Some of the best wealth building strategies are simple yet subtle

I took my kids to visit Disney World recently. Frequent readers of this blog already know I own a town home outside Orlando.

You might disagree with The Disney Company’s efforts to extend copyright law, but you cannot ignore the sheer brilliance of Walt Disney’s core idea to tap the public domain for stories.

That man has taken vintage stories from the past and breathed new life by writing music, creating cartoons and also attractions you can ride to enjoy these timeless classics.

Couple that with our constant rise in technology and Disney’s ability to re-release their movies in new formats with more bonus material, and you’ve got a recipe for success.

I was again reminded of how the parks and resorts appear to have suffered no recession whatsoever. You might disagree with the price if tickets, etc., but as a tentative investor, this company is rock solid.

Do I own any DIS stock? Nope. It’s not on my short list either. I find the dividend yield too low at around 1%. That and the fact that they only pay once a year simply moves it much lower than my other prospects.

But I would never fear the stock crashing or becoming worthless. People will be coming to the parks and the movie theaters for years to come.

Growth rates and their statistical fallacies

Have you run into some fund or investment vehicle where the seller advertises a tremendous growth rate?

Watch out, because you might be getting played for a sucker!

When you come in here, you look for the sucker. And if you can’t find him, then the sucker is you. –Mark Cuban, Shark Tank

Let’s imagine a very tiny index fund. It’s worth a measly $1. What is the total growth rate if it climbs to $2? 100%!!! Someone can legitimately tell you they have a fund sporting 100% growth. Of course, it only grew by $1 total.

What if your fund was worth $100,000,000 and increased by $1,000,000? The growth rate would be a tiny 1%. But it still grew by $1,000,000.

What this says is the percent and absolute dollar are BOTH important metrics.

A tale of two 401K funds

401K Fund #1

wealthA long time ago, I shifted the money that was going into my old 401K into an EIUL. This vehicle is geared to survive negative downturns and hence, only go up. In a sense, I think of my EIUL as my new 401K. Again, it doesn’t participate in market down swings, which has huge advanages. It also has better odds at beating the earning average of mutual funds.

401K Fund #2

house_cashBut that is not all. I travel with my family periodically to Florida, specifically to the Orlando area. My wife works for Disney, and we take their kids there 2-4 times every year. Spending money on hotels would have been outrageous. My wife heard from someone a few years ago cheap condos were. We finally bought one back in 2011 after I figured out that my bonus check that comes every six months could fund the entire thing, mortgage, utitilies, and all. Perhaps you’ve heard of the 401K condo?

On one hand, we have enjoyed every moment spent there. It’s great. Fully furnished. Appliances, bedrooms. I even have WiFi. The memories we have built are the best and only getting better. But that is not all. We bought it on short sale. Since then, the housing market has recovered and it’s estimated value has doubled. By paying it off slowly but surely, we are building equity. In the future, if need be, I can always refinance, invest the money into discounted notes, and pay off the loan. It’s another powerful real estate asset that offers more options.

“The investor with the most options wins.” –Jeff Brown

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Are you saving enough?

Financial speaking, the money that goes into both of these avenues is coming from my company salary. The total dollars is about 20% of my take home pay, which is not bad.

I’ve spoken before of this terrible investment exercise where people suggest you skip your daily $5 mocha and instead put that money into a mutual fund. According to those selling mutual funds, if you saved like that for 40 years, and 11% year after year, you would accumulate $1MM.

Except that in 30 years, $1MM won’t cut it. Assuming a 4% inflation, that dollar figure would be roughly equial to $208,000 in today’s dollars. Drawing 4% yield from that (as recommended by these same people) will grant you $8,320 Surrender 20% to Uncle Sam, and you’re left with $6700. We’re talking $560/month. What?!? So does skipping that daily mocha really turn into the cash generating machine you think it does? And do you really think you can earn 11% every year for 40 years, when Dalbar reports that people buying mutual funds can’t even average 4%?

That is pretty bad. If we are to turn things around, imagine that today we had $1MM.  How much would we need to start saving if we started 40 years ago? Doh! $5/day! So, set the wayback machine to 1975 and start chugging away. What is $5/day? About $1800/yaer. In 1975, median household income was about $11,800. This means that to save over $1800/year would translate to save almost 17% of gross income. Assume that 20% of that household income goes to the government and the savings rate against media take home pay would almost 20%.

So according to this, I’m on track to earning something the equivalent of $1MM in today’s dollars. My odds are much better because it isn’t based on earning 11% in mutual funds. And it isn’t based on having 40 years to save. Very few people start saving relentlessly when their 25. Instead, it happens in people’s late 30s/early 40s. They start to realize that their savings plan isn’t getting anywhere. So shift that 20-25 years of good solid savings.

Isn’t it time to switch to something that works with the odds rather than against them?

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VNR cuts dividend in half

newlogo7.9.10Vanguard Natural Resources, a stock I have written about many times, has cut their dividend from $0.21/unit to $0.1175/unit. That is an almost 50% cut. Good for me that I moved that money to discounted notes a few months ago.

Perhaps you’re wondering if I would continue recommending it? I would if it fits the need. For any critical analysis, you must understand the business. VNR is 85% natural gas. This has nothing to do with the oil market, which caused its price to tumble in the first place. In essence, a lot of people panicked and took a lot of the energy market down. In my opinion, VNR has been acquiring solid assets. They have a strong history of paying dividends.

To be honest, this appears like a great opportunity to collect some VNR stock at a discount. Again, if it suits your purpose. My purpose in owning VNR stock was to pay off an interest only HELOC. If my monthly payment on that debt was cut in half, it would no longer be the right tool for me.

My prediction (take it or leave it) is that VNR will eventually recover and slowly but surely be able to raise its dividend again. How quickly? I don’t know. But MLP stocks have a high payout ratio due to their corporate structure.

Thankfully I moved my money into a warrantied, discounted, first position note. It is paying off my HELOC at a higher rate than before and isn’t linked to tremors in the stock market.

I’m not a financial advisor. Don’t buy or sell anything simply based on my opinions. Do your own analysis and make your own decisions.

Building wealth isn’t free

habit-saving-moneyAll too common, I see people obsessing about fees at the wrong phases of building wealth. There are countless websites and forums where people discuss low cost index funds. The problem is, they haven’t calculated the Big fee that will hit them at retirement: taxes.

Standard IRAs and 401(K)s are designed to get you to sock away money tax free today, only to turn around and pay income level taxes at retirement. And to top it off, Uncle Sam demonstrates his hunger for that tax revenue by forcing you to start cannibalizing your savings at the age of 70 1/2. If you save up a big pile of money in something that pays a handy dividend, you can’t keep it forever. You will be forced to start taking minimum withdrawals.

To illustrate, I tracked down an online early withdrawal calculator. I plugged in $1,000,000 balance, and it told me that the age of 70 1/2, the minimum withdrawal amount was just shy of $36,500. To frame this in lingo that financial consultants use, we are all told to withdraw no more than 4% per year in retirement. 4% of that balance would be $40,000.

A subtle but little discussed point in all this is the “no more than” piece of that advice. The idea is that our retirement fund is expected to grow by more than 4%. Hence, ONLY withdrawing 4% should let our principle grow. But if we only have a 3% growth, we should ONLY withdraw 3% and hence NOT tap into the principle.

If we have a losing year, we shouldn’t draw anything at all. The hope is that our retirement funds would throw off dividends to fund ourselves. Anything else, and we are cutting into the principle and forever reducing future earnings and available cash. But these minimum withdrawals don’t grant us the ability to scale back to 3% or even skip a year of withdrawals. Instead, we are forced to cut into that principle so the government can get their piece of revenue.

It’s okay to pay taxes

TaxesIf there is any kind of lesson, it’s that taxes must be paid. The only question is when. People obsess over paying taxes today. They would rather push them off and score all the tax deductions possible. But that might not be the most efficient strategy nor the most stable one for your retirement.

The truth is, it’s better to pay the taxes now. That way, in retirement, there is no need to ship off a chunk of your retirement wealth to the government at who knows what tax rate. And if you use Roth IRAs instead of standard ones, there are no required minimum withdrawals! If there is any hint of what the IRS prefers, just checkout the fact that people making over $191,000/year can NOT contribute to a Roth IRA.

There is an old adage: would you rather pay taxes on a bag of seed or on the harvested crop? In true mathematics, if the rate at both times is identical, then you would pay the same taxes on either side. But that is rarely the case. And who knows what the tax rates will be 30 years from now?

Don’t forget about management fees

panic_buttonI’ve talked about fees many times. One really surprising article was about a couple that held dozens of mutual funds and never consolidated. They actually had a big chunk of cash. The effect was disastrous!

The couple in that linked article were paying a financial advisor 2.5% annually. Sounds small, except that they had saved up $1.3 million. Annual fees exceeded $32,000! Imagine paying $32,000 each and every year of your retirement.

The actual plan they were pursuing was to consolidates into half a dozen funds, and reduce annual costs to 1%. That is terrible! Cutting down to $13,000 in annual fees is terrible. The irony is that if they looked at the top ten stocks in each fund, they might find a lot of well recognized companies: Coca-Cola, Walmart, Apple, General Mills, Pepsi, Dr. Pepper-Snapple Group.

If they simply sold everything and bought $130,000 of each of the top 10 stocks, their annual fees would drop to nothing. There would be a one time cost of selling the funds and buying the positions, but after that, no management fees. And then they could drop the financial advisor! To top things off, they would probably rack up better dividends, dividend growth (like getting a raise in retirement), and also see asset appreciation.

Stocks aren’t the only way

Mortgage_Loan_Approved1Other options would include discounted notes. I’m in the middle of migrating my Roth IRA into a Self Direction Roth IRA. The plan is to buy warrantied, discounted notes. The noted fund I have joined sells 1st position notes at a discount. That means mortgages that were perhaps written for 5% would yield me something much higher, like 9-12%. They are also warrantied meaning that if the payee stops paying, I have the option to either foreclose and sell the property, or I can collect on the warranty and get back what I put in. Show me a stock or mutual fund that offers that.

As an example of discounted 1st position notes, imagine a note where the payee owes $100,000. Imagine it was written with a 5% interest rate. Monthly payments would be $536. The person holding the notes decides to sell it for whatever reason. Maybe they needed a quick source of capital. To move the note quickly, they are willing to accept $65,000. For $65,000, I can get that monthly stream of $536. Punch that into your calculator, and you’ll see that we are getting 9.9% yield on that investment.

To top it off, whenever the payee decides to pay it all off, I collect an extra $35,000 (remember, original balance owed was $100,000). If that happened five years out, the annualized ROI would be about 9%. Pretty good return on the money. And then I can take all this cash and buy more notes, boosting my monthly yield.

Thanks to having this inside a Self Directed Roth, there are no taxes involved. I have to pay a service fee to my note payment collectors of about $15/month. And the Self Directed Roth custodian needs a minimal fee as well. But nothing close $13,000 year! That is horrendous.

EIULs are designed to reduce costs in the future

EIULeffectThe last leg in my talk about good vs. bad management fees are EIULs. I frequently hear life insurance products criticized as being ridiculously expensive. The truth is they ARE very expensive….for the first ten years. After that, the costs drop dramatically.

Insurance companies design these products so that they collect their profits up front. That way, if you fall through on future payments, they don’t care so much. It also makes the products better guaranteed to last properly. A key ingredient, though, is to overfund as much as possible. By overfunding a policy, the cash value grows much faster. And the faster the cash value grows, the less total insurance must be bought. It’s a vicious cycle. If you slow down the growth of cash value, more of your premiums is used to fund the difference, i.e. the corridor between face value and cash value.

But when you overfund the policy, the total amount of insurance purchases through the life of the policy is greatly reduced and in the end, the annualized costs drop to somewhere like 0.5-1.5%. That’s pretty handy for getting a big chunk of cash in retirement that is completely tax free according to IRS tax code.

It’s not simple or easy to build wealth all by yourself. But delegating ALL decisions to a financial planner can be very costly when you reach retirement. The key is understanding the fundamentals of building wealth so you can hire the right experts to set up things most efficiently.

Are you saving big enough and smart enough?

rodin_thinkeI was recently approached (again) from a freelance writer, offering to write blog entries. I figured this would be similar. They would offer several articles, and I would find them filled with stuff and nonsense about 401K plans, which I have remarked countless times DON’T WORK. This time it was different. The articles given were even worse.

One of these articles pointed to a recent survey of Millennials and how were they doing regarding saving. All the status I could find were that Millennials were doing better by starting five years younger than Gen X, and auto-enrollment options for employer-based 401K plans has helped shift 401K participation from 81.4% to 84.6%

First of all, starting younger IS a good thing to do. When you talk about the power of compound interest and compound stuff-money-in-the-bank, every extra payment is good. In fact, if you pay off rental properties at an accelerated rate, it will make the interest rate almost irrelevant. What that links points out is that when you calculate the payment with a couple points of difference in the interest rate, you’re talking about a six month speed up of the payoff of that note. What speeds things up is making extra payments EVERY month, or EVERY year.

Hence, socking away extra cash from EVERY paycheck is the real ticket to success. Or at least, a key factor.

But something that really got my goat was how the article assumed that auto-enrollment was the reason that 401K participation had increased by 3.2%. First of all, no evidence was presented that this was the correlation at all. For such a small change in statistics, there could be a dozen factors. The slow recovery of the stock market (until a few weeks ago!) could make people more comfortable. Or watching the market rally here and there might make people start jumping in.

But the focus was on the entirely wrong points. The real question should be, “Hey Millennial, what rate of return are you getting with your savings?” and “How much cash flow do you predict you’ll have in retirement?”

When we ask these types of questions, our advisor should tell us, “You’ll make more in retirement then any year you ever worked.” Instead, the most common street advice is, “Don’t worry about taxes in retirement. You’ll be a smaller tax bracket.”

Uhh, why will I be in a smaller tax bracket? Is it because I’ll be making LESS then than I’m making now? After retirement might devalue my dollars perhaps 60%? And drive me to get ripped off by taking a reverse mortgage?

401K plans are betting on mutual funds. Mutual funds are doing horrendously. They always have. There is over 20 years of data showing that people that invest in mutual funds tend to get less than 4% a year in annualized growth. Ever since I pulled my money out of my 401K, and repurposed it with real estate and notes, my net worth has sky rocketed. My portfolio isn’t secured by shaky fishbowls of stocks that are supposed to mitigate the risk, but never do.

So I turned down this potential author, because this person didn’t seem to write in the same vein as any of my articles. No, my standards are quite high, and finding someone that shares this odd but evidence based quality of writing is hard.

Goodbye VNR, hello discounted notes

Mortgage_Loan_Approved1This may be a bit of shock to the readers of my blog, I have sold my entire stock position and used the cash to buy some discounted notes.

Say what?!?!

Anybody that has read my blog for awhile is aware that some of my most passionate articles have been about my big position in Vanguard Natural Resources (VNR). And it’s true. VNR has averaged a yield to 7.5%. In fact, in light of the recent sell off the market, their dividend yield is now looking like 14%+. Suffice it to say, VNR has been pretty good. To top things off, the HELOC I used to buy a majority of my position has been knocked down by 20% thanks to monthly distributions from my past position.

So why drop something so good? Because I have something better. First, a little background.

Discounted notes

What are discounted notes? A “note” is another word for a loan. And we’re talking about real estate loans, i.e. mortgages. When you secure a mortgage with the bank, they hold what is referred to as a note. When you buy a note from someone, you hand them a chunk of cash in exchange for receiving the monthly payments from whomever secured the loan. You also take over the lien on the property meaning that you have the power to foreclose and sell the property to get your money back in case something goes wrong.

To top things off, there are different positions regarding notes. When a foreclosure happens, the notes get collected in order. 1st position notes get first dibs on collecting on the sale until their obligation is satisfied, then 2nd position, etc. The name of the game is to get a first position, discounted note, secured by a piece of real estate, ideally where the value of the property exceeds what you paid for the note.

Time for a real world example in the realm of discounted notes. Imagine someone decided to buy a house for $125,000. They go to the bank and put down $25,000 cash and borrow $100,000 at 5% for 30 years. The monthly payment would be about $536/month to the borrower.

Now, for whatever reason, the bank that loaned out that cash needs some money fast. So, they decide to sell the note. Perhaps at the time, the balance is now down to $90,000 based on past payments. But to move the note quickly, they are willing to part with it in exchange for $65,000 of cash. That’s where you step in. If you have $65,000 burning a whole in your pocket, you can buy the note and start receiving $536/month backed by a total obligation of $90,000.

What are the numbers? Over twelve months, you would receive a little over $6400. And since it only cost you $65,000, the yield on that would be 9.9%. This is not only higher than the original loan’s rate of 5%, but is in fact higher than the 7.5% yield of VNR. Tiny hint: the note I bought is actually yielding 12%. Sweet!

In addition to collecting monthly payments, people are paying off loans all the time. Let’s fast forward and imagine that we managed to collect five years of payments. That would add up to $32,160. The principal balance would be down to about $79,000 (remember, you are the one collecting the interest). At that stage, the person, perhaps through inheritance, perhaps through devote saving, decides to pay off their note by sending you a check for that remaining balance. You have now collected a total of $111,160, virtually doubling your initial investment. Given the timeline of 5 years, that would be a 14.4% ROI. With your bigger pile of money, you can now go and buy some more notes. Rinse and repeat.

Tradeoffs

So what are the trade offs? There are always tradeoffs. When you buy a stock, you can get in and out in a second. You can buy a big position, and sixty seconds later, sell it all. I built up my stock position over a couple years and then cleared it out in no time flat. I sold VNR at a peak price of $30.85/unit. Today, VNR was dragging along at $17/unit thanks to the panic of the energy market. I nicely pocketed a nice 10% total gain on the money I had stuffed into my brokerage account. That wasn’t pure skill on my end. It was fortuitous. The time frame it has taken me to cash in and wait for a note has been seven months. I have been paying off my HELOC out of the 10% gain, and still come out ahead.

All in all, it’s pretty nice compared to this recent massive sell off that has fleeced many people’s mutual fund accounts.

Notes don’t work like stocks. Each note has to be investigated. Is it a first position note? Is it a performing note (meaning the borrower is currently paying and up-to-date)? What is the value of the property that is collateralizing the note?

This is an area where DIY can kill you. You need professional people that know this industry. It’s why I have been working with Jeff Brown for about a year and his efforts to find the best note investment company to work with. Jeff has decades of note buying experience, which means he knows the questions to ask when researching companies that deal with notes. In fact, he has fine-tuned what is known as the “Bawld Guy Fund” and how it operates to make it worth my time. For example, every note this company gets appears to have a life of about 20 minutes before someone snatches it up. Sound stressful? The Bawld Guy Fund lets top tier members get first dibs for two weeks. Then second tier members (me) get second dibs for two weeks. After that, any member can go for a note. That’s fair in my book.

The note I bought also includes a warranty, so if it stops performing, I can still collect and not lose my money. Did you even know about warranties? Didn’t think so.

At the end of the day, what we seek is yield. We want to grow our net worth with a solid yield. And as Dr. Dave has shown, we need double digit growth if we expect to enter retirement with someone of value. By slowly but surely moving my investment portfolio into real estate, EIULs, and discounted notes, my net worth is not based on flimsy mutual funds, but instead on tools that minimize losses during down years, and instead, are poised to do well in positive years.

Happy investing!

What is happening to the stock market?

graph_up2The stock market lately has gone CRAZY! So what’s happening? Well, I don’t have all the answers, but let’s look at some of what’s going on, and see what we can figure out.

At the beginning of this latest market crash, news reports came out about the price of oil dropping drastically. In case you didn’t know, oil is a key piece of the economy. Whose economy? Well, I know the most about the US economy, but oil is an international commodity, so it affects everybody. In essence, we all use oil to drive cars, fuel shipping trucks/planes/trains, and deliver most other goods of the economy. When oil prices fall, other parts of the economy rally. And when oil prices shoot up, other parts of the economy suffer.

So why is the whole market sliding down? One word: panic. Back in the 1970s, OPEC tried to control the oil market at an extreme level, and they actually contributed to a worldwide recession by pushing the oil market too hard. I’m not saying that is what’s happening, but when the price of oil moves a LOT, MANY investors panic.

All the oil stocks dropped off quite a bit. Strangely enough, stocks like VNR, which is 85% natural gas and has little to do with oil, has dropped 50% in the past 2-3 weeks. That is probably because many of the people that bought VNR are panicking that for some reason, VNR is next. In general ALL energy stocks will typically suffer a hit or a rally when stuff like this happens. A nice side effect for people like me that have a more long term aim at things is that I just reinvested a monthly dividend and picked up twice the usual shares.

But what about other things? VMW is a stock I pay attention to, because I still have a sliver of stock option. It has dropped to $77/share. It has nothing to do with the oil market. But many investors freak out and simply want to get their money out of the market when “shaky” situations like this occur.

This is known as systemic risk. Financial planners push mutual funds hard by selling the story of risk avoidance. They make it sound like during rough patches, mutual funds help you avoid such situations by spreading your risk across the whole market. The trick is, in these types of situations, emotions run high and people will pull their money out of everything. Hence, mutual funds will suffer losses just like other things. The trick is, when people cash out, they want their money. Mutual fund managers are forced to actually sell to dispense cash, and thus lock in losses. The time to get back to where you were takes too long and hence we all suffer.

The thing is, I have little money now invested in mutual funds. Instead, I have real estate, an EIUL, and other vehicles (one which I’ll post about soon!) My net worth has hardly dropped at all. And the yield on my investments is just as strong, meaning I’m not waiting for the market to recover nor am I waiting to “get back to where I started”. This saves me from having the proverbial “201K”.

I don’t have all the answers. I can’t tell you what the market is going to do next. But I can point out the risks that exist, and how mutual funds don’t provide the answers their salespeople claim. Everything comes with risk, and I have that nicely managed by having a super sized bank account filled with cash.

Happy investing!

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Financial Math III: Diagramming Cash Flows

This post will wrap up my series on Financial Math. I’ve previously written about:

In this article, I want to go over a fundamental mechanism any investor should at least be aware of: Cash Flow Diagrams. If you look to the right, you’ll see a common example.

The first line, that goes upwards, represents a burst of positive money you receive. The following payments, or negative cash flows, are essentially used to payback the initial cash flow. Do you recognize what common financial structure it is where you get a big chunk of cash up front, and then make small payments over a certain time period? That’s right, a loan.

For another cash flow, check out this one. It is the opposite. It shows a big chunk of cash being put out, followed by several small cash flows coming back. Can you think of any examples that match this? Buying a rental property and receiving monthly rent checks. Buying a big chunk of stock and then receiving dividend payouts.

At the heart of any financial transaction, investment, or purchase, you can probably see one of these two diagrams. When you are trying to make a choice on whether to buy a big chunk of stock OR put the money into a rental property, its useful to sit down and chart all the cash flows. Then, you can compare the two. The ratio between the the periodic payments and the invested cash is known as the cap rate, and it’s important to understand the cap rate for each usage of your money. When one opportunity yields less than the other, we refer to it as opportunity cost.

When you are about to pick a certain investment vehicle, it’s good to also make a list of the risks involved. Real estate has certain risks. Stocks have another. And paying off your mortgage early may carry fewer risks, but also consider the loss of opportunity if you don’t build up any positive cash flows in the future. Are you painting yourself into a corner of being house rich/cash poor?

Ever see those commercials where you can “get your cash now?” They are all about taking over your tiny positive cash flows, and swapping them with a big one right now. Believe me, those people make money. They simply calculate your cap rate, plug in a profit factor on top, and essentially calculate a smaller amount of cash to hand you than if you had kept the cash flows for yourself.

Hopefully, this series will have alerted you to the benefit in understanding some financial basics. Happy investing!

Financial Math II: Averages and standard deviations

GDvsS&P5001996to2012This Part II of my series on financial math. Previously we talked about some simple math tricks that can help you think faster on your feet.

In this post, I want to talk about some key statistics that get thrown around and how to parse them. I’m sure many of you have read this famous quotation:

There are three kinds of lies: lies, damned lies, and statistics. –Benjamin Disraeli (according to Mark Twain)

Statistics are what happen when we try to look at a whole batch of data points and spot some sort of trend, correlation, or conclusion. The reason they have to be looked at with a discerning eye is because people will either knowingly (or unknowingly) perform some sort of statistical calculation and then TELL us what it means. What they tell us and what the numbers actually mean can be very different.

rodin_thinkeLet’s introduce an example. Whenever you take a collection of data, such as amount of income earned by every person, and average it together, you can produce a couple different outputs. One is known as the mean. This is when you add all income and divide by every person. In these situations, it is easy for a small group of either very high earners or very low earners to skew the metrics one way or the other.

But if you instead take the entire collection of people and split them into two groups, right down the middle, and look at the mid-point, this is called the median. The median and the mean might be very close together, or they could be far apart.

By itself, these two different statistical values hold no bias. They simply show a slightly different perspective on the spread of income. But people can pick and choose which particular data set to show when making a point. They might choose the data set that better trumps their point of view.

Continuing with our current example, when people calculate such values, the purpose at hand is usually to deduce, where do I fit in? And that is why using the mean, which can be heavily skewed based on outliers, tends to not be as good of a statistic as the median when it comes to predicting things like that.

Another factor we want to know is how spread out is the data from the mean. To do so, we commonly use the standard deviation. If we tried to average the difference of each person from the mean, we would actually reach zero. That’s because half of the data points are greater and half are less than the mean, by definition. So to come up with something of value, we instead square the difference, average that, and take the square root. (In science, this is known as the root-mean-square).

Much research has been done that shows that anything with one standard deviation of the mean has about a 68% chance of success. Two standard deviations = 95%. Three standard deviations = 99%+.

Because standard deviation is so easy to calculate, you should always ask for it whenever someone, such as a financial planner or whomever, attempts to woo you with averages. “The average performance of this fund is 18%.” “What’s the standard deviation?” If they scramble from answering that, it’s a sign that you should probably run.

You see, the bigger the gain, the bigger the risk, and the probably the bigger the standard deviation.

You can see an example in a blog post I wrote for Dr. Dave. In it, I compare the average performance of the S&P 500 compared to an EIUL. To do an analysis, I figured that most people will have about 25 years to get serious about saving in either plan in order to “catch up” if they are late to the game. So, what if I looked at EVERY 25-year window of the S&P 500 going back to 1950, calculated it’s actual performance, and averaged them together? On top of that, let’s find out what the standard deviation?

Turns out, we have a 68% chance of landing somewhere between 4.77% and 9.53% in total growth. If we don’t do so well, we might barely be grazing past inflation. Or we might be well ahead of it. For something in which we only have one shot, I don’t really care for those odds.

Compare that to an EIUL, for which we must trade in a certain amount of highs to avoid certain lows. Turns out in that scenario, we have a 68% chance of landing somewhere between 7.52% and 8.84%. The 8.84% is certainly lower than 9.53% of the S&P 500. But in exchange we are almost three points higher than the low point, meaning our odds are pretty good of beating inflation, a key factor for investing in EIULs.

Neither of these stats factor in costs or how much cash you can put away. Remember, you can always clobber returns rates by putting away more money. The key is that means and standard deviations are important statistics you need to understand if you plan to take an active role in investing.

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