Pop Quiz: Checking our cognitive biases

When we make decisions, our brain takes lots of shortcuts. Kind of makes sense considering our brains operate on about 20 watts. For reference, the dimmest bulb in your house probably uses twice that.

Essentially, our brains have developed shortcuts to reduce computational complexity and still make decently sound decisions. The thing is, we kind of need these biases. If we analyzed every circumstance in high detail as if it was the first time, we would probably be overwhelmed by too much information. These shortcuts are known as cognitive biases.

We tend to operate within a certain paradigm, or rather, an entire collection of beliefs grounded in some key assumptions.  For this article, let's go read an article on 5 tips in picking mutual funds and see if we can spot the issues. Did you read it? Okay tell me if this sounds a bit crazy.

Testing your cognitive biases

Many studies have found that the average actively managed fund trails its benchmark over long periods. Over the last three years, managers across all domestic stock categories trailed their index, according to S&P Dow Jones Indices.

Doesn't sound good. Do you really think you can beat the average, or would it be smarter to devise a plan where averages are taken into account? This article acknowledges that over the long term, our mutual fund investments have little chance of beating the indexes. And yet, everyone around us seems to encourage us to buy them.

Even if a fund falls short for a year or two, it may wind up outperforming over a full market cycle, including bull and bear markets. And while there’s no magic formula for picking a winning fund, there are clues that can boost your chances.

This can be read the other way around. For every market cycle we should expect a year or two where the fund falls short. This article presents it as perfectly acceptable, but doesn't seem to discuss the real effect. If that had shown some numbers how this doesn't really have a drastic effect, I would be more open to accepting their opinion. But instead they kind of slide by this point and don't offer any numbers because they aren't there!

Mutual funds take a hit about every ten years, and the impacts on wealth creation are terrible! Repeated studies show that people panic, sell their holdings, and force mutual fund managers to sell, locking in losses. This causes funds to take hits. And if it's too bad, the fund is shut down with all assets allocated to another fund. This form of survivor bias tends to hide the real history of how bad mutual funds are. If you go searching for the mutual funds from ten years ago, things don't appear quite as bleak as they really were, because many of the bad funds have been deleted from history.

Unfortunately, performance data only takes you so far. The evidence is mixed on whether past performance has any predictive value.

Evidence of performance should be a primary component of investment choices! This quote implies that investing is partly based on evidence and partly a matter of luck. Look at the 40-year history of Berkshire Hathaway, which has had 500,000% total growth, and tell me that past performance ISN'T a predictor of future value. So why do mutual funds put that famous clause "past performance is not a prediction of future performance" on every prospectus? Because the underlying practices in managing mutual funds is inherently flawed. People like Warren Buffett, who know what they're doing, are able to do very well. Or look at real estate, a key investment of the rich, and tell me it it's a crap shoot. That's not the case. People that use sound tactics of buying quality property in well researched locations and hold sufficient cash reserves to mitigate risk have a consistently higher wealth building history.

"You’re lucky if you can get three to four years of outperformance,” says Wermers. “Longer term, it’s almost universally found that there’s no persistence in performance.”

And yet, financial advisers keep telling us to invest in mutual funds long term, because they have reduced the risk. This author seems to imply that we should only expect the real growth for 3-4 years. If we are moving investments around every few years, imagine the costs involved. Is this better for us, or the brokers? This is when I remember reading Where are customers' yachts?  It's a humorous book written in the 1940s about how only the brokers tend to profit from Wall Street. One astounding and still true point is that even brokers can't resist their emotions. They make great money in fees, but when the market gets boring, they are prone to invest in the market and let their cognitive biases lose them money.

Did you know people have a strong tendency to jump on a mutual fund after it shoots up. It's called the bandwagon effect. In investor-speak, we call that buying high. But when fund take a hit, people panic and sell after the drop. That is selling low. Both of these cause your mutual fund performance to nosedive.

Finally, check out that last sentence: longer term, it's almost universally found that there's no persistence in performance. If that didn't leap out at you, then you are still stuck amongst the herd of mutual fund investors.

Funds that don’t mirror their index may be a better bet.

What?!? The article opened pointing out that the average actively-managed fund underperforms the index over the long haul.  If that isn't a blatant contradiction, I don't know what is.

Conclusion

This article is full of contradictions. The author implies each tip will help you pick better funds, but each one is laden with caveats that point out how mutual funds are loaded up with luck. If you didn't stumble over them, it's a sign of the psychology the sales force of Wall Street has deployed to ease your mind on investing in mutual funds.

The proper way to approach investing in Wall Street is understand the fundamental business you are investing in. Do you really think mutual fund managers read every financial statement from the 100-200 stocks they invest in? Or perhaps they spend more time read charts, looking at stock price statistics, and other things to "guess" how well the stock will do. (BTW, Where are the customers' yachts? likened stock chart readers to astrologers.)

When Warren Buffett invests in companies, he looks at how they make money. He depends on good CEOs that show evidence of knowing how to run businesses. And he also only buys things he can get a good deal on. To get a glimmer of the evidence-driven manner he makes decision, go and read this year's letter to the shareholders. Do that, and you'll probably understand more than many analysts.

Here at the Wealth Building Society, we learn how to shake off Wall Street's salesmen and instead understand learn the fundamentals of business and other vehicles, instead of depending on others.

Apple and Chevron increase dividends

Apple

Apple recently made it's earnings announcements. It sold 37.1 million iPhones this year,which is an increase compared to last year's 35.1 million iPhones. They also sold 19.5 million iPads, up from 11.8 million. Some people are complaining about Apple because they're growth rate isn't as big now as it was a year ago. But make no mistake, they are still growing. Apply has had years of long term, steady growth, which is one of the reasons I bought this stock.

They have raised their dividend payments from $2.65/share up to $3.05/share. They are also planning to buyback more stock.

There is no doubt that the price of Apple's stuck has suffered. It peaked a few months ago around $700 and now is in the low $400s. But my plan to invest in Apple stock isn't based on the short term but instead the long term. I expect that twenty years from now, Apple stock will have grown in tremendous value. Not because of stock market fundamentals, but because the business has been a source of growth and innovation for decades. It's true that I bought some Apple stock when it was closer to the high, but I haven't sold it in panic. Instead, I bought more Apple stock when it was just a tad above $400. We'll see how that pans out in the long run.

Chevron

Chevron has also issued an earnings report. It has increased earnings from $3.15/share a year ago to $3.18/share this year. Considering that estimates were around $3.09/share, Chevron has done a good job beating them as it continues to show steady growth.

Chevron has been growing it's dividend rate steadily over the past twenty-five years. In this announcement, they indicated they are increasing from $0.90/share to $1.00/share, which is an 11.1% increase. That is great! It's one of the key reasons I invested in it.

Bottom Line

While I use real estate as my primary wealth building tactic, I am also keeping my eye on the handful of stocks I have invested in as well to form a second source of income.

Are you ready to seize the opportunity?

A couple months ago, I was presented with an opportunity I had not planned on when I initially formed my wealth building plan. I bought a new house using a little bit of creative financing. While we got a classic 25% down, 30-year mortgage, we opened a HELOC and borrowed an additional 15%, allowing us to reduce the amount of capital outlay.

This was all designed to let us sell the old house after we moved and minimize the amount of cash we needed to transition. But it opened the door to another wealth building opportunity. On one hand, I had an interest-only loan at 4%. On the other hand, I had a big check from the sale of our old house.

In classic money management, the natural approach would be to simply pay off the HELOC. But there are other options out there. I had already done the leg work of researching stocks, real estate, and some other things. One of the stocks I have a position in has been paying consistent, increasing dividends for over five years. It's an MLP which meant that it has to pay over 90% of its revenues to stock holders resulting in a high yield around 8.5%.

The opportunity was to make money the old fashioned way: arbitrage. Banks borrow money at one rate and then loan it out to consumers at a higher rate, making money off the difference. We can do the same. In this case, I had a lump sum loaned out to me at 4%, interest-only and could increase my position in VNR that would pay me 8.5% on a monthly basis. Each month, I can take every dollar of dividend and put it towards the HELOC, slowly paying off the balance of the loan. Eventually, I would pay off the HELOC and be left with a nice investment in a well paying stock!

Risks

To make wealth building decisions, we need to identify and weigh the risks. We also need an exit strategy. Essentially, we need to be ready to handle things if the risk actually kicks in. So let's list them out and see if we can spot a way to mitigate each one.

• HELOC interest rates rise

Right now, the gap between the HELOC and the stock is over 4.5%. If the HELOC rises 2-3%, there is still a profitable margin. Even if the HELOC rises 5% and somehow the stock does NOT increase payouts (like they have for the past five years), I don't have to panic. That probably wouldn't happen overnight, and it would still be possible to sell the stock position and immediately pay off the HELOC. I would have still made money.

• Stock value plummets

This is definitely a risk when buying any stock. Stocks are driven by logical circumstances, but they are also driven by irrational behaviors as well. The key is to not get swept up into day trading and instead look at the big, long-term picture. In our situation, it's important to realize that dividend yield is the critical value of buying more VNR, not appreciation. We aren't monitoring the stock for appreciation, but instead seeing that it keeps up its dividend payoffs. If the stock price plummets, we need to watch it and see if dividend payouts are being threatened, or if instead, it presents us with an opportunity to buy a bigger position. After all, one man's panic is another man's opportunity. If we keep getting the same dividend, then we can stay put and continue building wealth.

• Dividend payouts fundamentally change

The key part of this wealth building activity is to get regular dividend payouts that far exceed the cost of the HELOC. If the board of VNR stops making dividend payments or severely cuts their payouts, a serious reevaluation must be made. Some of our options on the table include selling the stock position and moving the money into a competitor. It's a valuable reason to research VNR's competitors, and there are many. That means that this wealth building activity doesn't have to wrap up with paying off the HELOC.

If all of these risks materialize at once, what then? No doubt we'd be in the middle of a a catastrophe! What then? First of all, we must recognize it's a highly unlikely situation. Even so, what would we do? Simply put, if the stock position drops and dividend payouts cease, then we can no longer continue our original plan of using the stock pay off the HELOC. Time to get out.

I have liquid cash as well as multiple investment properties. I could refi or sell a property and pay off the remaining balance of the HELOC. Or by that time, I might have another investment vehicle in motion that could take over paying off the HELOC. Any way this goes down, if this tragic change were to happen five years from now, we would have definitely accumulated more wealth. What's critical is having the research, options, and ability to seize this opportunity that fell out of the sky, and then actively tracking our progress.

Reward

So we've viewed the risks and weighed them accordingly. What rewards does this present us with?

• By seizing the HELOC money and investing it into an MLP stock, we might eventually pay off the HELOC and continue receiving the dividend payouts.

By building up a position in a tax advantaged stock like VNR, we can continue to pipe that dividend payout into other opportunities, like paying off real estate investment loans. We could buy more VNR and increase our position. We can also use it to buy up an alternative like BRK-B.

• VNR continues to increase their dividend payouts.

Right now, the payout is about 8.5%, which is already pretty good. Maybe that sounds like peanuts because you're financial advisor promised 12%. But let's assume VNR continues its trend of increasing payouts. It's possible I could be receiving 15% sometime in the future, perhaps after paying off the HELOC. Or maybe the increases come sooner and help me pay off this fixed debt faster. That would be great! It's one of the reasons for investing in stocks that have a history of increasing dividends.

• MLPs weather inflation pretty well.

MLPs by definition are involved in storage, transportation, and delivery of natural resources like oil and gas. Those commodities tend to increase in value with inflation. Their stocks do as well. That means as inflation rises, the chances that our stock value and dividend payments would rise is pretty good. It might not happen at the exact same moment, but in general these markets travel together. That makes this a good long term investment.

• Every dollars invested in paying off the HELOC is another dollar in our pocket

The HELOC gave us the opportunity to build some cash. Every dollar of dividend that goes towards the HELOC reduces our total liability. It also slowly reduces the monthly amount of interest we owe.

Would you really borrow money to buy some stock?

I hear this question often on radio shows and in blog articles. People have a life altering event that suddenly drops a big wad of cash in their lap. For example, a loved one passes away and they get an insurance payout. Or sometimes they got some big severance check and find another job. They call into these radio shows and want to know what to do with all this money.

The fact that they are calling into the shows is a strong indicator that they don't have a well developed wealth building plan. The tone of the callers often indicates they haven't really learned about stocks vs. real estate vs. EIULs vs. other options to build wealth. Instead, it seems like they either have some mutual funds or nothing. I don't hear much else, except the rare instance of a perhaps living in one side of a duplex and renting out the other side.

The host often tells them to go nuke the mortgage on their house. Sometimes you hear doubt in the caller's voice. Some even ask, "But I could invest it, right?" To me, it sounds like a glimmer of hope that they could make some money. Why? Because silently, they know their current plan isn't working. The followup from the host is usually what's meant to be a softball question, "Would you walk down to your nearest bank and borrow that money to invest it?" The caller always answers "heck no!"

If someone asked me the same question, I would answer a resounding "yes!" If given the opportunity to borrow at 4% interest-only and invest in something with a steady payback of 8.5%, then I would definitely make a profit! But most people haven't spent any time actively putting together a wealth building plan, so when these life changing events happen, they aren't prepared to seize the opportunity. Are you? If you're not sure, contact me and we can talk about it.

Cash flowing assets help dodge Murphy

In the past, I've mentioned big things to watch out for, including inflation and fees. I've also mentioned how your wealth building plan needs to be able to dodge pot shots from Murphy.

One of the biggest benefits of cash flowing assets is that even when their value dips, they still yield output. One of my holdings, VNR, yields around 9% annually, and it pays out every month. The payout has been consistent and I have only seen it increase. It's not guaranteed. But to get guaranteed, I have to accept something much smaller, like 0.1% on a money market account. My rental properties continue to yield monthly rents. Their values have been going up, but if they dipped it doesn't immediately cancel the lease. In other words, these assets will continue to keep bringing money despite their dip in value.

Don't bet the farm on mutual funds

If your investment portfolio is totally based on appreciating mutual funds, negative market performance will put an incredible amount of negative pressure on you. It has been shown in many studies that people fear losses more than they celebrate gains. When your market value drops, there is a historic tendency for people to sell to stop the losses. That may prevent the losses from getting worse, but it effectively makes the losses real instead of "on paper."

But if you own cash flowing assets, you don't have your entire investment tied to the appreciative value. Instead, the constant flow of cash, either monthly or quarterly, can make the appreciative aspect of the asset not as critical to building wealth. If we look at the history of wealth building, especially amongst the top 10%, we can see a definite pattern. The wealthy tend to own stocks, real estate, and business equity. These all can appreciate, but a key aspect is that they all generate cash as well. The wealthy aren't simply holding themselves at bay during negative years. They don't need the hand holding that many financial advisors are attempting. Instead, the wealthy have cash flowing assets and are actively involved in gathering money and strategically employing it to grow the assets, pay off excessive debt, or finding new assets.

So what happens when Murphy strikes? Your assets can drop in value, but still yield cash. You can panic and start selling assets, but the pressure may not be so strong. You may be getting hit by unfortunate situations, but knowing that more cash is coming if you hold onto your assets can help you avoid making a bad situation worse. You might not have completely avoided Murphy, but collecting cash flowing assets and not dropping them in a panic will certainly help you come out on top in the long run.

So long Murphy...until we meet again

As I received April's invoices, I knew it would only be a couple more days and I would finally get paid...for all four rental units.

I bought these units last Fall, and have been waiting for a tenant for months. It has been tough. I called the agent they hired to find tenants twice.

This is part of the price for buying brand spanking new rental units. They aren't occupied. Duh! Hopefully, this was the relative startup cost. My gut tells me that units with tenants may tend to attract future tenants because it shows that someone has decided the place was good enough to live.

It's not 'if' but 'when' Murphy decides to visit

Whether or not I'm right about future tenants, this exercise has definitely put me through Murphy Training 101. When the property manager sent me my first batch of invoices back in September along with rental agreements, I was nervous when I noticed that only three of my four units had leases. But I knew we had set things up real good. And then the first check came in. After paying that month's mortgage payment, I had plenty of left-over cash. Whew!

While that was good, I knew in the long run, we needed to be fully occupied, so I watched slowly, month-by-month. I was feeling a strong emotional desire to cut the rent rate and get someone into the unit. But my wealth building nature quickly interrupted that train of thought. I knew that would probably impact all future rents for the life of the property. It took me little effort to visualize how bad a $300 drop in monthly rent times 20 years would be.

You see, even if you raise the rents down the road, a drop up front would establish a lower overall baseline and take out a sizable chunk of total wealth. It would also impact the future sales price of the units as well. I understood this concept, but I lacked the real world, boots-on-the-ground experience to solve the problem.

So, when January rolled around, and we still had no tenant for the fourth unit, I called Jeff Brown. He quickly confirmed my assumptions about the negative impacts of cutting the rent. He explained how he had done a rent calculation and our mortgage broker had done his own, and they had both reached the same conclusion. To tie things up with a bow, he told me they had already a top notch pro to get those units rented. They had already rented several in that neighborhood, and the evidence was already rolling in that their rent rates were right on target.

Good things come to those who wait

There are some upfront fees. For one thing, they pay the agent who found the tenant out of the first month of rent. The property manager has also been paying to keep the lights on for several months, so that has to be paid as well. Finally, they had been keeping the lawn mowed. So I'm only getting about 35% of the total rent in April. In the Land of Investing Based on Fees, that is tragic and a ripoff. Such costs would never be tolerated. Instead, the recommendation would be to sell everything and put it into a low cost index fund.

But for those in the Wealth Building Society, this is fantastic. That's because I'm leveraged about 3.5-to-1, we have our tenants building the equity of our investment, we don't have to deal with much in repairs, and are smoothly cash flow positive with a nice cushion of cash. Next month, with all the one-time costs for a new tenant out of the way, should be even better.

Can your wealth building plan still net a good profit even if only 3/4 of it is in operation? Imagine that your mutual fund investments had taken a 25% hit. You would need 33% growth to recover from that. That isn't our case. We have a fixed mortgage meaning despite the shortage of rent for the past six months, our loans have been paid off consistently and the estimated values of the units have continued to rise. Not bad for my first run in with Murphy after diving head first into rental property. But remain ever vigilant. Murphy will strike again. We must be prepared.

Happy Income Tax Day!

Happy Income Tax Day!

Kind of a strange greeting, right? But this is one of my happiest years when it comes to taxes.

What may sound even stranger is the fact that this year, I have to write a bigger check then I ever had to in the past.

The reason I'm so happy is because when I file my taxes and write that humongous check, I get to zero out that giant liability that has been a part of my net worth tracking spreadsheet for almost a year.

My tax liability has been a guess, and a very conservative one at that. Basically, I assumed I would lose 50% of my 401K early withdrawal. That is probably a tad high. If instead, it comes to around 48%, my net worth will actually grow a little. It also means the vast majority of my 401K money is now out of that restricted, costly plan and instead totally in my hands. Whatever stupid tax that was tied to using that mechanism will be paid in full and behind me.

I have entered a new era. For about a year, my plan to dump my 401K and instead switch to something more productive has been in progress. This will be the last major step to making the transition. (See the graph to get a picture of what I mean by more productive).

Don't get me wrong

I don't like parting with such a big chunk of cash, but it means that the old way of saving up money in a deferred plan is gone. Instead, I'm now building up a portfolio of valuable assets that come with some of the best tax laws in the land. From here on, I will be focused on having the most tax advantaged strategy in play all the way into retirement.

If you're new to this site, then that may sound strange as well. Aren't deferred plans great because they let you duck income taxes while you save? Strangely, no. They were designed to instead make you pay even bigger taxes when you reach retirement. In fact, after avoiding taxes for 30 years, it might take as little as five years to blow through all the tax savings.

Retirement should have as small of a tax footprint as possible

That is no longer going to happen to me. Instead, when I retire, I will receive a big chunk of my rental income shielded by depreciation. I will also have the option of taking out tax free loans from my EIULs (I plan to have more than one by then).

These things all help deal with the fact that I probably will have paid off my primary mortgage, have no more tax deductions from my children, and would essentially be tax naked. I might have to pay some capital gains taxes when I sell a chunk of Berkshire Hathaway, but the dividends coming from things like VNR will be tax free thanks to its MLP status.

It seems a little strange that people so obsessed with fees happen to ignore the biggest fee out there: taxes. When you reach retirement it's probably a good idea to avoid as many taxes as possible. That is the point when you are most vulnerable and who knows what the tax rates and structure will be then.

But in order to get from here to there, I need to pay a bunch of taxes right now. This is what it takes to launch my wealth building plan, and today marks the day when its in full gear. See why I'm so happy?

Is your wealth building plan out of alignment?

The other night I was putting together my desk. We recently move to a new house, and I had to take apart this giant desk. Putting it together was tricky, because I had to remember where all the pieces fit together. When I had finally lined everything up, I noticed that the center section of desktop was off by at least an inch.

I have one of those big, U-shaped desks. I had connected the lower part of the U shape, bridging the two sides together. This vertical piece was the main support for the desk component that would sit on top. As I placed the desk component on top, it seemed alright on the near side, but was off by more than an inch on the far side. That wouldn't do!

So I took the top off and looked everywhere. I noticed that I had gotten the furthest bolt lined up, but had completely missed the second bolt. It was outside the support piece. This had to the reason! No wonder the cam lock never caught on to the bolt.

It seemed strange that being off by what was less than 1/4" could have cause the opposite end to be off by such a big amount. But I went back and fix it so both bolts were properly locked on in that support piece. Then when I dropped in the desktop, it lined up perfectly. That's when I remembered how small variations at one end become magnified the further away you get.

The same can be said about wealth building plans. Something that may seem like a small impact today can have a huge effect on your total growth in a twenty five year span. Studies have already shown that the exorbitant fees of 401K can end causing you to lose an average of 30% (or more) of your total growth.

Something small like 4% vs 1% fees in your 401K can have a detrimental effect long term. In one study, they showed that $155,000 on average was lost to high fees, which could equal an entire house in today's dollars. With that much money, I could easily see buying another half-of-a-duplex and getting an additional $1300/month in cash flow. Think you could use that?

But who pays attention to 401K fees? Not many, I'm afraid. Most people don't watch small stuff like that. Instead, they check if their value is growing or shrinking. When values plummet, people suddenly get interested and start moving their holdings into more conservative funds. This locks in losses, but the same fees are found in the other funds as well. This insidious issue continues unabated until its too late, when you are thinking about retiring. You want to, but discover there isn't enough money, or at least not enough to retire completely. Instead, you need to find some other supplemental income.

That is what happens when your plan is out of alignment and not handling things like high fees, inflation, and complex rules surrounding 401K.