… a forced flight away from stocks!

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I wrote a post a while ago about the Myth of Diversification – just another piece of financial ‘wisdom’ almost designed to keep you form retiring early / retiring rich …

Yet, despite the current melt-down that should prove that there is no real safety in diversification, the principles remain as mainstream as this comment from Francis illustrates:

That’s the idea behind diversification and re-balancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high.

It really doesn’t take a genius to make a few million if you can just buy low and sell high …

… but, it takes genius to know when to buy low and when to sell high!

Who knows where ‘high’ and ‘low’ really sit: they are relative, which serves (partially) to explain why market timing doesn’t work!

As the Dalbar Study shows:  mere mortals should not be in the business of trading stocks / timing the market; people who attempt this reduce their returns from 11.9% to only 3.9% … !!

No, we are simply investing for the long term, that’s why I asked Francis:

I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.

Quite rightly Francis responded by pointing out that we aren’t Warren Buffett, saying:

Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.

As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.

But, if we really aren’t Warren Buffett, how do we KNOW when “the valuation of particular resources is out of whack”? Well, according to Francis, that’s when ‘rebalancing’ comes into play …

But, how does re-balancing provide a ‘reasonable compromise’ to the fact that we are all (WB aside) “terrible at market timing”:

Let’s say that you have $100,000 invested: 50% of your money invested in stocks and 50% invested in bonds.

Let’s then say that stocks ‘devalue’ by 50% overnight (a huge market crash) … in the case of an Index Fund, this could simply be a cyclic response to the market that has occurred many times in history.

Suddenly, your portfolio has shrunk by $25,000, so now you have $25,000 worth of stocks at post-crash prices and $50,000 worth of bonds (their price/value hasn’t shifted in this hypothetical crash). That is, you have 33% in stocks and 67% in bonds … so what do you do?

Well, you buy $25,000 more stocks … or, do you sell $25,000 of bonds?

The reality is that most people don’t have the $25,000 in ‘loose change’ to rebalance by topping up their portfolio, so they shift money FROM bonds INTO stocks.

Yippee … except, what happens when stocks recover and/or bonds dip?

In that case, you’d be taking yourself OUT of the stock market (a 9.2% – 11.9% annualized return, depending on who/how is doing the measuring) into the Bond market (a 4% annualized return?) …

… a forced flight away from stocks!

Would Warren Buffet do this?

Heck no! Warren Buffett doesn’t worry about market dips; he knows the market always recovers, as long as the underlying businesses keep making money. In fact, he looks at market dips as a buying opportunity (didn’t he load up on Kraft, while we were all bailing out of the market).

He identifies quality when he buys (bet he didn’t own any Enron), but, he recommends that you buy a little piece of all of America’s finest companies (a.k.a. an Index Fund, so even if you do happen to buy Enron, it’s only a tiny sliver of what you own), if you don’t know how to do what he does.

Warren doesn’t ‘rebalance’ his portfolio into cash (no dividends even, because cash/bonds doesn’t produce as high a return as his investments can) … and, he certainly buys more when the market dips and NEVER sells.

Here’s what to do:

If stocks are the asset class that you like and if you think that the stock market (as represented by an Index Fund or one or a few individual stocks, if you prefer) represents acceptable value:

1. Buy stocks … as many as you can afford; and,

2. Keep buying whenever you can afford more; and,

3. When the market dips, it’s ‘on sale’ … buy even more; and,

4. Never sell.

That’s it … now you are Warren Buffett.

A random walk in the financial park …

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I’ve looked high and low and I’ve finally found it!

‘It’ is the source document for all of the commentators who have (rightly) suggested that Index Funds outperform actively managed Mutual Funds.

And, it is produced by Standard & Poors who publish the major Indices themselves:

The Standard & Poor’s Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds’ performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry.

And, here are their most recent findings (they are in the process of rebuilding their databases for 2008):

Indices continue to exceed a majority of active funds. Over the past three years (and five years), the S&P 500 has beaten 65.7%   (72.2%) of large-cap funds, the S&P MidCap 400 has outperformed 68.6% (77.4%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.2% (77.7%) of small-cap funds.

The solution is simple: don’t buy any of the funds in the bottom 65.7% 🙂

Great! But how?

Well, Mutual Funds are rated by Morningstar as 5-Star (best performance) to 1-Star (worst performance) so, we should simply buy 5-Star funds, right?

Wrong … because Morningstar – even though it is the best / most highly regarded of all the Mutual Fund ratings services – is only based upon past performance, which is NO guide to how any rated fund will perform in the future as this independent research review found:

They find, for example, that five-star US equity funds significantly outperform one-star funds only 37.5% of the time; at the same time, these same funds significantly outperform three star-funds 18.75% of the time. It is clear then that—compared to a random walk–Morningstar’s ratings system offers no added value in terms of predicting mutual fund returns.

If the best can’t do it, do you think you can?

And, do you want to leave your financial future to a ‘random walk’ in the financial park?!

So, why do funds tend to fall short of the ‘market’?

Well, partly because of a tendency to trade stocks too much (the fund managers like to ‘look busy’) and partly because of fees … Mutual Funds tend to fall short of the market by the amount of the fees that they charge!

The ‘small moral’ of the story: invest in the Indices …

… find a low cost Index Fund that will do the job; by as much of it as you want and hold it for the long term.

Of course, the ‘large moral’ of the story is: who the hell is content with 11.9% maximum long-term stock market index returns, anyway 😉

Who are 'the rich', really?

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“The rich are different from you and me.” — F. Scott Fitzgerald

“Yes, they have more money.” — Ernest Hemingway

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I received a pretty strong reaction from some readers to a post – largely tongue in cheek – that had a ‘social moral’ …

… that ‘rich people’ are actually just ‘people’ who happen to have a few more zeros in their bank account.

For a start, let’s look at how they got there: inheritance; marriage; luck; hard work [AJC: although, ‘marriage’ could also be included in this last one 🙂 ]

It’s a stretch then to say that ‘The Rich’ can be genetically or socially any different to the ‘The Not Rich’: what are the common traits required for each of the above methods? None obvious to me …

So, if anybody can get rich, why should ‘The Rich’ be any better or worse on any human scale (e.g. being socially responsible; giving to charity; etc; etc) than anybody else?

On the other hand, they may have the means to display their characteristics more obviously – for better or worse 😉

But, let’s not generalize, let’s turn to Prof. Thomas J. Stanley, former professor of marketing at Georgia State University (author of The Millionaire Next Door and The Millionaire Mind); I found a summary of the latter book by noted economist Prof. Mark Skousen who says:

Here are the results of his (Prof. Stanley’s] survey of over 1,000 super-millionaires (people who earn $1,000,000 a year or more):

  • They live far below their means, and have little or no debt. Most pay off their credit cards every month; 40% have no home mortgage at all.
  • Millionaires are frugal; they prepare shopping lists, resole their shoes, and save a lot of money; but they are not misers; they live balanced lives.
  • 97% are homeowners; they tend to live in fine homes in older neighborhoods. (Only 27% have ever built their “dreamhome.”)
  • 92% are married; only 2% are currently divorced. Millionaire couples have less than one-third the divorce rate of non-millionaire couples. The typical couple in the millionaire group has been married for 28 years, and has three children. Nearly 50% of the wives of the super-rich do not work outside the home.
  • Most are one-generation millionaires who became wealthy as business owners or executives; most did not inherit their wealth.
  • Almost all are well educated; 90% are college graduates, and 52% hold advanced degrees; however, few graduated top of their class — most were “B” students. They learned two lessons from college: discipline and tenacity.
  • Most live balanced lives; they are not workaholics; 93% listed socialiazing with family members as their #1 activity; 45% play golf. (Stanley didn’t survey whether they were avid book readers — too bad.)
  • 52% attend church at least once a month; 37% consider themselves very religious.
  • They share five basic ingredients to success: integrity, discipline, social skills, a supportive spouse, and hard work.
  • They contribute heavily to charity, church and community activities (64%).
  • Their #1 worry: taxes! Their average annual federal tax bill: $300,000. The top 1/10 of 1% of U.S. income earners pays 14.7% of all income taxes collected!
  • “Not one millionaire had anything nice to say about gambling.” Okay, but his survey also showed that 33% played the lottery at least once during the year!

Thus, we see how the super upper-income families of this nation are not the ones contributing to crime, welfare, divorce, child abuse, and a spendthrift society. But they are playing a lot of taxes and making a lot of contributions to solve these social problems.

But one still wonders, why are any of the ‘Rich = Bad’ believers reading a blog titled:  How to Make $7 Million in 7 years?

To cap off the week …

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I can’t think of a better way to cap off a week’s commentary on the current financial meltdown than to 100% plagiarize this letter to the New York Times – it’s by none other than Warren Buffett …

… so, read carefully as to what a conservative guy who has almost 100% of his PERSONAL assets in nice, safe government bonds is doing right now.

[AJC: I was going to highlight the critical sections for you, but it’s ALL critical, so if you just want to give it your usual 27 second scan, that’s your problem 😉 ]

October 17, 2008
OP-ED CONTRIBUTOR

Buy American. I Am.
By WARREN E. BUFFETT

Omaha
THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities. [Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company]

’nuff said 🙂

Making Money 301? Hold on to your horses ….

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Part 3 of a 3 part series on weathering the current financial storm …

By now you know that when we have made our Number, our #1 objective is to hold on to our money!

We do that by a combination of wise spending and savings habits (learned way back in Making Money 101, and practiced almost to the point of stupidity in Making Money 201) and very sound investing strategies.

Firstly, though, what do you do if you have just had the wind kicked out of your 401k’s sails by the sudden crash?

Well, it really shouldn’t be an issue, because the chances are that you planned for an annual stock market return of something like 11% – 12% over 20 years and you overachieved dramatically for most of it … but, rather than increasing your spending based upon your unexpected ‘good fortune’ you realized that all good things must come to an end and you gritted your teeth expecting a reversal to bring you back to earth.

In fact, if you were really smart, you set yourself 10 or 20 year ‘targets’ and when you achieved those, you started preparing for Making Money 301 early and sold down your excess stocks and/or real-estate (i.e. the equity in excess of your ‘target’) and moved it into cash, bonds, or far more boring commercial real-estate investments (using minimal, if any, borrowings).

Now you are retired (well, you at least aren’t counting on any outside income), but you have been battered and bruised a little by the current ‘meltdown’ so your buffer isn’t as large as it was a few months ago, but you are still OK.

[AJC: I’m speaking from personal experience, now]

Remember, your Rule of 20 strategy was designed to deliver 5% of your ‘nest egg’ to live off each year, leaving another 5% to be reinvested to keep pace with an expected 5% average inflation … in other words, produce an indefinite stream of annual income that grows with inflation.

The problem is 5% + 5% = 10% AFTER TAX, so we NEED a 12% to 15% compounded annual growth rate to make all of this work …

… and, the current crash has probably temporarily wiped out most of any buffer that we had managed to retire with i.e. any money that you managed to salt away in excess of expectations … who said that EXACTLY Your Number was going to fall into your lap EXACTLY on Your date?!

What to do, given that there are signs of a prolonged flattening of the market?

Here are a some advanced strategies, sensible in ANY market for Making Money 301, but particularly now:

1. Do NOT keep your money in CASH (other than a 2 year Emergency Fund) – if you have no buffer, then every year you earn ONLY 5% on your CD’s is a year that you are really LOSING 5% of the remaining value of your ‘nest egg’ to inflation!

Equally, do not keep it in a cash-equivalent (e.g. bonds – with the exception noted below) OR in stocks or Index Funds: you need a min. 5% return – indexed for inflation) UNLESS there are stocks that you understand/love that pay a 5% dividend and you are 100% certain that dividends won’t be cut in the coming recession.

2. Purchase commercial property for 100% cash or very low LVR (Loan-to-Valuation ratios), such that the net rents each year provide EXACTLY the annual income $$$ amount that you are looking for + 25% ‘buffer’ (for vacancies, repairs/maintenance/etc.). If you are worried by commercial, residential (or a mixture) is OK.

You can spend the entire rent (except for the buffer) as it will:

a. Keep up with inflation, because you will have a CPI ‘ratchet clause’ in your lease, if you rent well, and

b. Your capital (represented by the property itself) will also at least increase with inflation, if you buy well.

3. Buy a select group of ‘blue chip’ stocks that you love/understand (etc., etc.) on low historic P/E’s and write Covered Calls against them; this works well in a flat-to-slightly-growing market, so the current volatility may need to settle into a more extended period of gloom-with-some-slight-hope before you can execute properly … but, now’s a great time to start (very!) small and experiment!

4. Be boring: buy TIPS (Inflation protected Treasury Bonds), but only if you applied the Rule of 40 instead of the Rule of 20 … these currently only produce about 2.5% TAXABLE annual income (except if your Number is so small that ROTH IRA’s – or similar – will do the job for you).

Only buy the TIPS using 95% of your ‘nest egg’; retain 5% of your cash (over-and-above that emergency fund – although, holding TIPS means that you can probably cut this back, as well) … use it to start buying Calls against the market (pick an ETF that tracks the S&P 500) or, against 4 or 5 individual stocks if you are more daring.

While you’re waiting for the market to stabilize a little, now’s a good time to start slow and practice: after each major pull back, buy a Call and see if you can make a gain on the upswing (set a profit target and sell when your reach it … wait for the next ‘pull back’ and try again).

5. Buy a Fixed Annuity – costs suck, but if you can’t do 2. or 3., what’s really left for you besides TIPS or this?

And, if it (in fact, any of these strategies) produces your required Annual Income Number (the annuity MUST be indexed for inflation) who cares? But, remember to spread your risks over a few insurers (remember AIG?) … you don’t want them to go down holding your cash (keep in mind that even if the insurer crashes, your underlying investments should still be safe and be handed back to you … at least, that’s how the story goes)!

So, for any rich readers out there sweating my posts (you know, like the doctors who watch ER just to point out all the faults: “Oh, what a bunch of BS … he’d never spline the clavicle with a Humphreys 458!”):

What’s worked for you in past ‘bear markets’? What do you think will work for you in this one?

Making Money 201? Whoohoo … time to have some fun!

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I’ve just loaded 14 new videos into the Vault (click on this link, or check the VodPod Widget on the right hand side of this page for the latest) …

Now for today’s post: Part 2 of a 3 part series on weathering the current financial storm …

OK, so we’re all panicking … at least that’s what the media seems to be telling us as 180 year old investing firms crumble, banks crash and the financial markets are in turmoil, even after a $700 Billion ‘rescue package’.

Time to run for the hills?

Well, if meeting average market returns over a long period is enough to satisfy your needs, read yesterday’s post … click the close button on this page NOW (and, also on every personal finance page / news source hot tip / etc. /etc.) … and, live happy my friend: by the time that you retire, the events of today (and, the two or three more ‘meltdowns’ that you will no doubt live through) will be distant memory and you can only hurt your financial prospects by paying any attention to current events … and, I mean any given set of ‘current events’ between now and the day that you sign-off for ever.

But, that’s not you, is it?

You want – nay, need – extraordinary returns, extraordinarily soon … right?!

In that case, maybe it’s time to listen to our good friend Warren Buffett – The World’s Greatest Investor:

“Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics is equally unpredictable, both as to duration and degree. Therefore we never try to anticipate the arrival or departure of either. We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

– Warren Buffett, 2001.

So, does this seem like a time to be fearful to you … or a time to be greedy?

According to Warren, it’s a time to be … greedy: how?

Well, in the current market, everybody knows that cash is king … so, let’s go and make lots more of it!

Before we take off, let’s do a quick ‘pre-flight’ check; do you have your financial house in order?

Let’s see: your 401k has taken a hit, your house has devalued …

… but, you have little credit card or consumer debt, and you are socking away money regularly. So, CHECK.

Great!

Welcome to Making Money 201, which is all about increasing your income through some combination of hard work and risk-taking – the combination that you choose is entirely up to you (and, how ‘steep’ your Number/Date ‘mountain’ will be to climb).

Why do we need more income (besides the obvious!)?

Because, everything financial is on sale right now: stocks, real-estate, loans … the whole box ‘n dice … so, we want to be ‘cashed up’ to take advantage of all the bargains coming our way.

The only problem is ‘market timing’ … take a look at this chart from the Wall Street Journal:

It shows the stock market from 1900 to today, every year across the bottom … but, the right hand side shows a logarithmic (i.e. exponential) scale.

This means that the next move in the market, over a (say) 20 year bull market, will take the Dow Jones from 1,000 to 10,000 … sounds HUGE (and, it is: 10 times your money in 20 years!) … but is ‘only’ an annual compound growth rate of 12%.

The problem, though, is in the RED areas of the chart:

These show the Super Bear Markets – which can be described as FLAT periods in the market that can last 10 to 20 years (if history is any guide) interspersed with volatile short-term up/down movements.

So, I see two possible strategies:

1. Build up CASH

… to be positioned to take advantage of the Next Great Bull Run. Or, maybe we invest in property – I’m sure that we could produce a similar chart.

Here’s what to do: tighten your belt … resign yourself to very limited increase in lifestyle for now … and, take all of your excess income from your full-time business, part-time business, 2nd job, lottery winnings, inheritances, whatever and, buy stocks (and/or real-estate) whenever you can.

Look for bargains in the market (you know, great companies paying good dividends and/or growing profits even now, that have been beaten down to less than 12 to 15 P/E … better is 8 to 10 P/E) and start buying into 4 or 5 of these … and, keep buying! Don’t stop … ever.

This will create your own mini-Berkshire Hathaway, making you a mini-Warren Buffet: you have a ‘cash machine’ (job/s, business/es) and you use it to buy good businesses cheap; then you hold forever. If the price goes down, so what? You simply buy more at the cheaper price as soon as you can afford it. And, if the price of the stock goes up, good fer you, Son … now and go an’ buy yerself some more!

When the market does ride the next wave (one that you will only see in hindsight) you will really see how cheap you got in …

2. Ride the volatility

The first is the ‘safe’ strategy, but will net us closer to 0% growth over the life of the Bear Market than the greater-than-market returns that we need … we need time to ride the downturn and pop out the other end with a basket of great stocks/real-estate assets bought at relatively cheap prices.

But, if you are able to accept some significant risk, there is another way …

Now just might be the time to take a business / trading approach to the market!

In a volatile market, we don’t know from one day/week/month to the next whether stocks will be significantly up or down … but we do know that they will change: often significantly.

This can be an ideal time to speculate with options … but, only with money that you are prepared to lose in the hope that the upside justifies the risk.

Sounds a lot like a business, doesn’t it? Which is why this is an ideal Making Money 201 Income Building Strategy for those who can stomach the ride.

What do I do?

Pick a stock that you like, but that has great volatility … ‘tech’ stocks are ideal for this (AAPL, RIMM, etc., etc.) and buy an equal quantity of PUTS and CALLS at the smallest gap around the current stock price. Sometime during the month, in a volatile market like this, it’s a reasonable bet (at least, I like to think so) that the price will change. If it does – by enough of a margin to pay for the cost of the options – you win!

Of course, you could flip/trade houses, if you prefer real-estate … but, the strategy is essentially the same: add value from volatility and/or sweat to ‘create’ returns in an otherwise generally flat market.

So, if you’re in Making Money 201, why don’t you share with us what you are you doing to not only weather the storm, but profit from it?

Making Money 101? What to do today!

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I write about advanced financial strategies; these are designed in three stages: Making Money 101 – Get on your feet, financially speaking; Making Money 201 – Build your wealth; and, Making Money 301 – Keep your wealth.

Another way to look at it is that my blogs are all about getting you to your Number, then keeping you there!

Since we are dealing in time-frames of years (at least 7 years to go from ‘zero to financial hero’) we have to expect to deal in all phases of market cycles – both the up’s and the down’s – so I avoid talking about specific ‘today’ strategies in favor of the longer-term.

However, my son has said that I need to help people through the current financial ‘crisis’, so that’s what I am going to do over the next 3 days:

Today, advice for all those Making Money 101 …

Wherever your money is right now, keep it there!

That’s it, thanks for reading 😉

Oh, you want details?!

OK, here it comes:

– If you are currently in cash, stay in cash.

– If you are currently in stocks or mutual funds, stay in stocks/mutual funds.

– If you are currently in real-estate AND can afford the payments and are not ridiculously in credit card and other consumer debt, stay in real-estate.

Why?

Well, as this post explained, over the long run, you will achieve the market averages for all of these investment choices … only if you stick with them through thick and thin.

Right now qualifies as being about as ‘thin’ as anything in the last 100+ years 😉

If you run away during the bad times (now) and only buy in the good times (2006) you will be buying high and selling low: the exact opposite of what you should be doing …

… then, you will be lucky to make 3% or 4% annual returns – the same (or less) than if you had kept your money in cash!

So, for those MM101’ers out there, what are you doing with your assets while the financial world seems to be crumbling around you?

The Sensible Flipper …

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No, we are not talking about sweet, intelligent, trained TV dolphins – for those of you old enough to remember the show …

… we are talking about people who buy a piece of real-estate, merely to (perhaps clean it up a little or even do a ‘gut rehab’ then) resell it at a (hopefully) decent profit.

On a larger scale, ‘flippers’ are called ‘developers’ or ‘property speculators’.

In all cases, we are not talking about a Making Money 101 – or even a Making Money 301 – INVESTMENT strategy, we are talking about a Making Money 201 INCOME strategy a.k.a. a true BUSINESS.

Dustbusterz says:

i was just watching your video on what it takes to earn 1 million in 20 years and how time can be the determining factor. in that video, you mentioned flipping real estate. you said you could build up to where your flipping more and more properties(using this as a business). your warning said watch out because the market could crash leaving you high and dry. but i believe( and correct me if i am wrong here) those who are smart( read educated) in real estate should never have to worry about such things as crashing real estate, because they would know exactly where to buy and when to buy and how to buy to avoid this situation. you see, even when the market is crashing ( such as is happening now) you can still find deals areas that are appreciating not crashing.that might take you out of one stater or even out of the country. but you can always find property that is going up in value. that will make you money.

It’s funny, if we had read my previous article – or even this one – a year or two ago, we would be in one of two camps:

1. I like the idea of flipping: in which case, we would be nodding “yeah, yeah … be careful … yadayadayada” all the while looking for our first/next flipping deal, or

2. I don’t like the idea of flipping: we would be reading with the idea of confirming our already ‘set in concrete’ idea that flipping is bad.

But, sitting in the current market, we’re all nodding and saying “how could those idiots not see the crash … they deserve what they got …”

The reality is that those who DO flip put themselves at risk of loss …

… but, so do those who DON’T: they run the risk of loss of missed opportunity.

My point being that there is nothing inherently wrong with developing, or even flipping; they both serve a purpose, they both generate chunks of cash where none existed before; they are both legitimate businesses for those who are so inclined.

That just doesn’t happen to be me …

Just to remind you, the problem with developing/flipping is not one of lack of market knowledge – although, you HAVE to understand exactly what you are getting into to have any chance of success – it’s getting caught out by sudden market changes.

In essence, you are timing the market – hoping that the market stays on a flat-to-upwards trajectory for the whole time that it takes to:

– Close your acquisition

– Make whatever developments or improvements you deem necessary

– Re-market the property / properties

– Close your sales

This takes weeks to months to years depending upon the scale of the project … which leads to another point; the larger the project, the more risk because time is elongated. Markets can change dramatically in just months and certainly years (weeks is another matter, entirely).

The motivator for any flipper/developer is profit – in many cases, this is their INCOME, remember? And, they usually roll one closed deal into the next bigger open deal in a rising market …

… but, we know what eventually happens to rising markets.

However, eventually even the down cycles run their cathartic course … including the current real-estate crash.

Sooner or later, the time will be ripe in most US markets – and, is certainly ripe already in some – for the flippers/developers to come back out of hibernation … or bankruptcy.

Here’s how to do better next time:

1. If you are working on single deals – this one is easy: make sure that you can rent out the property and HOLD for as long as it takes, in case you aren’t able to flip it quickly. Your only risk then is lost opportunity: while you are holding this deal, you may not be able to get onto the next one.

2. If you are working on larger/multi-property deals – develop/rehab with the idea of retaining a proportion of the units for yourself (as long term, buy/hold rentals). Obviously, you are ‘buying’ these from yourself at ‘cost’, so a profit margin should be built in.

If you plan your largest deals correctly, you shouldn’t need to worry about the market ‘going south’ on your most recent deal … you should be protected (e.g. put each ‘deal’ in a separate LLC and offer no personal guarantees, if at all possible) … this may be possible or may not.

Assuming that you can protect yourself from catastrophic loss on your latest deal, then retaining some equity for yourself (i.e. by buying a few properties out of this deal and all previous deals) ensures your long-term wealth, so that you aren’t simply rolling up all of your profits each time …

… it’s like taking some money OFF the craps table each time, because you know you won’t be able to roll the same number over and over before a 7 or 11 eventually hits, wiping you out completely.

I like to think about it this way:

– Imagine that you start with $150

– Through your first deal, you double that to $300

– Instead of buying two new $150 deals and trying to score big again i.e. to make $600 ($300 x 2),

– You split your $300 into three piles: invest one pile outside of your next deal, and buy two new $100 deals

– You split the $400 profit from these two new deals into three piles … and, so on

The next time you try anything that is speculative, try the Double-Then-Divide-Into-Three Rule … let me know how it works for you!