Alchemy works!

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Bill is a reader from Malaysia; he read my post on diversification and sent me the following e-mail:

I came across this article which is from Australia

http://www.propertyupdate.com.au/articles/242/1/A-strategy-most-people-use-to-avoid-wealth/Page1.html

The gist of this article really go in line with your premise of focus vs diversification.

Having said that, the author also espouses that one needs to focus oneself in getting the first one million then only talk about diversifying in other wealth building strategies. Similarly, in my country, we always believe that as long as having earned the first bucket of golds, more buckets would come.

I believe that the above might be a generalised notion, may I ask, in your scenario, did you make the adequate money from your finance company first, then only embarked on the other wealth building activities?

Firstly, to answer Bill’s excellent question: no, I didn’t wait for my finance company to make ‘adequate money’ before venturing into real-estate; these were concurrent strategies … I used the cashflow from my business to help finance the real-estate (i.e. building up cash for a deposit; then using business profits to help cover the mortgage and other costs of holding the real-estate where the rent was insufficient).

But, this is not a question of diversification …

… this is a question of using ACTIVE income to fund PASSIVE investments. This is ALWAYS a good idea!

It is like alchemy: turning a serviceable but somewhat worthless substance into something exceedingly valuable: alchemists believed that they could come up with a ‘formula’ to turn lead into gold … in the current market, wouldn’t that be wonderful?!

Similarly, ‘financial alchemy’ seeks to turn serviceable but somewhat worthless income from your job or business – ‘worthless’ because you can suddenly lose your job/business – into something far more enduring: passive assets (e.g. stocks; bonds; real-estate; gold; etc.).

This is not the same as diversifying … diversifying would be then buying more than one class of passive asset in an attempt to reduce risk. See the difference?

And, as the Australian article correctly points out: wealthy people got that way by concentrating on the one thing that they do best …

Why the 'wrong' people are rich!

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Yesterday’s post on the use of HELOC’s v. ‘standard’ mortgages brought up the concept of using the right tool for the right job.

Since this is a vital concept, I want to make one additional point, and I’ll do it in response to a comment that Moom left me on that original post:

Aren’t HELOC rates above 1st mortgage interest rates? Or if you have no first mortgage you can get a lower rate? Diane: At AJC’s level mortgage interest on owner occupied property is not tax deductible I think, while interest on investment loan is. Which might explain the HELOC strategy?

Moom is partially correct: at my level, tax detectability of the home loan portion is limited.

Having said that, since I am trading I may be able to offset the entire interest cost against my gains on the stocks anyway (a question for my accountant, I guess).

But, to be honest, I very rarely consider tax consequences or even cost differentials when making these kinds of decisions (unless major).

Read that again, because it goes against the concept of ‘millionaire as financial genius’ which is a mythical image that most of us erroneously carry.

Not only that, it serves to explain why the wrong people are rich!

So, I’ll repeat:

I very rarely consider tax consequences or even cost differentials when making these kinds of decisions (unless major).

This doesn’t make sense, does it? Because:

‘Rich people’ know every dollar that they have coming in and out, right?

‘Rich people’ ‘spreadsheet’ every decision that they make, right?

‘Rich people’ know the tax consequences of every decision that they make, right?

‘Rich people’ know ALL the alternatives – and, the costs thereof – and choose the lowest cost alternative every time, right?

‘Rich people’ are the smartest, most financially astute people around, right?

Wrong!

Some rich people know these things, but in my experience most don’t (at least not to the level that you might expect) …

… in fact, most rich people that I know are not the most financially astute people around. They just have the most financially astute people around them.

The financially astute people are in the supporting roles! They are the B-movie stars or ‘best supporting’ actors, not the guy carrying the ‘best actor’ Oscar …

Why?

Because ‘rich guys’ became rich by ACTING when more financially astute people would still be ANALYZING …

Because ‘rich guys’ became rich by focusing on INCOME when more astute people would still be focusing on EXPENSES.

For example, I create INCOME … I pay advisers to help me minimize EXPENSES:

– I pay an accountant to advise me on tax consequences.

– I work with a private banker to help me with finance products and interest rates.

– I work with a broker (rarely) if I need help to put together a new hedging strategy.

But, it is I who creates the new business concept; the new investment strategy; and, who makes the next real-estate purchase …

… and, it is the huge increase in INCOME that these decisions can make (and, have made) that have been far more important to the increase in my personal net worth than any cost/tax-based ‘adjustment’ that my accountant, banker, or broker could have made.

So, when Moom asks about interest rate differentials, and tax advantages, I have to say that I generally don’t even think of these – at first …

… I look primarily at UTILITY.

Which product do I think will best help me achieve the increase in INCOME that I am looking for?

9 out of 10 times I will go with that approach, even if my experience points in the direction that it will cost a little more in interest or may be slightly less tax-advantaged.

If I am not sure, or it seems like it may not be a close call, then a quick phone call to one of my panel of advisers will usually do the trick.

So, why did I choose the HELOC even though it costs a little more in interest (and, possibly more in tax, as well)?

Because, at the time, it seemed like the right thing to do. Simple!

Different horses for different courses …

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I posted recently on using a HELOC as part of your emergency fund strategy and Diane noticed that I had mentioned my own use of a HELOC in an older post about my own home purchases.

Diane said:

I’m confused. You pay cash for the houses, then take a HELOC? If memory serves me, you never hold more than 20% of the house value, AND mortgages interest rates are usually lower than HELOC’s interest rates AND mortgage interest is also tax-deductible (at least to me)whereas the HELOCs may not be (seem not to be by what I’ve read). What am I getting wrong here? (and thanks for tackling this subject!)

This is a great question because it highlights how the rules of money ‘flip flop’ when you move to the next stage of wealth: from Making Money 101 to Making Money 201, then Making Money 201 to Making Money 301.

And, I have two quick comments to make on these transitions that I will expand on in future posts:

1. These are not necessarily hard/sudden transitions e.g. while you are still getting your financial house in order (Making Money 101) you can also start to increase your income (Making Money 201); before you fully retire, you may also be working on migrating your investments to help you preserve your wealth (Making Money 301).

2. The rules of money DO change during these transitions, which serves to explain why many people who do well with Making Money 101 falter at Making Money 201 (for example, they are unable to open themselves up to the idea of increasing debt after they just finished working so hard at eliminating their ‘old’ debt).

And, the HELOC is a great example of both …

In the post on Emergency Funds, I floated the idea of not taking a guaranteed loss (by parking 6 months cash in a CD, as most ‘experts’ recommend) to forestall a potential disaster. I suggested building up reserves for known/expected costs, and using a combination of insurance and HELOC’s for the true ‘unexpected’ emergencies.

This is a great Making Money 101 and Making Money 201 strategy as it provides more capital for investment, in the likely event that there will be NO serious emergency … of course, if you do have an emergency you may have a more difficult recovery if the cash isn’t already conveniently sitting in the bank.

Your choice, entirely.

But, as a Making Money 301 strategy? Well, I have enough cash on hand at all times to cover any emergency … or, opportunity. I don’t need a HELOC for that … and, when you retire, neither should you.

Why?

The rules ‘flip flop’: you no longer have the time to recover from an emergency (your investments by now are mostly set for passive/fixed income … not growth), but you also don’t need to be investing 100% of what you have available in order to live.

When calculating your Number, you ‘anticipated’ emergencies and have arranged your finances and investments to that you have excess cash on hand at all times.

So, why do I have a HELOC?

Well, this comes to the second post that I mentioned:

When you are still Making Money (101 or 201) you want at least 75% of your Net Worth in investments at all times … and, this still holds true when you are retired and concentrating on preserving your wealth (301) … just in different investments.

So the 20% Rule ensures that you don’t have more than 20% of your Net Worth invested in your own home at any point in time.

This means that if you want to buy a house that costs more than 20% of your Net Worth (as it will for most in Making Money 101 and 201) you will need to borrow … for this, I suggest locking in a fixed-rate mortgage for as long as the bank will give it to you.

But, it also means that your house may cost less than 20% of your Net Worth … think about it: if your Net Worth was $7 Million, you could spend $1.4 million cash on a house.

If you wanted to borrow, say, another lazy million from the bank, then you could spend $2.4 million on a house (provided that you can cover the mortgage payments).

It all depends on your lifestyle needs.

So, my current house fit within the 20% Rule for me, cash paid. So, no mortgage required …

But, as I mentioned in that post, I hate seeing so much ‘dead money’ tied up in a house … so why not do something with it?

Hence the HELOC of approx. 50% of the value of the house: I use it to invest in stocks; if the market is travelling badly, I can cash out these stocks, pay down the HELOC and have little to no costs. Tax is only a small issue at these levels … I am well over the IRS maximum no matter which way I go.

But, when the market appears ‘right’ again, I can immediately draw down the HELOC and invest. For this specific purpose, the flexibility of a HELOC far outweighs the interest-cost advantage of a standard mortgage.

Of course, a better use for the ‘spare equity’ in my house might be another real-estate investment; since these are (for me) invariably ‘buy/hold’ a HELOC is poor for that purpose and I will then switch out of it.

Different horses for different courses … thanks, Diane!

Pareto's Principle Revised …

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There is a common thread running through the Personal Finance blogosphere that goes something like this:

80% of people live beyond their means, but the 20% who live within their means & save diligently will be A.OK

Then I come along and run a whole series of posts seemingly debunking various financial ‘truisms’, such as the old ‘save you way to wealth via your 401k’ chestnut and many people no longer know what to think!

Heidi summed up the mixed feelings out there nicely in a comment to one of my many recent 401k posts:

Very interesting. Goes against the grain of all of the personal finance blogs I frequent. I do have to agree with Lee, though, that at the very least [their 401k’s] gets people saving. I know way too many 40 year olds who haven’t even started and are too strapped for cash living their keeping-up-with-the-joneses lifestyle.

To me, this is not an all or nothing situation … you can save via your 401k (if you like) but, at the same time still do other things to set yourself financially free.

I was struggling to find a way to illustrate this when I came across this post in the Simple Dollar; Trent says:

In a visual way, my spending used to look something like this over time (with green representing spending and blue representing income):

graph 1

… and now it looks something like this:

graph 2

Aha!

At least, this represented an ‘aha moment’ to me …

… you see, Heidi is concerned about the 80% of people who follow Trent’s old pattern: they spend what they earn and then some.

We all know what to expect from their financial future: disaster!

So Trent’s blog, and most other personal finance blogs are aimed at the 19% of other people who see the folly in that pattern of living and concentrate on frugality (and, saving the difference) to turn their financial lives around. They try and follow Trent’s second chart.

But, now we have a mathematical problem … our Pareto’s Principle (a.k.a. The 80/20 Rule) only adds up to 99%:

– We have the 80% who are financial deadbeats and don’t bother reading personal finance books or blogs, let alone implement any of the simple methods to keep themselves out of the poorhouse

– The we have the 19% who do read the PF books/blogs and practice at least some of what they preach

What about the ‘missing’ 1%?

They are the ones who realize that as well-meaning as the common financial wisdom is, it can never actually make them all that much better off than their ‘poorer’ cousins … saving alone will not make them rich (or even wealthy)!

So here is how Trent’s chart for the 1% who do want to become truly financially free needs to look:

It’s a simple three step process:

1. Start implementing some sound Making Money 101 techniques to get your ‘green line’ of spending in order (most PF Blogs stop there), then

2. Start implementing some sound Making Money 201 techniques to get your ‘blue line’ of income (job/investments/business) pumping (but, don’t make the mistake of letting your ‘green line’ follow; instead invest the difference between the two lines wisely), then

3. When you retire (early!) and your ‘blue line’ disappears altogether, use sound Making Money 301principles to make sure that you can still safely maintain your desired ‘green line’ spending level … then, relax and drink plenty of pina coladas whilst lying in your hammock.

So, Heidi, we aren’t really saying that the other PF blogs (and their devotees) are wrong … we’re just asking a simple question:

Once you have your saving ‘house’ in order, why stop there? 😉

The 401k revisited …

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I’ve written a series of posts about 401k’s with the intention of encouraging each and every one of you to assess why you are choosing to ‘invest’ in your 401k over-and-above any other investment choice.

I received a comment from Timmers that I wanted to address here because he raises some interesting points … I will break up his comment into the relevant pieces:

As a person who invests in both 401k and Roth IRA as well as residential real estate …

Let’s stop it right there and understand that we are talking about three totally different things here:

1. 401k is not an ‘investment’ as I have previously defined it … it is a limited, tax-efficient savings strategy with benefits (e.g. employer match). Limited because the underlying investments are usually (not always) costly and relatively inefficient ‘products’ packaged for the employer by their 401k provider.

2. A ROTH IRA is not an ‘investment’ … it is a tax-advantaged vehicle in which it may be possible to make investments. Interestingly, you can usually use one to invest in a wide variety of means including: funds, stocks, real-estate.

3. Residential real-estate may be a good or bad investments, depending upon where, when and how you buy … coming off the top of the ‘bubble-and-bust cycle’, I doubt whether I need to explain this further, here. However, it is important to realize that residential real-estate is not the only form of real-estate investment available to you.

Anyhow, on with Timmers’ comment:

… I have to also add one other Major argument for real estate as a retirement strategy. That is, if investing right and long-term, real estate is much more of a sustainable investment. That is, if you have held it long enough to pay down the mortgage, you simply can live off of the rental income. After drawing out the rental income for one year—guess what? It hasn’t gone down in price but usually up—at least maintaining parity with inflation if not more (sometime much more if you invest right). AND…(the best yet)….you still have the same amount of money available to you as the year before plus a little more (if you haver raised the rent).

This is a masterful strategy of the Making Money 301 kind i.e. something that you want to consider when you have already made your pile of money and are considering (a) how to keep your principle (‘nest egg’) safe and (b) have a safe amount that you can withdraw to live off every year without worrying about inflation OR your money running out.

However, paying off the principle as a Making Money 201 strategy (i.e. building your ‘nest egg’) may not be wise as you then need to think about what you are going to do with the excess cash that the property is spinning off … you will need to invest elsewhere anyway.

That is, the simple difference between real-estate as a wealth-building activity and a wealth-sustaining activity is how much equity you allow yourself to have in each property that you own:

i) Wealth-building: more properties, with less equity in each.

ii) Wealth-preserving: fewer properties, with more equity in each.

Finally, Timmers switches back to 401k’s:

The problem with 401K investments is that unless you have enough to live off of the dividends (out of the question for the vast majority of people), you are drawing down your investment every year. It is not sustainable like real estate. Granted, you must maintain your residences, which is an ongoing cost, but a smart investor always plans for the major repairs/renovations and has money set aside for the smaller ones. To be honest, I am so tired of the constant 24/7 blather of the stock market investment complex that has its tentacles in every media outlet. They want to keep spinning a song that hasn’t produced for most mainstream investors the past ten years (but has for their jobs and income). I am grateful for AJC’s contrarian and no-nonsense approach to most of their blather.

To this, I can only say ‘thanks’ and add some recent comments from the Tycoon Report:

If this market were a horse, I think we would have shot it already to spare it further misery … we have to readjust our perspective of the US equity markets. This is not a buy and hold the S&P 500/DOW 30 market, and it probably won’t be so again until about 2015 – 2018. This is a sector driven market brought about by a slowdown in profit growth and driven by spiraling commodity costs. Index investors get crushed in markets such as these …

If you are a diversify-and-save-via-your-401k kind of ‘investor’, this Kind of makes you sick, doesn’t it?

Good Luck!

It's not what you earn that counts …

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I wrote a post a short while ago assessing whether the rich should invest in Index Funds.

I received a few interesting comments, including this one from a reader named Mike, that I thought I should share with you all:

Would you do a post that considers the lifetime earnings of different people? Reason being I read an article that high school graduates earn an average lifetime earnings (from 25 to 64) of $1.2 Million. For people with a college degree this goes up to $2 million, with a Masters it’s up to $2.5 million and a PhD brings in $2.9 million. For people with professional degrees (doctors & lawyers I presume) the number goes up further to $4.4 million. Still not bad, an average of $100K per year for the latter category. For the purpose of this article I’m assuming that all earnings are reconciled to net present values.

So you’ve managed to earn $7 million in 7 years… that’s really impressive and nearly twice that of a doctor’s lifetime earnings. What have you earned throughout your life?

For me I’ve earned $2 Million in my life to date. More than half of this has come in the last 3 years. I’m 35 now and have been working since I was 23. I figure between now and age 65 I should be able to earn a total of about $8 million more with an medium / optimistic case. I will pursue investments but realize high risk brings high reward but potentially devastating losses. For example I’ve taken a large position ($110,000) in a Chinese stock with what I believe to be very strong fundamentals and have researched this company for the last 4 months in detail. In the last 3 weeks the stock is down 30% from where I bought in…! So I don’t put everything into high risk investments for that reason.

I think starting a business has elements of this… if your business crashed you would have lost it all I guess?

Firstly, here is the official government report that I believe Mike is referring to:

http://usgovinfo.about.com/gi/dynamic/offsite.htm?site=http://www.census.gov/prod/2002pubs/p23%2D210.pdf

However, I am totally unconcerned with income or lifetime earning potential … I believe that there is very little correlation between what a person earns today – or over their lifetime – and, how wealthy that they are …

… you see, it’s not what passes through your hands, but what sticks that counts!

I remember reading the book that passes for a ‘bible’ amongst the personal finance community: The Millionaire Next Door (because, to a casual reader, it appears to equate ‘frugality’ with ‘wealth’, which of course is only a small part of the story) and was struck by the story of two doctors:

Both were on super-high incomes, yet one doctor was ‘rich’ and the other ‘poor’ …

… one had saved/invested a good proportion of his ridiculously high earnings, but the other had lived the ‘high life’ and was in debt.

Same income … vastly different outcome.

So, when Mike asks:

So you’ve managed to earn $7 million in 7 years… that’s really impressive and nearly twice that of a doctor’s lifetime earnings. What have you earned throughout your life?

… I say: I didn’t ‘earn’ $7 million in 7 years in the traditional sense; plenty of corporate CEO’s, super-high-flying attorneys, and some medical specialists earn more that that in 7 years (some in 1 year).

In fact, at the time my ‘take home’ and total combined business incomes were less than many professionals earn, and certainly nowhere near the stratospheric heights that I just mentioned …

… no, I ‘earned’ the $7 million by investing my far more modest earnings and my Net Worth grew faster than my earnings ever could.

Keeping the ‘two doctors’ story in mind, do you now see why I don’t care what my lifetime income was? If not, consider Mike’s closing question:

I think starting a business has elements of this… if your business crashed you would have lost it all I guess?

The answer to this question is the key to Making Money 301 (keeping your wealth) and explains why income is so unimportant from a wealth perspective:

For the ‘poor doctor’, when his income stops so does his (financial life); if he loses his ability to earn his ‘paycheck’ through some disaster (he certainly doesn’t have the luxury of retiring, yet) he is just on broke!

But, it’s possible that our ‘rich doctor’ may be O.K. albeit at a lower standard of living … at the very least, he is debt free. At best, he has some passive investments to help sustain him and his family … probably not enough to sustain his current lifestyle, though.

In my case, I ploughed as much income into investments as possible and waived all ‘pay increases’ (I could have ‘paid’ myself a higher proportion of my business profits, but chose not to) …

… in fact, my wife kept working, as she earned more than I took home.

In doing so, we put ourselves in a position where it would not matter if the businesses crashed … we would not have lost it all. In fact, the bulk of the $7 million in 7 years was in passive real-estate … selling the businesses just two years later was the ‘cream on top’.

The Making Money 301 ideal is this:

Earn money, plough 100% of it into investments, live off the income of these investments as though you were already retired … increase your spending only as the portfolio income increases.

Simple and self-sustainable … of course, for most people, the ideal is not achievable, which is why you start with ploughing 10% of you income into investments, and build from there …

BTW: Visit this week’s Carnival of Personal Finance; we have an article published there ,,,

The lament of the middle-class millionaire ….

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I must confess that I understand EXACTLY what this ‘poor woman’ is saying …

http://www.cnbc.com/id/15840232?video=768292103

Ryan (who is one of the Final 15 in my 7 Millionaires … In Training! ‘grand experiment’) sent the link to me saying:

About 6 months ago I did a similar exercise to determine how much I would need to “retire” and live the kind of life I wanted to (travel, philanthropy, golf, bigger house,activities, etc.). Although it seemed like a stretch to even write down, I settled on $10 million in 10 years. After watching a show on cnbc, in particular this clip, http://www.cnbc.com/id/15840232?video=768292103 , I think it’s time to revise my estimate!!! And to think that a couple of years ago I thought if you had a million dollars you could do anything you wanted.

The exercise that Ryan is referring to is the culmination of a series of posts on http://7m7y.com designed for one purpose and one purpose only: to help you find your Number.

This video – I believe – helps explain why I think that your Number should be couched in terms of required living expenses rather than some nebulous lump sum (such as $1 million; $5 million; $10 million; etc.) … although I also show you how to calculate the ‘lump sum’ that you will need.

But, Ryan doesn’t need more than $10 Million (a.k.a. $500,000 per year … indexed for inflation) to live a life that simply involves “travel, philanthropy, golf, bigger house,activities, etc.”; he just needs to realize that on $500k per year:

1. He will not be able to afford ownership (fractional or full) of multiple houses, jets, yachts and the like (although one used Ferrari isn’t out of the question), and

2. He will NOT be rich … rather ‘comfortably off’ – at least, according to Felix Dennis the rather quirky (and exceedingly rich) British/American magazine publisher.

… it’s a tough life 😉

Should you lend money to others to buy real-estate?

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A member of Networth IQ asks:

I’m debating on loaning a friend around 30k that I will dervire from a HELOC on my primary residence. I will recieve a flat 16% interest over the 6 months of the loan, and an extra 3% per month for every month if it’s not paid within 6 months. This moeny will be used for remodeling expenses on his investment property. We are in the process of creating a promisory Note and mortgage note for the loan.

Now, I know this is risky for a few different reasons but I don’t know how else I could generate $4,800 over 6 months for an investment of 30k.

Is there any glaring reason not to move forward with this loan?

D’ah, yeah!

Don’t go into business with relatives or friends … and, don’t lend money to them – which is pretty much the same thing, anyway …

… unless they are collateral damage and you are prepared to foreclose on them or sue them at the drop of a hat.

But, for the sake of this post, let’s put aside the “friends” issue and focus on the underlying ‘investment opportunity’ laid out in the question:

This goes to a debate that I was having on another topic about Trust Deeds …

[AJC: worth reading just for the entertainment value … you get to see how closed minded and rude some people can be when encountering contrarian thinking] just scroll back to see it)

… my contention is – all other things being equal – is that if you are going to take the risk, why not take the upside as well?

We don’t know the outcome of the remodelling of the investment property. For example, is this ‘friend’ going going to remodel then flip? Or hold?

Let’s take these two scenarios one by one:

Rehab/Flip

You have to ask yourself what the chance of success is in the current market?

Because, if you lend the money and the flip is not successful, how do you get paid back without suing/foreclosing? And, you presumably stand behind the bank, so what chance do you have of getting your money back, if you do foreclose?

If you are going to take this risk, you may as well be in the full-hog and hold equity in the deal to get the full upside, as well.

On the other hand, if the flip is successful, you have taken a major risk for limited upside: if the property can be sold to (a) pay you back your principle, and (b) pay you the interest owed to you, and (c) give the ‘friend’ their required profit, why don’t you just take a split of equity in the deal instead of (as well as?) the interest.

In fact, I would be asking for a split of the profit or equity in a rehab/flip deal, with a minimum payout of the interest component that I would have expected … a kind of cake-and-eat-it approach. Friend or no friend … take it or leave it offer.

Buy/Hold

There are only two ways that I see this as a likely scenario:

1. The Rehab/Flip scenario didn’t work, so the investor/friend team are forced to hold on to the property (foreclosure being the ugly alternative, as discussed above), or

2. The friend intends to approach the bank (or another one) to refinance on the new post-rehab, presumably improved, valuation and use some of the proceeds to pay out investor out … in the current market, a lot of if’s and but’s in there!

The safest approach for both parties in this scenario is to borrow the unimproved value from the bank, add in the $30k from the HELOC as ‘equity’ and hold the property together under some agreed equity split. Paying HELOC interest the whole time doesn’t make sense, so the partnership agreement should spell out the requirement to at least try and refinance every so often.

The advantage: the property increases in value over a sufficiently long hold period (in the current market, who knows how long ‘sufficient’ will be … which is why buy/hold, at least as a backup option to flipping, is so attractive) and you get the negotiated % of the upside.

So, in both cases, by lending the money, you take on significant risks associated with the underlying investment, without access to the underlying capital returns. Why do it?

One final note: by using a HELOC to invest in this new property you are gearing to the max.

This, of course, is a good thing ifyou are (a) certain to flip at a profit, or (b) able to hold and cover the costs of the HELOC long term (or refinance out of it) … pretty big if’s, if you ask me 😛