What you should and should NOT do when investing in stocks

newlogo7.9.10For those of you tracking my reinvestment in VNR, you may have seen it drop to a historic low of $1.47/unit. Given I reentered the market at $3.17/unit, this is a 54% drop from what is an astounding low!

Time to panic? No.┬áIt’s time to play the market long term. Remember this:

I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years. –Warren Buffett

I have invested in VNR under the assumption that I can make cash on a monthly basis. Driven by the lower prices, VNR has already reduced the distribution to match. In my humble opinion, the further drop in prices is more emotion and less facts.

This morning I saw an article citing how VNR is in a great position for people to score some arbitrage. That is when you make money by leveraging a change in value. This article has in depth analysis on how this is the time to buy since the author is predicting a quick recovery to a more stable price.

I don’t go for that. That is betting on appreciation, something I wouldn’t do short time. But I do use that analysis to back up my assertion that the current price isn’t based on fundamental risk in the company, but instead that the market is getting loaded up on emotion relevant to VNR.

panicDon’t invest in the market if you are riding on emotion, because it will get the best of you. Emotion is the reason mutual funds are a terrible failure. We are constantly pitched how they let us sidestep the risk of the market, but when things drop, people panic because it MUST mean something is wrong.

For those that don’t sell their mutual funds during losses, fund manager are forced to sell anyway to make pay outs. It doesn’t matter if we panic or not. Other people freaking out will drag us along. If you buy individual stocks and can keep your cool and stay objective, then you can make money in the long run.

DO: Invest in stocks if you have done extensive research, you understand how they make money, and understand dividend payouts, risk of making dividend payments, and have an exit plan.

DO NOT: Invest in stocks if you are looking for a quick buck, hoping to make your money on appreciation, or need a certain cash value at a certain time in the future.

15 year vs. 30 year mortgages

A topic you can always find vibrant discussion on is whether you should finance your home with a 15 year or 30 year mortgage. Among the many articles I’ve read on this subject, there seem to be two major opinions: 30 year mortgages offer more flexibility with a lower payment and 15 year mortgages help you eliminate debt more quickly.

Analysis based on inflation

Something that seems rare (only found it in one article) is the discussion of inflation. So I did what any truly independent, active investor should do: I crafted a spreadsheet to analyze both of them including the effects of inflation. The results are surprising.

First off, let’s assume you are borrowing $200,000 at 4%. For a 30 year mortgage, your monthly payment (without taxes and insurance) would be about $954. If you add up all the payments and subtract the original balance, you’ll find that total interest paid on a 30 year note comes to $143,739.01. That is 75% of the purchase price!

Compare that to a 15 year mortgage. Your monthly payment (assuming they are at the same rate) would be higher at $1479.37, which is more than $500 higher. Adding up 15 years of payments and subtracting the loan balance results in total interest of $66,287.65. That is less than half of the 30 year note’s total interest charges. You would be saving about $80,000. Sounds big, right?

Not so fast payoff breath. We haven’t factored in what you can buy with a $20 bill 30 years from now. If we pick a steady annual inflation rate of 3%, then each year, the amount of debt you pay becomes less and less in effective dollars.

The first year of payments on a 30 year note would total $11,457, but in the second year, that amount of money would only be worth $11,124 in today’s dollars. Go on out to year 30, and that amount of money would only buy what $4862 will buy today. Your dollar’s value would decline by almost 60%. If we reduce each year’s payment by 4%, total all those payments, then subtract the original balance, the amount of EFFECTIVE interest you will have paid is only $31,318.65. Inflation will have effectively knocked out $90,000 of that interest.

Let’s compare that to how inflation impacts a 15 year mortgage. The first year of payments will add up to $17,752, but the 15th year will effectively become $11,736. Add up those inflation adjusted payments, subtract the original balance, and you have an EFFECTIVE total interest of $18,286.16. In this situation, inflation has knocked out $48,000 of interest payments.

Bottom line: a 30 year note will reduce your interest payments to $31,000, effectively sidestepping $90,000 in interest. A 15 year note will reduce your interest payments to $18,000, skipping $48,000. The difference between these two is now only $13,000. Are you ready to put down an extra $500 each and every month only to save $13,000 in the long run?

Assumptions

Let me put all my cards on the table. This analysis has a LOT of assumptions.

It assumes inflation is 3% each and every year and is consistent. It assumes you can secure a 4% mortgage and that 15 and 30 year notes have the same rate. I’ve heard that rates have already risen even more than that. The bigger the gap between your loan’s rate and inflation, the more total interest you will save with the 15 year note. You can probably guess that if 15 year notes are a little cheaper than 30 year notes, you can save even more interest.

But if inflation rises in the future, things can quickly shift in favor of the 30 year note. If you had 5% inflation with a 4% note, then the 30 year note would save you almost $10,000 in total EFFECTIVE interest. 6% inflation moves 30 year savings to over $15,000. I’ll let you imagine what happens if we have any form of runaway inflation in the next 30 years.

This analysis assumes you stay in the same home over the life of the loan. Banks have studied how long loans last, and the average appears to be 2-7 years. That’s why they add extra fees if you want to reduce the interest on your loan. They know you probably won’t stay long enough to realize the savings and are locking in their profit.

Risk vs. Reward

Why do banks want to encourage you to take a 15 year note? After all, they tend to offer slightly lower rates for 15 year mortgages. In fact, I can remember seeing a giant banner at my old bank that bragged “save over $100,000”.

Banks aren’t stupid; they do things that serve their best interests. What is the advantage to them? Basically, they get their capital back sooner rather than later. The faster you pay off the balance, the faster they gather their profit and get recapitalized. And since this article is focused on inflation, they prefer getting their money in today’s dollars rather than tomorrow’s devalued dollars.

Always remember that fixed debt favors the borrower in times of inflation, because future payments are always worth less. In fact, in one article, someone commented how his father once had to work two jobs to afford a $3000 mortgage he had taken out decades ago. But towards the end of the loan, his monthly payment was in the range of $98 and he liked to brag about it!

The faster you pay off the balance, the more liquid the bank is and the less liquid you are. You are pouring lots of equity into the walls of your house, which you can’t eat or generate cash flow. But the bank CAN generate cash flow by using your payoffs to lend other people money.

Math vs. Psychology

There is another dimension to this analysis. You can crunch numbers all day, but many people flat out don’t want debt. They detest 30 year mortgages, and thanks to the huge upswing from the anti-debt crusaders, they feel strengthened to take out a 15 year mortgage. They are happy to be ten years in, with only five years left to go, and celebrate the fact. They want to enter retirement with no debt. In fact, they are happy to point out how they “must have done something wrong” in a jesting style when they approach the time frame and having paid off their mortgage.

I would like to enter retirement with no debt either, but I would prefer to carry debt if it meant I had more cash flowing wealth. After all, true financial freedom isn’t being debt free. It’s when you have enough solid cash flowing assets such that you can pay off all your debts if you had to, but you simply choose not to. Being house rich and cash poor is not a good way to live your retirement. People that enter retirement with little income tend to end up working at Walmart or taking out expensive reverse mortgages.

I think I’ll stick with my 30 year 3.625% mortgage and let it ride.

Building your wealth automatically

I remember waiting in my boss’s office a few years ago. I believe he had a copy of “The Automatic Millionaire” on his desk. I couldn’t resist flipping through a few pages. I never found myself a copy to finish. But I remember some quick tidbits.

One thing it mentioned was focusing on setting up things on auto-pilot. I don’t know if this book talks about paying down your home mortgage with extra automated payments. I would never do that. But the fundamental concept of automating things as much as possible is still valuable.

First of all, I have automated payments on all my mortgages. This ensures I stay current on everything. The first step of building wealth is not getting behind on anything. It puts your credit at risk and can also damage wealth building opportunities. When extra cash starts rolling in on your rentals (like getting a 12-month lease), you can call up your bank and increase you payments to build the equity in your rentals faster. Instead of remembering to do this every month, making it automatic helps.

Dividend payments coming from stock investments are a source of automatic cash flow. It’s not guaranteed, but if you pick solid blue chips, you’re odds are pretty good. One automatic option is picking “DRIP” and being paid in more stock. There are tradeoffs with automatically reinvesting dividends. One pro is that it avoids broker fees, but a con is that it forces you to reinvest in the same stocks. Maybe this is alright while your portfolio is small, but when it gets big enough, it might be better to collect cash, and then gather all your dividends, and invest in the best valued ones in your portfolio (discount price/strong dividend yield).

Building your cash reserves automatically is good too. That’s why my $2000 cash flow positive rentals is being split into two things. Half is going towards the smallest rental mortgage, while the other half is going straight into my cash reserves. The first step towards building wealth is to build liquidity. I can grab some cash on a minute’s notice if I need to, but in the long run, I need more cash on hand.

Automating your strategies makes it easier to stay the course, but none of this is a substitute for actively managing everything. And don’t forget to log your holdings and liabilities monthly in a spreadsheet so you can keep a pulse on everything.

Rippling effects from the lack of liquidity

I was sifting through twitter and saw something about a book reading involving the history of Superman and his creators, Jerry Siegel and Joe Shuster. The article mentioned recent court cases, so I did some digging.

Apparently, Jerry Siegel’s heirs won a case four years ago to retain 50% of the rights of Superman. But in a more recent case, the heirs of his partner, Joe Shuster lost due to a huge game changer. Jean Peavy, Joe Shuster’s sister, had struck a deal with DC Comics back in 1992 to pay off her brother’s debts and included receiving $25,000 a year for the rest of her life.

I don’t have all the details, but several disparate things I had heard recently came together in my mind, and I thought I would share them.

Liquidity can help avoid dangerous debts

I have mentioned before how cash reserves can protect from financial disasters. I don’t know the specifics of Joe Shuster or his sister, but I can speculate that if either one had maintained better cash reserves to shield them from hiccups, she never would have panicked and sold off her rights to Superman.

Or look at it from DC’s point of view. If you had the chance to buy 50% of the rights to Superman, an American icon connected with seven movies in the past 30 years that grossed over $1.4 billion at the cost of a little debt and an immediate annuity of $25,000/year for one person, would you do it? Heck yeah! In financial-speak, it’s called a steal.

How much is enough?

I have seen this example several times. If someone could promise you 5x your current annual income at retirement, would you take it? Would you trade in some cash flowing assets for such insurance? It sounds pretty big, right? But do you really know what things will be worth in 30 years?

I have a friend whose family owns a chunk of land down in Mexico. It includes mineral rights. This results in them getting rent payments periodically due to pipelines that run over the property. She has been told by her family to never, ever, EVER sell that land. And that advice is very good. Makes sense, right?

So what might cause someone to sell that land in the future? Tragic, badly managed debts that drives someone to panic. When we panic, we tend to make emotional decisions, not rational and well reasoned ones. We try to stop whatever is causing us to panic no matter the cost.

Thinking ahead

Someone that comes to mind when I think of future rights is George Lucas. When he was pitching the original script for Star Wars, a lot of people didn’t think he had much. He was finally able to get a studio to produce his movie, but he deliberately declined taking a director’s fee in exchange for a lot of rights including merchandise as well as the sequels. Back then, this was relatively unheard of. People that wrote a script and directed a movie didn’t do stuff like that. But George Lucas traded in a lot of immediate payments on Star Wars and instead held onto what would become a boon in intellectual property.

Now let’s be honest. If Star Wars had failed miserably, he probably would be relatively broke, so it was a risk. But because it was a success, George Lucas was able to start reaping an incredible flow of cash from toys, kits, books, future movies, and ultimately selling all of LucasFilm to Disney for $4 billion.

Anytime you have the opportunity to create something, whether it’s a business, a book, or something else, think about how much you can skip now in exchange for more down the road. Can you take a smaller payment in exchange for equity? Can you afford it? Do you have enough cash stored up in the bank to hedge such a risk? Are you taking steps right now to build up your cash reserves making you are prepared for these future opportunities?

The power of liquidity

Earlier this month, my family moved to a new house. This time, we had much more control over the entire process. We bought our new house, took the appliances and other things that we wanted, fixed up the old house, and then put it up for sale. This was all thanks to our liquidity.

Cash empowers you to make a better deal

We were not in a crunch to negotiate on the new house with any contingency clauses. Asking for a contingency clause on the sale of your existing home can make it harder to get the best deal, because the seller knows you may be tight. Remove the need for that clause, and you remove the “cost” of that convenience.

We also took what we wanted from the old house. This included the refrigerator, the window treatments, the TV & mount up on the wall, and some other things. Basically, with them removed from the property before a single potential buyer saw it, there was no need to negotiate $2000 here for window treatments, or $1000 there on the house price over a $400 appliance.

With everything gone, the house looks way bigger. It’s already a big house, but removal of all furniture makes it even more appetizing to prospective buyers.

My father-in-law and I were able to fix the handful of issues before even talking to a home inspector, propping up the quality of the house. This removes the things the buyer can complain about and start negotiating over. It doesn’t mean there will be no negotiations, just that there will be less on the table to argue over, allowing us to get to the real selling price much faster.

What made it possible? The fact that I had a big chunk of cash in the bank. With that, I’m able to carry the cost of two mortgages long enough to find the right deal.

Cash is just the first requirement

Of course, this requires having a fantastic selling agent (which I do) as well as a solid neighborhood. Since they finished every house in this subdivision over a year ago and finally finished the roads, things are ripe for the taking. Given that the comps on the house were noticeably higher than the original purchase price, and the past three years of mortgage payments had knocked out a chunk of debt, we were poised for a good sale.

But don’t forget: cash is the first requirement. Without a lot of set aside cash, many of these options simply don’t exist.

With enough cash, we can take our time, get a good price on it, collect our equity, and replenish the bank accounts. If we didn’t have such liquidity, we probably wouldn’t even have done this deal, and had to pass on this fantastic new house.