Hope you enjoy this only-very-slightly-related video of Gwen Stefani for my Videos on Sundays series:
http://youtube.com/watch?v=nCISSGjcHL4
AJC.
If I were a rich girl …
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Why do we need middle-men?
I read an interesting article in the Tycoon Report yesterday … one that I would normally gloss over because it was not their usual meaty, financial “how to” type of article, but it said:
By now must know where I stand on capitalism. I told you then and I will tell you again that unfettered capitalism is NOT a good thing … the problem with capitalism is that, by design, it rewards deviant behavior.
For example, let’s say that you are a conventional doctor with his/her own practice and you take insurance. You get rewarded based on how many patients you see, how many drugs you prescribe, and how many procedures (e.g. surgeries) that you do.
Does this make sense to you?
Wouldn’t it be better if the doctor were compensated based on how healthy you were? Or if he got you to stop smoking or to exercise more? In other words, shouldn’t he be compensated based on making you healthier or keeping you from being unhealthy? Shouldn’t both of your interests be aligned so that there is no conflict?
An extremist view perhaps, but it was ‘food for thought’ and actually reminded me of something that Warren Buffett said … so I went through my files and dug it up!
In his 2006 letter to shareholders, Warren Buffett was scathing of what he calls “helpers”, that is stockbrokers, investment managers, financial planners and so on”
A record portion of the earnings that would go in their entirety to owners, if they all just stayed in their rocking chairs, is now going to a swelling army of helpers.
Of all places, this was first picked up as a major issue in Australia, because one of Buffett’s targets was the financial planning industry, which has been under the spotlight down-under, resulting in major new controlling legislation for this ‘industry’.
Helen Dent, a director of the Australian Shareholders’ Association, says that she “personally” agrees with Buffett’s scepticism of financial advisers:
Look, let’s face it, most people when they start thinking about investing, they ask their friends and they ask their neighbours and workmates what they’re doing before they get anywhere near an adviser.
The commissions that are paid to financial advisers, that you actually pay, is effectively coming from the producers of the financial products. That’s, on the whole, where the financial advisers are getting the bulk of their income from.
Most financial advisers are tied to financial institutions. That means that the range of products that they suggest to you is often bounded by what the financial institution says they can offer. It’s not bounded by what’s in your best interests.
So, what do you think?
Will you ever put a penny in your 401k again?
I stuck my neck out, and made a candid admission; as expected, I copped a little flak – after all, I admitted to the world that I don’t even know how much is in my own Retirement Accounts 😉 Whoo boy!
What surprised me is that I didn’t lose readers … I even gained some; Josh pointed to the reason why in his comment to that post:
Controversial? This article was absolutely controversial and that’s why I come here. If you want extraordinary results you need to make controversial moves, a.k.a “taking risk”.
Thanks, Josh. Here’s how I see it:
I’m not a risk-taker, far from it … to me, the so-called controversial move is usually not “a.k.a. taking risk” …
… blindly following Conventional Wisdom can be the riskiest move of all because you may unwittingly be risking a good proportion of your financial future!
To prove my point, and (hopefully) change the way that you look at investing in your 401k forever, let’s take this example from another comment to that same post, by Alex:
This strikes me, in a good way. I am about to be eligible for the 401k at my company. Normal people who cannot think of anything else better (and safer) than sticking their money in the funds.
Correct me if I’m wrong, what you are really saying is: instead of saving diligently and sticking $30,000 into a fund, maybe that same $30,000 can be used as a down payment for a rental property that will both appreciate and generate cash flow.
Now, I cannot advise Alex – or anybody else – on what to do with their money … that’s the job of financial advisers.
But, isn’t it Rule # 1 of Personal Finance to FIRST PUT YOUR MONEY IN THE 401K TO GET THE COMPANY MATCH?
After all, isn’t that FREE MONEY?
If the employer matches your entire contribution, aren’t you getting a 100+% return on your investment … impossible to match anywhere else?
Absolutely, which is why almost every personal finance writer (be it books, magazines, or blogs) recommends to at least invest to the limit of your employer’s matching contribution …
…. except for one problem, this thinking doesn’t hold up to scrutiny!
You see, your money is in the 401K for the long-run (isn’t it?) … your contribution – and your employer’s match is only a Year One issue; over the long run, your Contribution (with the employer’s match) will tend to a much, much lower return.
Alex’s question is: will that $30,000 be better off in the 401k or in a rental property?
The only way to find out is to run some numbers over the expected life of your ‘plan’ to see what happens … fortunately, just like a cooking show, I have prepared the numbers for you and here are some very interesting results:
SCENARIO # 1 – Assumptions
A. Let’s simply take Alex’s question ‘as is’ i.e. make a one-off $30,000 contribution to the employer’s 401k:
We will assume that the employer is VERY GENEROUS and match 100% of the entire $30,000; and we will assume that the markets are equally generous and compound an 8% return for us – tax free – for 30 years.
B. Alternatively, we can put that entire $30,000 as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by a more conservative 6% (also compound) each year. We will also assume that Capital Gains Tax (15%) is payable.
SCENARIO # 1 – Results
1. We know that in Year 1, the employer’s 100% match provides a 100% return on the 401k; but, in year two that return drops to 58% (the employer’s $30,000 ‘match’ effectively becomes a $15,000 ‘return’ over each of the two years … then add the 8% Net Managed Fund Return).
This rate drops each year – because we are looking for the equivalent compound return, it drops fast – so that it only takes 9 years for the overall compound return to drop below 20% and by Year 18 through to Year 30, it averages a compound return of ‘just’ 11% – 12%; still almost twice real-estate, though!
2. The total amount available to cash out of the 401k at the end of the 30 years is $559,000
3. However, if the entire $30,000 was used as a deposit on real-estate, even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return will be $713,000.
That’s a 28% advantage by putting the $30,000 into real-estate instead of the 401K …
… a greater overall $ return even though the % growth was half that of the 401k!
How can this be so?
The power of leverage (we borrowed 80% on the real-estate and nothing on the 401K except for the employer’s Year 1 ‘match’).
But, wait, there’s more!
The property is an investment property (if you choose to live in it, simply figure that you pay yourself a ‘market rent’ and these conclusions still hold true) … so, we can assume:
That we fix the mortgage at 5.25% (that’s $8,000 a month), and average a 5% rental return based on current market value (means that our ending-rent grows to nearly $36,000 a year!), and assume that 25% of rents will go towards expenses (other than the mortgage) and vacancies (a useful Rule of Thumb).
4. The net income (with any ‘surplus’ over mortgage and expenses being held on CD at a 30 year average of just 5%) is an additional $217,000 for the real-estate option.
Taken together, here’s how it looks:
| Total Return: | |||
| 401k | $ 559,036 | CGT+Income | CGT Only |
| Real-Estate | $ 930,476 | 66% | 28% |
So Alex, by (a) forgoing the exceedingly generous employer match in your 401k and (b) putting that $30,000 into a pretty tame residential real-estate investment instead, your overall 30 year return increases by 66%
Now, this is not how the ‘real-world’ usually works:
We don’t usually invest in one lump sum … we usually make annual contributions to our 401k of 10% – 20% of our salary. So, how does The Alex Plan work under this ‘real world’ scenario?
Let’s see …
SCENARIO # 2 – Assumptions
A. Let’s adjust Alex’s question to instead make an annual contribution of 10% of an assumed annual salary of $50,000 (4% inflation-adjusted, so that the contributions also increase by 4% each year) to the employer’s 401k:
We will assume that the employer will remain generous and 100% match the employee’s contribution each year; and we will assume that the markets are very generous and compund an 8% return for us – tax free – for 30 years.
B. Alternatively, we can simply put each year’s contribution in a bank account (earning a paltry average of 5% over the entire 30 year period):
When we save around $30,000 [Year 6] , we take that money out of the bank as use it as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by 6% (also compound) each year. We will also assume that Capital Gains Tax is payable.
Once be buy the house, out bank account is depleted, but we are still saving 10% of the employee’s salary, so we start to build the bank account up again … of course, similar properties get more expensive, so we wait until we have saved around $38,000 [Year 11] as 20% deposit and buy our SECOND property … then we repeat: saving around $46,000 [Year 16] for property THREE, and around $56,000 [Year 21] for property FOUR and final.
Why final? Well, we are within 10 years of retirement, so the BEST PLACE for our final 9 year’s worth of annual contributions is probably the 401k … 9 years is simply not long enough to chance the property market (for this reason, we could even be really conservative and also forgo the purchase of the 4th property).
SCENARIO # 2 – Results
1. The numbers are too complicated to measure the effect of the employer’s match on the hypothetical return … but, the overall numbers are far more important.
2. The total amount available to cash out of the 401k at the end of the 30 years is now $1.8 Million (now, you know why you want to make annual contributions to your investment plan!).
3. With the purchase/s of the 4 properties (the last of which we hold for just 10 years), even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return on the FOUR properties (plus the final 9 years of 401k savings) PLUS the net income for each of the FOUR properties, will be $2.4 Million.
That’s a 32% advantage by putting 10% of your salary into real-estate instead of the 401K …
| Total Return: | ||
| 401k | $ 1,833,746 | CGT+Income |
| Real-Estate | $ 2,412,898 | 32% |
Before you say, well 32% is just too much work to worry about … you’re not thinking like a millionaire. Over the 20 years, you will have built up enough equity in properties #1, #2, and probably #3 to also purchase properties #5, # 6 and possibly #7. And, so it goes until rich …
So, Alex, will you invest in your 401k? If you have a lump sum … I’d guess definitely not?
But, for your long-term savings plan: the 401k is certainly more convenient … but, is that convenience ‘worth’ $600,000 (or – a lot – more!) to you?
That’s only a choice that you – and, aspiring followers of The Alex Plan – can make 🙂
Should you buy Berkshire Hathaway instead of an Index Fund?
After yesterday’s post which was aimed squarely at my readers who want to get rich – I hope all of you 😉 – I thought that I should write a follow-up piece aimed at the window-shoppers who are stopping to look at my Get Rich(er) Quick(er) wealth creation ‘catalog’ but have no intention of ‘buying’ …
This question arose as a result of a recent article on Get Rich Slowly which references the same Warren Buffett quote that that I posted yesterday:
What advice would you give to someone who is not a professional investor? Where should they put their money?
Well, if they’re not going to be an active investor — and very few should try to do that — then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time.
Get Rich Slowly then went on to say something very interesting:
Buffett has said this time and time again, which is why I’m baffled when people use Buffett as a reason to not diversify. I am not Warren Buffett. Neither are you. Unless you have Buffett’s combination of patience and intense research, you’re better off putting your money in an index fund. (As one reader recently noted, if you can afford to buy a share of Buffett’s company, Berkshire Hathaway, you’re getting the best of both worlds: a diversified portfolio picked by Warren Buffett!)
… which I also commented on yesterday, but it’s the “one reader” comment at the end, that grabbed me.
If Warren Buffett is indeed the World’s Greatest Investor (he is, without a doubt!), and you want to diversify as he recommends, why not forget about the “low cost index fund” option altogether, and jump straight to the top i.e. into Berkshire Hathaway (the company that Warren controls)?
Why?
Because, Warren didn’t recommend it … he’s too ethical to recommend it … in fact, he even says openly that an investor with $1,000,000 can achieve far better returns than he can nowadays, because Berkshire is just too darn big to move quickly and must invest in such large sums that the number of opportunities out there are much smaller for them than for us ‘little guys’.
Of course, the occasional ‘big opportunity’ opens up for Berkshire Hathaway, because of their $60 Billion ‘war chest’ … in the meantime, that $60 Bill. just sits in the bank barely beating inflation.
Even if Warren were still at his ‘smaller, more nimble’ peak, he still would NOT recommend that you do as “one reader” suggests because:
1. You would be buying just ONE stock … admittedly one that has performed well in the PAST and MAY (or may not) perform well in the future, and
2. You would be buying into only a partially-diversified conglomerate … a ‘piece of Warren’ rather than a ‘piece of [the whole of] America’.
So, if you are on the path to saving rather than investing, do what Warren Buffet himself suggests: stick to low-cost index funds …
… only buy any individual stock – including Berkshire Hathaway – if you are in the business of investing and really know what you are doing.
Are you in the habit of saving or are you in the business of investing?
If you’re in Colorado, tune your dial to KRYD FM tomorrow morning (that’s May 22) @ 7.15 am when 7 Millionaires … In Training! hits the airwaves!!
If you listen in, you’ll find out that I have a face for radio and a voice to match … c’est la vie …
Take note that I said OR … I didn’t say AND …
In fact, most financial writers/bloggers/commentators take it as a ‘given’ that you will do exactly that: save a certain % of your salary and plonk it into your 401k to get the company match and have it invested in the restricted group of managed funds offered by your employer and/or 401k provider.
They’ll recommend that you dollar-cost-average your way into, say, a low-cost Index fund … and, you’ll be surprised to know that I agree and so does Warren Buffett:
What advice would you give to someone who is not a professional investor? Where should they put their money?
Well, if they’re not going to be an active investor – and very few should try to do that – then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time.
Now, I agree that this is indeed an elegant and simple long-term SAVING strategy for the Average Joe who thinks that they can save their way to wealth … $1 million by 65 … whoohoo!
But, if you want more (and, you probably should), then you have to move to Part B i.e. get “in the business of investing” …
That usually means one – or, for the rare genius, a combination of – four things:
1. Get in the business of running a business (that’s what Warren Buffett does … contrary to popular belief, he is primarily a business owner … he owns or controls 76 major businesses!)
2. Get in the business of learning about and selecting a FEW individual stocks (that’s what Warren Buffett does … he owns / has owned stock in Coca Cola, Kraft and many others)
3. Get in the business of learning about and actively investing in real-estate (that’s what the rehabbers, flippers, foreclosure experts, etc. do)
4. Get in the business of climbing/clawing/backstabbing your way to the very top of the corporate ladder (that’s what America’s Fortune 500 CEO’s do)
Usually, it means choosing just ONE of these as your main Making Money 201 path to income – at least, that’s what I did – then choosing a SAVING strategy to convert that income to passive assets to keep your wealth growing and fund your eventual retirement:
I was in a corporate job for nearly 10 years … after about 6 years, even though I was doing ‘very well’ (for my age, position, seniority, etc.) I realized that Option 4. wasn’t for me – I would never become a CEO of somebody else’s company.
I didn’t know much at all about either 2. or 3. but I did have a sudden urge for Option 1. – so that’s what I chose!
My first business was a bit of a ‘sleeper’ – it started its life as a very small (and new … I joined one year after inception) family business and grew fairly slowly. Because it was barely breaking even, I bought the family out and managed to get it to grow rapidly and substantially. I still keep it 15 years later, although, it has run very well without me for a number of years now.
I used the profits from that business (the nice little cash-cow that I turned it into) to fund a few start-ups, most of which I subsequently sold.
But, when all of these business were running, I SAVED a good proportion of the profits in various ‘savings’ vehicles: mainly real-estate and a little (at that time) in stocks … none in funds.
Why do I say ‘saved’?
Because I didn’t ‘actively invest’ in them … I wasn’t in the business of investing … I was simply in the habit of saving. I happened to select a non-standard mix of savings vehicles to put my money into (e.g. real-estate and stocks, rather than CD’s and Funds) … then I held on to them … and let time (and the markets) take care of the rest. Because I could put so much in, I eventually got so much out.
It was a Making Money 101 strategy.
My % returns from the businesses were spectacular … my % returns from my ‘savings’ were ordinary … yet, each played a critical part in my current financial success. Interestingly, my overall $ returns from both were excellent!
In the last few years, as I geared up for my ‘retirement’, I have revisited these options and moved away from business and to investing … because I gave myself so much exposure to both real-estate and stocks over the years, I have built up the skills in both to allow me (for some time, now) to actively (as well as passively) invest in both as a Making Money 301 wealth protection strategy.
But, if you want to become financially free, at a relatively young age, with a relatively decent passive income (you’ll have to plug in your own numbers), then you will need to find one of these four options that interests you, and hope that it delivers spectacular returns for you …
… for most people, Warren Buffet and I also agree that it’s unlikely that it will be in stocks, at least according to this little exerpt as reported by Soul Shelter (whose brother, Charles, attends Berkshire Hathaway events in Omaha each year) who relayed this anecdote from Buffett’s 2006 shareholders’ meeting”:
One shareholder asked a question along the lines of ‘how should I study investing in order to build wealth in my spare time?’
Buffett replied that, for most people, the bulk of their income is going to come from earning power in their chosen profession. Therefore, from the standpoint of building wealth, free time is better spent sharpening one’s professional skills rather than studying investing.
This statement applies directly to my Option 4.; it equally applies with a little modification to any of the other options (e.g. Option 1: … for some people, the bulk of their income is going to come from earning power in their chosen business. Therefore, from the standpoint of building wealth, free time is better spent sharpening one’s business skills rather than studying investing).
In other words, select where you will make your money, and focus all of your energy, research, and attention into that … focus!
Of course, if you’ve decided that your financial future lies in the business of investing then here’s what you should do:
Do not as Warren says … do as Warren does!
PS We were featured in the Q&A for the latest Carnival of Finance; visit it here: http://moneyandvalues.blogspot.com/2008/05/carnival-of-personal-finance-153-q.html
Don't let all of those stock investment choices fool you …
People new to the world of finance are often blinded by all the options available for investing in the stock market:
– Direct investments in stocks – but which ones? Growth? Value? Invest far and wide? Or only in a few?
– Trading stocks or options – how to value and trade? Fundamental Analysis? Technical Analysis?
– Investing in packaged products – Mutual Funds? Index funds? ETF’s? REIT’s?
I wrote a post recently that summarized these options; here I simply want to add a little more info …
Investopedia Says:
The building of a factory used to produce goods and the investment one makes by going to college or university are both examples of investments in the economic sense.
This means that the true definition of an investment is something that makes a little money now, or more likely a lot of money in the future.
Therefore, while I say that there are three sensible ways to invest in stocks, there are only two investment methods recommended by Warren Buffet:
1. Buy and Hold low cost, diverse Index Funds (check out Vanguard‘s web-site, and others) – this is a long-term, low risk (if your holding periods are 20 – 30 years) strategy that can help you fund a normal retirement.
“By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals” W. E. Buffett – 19932.
2. Invest in a FEW stocks in companies that are (a) undervalued (b) have a large margin of safety (c) that you love and (d) are prepared to HOLD until the rest of the market decides that they love them, too (at which point you can cash out or keep holding for the long/er term). “I never attempt to make money on the stock market … Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” W. E. Buffett
Anything else is SPECULATING i.e. the process of selecting investments with higher risk in order to profit from an anticipated price movement.
Investopedia Says:
Speculation should not be considered purely a form of gambling, as speculators do make informed decisions before choosing to acquire the additional risks. Additionally, speculation cannot be categorized as a traditional investment because the acquired risk is higher than average.
Speculation should not be considered purely a form of gambling, as speculators do make informed decisions before choosing to acquire the additional risks. Additionally, speculation cannot be categorized as a traditional investment because the acquired risk is higher than average.
Lots of people have made a ton in trading stocks and options (e.g. George Soros, but he was smart enough to know to quit gambling when you are ahead) – the key is to be able to make informed decisions …… my question to you is, how informed are youif you are merely following the herd, reading the popular press, drawing trends on a graph using the same trends that millions of other investors are looking at, doing a rudimentary analysis of the same sets of financials that every analysts worth his salt is poring over?
In short, what is the ‘special sauce’ that you are applying that will let you buck the trend and speculate successfully, like George Soros?
“A public-opinion poll is no substitute for thought … let blockheads read what blockheads wrote.” W. E. Buffett
And, buying most high-cost Mutual Funds or other packaged products is not investing either …
“We believe that according the name ‘investors’ to [people or] institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’ “ W. E. Buffett
So, take Warren’s advice: unless you have a strong reason to do otherwise, stick to one – or both – of the only two ways of investing in stocks and, over the long-term you are very likely to outperform all but the luckiest of those speculators out there …
Cash is an investment, too
Aspiring ‘investors’ tend to laugh at low-return strategies like keeping money in CD’s or paying down mortgages – and, as a long-term investing tool (now, that’s a tautology) they do suck.
But, as a short-term ‘money parking’ tool there’s nothing better … and there’s no time like the present to dust off those borin’ ol’ Ramseyesque strategies, as this article from the Tycoon Report suggests:
The most successful investors in the stock market aren’t always invested in stock. They’re only invested when the odds weigh heavily in their favor.
You must have the discipline to know when to stay out! For most people, this is one of the easiest concepts to grasp, yet the hardest to follow. This is something that comes with experience. It’s something that most people have to learn several times throughout their investment life.
People ask: “When do I know when it’s the right time to be in or out?” The answer is: If you’re asking that question, it’s time to stay out.
Otherwise, find an account or stable investment vehicle that offers you a nice interest rate. You can look at Treasuries, Certificates of Deposit, money market accounts or a bank or broker offering a relatively high-yielding interest rate.
The point is to sit in something safe while you wait for trades with a high probability of success to present themselves.
Savvy investors are willing to sit in a risk-free interest bearing account for years if need be, and you should get comfortable with taking the same stance. What’s likely tied for first place on the individual investor’s list of most common mistakes is the notion that if you’re not in the market, you’re not making money. Anxious and over-eager investors force trades at the wrong time, mainly because they’re afraid of missing the next big gain.
Fear of missing the next winner is a killer. Professional investors know that cash is a trade too.
I love that last line … that’s why I ripped it for the title to this post!
Right now, I am sitting in cash … and, I have been totally out of the market for a few weeks now even though there was a rally in between.
I am waiting for the right time – read: after the market starts climbing again (I’m happy to miss the absolute bottom) and I am sure that represents a longer-term trend OR until I find a stock that I feel won’t go much lower even if the market doesn’t rally for a while.
Same applies for real-estate, although I am actively looking for deals right now … residential isn’t my preference (I have plenty of exposure to that sector) as I am totally out of commercial right now and would like to get back in if the cash-on-cash returns improve a little (as they should as the recession takes hold, then eases a little).
Having said that I am in cash … it isn’t in your ordinary Mid-West Bank deposit account or CD … it’s legally earning 7.5% interest, hedged against the falling US dollar.
That’s why it’s often true that the rich get richer … because they have more investing options.
Still, the principle applies: sometimes, it’s OK to stay in cash or [AJC: perish the thought!] temporarily pay down a mortgage.
Gold and Silver is God's Money!
Just gotta love Robert Kiyosaki … he has a way with sensationalizing the really, really boring subject of money:
http://youtube.com/watch?v=FOKn7tiUMyc
Hope you enjoyed this latest installment of my Video on Sundays Series – for the entertainment value as much as (more than?) the ‘educational content’ …
AJC.
Oops … I just broke The 20% Rule!
Last days for ‘pre-applications’ to become one of my 7 millionaires … In Training! Click here to find out more …
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If you’ve been following this blog, you will know that I have a radically different approach to owning your own home than the Dave Ramsey’s of this world who advocate paying off your own home early:
To be fair, Dave and I are actually saying two different things:
1. Dave Ramsey is saying not to carry any personal debt at all – INCLUDING your own home, since it doesn’t generate an income. And, there are certainly many who advocate this approach.
2. I am simply saying that the EQUITY in your own home shouldn’t exceed 20% of your Net Worth.
Now, if your house is worth more than 20% of your Net Worth, and for most people it will, then by definition I am saying that not only is it OK to borrow the rest … you HAVE to borrow the rest!
When you are old and gray, then Dave Ramsey’s approach is fine … but, when you have a plan to retire wealthy, your home – and, your ability to borrow against it – become key.
So, when I told you in a recent post that my house was worth $2 Million … my wife and I actually met BOTH my criteria and Dave Ramey’s as we paid cash and the house fit well within the 20% Rule for us.
As it happens, I can’t stand to see a ‘dead asset’, so we agreed that I could take a substantial line of credit against the house (more than 50% of the current value of the house as a HELOC) and use it to fund some investments … I recommend this approach, even if you fit within the 20% Rule, because you should be maximising the amount that you have invested at any point in time …
… of course, as you get closer to retirement, you may choose to wind back again – as Dave Ramsey suggests – I haven’t, but that’s just me 😉
Now for a ‘small problem’ … a few days ago, we bought a house worth more than twice as much as our current house … at least, it had better be worth more than twice as much, because that’s what we paid.
This means that we have temporarily broken the 20% Rule … d’oh!
It’s not as bad as it sounds, but I wanted to share this story so that I could walk you through our thinking process, because it will be inevitable that you go through a similar process as you gradually step-up your lifestyle (the side-benefit for all of those who read this blog … we hope!):
1. We are taking a very conservative view of our Net Worth: I tend to discount the sale value of any businesses and similar risk-assets that we may have, when calculating our Net Worth, as they can be taken away.
With these ACTIVE assets included, we are well within the 20% Rule, and very close to it even when only counting PASSIVE assets (a MUCH more conservative way to view Investment Net Worth that we will discuss in future Making Money 301 posts).
2. We paid cash for the house (well, we have only put down the deposit, so far, but will pay cash at closing).
The remedy?
Simple: as we did with our current house, we will take out a home equity line of credit and use that for investment purposes.
This means that we have effectively shifted the borrowed portion of the equity in the house from the personal side of our ‘ledger’ (bad) to the investment side of our ledger ‘good’ …
Used this way, borrowing is a positive tool to be used to advance your financial position, which is why I disagree with the Dave Ramsey approach for those who need to step up their lifestyle and have a solid reason for doing so [read: driving desire to achieve some Higher Purpose in their lives] …
… or, if you prefer the Dave Ramsey approach, simply wait before buying the house.
Financial choices abound!
BTW: to be ultra-conservative, we may instead simply use, say, 50% of the equity in this new house (perhaps more, certainly no less) to secure further income-producing real-estate investments (rather than stock purchases) that we intend to hold for a VERY LONG TIME.
As our Net Worth rises, will we pay down that loan (i.e. HELOC)?
We could … as we would again ‘fit into’ the 20% Rule. But, we probably won’t – because the 20% Rule is a minimum standard and there is nothing wrong with investing more, particularly in conservative, long-term buy-and-hold investments.
I see holding such investments, and borrowing a reasonable proportion to fund them, as less risky to my financial future than the typical ‘save and never borrow’ approaches … but, only because my financial future has to be reasonably BIG … certainly more than a simple savings approach could ever achieve.
That’s how we deal with upgrades to our living standards … perhaps, it’s a model that you can follow, too?
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People will usually trade equity for peace of mind …
There was a bit of to/fro on a recent post that I wrote about applying the 20% Rule; one of my readers pointed to a contra-view on an excellent blog by 2million who advocated paying down his home mortgage, whereas I advocate not to (as long as you always ‘fit’ into the 20% Rule), so I wrote to $2mill and asked him to clarify his position.
$2million wrote back and said:
I previously posted an analysis that I did that showed i would earn an after tax return of 6.7% on the mortgage prepayment your commenter is referring to (due to being able to cancel PMI). I am only chasing returns — not paying off my mortgage — I felt this was the best no-risk investment for our cash savings.
Now, I have written recently about this very subject – why the small gain in reducing interest rates is offset by the huge benefit of leverage, particularly when applied to an appreciating asset such as your own home – but, so many people still choose to pay down their mortgage instead.
Why?
I think that $2million speaks for most people who recommend or follow this approach when he says:
Feels good to paydown mortgage emotionally, but have always recognized its not the best return for the investment.
“Feels good emotionaly” a.k.a. ‘peace of mind’ – perhaps one of the most motivating statements in the business world …
… how many $20,000,000 mainframes have IBM sold because ‘buying IBM’ would give the CIO ‘peace of mind’?
It is also truism in the personal finance world that people make decisions emotionally, then look for rational reasons to support their decision … it’s why it’s very difficult to change the way that people think … first, they have to WANT to change.
It’s why it is said that you have to “win their hearts THEN their minds will follow” …
Jason Dragon [great name!] was the commenter on both $2million and my posts; he wrote me an interesting e-mail the other day:
In the investing club I belong to we have a saying. “People will usually trade equity for peace of mind” and it is so true. This is the reason you can get a house for 60 cents on the dollar because someone is 1 payment late and scared. It is also the reason that people don’t invest like they should. It just boils down to the fact that most people are too risk adverse.
This is one of the best times in history to see emotion-driving-rationality at work: look at the emotions that pushed the markets and real-estate so high all the way through towards the close of 2007 … to be followed by an equally emotional ‘crash’.
Sure, there were economic reasons for both … but, the emotional swings were much, much larger than the rational/economic swings on their own could justify.
Where the heart goes … the mind will follow; it’s why I say on my About page:
If your target is just an amount like $1 Million in 15 years, then you do NOT need to read this blog – you will get far more benefit for your time invested in reading here, here, and here, or probably ANY of the places listed here.
… there’s no reason to waste anybody’s time … if they don’t need $5 mill. – $10 mill. in 5 – 15 years, then why bother reading a blog about the rationality of ignoring much of the Common Wisdom surrounding Personal Finance?
But, for those who have the burning need to break through and be truly financially free – Jason has some more words of wisdom:
One nugget of info can change your life. It is much easier to live below your means if you increase you means. You do need to control costs, but spend more time increasing income than controlling costs and you will be ahead in the long run.
Jason, it’s true: one nugget of info can change your life (little did I know it at the time, but it did for me) …
… but, first your heart has to be receptive to that change!
AJC
PS 2million did later explain that he put money into his mortgage as a temporary savings strategy – as it offered a better rate of return than other savings or debt repayment options available to him. 2million is a blogger after my own heart, who intends to pull that money out to buy his 3rd investment property soon.