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July 19, 2011

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Umm word of caution. This is how alot of boomers got caught in the last drop in the market. They should not have had 80% in stocks when it dropped like a stone. Most needed to do this becasue they failed to save and many lost ALOT.

The very last bullet point is what I think is key. Most people think that just paying attention to the investments is all they need to do, but if the money in other, liquid vehicles isn't having the attention it needs, they can be losing out greatly. Plus, the wondrous idea of the "forced savings" by having large amounts of withholding taken out of paychecks really fits into here. How can anyone be maximizing their moneys ability to work for them if they can't control where it is and aren't gaining a single cent from it. Seriously, that's got to be the biggest waste of potential earnings power (or ability to pay down debt).

This is a great post- I needed the reminder to really dig through my investments (especially retirement holdings) and see what needs to be tweaked, if anything.

One thing I always do is try to invest in funds with the lowest expenses. However, I suppose those expenses could change over time and I may not be aware of it.

Hey FMF! Actually I have a question about something you mentioned in your post. I didn’t know you had the intention at one point to purchase another home (presumably bigger than the one you live in now) with cash. Why did you change your mind? I am in the middle of this conundrum right now (invest or save cash to trade up in home). Thanks!!

Nate --

1. We couldn't find the house we wanted.

2. Eventually the cost was simply too much (we had to sell our place, buy some new furniture, etc.)

3. We decided we'd rather spend the money on travel (we're headed to the Caribbean this winter and more to follow that).

Two years after the fact, we're happy we didn't upgrade.

"Though return rate is important, the impact of the savings is driven more by the time and amount invested than by the return rate. If you add $2,000 extra savings per year to the $100k noted above at 6% you end up with over $1.3 million over 40 years. And if you save more than $2,000 a year (which most people can), you can end up with an even bigger nest egg."

I disagree. Obviously, all three factors are very important. However, consider: $100,000 invested at 6% for 40 years produces $1,028k. Adding $2,000 per year to compound results in $1,338k. But investing the same $100,000 at 7% for 40 years, without adding any more to the pot, results in $1,497k - and you get to keep your $2,000 per year. If you can make 8% return, your total after 40 years is $2,172k. It would require $211k upfront to earn the same amount if only earning 6%.

Jonathan --

1. You're keeping time the same in your calculations. Try the numbers at 20 years and you'll see how important 40 years is.

2. You have to add in the "ease" and "reasonability" factors into the equation. Which is easier to do -- saving $2,000 per year or earning an extra 1%? IMO, the former is way easier. And at some point, earning an extra 1% isn't even reasonable (the best in the world try it and fail.) You're failing to account for that.

For more specifics, you need to read the links I have above in the post -- they provide additional details.

FMF,

In my view, while time is obviously very important for growth of money, the rate at which it grows is more important than the raw dollar value. True, you'll have far more money if you leave it to compound an extra 20 years. But that's 20 years you don't have access to the money. If I can earn 8% on my money, then to hope to have $2,172k in 40 years is the same as having $466k in 20 years is the same as having $100k today.

Further, you and I invest very differently. If I invested in the traditional markets, I would probably target index funds, as yours and other blogs have sold me on the idea. However, I invest in rental property with conservative projections showing I'll return 16%. With a little optimism in the projections, the returns rise quickly to 20%, 25%, or 30%. If things go really badly, they may only return 12%. However, the rate of return is substantially in my control based on the work I put into selecting the properties, financing them, choosing tenants, and managing those tenants.

Jonathan,

> If things go really badly, they may only return 12%
Are your projections really accurate? A +12% worst case scenario seems very optimistic to me. What if you have a cash flow problem because of vacancies (or worse because a tenant isn't paying)? Couldn't you lose everything?

>However, the rate of return is substantially in my control >based on the work I put into selecting the properties, >financing them, choosing tenants, and managing those >tenants.

There are still a lot of factors you can't control- the rental rate in your area, the housing market, and the tenants- as a previously great tenant could end up as a nightmare if they are laid off and stop paying rent.
To make a fair comparison with a passive investment like index funds shouldn't you account for the value of your time? If you weren't managing those properties, etc. you could do some other work which would earn you income.

-Rick Francis

Rick,

Yes, there is more risk involved, and yes, I may have understated the "worst case." However, the fact remains that I own a
tangible asset with intrinsic value that generates a known income. To date, my wife and I have spent less than 20 hours in purchasing, fixing up, renting, and managing my first property, and it generates $400 per month (a 16% return). There are many variables that can affect the investment, but many of those can be mitigated by good planning and careful tenant selection. And there is a lot of upside.

I didn't come up with all this myself. I've seen it done by many people, and several of those highly successful investors have been advising us every step of the way.

Instead of focusing on trying to squeeze out an extra percent year after year, you can get an even better return by focusing on missing bad downward slides. Pay attention to underlying valuation metrics (things like P/E for stocks, or price vs median income for residential real estate) and get out of sectors that are badly overvalued, and get in to sectors that are undervalued. You don't need to be as sophisticated as Warren Buffett; the idea is not to get every last percent, but to notice the really big trends.

Just as an example, if we both started with $100k in 2007, you got the same returns as the Dow, and I held cash and then transitioned into the market after the crash (which I actually did), you'd now have $90k to my $150k. If I get a 5% return going forward and you get a 6% return going forward, it'll take you 54 years to catch up. And that's if you can actually manage the rather difficult task of boosting your returns by 1% over 54 years.

That paragraph on the post was made in the context of having most of my money sitting in a savings account.

I don't really care about compounding for 40 years. For early retirement, what's important is how much cash flow I can get now and how much money I need to generate that cash flow.

Going from 5% to 6% is a 20% increase which means that you can get away with 20% less assets. That means you can retire 20% sooner. If you planned on working 10 years, you can cut it down to 8.

Of course, there's a limit to how much return one can safely get and have one's portfolio survive.

PS: The best money managers in the world don't work for mutual and pension funds which make up most of the market ;-) This is like saying that the smartest students in school went on to become teachers. Usually the opposite holds with a few exceptions (personal anecdote). The smartest money managers work for private companies and wealthy individuals. They are not part of some mutual fund family that tries to beat the market on a quarterly basis. Now, can a motivated self-taught individual learn enough about investing to beat someone with a college degree in economics and some professional certification who graduated in the bottom half or quarter of their class and spend more time writing reports than reading them. Definitely :) ... especially since we have no handicaps like being required to be 80% invested in stocks or having to move $100 million worth of GE or whatever.

@ Jonathan:

This is a bit off topic, but I am curious as to how you gained access to multiple successful real estate investors and how they came to be your advisors. Are they family members or family friends or are they paid advisors?

CT - Family, and friends and business partners of family.

ERE --

"Can a motivated self-taught individual learn enough about investing to beat someone with a college degree in economics and some professional certification who graduated in the bottom half or quarter of their class and spend more time writing reports than reading them. Definitely."

Of course people can -- there are always exceptions to the rule. The question is is it likely? No, it's not.

@ Jonathan:

That's awesome! Consider yourself very blessed to have that kind of influence and guidance in your life.

FMF -

I would argue that it IS likely, based on ERE's premise (which perhaps you didn't read too closely?): I picture someone with an economics degree who graduated in the bottom 25-50% of his class and a professional "stock analyst" certification as someone who has been taught to think like a salesman selling stocks, buying on trends, and trying not to lose to the market.

On the other hand, a motivated and self-taught investor, working with his own money by his own rules, and buying and selling on fundamentals and careful analysis, could very easily do better than a corporate employee working with clients' money.

To add to my point ... if those "experts" are so good, why are they still working for a salary? It shouldn't take an expert more than a decade to accumulate enough to bankroll himself and start investing for himself... if he is indeed any good.

On the other hand, yes you need to be a "motivated self-taught individual". First and foremost an successful investor needs to be able to think. That is to be able to form ideas of his/her own and think critically about them. This ability + the motivation is not common. However, it is not exactly rare either.

If you look at what you need to become a CFA, one of the things that pop out from the way the curriculum is structured is that the ability to think independently is not one of them. All you need (in a nutshell) is to be able to read a financial statement, take its numbers and put them into an excel spreadsheet, use a simple extrapolation from some nearly arbitrary ratio to get a target value, and then issue buy and sell orders based on that. If you can make this sound intelligent while doing it, you too can be an analyst.

Indeed, fund investing (including index funds) is big business. It's all about attracting customers and selling your fund. The money is made in management, not in growing your capital. You could actually do well in buying, not the funds, but the companies that run the funds. Now what does that say about "experts".

The best argument for index investing is that if things go badly, at least it goes bad for a great many other people. There's comfort knowing that you'll never do worse nor better than average. This comfort has value. If I didn't care about economics and investing at all, I'd most likely be index funds as well.

Jonathan --

I don't think you are reading what I've linked to above -- in particular the "isn't that easy to reach" link...

You might think it's likely, but I would disagree completely. And I think if you look at the evidence from a variety of sources you'll see that it's not likely at all for most people. Yes, there are exceptions, but an individual person simply can't decide to be a great investor and then work hard to make it (and be guaranteed success) just like any particular individual can decide he wants to be an NFL quarterback, work hard to get there, and be guaranteed success.

@Early Retirement Extreme

>It shouldn't take an expert more than a decade to >accumulate enough to bankroll himself and start investing >for himself

If you are the next Warren Buffett you would still need half a million before you could possibly go it on your own:

Here is my analysis of why
http://ponderingmoney.com/2009/10/23/you-need-half-a-million-dollars-to-pick-individual-stocks/

I agree with FMF it IS HARD to beat the market. When I was younger I tried it- and unfortunately I did beat the market in the short term. The problem was that a few bad descisions wiped out those extra gains and then some.

If I had failed miserably I would have stopped trying to beat the market and would have been better off today.

It is also a lot of work to try to keep up with the market- I just don't want to spend that kind of time on it.

Finally it's hard to prove you are really skilled (instead of just lucky). It takes decades of data to know if a fund manager is consistantly beating the market so how can you fairly judge if your perforance is luck or skill?

-Rick Francis


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