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

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.

Exercise

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.

Diet

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.

Spouse

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.

Children

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.

Investment Lesson #3 - Stocks

Stocks are one of the most popular and accessible investment vehicles for individuals as well as institutional investment firms. But what is a stock anyway?

According to Wikipedia:

The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in quantity and value.

Security, gee doesn't that sound safe? It's basically what is invested in a company also known as its market capitalization. You may have heard of stocks referred to as securities or equities. The value isn't just the value of the assets that it owns, it's also what price investors are willing to pay to own a piece of that company.

Back to Wikipedia:

Market capitalization/capitalisation (often market cap) is a measurement of size of a business enterprise (corporation) equal to the share price times the number of shares outstanding of a public company. As owning stock represents ownership of the company, including all its equity, capitalization could represent the public opinion of a company's net worth and is a determining factor in stock valuation.

When you buy the stock of a company you are basically becoming a part owner of that company. Although you might not make day-to-day business decisions, as a stock holder you do vote to accept or reject things like who should be president of the company, who should be on the board of directors, if they should continue to use the same accounting firm and other matters that the board of directors decide to present at a meeting with the stock holders. That's right, you actually get invited to a meeting though most of the stock holders at large publicly traded companies usually vote through a proxy. Some privately owned corporations issue stock but generally when we speak about stocks we're talking about tiny pieces of public companies that are bought and sold through the major stock exchanges via brokerage firms. There are several types of stocks, common stock, non-voting "preferred" stocks that pay dividends like bonds. Then there are some things like ETF's (exchange-traded funds) that are traded in the major stock exchanges which aren't really stocks but they represent groups of companies and then there are mutual funds which we'll get into detail later. It may sound complicated at first, and it gets even more complicated as you get deeper into it. That's why there are so many financial advisers, stock brokers, financial analysts and reporters broadcasting a never-ending stream of spreadsheets, earnings reports, graphs, ticker tape and, well--confusion.

The first point I should cover is why would a company want to go public and invite total strangers to become part owners? The simple answer is, to raise money. Why not just take out a loan? Companies do take out bank loans and issue bonds, which you've learned from our last lesson are loans that investors can buy and trade--but these are debts that must be paid back with interest. Debt reduces the value of a company. Stocks represent the equity of a company and doesn't need to be paid back. If a company is expected to be profitable, investors will tend to bid up the price of the stock. The price of the stock multiplied by the number of outstanding shares equals the company's market capitalization. The company can then sell some more stock which might somewhat dilute the value of those outstanding shares but the money raised does not need to be paid back.

It is to the company's best interest, and to their stockholders, to keep the stock price up. Sometimes companies even buy back their own shares to take them out of circulation and raise the value of the outstanding shares.

There are many factors that go into the value of a company's stock price. Obviously there's the number of outstanding shares, the hard assets owned by the company and the revenue it generates but there's also price to earnings ratio, debt ratio, price history, analysts' expectations, meeting estimated earnings and many other factors. Different industries are also valued in various ways. A hi-tech company developing a cure for cancer may need money for many years of research and testing before it becomes profitable, but if investors believe that the company will succeed, the stock price can go through the roof even while the company is loosing millions of dollars. Of course if the clinical tests fail the stock price will most likely come crashing down.

I should emphasis that I had no role model when it came to investing. In fact my father was very much opposed to investing in stocks and referred to it as legalized gambling. He blamed Wall Street for the economic recession that resulted in his becoming unemployed in the 1970's (see Recession of 1969-70) and he never invested in stocks. Neither did my mother, though she wanted to start a business, invest in real estate and do other things with the money she put away in the family savings account.

If there was only some reliable source of information that could guide me through this treacherous but potentially highly profitable stock market. In fact there was, or at least at the time I thought I found the sage who would make sense of the stock market. I was still in high school when Wall $treet Week with Louis Rukeyser first aired on the local public television station (PBS) but I tuned in every Friday evening whenever possible to listen to Louis Rukeyser explain complex investment strategies in simple to understand terms, quiz his panel of investment experts on the future direction of the market and find out what stocks his special guest was buying.

Years later when I still had my photography studio and was getting myself out of debt I decided to start investing in the stock market. I had a list of stocks which I thought might make good investments, not too risky with fair growth potential, and called up the local Merrill Lynch office, got in touch with a stock broker and set up an appointment. When I got to the office I was in awe, it seemed that I stepped right into a major stock exchange though it was just up the street from my studio which was at that time in Orange County, California. We discussed various stocks on my list and the broker suggested I buy shares in Weyerhaeuser. I was familiar with the name because I've seen it stamped on lumber, reams of paper and even my parents mortgage was through Weyerhaeuser's financial division. I bought 30 shares and became an investor. The broker was telling me strategies like buying more on the dips and selling if it outruns its 200 day moving average then buying back as it dips below the moving average but the stock didn't move very much. In fact, it was a very boring stock and underperformed the construction sector as well as the overall stock market. Obviously the broker recommended the wrong stock for me. I waited until it rose in price, just a bit, and sold out my position. Even though I sold at a higher price I didn't really make a profit because I had to pay the broker's commission. If I would have bought and sold several times like the broker suggested, I probably wouldn't have made more money but the broker would have received his commission every time I traded. This is known as "churning" and is illegal if overdone. In any case, I didn't loose my shirt and it was a good experience seeing how it all worked.

I still had an appetite for investing so I hit the books. That's when I found out about mutual funds. Oh sure, I knew something about mutual funds because many of the experts on Wall $treet Week were mutual fund managers but because it was a PBS series they were not allowed to advertise their funds on the air. Mutual funds are basically investment vehicles where a group of people pool their money and allow a manager to invest it for them. Sure, rich people have investment managers but they charge quite a lot for their services and have minimum investments of hundreds of thousands of dollars. Some mutual funds have minimum opening investments of just a few hundred dollars--some even waive the minimum if you sign up for an automatic monthly investment plan of as little as $20 per month. At least that's what it was when I was getting started. Some of these mutual funds were getting fantastic returns, far above the market averages and the mutual fund companies were hiring the best money managers and paying them a king's ransom. The Magellan Fund had returns averaging 20% when I looked into it and advanced as much as 116% in a single year! Alas, the minimum investment was far beyond what I could afford but I did find 20th Century (now American Century Investments), Strong Funds (now either out of business or absorbed by another company) and finally Fidelity Investments--the company behind the Magellan Fund.

At this point I wasn't completely out of debt and if there one thing I learned from all that reading was to pay off creditors before investing. Then an interesting event happened, Black Monday -- the stock market crash of 1987. Stock market crashes have happened many times in history. Perhaps the most famous was the crash that triggered the Great Depression in the 1930's, aka Black Tuesday, but similar events have happened long before, for example the panic of 1901 and tulipmania in the 1600's. It seemed like everyone was panicking in 1987, everyone except Louis Rukeyser. What did he know? Were his personal investments impervious to the crash? What he knew was that a crash was a perfectly normal event in the crazy world of stock market investment and it should be seen as a buying opportunity. In fact there is a style called "contrarian investing" where you basically try to do opposite of what the majority of investors are doing.

Once out of debt and into investing through mutual funds a few interesting changes occurred with me. First of all, it was much easier to save because I didn't have as many bills to pay. I also found that instead of buying the latest and greatest photography equipment or getting a new car, I was more interested in building up my investment portfolio. I did almost buy a house around this time but we'll get into that story in the real estate lesson. I set a goal of building my investment portfolio to $500,000, move to a quiet town and retire as early as possible--certainly no later than 55 years old. This was a time when my father was very ill and eventually died of liver cancer. Working, making lots of money and collecting material possessions didn't seem very important to me anymore.

My mom was getting interested in what I was doing and asked if I could help her out with some money she had set aside. Reviewing her finances, one of the first things I recommended was to pay off her mortgage. Even though there was only a few years left to pay off the house I was able to save her several thousand dollars in interest. We opened up a joint account at Fidelity Investments and deposited $20,000. I was much more conservative with her money and found out that her account would often outperform my own more aggressively invested portfolio.

It was around this time that I started working in the motion picture industry. I liked photography, but I didn't enjoy paying bills, going on appointments, collecting what was due to me, much of my profit would have to go back into the business in order to grow and things like health insurance for a self employed single guy was getting very expensive. Working a union job I got free health care, retirement benefits, a decent salary, had few expenses and it was fun, or at least it was a change from what I was doing the past 10 years as a still photographer.

I continued to read investment books. I found out that when the news reported on "The Dow" it was only a group of 30 companies picked by the company that owns the Wall Street Journal. There are other indexes that are useful for reporting stock market averages like the Standard and Poor's 500 (here's a link directly to Standard and Poor's), the Russell 3000 and the Wilshire 5000. All of these indexes give the "big picture" of how the overall market is performing. But who wants to be "average" right? I was looking for ways of doing better than the market averages.

One method involved investing in only no-load mutual funds offered by Fidelity Investments. The idea behind this is that there are far too many mutual funds to try and follow, about 9,000 in total, so by picking just one company and narrowing it down to only the funds without up-front fees or commissions, known as loads, you would be choosing from some of the best quality funds. There were still too many funds but by subscribing to a newsletter called Fidelity Monitor, you could get recommendations depending on your investment goal and model portfolios showing how well the picks performed.

Another method involved investing only in one Fidelity sector fund at a time. The way this works is that not all market sectors move in the same direction at the same time so if you can identify which sector is moving up the fastest, jump on that and ride it until another sector performs better. Investing in a sector fund was supposedly safer and easier than picking individual stocks and there were several indexes that could be used to verify movement in the various market sectors. I subscribed to a mutual fund newsletter called the All Star Fund Trader. because their single sector fund history included several years of outstanding performance, over 40% in some years, while managing to avoid the worst market downturns by switching into a money market fund.

Mutual fund investment newsletters are plentiful, all promising fantastic returns. There's even a company that rates the newsletters, Lipper. However, subscribing to these newsletters can get expensive. I was paying about $400 per year for just two newsletters. Somehow I wasn't getting the same returns they were reporting. Maybe I wasn't switching funds at exactly the right time? Maybe they had more money and thus lower fees in their accounts? As it turns out, most newsletters overstate their returns.

I was doing fine with mutual funds and was satisfied with the strategies and returns I was getting until the early 90's when I signed up for America Online and got access to a whole new world of real-time investment advice. One of the most popular forums at AOL became The Motley Fool which was started by a couple of brothers, David and Tom Gardner, just out of college. They wrote articles which turned into books about investing using an entertaining writing style. They suggested beginning investors start with an index mutual fund that tracks the Standard and Poor's 500 stock index. However, they also wrote about why small-time individual investors have an advantage over large institutional investors when it comes to picking individual stocks. Things have changed since I bought those few shares of Weyerhaeuser as discount brokerage firms started becoming more popular. You no longer had to deal with a stock broker, trading stocks could now be done online. I followed the Gardner brothers portfolios online and they outperformed everything I have ever seen before. I was interested in improving my returns so I started selling my mutual funds and buying individual stocks.

This was also around the time I met Rosie, got married and bought a condominium. We'll get into more details about our first home in the real estate lesson but let's just say that I was able to put a down payment of 20% and still had plenty of investment money left over to continue playing the market. I kept reading and taking on more risk, it seemed so easy to make money. I didn't know it at the time but I was riding one of the longest running bull markets in history.

As you've learned from the previous lessons, I don't like to borrow money. However, there are some situations where taking out a loan makes sense. One of them is to leverage an investment. My Fidelity brokerage account qualified for margin trading. What this meant was that I could buy more stocks than I had money in my cash reserves. The way it works is that I basically take out a loan using the stocks that I own as collateral. Fidelity would charge interest on the margin positions but the rate was low compared to other kinds of loans because it was secured by the value of my investment portfolio. I could pay off the loan by depositing more cash or selling some stock. Buying more stock than I could afford has it's risks. If the value of my portfolio falls below the outstanding margin balance I could get a margin call and some people have been wiped out financially when the stock price fell so rapidly that they couldn't sell the stock fast enough to cover the margin call. I used margin sparingly back then but don't use it at all these days.

There is another form of borrowing that I learned from reading The Motley Fool, but never used. If you believe that the price of a stock is going to fall, you can actually profit from it. The technique is called short selling or shorting a stock. The way it works is that you borrow some shares of the stock you want to short from the brokerage firm, sell it, wait for the price to fall, buy it back when it hits your target price and then return the stock to the brokerage firm. You get charged interest for the value of the shares you borrow so it is very much like taking out a loan. Some people have make fortunes on other people's misfortunes but short selling involves quite a bit of risk. The possible gains are limited (the price can only go to zero) but there are no limits to the possible losses you can incur if the stock price goes up.

By the late 1990's I amassed a sizable portfolio for Rosie and me as well as for my mom. I was also working on a job that required lots of overtime so I was earning a rather large salary but didn't have the time to enjoy it. We did have cable service at work and we had the financial news running in the background. It was impossible to ignore what was going on with the technology sector of the market. Anything associated with computers, networks or had a dot-com in the company name was skyrocketing in price. I started trading companies like Yahoo, Amazon.com, AOL, Microsoft, Apple and lots of lesser known start ups that have gone extinct since the Dot-com bubble. Of course I didn't know we were in a bubble and I was getting into dangerous territory but I was making lots of money. I didn't feel comfortable, one day I'd make a 20% profit on a trade and the next day I'd loose 40%, I still owed a hefty mortgage on the house, I was burning out at work. Keeping up the portfolio was taking up more of my time. I would get up before the stock market would open to place my orders and would use tactics like stop loss and limit orders to keep any losses to a minimum. These were the days when everyday people were getting into day trading and even though some of my orders would trigger buy and sell commands on the same day, I didn't want to get into what was looking more and more like gambling.

I decided to sell out most of my non-retirement positions and pay off the mortgage. I was a great feeling for Rosie and me not to owe on the house. Some of my friends thought I was crazy to do this, they were taking out home equity loans in order to buy more stocks. For about a year it looked like I made the wrong choice, the market kept climbing. I did continue trading in our retirement accounts and there was my mom's portfolio that I was still managing but I wasn't trading at a maniacal pace.

I also started investing in ETF's which are sort of like index mutual funds but they can be traded like stocks. The advantages they had over mutual funds included being able to set buy and sell order automatic triggers. The disadvantages included not being able to setup automatic reinvestment of dividends (some companies pay stockholders dividends on the profits) and having to pay the bid and asked for spread which is something that brokerage firms would rather you not find out about because it adds to their profit and isn't as up front as the discounted commission fees given to online traders.

At this point I also started investing in an index mutual fund. I read about John Bogle and his market theories. To quote: "Mutual Funds can make no claims to superiority over the Market Averages." In fact the majority of mutual funds under perform the market averages and in addition are tax inefficient because they tend to trade often and the mutual fund investors are taxed for any distribution even though they don't usually receive the pay out. I opened an account in his Vanguard S&P 500 Index Fund and set up an automatic investment plan starting at something like $200 per month. We never noticed the money going out every month and every year I increased it a little more.

When the dot-com bubble did finally burst I was in the process of buying our current home so I was almost completely out of the stock market and since my mom was moving in with us, her account was mostly in cash. Well, so I'd like to say, our retirement accounts were still heavily invested in stocks and I saw the value of our retirement portfolio tumble. At one point my retirement account was worth about half of what it was when the market peaked. Remembering my lessons from Louis Rukeyser and the Motley Fools, I didn't panic, I saw it as an opportunity to get back into the market so I started building back our investment portfolio.

Most of my new investments in our Fidelity account were either ETF's or stocks of companies I knew quite well. When I started working at DreamWorks Animation the company gave every employee 100 shares of stock when it first went public. I thought that was a good gesture so I bought another 100 shares in their employee plan. However, I always liked Pixar movies better so I also bought Pixar stock too. As it turned out Pixar far outperformed DreamWorks Animation until Disney bought Pixar in 2006.

Now I must admit that every once in a while I'd take a very small portion of my portfolio and invest in something outrageous. Once we were discussing electric cars at work and I discovered a company called ZAP, for zero air pollution, that imported electric cars, scooters and bicycles. I found out that their stock was trading very cheap because a deal they were trying to make to import Smart cars fell through. I did some research and found that many investors were shorting the stock and it was down to about $0.30 per share. I bought 1,000 shares for about $300. As it turned out the company announced plans to import cars from China, the stock started to climb, I bought another 1,000 at $0.50 per share and then something amazing happened, the stock was caught in a short squeeze. One day I looked at my account balance and found that the stock shot up to over $1 a share. I sold enough to cover my initial investment so whatever happened next would be pure profit. It went as far as $3 per share then started heading back down. I've heard of 10 baggers but this was the first time I experienced it.

This lesson on stocks came out much longer than I anticipated. Of course there's much more that I could have included. Here are a few more tidbits just to make the lesson more complete.

Warren Buffet - Berkshire Hathaway.

Warren Buffet is one of the wealthiest men in the world. He is the chief executive officer (CEO) and primary shareholder of Berkshire Hathaway, Inc. He made his fortune by investing in companies. There are many books about him, his investment style and his philosophy but what I found interesting was that you could hitch a ride on his current investment strategies simply by buying shares of his company. The original (A shares) Berkshire Hathaway stock never split, as I write this one share of Berkshire Hathaway will cost you $120,600. There's also a second offering (B shares) that does split and is much more affordable for the average investor. I owned some of these B shares for a while. During the time I owned them, the stock underperformed. Sure, Warren Buffet was one of those people who made some very good decisions early in his career and was able to maintain an average investment return of about 20% for many years, but eventually his investment portfolio became so big that now it is difficult for him to outperform the market averages. In fact many people would probably agree that his investment portfolio affects the overall market.

More foolishness.

What about the Motley Fools? They are still around but the outstanding returns they were reporting in the mid-nineties aren't looking so impressive these days. Much of their early successes had to do with them including America Online in their portfolio which at the time was one of the best performing stocks. As far as I know the main reason they bought share of AOL was because they started as an AOL forum and included the stock out of courtesy to their sponsor. Their other stock picks did go up, but lagged way behind AOL. They wrote several books about stock investing including one for more conservative investors called "The Foolish Four." The idea behind this was based on an older strategy called Beating the Dow or Dogs of the Dow. Basically, you buy the worst performing stocks from the 30 companies in the Dow Jones Industrial Average. The idea being that these are the best managed companies in the world and their excellent management team would do everything possible to keep up with the other companies on the index or Dow Jones will drop them from the list. How well has it worked? Below average and they stopped recommending that strategy. After the dot-com bubble burst the Motley Fool lost 80% of their staff and they nearly went out of business. If you look at their current portfolios you'll see that they can't consistently outperform the market averages.

We still haven't recovered from the dot-com crash.

Most of the hi-tech companies that fueled the dot-com craziness of the late-nineties were listed on the NASDAQ. An index which includes all of the companies in that stock exchange, called the NASDAQ Composite Index, reached an all time high of 5,132.52 on March 10, 2000. Today, over 10 years later, the index stands at 2,288.47, less than half its peak value. The overall market has done much better. For example, the Dow Jones Industrial Average which was at 10,367.78 on March 10, 2000 is now at 10,653.56.

Note: Just to clear up any possible confusion, you can't directly compare one company's stock price to another company's stock price and you can't compare stock indexes to each other by their "points." These are relative values and it is like comparing the currencies of different countries.

Don't try to time the market.

You've probably heard the old rule, "Buy Low and Sell High." When applied to stock trading this is known at "Market Timing." Basically, you buy when the market drops and stock prices are relatively cheap and sell when the market peaks and stock prices are expensive. The problem is, how high and low will the market go? Jumping in and out of stocks often causes what's known as a "Whipsaw Effect." The way this happens is that your buy order is executed then shortly thereafter the stock drops enough to trigger your stop-loss order. Forecasting market direction is difficult though in hindsight it seems easy to figure out when you should have bought and sold. I tried to time the market and have failed to do any better than average. That said, though I don't really believe in luck, I guess I've been lucky--that's a paradox, isn't it? I cashed out of my non-retirement stock investments in the late 1990's in order to pay off the mortgage, just about a year before the dot-com bubble burst. I also made a major change in our investment portfolio in early 2008 in order to reduce risk and simplify. By putting about half our money in a bond mutual fund I kept our losses from being much worse during the housing bubble crash that caused a very serious economic recession. Had I tried to time these events I most likely would have missed them.

Dollar cost averaging vs. a systematic investment plan

I didn't really explain Dollar Cost Averaging properly. The way it works is if you have money saved up and ready to invest but instead of investing all of it at once in one lump sum you make small periodic investments until it is all invested. This works when your investment period includes a market dip but basically dollar cost averaging is a form of market timing and it generally doesn't work any better than lump sum investing. In fact if you're investing during a bull market dollar cost averaging does much worse.

However, a systematic investment plan does work--Finally, you're probably thinking, something that works! In this case you're also making periodic investments but you never had a lump sum in the first place. If you invest the same amount every period which is usually monthly but it could be weekly, quarterly or yearly, you're buying more when prices are low and less when prices are high. In the long run this investment strategy works very well. Of course systematically saving is the first step in building wealth and the more you can put aside, the faster your savings will grow. The more money you have saved, the more you can invest--just don't invest it all, remember to always have a cash reserve just in case.

Looks like I ended up on my soapbox lecturing about savings once again so I'll end with another famous quote, this time by cowboy philosopher Will Rogers:

• "If you got a dollar, soak it away, put it in a savings bank, bury it, do anything but spend it. Spending when we didn't have it put us where we are today. Saving when we've got it will get us back to where we was before we went cuckoo."

--Will Rogers, Nov. 24, 1930