Regression to the Mean – it’s everywhere

There is a statistical concept I learned about from Dr. Dave Shafer: Regression to the Mean. It’s a simple concept, but one that when ignored, can cause enormous financial headaches. In essence, things can and do revert back to the mean rates.  The more extreme things get from the mean, the sharper things will swing back to the mean. Hence it is important to learn what the mean rate is, and not build on top of extreme positions.

A financial example

The Dalbar Report has been published for 20 years+. Each year, they do a lookback to see how investors that buy mutual funds fare. And the results are the same: terribly! The average rate is in the neighborhood of 4%. The market itself may grow by a bigger amount. But we aren’t the market, we are individual investors. To shoot for 12% as certain radio personalities advocate would entail getting triple the average rate of everyone around you. If you visit a financial planner and he pitches some precious metals mutual fund that grew by 85% over the past two years, you are setting yourself up for a shocking correction. For something that extreme, a huge correction is coming. See why people say “don’t chase returns?”

A gambling example

This concept appears in other places. A classic one are casinos. I’ve had friends point out that roulette wheels have no memory. The table doesn’t remember the previous spin, so the odds are the same. That isn’t what “memory less” means in betting odds. A betting system with memory is where a form of “state” exists. Such as dealing cards. Each card you receive is impacted by what was dealt previously. Betting red vs. black pays 50/50 odds. If you see red come up ten times in a row, odds are starting to mount that black will be next. The reason casinos stay in business, i.e. make money, is because they count on regression to the mean. They know that red and black will shift back and forth based on these odds. And the casino house DOESN’T PAY the odds. For red and black, they put two extra numbers on the wheel that are neither, but still pay you as if those losing options don’t exist. This is their cut, and is something like 3.5% on the average (if memory serves). Every game they play is based on regression to the mean and they aren’t stupid.

A literary example

As my final example, look at any industry. There are always big, visible leaders. For authors of fiction, there are best selling authors like J.K. Rowling, Michael Crichton, and others. They make big money. This draws other people into the field. In truth, a lot of people never get published. A vast number of people that do, never make big money. Regression to the mean says that if you average all these people together, the industry as a whole doesn’t average big pay for most people. If and when that average starts to climb, basic economics says that more people will flock to it, and pull the average back down. When the average falls, people will leave it, allowing the average to rise.

Take this concept and look around. You may start to notice it elsewhere. So what does it mean? When building a wealth building plan, use the averages to your advantage.

  • Most people don’t save a lot of money. First step: save money!
  • A lot of people count on other people to earn big money for them. Second step: get active and learn how to do it yourself!
  • Too many people get caught up in paying fees instead of picking avenues that actually build wealth. Third step: Shop around for vehicles that have a long history of building wealth and THEN be willing to pay the best experts to do it right.

Happy wealth building!

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!


It’s the yield, stupid!

habit-saving-moneyWhen it comes to building retirement wealth, you must keep your eye on the ball. What does that mean? Simply put, your goal is having the biggest after-tax cash flow when you reach retirement. Cash flow now, 25 years before potential retirement, is foolish. If you take a step that results in MORE cash flow today but produces LESS cash flow in retirement, then it was the wrong step.

Something to look at is the yield you currently receive. In essence, at any given time, you have a pile of cash. Your pile of cash should be earning some degree of cash. The rate it earns is the YIELD. If you have $100,000 and it nets you $5000 a year, you have a yield of 5%. We can discuss lots of different assets and their various yields. Real estate, CDs, mutual funds, bonds, stocks, whatever. Bottom line: your cash needs to be put to work. And the higher yield the better.

Duh! That part is obvious. What is more subtle is that you need to always look at all money coming in as cash flows. You may have a daytime job, which is one cash flow. But you may also have real estate properties generating cash. Your stocks may generate dividends and distributions. But at the end of the day, you need to know what your total yield. And then you need to be willing to investigate options that can increase your yield.

At that point, it becomes easy to evaluate whether or not debt will help or hinder your growth of wealth. When real estate can generate 5% growth and you leverage it 4-to-1, you dial things up to 25%. Borrowing money at 4.5% becomes a no brainer. The remaining hurdle is hedging the inherent risk that higher yields produce. One of the biggest ways to immunize yourself from real estate risk includes:

  • Having a big bag of cash sitting at the bank. How much? Think about 100% vacancy for a year.
  • Buying top quality property. This draws top quality tenants. It costs more but reduces the risk of renting to non-payers that must be evicted.
  • Renting in a landlord-friendly state. Hot tip: I don’t own rentals in California, and won’t in the foreseeable future.
  • Become a macroeconomic investor. Invest where the big indicators show a good rent-to-cost ratio (like Texas).

And never, ever, ever pass up opportunities to sell one asset if you find another that shows a consistent, sustainably higher yield. Because the higher the yield, the fast you can put that cash flow towards buying MORE quality assets to generate cash.

Good luck.

Why you shouldn’t fear bankruptcies the way the press does

If you make investing decisions based on the news, you will suffer debilitating setbacks in your portfolio time and again.

What comes to mind when you think about Sears & Roebuck today, compared to what you remember as a kid, and what you may have heard about this company decades ago? Sears was historically THE company to buy general merchandise.

I remember reading The Great Brain books as a kid. It’s a collection of stories told from a younger brother about his big brother, aka The Brain, who is quite smart, but governed by a money loving heart. Anyway, these books set back in the days when silver dollars were common currency, the character mentions having the rare and golden opportunity to order from the Sears catalog. As a kid, I remember that Sears was the place to get all sorts of stuff. But what do you think of it today? Do you flock to that store to buy things? Or do go elsewhere.

So would you consider investing in that company by purchasing its stock? Perhaps not. Take a step back. If you had the chance to buy stock in Sears thirty years ago, would you take it? Perhaps. But what if you knew everything you know now about how its gone down hill over the past years? Would you buy it then? Read this article for details on exactly how might fare.

Based on bad new stories over the years, you might say “no!” But if you actually looked at the balance sheets over that time frame, you would actually do quite well. Sears grew big and accumulated many various assets. As it crumbled, it sold off pieces into separate businesses. As a stock holder, you would hold lots of different companies, all generating profits. In fact, you would do quite well.

How can this be? As stated by the economic Nobel laureate Milton Friedman, “when companies go bankrupt, their factories don’t go poof.” Assets are sold off. New management is hired. Things are repurposed. New businesses plans laid out. Mid and senior level managers may get rolled and some employees may suffer, but in general, the core underpinnings of the company get refreshed, not burned to the ground.

This point seems to be lost on the press in general. Any shutdown of a company seems to draw reporters to find the saddest stories and turn them into headlines. They never bother to find these people a year later, and see how they are doing. On rare occasion, I saw a journalist actually find one such employee, only to discover that they were doing WAY better than before. They used to putter along with a poorly performing company. But getting tossed forced them to find something else, and they actually found something better.

Looking at a friend’s decision to sell off a rental

A close friend of mine recently completed a big shift in finances.

They had lived for years in a small home and managed to pay it off. Then they moved to a slightly bigger home and turn their first into a rental. Apparently they were able to use the rent from the first home to pay the mortgage on the second.

The big change is that last month they sold their old home at a profit from what they had originally bought it for. They took all their equity and paid off their current home’a mortgage.

He went on to tell me that somehow even with the rent he had a hard time making ends meet. He has never made close to what I make so I can’t sleight him for doing what was best for family.

He also said the stress was bad. They always feared getting a bad tenant that would trash the place. We have visited them countless tunes before they moves and I can testify it wasn’t a Class A place.

The final nail in the coffin was the amount of emotional attachment he had to the place.

This may not be what I would have done, but I don’t have his financial position, his stresses, or his situation. No way I can criticize something like that. He got good usage out of the equity of his old home and managed to work his way to a better situation. I can only wish him the best.

The right way and the wrong way to invest in real estate

As I often do, I turned on the radio and listened to a popular anti-debt radio show. Someone called in because they were in the midst of a financial calamity.

  • They had lost their job in the past month or two
  • They had relocated to a new area
  • They owned two rentals. One was vacant and the other hadn’t seen a payment from the tenant for five months
  • The caller had filed for Chapter 7 bankruptcy ON THEIR OWN
  • All 401K funds were depleted, and this person was flat broke
  • This person had no attorney to assist with the bankruptcy, but for some reason did have an attorney involved with the real estate

I was a bit shocked at all this. As radio host said, Chapter 7 bankruptcy is the “atom bomb”. It’s where you nuke all debts and simultaneously give up all assets, except possibly your primary residency. The caller had just moved and was trying to rent out their previous residency, but was failing. The host informed the caller that everything, including their leased car was going bye-bye.

The caller tried to argue, and the host told them they were crazy for trying to do a bankruptcy without an attorney. One of his first questions was, “Why didn’t you sell the rentals?” Answer: “There was a tenant. I couldn’t do any showings.” That is the most ridiculous thing I ever heard! Let’s see if we can walk through all this and see what mistakes were made.

Rentals don’t have to be empty to be bought or sold

Rental owners buy and sell all the time. There is no requirement to empty the unit out to sell it. Perhaps the tenant was being belligerent and making it difficult if not impossible to conduct showings. This would certainly make sense if they were five months behind on rent payments. The tenant knows good and well that a new landlord would probably have them evicted with no questions asked.

Don’t allow a tenant to stay in your unit and miss five months of payments

It may seem obvious, but the caller appears to be doing the land lording themselves, and they are doing a terrible job. When someone is five months behind, it’s time to evict them. The chances of getting caught up and then being on time are near non-existent.

Maybe there is something else missing, like a tenant that knows the legal system and has managed to fight making payments as well as fight evictions. They’re out there, but they are few and far between. From everything I’ve read, tenants that get behind are usually taking advantage of the owners.

I highly doubt this person had decent cash reserves

One of the most critical aspects to owning rental property is having plenty of cash to handle vacancies, repairs, evictions, etc. Think 6-12 months of mortgage payments.

You must be ready to go through the rough patches where you aren’t collecting any rent. Without cash reserves, you will be forced to dig into other sources of liquidity like 401K or just about anything. And it will also drive you to panic and make rash judgments. Having adequate cash reserves can calm you down and allow you to weather Murphy storms.

For some things, you NEED the experts

I wouldn’t dream of entering bankrupcy without a highly competent attorney. This is an area you can really screw up. I don’t know the law and what all my options would be. I would prefer to avoid bankruptcy altogether, but if it happened, this is where avoiding legal bills can cost you a whole lot. This person instead of selling the rental unit, is essentially throwing away a valuable asset.

Another area where it pays to find top notch experts is property management. If they had a good manager, that tenant would probably be evicted and someone much better, more stable, and better qualified would be in the unit and paying rent. The rental asset would be growing in value, not becoming a nightmare.

Finally, finding someone to scout up a tenant for the other unit is a great place to invest cash reserves. I have used someone to ensure my final unit was rented, and if I get another vacancy, I wouldn’t hesitate to hire her again. This is outside my expertise and I very well don’t expect the property manager to serve my interests in that capacity.

The likely outcome

This caller is probably never going to THINK of buying real estate ever again. Debt is probably off the plate as well. That means the idea of finding quality property, renting it to well researched tenants, and having professionals manage it are non-existent.

The results? This person will probably do everything to clear out any remaining debt, and then focus on investing in index funds and other things. That means that they might build up some pile of cash to retire on, but they aren’t going to get that nice retirement. I doubt they will scrape together enough money to be enjoying big cruise trips, but instead, will probably have to get a supplementary job to make up for what they don’t have.

The thing is, they won’t know what they’re missing. Sure they’ll have some peace of mind about having no debt, but they won’t exactly be living the high life either. It’s a form of survivorship bias, where you don’t know what you’re missing, and hence happy with what you got. If they are able to scrimp together $500,000 in index funds by retirement, they’ll probably be pulling $20,000/year before taxes. Could you live on that now? What about in 15 years? They’ll never never know what it means to be pulling $10,000/month+, tax sheltered because they got spooked from sloppy DIY practices.

Get rich slowly

My whole portfolio is engaged. My rentals are fully leased. My stocks are purchased and yielding cash. And my EIUL is getting loaded up on a monthly basis while starting to gather credits.

In short, everything’s doing great. But I’m starting to feel the desire to invest in more stocks. I can see the success of my purchases in small bits and pieces, and it creates this desire to get some more stock, to see it grow faster.

This is what I keenly read about in Where are the customer’s yachts?  In the book, the author wryly notes how stock brokers make good money selling to clients during booms and panics. But when things are humming along with no excitement, these same brokers do themselves in by not being able to resist “tinkering” in the market. They feel an emotional urge to get in. The problem is, emotion-driven investing is often ruinous.

It’s important to put together a plan. Have contingencies in the event you get another splurge in capital or if part of the plan goes sour. And when you feel emotional drives, cross check them against your plan. But don’t let emotions take over and upset your plan. Warren Buffett along with other successful dividend investors recommend unplugging from daily financial news. Part of this news drives a desire to “feel the pulse” and get active. Are you reading too much? Worried too much about dips in the market? The idea is to invest in solid companies when they are priced right, and then ride them out.
In short, I don’t need anymore stock right now. It’s not the right time. Instead, this is the time to let my plan cruise along as it is. It doesn’t hurt to research options, but don’t do something just because you have a hankering for it. What do I mean by “cruise along”? Perhaps a year from now would be a good time to revisit this idea. And there it is.

Don’t get swept up in trying to get rich quickly. Instead, do boring stuff, like collect rent once a month on your rentals. Collect stock dividends once a month (if you’re lucky), or every three months. But resist the need to speed up the action. If you can’t resist, this isn’t for you.

If you are going to invest in stocks, you have to be able to decide when to get in and when to wait. There is no glamor in getting rich slowly. But that’s the path that is the most likely to succeed. Those who seek to move quickly run a greater risk. Don’t confuse decisiveness with getting rich quickly. After realizing my 401K wasn’t working, I decided quickly and moved towards real estate. It has taken me a year to get that plan in action. But now that that move has been made, it’s time to watch things unfold.

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?

So long Murphy…until we meet again

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

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

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

It’s not ‘if’ but ‘when’ Murphy decides to visit

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

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

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

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

Good things come to those who wait

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

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

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

The speed of gains and losses

Lost time while driving

Have you ever gone on a long road trip? What happens when you run into bad traffic or stop for a meal? You lose time you can never make up.

For example, imagine you are traveling 750 miles, driving 75 MPH. Assuming you had a gigantic tank of gas, it would take you ten hours to make the trip.

But what happens when you run into some bad traffic situation? For about an hour, you are crawling along at 25 MPH. In that one hour of bad traffic, you essentially lost 50 miles of driving distance you originally planned. Assuming you get back going at your original speed, it will take an additional 40 minutes to complete your trip.

But you like to push things but driving a little faster, say 85 MPH. If the traffic slowdown had happened in the 10th hour of your trip, you can cut down the extra time to a hair less than 30 minutes. That extra speed only bought you an extra 10 minutes.

To get back on track, you would have to drive an equal amount of time at 125 MPH. Or twice as long as the slowdown at 100 MPH. Or triple the length at over 90 MPH. But that assumes you don’t run into other delays, like gas stops, food breaks, or other things.

Driving losses vs. investment losses

What does this have to do with money? It is more real world examples of the math of losses and gains. When we suffer losses in the market, we have to work harder to get back to our starting point. It illustrates why EIULs provide an amazing tool when it comes to building wealth thanks to their ability to avoid losses.

Investment advisors are all too eager to point out that given enough time, we can recover from the market losses that we hit, like in 2001 and 2008. While true, it leaves out consideration for when the losses happen. If our traffic slowdown had been during the first hour of our trip, we would have much more time to make up for it, but if it was towards the end, we are doomed to be late. This is simply another example of sequence-of-return risk.

Investment advisors rarely talk about this unfortunate aspect of financial growth. Instead, they focus on hand holding and reminding their clients that over time, their investments will grow at a nice 12% level. They tend to avoid mentioning things like how the Dalbar Report has shown that mutual fund investors usual get less than 4%.

Learning how to do the math yourself makes it possible to discriminate between financial facts and financial sales pitches. Farming out all investment planning to someone else leaves you prone to not tell the difference. But doing your own homework, learning the real growth of the S&P 500, and learning how big slowdowns towards the end of your trip to retirement can delay your arrival at retirement is key to real wealth building.