Tag Archives: Starting Out

The time of your life?

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It’s interesting that I drafted this post 3 or 4 weeks ago, just before the current wave of stock market crashes hit us; now, of course, I am ‘preaching to the converted’ …

We spoke about getting – or beating – average returns from either stocks or real-estate, but David points out: what is an average financial return?

I agree with you about the number. However, think you should use real rates of returns not some theoretical possibility. For example your number on mutual funds is 9.5%. Well actual rates of returns for individuals investing in mutual funds averaged 4.4% over the last 20 years (Dalbar, Inc. Vanguard, etc.).

So, what are the average returns for the stock market?

First, define the ‘stock market’:

Do you mean the US market? International (if so, which country or countries)?

If US, do you mean large cap (the stocks with the largest total stock market value or ‘capitalization’)? Or, small cap? Or, do you mean stocks listed one one of the alternative exchanges such as NASDAQ?

Or, do you simply mean ‘all’ stocks listed on the New York stock exchange (NY Composite), or ‘only’ 5,000 stocks (Wilshire 5000) or perhaps ‘just’ 2,000 of the listed stocks (Russell 2000)?

If ‘large cap’ do you mean the top 500 stocks listed on the NY stock exchange (S&P 500) or perhaps the just the largest 30 (DJIA)?

The point here being that there is no such thing as an ‘average return for the stock market’ … you have to decide how you want to slice ‘n dice it first!

Semantics aside, let’s pick an Index – say, the S&P 500 – how has it performed?

Pick a Number!

Here is data taken from Econstats.com and summarized here into the average returns of the S&P 500 for various 10 years periods from 1989 – 1998 through to 1998 – 2007:

10 years too short?

OK, let’s find an online calculator and see how the S&P 500 performs over various 25 year periods:

In case you can’t read the diagram:

The best 25 year return (since 1871) for the S&P 500 was 17.6%, but the worst was 3.1% .. yah think that might make a difference if you your whole damn retirement strategy was hinging on achieving ‘average’ returns?!

BTW: If, you were ‘lucky’ enough to get the average, it was 9.4% …

… but, here’s the problem:

In ‘real life’ people don’t get the average!

Firstly, they rarely choose the S&P 500 … they usually gamble on just one or just a few Mutual Funds that used to perform better than the market (but, rarely ever do again).

Secondly, they pay fees that knock down returns by an average of 1.5%.

Thirdly, even if they do buy into a low cost Index Fund that tracks (say) the S&P 500, they actually rarely stay the course for the full 25 years (take another look at even the 10 year chart, above, if you want to see what that can do to the reliability of your returns).

Don’t believe me?

Check out the Dalbar Study

… then, scroll all the way back to the graph at the very top of this post:

Pictures really do tell more than a 1,000 words 🙂

The fractal market …

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What does this fern leaf and the stock market have in common?

Surprisingly, a lot!

For a start, this is not a drawing or photo of a real leaf … it’s a actually a computer-generated image derived from just a few short lines of computer code.

It’s a ‘fractal image’ – a branch of mathematics that uses randomness (with many similarities to ‘chaos theory’) to describe natural objects so that they look ‘real’ to the naked eye … again, using only a very simple mathematical formula!

The two most interesting things about fractals:

1. They are easy to generate – they are based upon replication of a very simple formula, over and over again. Order-in-Randomness takes care of the rest

2. As you scale up or down the picture looks remarkably similar ….. take the leaf to the bottom right and blow it up to full-size and you will see something very similar to this original image

What does this have to do with the stock market? Well take a look at the following two graphs:

These both indicate movements in the Dow Jones Industrial Average; what’s interesting isn’t the direction … it’s the shape …. they both indicate a random series of up/down movements in a general direction (that, too, seems to change randomly).

The interesting thing about these charts is that they are the same chart (almost)!

One is a 1 year view of the Dow Jones, the other a 3 year view (it should be easy to work out which is which!) …

… you see, as the IBM scientist who ‘founded’ fractal geometry (well, actually revived … it was ‘discovered’ in the late 19th century by a scientist named Julia) in the 80’s discovered, the stock market is fractal.

While the movement is seemingly random, each piece of market movement when enlarged looks very similar to the larger scale movements … so we have up/down movement in the stock market at every scale: daily, weekly, monthly, annually that actually behave quite similarly.

The frustrating thing is this: chaos theory abounds.

Chaos theory says that when systems become complex, a very small apparent change in one variable (i.e. number) can suddenly have a HUGE change on the whole.

It’s why they say that a butterfly flapping its wings in Japan can cause a hurricane in Louisiana …

You can’t think of a system (except in Nature) more complex than the stock market: thousands of stocks make up a market … each one is a real-live business generating revenue, controlling costs, dealing with market/economic/government changes on a daily, or even minute-by-minute basis.

The whole shebang can move up … down … or sideways. But, within each movement is the movement of each company’s stock. The price of each individual stock is fixed by the investors: are they net buyers or sellers in this micro-second (that’s how fast the stock exchange moves)?

Suddenly, one mutual fund executes it’s order to sell Company A and the effect is minimal, either on that company’s stock or on the market. But, on another day a ‘perfect storm’ arises (an announcement by the feds of a change in interest-rates; a war in the Gulf erupts; etc.) and that same sell-off triggers a panic.

Who can predict it?

Nobody … and, that’s the point … look at the charts: do you see anything that looks remotely predictable in that lot?

Do you want to bet your financial future on where the stock market is heading, even for the next 3 years?

I don’t … but, I do know that while the market can (and, does) move dramatically & randomly, there is an underlying force driving it relentlessly upwards:

The companies that make up the market are producing widgets, and inflation is always making the price of widgets go up/up/up (with an occasional, but only short-term pull-back) inevitably pushing their profits (hence stock price) along with it … where inflation goes, the stock market will surely follow … eventually.

But, who can say exactly when?!

So always be a buyer and holder … never a seller be.

Your Number

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Nowadays, somebody only need to write “The” and “Number” next to each other and we automatically know what it means: the amount that you need in your nest-egg so that you can finally throw off those corporate shackles and ‘retire’ …

… well, do anything other than ‘work’ for your daily crust.

The only problem is that nobody tells you how to find The Number!

I should know, I read books on the subject and they all focus on rubbish like: “multiply 75% of your pre-retirement’ salary by 13”.

Which has some obvious problems:

1. How do I know what my pre-retirement salary will be?

2. What if I spend more/less in retirement than when I was working?

3. How will I know my money will last?

The reality is that – for most people – there is (and should be) a total disconnect between how you make your fortune and how you spend it!

In other words, just because you earn $x before you retire, it doesn’t mean that you will spend 75% of $x to 125% of $x (as most financial authors assume) in retirement.

So, I came with my own method – and, it worked for me!

Here’s how:

1. Complete a simple spreadsheet of your major (non-investment) personal purchases, income, and living expenses now and over the next 1, 5, 10, and 20 years. Don’t forget to apply the Inflation Adjustment Factors!

2. To help I have listed the typical expenditures of a $100,000 a year lifestyle, a $250,000 a year lifestyle, and a $550,000 a year lifestyle. These should provide some reference points to calculate your own future living expenses.

3. Use the spreadsheet to calculate Your Number and Your Date.

That’s it!

… and, I’m betting that it won’t even resemble your expected final salary – in fact, I’m betting that the number is so damn big’n’scary that you won’t even get there just on any typical salary – even with your 401k maxed 😉

A new look at our 7 Millionaires … In Training!

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I’m hoping, but not sure if you are staying in touch with the goings on at our ‘sister site’ http://7m7y.com – the home of what I still call our ‘grand experiment’ to make a lot of people rich by applying the principles that I write about here …

Jeff asks:

I have a question about how your readers now fit into the conversation on 7m7y.com as the site’s focus changes. Since you have named your 7 MIT the posts and comments have naturally shifted focus toward those individuals. As I review the discussions, it appears to me that the conversations and comments have become almost exclusively between you and the seven with little engagement from outside.

Do you see a place here still for the team of benchwarmers who have been to practice but didn’t make the team? I have learned a lot about myself and my desires through the series of exercises that led up to the 7MIT selection. Will there be more “try this at home” exercises moving forward or will 7m7y.com become increasingly tailored to the seven?

You see, I don’t just want to create 7 Millionaires … In Training! I want to create 70, or 700, or even 7,000 Millionaires … In Training!

So, there are no ‘bench warmers’ in our 7m7y Community – don’t be a wallflower (!) – but, you do get to choose your level of involvement:

1. You could just passively read along and pick up a lot of valuable information that isn’t in this blog, and

2. You could comment/criticize/congratulate, and

3. You could ask/answer questions of anybody (including the 7MITs and me), and

4. You could participate in the same exercises that I purposely post online, and

5. You could even share your own progress by e-mail/comment/feedback.

If you do want to participate – and I sincerely hope that thousands of readers like Jeff will – I suggest that you hop over to that site and bookmark it because it is an unusual blog … by it’s nature: http://7m7y.com is fluid, not static!

That’s also why I have come up with some additional navigation options for that site … let me know what you think!

____

Visit us at the Money Hacks Carnival, kindly hosted this week by The Financial Blogger.

It's the gradient of the curve …

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Making millions is serious business …

… don’t worry, here’s a short-cut where you can jump straight in  )

Now, back to today’s post ….

___________________________

That’s right, it’s not the size of the mountain … but, the gradient of the curve that will get you!

Given enough track, any train can climb any mountain. The track just can’t be steep … hence lots of track … hence lots of meandering around and around to get to the top (if that’s where a train really wants to go) … hence lots of time.

The train can get you there, it just can’t do it very quick!

Similarly with your Number … the size of the number doesn’t phase me, nor should it phase you …

You want a million dollars?

Easy, buy a $100 unit in a low-cost Index Fund and wait …

83 years.

Want a million in today’s buying power? Then, you’ll need to wait another 38 years.

Want $5 Million in today’s buying power? Just wait 21 years more!

You see, it’s not the size of the mountain that will kill you, but the gradient (steepness) of the sides that you need to climb.

That’s why we also need to know the Date that we want to achieve the Number:

Enter your starting Net Worth, your ending Number, and the number of years in between into a simple on-line calculator, and it should tell you the Average Compound Growth Rate required to go from the bottom (you current Net Worth) to the top (your Number).

The Average Compound Growth Rate is a measure of how ‘steep’ a financial mountain you need to climb … and, that should tell you whether you need a train, a fast car, or a helicopter to get you to the very top in time.

According to Michael Masterson in his book Seven Years To Seven Figures:

Required Compound              Investments

Growth Rate                             Required

4%                                                  CD’s

8%                                           Index Funds

15%                                              Stocks

30%                            Real-Estate together with Stocks

45%              Real-Estate together with Stocks and Small Businesses

50%+                           Start Your Own Business

So, how big is your mountain? More importantly, how steep the gradient?

And, are you prepared to try a new mode of transport, if that’s what is required?

If not, you’ll either need to find a smaller mountain (deflate your expected lifestyle) or simply give yourself some (a lot?) more time!

To focus or not to focus, that is the question …

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Put all of your eggs in one wealth-building basket or not?

That is the question posed by Bill, who says:

I guess you are trying to espouse that one must FOCUS on ONE thing which creates the abundance of ACTIVE income and then leverage further to create PASSIVE incomes via real estates…

And, he would be correct – except that it doesn’t need to be real-estate for either creating or maintaining wealth: it can be whatever turns YOU on.

Because you will only make money where your passion lies … not where anybody else’s lies.

As to my views on focusing on just one thing to create wealth, I am also ambivalent to that – although, I would highly recommend a single wealth building focus to most people.

Generally, to build wealth, do exactly as Bill suggests: “FOCUS on ONE thing which creates the abundance of ACTIVE income” … that way you give a positive variance the greatest chance to kick your wealth into high gear.

Look at it this way; if you split your time and money evenly between two activities:

– one with a solid entrepreneurial 35% compound growth rate

– the other with a slightly-above-market 15% compound growth rate

Then for every $100,000 you ‘invest’ over 20 years, you have the following outcomes:

All @ 35%        Split 15% / 35%      All @ 15%
$29,946,192    $15,684,684           $1,423,177

Significant or not? Try it at 50% v 15% …

Well?

I can tell you this; looking at these numbers will tell you an awful lot about your likelihood of even launching your ‘financial career’:

1. The Job-for-Lifers will be looking at the 15% returns and saying “well if I can turn $100k into $1 million just by investing it in an index fund what the hell am I wasting my time here for?”

… and, they will be right.

2. The ‘wannabes’ amongst you will look at the difference between the passive-style returns over 20 years of the All-or-Nothing approach and the Spread-My-Risks-A-Little split approach and say “well if I’m not sure of the ‘next big thing’ I should put some of it in to the Big Venture and the rest into something a little safer or another venture just to be sure”

… and, they will be right.

3. The true Millionaires … In Training! amongst you will be looking at one number: the one that matches most closely (or exceeds) their Number … the amount that they simply MUST have in their nest egg. And, they will (usually) be saying “I have to go for gold – the highest possible return in my chosen field …. but, if I give it a good try and it doesn’t seem capable of producing the return that I expect, I will quickly abort mission and try again”.

… and, they will be right.

It depends on how serious you are …

What is risk?

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Jeff raises a great question about the nature of risk; he is talking specifically about real-estate investing when he says:

After reading a couple books, it looks like the majority of the return comes from leveraging your money and keeping your money leveraged over your holding period. Also, reinvesting your cash flows into another investment (instead of living off of them) adds additional compounded return over the long haul. These, however, dramatically increase risk…but, no risk, no reward.

Now, I need to make a point right here: I talk about real-estate (RE) investing a lot … and, I certainly made a lot of money in RE … so, it follows that I am in love with RE, right?

Actually, no.

I hate investing … I dislike real-estate … I abhor risk …

…. it’s just that I hate NOT investing even more. Seriously.

I have a lot of money sitting in the bank earning interest (an excellent rate, if I may say so myself); but all I can think of is that it’s not working fully for me … I am not anywhere near maximizing my return. Where’s the capital gains?

In the bank, there is none.

So, I am FORCED to look elsewhere to invest, and I inevitably end up back at real-estate. I do it because, for me, it represents the best risk/reward trade-off that I can find … IF I am certain that I can cover the cash flows if things go south for a while (repairs and maintenance, loss of tenancy, etc.).

Jeff is absolutely right about RE’s ability to get returns ” from leveraging your money and keeping your money leveraged over your holding period”.

But, back to Jeff’s questions about risk: when Jeff says that leverage = risk, he is technically correct but absolutely incorrect.

Let’s take a look at the technical nature of risk:

Case 1 – RE v CD

We compare the risk of investing our $100k into a $100k piece of real-estate (no borrowings, and for the sake of the discussion no closing costs) v. into a bank CD and we realize that the piece of real-estate and CD produce differing rates of return: according to common wisdom, slightly above inflation for the RE and about even with inflation for the CD.

But, the RE can burn down, lose a tenant, etc. etc. Of course, on the plus side, you can rehab the property cheaply and increase returns; choose better tenants; find a high-growth area; etc.

The CD is fully government-insured (hence the $100k limit for this exercise); and, you can look around for the best CD deal (from an insured bank!) in town.

Bottom line: Slightly different rates of return, markedly different risks.

Intuitively, we understand that there is a relationship between risk and return and the RE v CD example illustrates that in a way that we can all understand.

Case 2 – RE v RE

Let’s say that you decide that the better return from RE is worth the increased ‘risk’.

RE can be leveraged; so that must increase risk? Again, technically ‘yes’, but let’s look at it in practice:

0% leveraged RE v 100% leveraged RE:

If the ‘sub-prime crisis’ didn’t show the risk (not necessarily the folly) of ‘no money down’ RE deals, then we may as well stop the discussion right here, because we all know that fully-leveraging a property is much more risky than owning it outright (it’s why we pay down our home loans, right?)

But what about 0% leveraged RE v just 20% leveraged RE?

Does that seem a lot more risky to you? If not, what about 0% leverage v 40% leverage … and so on.

In other words, risk is also personal: once you decide to invest in an asset class – say, RE – there is no magical point at which leverage becomes ‘risky’ or ‘not risky’ (unless you were one of the people who thought that 20% leverage was ‘risky’).

The point here is to show that whilst there is indeed technical risk, it can be highly subjective and frankly far less important to your financial decision making than ‘absolute risk’ …

Absolute Risk

To put this in perspective, we all know that trying to jump over roofs between buildings is risky. Much more ‘technically’ risky than going through the fire doors, down the fire-stairs, into the street, then reversing these steps in the next building …

… but, if you are Jason Bourne and a CIA Operative is coming through the doorway behind you with a BIG GUN (did I mention that you were out of bullets?) to ‘take you out’, don’t you think that you just might suddenly ignore the ‘technical risk’ and jump across anyway (if you thought there was any reasonable chance that you might make it)?

Instead you might decide to try and surprise the armed assailant with a karate chop (what is the ‘technical risk’ of karate chop v armed assailant?) … in other words, you mostly ignore ‘technical risk’ because the ‘absolute risk’ of failure is too great.

Equally, financially-speaking, ‘absolute risk’ is the only risk that really matters; it simply asks:

What is the risk that [insert preferred method of investing here] won’t be enough for me to make my financial goals i.e. my Number /Date?

If putting your money in a bank CD that earns 4.5% gets you to your financial goals, then that’s probably what you will/should do.

But, if it won’t what do you do?

It all depends on how important your financial goal really is, doesn’t it?

The Perpetual Money Machine begins to wind itself up!

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————–

I’m about to find out if I can make money on-line … read the latest installment (just posted) here!

————–

Your Perpetual Money Machine begins to wind itself up (in the case of selecting RE as your ‘income capacitor’) simply when the property portfolio that we discussed on Wednesday becomes cashflow positive …

… this is a critical point in time, because now we can exponentially accelerate the size of our pool of capacitors!

Now, we can take our 15%++ (continually growing as our income stream continues to grow) and ADD the excess cash spun off by our profitable property portfolio (assuming that we selected real-estate, as our ‘income capacitor’ i.e. storage device for money) …

…. this ALL goes into: new properties!

Now, Scott is building a whole bank of financial ‘income capacitors’ …but, for what purpose?

Aah, until the point in time that the income from these ‘capacitors’ is enough to replace Scott’s income from his inventions and movie royalties!

If you have been following the process, this can happen surprisingly quickly (5 to 10 years) IF the income stream that Scott is seeding with is large enough to purchase large ($1 million+ each) commercial properties.

If residential (incl. larger multi-family) you can expect it to take a little longer, as these tend to start more cashflow-negative, or grow too slowly.

At this point in time – assuming that the income-replacement is sufficient to satisfy Scott ‘forever’ (if not, keep working/building a few more years) – we have our Perpetual Money Machine!

You see, the real-estate will continue to grow, even if you no longer continue to ‘seed it’ with more income … in fact, it will grow (on average) at least according to inflation, producing an income that also at least grows with inflation (even allowing for keeping 25% aside as a buffer against repairs/maintenance/vacancies/etc.).

Scott can spend that entire income with impunity, knowing that his capital is never at risk … just like cash in the bank, only better because the capital also grows (at least) with inflation …. provided that your outlook is long enough.

On the other hand, if Scott chose to put his money into Berkshire Hathaway stocks, instead of the real-estate portfolio that we discussed here, which have grown at 21% compound for the past 20+ years (although, not even Warren Buffett suggests that that rate of growth will continue), then Scott can simply sell down enough stock each year to fund the next year’s income.

Different tool, hopefully a similar result …

In either case, when Scott’s royalty income stops, his Perpetual Money Machine seamlessly and automatically takes over.

Nice for some 😉

PS The mechanical/electronic Perpetual Motion Machine is impossible in physics (although, quantum mechanics may provide a solution) … the one depicted in the image above was built in 1996 and resides in a vault in a Norwegian gallery: it once ran as long as 14-days in a row without stopping … hardly ‘perpetual’ but pretty, damn good!

Who ever said that you need to be smart to be rich?

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If you didn’t think so before, then this really objective 😉 ‘quiz show’ will prove otherwise …

… not sure, though, what Michael Moore has against the ‘rich’:

1. Who else is going to fund all those charities that help the poor and underprivileged?

2. Who else is going to pay all those taxes support the rest of the nation?

3. Who else is going to provide jobs for the ‘working class’?

4. Who else is going to have time to watch his dumb videos (the rest of America is too busy working)?