Wednesday, September 4, 2013

Nuts and Bolts of the Joe Dominquez Investment Strategy are Still Valid

Joe Dominguez
The book that has made the biggest impact in the way I think about money is "Your Money or Your Life : 9 steps to transforming your relationship with money and achieving financial independence" (a.k.a. YMOYL) by Joe Dominquez and Vicki Robin. Although I didn't follow all of the 9 steps as meticulously as described in the book, the lessons did stick. Well, maybe with the exception of the last step, managing your finances. Basically, Joe Dominguez suggested keeping a six month reserve of cash and investing the remainder in long term government bonds. There's more to it than that but perhaps that chapter created so much dissent in the retirement forums, book reviews and opinions expressed by financial planners that when the book was revised and updated in 2007 that final chapter was mostly rewritten. Was this a good move? In my opinion, no. What separated YMOYL from other books on investing or personal finance or retirement or personal growth or self help (YMOYL was all of these) was the concept of going all in on government bonds. I must admit that until recently I thought that putting all your eggs in one asset class, especially treasuries, was not a great idea but the more I studied retirement planning, it became clear to me that this is what made YMOYL stand apart from other authors who claim to show you the most secure path to financial independence. If you want to read, or re-read YMOYL I suggest finding a copy before the 2007 revision. At the very least, skip chapter 9 and read that chapter from original version, fortunately is it archived online. If you'd like to get a bit more personal with Joe you can hear him lecture on the audio series that preceded the book, "Transforming Your Relationship With Money" which is still available. The audio series are recordings from Joe's lectures that preceded the book, the message is presented differently than the book and works well on its own.

A while back I wrote a multi-part article on investment lessons for one of my nephews and although I recommended YMOYL, I don't think Joe would have approved of the advice I was offering. As unconventional as his methods may seem at first, he had some very compelling reasons to do what he did and to suggest that the reader do the same.

Before getting into to it, a disclaimer. Nothing in this blog is to be construed as investment advice.

Joe Dominguez died on January 11, 1997 at age 58 which is coincidentally the same age that I am today. Joe quit his job and never returned to work, at least not for money, when he was only 31 years old. Obviously Joe knew a lot more about investing than I do and probably a hell of a lot more than most retirement experts. He worked as a stock analyst until 1969 saving $100,000 that provided him with a steady income of $6,000 per year. There are reports about how Joe lived an extremely frugal lifestyle yet gave away a small fortune to charities. At the time of his death his nest egg had grown to more than that original amount though I could not confirm his final balance. All this despite having major medical expenses on cancer treatment towards the end of his life.

Many people reading the original YMOYL would think that what Joe accomplished in 1969 was unique to that era and funding your retirement these days requires exposure to equities and a risk managed approach to investing. I disagree.

How much is enough?

When the book was published in 1992 and I was single I could get along just fine on $20,000 a year, now that I'm married and have a more upscale lifestyle (two can't really live as cheaply as one) let's double it up to $40,000 per year. Mind you this is a big downsize considering that this is closer to my yearly tax bill rather than my current salary.

I got these figures using the steps outlined in YMOYL, not the advice given by retirement experts saying you'll need 70% of your pre-retirement income. The figures are based on my somewhat frugal lifestyle and are pretty close to my actual expenses while I'm still working. For more on frugality as defined by Joe refer to chapter 6 of the original YMOYL archived online.

Who are you going to trust?

If I were to ask a retirement expert for advice the expert would most likely run a few calculations and recommend that I invest $1 million in a balanced portfolio made up of a balance of stock and bond index mutual funds or electronic transfer funds (ETF's) along with an annuity for good measure in order to withdraw 4% annually and increase my withdrawal in subsequent years by the Cost of Living Index (CPI) in order to keep up with inflation. This plan should give me a steady cash flow for the next 30 years or until I'm dead, whichever comes first. If you have researched retirement planning this will sound very familiar to you.

Joe doesn't recommend going to a financial planner or a stock broker or to buy mutual funds. To quote Joe directly:
Step 9 is about empowering yourself to make wise financial choices, and your first lesson involves educating yourself so as not to fall prey to unscrupulous brokers, financial planners and salespeople who want to put you into all manner of investment vehicles that pay them handsome commissions.
He also doesn't suggest you try to figure out what the next hot investment will be or to listen to economists:

There is an old saying, "If you get ten economists together, you will get fifteen different opinions."

The more I think about it the more it seems that Joe was one of the few people making sense of the confusing world of personal finance. When the book was revised the book's original co-author, Vicki Robins along with her new collaborator, Monique Tilford, sought out advice from Mark Zaifman, a fee-only financial planner (his company is, Tom Trimbath, a stock trader (author of Dream. Invest. Live.) and others that were probably more knowledgeable in the products and services that they were selling rather than the philosophy behind Joe's investing strategy.

Here are Joe's words:
One of our primary missions in this book is empowerment-allowing you to take back the power that you have inadvertently given over to money. As we will see later, this includes the power you have turned over to various financial "experts" to external circumstances and to financial beliefs and concepts.
Becoming "knowledgeable and sophisticated" does mean learning enough so that you can free yourself from the fear and confusion (or pride and prejudice) that pervade the realm of personal investments. The principles and financial strategies outlined in this chapter are safe, sensible and simple. They are also very inexpensive to implement and do not require extensive financial management or expertise.
Compare that to this passage in the revised edition:
However, there are independent financial consultants who work for a fee, not for commissions on products. Be sure to hire a "fee only" consultant. This is the only way you can be sure that your advisor will never benefit financially from any of the specific investments she/he recommends to you. (You can find a list of them at Also, try to find a consultant that supports the principles in this book. Otherwise, your planner is likely to recommend higher-risk investments that are not in alignment with a typical FIer's* investment objectives.
* FI can mean Financial Integrity, Financial Intelligence or Financial Independence something that was disambiguated in the revised edition by using FI1, FI2 and FI3, though I find it more confusing than helpful.

According to Joe, his methods are safe, sensible, simple and free from fear and confusion. So why seek out an advisor that will charge you a fee and will most certainly instill some fear, add risk, confusion and throw in a little greed--after all if the advisor can't get you a better return than Joe, what's the point in hiring an advisor?

In my opinion a better update to the last chapter would have been to tell the reader to forgo advisers and brokerage firms altogether and simply open an online account with Treasury Direct where you can buy treasury notes bills and bonds in denominations as low as $100 without paying any fees whatsoever. There's quite a few choices at Treasury Direct including I Bonds and Treasury Inflation-Protected Securities (TIPS) for those who fear inflation but Joe's favorite would probably be the longest term (30 year) bonds.

Is investing in treasuries still a viable option?

If I would have invested in long term bonds when I first started saving and kept at it I would have caught the record high yields of the 80's, peaking out at over 15%, and the average return of my portfolio would be in the vicinity of 7%. The value of the bonds rise as interest rates fall (and vice versa) so most of the older high yield bonds would be worth more than their face value. This didn't matter to Joe because he recommended holding them to maturity, though this is something even he admits that he hasn't always followed.

Sure, that's all well and good but bond yields are low and what if they drop even lower? Let's go to the extreme and say that I don't trust the government so I stuffed that $1 million into my mattress. According to Joe, "mattresses produce income for only a small part of the population" and in fact the best I can do is to draw that $40,000 per year for 25 years without any cost of living increases or just under 19 years with 3% yearly increases at which point it will be depleted. Mind you this mattress strategy will cannibalize the investment, a.k.a. capital, but then again that's what you do with a portfolio of stock and bond mutual funds. The only upside to the mattress method over collecting interest is that I won't have to pay income taxes. Think about it though, provided that I don't tell anyone that I've got $1 million in my mattress, there isn't much risk. Though this isn't something any sane person would do, how terrible can it be? In my case I would only need to fully rely on my mattress money for the next 12 years until I am obligated to apply for Social Security at age 70 and receive monthly checks, with yearly cost of living increases, for the rest of my life. In addition I'll be receiving a pension from work. Include my wife's benefits into the equation and that's two Social Security and pension payments that will amount to substantially more than $40,000 per year. So I should be doing fine even after my mattress money is spent and that's without any interest. Treasuries pay interest, maybe it isn't much right now but at least it is more than the mattress.

Alas, I don't hold any treasury bonds and I'm not a young lad that might be able to catch the next rise in interest rates. As I write this the yield on 30 year treasury bonds are at 3.7% so if I drop that entire $1 million nest egg the financial advisor told me I needed on long term bonds I would be getting $37,000 per year in interest payments albeit without cost of living increases but with a government guarantee and I'll get the $1 million that I invested back when I'm 88 years old. The hit is only 0.3% less than the 4% quoted by the advisor. Investing in treasury bonds would most likely make up this difference because U.S. treasuries are exempt from state and local income taxes while other investments may not be as tax efficient. Now a government guarantee might not seem very secure these days, but ask people who have lost money in the stock market or real estate what a guarantee of getting back their original investment is worth.

What about inflation?

Sure, we've all heard stories of how Social Security will go bust, the government will default on its debt and inflation will take what's left of your pension and savings but how likely is that, really? The first two haven't happened yet so let's look at inflation.

Joe believed that our fears of inflation were inflated. Indeed he made it through years of double digit inflation. The most common measure of inflation is the Consumer Price Index (CPI) which is a list of items weighted by consumer preference. According to Joe the CPI isn't a cost of living index. You don't buy a refrigerator every year and if cold weather makes the price of orange juice skyrocket while simultaneously a bumper crop of apples makes the price of apple juice plummet a financially intelligent shopper switches to apple juice.

He listed the 1970 prices of several items that have remained the same or even decreased by 1990. Now in 2013 several of his examples are still valid. In his example of a family of 4 going to a movie was $15 to $20 in 1970 while in 1990 it was only $4 including the drive, popcorn and soda, I suppose he was referring to being able to rent a video in the 90's. Today a Netflix or similar subscription is only $8 per month and you don't need to drive, the trimmings can be bought at a discount and practically every night can be a movie night. When I was in the Navy in the 70's I had a Volkswagen fastback that cost $5 to fill up for a week of driving around San Diego. Now I use a Vespa to get around the neighborhood where I work and can get everything I need in a smaller geographic area. Though gas prices seemed high in the '70's they are much higher now yet I can fill the tiny Vespa tank for about $5 and it lasts me nearly a month. Joe's usual lunch in the '70's costs around $2 while his '90's lunch was only $.60. He didn't elaborate on what was on his menu but I sometimes buy a 10 pound bag of potatoes for $2 which lasts me over a week, I simply microwave them at work so I don't even spend anything to cook them. If you fancy something more interesting Ellen Jaffe Jones wrote a recipe book titled "Eat Vegan on $4 a Day" and Dr. McDougall claims that you can get by fine on just $3 per day.

I've read studies that show as people get older they tend to spend less. They must have studied healthy old people because medical expenses have most definitely increased. According to Joe you can lower your medical costs with proper lifestyle choices. Indeed one of the top causes of death today is misuse of prescription drugs so avoiding doctors as much as possible might even increase your longevity.

It may seem that Joe was recommending not to factor in inflation but that's not really the case. He did make a point not to fear inflation but one of his mantras was "enough and then some." By living below his means, even on interest payments alone, he was able to keep buying treasury bonds and increase his income. Going back to my example of needing $40,000 per year income, Joe's method  at determining the Crossover Point to financial independence was to base it on your total expenses while working. In another step he had you ask, "How might this expenditure change if I didn’t have to work for a living?" So if I could raise my investments to $1,081,081 to make my goal income with a 3.7% bond yield but really end up getting by just fine on $37,000, the $3,000 surplus is invested back into bonds and provided I can keep living below my income the surplus will continue to compound and the investment income will increase every year.

So that's all there is to it, just put all your money in treasury bonds?

There's more to it than that. Joe recommends having at least a 6 month cash reserve put aside for emergencies. He recommends the following criteria to whatever you do with your capital:
1. Your capital must produce income.
2. Your capital must be absolutely safe.
3. Your capital must be in a totally liquid investment. You must be able to convert it into cash at a moment’s notice, to handle emergencies.
4. Your capital must not be diminished at the time of investment by unnecessary commissions, “loads,” “promotional” or “distribution” expenses (often called “12b-1 fees”), management fees or expense fees.
5. Your income must be absolutely safe.
6. Your income must not fluctuate. You must know exactly what your income will be next month, next year and twenty years from now.
7. Your income must be payable to you, in cash, at regular intervals; it must not be accrued, deferred, automatically reinvested, etc. You want complete control.
8. Your income must not be diminished by charges, management fees, redemption fees, etc.
9. The investment must produce this regular, fixed, known income without any further involvement or expense on your part. It must not require maintenance, management, geographic presence or attention due to “acts of God.”
If Joe is right does that mean that the financial experts are wrong?

There are lots of people claiming to be experts though most are just adding to the noise. I wanted to find out what the "real" experts were discussing. When I did my research I looked up scholarly papers and what I found was very scary.

In their paper, "The 4% Rule is Not Safe in a Low-Yield World," authors Michael Finke, Ph.D., CFP®, Wade D. Pfau, Ph.D., CFA and David M. Blanchett, CFA, CFP® claimed that withdrawing 4% from a typical balanced stock/bond investment portfolio is too optimistic. Considering that the 4% rule was a worse case scenario that has gone through exhaustive regression tests, that's a grim outlook.

Books on investing have almost universally pointed out that stocks have always outperformed bonds in the long run and nobody can predict the future. That isn't quite true. Long term treasury bonds were the best investment during the several years of the Great Depression and most recently they have once again outperformed stocks. Low interest rates and a stagnant stock market can last for decades like what happened in Japan since the 1990's. As far as predicting the stock market's future, it is possible to look 10 years forward with a fair amount of certainty. In the paper, "Can We Predict the Sustainable Withdrawal Rate for New Retirees?" Wade Donald Pfau of the National Graduate Institute for Policy Studies (GRIPS) presented a formula that predicted the Maximum Sustainable Withdrawal Rates (MWR) and back tested it to 1883. The following graph not only shows you how closely it tracked the actual MWR, but it shows a frighting prediction of where we're headed. That 60% stock, 40% bond balanced portfolio will have a predicted MWR of less than 2%. In addition, the pessimistic side of the 96% Confidence Interval hit bottom so it could be much worse.

Of course there are some studies that show a more cheerful future but even at today's 3.7% long term treasury rates, a relatively comfortable and worry free retirement is possible using Joe's treasury bond investment strategy.

What will I do?

I'm not really sure but reading the latest studies and re-reading the original YMOYL is a good start.

Thursday, July 21, 2011

Investment Lesson #7 - Creating a Lifelong Income

It has been a while since I finished blogging my series of investment lessons but perhaps the most important lesson was missing. One of the goals of investing is so that you won't run out of money. Ideally, your investments will someday provide you with a lifelong income.

A few weeks ago I took an extension class at UCLA called, "Your Transition to Retirement: Creating a Lifelong Income" taught by Paul Heising, MBA, CFP. Here's the course description from the catalog:
This course is ideal for those who are recently retired and those concerned financially about whether or not they will be able to retire some day. Unlike other retirement planning courses that focus solely on the accumulation of assets, this course also covers the transition from accumulation to the distribution phase and identifies critical financial strategies so you don't outlive your money. Key planning areas covered include identifying the most common mistakes that retirees make and how to avoid them, determining the income you will need in retirement and where it will come from, a review of withdrawal rate strategies based on recent academia studies, and creating a lifelong income so you won't outlive your money. Participants leave the class with a clearer understanding of how to analyze their options and successfully manage their own transition from accumulation to distribution. This course also includes many examples of real life retirement and investment situations.
There were only about eight of us enrolled, which illustrates just how shamefully ignorant most people choose to remain about their future. Did I learn anything? Yes, lots. Would I make any changes to the investment lessons I already published? Not really--there is a big difference between the accumulating stages of investing which I covered in these lessons and drawing an income from your investments.

It would take much more than a single blog post to cover everything that was discussed in class so I'll just hit on some of the highlights that I found interesting.

The most common mistakes people make when it comes to retirement planning:
  1. Underestimating how long you will live in retirement.
  2. Not recognizing the impact of inflation on reducing your purchasing power.
  3. Investing too conservatively relative to your income needs.
  4. Excess withdrawal rates and point-in-time risk.
  5. Not understanding tax planning and how it can be a benefit.
  6. Overlooking health care issues and costs.
  7. Not understanding the importance of estate planning.
It seems that the general thinking among the people that I know is to work until forced to retire somewhere around 65 years old and then social security or the company pension will take care of them. Basically, these are just excuses for not saving or planning for retirement. Then there are the all too common stories of people working well into their golden years then dying a few years after retiring. If you have the discipline to start saving and investing early in your working years, there's no need to put off retirement until the government or your employer tells you that it is time.

So how do you plan for retirement? First of all plan to be retired for a long time. There are charts and tables drawn created by actuaries that show statistics like two thirds of all humans who have reached the age of 65 are alive today and if you are a 65 year old female your life expectancy is 85 but a woman who is 85 today will likely live to over 92. No one knows how long they will live and most of us don't really want to think about it too much but to be on the safe side, plan on living 7 years or more beyond your life expectancy. Even if you wait until 65 to retire, we're talking about spending 30 years in retirement. Considering early retirement? Plan for 40, 50 years in retirement or even longer.

As you age your money will be worth less because of inflation. The rate of inflation varies from year to year. I remember some years where we had double digit inflation and people bought things now because they knew that the price would only go up if they waited. Annualized from 1914 through today inflation grew at a rate of 3.29%. Using the Rule of 72 that means that the cost of living doubled every 21.88 years.

Investments should stay ahead of inflation and this brings up the subject of real rate of return. Historical rates of return for an all stock portfolio average out to 10.3% per year, intermediate treasury bonds have returned 5.1% and a blend would of course be somewhere between the two. However, inflation eats away at the earning power of the portfolio so stocks real rate of return drops to 6.8% and treasury bonds to 1.75%.

It would make sense to try and maximize your return within your risk comfort zone but many people tend to invest for retirement too conservatively. Not only is it difficult to accumulate enough to retire, the funds will run out quickly. The consequences are outliving your money, having to reduce your spending, return to the workforce or trying to make up for it by taking on more investment risk during retirement than is prudent.

That brings up the point of excessive withdrawal rates and point-in-time risk. Ideally your withdrawal rate will be enough to cover your lifestyle, keep up with inflation and either run out when you die or maybe leave a little something for your heirs. Point-in-time risk can't be predetermined unless you know which direction and how far stocks and bonds will be going in the future, in other words you will only know you retired at the wrong time when you run out of money! Let's say your investments drop 50% as has happened many times in history. Your portfolio would have to gain 100% just to get back the where you started but let's say you decide to take a 4% withdrawal rate, which is pretty standard, you'll need a 132% increase to recover.

At this point the prospect of ever retiring may seem pretty slim, but using computer modeling and historical stock market returns an initial investment in 1972 of $200,000 in an all stock portfolio with an initial withdrawal rate of 7% and adjusted to keep up with 3% inflation would last over 30 years. The initial withdrawal would start at $14,000 and by 2005 the annual withdrawal would increase to $37,133 and the total withdrawals for the life of the investment added up to $838,405. What did this portfolio in was the dot-com bust of 2001, a bear market which it never recovered from. Reducing the withdrawal rate from 7% to 5% and keeping up with 3% cost of living increases on the same $200,000 all stock portfolio would start you out with $10,000 (in 1972) and by 2011 you would be taking out $30,748 per year and still have plenty left over. In fact despite the 35 years of withdrawals the portfolio would have grown to $2,448,813 in 2011.

It would seem that the answer to maintaining a life-long income is to invest only in stocks and don't be greedy with the withdrawals but it isn't that easy. Starting a withdrawal plan right at the beginning of a long and deep bear market is risky. How much risk are you willing to take? You won't really know until your portfolio is down 50%, 75% or even 90% as has happened in past bear markets. It is difficult to stomach these declines and stay fully invested. Many investors panic and sell right at the bottom, their portfolios never recovering. A way of smoothing out the bumps of the stock market is by adding bonds to the portfolio. A stock/bond portfolio mix is a bit more difficult to model but assuming that the bond portion of the portfolio earns a fixed rate of 4%, a 60/40 stock/bond mix of $200,000 starting in 1972 with a 5% withdrawal rate and 3% annual cost of living increase would not be drained by 2011. The portfolio would still have $309,267 left over, much less than the all stock portfolio but with a lot less fluctuation in value. In addition, in order to keep the portfolio balanced you will be withdrawing from the portion of the portfolio that is performing the best for that year. For example, in a stock bear market you'll draw from the bond portion. If the stock portion drops significantly then funds should be transferred from the bond portion to the stock portion to keep the target stock/bond mix. This will automatically force you to buy low and sell high, which is exactly what you want to do.

Another factor to throw into the problem is taxes. Stocks and bonds will pay out taxable dividends. You will be taxed on these dividends even if you don't withdraw them so it would make sense to shelter as much of that income from taxes as possible. In addition, if you have a choice of adding to a tax free or tax differed account like an IRA or 401K, it is probably a good idea, especially for the bond portion of your investments. Exactly how to figure out what works best is beyond the scope of these basic investing lessons but I will say that I have converted all of the retirement accounts that I had control over into a single Roth IRA. I've also got a pension from the trade union I belong to and of course there is Social Security but I don't have any say so over how that money is invested. In fact, I don't even factor those funds into my retirement equations because there's no guarantee that there will be anything left by the time I'm eligible.

Right now my biggest obstacle for taking an early retirement is health care. It isn't that my wife and I have any serious health issues, it is because insurance is very expensive in the U.S. and being under covered can be very risky to our finances. In fact it is the main reason that I continue working--to collect my union health benefits. Although we covered several options in the class, none of them seem as cost effective as putting in just enough hours to qualify for a good group health plan. Until, that is, Medicare eligibility kicks in. Again, this subject is a bit beyond these investing lessons.

Finally, estate planning. Ideally, your investments run out right at the time of your death but if that's not the case it is much better to have some left over instead of the other way around. If you want to leave anything to your heirs you'd better look into drafting up a will and possibly moving some major assets like your home into a trust. Like the last few points covered, this is also beyond these investment lessons but it is worth mentioning in case your investments outlive you.

Is it possible to invest enough to eventually live comfortably or are we commended to working the rest of our lives? It depends on your definition of living comfortably. Some people work only a few years and retire in their 40's or even their 30's, others struggle until they are forced out of the workforce in their 60's and 70's with no savings. Someone who learns basic principals of investing and puts them into practice should be able to accumulate enough investments that will provide enough of an income to live off of the investments for a lifetime.

Just to make sure I got the concepts of creating a lifelong income, I created a few spreadsheets and experimented with some what-if situations. Although taking a larger percentage along with a bigger risk of say 7% from a 100% stock portfolio, if the stock market doesn't cooperate and you fall into the trap of a bear market early in your retirement there is a good chance of running out of money. Your chances of avoiding lots of anxiety by living frugally and drawing between 3% to 4% of a balanced portfolio. How you balance it of course is very individual but let's say that if the portfolio is made up of 50% stocks and 50% bonds, deciding whether to draw from the stock or bond portion of the portfolio becomes very easy. There's no need to constantly re-balance. Simply draw from stocks when they outpace the bond portion of the portfolio and from bonds in the years they outpace stocks.

Overall the lesson learned from the UCLA class was that not only it is possible to fund your own retirement but with the current state of Social Security, company and union pension plans, it is probably the only way to guarantee a lifelong income. Note that the goal of investing isn't to be able to live a luxurious lifestyle. In fact living frugally not only helps when you're saving for retirement, it is imperative in order to create a lifelong income.

Wednesday, December 15, 2010

Investment Lesson #6 - Asset Allocation

Asset allocation is simply how much of your money you split into stock, bonds, real estate and other investments. You've probably heard the old saying, "Don't put all your eggs in one basket." In the financial world that usually refers to diversification as a means of reducing risk. However, there's a flip side to this, "Put all your eggs in one basket and--watch that basket." The meaning of this is that someone who concentrates his efforts in one area is more likely to succeed.

So which is best for you? It depends. Let's start by taking a wider view of asset allocation, a much wider view.

In the big picture, everything available to you, both tangible and intangible, are assets. A nice smile, a bicycle, money and time are all examples of assets. The opposite of assets are liabilities, these are things that hold you back. The most obvious example of a liability would be debt, but it could also be a pimple on your face or a lack of time. We all have a mix of assets and liabilities. That nice smile could overpower the pimple on your face and a strong will could overcome a severe handicap. Likewise as you have learned in lesson #2, if you have a long time frame to invest in, it could offset not having much money due to the power of compounded return on investment.

Sometimes an asset could turn into a liability. For example, owning stocks during a bear market or holding long term low yield bonds while interest rates are rising. But what if you owned both stocks and bonds?

Over the long term both stocks and bonds have given investors positive returns. However, they don't always move up and down in value at the same time. In fact there are times when they move in opposite directions. Having a mix of stocks and bonds is known as a low-correlation investment mix and this is generally what financial managers recommend in order to minimize risk.

What is the ideal mix of stocks and bonds and for that matter, which stocks and bonds work best for this method of asset allocation? I would recommend something that closely resembles the "Couch Potato Portfolio" in Paul B. Farrell's book, The Lazy Person's Guide to Investing. Farrell's portfolio is a 50-50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Total Bond Market Index Fund (VBMFX), I substituted the Vanguard Total Stock Market Index Fund for the 500 Index Fund because I wanted to have greater diversification in the stock portion of the portfolio. This asset allocation has served me well during the crash of 2008 when stocks plummeted and the subsequent interest rate cuts by the government to restart the economy boosted the value of bonds. Although the target 50-50 ratio got out of whack at times, I didn't have to exchange shares to rebalance. I simply kept up my regular monthly investments and bought into whichever fund was lower at the time in order to get the mix back to 50-50. The advantages to this are, and I quote from the book:
  • No complicated accounts.
  • No diligent reading of the financial press.
  • No phone calls from brokers with "opportunities."
  • No meetings with investment advisers demonstrating their constant supervision of accounts.
  • Very simple tax returns.
So that's it. This is all you need to know about investing and asset allocation. If you skipped all the other lessons and heed the advice of these last few paragraphs, you'll probably be a successful investor practicing not only the advice of, "Don't put all your eggs in one basket," but also allocating as little of that valuable asset, time, to managing your investments.

Of course you could change the mix depending on your age and your risk tolerance. Generally, younger people have a longer investment horizon (the horizon generally referring to retirement) and want their investment to grow in value while older folks usually prefer a steady income stream from their investments. Jack Bogle, the founder of The Vanguard Group, suggests holding a mix of stock and bond funds equal to your age--in bonds. In other words a 20 year old would own 20% bonds and 80% stocks while an 80 year old would own 80% bonds and 20% stocks. The 50-50 split worked fine for me but then again I'm in my 50's.

Now let's put all our eggs in one basket.

If you take a look at the richest people, the very top few, you'll find that most of these people are wealthy because of one thing, one business with one main product or service, they are specialists. Each empire might be made of computer software or manufacturing or communications or real estate or even royalty but most every ultra-rich person has made their money in a single field. Unless they have inherited their wealth and are living off of a trust fund, these very wealthy are pretty much fully invested in their one thing.

I have seen first hand how a couple of very wealthy individuals work, Steve Jobs and Jeffrey Katzenberg. I can't say that I've gotten very close to either of them or that I'm much of an expert on their lives and working methods. What I can tell you is that these two remarkable men work much harder and are more focused on their work than I or anyone else that I have met.

I can't give much advice into what single investment is going to work best for you. Whatever you do choose, you had better know it well.

Though I usually prefer to keep a mix of stocks bonds and real estate right now most of my money is in real estate. As I write these words real estate prices are down which make it a good buying opportunity. I can't say if the housing market hit bottom yet but the prices of a condo on the beach have come down to a point where we don't have to look to Mexico for something that we can afford. We found something just a few miles away so we're buying it. I made it a point in the real estate investment lesson that it isn't an investment until you rent it or sell it, we'll be renting out this one. In a few years when the housing market hopefully recovers we plan to sell our house and move into the beach condo or perhaps sell the condo if we decide we're not cut out for beach living. In order to make this deal I had to cash out our non-retirement stock and bond funds. I didn't take out a mortgage this time. Even with today's low interest rates, the last thing I wanted to do was to get myself into debt.

Am I crazy to do this? Like the saying goes, "hindsight is 20/20," so ask me in a few years. Interest rates have been at historic lows for the past couple of years and at some point it will most likely start moving up. This makes bonds unattractive and holding long term bonds very risky. Stocks will most likely continue their long term upward trend but like always, it will be a bumpy ride. I recently traded the Vanguard Total Bond Market Index Fund that I held in my Individual Retirement Account for the Total Stock Market Index Fund.

Working out your own asset allocation strategy is highly personal. It really depends on your tolerance for risk, your perception of investment conditions, the amount of time you can devote to studying your investments and it is also dependent on your tax situation. Earlier I mentioned that I held the bond funds in my retirement accounts. Assuming that I will be holding onto my IRA's for several years before making withdrawals it might seem at first that stock funds would be a better choice. It isn't, at least not if you are holding a mix of stock and bond funds. The reason is because of tax efficiency. Bonds generate income and that income is taxable. Most of the gains in stocks and real estate come from growth, also known as capital gains. Those type of gains aren't taxed until the asset is sold.

Although you can get by fine and be a successful investor with a very simple asset plan, the study of asset allocation, also known as modern portfolio theory, can be very complicated.

From Wikipedia:
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.
I first learned about about "behavioral economics" just a few days ago. In a way, it neatly sums up these investment lessons.

Again, from Wikipedia:

Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns and the resource allocation. The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.

Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest.

Investing has as much to do with our psyche as it does with interest rates and return on investment. Before you spend another dollar, consider your choices. Do you really need to buy that new toy or would it be better to pay down your debt? Can you picture yourself free to choose how you spend your time or are you going to be stuck in a job where you don't have this choice.

Let's end these investment lessons with one final quote. This is a definition of money that has profoundly changed the way that I think about my own personal finances:
"Money is something we choose to trade our life energy for....This definition of money gives us significant information. Our life energy is more real in our actual experience than money. You can even say money equals our life energy. So, while money has no intrinsic reality, our life energy does--at least to us. It's tangible and it's finite. Life energy is all we have. It is precious because it is limited and irretrievable and because our choices about how we use it express the meaning and purpose of our time here on earth."

--Your Money or Your Life,
Transforming Your Relationship with Money
and Achieving Financial Independence

by Joe Dominguez and Vicki Robin

Tuesday, December 14, 2010

Investment Lesson #5 - Other Investments

There are many other ways to invest besides stocks, bonds and real estate. Let's look at some that I've got experiences in and a few that I have never tried.

Start or Buy a Business

When you buy stock you are purchasing a tiny piece of a company, when you're Warren Buffet you buy enough stock to take control and can pick someone to manage the company. You can do that on a much smaller scale either by yourself or with a few partners but what often happens when you buy or start a business is that you end up running it. In fact you could say that you're buying yourself a job.

There are several ways to set up a business, basically it is going to be either a sole proprietor, partnership or corporation. I've had experience with sole proprietorship, it is the easiest to set up and corporation, which is the most difficult. A corporation is a legal entity. Why would you want to do this? Usually it is either to protect the owners from liability or to take advantage of some tax laws that favor corporations. Doctors and lawyers set up limited liability companies (LLC) to protect themselves against law suits. Several actors, directors, cinematographers and others who work in entertainment and make a substantial salary have set up corporations. When they are hired to do a job the studio actually makes a contract with the corporation. All payments go to the corporation without withholding taxes and the corporation is responsible for paying the taxes, insurance premiums and other details. The big advantage is that nearly all the expenses can be deducted including meals, all travel, tickets to sporting events, yachts and so on which are expenses that are normally not allowed to a sole proprietor or partnership. I formed a corporation for the job I had in Israel in order to take advantage of a tax treaty between the U.S. and Israel. It actually worked well for me until someone took over accounting and decided that I shouldn't be paid as a corporation but as a foreign worker who needed to pay Israeli income tax. I fought them on it and won that battle but only because I put in my notice to leave by then and they would have had a very hard time taking back 25% of what they already paid me.

I made a living in photography since I was in college in the early 70's until I got into motion pictures in 1992. A part of that time I had a studio and had to deal with all the details that go into running a legitimate business--business licenses, special taxes, hired help, accounting services, insurance, open accounts at the photo supply store and laboratory (this was before digital cameras) and of course doing all the running around to get the jobs, shoot and deliver to the clients. Then there was the big wait until the client pays the invoice. Most paid within 30-60 days, but sometimes it took longer, once I had a client that took over a year to pay. Having to pay for all of the costs of the job up front I often felt like I was giving interest free loans to my clients. One excuse I heard over and over was, "you'll get paid when I get paid." That didn't make sense because it wasn't their client that hired me. A few times I ended up filing lawsuits in order to collect what was owed to me. I even had a client go bankrupt and another move to another state without leaving a forwarding address. Obviously I didn't collect in those cases.

In order to grow a business you've got to feed it. This means that a portion of the profits have to go back into new equipment, advertising, supplies and possibly hiring workers. What happened to me was that the more successful I got, the less photography and more management I seemed to do. I knew some photographers who specialized in location work, mostly for clients like Life magazine, Sports Illustrated, Fortune and other well known publications so I asked them how they ran their business. To my surprise, none of them had business licenses or paid business taxes, they were pretty much "flying under the radar." Why were they able to get away with it? Exposure, and I don't mean like in photography, I mean that because I was renting a business location I was an easy target for the taxing authorities while these other photographers were working from their homes but being contracted in different cities, shooting in various location and were generally difficult to track down. What's the lesson in this? For me it was that business laws are sort of a gray area so instead of doing everything "by the book" just do your thing and figure it out as you go along. In addition, it turns out that to be successful you don't really need lots of equipment or even a place of business--you need clients and you need the means to deliver what your clients need.

If you're considering buying or creating businesses as an investment so that you can eventually retire, you need to find something that will be able to sustain itself with a minimum of involvement. Many business owners are very hands-on and they can't stand the idea of handing over management decisions to someone else. To put it another way, investing in a business can consume your life.

Life Insurance

There's basically two types of life insurance, term and whole life. Term life insurance isn't really an investment, at least not for the person who is on the policy, because the only way to collect is to die. Whole life insurance can be defined as an investment because it accumulates a cash value that you can borrow against, use in case of emergency or possibly convert into an annuity to use in retirement. At first it may sound like a good deal, but returns on insurance policies are usually much lower than other investments because of the fees and commissions that are built into the policies. In addition, if you want an early out of the contract there are substantial penalties and fees.

Frankly, I wouldn't recommend getting whole life insurance to anyone and would only consider term insurance if they are the sole bread winner of the family or have lots of debts and don't want to pass that along to their heirs. The only life insurance that I have ever had were the ones that came as a part of a contract. When I was in the Navy my parents would have been awarded a very small sum if I would have died in the line of duty and right now Rosie is entitled to a tiny life insurance payout as a part of my union contract.

I mentioned annuity a little while ago, this is another insurance product. It is basically a retirement account. You can buy an annuity through a whole life insurance policy, a part of the premiums go to building up an annuity, or you can hand over a load of cash in exchange for a guaranteed income for life. Again, there are fees and commissions tied to annuities so their return usually isn't as good as managing an investment portfolio yourself but somehow the insurance companies have managed to influence tax laws in their favor. I'm not considering an annuity for ourselves right now but I can see how it could be comforting to know that no matter what happens to stocks, bonds or real estate, you have a guaranteed income that will last the rest of your life.

Gold and Precious Metals

There are several ways to invest in gold, silver, platinum and other precious metals. One way not to invest is through jewelery. Chains, rings and other such items have a small amount of precious metal in them and there are too many variables when it comes to assessing their value. An easy way to invest is through coins, but again there are other forces like numismatics value. Then there are gold bars or you can buy shares of a mining company or a mutual fund that invests in mining operations. I invested in a gold mutual fund once and found that it was very volatile, in other words, risky. What? Don't people often buy gold to avoid risk? Many people believe that it is a hedge against inflation and in times of world turmoil gold is a safe haven. Perhaps in extreme situations it is true, but I'm not sure it I would invest in precious metals. Even though gold is trading today at a very high $1,234.55 an ounce, according to some financial analysts' estimates it hit an inflation adjusted high in 1980 of $7,150.

Options and Futures

I'm lumping options and futures together because they are very closely related. We're getting into an area known as derivatives, which is basically something that has a value determined by something else. When you buy an option, or a futures contract, you're trying to predict the future price of a stock or commodity.

The history behind these investments goes way back to a story credited to Aristotle about Thales, a poor philosopher from Miletus.
Thales invented a "financial device, which involves a principle of universal application." Thales attempted to predict the quality of the olive harvest in the fall. Based on his estimate of a good harvest, he contracted with local olive-press owners to buy exclusive use of their olive presses when the harvest was ready.
Thales bought low because no one else pretended to guess on the quality of the harvest. The olive-press owners, being human, wanted money now rather than later, so they hedged against the possibility of a poor yield. The quality of the crop was irrelevant, because at harvest, presses are always needed.
Thales owned the rights on all of them, and he rented them at rates he set, which made him rich.
The most popular futures market is the Chicago Board of Trade (CBOT), established in 1848, but it wasn't the first. The Dojima Rice Exchange was in operation since 1710 in Japan and the Shoguns were trading rice futures long before that.

Here's how it works--futures trading in the U.S. started with wheat so I'll use that for the example. A farmer wants to know how much wheat to plant so he gets a contract from a buyer. The contract helps the farmer determine not only how much to plant, but it states an agreed price and the date of delivery for his harvest. The farmer can now use that contract as collateral on a loan to buy seeds, fertilizer, equipment or whatever else he needs to meet his obligation. This is known as a futures contract.

Options are a bit different. The Chicago Board of Trade (CBOT) established the Chicago Board Options Exchange (CBOE) in 1973 though the use of options is a very old business practice. The difference between an option and a futures contract is that while a futures contract must be completed, the holder of an option has the right but not the obligation to engage in the transaction. For example, you think a certain stock is going to go up in price but instead of buying the stock you buy an option to buy the stock at a price lower than what you think it will go to on a certain date. If that stock goes higher than your option price, you can buy the stock at a discount and make a nice profit. You can also work this the other direction if you feel the price of the stock is going to fall. Something interesting about options is that most options expire worthless. That's right--most options are not exercised and no trade ever takes place. So what's the point? The few times that options are completed, lots of money can be made or in some cases a large loss can be avoided. In addition, options can be traded during the life of the option. The worse that can happen if the option expires worthless is that you loose the premium paid for the option. Some stock holders sell options on their holdings. Knowing that in most cases the options expire worthless, it could be a good way to make money on your holdings. However, if an option is exercised, the stock holder is obligated to complete the transaction and perhaps sell the stock at a discount to its current price.

Things can get very complicated very quickly in futures and options trading. In some cases it can keep your losses in check, in other cases it can be a highly leveraged investment that can make huge profits as well as force a trader into bankruptcy. Investments into derivatives are often taken on by hedge funds which are acknowledge by the Securities and Exchange Committee (S.E.C.) but not regulated by them.

I have never traded options or futures and doubt I ever will.

Though the futures market had a good reason to establish itself, I believe that once traders outside of the industry got involved the reason for its existence was distorted and now commodities prices are no longer driven by supply and demand but on speculation. In other words, much of the trading in commodities these days has nothing to do with a supplier and a buyer making a contract.

If you're interested in a short introduction to commodities, here's an excerpt from Understanding the Commodities Markets:

True agricultural businessmen, such as farmers or agricultural exporters use commodity contracts to hedge the price fluctuations of their products. Speculators, however, take advantage of price movements, and are not interested in the buying or selling of the actual commodity.

With careful use of options, I feel that it is possible to increase returns on stock investments and possibly avoid large losses. Here's an excerpt from Common Questions about Stock Options and Derivatives:

An option instrument and other similar derivatives can serve an important purpose in any investment plan. Believe it or not, using them often gives protection against risk rather than adding to it.

Still, it is a very advanced investment vehicle and not for the faint of heart.

Tax Liens

When local governments can't collect property taxes they sometimes sell the tax liens to investors. You might compare tax liens to high yield "junk" bond with a very important difference, in case of default you are entitled to foreclose on the property so the risk is minimal. Some real estate investors have bought property at huge discounts using tax liens. However, the majority of tax liens are redeemed before the property is foreclosed.

I looked into tax liens but never got into it. I found that it take much more effort than stock and bond investing. In fact there are agents that will help investors find and purchase tax liens, for a fee of course.

Art and Collectibles

Some people have made a fortune collecting things. Of course it takes a special appreciation and knowledge to become a successful collector. Collecting is a rather esoteric investment compared to other options and assessing works of art is still very subjective compared to how stocks and bonds are priced. It seems to me that the most successful collectors took it up as a hobby, those who enter this field with the intent of making a profit are at a disadvantage unless they are very well informed.

We've got a few works of original art but only for our own enjoyment, they are not for sale. Of course if someone walks in and offers a boatload of money for something that's hanging on our wall we'd certainly consider it!

Ponzi Schemes

Okay, this isn't really an investment but so many people have fallen into this trap that it's worth mentioning. Ponzi schemes and its close relative, the Pyramid scheme, is when investors get their own money and money from new arrivals in the scheme as a payout. In other words, it may seem that you're getting a great return on your investment but in reality no investment is being made. You would think that the warnings signs to such a scam would be obvious but as the Bernie Madoff scandal has proven--it can go on for several years without detection and even the very wealthy can fall victim.

By the way, Social Security has often been compared to Ponzi schemes and the government has responded to this accusation. It's actually a very interesting argument!

Invest in Your Health

I'm putting this in because the leading causes of personal bankruptcies in the U.S. are due to medical debt. Sure you can buy health insurance, which is an expense and not an investment, but that doesn't really make you healthy. I might be stating the obvious so I'll just refer you to a famous quote:

There is this difference between those two temporal blessings, health and money: Money is the most envied, but the least enjoyed; health is the most enjoyed, but the least envied: and this superiority of the latter is still more obvious when we reflect that the poorest man would not part with health for money, but that the richest would gladly part with all their money for health. ~ Colton
Keeping to the subject of investing, let's see how health and investment are related.

It goes without saying that the less you need to spend the more you have to invest. I believe that keeping healthy is actually less expensive than leading an unhealthy lifestyle. I'll break it down into a few general categories--if you don't agree with me, that's fine, as long as you can rationalize your position.

I should emphasis that when I was in the service and then in college I prided myself at not being a picky eater and having a "lead belly" that could digest anything. My exercise was made up of various games or lifting weights in order to look good but I hadn't made the connection between exercise and health yet.

Then there's the old adage, "time is money." Well, the longer you live the more time you have for your money to grow and the more money you will eventually have. I should add, the more healthy years you have to live. Old people often are poor as a direct result of not being healthy.


The leading cause of death is heart disease. The heart is a muscle, so doesn't it make sense that the most import muscle to exercise is the heart? You might have great abs, biceps, deltoids but really, have you ever known anyone who dropped dead due to a weak bicep? In my personal research I've determined that there are a couple of different theories on what makes the best exercise, one is aerobic which is a moderate exercise level over an extended period of time and the other is anaerobic, high intensity exercise for short periods--no longer than 2 minutes. Aerobic exercise is for endurance, anaerobic for strength. Certainly both strength and endurance are important but if I only had the time for one, I'd exercise my heart for endurance. Of all the exercises that raises the heart rate to a beneficial aerobic zone, walking and running are the most easily accessible. I couldn't get Rosie to run and she doesn't like walking fast enough to raise her heart rate but I got her to walk up hills and that works for her. I found that running, when done properly, is an easy way to get my heart rate up. I also have no gym fees and require no special equipment, not even shoes are really needed so I have no exercise expenses.


So many people think of diet as something you do until you reach a weight goal then get off of it. That's dieting, I'm talking about diet as a life-long habit. If you don't believe diet has anything to do with money, check what I stumbled on in a Wikipedia article on diet:

A three-decade long study published in the British medical journal, The Lancet, found that Guatemalan men who had been well-fed soon after they were born earned almost 50% more in average salary than those who had not. The blind trial was performed by giving a high-nutrition supplement to some infants and a lower-nutrition supplement to others, with only the researchers knowing which infants received which supplements. The infants that received the high-nutrition supplement had higher average salaries as adults [3].

Hopefully the first thing your mom did for you when you were born was to feed you!

Shortly after my father died of liver cancer I attended a Sierra Club meeting where Dr. Michael Klaper who was a director of an organization called Earthsave gave a presentation on how our food choices affects the ecology. This group had a theory to solve many of the world's problems by promoting a vegetarian, or even better yet a vegan lifestyle. Dr. Klaper's arguments were very convincing and later I found out that Earthsave was started by John Robbins, who was in line to inherit the fortunes of the Baskin-Robbins ice cream fortune but he gave it up to promote a healthier lifestyle. I became mostly vegetarian and though I've been on and off the wagon so to speak, I really do feel much better when I abstain from eating animal products. At one point my cholesterol level shot up when I was working in Israel which I believe was due to work stress and the fact that Kosher restaurants are either dairy or meat and the dairy restaurants put cheese on almost everything, including watermelon! I was able to bring back my cholesterol to "normal" levels largely because I followed the dietary advice of John McDougall who advocates a starch based, vegan, diet. Here's a link to Dr. McDougall's official website, there's lots of interesting reading there.

Of course there are plenty of people that would vehemently try to discredit any benefits of a vegetarian diet. I've been pointed to several articles that come to the conclusion that not eating meat or dairy products are detrimental to your health. Every one of the studies used as reference in those articles were sponsored by the meat council, dairy council or some special interest group that promotes animal products. Yet there are many legitimate articles and scientific studies that have concluded that what we need is more more fresh fruit and vegetables in our diets.

As far as finances and diet--I found that a healthy vegan diet is much cheaper than a meat based diet. I emphasize healthy vegan diet because there's plenty of vegan junk foods available.

Dietary Supplements

If you have a healthy diet there's no need for dietary supplements. Of course the manufactures and distributors of supplements would argue against that statement but remember that their interest isn't in your best interest, it is for their financial gain. There has even been some pretty convincing studies that suggest dietary supplements are actually harmful. Dr. McDougall posted an interesting article on his website: Just To Be on the Safe Side: Don't Take Vitamins. Here's an excerpt.

Supplements Make People Sick
People believe in supplements, even though the preponderance of scientific evidence condemns taking isolated concentrated nutrients. Most carefully studied are the effects of beta-carotene, vitamin E (alpha-tocopherol), and folic acid. Randomized controlled trials involving more than a hundred thousand subjects have proven that taking these and other supplements increase a person’s risk of heart disease, cancers, and premature death. Damage to the kidneys in diabetics and an increase in the severity of respiratory infections have also been shown. Vitamin supplement manufacturers, stores selling vitamins, medical doctors, and dietitians should act responsibly and warn consumers about the serious health hazards from these highly profitable potions. For the same reasons, fortification of our food supply (cereals and flours) with folic acid and other nutrients should be stopped.

In my opinion products like whey protein powders fall into the category of food supplements. I haven't always felt this way, when I was growing up we were taught that scientists were working on the world hunger problems by isolating and packaging nutrients in concentrated form. I believed that some day our diet will consist entirely of highly processed foods--better living though chemistry!

The financial impact of not taking dietary supplements is saving money that would have otherwise gone to waste.


As humans we are social animals that are programed to have mostly monogamous relationships. Well, a lot of people would probably argue with that statement but for some strange reason we live in a society that frowns on having multiple simultaneous sexual partners so you're eventually going to have to pick just one. That's not something to take lightly, make the wrong choice and a costly divorce can set your investment goals back several years or worse, it can destroy you emotionally and financially. Some people would say that I waited far too long before I found a mate, but I don't regret it a bit. I found someone who had a successful career, someone who owned a house, had some savings and most important of all, didn't need anyone to depend on. In other words we didn't have a dependency issue. This is something that you don't normally find when you're young. In addition, it is best if you marry someone who is also a best friend, someone that perhaps won't always agree with you but will challenge you mentally. I'm never bored with my life partner! Though I have been the main bread winner in our relationship, Rosie does work and brings extra income to the household. In addition, she shares much of my frugality and desires to work less and spend more time simply enjoying life. The point I want to make here is that the choice you make for a life partner can improve your financial situation.


Just like we are hard-wired to seek out mates we are also programed to reproduce. However, I would be willing to bet that many people don't really plan on having children, they just "happen."

Couples have children because of religious reasons, pressure from parents wanting grand children or because their friends have children. Then there are people that believe that by keeping the family name going or spreading your DNA around this will somehow make you immortal. Do you really believe any of these are good reasons to procreate?

Don't get me wrong, I'm not totally against having children even though we did not have any children ourselves. However, like anything else that has a big impact on your life, you had better be damn sure you know what you're getting into.

The cost of raising a child can be quite high. According to a U.S. Government report:

WASHINGTON, June 18 (UPI) -- Raising a child from birth to age 17 cost middle-income parents $222,360 last year amid rising childcare and education expenses, the U.S. government reported.

Think about it, using these numbers raising four children to age 18 will cost an average of nearly $1-million. The report goes on to state: "annual expenses ranged from $11,650 to $13,530 a year, depending on the child's age." I think this is highly under estimated, when one of our nephews was living with us we spent far more than that. In addition, expenses tend to continue after age 17. How many people do you know that have graduated college and yet are continuing to sponge off their parents? And who paid all of those college expenses? Helped with the down payment on the first house? The expenses go on and on and usually up and up.

I have friends tell me that they could not do what I'm doing, retiring early, saving money, traveling overseas, because they have children. One of them told me, "The rich get richer and the poor get children."

Of course you could argue that children will bring fulfillment to your life that no amount of money can buy. Yes, that may be true but what's also true is that when they are young you will probably be busy working and not have much time to spend with them, when they become adolescent your children will hate you and won't want to spend much time with you and when they become adults they will have their own lives and be too busy to spend much time with you.

Back to the subject of finances and investing, the bottom line is--children are expensive.

Investment Lesson #4 - Real Estate

Real Estate refers to land and buildings attached to the land though we could expand it to include mobile homes. In the past only royalty owned land and everyone else had to pay rent to the kings and queens either directly or through lords. These days it is common to either own your home or pay rent to a landlord. Of course real estate also includes office buildings, shopping malls and other structures intended for commercial purposes.

Compared to opening a savings account, buying bonds, mutual funds and stocks, real estate my seem like an advanced topic for a beginning investor but hang in there.

Let's begin with what I believe is the simplest way to invest in real estate. Buying shares of a Real Estate Investment Trust, REIT. The overall value of this type of investment tends to fluctuate just as much as stocks do. In fact I have owned REIT's and found them virtually indistinguishable from stock mutual funds. The investors' money is pooled together and the REIT invests in buildings that are leased and managed. REIT's are regulated to pay out at least 90% of their profit to the investors. Of course you may be wondering what's keeping the managers from keeping most of the profit for themselves. That's the "trust" part--OK, let's get into managing real estate by ourselves.

Much of my experience in real estate has to do with the homes that we have owned. Real estate agents talk about owning your own home as an investment but in my opinion your own home is an expense while a home you rent out or intend to immediately re-sell is an investment. You usually don't receive an income from the home you're living in so all the money that goes into the mortgage, taxes and maintenance are expenses. The only way to get money out of your home is to either rent it out or sell it. Real estate agents will tell you that you can get cash from the equity of your home but I hope you are reading "Debt is Slavery" and know by now why that is usually a bad idea.

Over the long term I have heard that bonds return on average about 6% per year, with stocks it is around 9%, but what about real estate? Property values barely out pace inflation, a measly 5%. So, why would anyone want to get into the complex world of real estate investment?

There are a lot of forces that go into real estate investment. One of the most important is called leverage. Let's say you want to buy an apartment building. You don't just plunk down a load of cash, you take out a loan, or as it is known in real estate terminology, a mortgage. You make a down payment of let's say 20% and mortgage the remaining 80%, you bought 100% of a building but only paid 20% of the purchase price. Your stake in the building, your equity, is less than the amount of the loan so technically, you're in debt--you owe more than you own. Now you've got a mortgage to pay but you are collecting rent and most of it goes to the monthly mortgage payments. If you made a good deal you're collecting enough in rent to pay the mortgage and other miscellaneous expenses like property tax and maintenance. Let's say the property value does go up an average of 5% per year. How much does your equity go up? Sure, you're paying off some of the principal of the mortgage every year but not much so let's not even factor that in.

Original purchase price --------------------------- $1,000,000
Mortgage 800,000
Down Payment (original equity) 200,000

5% property value increase after 1 year ------------$1,050,000
Mortgage 800,000
Equity 250,000

Note: Don't be alarmed by the size of these number, I'm trying to give you a realistic scenario and you could buy a small apartment building in Los Angeles for around a million dollars. Also, these are easy numbers to work with.

You're still making 5% on 100% of the building's value, but since you only put up 20% of the money you're actually making a 25% return on your investment. What about the bank? They're making whatever percentage rate that's on the mortgage, these days it would be around 4.5%. Why would they settle for such a small return while you're making the big bucks? You're taking all the risk and doing all the work, if you don't pay the bank they can take back full ownership of the building no matter what balance is left to pay off the mortgage.

You might wonder if you can increase your leverage by making a smaller down payment, say 10% or even 5%. The problem with this is that your monthly mortgage payment increases and the bank will add other charges like Private Mortgage Insurance (PMI) making it unlikely that the rental income will cover the mortgage, taxes and maintenance costs.

Of course this is an oversimplification. There's all sorts of charges and expenses that you have to deal with when owning rental property, but this is basically how leverage works in your favor. What if the property value drops? Hopefully you still have tenants paying the mortgage so you can wait it out until property values rise again--they usually do over the long term. One thing to take into consideration is that you haven't really made a profit or loss in this deal until you cash out by selling the property.

Something else to consider is if rentals go up during the time you own the property, you'll eventually have a decent cash flow. I had a friend who owned a few rental properties for many years and a large part of his personal income came from the rent he collected on those properties.

There are lots of other ways to invest in real estate. If you can find a property that is close to defaulting on the mortgage you might be able to buy it for a substantial savings either from the unfortunate owner who is about to have his credit rating destroyed, from a foreclosure sale or from the bank (short sale), then fixing it up and flipping it. There are even ways you can buy property with no money down by taking control of a distressed property. This is what so many get rich quick in real estate schemes are all about. I have watched several infomercials by real estate gurus like Robert Alan, Carlton Sheets and Ron LeGrand. I've also read books on real estate investing, including "Real Estate Money Machine" by Wade Cook. It seemed simple enough but rather risky. How risky? In 1987 Wade Cook filed for personal bankruptcy and in 2007 he was sentenced to 88 months in Federal prison for tax fraud. Lots of wannabe millionaires who followed similar real estate investment schemes have either ended up bankrupt and/or in jail. Now don't get me wrong, there are legal ways to make a fortune in real estate. It isn't easy, in fact it takes a lot of work compared to other investments.

So much for what I haven't tried--let's get into some of my personal experience with real estate.

When I was helping out with my mother's finances I noticed that she was still paying off the house. My parents bought that house over 20 years ago but they still owed about half of the original purchase price of the house. How can that be? On a normal 30 year fixed loan the payments are fixed. In the early stages of the loan the principal amount is high so there is more interest due but as the principal is paid down there is less interest. As a result, the principal isn't halfway paid off in 15 years but in about 20 years.

I entered some nice round numbers into an online amortization calculator to illustrate how this works. Here's a $100,000 loan amortized for 30 years with a 5% interest starting in January 2000.
Amortization Schedule
Year Interest Principal Balance
2000 $4,966.49 $1,475.37 $98,524.63
2001 $4,891.01 $1,550.85 $96,973.79
2002 $4,811.67 $1,630.19 $95,343.59
2003 $4,728.26 $1,713.60 $93,630.00
2004 $4,640.59 $1,801.27 $91,828.73
2005 $4,548.44 $1,893.42 $89,935.31
2006 $4,451.57 $1,990.29 $87,945.02
2007 $4,349.74 $2,092.12 $85,852.89
2008 $4,242.70 $2,199.16 $83,653.74
2009 $4,130.19 $2,311.67 $81,342.06
2010 $4,011.92 $2,429.94 $78,912.12
2011 $3,887.60 $2,554.26 $76,357.86
2012 $3,756.92 $2,684.94 $73,672.92
2013 $3,619.55 $2,822.31 $70,850.61
2014 $3,475.16 $2,966.70 $67,883.91
2015 $3,323.37 $3,118.49 $64,765.42
2016 $3,163.83 $3,278.03 $61,487.39
2017 $2,996.12 $3,445.74 $58,041.65
2018 $2,819.83 $3,622.03 $54,419.61
2019 $2,634.51 $3,807.34 $50,612.27
2020 $2,439.72 $4,002.14 $46,610.13
2021 $2,234.97 $4,206.89 $42,403.24
2022 $2,019.73 $4,422.12 $37,981.11
2023 $1,793.49 $4,648.37 $33,332.75
2024 $1,555.67 $4,886.19 $28,446.56
2025 $1,305.68 $5,136.18 $23,310.38
2026 $1,042.91 $5,398.95 $17,911.43
2027 $766.69 $5,675.17 $12,236.26
2028 $476.33 $5,965.52 $6,270.73
2029 $171.13 $6,270.73 $0.00

If you add up the principal column it should add up to $100,000 but because of rounding errors on the calculator it only adds up to $99,999.98. Care to add up the interest column and add it to the principal? It's $93,255.79 in interest so $193,255.79 is what will be paid to the bank over the life of this loan, basically you will pay the bank double what you borrowed. Mind you 5% is a very low interest rate. Rates on 30 year fixed home loans were at about 10% when Rosie and I got married and have spiked even higher in history. Try plugging those numbers in an amortization calculator.

My mother was shocked to learn that after making mortgage payments for so many years she had so much more to go in order to pay off the house. I pointed out that by taking the money she had in a very low interest savings account and paying off the mortgage she would save several thousand dollars that she still had to pay in interest over the remaining life of the mortgage. She took my advice and asked me to take care of her finances for the rest of her life, which I did.

Around 1988 I almost bought my first home. I was still making a living as a photographer but recently got out of a studio space that I was renting in order to concentrate solely on location jobs. One of the most important parts of the property that I was looking for was a garage where I could lock up my van and equipment. I found a very small house with a full sized garage near my parents. The structure was tiny, about 400 square feet, but it had a large backyard, enough for a pretty decent vegetable garden for now and room to expand the house when I needed the extra space. I called the agent who was handling the listing and put in an offer, along with a "good faith" check of about $1,000. The house was listed for around $92,000 and I started the transaction by offering $90,000, the seller accepted. One of the first things that happened was that the house was inspected by an expert and appraised. It was appraised at about $97,000 (I'm pulling these numbers from my memory so they aren't exact but well within the ballpark). I was planning on putting 10% down--in my earlier examples I used 20% because that's "normal" for rental or commercial property but this was a house that I was planning to live in and I didn't want to put my entire life's savings into it. One of my photography clients was a mortgage banker so I approached him with it and asked if I could qualify for an $81,000 loan ($90,000 minus the $9,000 down payment). "No problem," he said, but his company only accepts their own appraisers' valuations so he had it appraised again. This time it was appraised at $85,000. What this meant was that I could only get a loan for $76,500 and I would have to put up $13,500. I looked at other options including something called a VA loan which I qualified for because I was a veteran but nobody wanted to work with me on it because of the government bureaucracy involved. In addition, although I could technically buy a home with no down payment, I wouldn't be able to qualify because of the high mortgage payments and my very unstable freelance income--so much for serving your country! By this time I got to know the owners quite well. They were a cool, semi-hippie, unmarried couple who used to live in the house and leased it out when they moved to a nicer neighborhood. Their renters subleased the garage and they even had someone living in the garden shed! I actually started moving in and staying there a few nights just to see what it was like and discovered that it was a terrible neighborhood. The seller then suggested cutting out the real estate agent so he wouldn't have to pay her commission--she was representing both the buyer and seller so she would have gotten double commission, 6% for selling and 6% for buying and that 12% ($10,800) had to be paid by the seller. Of course the real estate agent could have sued both of us for breach of contract. It was all getting too weird so I backed out of the deal. I think I got back a little bit of the $1,000 I put in when I made the offer.

It was almost 10 years later that I finally did buy my first property. This time I was married, had a mostly steady income and enough money to put 20% on a $240,000 townhouse in West Hollywood. I actually had to qualify without including Rosie and her income because she was working on "The Mask of Zorro" and couldn't sign the loan papers during the escrow period. I was working in Northern California at Skywalker Ranch and flew down to Los Angeles every weekend to take care of things--other than that, the deal went through very easily. It was a bit scary having to pay $1,500 per month on the mortgage for the next 30 years, up until now the most I ever paid in rent was $850. As it turned out we didn't have any trouble making the $1,500 monthly payments and we were even able to put some money into an investment account. Interest rates were quite high at the time so when rates dropped I took the opportunity to refinance the loan, basically that means that we paid off the old loan with a new loan. I paid down the loan when we refinanced and lowered our payments to $1,300. This was a time when we were both working and the stock market was booming with the dot-com craziness. I was caught up in this irrational exuberance but it nagged me to owe money to the bank. I started to pay down the mortgage by paying more than $1,300 every month. At this point you might be thinking why would I do this? Only the interest on the loan is tax deductible, but only a small percentage of it--my feeling on the mortgage interest tax deduction is like having to pay a dollar in interest for every fifty cents saved in taxes--in reality it is probably even worse than that. Paying down the principal didn't lower our monthly mortgage obligation. If we were making more money we could have been able to afford to move into a larger house, but we liked our condominium just fine. What was I thinking? First of all, a mortgage is literally a contract to the death. Many people never live to see the day their house is paid off. I was doing quite well with my investments but I knew that I could lose it all with a few investment mistakes. The safest investment I could possibly make was to pay off the mortgage, the loan papers told me exactly how much I would be paying into the mortgage and it was much more than our home was worth. If we fell on hard times and missed a few payments the bank could repossess our home no matter how much we already paid into it. I cashed out most of my stock holdings and paid off our first house, two years after we first bought it, one year after we refinanced it. The bank had a clause that levied a $6,000 prepayment penalty, but they never charged it to us. I doubt they had much experience with borrowers paying off their loans that early.

We might still be in that first home if it weren't for another situation that came up with my mother. At the time she was almost 80 years old and living alone. She wanted to live closer to her sons but still be independent. What she didn't want was to go to a retirement home, not yet. Rosie and I looked into several options, the most reasonable seemed to buy a duplex so we could have her right next to us. However, the duplexes we found were not as nice as our condo. We kept looking for something without stairs, nearby, nice neighborhood close to shopping and a hospital--just in case. Then one day after seeing yet another disappointing duplex I suggested looking at open houses in an area where we would like to move into, just a few blocks away from our condo. We saw a couple of very nice houses and Rosie almost cried telling me why were we looking at places that we couldn't afford, these houses were listed over $800,000. What we learned was that these homes had garages that were converted into guest houses. I did some calculations and if we sold my mom's house and rented out our condo, we could make this work. We made an offer on one of the houses, the owners counter offered and we finally settled on a price of $750,000. When we were going through the escrow period we found out that one of the condos in our building sold for a very high price so we changed our plans from renting it out to selling. I can't say that everything went smoothly but we were able to sell both our condo and my mother's house and buy the house that we now live in. Our condo sold for $420,000, nearly twice what we bought it for, and my mother's house, which my parents bought around 30 years ago for $22,000 sold for about $350,000. While our condo was in escrow we had to take out a mortgage which we easily qualified for in order to close the deal on the house, but our intention was to pay it off as soon as possible. We were able to pay off the mortgage in just two months. That seems to impress lots of people but I can tell you that those two months really hurt, $4,000 per month going mostly to the bank to pay interest on the loan. The funny thing was that the both times we bought homes I was between jobs and collecting unemployment benefits. Fortunately I didn't have to dip into our other investments because I kept an emergency cash account that easily covered these expenses.

Not having a mortgage allowed us to continue building up our savings and investments. At one point Rosie was becoming interested in owning an apartment building. She had some friends who owned rental property and they were doing quite well. She also wanted and investment that she could manage herself because she didn't understand the type of investing that I was doing. I agreed with most of her arguments except one--real estate always goes up, never down. We were very fortunate to have sold our condo at nearly double what we paid for it about 5 years earlier, and our house was rapidly appreciating in value but I have seen housing prices drop several times. When you have a loan on a property that is declining in value, leverage works against you. If the value drops to less than the amount of the loan, it is called an upside down mortgage, underwater loan or negative equity. However, at the time prices were going up and banks were coming up with all sorts of creative ways to package up loans in order to make it affordable to home buyers. One type of loan that has been around for several years ties the interest rate to an indicator of current interest rates, usually Treasury bills, this is known as an adjustable rate mortgage (ARM). These mortgages have lower starting interest rates than conventional fixed rate mortgages where the interest rate never varies, but there is a possibility that the interest rate could rise during the life of the loan to the point of becoming unaffordable. Other loans had low interest rates for a few years, usually 5 years, and would then either go way up in interest or would require a huge balloon payment. The way these loans were marketed the borrower would either move or refinance the loan before the balloon payment became due. Some loans required that the buyer pay the interest only for several years so none of the principal would be paid down and some were even negative amortization loans where the borrower wouldn't even pay the entire interest due so the loan kept growing with every payment. I didn't want to have anything to do with these loans and would only agree to taking out a 30 year fixed rate loan. By the way, eventually when housing prices did fall during the subprime mortgage crises these "creative" loans were termed toxic mortgages. In any case, one of Rosie's friends was a real estate agent and she found us a four unit apartment building a few miles away in an area known as "Melrose Hill." My requirements were that the rental income at least matches the mortgage payments, one thing I didn't want was an "investment" that we had to keep feeding in order to keep. We put down $150,000, mortgaged the rest of the $750,000 purchase price and became slumlords. For the most part Rosie enjoyed dealing with the tenants but every time something went wrong, stuck toilet, clogged drain, etc. I had to get involved. There was a community coin operated washing machine and dryer and we used to pay our smaller cash expenses with the quarters we collected. Technically we were supposed to report those quarters on our taxes but we didn't, in fact we in a rather gray area with some of the income and expenses we were reporting on the apartment building. That's actually quite typical with landlords. We would buy paint and use what was leftover on our house, you know, things like that. My friend with the rental property used to go to Home Depot and collect receipts off the floor to report extra expenses. Of course we had quite a bit of fully legitimate expenses too, during the time we owned the building we made several improvements including building a new enclosed patio on one of the units. When tax time did come, we had more deductions than we anticipated. You see the tax codes were written to heavily favor property owners. We could deduct all of the interest we were paying on the loan because it was a rental property. We could also depreciate the building which gave us even more deductions. For tax purposes we were loosing money but we were actually breaking even. After owning the building for just over a year I was noticing that real estate prices were rising very quickly. I suggested putting the building on the market for $1-million, after all if somebody buys it for that we would make a quick profit and it didn't really matter to us if it didn't sell right away because the renters were paying our mortgage. We got an offer for $950,000 and took it. Remember earlier in this lesson how leverage can work in your favor? We made a $200,000 profit on a $150,000 investment. Well, that's if you include the real estate agent and the bank under "we" because we had to pay commission, interest, loan fees and so on. However we did manage to double our money in just one and one-half years. This was the best return on investment in the shortest time that we have ever made. Though in a way I pitied the couple who bought the building, they had to take out two loans and there was just no way that the rents could cover the cost of their mortgage payments.

We looked for another apartment building near the beach so we could possibly keep one of the units for ourselves, but every time I tried running the numbers I couldn't get it to work. Somehow the real estate agent could get a positive cash flow out of the buildings she showed us but she was doing it with some loans that would charge just 1% interest for 5 years and then would come due. She too was convinced that the buildings would only appreciate in value but I wasn't that sure. I saw too much risk in her plans. Eventually I was proved right, the real estate bubble that burst in 2007 was triggered by bad loans on declining property values.

We still wanted to live by the beach so we looked for opportunities in Mexican properties. Once we made a trip to Mazatlan, Los Cabos, Todos Santos and La Paz searching for a beach home that we could live in part time and list it with a vacation rental management company for the rest of the year. We almost put an offer on a beautiful architect showpiece home in Cabo San Lucas but we didn't file the paperwork when we found out that access to the beach for that community of homes had been cut off. Good thing we checked, the real estate agent claimed he didn't know anything about it.

There are houses in our neighborhood that are selling for over $2 million, by some estimates our home is currently worth about $1.5 million but like I said, it isn't an investment unless you rent it or sell it. I have considered selling the house and moving to a more modest place away from the city, but we weren't quite ready to retire--or rather, Rosie didn't want me to retire just yet. I wanted to move to at least a semi-retired lifestyle so we came up with the idea of remodeling the garage, moving into it and renting out the house. People that I talked to about this either thought it was very smart or very desperate--how bad was work that I had to do this? We aren't really suffering at all. We were able to rent out the house for $4,000, the same as the mortgage I had to pay when we first bought it. Of course since we don't have a mortgage, the tenant is actually paying our living expenses. Sure, we have to deal with a tenant with a couple of kids living right next to us but so far it has been more than worth it--and actually kind of fun!

I can't claim to be an expert on real estate investing. By my definition we really made one investment in a single apartment building. Maybe not buying the properties we passed up were the best real estate investing decisions we made, maybe not. In any case, a part of the reason we can afford a comfortable semi-retired lifestyle is because of the deals we made in real estate.

In any case, for now our downsizing experiment is working and we're still thinking about selling the house and buying a small place by the beach, but not necessarily in that order. As I write this the real estate market is way down. Has it bottomed out? Who knows, all I know is that condos by the beach that used to sell for $1-million are now within our means. If we do buy a place we'll probably hold onto the house until the market recovers--at least we hope it recovers in a couple of years or so.

One last note about real estate investing. If you think being a landlord with a bunch of apartment buildings is a retirement, think again. It is a lot of work! In fact, you're running a business which is something we'll get into in the next lesson.