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. It’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.

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!

habit-saving-money

Mutual funds are just fine…if you’re rich

rodin_thinkeI listened to a famous financial radio host talking on another radio show this morning. The question was asked, “do you still believe in the 401k?”

His answer? “I invest in some mutual funds in a 401k along with rental property I pay cash for.”

I listened to this and could immediately see the fallacies in such a statement. Let’s dig in and examine them.

First of all, the key to building a retirement portfolio is putting money there. Duh! The reason many of us read a report or a prospectus is because we don’t have gobs of money to fund a portfolio. Instead we have much less so we must lean on the power of ROI and compound interest.

What do I mean? Imagine you made $1,000,000 each and every year. What if you could live off just half of that? I promise you: saving $500,000 every year for twenty years will set you up real nice.

With no growth at all, that adds up to $10 million. And if you bought something that yielded a paltry 1%, you would be raking in $100,000 forever without dipping into the principle.

Instead of plowing half a million into some 1% CD, what if you peeled away half of that and bought a new rental every year all cash? I think accumulating twenty rentals would be very nice.

$5 million in rental equity could easily yield $20,000/month in rent. Apply Murphy’s rule and assume you only get half due to repairs, maintenance costs, vacancies, etc. $10,000 is still pretty good.

Combine that with an adjusted $4000/month in CD interest, and you will do just fine.

As a side effect, people would probably stand up and take notice. The synergistic effect would let you write books that would sell like hot cakes because everyone would want to know how you did it.

So how did you do it? The secret is the original business you built that generated all that capital in the first place!

If none of us become entrepreneurs, we have to think up other ways to scrape up some capital. If your rich, you can afford to pay all cash. Not rich? Then your stunting your returns by going too debt-is-evil. There are good ways to take in debt and mitigate the risk.

Make no mistake. We can still accumulate $5-10 million in rental property. We just have to be ready to take on strategic debt, hire the right experts and do things smarter. We have to keep our eye on the ball.

We can become very successful. Sadly no one will want to read a book about how we did it. Oh well. You win some you lose some

But it irritates me when certain rich people go out of their way to tell us that mutual funds are great for everybody. They’re not. They suck. It just doesn’t matter how badly they suck when your pile of gold is really big.

To generalize that this approach to building retirement wealth works for eveyone is ridiculous. History doesn’t support it. And this is where I must part ways with this radio host when he begins to talk about investing.

How to build retirement wealth

If you are a new reader here, perhaps it’s time for an introduction. I like sharing my opinions on how I am building retirement wealth. I also like to document how my own investments are doing. Some of these ideas might sound outrageous or in contradiction to what you’ve heard from your financial planner, financial adviser, or some popular radio hosts.

But the concepts I lay out in my articles are backed up by historical evidence. In fact, I look at history to try and determine the best ways to build wealth. Do you know how you always hear “past returns are no guarantee of future returns”? While true that there is no guarantee, trying to shirk the past and it’s strong evidence is reckless and frankly won’t lead to a good retirement.

So what are the investment vehicles I employ?

  • No mutual funds.
  • No 401K or IRA wrappers.
  • Direct ownership of stocks (not mutual funds).
  • Leveraged real estate
  • Over funded cash value life insurance (also known as permanent life insurance)
  • Build wealth using various forms of arbitrage

These may the types of vehicles I use, but it also includes the concept of actively managed wealth building. Some of these vehicles may be considered passive forms of income, but it takes an active approach to do it right. The concept of simply dumping money into a mutual fund inside your 401K and assuming it will grow to serve you in retirement just doesn’t work.

No mutual funds

The Dalbar report has been monitoring mutual funds and tax deferred savings plans for 20 years. According to the 2013 report, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. In 2012, they reported the average performance of investors in equity funds was 4.25%. They further indicate that this is mostly tied to investor behavior rather than fund performance.

The performance numbers are clear: people investing in mutual funds average poorly. Dalbar goes on to make a judgment that it’s the consumer’s fault. This might or might not be a valid judgment. But is that relevant? If people don’t do well, and haven’t been for 20 years, do I really want to plan my retirement under the assumption that I can beat the average? I’m sure it’s what most others think. Dave Ramsey is happy to quote the FDIC in saying that 97.3% of people don’t follow through on their promise to pay off a 30-year mortgage in just 15 years with extra payments.

So why would we expect people to follow through on their attempt to not buy when things rise and sell when a market correction hits? I prefer to build my wealth building plans using the averages.

No 401K or IRA wrappers

401K and other government wrappers come with an incredible entanglement of regulations, restrictions, and other tricks to basically keep your hands off the money. The concept is to get you to put away money and keep your hands off of it until you reach retirement age. But many investment houses take advantage of this situation in the sense that mutual funds and other vehicles available tend to have the highest expense ratios.

People will eagerly point out things like IRAs as giving you more control, but the government has strong limits on how much you can put into an IRA. Suffice it to say, the limits on IRAs aren’t enough to build a retirement plan.

And do you really think the government designed the 401K to help you set aside money and save on taxes? The government wants you to put away money today without paying any taxes, so that you will grow the money into something bigger, and then start paying full blown income taxes when you reach retirement. Yikes!

It’s true that I have a Roth IRA and a 401K, but that is money I put in before I realized it wasn’t working. As you’ll see below, most of that money has been re-applied and is already making way more than what it used to. The only money I have left is trapped in my current company’s 401K and I can’t get to it. The Roth IRA I have is small as well and would serve little benefit if I extracted it.

Direct ownership of stocks

This one really stuns some people that I meet. I don’t like the dismal performance of mutual funds combined with their fees. Instead, I prefer owning stocks directly. If you look at all the studies done over the years, there is one stock market strategy that has proved fruitful: buying and holding dividend-paying stocks.

If you look at people like Warren Buffett, they have created billions by acquiring strong companies when they were on sale. Warren Buffett has also bought cash flowing stocks and companies, and reinvested their proceeds in other strong companies. This has created a compounding affect that has let him beat the S&P500 for years by great margins. The book value of Berkshire Hathaway has averaged it’s growth by 28% during the boom years, and by as much as 18% during bad recessionary times.

It’s not hard to find solid companies. In fact, there are many blog sites dedicated to this, such as Dividend Mantra and Dividend Growth Investor. The companies they invest in are not fly-by-night shady outfits. Instead, they mention thinks like Coca-Cola (KO), Walmart (WMT), and other names you’ll recognize. Companies like Coca-Cola have created millionaires for decades. You can find a list of companies that have paid consistent dividends, increasing them year after year, for over 25 years. It’s not that hard. It turns out, these are some of the best investments regarding inflation. A company that has managed to increase payouts to its shareholders through thick and thin is pretty solid.

Leveraged real estate

After the 2008 housing melt down, many people won’t entertain investing in real estate. The problem is that newspapers were reporting the worst scenarios regarding foreclosures. The truth is, 99% of mortgages are current and paid for. The number of people that suffered rate hikes on risky loans while having insufficient money to keep up were a fraction of a percent.

Real estate has shown a more consistent growth rate than mutual funds. And real estate is one of the easiest investments for middle class people to get into. Using prudent leverage, an average 4-5% growth can turn into 20-25% growth in your investment capital. That certainly beats the 4.25% average growth of mutual funds. Again, this is what happens if you use the averages. You can make more and take on riskier, higher paying options, but why take a risk? You’re already ahead of what mutual funds in 401K wrappers have to offer.

Since real estate was a no brainer, I cashed out my 13-year-old 401K from my old company, paid 37% in taxes and penalties that year, and used it to buy two duplexes with 20% and 25% down. I couldn’t be happier.

The rentals I own are paying me a nice monthly profit as the tenants pay off the mortgages for me. I keep a fair amount of cash in reserve to handle vacancies. And seeing my property yield monthly cash helps me to focus on that instead of pure growth in value.

Over funded cash value life insurance

This is one that stirs a lot of discussion. People have been preached to that cash value life insurance is a rip off and to never, ever, ever buy it! Phrases like “buy term and invest the difference” as well as “don’t mix insurance with investments” flies all over the place.

The thing is, many of the people that preach this opinion have an incomplete knowledge of how it works and how it was designed to function.

To be clear, I’m talking about EIULs, or equity indexed universal life insurance. And the critical component is over funding the policy to the limit set by the IRS. Essentially, buy a policy where you get the minimum amount of death benefit for a given amount of money. That causes your cash value to build faster. If you get the maximum amount of death benefit, then your cash value grows very slowly and it becomes an ineffective tool in storing wealth.

EIULs that are over funded give you the option down the road to borrow from the cash value. Essentially, you borrow money (without paying it back) and when you die, the loan is paid off with the death benefit. Whatever is left over is passed on to your beneficiaries.

EIULs have the benefit on not investing in the stock market, but instead in European options on the market. This is how they institute caps such that your principle is guaranteed to growth somewhere between 0% and 15% of the index it is linked to. If the index goes negative, your cash value stays the same. But if the market goes positive, so does your cash value.

You may not be aware, but that facet is incredibly powerful when it comes to wealth preservation. So many people have seen huge booms in their mutual fund holdings, but the overall performance is knocked back to that Dalbar average of 4.25% due to losses. If your account shrinks by 30% in one year, and then grows by 30% the following year, are back to where you started? Nope. $10,000 would drop to $7,000 and then grow back to $9,100. But if you had an EIUL, that $10,000 would stay put, and then grow to $11,500 (0% loss followed by a 15% gain based on the caps).

EIULs are very expensive for the first ten years; a fact many people like to point out such as Suze Orman and Dave Ramsey. But after ten years, the fees drop to almost nothing. After twenty years, the fees will probably average between 0.5-1.5%/year. Sure beats the 2-4% average cost of mutual funds. And then you get to start taking out tax free loans (compared to mutual fund payments at income tax rates), there is even less to fret about in retirement.

Once I understood the entire picture of what EIULs could and couldn’t do, it was a simple decision to stop investing money in my company 401K and reroute that money into an EIUL.

Build wealth using various forms of arbitrage

Something people are unaware of is how banks make money. Banks borrow money from the Federal Reserve at rates like 3.25% and then turn around and lend it out at 4.25%, pocketing the 1% difference. You can use the same concept.

I took out a HELOC against my home for (PRIME-0.25%) with a floor of 4%, so right now, it costs me 4% to get this money. Then I bought a position in Vanguard Natural Resources, an MLP that has been paying 9% distributions on a monthly basis. As I pay off the HELOC, I am essentially pocketing the 5% difference.

This is also referred to as equity harvesting. All that equity in my house was earning 0%. I am getting the cheapest form of money available, a mortgage, and using it to collect cash flowing assets. After I pay off the HELOC, I can redirect the money towards paying off investment mortgages, buying other dividend aristocrat stocks for even more passive income cash flows, or increase my position in Vanguard Natural Resources. And at that point, I can also renew the HELOC to get more investment capital.

When people ask “would you take out a $50,000 loan on your house and invest it?” my answer is a resounding “yes!”

Stay tuned

I hope you enjoyed this introduction to the concepts of build wealth at the Wealth Building Society. Wealth building isn’t hard, but when you boil things down to sound bites used by radio entertainers, some of the worst advice gets out there. Are the people that are telling you to only take out 15 year mortgages and pay them off as fast possible retiring on mutual funds? Are these people maxing out 401K and IRAs, or are they building wealth through writing books, running TV and radio shows, and piping their business equity pay offs into rental property?

Reading the darndest things

While waiting in a doctor’s office, I couldn’t resist flipping through a copy of Money magazine and reading their title article “101 Ways to Build Wealth”.

I predicted it would be filled with classic advice, like investing mutual funds, maxing out your 401K & IRA, open a 529, and several other things that don’t have enough evidence to back them up. Essentially, things I would never use.

I was mostly right. But what startled me was item #75 buried towards the end. It indicated that now might be the time to get into real estate. I was pleasantly surprised to see Austin listed at the top in job creation, as you can see in the attached picture to the right. The tip nicely pointed out how job growth is a strong indicator of rental markets, a fact keenly mentioned in the middle of a podcast interview with Jeff Brown.

It was delightful to see references to stocks I had already learned about from the Dividend Growth Investor. I have used his website to help develop criteria for adding dividend aristocrats to my wealth building plan. The fact that I had already heard of them made me feel like I was ahead of the curve slightly in wealth building.

The tips about mutual funds were spread throughout the article. I saw a recurring pattern where they would synonymously refer to mutual funds and stocks both as equity holdings. In essence, when people talk about holding stocks, they really mean stock-based mutual funds. The commonly preached mantra is that stocks are way too risky, and mutual funds are simpler a safer way to hold the same thing. No attention is paid to overall buy-and-hold stock performances compared to buying mutual funds from the perspective of wealth building. They really aren’t the same thing, and mutual funds aren’t inherently safer. Instead, mutual funds mitigate away too much upside for the sake of not enough downside protection. Combined with terrible fees, they are a horrendous way to build wealth, and the historical evidence proves it.

Basically put, real estate is the biggest component in my wealth building plans, and this article nicely made reference to it. Stocks also play a key role in developing another basket of income. But not mutual funds. I was glad that they didn’t totally avoid the subject of these two.

Survivorship Bias or How to Hide Failing Mutual Funds

I have written previously about cognitive biases. Even since I learned how much financial success and failure is governed by psychology from Dr. Dave, I have paid much more attention when I spot people mentioning cognitive biases.

One of the most insidious ones is survivorship bias. It is what happens when past failures vanish from our sight, and all we can see is success. We are pressured to accept almost any reason couched by the survivors, real or imagined, and use it to drive future decisions, right or wrong.

A thought experiment

The best example is one I read in Where are the customer’s yachts? In the book, the author mentions a thought experiment where you hand out quarters to 100,000 different people. Everybody flips their coin. If you flip heads, you stay in the game; tails and you’re out. One flip, and 50,000 people are out by natural odds. Flip again, and you’re down to 25,000. Suffice it to say, after 10 flips, there would be a hair less than 100 people left in the game.

At that point do you think anyone would be listening to the losers? Or would they prefer to ask someone who had flipped heads ten times in a row how they did it? I think you know the answer. At that point, the winners would probably be giving tips on how to flip the coin, how to catch it, how to stand, which direction to face, and any number of other ridiculous ideas. And we would all be drinking it in. Nevermind that 99,900+ people had just lost. That would be old news!

Survivorship bias overestimates past mutual fund performance

What else explains the fact that in one study, only eight out of 203 mutual funds beat their relative indices? Most funds fail at building wealth, but somehow that isn’t a highly recognized fact. Instead, most of my friends are still slugging it away in their corporate jobs, stuffing money into their 401k-wrapped mutual funds.

Here’s a tidbit that might stun you. Mutual funds that fail are shut down and never heard from again. Their assets are reallocated to another fund. The mutual funds of today aren’t the same ones from ten years ago. Do you think that type of past performance is factored in risk assessments by your financial planner?

Heck, I experienced this once, years ago. I didn’t think much of it. Instead, I figured they were routing my money into something better (hello confirmation bias!) If I was to go back to that same financial institution and evaluate all their funds, I might get a certain number on general rate of success. But that fund I used to have wouldn’t be included in that metric of success. See why this survivorship bias is insidious? It’s not evil or conspiratorial. It simply causes the data of failures to vanish without effort.

How can we combat these biases? 

Let’s try something different. Go visit Berkshire Hathaway’s website and start reading their annual letters to the shareholders. You’ll find data going back to 1977 written by Warren Buffett himself. Read them all and you will probably understand much more intimate details about business and finance.

Next thing: Go and read every blog entry by Jeff Brown, aka the Bawld Guy, a real estate investment broker, especially the ones before the video segments (sorry Jeff, but I miss the writings!) That might take some time, since it goes back to 2006. An article-a-night will help. You will get another perspective on real estate and how it stacks up against mutual funds and stocks.

I have spent at least a year reading both sources of information. This might sound narrow and focused on just a couple perspectives, but it actually shattered my established set of beliefs of the mutual fund industry. When that happens, you are willing to read more articles by other people, and review them more objectively.

No longer did I read things and filter them through my impaired assumptions. Instead, I started applying a lot more critical thinking and began to notice when writers used generalities & assumptions vs. specifics & evidence. The ones lacking evidence stick out like a sore thumb, and sadly appear to be in the majority.

The outcome?

At the Wealth Building Society, we try to point out evidence-based financial realities and cognitive biases. That’s why I’m hoping this blog can shake your financial foundations and help you start objectively looking at wealth building advice with a critical eye. And if you want to talk, feel free to contact me.

Mutual funds have a terrible track record

In case you haven’t noticed, I don’t like mutual funds. They don’t offer the wealth building power many people seem to think. But I’m not the only saying this. If you want to see a somewhat shocking realization, checkout this linked video.

In the video, the presenter takes 50 years of S&P 500 historical data, and examines what would happen if you invested money at the get-go. It shows how an average rate of return may be 7.4%, but you are only getting a 6% of actual return.

But it doesn’t stop there. The presenter plugs in a 2% annual fee, which is pretty standard combined with a 28% tax bracket. That leaves a paltry 3.1% actual growth rate. To summarize, he shows that if you started with $1000, the market would have grown it to about $18,000. But with fees and taxes, it gets knocked down to a little over $4000. Can you imagine someone else taking $14,000 out of your $18,000? It’s ludicrous! That’s swiping 78% of your total growth. Who wants that?

Let’s look at a column written by someone that tried to get into the mutual fund business as a fund manager, but seemed to have trouble. It’s ripe with examples of all the fallacies that go into mutual fund management. For one thing, there is a real lack of innovation. This guy had some new ideas, realized by his career, but were considered too radical to get hired as a fund manager. Instead, he points out that they seem to prefer hiring straight out of business school. It brazenly points out that mutual funds are aimed at making their money in fees, not gains in the market. That’s right. They would rather rope in lots of clients so claim their fees rather than earn you money. The fund he looked at getting hired for had high fees and low results, yet still had buyers. The hiring manager’s response was kind of like, “why change it? It works.” Mutual fund managers are driven by selling their fund and making money, not on earning good results for you. The final point (and I can’t list them all) is that mutual fund managers think they really know what is going on inside companies. The truth is, they don’t. Mutual funds usually have holdings in 100-200 stocks. There is no way they really have the time to sit down and read every press release, every financial statement, and every balance sheet for that many stocks and keep up. So instead they rely on other things like technical fundamentals, charts, and other outputs. Essentially, they think that by monitoring some basic indicators, they think they can time the market just right and do better than everyone else.

This might surprise you, but study after study shows that actively managed funds lag their relative indies all the time. Read this column about the Myths of Mutual Funds and you will see more proof. For example, from 1984-1998, only eight of 203 mutual funds that exceeded $100 million in assets actually beat the the Vanguard 500 index. That is a 4% chance of success. What’s even more amusing is how this author points out that getting dealt two face cards and shouting “Hit me!” has a higher chance of winning. Yikes!

A quote from David Swensen, who grew Yale’s endowment from $1.3 billion to $14 billion at an average annual return of 16.1%, says, “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.”

Mutual funds are definitely not the way to build retirement wealth. Instead, they are they way to sponsor an MBA.

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.

All fluff and no stuff

On twitter, I saw a promoted link from a well known financial service company. It was a link to video about how a family forged a path in investments to not only send their four children to college, but to also have their own golden retirement. As I watched this short video, I kept waiting for specifics, but turned out to be nothing but marketing fluff.

There was a sweet description of how this family was formed. The family realized it was better to live in a smaller house rather than a mini-mansion. This prioritization would make it possible for them to send all four of their kids to college with good, solid investments. The parents were also happy that they could split their attention equally with their own retirement. In the end, they wanted to be the “party grandparents” meaning they hoped in retirement, their kids and grandkids would be visiting them often.

See any issues here?

For an ad showing the power and value of investing in your child’s future, the video had little concrete info.

  • Is this financial institution succeeding in sending high school graduates to college?
  • Are people coming in short of needed funds? 
  • What about the people that saved up money in these plans, and their kids turned out to not want to go to college?
Guess what: the video doesn’t answer any of this. No demonstration of how they have the edge over any other investment house you can find.

Studies show that parents aren’t saving enough money to send kids to college. But what is the core reason behind that? Parents are lazy or not doing things right? Or is it because the cost of college in relation to average income has risen? It’s a complex issue, because while tuition has been rising, the number of dollars in various forms of student aid has risen as well. Essentially, it may next to impossible to predict what college will cost when your kids get there. But this video talked about none of that. Instead, the two concrete things it mentioned were: buy a smaller house, and split your investment dollars 50/50 between your kid’s college and your own retirement.

Too many assumptions
Something I notice frequently in any discussion of 529 plans or other college savings plans are a list of implicit assumptions.
  • Investing for college means investing in mutual funds
  • We are only talking about college. Other vocations and plans are simply off the table
  • You can and MUST save for your kids’ college.
Almost nothing is said except the occasional comment about picking a good fund manager, and not getting hung up on the returns of the fund. Huh??? A good fund manager should lead to good fund returns, right? I have noticed that they are coming up with strategic funds that are based on coming to fruition in a certain year. Essentially, people starting with a 5-year-old child have different saving needs than someone who is 15. While this makes sense on the surface, is there any evidence out there that this beats the existing funds?
What leads me to say no, is because these plans have the same structure as any other 401K or VUL. You can put in a certain amount of money, and then pick what funds to use the money on. If you have trouble with a certain fund, you can rebalance your money into other fund. 

In investor speak, that means sell when the fund is low, and buy some other hot fund when it’s high.

In case you aren’t aware, that will kill your chances at growth, just like any other mutual fund based approach. Considering that the variation of mutual fund performance has been really wide over the years makes it a real bet on whether or not mutual funds can beat their historical performances, let alone the potential inflation of costs of college.

There is a huge assumption that college is the best route to go, and it is best for everybody. That simply isn’t true. Some of the richest people out there never went to college. That doesn’t mean college is bad for you. It just means it isn’t the end-all/be-all of your career. I personally know people that went into home construction and made a fortune. Some of them weren’t good at storing the wealth they had built, and suffered tough times during 2001 and 2008 when home construction slacked off. There are many career paths that aren’t necessary found through college. It means that we need to keep this type of flexibility in mind. If you sink lots of money into a 529 plan and your child picks an alternate career path, what then?

So what is something that might work?
Well, it just isn’t fair if I don’t put my own cards in the table. I have several strategies in play that should help me offer my children the support they need when they get to college.
  • Invest in real estate
  • Buy an EIUL
Real estate, when you focus early on growth, is a plan to get as much property as possible with a reasonable down payment. It doesn’t mean putting 50% down, nor 0%. Instead, something like 20-25% is a good fit. With that, I can probably buy twice as much as the 50% and four time as much as the person that wants to make a cash purchase. The plan is that in 18 years, I should be able to strategically build up a decent portfolio of many rental properties. When the time is right, I have many different options. I could sell one of my properties and probably put my kids through with that. You must realize that my crystal ball is as cracked as yours, so I cannot confirm that the value of real estate will rise at the same pace as the price of tuition, but I think it has much better odds than the value of mutual funds. I might also be able to use the cash flows from my rental portfolio and not sell anything. Or some combination thereof.
Real estate provides great tax advantages in that most if not all of the rent will be shielded by depreciation. This is better than the fancy tax laws used to make 529 Plans look nice. Did you know there are limits on what you can contribute to a 529 Plan? Things like gift taxes come into play. But if you simply pay a child’s tuition direct to the institution  it doesn’t trigger any tax laws, apart from shrinking your own estate.

Unfortunately, if you own rental property and seek student aid, you will have to report it as part of the evaluation. But that’s okay. If rental property provides the means to make it happen, that’s okay.

I also have an EIUL that in 15 years, may be feasible to borrow from if needed. Then I can pay it back when the time is right using my rental property to support my own retirement plans. Did you know that built up cash value in any permanent life insurance is not considered when determining student aid? The money stocked away there is off the books and not even looked at.

Both of these options provide much more flexibility to supporting your children’s future plans. They also don’t pull you off the path of building your own retirement, one of the best gifts you can give your children. Since the history of real estate and permanent life insurance is much stronger and not as risky, then it would appear to have a lot more substance than that video I saw about this family’s plans.

Does your 401K have $2,000,000 in it?

That’s how much you need if you plan to retire and draw a measly $80,000. Where did I get that figure?
Most financial advisers recommend withdrawing no more than 4% of your savings. The idea is that if you’re account grows at a decent amount, then that should still leave the principal balance in place. But what if you have a negative year? You either need another source of money, or you will have to cut into your principal.

So, assuming you have a 401K holding $2,000,000, when it comes time to retire, you call ’em up, and ask them to cut you a check for $80,000. Then when it comes time to file your taxes, are you ready to pay your dues to Uncle Sam? Assuming you have an effective tax rate of 25%, you are left with $60,000. Oh, remember all those tax deductions you used to get for your kids, and for the mortgage interest you paid when you had one? Gone. What about tax deductions for money stashed in a 401K? Gone. Yup, you’re, as BawldGuy says, “tax naked.” Ouch!

And don’t expect a thank you from Uncle Sam. He teamed up with Captain Corporate America and put this plan together in the first place. They knew you were going to be stuffing tons of money into your plan, because everyone else is too, so they rigged it so they could get a slice of your pie in retirement.

Cross checking with reality

What’s that? Your 401K isn’t close to $2,000,000? What do you have? Is it greater than $80,000? If so, you have beaten the average. The average amount of retirement savings for people ages 55-64 is around $80,000. Maybe you have something like $100,000, and are 20 years away from retirement. How much growth do you think you’ll need? Over 16% each and every year.

Ouch 2! But wait. Doesn’t the power of money grow exponentially? What if you are a bit younger and actually have 30 years until retirement? Pay it no mind that 30-year-olds average even less in retirement funds. To get from $100,000 to $2,000,000, you need 10.5% growth every year with no losses. Now that’s better, but better NEVER means good enough. Considering the average performance of investors using mutual funds over the past 20 years has been less than 4%, what are you odds you can do 2.5 times better than everyone else?

Losses will mess up your growth

Don’t forget that the math of losses and gains says that for any negative loss, you need an even bigger gain to get back to where you started. Let’s say you were shooting for 10.5% this year, but instead got hit by an 8% loss. What would need next year to get back to where you started? 8.7%. But that’s just to get back to where you started. Get back on your original plan of averaging 10.5%, you would need over 32%. Spread your recovery time over two years, and you only need 21%. In investor-speak, we say not going to happen.

Simply put, mutual funds inside 401K plans don’t work. They never have. Otherwise, you would be hearing about all these people retiring on their fabulous mutual funds. And double check those celebraties who keep telling you to dump all extra capital into paying off your home mortgage. Are those people retiring on mutual funds? Or are they retiring on money made off their TV and books, and possibly their own cash flowing rental property?

What does work

The key to retirement is acquiring cash flowing assets. That way, your retirement isn’t based on liquidating your portfolio. This more than anything can protect you from big time market downturns. Don’t worry about paying your personal home off early. It doesn’t yield any money. Instead, you should be seeking rental property, stocks, and permanent life insurance. These items really form the basis of a wealth building plan. If you want to discuss your options, drop me a line and we can chat.