’t lose)

OR

ii) Three times more likely, Tomorrow selects one of the three suitcases that contain $1 Million and the chance of winning on the next round drops from 75% to 67% (3 suitcases left: 2 contain $1 Million and 1 contains $300 only)

The significance?

From this round on, the Banker Deals can only get worse, because the next round after this one would leave just 2 suitcases (assuming that she hadn’t won by then) … or, a 50/50 chance (and, we’ve already seen how much the Banker will rip her off on that)

In fact, Tomorrow is effectively paying for each ‘roll of the dice’ from here on in … whether she realizes it or not …

So, if she turns down $677,000, Tomorrow is really saying: “$1 Million or Bust … I’m going all the way, Baby!” … because she will surely turn down the later, much lower offers (been there, done that!) as well.

So, Ms Rodriguez really has just two practical alternatives:

1. A guaranteed $677,000 if she walks away right now

OR

2. A 75% chance of winning $1 Million AND a 25% chance of walking away virtually empty-handed

Deal or No Deal?

Just like last time, make a vote & drop your vote into the comment section below (I’d love to hear your reasons) … next week, we’ll check out what our readers had to say … it should be interesting!

In the meantime, do you want to know what Ms Rodriguez chose? Do you agree?