Why am I posting a really nice Christmas video on January 25th?!!
Well, it’s simply to make a point …
… it doesn’t matter how late you start, but how well you execute that counts.
Just ask Ray Kroc (McDonalds), ‘Colonel’ Sanders (KFC), my father (who started a business at the age of 60), and (hopefully, soon) our very own Lee Martin …. old is the new young 🙂
It’s sad, but true … it seems that money does make the world go around.
It’s what seems to drive people to make – lose then make – lose … and, so on … their money. It becomes an end rather than merely a means.
But, I have a slightly different view:
1. FIRST decide WHY you need the money … I call this Understanding Your Life’s Purpose
2. THEN decide HOW MUCH money you need in order to do whatever it is that you need the money for (and, by WHEN) … I call this Calculating Your Number
3. FINALLY, when you DO get to your Number, STOP and LIVE YOUR LIFE.
When I’m not writing posts here, I’m hanging around the Share Your Number Community Site, talking to the other members.We launched this site in 2008, and in 2009 we are planning a major expansion so please join now … it’s FREE and easy!
Remember, helping others get to their Number is the best way to get to yours …
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I have been itching to write this post for some time now, and yesterday’s post about investing in income-producing real-estate v speculating in (hopefully) appreciating RE should have provided the necessary comments/questions …
… but, it didn’t 🙁
However, Steve chose this particular day to finally complete his comment on a post that goes back 6 months … a comment that is right ‘on topic’ for me … and, is a question that all of us should be asking … so, thanks Steve!
Here’s what Steve had to say:
I don’t purport that he is write [sic] in his article but would really love to hear your views on [this] story…
http://seekingalpha.com/article/84850-investing-in-dividend-paying-companies?source=d_email
what i liked about it is the dividend paying stock situation. certainly i wouldn’t consider as an only avenue to wealth, but do you feel dividend paying stocks are a better choice than non dividend paying stocks?
The article promotes a method of investing that the author claims returns “a little over 8.68% annually … while not earth shattering by any means, compare[s] very favorably with the market’s performance over the same period. From July 1988 to now, the S&P 500 has advanced … around 7.86% annually.”
The ‘now’ is actually July 2008, so only reflects some of the recent stock market losses, but the principle is clear, at least according to the author: invest in dividend-paying stocks …
… and, this is certainly ONE (of many) Making Money 301 tactics that I recommend when you have made your Number and are trying to preserve your wealth. However, it is just that – a tactic – and, certainly not the best one there is.
Given this, and my strong recommendation that you invest in RE for income, you might be a little surprised to hear me say:
As a Making Money 101 or 201 strategy, seeking out dividend-paying stocks is almost irrelevent!
Why?
Well, let’s take a look:
Stocks return in TWO main ways, just like real-estate:
1. Capital Appreciation
2. Dividends
Just like real-estate, the price of a stock tends to go up according to the profits of the company. When I say “just like real-estate”, I mean just like commercial real-estate … residential real-estate has other, less tangible drivers of future value. So commercial real-estate tends to rise in value as rents rise, and stocks tend to rise in value as the company’s profits rise.
Naturally, inflation is a key driver (forcing rents/profits up, hence the price of the real-estate/stock) but there are plenty of other ‘micro’ and ‘macro’ factors as well e.g. for real-estate it could be job growth, for companies it could be competitive pressures, etc.
This is what I would call the Investment Factor that tends to drive up the value of such investments, and you can generally be confident that prices will increase according to this factor – over the long-haul.
An equally important factor is ‘market demand’ for that type of investment, which is reflected in ‘capitalization rates’ for real-estate and ‘Price-Earning (PE) Ratios’ for stocks … this is essentially a measure of how long somebody who buys that investment is willing to wait to get their money back via future rents/profits.
This is what I would call the Speculation Factor that tends to drive up or down the value of such investments, and you can never be sure which way this will drive prices – over the short-haul.
Unfortunately, as recent market events in both real-estate and then stocks have very clearly shown – the Speculation Factor has a much greater effect on pricing than the Investment Factor … unless your time horizon is very long, indeed.
This is why it is much better to look for the underlying investment returns, unfortunately often mistakenly confused with …
Because Real-estate produces rents – and, hopefully positive cashflow after mortgage and holding costs are taken into account (which, should be your main criteria for investing ), people often confuse dividends paid on stocks with returns on real-estate investments.
This is not the case:
Whereas real-estate returns are simply the rents that you receive less the costs (e.g. mortgage, repairs and maintenance, etc.), stock dividends do NOT directly reflect the profits of the underlying business.
Commercial real-estate usually provides an investment return set by a ‘free market’ (for things like competitive rents, competitive interest rates, etc.) …
… but, the dividends on most stocks are simply set by a board of directors according to whatever criteria makes sense to them at the time.
People who invest in dividend-paying stocks are confusing dividends with company profits … but they are NOT directly aligned: a company may make super profits and not pay a dividend at all (for example, Warren Buffett’s own Berkshire Hathaway has NEVER paid a dividend).
A company that makes NO profit may still choose to pay a dividend (perhaps from cash or even borrowings) … just to keep their shareholders happy (for example, in 2004 Regal Cinemas paid a $5 per share dividend; “to make the $718 million payout, Regal first had to borrow from its banks”).
Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T?
I’d love to hear your views …
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You can also find us at the latest Money Hacks Carnival, hosted this week by Money Beagle …
There was a craze that hit Australia in the 90’s and America in the 2000’s … we know the result, but what was the cause?
It was the ‘negative gearing’ craze …
… people were promoting real-estate purchases on the basis that you take a loss now and make a (hopefully, huge) capital gain in the future.
The benefits that used to be promoted by the real-estate gurus are stated very nicely in this comment on Andee Sellman’s blog:
You have forgotten tax benefits which can be substantial. Also, the actual equity needed to purchase his investment could have been minimal compared to the purchase price. Most importantly, over time the tenant and the tax man pay for the majority of his investment.
Now, I would understand this comment if it were from 2005 or even 2006, but it is from only a couple of months ago …
… if we don’t learn from our mistakes, we are doomed to repeat them!
When real-estate is going up in price, it is easy to get caught in the trap of buying on the basis of future capital appreciation, and use tax deductions on the mortgage and depreciation benefits on the building and improvements to help ‘soften the blow’ as running costs were typically higher than the income (in some places, severely so … yet we still bought!).
Given the current market we all KNOW the problems this causes, but real-estate – and sentiments – cycle every 7 to 10 years, so WHEN you forget what happened in 2007 and 2008 during the next boom, pull up this blog and remember:
Treat your real-estate investment as a BUSINESS.
A real business is bought (or started) because it does (or soon will) produce profits and free cash-flow year in and year out, and then MAY be sold at a future date for a speculative gain. At least, that’s what happened to me …
… I can’t understand why we shouldn’t look at any other investment, including property, exactly the same way?
Can you?!
Too much talk about Numbers, Dates and Compound Growth Rates can make your head spin!
But, Scott makes an interesting observation:
What I learned from this post and using the Annual Effective Rate calculator: http://www.investopedia.com/calculator/AnnualEffectiveRate.aspx
is that if I keep up my focus, work and investing for another 5 years past my 10 year date, I can drop my required compound growth rate by 3%(from 40% down to 37%), however, quadruple my number accomplished from 4 million to 16 million, and i’ll still be in my 40’s.
Incredible what taking a little more time can do for you!
What Scott says is absolutely true, but also consider:
How much does delaying your Date by 1, 3 or 5 years (say) REDUCE your compound growth rate if you KEEP your Number?
Also, what does reducing your compound growth rate do for you in terms of changing the way that you need to think about building up your nest egg?
Does it mean that you no longer need to start a business, or invest in real-estate? Will keeping your money in Index Funds via your 401k do the trick?
So, rethink your Number and Date – but NOT at the expense of your Life’s Purpose …
… then, when you do get to your Date, DO allow the momentum of the activities that got you there to carry you on just a little bit further … you could double your Number, just like that!
Don’t believe me? It’s exactly what I did in the two years following my own 7 million 7 year journey 😉
I saw this on Get Rich Slowly and wonder what you think of it?
Since I didn’t allocate my own spending this way ‘on the way up’, I can’t comment either way … but, maybe some of you can?
Here’s how it works:
You take your After Tax income and divide it into three categories:
1. Needs – These are you ‘must haves’ i.e. things that you can’t go without: rent/mortgage; car; electricity; basic food (the book provides a ‘rule of thumb’ for this); and, so on.
You allocate 50% of your after tax income to these needs; given that we already have the 25% Income Rule (spend no more than 25% of your after tax income on rent/mortgage) that leaves 25% on all the other ‘needs’.
2. Wants – According to the book, you should have fun – and, budget 30% of your after-tax income for it. I happen to be of the same mindset … what is money, if not for spending (except that you must do it in a way that allows you to live your Life’s Purpose by your desired Date).
According to the book, ‘wants’ include additional food (i.e. lamb chops instead of dog food?), your cable TV and internet (these are definite needs for me, especially on my 100″ home theater screen … but, I can afford it!); trips and vacations; and, so on.
3. Savings – that leaves (or should leave) 20% of your after-tax income for your 401k investments and other savings/investment … since this is 5% to 10% more than most authors suggest, I commend it. Just remember, that even with 20% you’re not going to be able to save your way to wealth.
All in all, it seems like a pretty good savings plan to me … what improvements would you make?
What is the relationship between your income and your Net Worth? Does paying down a mortgage increase your Net Worth … these are the comments made by Diane to a reader who said that they had income that was going into CD’s, but still had a mortgage:
[If] you are paying down your mortgage some – rather than just interest … then your net worth may be going up [?]
I told Diane that it doesn’t work that way 
Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces both your CASH (on hand) and MORTGAGE balance columns in your NWiQ profile …
… your total of Assets – Liabilities (hence, your Net Worth) remains the same!
Diane took me to task:
I assume [that you would be] applying income to [your] net worth and that is NOT reflected in the assets/debt columns of the networth calculations – it’s future cash for the most part (those who have incomes ;)) — or did I miss how else the income is reflected other than as a header above (along with our education)???
These are very good ‘technical’ questions, that I can explain (for those who are business/finance minded) as follows:
Income/expenses is/are a bit like a business’ P&L (Profit and Loss Statement), and your Net Worth is like a Balance Sheet … the former is a ‘work in progress’ and the latter is a ‘snapshot’ at a specific point in time.
Both cash and loans sit on the Balance Sheet … or, in our case, on our statement of Net Worth. Simply moving amounts around does not change either. Your Balance Sheet only changes if you make or lose money, grow or reduce assets (as long as you are not turning them into cash or some other balance sheet item).
Similarly for your Net Worth: decreasing a positive bank balance (on one side of your Net Worth statement) in order to similarly decrease a negative house balance (a.k.a. a mortgage) on the other side hasn’t changed anything – except where you keep various components of your Net Worth.
On the other hand, earning more profits (reflected in a businesses P&L) is similar to earning a salary or other income for a person (income) provided that you don’t spend it all (expenses) …
… they all help to increase your Net Worth (or improve the value of the business, as reflected in an improved Balance Sheet).
BUT, it doesn’t matter if you ‘store’ that extra income in a bank account (i.e. the CASH column of your NWiQ profile) or in your mortgage (effectively reducing it) … your Net Worth goes up by the amount of income that you saved since you last calculated your Net Worth.
As Scott says:
As long as you are living in your home, it is a liability and costing you money if anything.
That is, unless you are prepared to tap into that home’s equity and use that money to invest.
Yes, it’s what you ’save’ from your income (i.e. after expenses) that goes into improving your Net Worth regardless of whether you use it to build up your bank balace, pay down debt, or – as Scott suggests – buy a new asset.
OK – close your eyes (actually, keep them open so you can keep reading!) and imagine the complexity of analyzing cashflows and proformas for a real-estate deal north of $2.5 million …
Daunting, huh?
Well, that may be how OTHERS analyze a deal, but not me … all of my deals are done on the backs of envelopes … well one clean sheet of paper. I have this one right in front of me, in my own scrawly handwriting.
On the strength of it, I have authorized my Realtor to make a written offer, with a $200k ‘earnest money’ deposit on the $2.7 Mill. office/warehouse. Sure, the proformas will come later, but I’ll get him to prepare those for the bank … while I’m at the beach or off skiing someplace!
Here’s what the piece of paper says:
Purchase Costs
$2.7 Million (incl. $100k broker commission)
$5k Building / Environmental inspections
$15k Closing Costs (legals, bank fees, appraisals, etc.)
Of these, the $5k for the inspections is my only financial risk, as I need to undertake these during ‘due diligence’ (we’ll talk about this in a future post if the deal gets that far).
Finance
$2.7 Million Purchase Price (incl. broker’s commission)
$ 2 Million to be financed
Note: this is approx. 75% of purchase price to be financed; this is high for commercial which can be as low as 60% being the maximum that the bank will fund.
$700k – so this leaves me 25% of the purchase price, or $700k, to find as a deposit.
Note: I’m sure that the owner’s won’t ‘carry back’ a note on this one, as the whole purpose of the sale is to raise cash to keep their business afloat or growing.
So, that’s the purchase / financing side of the equation, now let’s see if it can make me any money …
Income
$175k – Rent for Tenant 1 @ $8 / sq. foot
Note: the current owners will lease 2/3 of the property for the above fee (probably 5 years, with a 3% yearly increase)
$80k – Rent for Tenant 2 @ $8 / sq. foot (we need to find this smaller tenant)
Note: the property is street front with car park, so we feel is should be easy to find a second tenant in the $6 – $10 / sq. foot price range
$255k TOTAL INCOME
Expenses
Note: the GREAT thing about commercial properties is that most expenses (and in a ‘triple net property, all expenses – unfortunately, this is NOT one of those) are handled by the tenant, leaving me just …
$45k Taxes
$7k Building Insurance
$10k Management Fees
Note: Rental management fees can vary from 4% – 6% of the rent if you don’t want to deal with the tenants yourself; keep in mind that commercial property is very different to residential and you won’t have as many issues dealing directly with commercial tenants – they are responsible for all repairs & maintenance … but, if the roof springs a leak, you’ll be expected to act quick! I will use an agent ( my friend).
$130k – Bank Interest @ 6.5%
Note: this is the ‘biggie’ and I haven’t spoken to any banks, yet; obviously, that’s my next port of call but my Realtor friend tells me that I shouldn’t have any problem getting funding fixed for 7 years (or a 25 year P&I loan with a 7 year balloon) around these rates. Variable can be as low as 4%, but I prefer to ‘fix my costs’.
$192k TOTAL EXPENSES
In the final part [AJC: when I return from my ‘winter break’ on Jan 5], I’ll summarize this all for you and explain why I like the deal so much …
There is a certain appeal to diversification, particularly when seen as a risk-minimization strategy.
Rick sums this ‘certain something’ up nicely in this recommended twist to how he would set up his own Perpetual Money Machine:
Nothing in life is without risk- but you can minimize risks by diversifying- use multiple types of wealth capacitors some properties, some stocks, even some bonds. You can further diversify with a mixture of commercial and residential properties, properties in different locations, etc.
Similarly you can diversify stocks through buying small cap, large cap, mid cap, and foreign stocks.
If you diversify you can be fairly sure that one bad event doesn’t ruin everything. Of course if the sun goes supernova all bets are off but barring that you should do fine.
And, this is certainly appealing …
… don’t forget that I have been well diversified in almost every area that Rick mentions: multiple businesses; multiple RE investments in different classes (residential; commercial; single condos / houses; multifamily; retail; office; etc.); stocks (but, no mutual funds of any kind … and, I intend to keep it that way!) … but, I don’t recommend it!
Why?
I see two problems with this:
1. You spread yourself pretty thinly – you risk becoming a Jack of All Investments But Master of None … this lack of specialized expertise (which you can, of course, try and ‘buy in’) and focus can actually INCREASE your investment risk, hence DECREASE your investment returns, and
2. You automatically consign your returns to the mean/average – not all of your investments can perform as well as your best investment …. if you are comfortable with this ‘best’ investment (or, at least one of your ‘above average’ ones) surely you would put more effort into doing more of those?
The usually arguments FOR diversification then say things like “well, look at the sub-prime and what that’s done to [Investment Class A], therefore you should also do [Investment Class B]” …
… but, they conveniently forget that [Investment Class B] tanked 5 years ago, and will probably tank even worse 5 years hence, whilst [Investment Class A] recovers.
If you diversify you run the risk of averaging your returns down.
In other words, if you can choose your investments wisely your best hedge against risk are a combination of:
a. Time: make sure you can hold the damn thing for 10 to 30 years … if you have a short investment horizon, no amount of diversification will protect you.
b. Higher Returns: if you can hold long enough, every investment worth its salt will recover – and, then some; and, isn’t a ton of cashflow a great ‘insurance’ against risk?
Of course, if you can’t choose your investments wisely, then a ‘regression to the mean’ becomes a GOOD thing … just don’t expect to get rich if you can’t develop any special expertise 🙂
Nope, Rick, my Perpetual Money Machine – which asks me to generate my active income one way (e.g. my job or business), and then create passive income in another way (e.g. stocks or real-estate) gives me all the diversification that I need!
Why bother?
I wrote a post about an insidiously appealing – yet flawed – approach to investing promoted by the financial services industry (I wonder if high turnover helps them or hinders them?) called ‘re-balancing’ …
… even if it were sensible (it’s not), it requires an even more flawed base to sit upon: a diversified portfolio. Now that is something that the financial services industry makes money from! 🙂
That post inspired a discussion with Jeff, who provides some useful number-crunching to support his ultimate argument for rebalancing:
Consider two cases in the first you rebalance in the second you don’t:
Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancingNo Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recoveryNote rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.
What if the order was different?
Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
62.5K 62.5K 125K Rebalance
31.25K 62.5K 93.75K Market drops 50%
46.9K 46.9K 125K RebalanceNo Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
37.5K 50K 87.5K Market drops 50%Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance.
So, it seems that rebalancing is inexorably tied to diversification: do one and you should do the other, but what of the reverse?
Let’s turn again to Jeff [AJC: I cut/pasted a couple of Jeff’s comments … you can read the entire thread in its original form here] , who says:
If you have elected to diversify your portfolio I would argue that you should rebalance to maintain your initial asset class mix.
You add bonds to your portfolio to reduce risk. Failing to rebalance increases the your risk as time goes on…which is typically the opposite of what most investors desire. The reason you do this is not to maximize return, but to maintain the same risk that you had when you started.
The real reason people diversify into higher risk asset classes is to increase their return per unit of risk. Even when a higher risk asset class increases the overall risk of your portfolio, the excess return is disproportionately large when compared to the excess risk. Thus, overall the return per unit of risk increases, helping you to maximize the amount of return you receive for the risk that you take on.
Rather than focusing on return per unit of risk, shouldn’t we look at risk per unit of required return?
Surely we should:
1. FIRST look at what RETURN we need in order to achieve a required financial goal, and
2. THEN compare the risk-profile of the various choices that can produce the desired return or better (hence, required annual compound growth rate) NEEDED to get us there, and
3. USE THAT menu of qualifying investments to make our investment selection from?
If your financial goal – e.g. Your Number – is sufficiently large and/or your desired timeline – e.g Your Date – sufficiently soon, diversifying/rebalancing may be among the highest risk options available, along with any other investment strategy that fails to meet your required annual compound growth rate!
Diversification/Rebalancing simply may not return a high enough amount to fuel the annual compound growth rate required to get you there!
In which case, you only have some combination of the following three choices:
i) Reduce your Number, and/or
ii) Extend your Date, and/or
iii) Accept a higher level of technical risk in your investment choice/s
But, is there a point in life when it makes sense to switch to a risk-above-return strategy?
Yes!
As Jeff says:
As I get older I will be increasing the % of bonds that I hold and will be rebalancing.
But, I would not (first) look at my age … again, I would first tie this to my financial goal i.e. my Number:
When I reach my Number (or, if I fail and am within 7 years of my latest retirement age), I would shift to a Making Money 301 Wealth Preservation Strategy, such as:
1. That promoted by Prof. Zvi Bodie (Worry Free Investing) – putting 95% – 100% of my Investment Net Worth into Treasury Inflation Protected Securities (TIPS) and the remainder (0% – 5%) into call Options over the S&P 500, or
2. That promoted by Paul Grangaard (The Grangaard Strategy) – putting 70% of my Investment Net Worth into a low cost S&P 500 Stock Index Fund and 30% into a bond-laddering strategy to cover my anticipated spending for the next 5 years (then ‘repeat’ every 5 years), or
3. Putting 80% of my Investment Net Worth into positive cashflow (before tax) real-estate (I would ‘jiggle’ my deposit amount to ensure at least a 6.5% return p.a.) and keeping 20% in cash and CD’s as a buffer against vacancies, repairs and maintenance, taxes, etc.
4. If all else failed, or as a ‘last ditch’ effort to avoid leaving too much in cash/bonds, a diversified portfolio of stocks and bonds … possibly to be rebalanced each year.
But, the last word goes to Jeff:
This, of course, doesn’t mean anything unless the new return is something that you desire.
Indeed 😉