Tag Archives: millionaire

Left Brain v Right Brain

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brain

Are you left-handed?

I find myself noticing actors in movies and on TV who are left-handed …. it seems (but, maybe my reticular activating system is blinding me to the statistics) that more leading actors are left-handed than the typical 10% or so that is the society ‘norm’.

Artists, too …

So, is there truth that the right-brain controls the left hand? And that the right-brain is responsible for our emotional / creative side? In which case, left-handed people are more creative?

I’m not sure.

But, I DO know this to be true:

Most decisions are made emotionally then justified rationally

I heard this once many, many years ago … and, even though it is widely quoted, I have not managed to find the source … but, I have found it to be true in business, investing, and in life.

It helps to explain impulse purchases despite reading the classic ‘frugality’ blogs like Get Rich Slowly.

It helps to explain the behavior of the stock market, supporting the findings of the Dalbar Study.

It helps to explain my wife šŸ™‚

It helps to explain why the real answer to the Deal or No Deal conundrum is “Not Sure” …

… the reality is, you will NOT know what you will do in the same situation until you are faced with the same ‘on the spot decision’ yourself.

UNLESS …

Unless You Have A System to Guide You

Anytime you have a ‘rational’ decision to make – and, you can at least anticipate that you will one day need to make such a decision – then you MUST prepare ahead of time with a system thatĀ  you strongly believe that you must follow in order to achieve [insert very strong emotional outcome of choice].

The System, of course, will be a rational system: it will be well grounded in research, logic, and proven results.

And, it must be one that – in advance of the real decision that you will face – you strongly believe and/or have faith in.

Religions offer such a system for Life … if you subscribe to one, you do it because of Belief and Faith and then you follow it ‘religiously’ – according to your level of belief – or suffer the consequences …

… consequences that may range from guilt and/or discomfort on the mild end of the ‘consequences spectrum’ to great fear of [insert religious punishment of choice] on the extreme end of that same spectrum..

And, this blog is slowly unfolding such a system for Personal Finance. If you do not follow it, you may (on the mild end) feel guilt and buyer remorse, and (on the extreme end) fear that your money may run out before your do. Somewhere in the middle should be the very real fear that you won’t achieve your Number in time (i.e. by your Date)

The key is that when the decision pops up, the emotions around failing to follow the system must outweigh the emotions (temptations?) leading you towards the irrational decision …

…. ultimately the execution of the decision will always be made ‘in the moment’ and emotionally, and then you will justify your success – or failure – rationally later on so that you can live with your choice.

That’s why you need to commit the 7million7years version of this ‘truism’ to memory:

Most decisions are made emotionally then justified rationally unless you have a system to guide you!

Now, go find a system for personal finance that you feel that you MUST follow – and, a strong reason for doing so (e.g. so you can get on with living your Life’s Purpose … seems a pretty strong reason to me; how about you?) – and then follow it, or suffer the consequences … harruummph! šŸ˜‰

Real Cashflow, Fake Cashflow – Part II

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Last week I told you that there are three types of positive cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Today, I want to discuss the first of these … cleverly designed to make Negatively Geared real-estate look like a good deal!

Tax Cashflow

In the first installment, I explained that most real-estate (especially residential real-estate, and single family homes and condos in particular) has more costs (e.g. mortgage interest, vacancies, repairs & maintenance, provisions, etc.) than income (i.e. rents), forcing us dumb investors to gamble on the future appreciation of the property … and, we can see where that has lead us!?

So, those developers and promoters with lots of real-estate that costs way too much to buy found some money to help you cover your losses and turn them into a ‘profit’ … from this, comes our first opportunity for the Holy Grail of Real Estate: Positive Cashflow property i.e. one that puts money INTO your pocket each year.

Now, I said each year for a reason: tax.

Uncle Sam will help you to help these property promoters to become rich by encouraging you to buy their overpriced, under performing real-estate! Take Scott, for example:

My wife and I have been pondering this very same topic with our rental(which was our previous home). We are negatively geared by $250.00/month on that property, have great renters that have completed their 6 month lease and are continuing to rent month to month while they continue to try and get their home in Connecticut sold, then move on to purchase their own home here in Louisville.

Money seems to be tight for them from all that I can see, however they are able to make this rent each month, so Iā€™m a bit afraid of raising rent on them, but it really troubles me to be negatively geared for the moment. This property (according to this years filing) has given us a pretty large tax deduction, which has certainly saved us money, perhaps enough to pay us back the monthly amount we have lost to make us break even. Not to mention, it is in one of the most premiere areas of the city and has enjoyed one of the highest appreciation rates this city can offer, but as your post suggests, we donā€™t want to get caught up in the hope of appreciation.

As Scott has discovered the ‘secret’ is in tax-deductions …

… naturally, almost all the expenses that you have on an INVESTMENT property are tax-deductible, not just including mortgage interest (as in your own home) but, also ‘business’ expenses like repairs and maintenance … even vacancies allow you to earn a little less income, so you pay a little less tax … but these will probably not make a property cash-flow positive on their own.

Actually, the real secret is in the ‘provisions’ … a provision is a fund that you build up over time to allow you to cover major costs later (e.g. an Emergency Fund is a kind of provision).

You see, Uncle Sam allows you to ‘build up’ a fund over time to replace the building that you have on the property, and all the things that you have inside the property (e.g. stoves, lights, carpets, curtains, etc., etc.). You probably borrowed the money to buy all these things – and, are tax deducting the mortgage interest – but, the nice people at the IRS allow you to take a ‘double deduction’ in the form of a Depreciation Allowance on these items, as well.

It becomes another expense that you can get a tax deduction on, and because the property may not have enough income (hey, it’s already Negatively Geared!) you can lower your personal tax bill instead.

By paying less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

When you ‘run out’ of personal tax deductions you can’t make any more properties Tax Cashflow Positive … it’s all smoke-and-mirrors.

So, when it comes to real-estate, you want tax deductions and you want tax cashflow, but you don’t want to buy a property that only has this kind of cashflow, if you can find something better.

In the next installment, we’ll look at something even more fun: Fake Cashflow.

My spectacles are still cracked!

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On the subject of diversification and rebalancing (you can’t have the latter without the former, although the reverse is certainly NOT true), Rick says:

I donā€™t expect the market to behave consistently over any significant period of time. The reason I chose an example with no gains was to show that rebalancing can make a profit from volatility even when there is no underlying price appreciation. I suspect that is the mathematical explanation behind the study SiliconPrairie referenced. If a market was continually increasing then 100% stocks should do better- not that that is very realistic either!

I can believe some rebalancing could do better- especially with all of the market volatility weā€™ve had this year. I really wish I could time the market. I console myself with the fact that no one can really time the market with long term success.

I can rebalance though- as it can be done with a calculator rather than a crystal ball!

What Rick says is true …

… just understand that if you are committed to a diversification / rebalancing strategy, you will most likely:

a) under-perform the market over LONG periods of time (simply because you will have less in the market – on average – than a 100% stock portfolio)

Remember: the market (DJIA) has NEVER returned less than 8% in ANY 30 year period over the past 100+ years – I strongly suspect that if you were 100% invested the day before the market started to crash in October 2007 and simply waited 30 years, the same will hold true – and,

b) have to content yourself with not being able to reach a Rich(er) Quick(er) Number:

http://7million7years.com/2008/09/30/its-the-gradient-of-the-curve/

That’s OK for some … but, the premise under which I write is that it’s not OK for my target audience. That’s all šŸ™‚

Is it OK for you?

No such thing as a free lunch …

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no-free-lunch

This concept has come up three times recently, so it deserves a post of its own!

First Time

My son asked me why he can’t buy a car (when he’s old enough) on finance, and I explained it to him…

… he then asked me the million dollar question:

What about if there is a 0% finance deal on the car? Can I finance it then?

And, my answer was:

There’s no such thing as a free lunch.

Second Time

Ryan was posting about his car and Josh commented:

I would suggest buying used until you have cash to buy a newā€¦BMW, you have no maintenance bill for 4 years, 50,000 miles.

And, my answer was:

There’s no such thing as a free lunch.

Third Time

I wrote a post about a hypothetical real-estate deal, with the key feature of a rental return guarantee. Rick said:

The description sounds like a good deal to me for a low risk- a guaranteed 7.5% return + possibility of great appreciation. It really sounds too good to be true.

And, it is (too good to be true); you see:

There’s no such thing as a free lunch.

… really, there isn’t. Somewhere along the line you are paying.

Let’s take the last case first: guarantees are usually not worth the paper they’re written on. Especially when they are “thrown in” to make a “great deal” sound even better. In the real-estate deal the ‘guarantee’ could actually cost you money, if the developers/promoters have to borrow money against the future value of the project to make a current payment to you.

In mostĀ  new projects where, say, a 2 year rental guarantee is offered, the value of the guarantee is built into the price that the property is offered to you at … might explain some of the very dramatic rises and falls in RE values in Florida, for example.

Similarly with the second example of the ‘free servicing’, which is – of course – built into the price of the car. Naturally, if you simply MUST have a brand-new BMW then you will get the ‘free’ servicing with it. On the other hand, if you can buy a used BMW just after the ‘free servicing warranty period’ has expired, you will be buying at the best possible price point, because (in a normal market) you should expect a sudden drop in the value of the car … this sudden drop represents the real, current value of the ‘free servicing’.

If you understand this concept, then so-called 0% down deals should become obvious … YOU are actually paying for all of the interest, at commercial rates, up front!

I did some consulting work for a finance company that underwrote so-called “2 year interest free” loans on furniture sales for large retailers; they made their money because the store paid a fixed amount up front when you signed up to the deal, then the finance company HOPED that you would not be able to make all your payments on time, because the ‘fine print’ on the deal then let them charge you interest at credit card rates (19% p.a. to 29% p.a.) on the entire financed amount for the entire time that you had the “0% loan”.

Here’s the test; always ask:

… and, if I don’t take the [insert: free lunch du jour] how much do I have to pay then??

Then you can decide if the free lunch is something that you can afford!

Time to hop back in?

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buffett_chart1

Fortune Magazine publishes the above chart and says:

There should be a rational relationship between the total market value of U.S. stocks and the output of the U.S. economy – its GNP. [Warren Buffett] visualized a moment when purchases might make sense, saying, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you.”

Well, that’s where stocks were in late January, when the ratio was 75%. Nothing about that reversion to sanity surprises Buffett, who told Fortune that the shift in the ratio reminds him of investor Ben Graham’s statement about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.

Now, I don’t have a crystal ball, but it appears that most of the world’s greatest Value Investors (a technical term for ‘cheapskates’) are hopping back into the market, as this article – this time from Forbes – says:

Over the past several weeks, more and more of history’s most successful investors have turned bullish. Warren Buffett, John Neff and David Dreman–all of these gurus and others have said that they are now in full buying mode. Even Jeremy Grantham, a notorious bear, has said that stocks are cheap, as cheap as they’ve been in two decades, in fact.

I’m wondering: if you were prepared to buy when the market was high and people were beginning to speculate whether it would last, why wouldn’t you be prepared to buy (and hold for the long-haul) now, when the market is closer to the bottom than it was then?

I have some money that I can get an immediate 33% ‘kick’ by moving it from the US to Australia (due to favorable exchange rates), yet I am sorely tempted to keep it in the US and trade options with it, as I feel that there will be great volatility between a Dow of 8,000 and 9,000 … the time when traders make (and lose) fortunes.

Not suggesting that you do the same, but I am suggesting that if ever there were a time to buy (for the long-term), it might be right now … there might be deeper bottoms still to come, but there will be higher, highs as well … by buying and holding now, you will ride out those bottoms (if they come) and guarantee that you will reach the highs (when they come) … how can that be a bad thing?

… and, loving it!

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Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it’s NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellersĀ (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:

Enron

When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one šŸ™‚

Martha

When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too šŸ˜‰

Warren

The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient MarketĀ Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%

House or Home? 7 Case Studies …

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The real advantage of my 7 Millionaires …. In Training! ‘grand experiment’ for the rest of us is that it provides some great ‘real life’ case studies of the topics that we talk about on this site.

For example, we talk a lot about your house, as – for most people – it’s your largest single purchaseĀ  …. assuming that you don’t intend to actually get rich and go off and buy yourself some REAL investments šŸ˜‰

Here is where each of the 7MITs are at with their current housing; if any of these case studies interest you, click on the link to read their full post and be sure to scroll down and read all the comments:

Scott talks about both his current home (he has kept his previous home as a rental) and compares his current dual income to the 25% Income Rule – although, there is a question about his wife’s income to be answered.

Ryan isn’t sure whether he bought the ‘bargain’ home that he thought he was getting; should he pay down the mortgage to compensate? Read the post – and the comments – then let us know (either here or there) what you think?

Jeff is a Navy Pilot, so it should come as no surprise that he: (a) moves a lot, and (b) gets some housing assistance. Jeff is seeking to capitalize on his unique situation by flipping his current home … why don’t you add your comments to those that are already on his post?

Mark has a home that he wants to keep as a rental. Is he making the right move … and, is he using the right metrics to help him make the right decision? Also, in the comments, we examine whether Jeff’s (yep, back to the Navy Pilot) house is a home or an investment.

Josh is the ‘free accommodation at home’ guy … sigh! I (slightly) remember those days. But, does Josh have a housing decision to make (he has been give the task of managing his grannie’s flat)? Read his post (and the comments … feel free to add one of your own) and YOU decide!

Lee asks the critical question: house or home? We also have (read my comment) a totally new version of the Old Age Pension to offer Lee …

Diane lays an interesting ‘life situation’ on us: when do Life Partners combine assets and liabilities and when don’t they? Also, if finances are separated, how do you calculate where you are REALLY at financially? It can (and should) be done, but how? Diane has taken the same ‘live at home with parents’ path as Josh (for now) … what advice can you add?

If you are still deciding how much house YOU can afford – and, want to learn more about the 25% Income Rule and the 20% Equity Rule – start with this post, and work backwards through the links.

Tempting deal … bad deal!

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picture-1My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I donā€™t have to invest the full 100k. I can finance most of it, secured by the real estate. So, letā€™s say I can finance 80% of it, which means I ā€œonlyā€ need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

– very well-established commercial strip-mall in a great area

– fully rented, with long leases

– currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

– It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t šŸ™‚

– There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee isĀ  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee …

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

Real Cashflow, Fake Cashflow

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cashflow

This is the first installment of a four part series on what I describe as the three types of cashflow (as it relates to Real-Estate) … feel free to weigh in!

________________________________

I think, by now, most of our readers no longer subscribe to the “buy property for the tax deductions and future appreciation” scams of the 90’s and 2,000’s that resulted in one of the biggest property busts that the USA has ever seen.

But, I fear a new mantra – not quite as dangerous, but one that can squash your future returns (hence, financial dreams) like a kink in a fireman’s hose [AJC: that’s probably the worst simile that I have ever written] …

… it’s the ‘positive cashflow’ mantra.

You see, there are three types of positive cashflow, when it comes to Real Estate … and, I’m not sure that you will read about this anywhere else, but here it comes:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

… only one of which we are really looking for, although, any great property purchase will probably exhibit characteristics of all three.

First, though, let’s review the typical property; the one that doesn’t produce any cashflow at all and loses you money … it’s negatively geared!

Negative Cashflow

A property produces rents – hey, even your home produces a ‘rent’ … it’s just that you don’t bother to pay it to yourself, but you should šŸ˜‰ – and those rents are offset by costs: e.g.

– Mortgage Interest

– Repairs and Maintenance

– Vacancies

– Provisions

And, there are many others …

… interestingly, the last two aren’t strictly a ‘cost’ but a lost opportunity to earn rent – it amounts to the same thing: more cash going out than going in.

If the property has more expenses going out than money coming in from rents it is said to be Negatively Geared; this simply means that you are losing money!

So, why do you do this? Well, the promoters of such property – and, there are many such ‘promoters’ (e.g. builders, developers, real-estate agents, etc.) – will say that you do it for the FUTURE APPRECIATION …

… definitely lose a little bit of money today for the chance to make a LOT of money in the future.

There’s a word for that: gambling. I prefer poker; you may prefer lotteries; let others gamble on this kind of real-estate.

In the next installment in this special 4-part series on real-estate, I will cover the first kind of ‘positive cashflow’ real-estate: Tax Cashflow.