Tuesday, December 14, 2010

Investment Lesson #5 - Other Investments

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

Start or Buy a Business

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

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

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

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

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

Life Insurance

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

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

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

Gold and Precious Metals

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

Options and Futures

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

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

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

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

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

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

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

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

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

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

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

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

Tax Liens

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

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

Art and Collectibles

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

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

Ponzi Schemes

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

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

Invest in Your Health

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

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

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

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

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

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.

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