Company stock options

Does your company offer stock options? The first thing that may come to mind when you hear about “stock options” is Enron and all the scandals. The media didn’t hold back in reporting about people that had their entire retirement savings vested in company stock and watched it all get wiped out.

But that isn’t what this article is about. Those were people who had invested their entire retirement savings into company stock plans for years. Stock option grants are something different .Some companies offer you a chunk of stock either when they hire you, or an option later on to buy shares with part of your pay check. Companies that offer stock options also have 401K funds and the whole gamut of investment vehicles (which I don’t recommend) as well, so you aren’t steered into putting all your retirement savings into company stock.

Given that, let’s dive into what’s available in the world of stock options.  First of all, stock options come in many different flavors. They should be analyzed like any other financial instrument.

  • What are the risks?
  • What are the costs?
  • What are the upsides?
  • What are the downsides?

Given this much, let’s delve into some of their aspects and see if we can reach some conclusions.

    Stock Option Grants

    First of all, let’s look at grants. These are chunks of stock the company agrees to give based on a certain schedule. The quantity of stock is part of your salary negotiation and after you’re hired, it’s a done deal. Some companies might issue more grants later on, but there is typically no negotation at that stage.

    Generally, grants are structured with a certain dollar figure in mind, and are set up with a strike price discounted against the current value of the stock to support that. For example, they may set the price at which you can exercise 20% below current price and then figure out how many shares to issue to achieve a certain dollar figure. If they plan to give you $20,000 worth of stock and the stock price is $100, they might issue 1000 shares with a strike price of $80/share. That would leave with a profit of $20/share x 1000 shares.
    It is common that stock options are not granted immediately, but instead on a certain time table. For example, you receive 25% of your grant one year after your hiring date, and the rest spread over the following three years on a monthly basis. Or it could be something completely different. There is no end to the permutations.

    When it comes time to exercise your option, there are usually several choices. An often seen choice is the ability to buy the stock at its discounted strike price and sell it at market value, all on the same day, letting you pocket the difference. Using our previous example, if you have receive 250 of your 1000 shares, and the price hasn’t moved since they hired you, you can expect to receive $5000 before taxes and fees. If the share price has doubled to $200/share, then you would get $30,000. Big difference ehh? But if the stock price has fallen to the point of being below the strike price, then you would have to pay, so it’s highly unlikely you would even exercise your option at that point.

    Let’s examine the risks. It’s possible to negotiate for more options, but one risk is that they might reduce your salary. When I secured my existing job, I knew that stock options were relatively risky, and so I argued that I couldn’t pay my mortgage or feed my family on stock options. I got a higher salary because that was right for me. You might be different. Perhaps you already have enough salary from you or your spouse, and so would like to take on the risk of a bigger stock grant.

    Upsides? If the stock price soars, you can make a big profit. Just be prepared with a strategy if your stock option turns into big money.

    Downsides? Your stock option can fall flat and become worthless. This is a real risk, so don’t plan on big stuff based on your stock option. Always have an exit strategy if your option fizzles. For example, my current stock option has yielded tremendous gains in the first two years, but in the past six months, the price has fallen. Since I don’t need it for anything, and have other parts of my wealth building plan in action, I am waiting on a better time. That is risky by itself, and carries certain psychological challenges.

    You can never know if it’s the best time to cash in on an option. When things go sour, our psychological instinct is it sell and stop the losses. But if you wait, things may recover. Or they may not. This is tough to weather, and is a key reason you shouldn’t depend on your stock option as a central part of your wealth building plan.

    But there are many hidden positives. Whatever I get out of it is more than I would have gotten at my old company. And my company has already granted me another stock option about a year ago that is starting to vest. Plus, they plan to roll out a third one in the next few months. These are really great opportunities to let come to maturity, so I would never turn them down.


    There are other stock options known as Employee Stock Purchasing Plans (ESPPs). This is a deal where your company sets aside a piece of each pay check (perhaps 5%) over a given time frame, like six months. Then on a certain scheduled day, they use that money to buy stock at a discount like 15% below market value. You can opt to sell the shares on the same day, exacting an almost guaranteed 15% profit. I have even seen companies that look at the beginning and end of that six-month time period, and offer 15% discount on the low point, sometimes offering an even bigger profit potential.

    What are the risks with an ESPP? The risk is actually quite small. Given that you are awarded the shares and can sell on the same day, it’s almost a guaranteed profit. Only if the stock has a huge nosedive on one day, a rare event, would you suffer a loss.

    Costs? Basically, how much of your paycheck can you do without? It’s coming back in six-months, so this isn’t a long time to handle.

    Upsides? If you get the stock at 15% discount, and at the time of purchase, prices have risen 10%, you could be looking at 25% growth.

    Downsides? If you hold onto the stock instead of cashing it in on the trading day, you enter the psychological battle of deciding when to sell the shares.

    Bottom line: I would set aside as much I can afford to get that return six months later. In general, I would shoot to cash in on that growth every six months and not try to time them.


    I have seen other financial advisors and talk show hosts generally look down on stock options. They describe them as risky, dangerous, and invitations to financial ruin. That is way overblown and without merit. However, don’t trade in important salary for options. You can’t depend on the returns of stock options. Instead, they are an opportunity to gather more capital to feed your wealth building plans. Also, if I haven’t made it clear, stock options have lots of variations. I have mentioned a few types that I have dealt, with this shouldn’t be considered comprehensive. If you have encountered another variant, feel free to leave a comment or send me a message.

    Tax deferred mechanics of MLPs

    I have seen many articles where people discuss buying and selling MLPs. There are some finer points not covered in most, and its taken me awhile to learn them all, so I thought it would be perfect to capture them here.

    First of all, when you buy units of MLPs (master limited partnerships), the cash distributions have many tax advantages. Before we get too deep on that in this article, let me first prep you on some terminology.

    • MLPs have units, not shares
    • They pay distributions, not dividends
    • They have cost per unit, not price per share
    • They have earnings per unit, not earnings per share
    • All things are reported on a K-1, not some 1099 variant

    There are other terms, but you get the idea. The terms are relatively interchangeable, but it’s important to realize you aren’t buying shares of a classic corporation. Instead you are buying a stake as a limited partner in a company that doesn’t pay any taxes.

    Tax deferred benefits

    A huge majority of the cash distributions are tax free (probably 80-90% of it). You won’t know precisely how much until you get your annual K-1 statement.  The small amount that doesn’t fit this will be considered ordinary income, and it’s possible to have losses.

    The tax deferred part is considered return of capital. This means that you won’t owe any taxes until you earn back your original purchase amount. After that, anymore return of capital requires paying capital gains tax rates. According to 2013 tax codes:

    • It’s 0% taxes if your income is in the 10-15% bracket
    • 15% if you’re in the 28-35% bracket
    • 20% if you’re in the new 39.6% bracket, plus some supplementary taxes tied to Obamacare
    In exchange for not paying taxes on the distributions, your cost basis drops with every distribution. This means that if you plan to sell, the tax ramifications could be big. But if you can keep your position then it becomes a very well structured cash flowing asset.

    Let’s dig a little deeper with an example. You buy 1000 units at $20/unit. That means you plunk down $20,000. The distribution is 8% at $1.60/unit. Spread over quarterly payouts, you can expect 40c/unit every three months. In this case, we can expect $400 every three months, adding up $1600 in annual distributions.

    Now let’s assume that 90% of the distribution is return of capital. First of all, it means that $1440 of that distribution is tax deferred. We get to keep it all. Only $160 is considered personal income and has to be reported when we file our federal tax statement. If we were in the 28% bracket, this $1600 distribution would result in us owing the IRS $44.80. Not bad!

    In exchange for deferring $1440, our cost basis of the stock will drop from $20,000 to $18,560. That means that if the stock price didn’t move at all and we sold our entire position, we would still have to report a capital gain of $1440.

    Heck, if the market value of our position fell to $19,000, we would have lost $1000 in stock value, but still be viewed at a $440 gain in appreciation in the eyes of the IRS.

    Now do you see why I advocate not selling ever? At this rate of payout, we can expect to get almost 14 years of payouts before our cost basis drops to $0. At that point, if we are in the 28% tax bracket, we would have to start paying taxes of $216 on top of the regular taxes we have been paying all along, still leaving us with a tidy sum of money every year. Of course many MLPs raise their distributions down the road, which totally changes the numbers. We might reach a $0 cost basis much sooner, but if that is the price for getting a higher distribution, I accept!

    When you pass away and your heirs or beneficiaries inherit the units, they get a “stepped up cost basis”. This means that the entire cycle begins anew as their cost basis is reset to the current market value at the time they inherited the units. The cash distributions are once again tax deferred until their entire value is paid back. For the record, if your heirs wanted to cash in without a huge tax bill, this would be ideal time to do it before the cost basis drops.

    Another piece of the MLP puzzle is the fact that they often do business in multiple states. Because you aren’t shielded by a corporation, you as a limited partner, are viewed as doing business in every state where the MLP operates. You might have to file state income taxes in certain states. Vanguard operates in nine states, so the total distribution is spread across them, and the states that do have income taxes typically have a minimum dollar threshold you have to cross before having to file a return. It means that unless you own huge amounts of the MLP, this might not even be an issue. Talk to your CPA for more details.

    It’s quite a good cash flow machine if you can find spare capital or possibly finance it at today’s low rates (like an interest only HELOC). The critical thing is to understand the tax mechanics of MLPs so you aren’t surprised.

    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.


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

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

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

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

    Apple and Chevron increase dividends


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

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

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


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

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

    Bottom Line

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

    The gap between fund performance and investor performance

    One tool I have looked at a lot is Dalbar’s Quantitative Analysis of Investor Behavior, known by many as simply the Dalbar Report. It is a study that looks at the last 20 years of data. They have been doing this study for over 10 years. It a rolling study in that each year, they add the latest year and drop the oldest year. Then they look at how investors are doing that invest in mutual funds.

    The results? Not good! At the end of 2010, the 20 year average of the S&P 500 was 9.14% while investors in mutual funds averaged 3.27%. Yikes! So does the report say WHY there is such a big gap between the index itself and investors? They claim it is investor behavior and basically their fault for only holding a given mutual fund for less than three years.

    You see, Dalbar sells the report mainly to financial advisers telling them that not only must they help their clients pick good mutual funds, but they need to do a little bit of hand holding and have them stay the course when they pick a mutual fund.

    I investigated criticisms of the Dalbar Report a bit, curious what members of the financial community thought of this. After all, how often have you heard these damning statistics against mutual funds? Did your HR department send this information out in an annual notice along with other news about 401K options? Didn’t think so.

    It appears there is one big concern with Dalbar’s methodology. What I read was wordy, but could be summarized simply as, the first ten years were during the Great Bull Market, while the last ten years were during the Lost Decade. Strangely, this criticism seemed to attack the explanation of the gap, meaning it wasn’t 100% the investor’s fault, and that comparing these two figures was like comparing apples to oranges.

    The Great Bull Market was a highly unusual time period. It stretched from 1980-2000. The equities markets grew strong during this whole period. If you had a lot of money in the markets at this point in time, you would have done well. But when 2000-2001 hit, we got a major market correction. What made things much worse, was that another correction hit in 2008. In my personal research of looking at S&P 500 data going back to the 1950s, it appears that we encounter a market correction about every 10 years, so missing one for 20 years almost demands this double correction.

    But at the end of the day, what does it matter WHY there is such a gap. What is critical in putting together a wealth building plan is to look at investor performance and realize that mutual funds don’t work. This fact of there being ten good years followed by 10 flat years just proves the existence of sequence of return risk and how insidious it can be. To solve this problem, we don’t need to debate whether or not investors are to blame for their actions over the past 20 years. Instead, we need to build a plan that assumes this behavior will continue, as it has each year since Dalbar began their studies.

    We need a combination of tools that will help us build wealth without causing us to panic during down years, like rent producing real estate. Buying a handful of stocks that not only have a solid history over decades, but also involve products we fully understand would also be helpful. Finally, putting a chunk of our accumulated wealth into a EIUL, a vehicle that was designed to avoid losses as well hedge against inflation and future taxes. All of these tactics, when used together can provide a much more effective approach to building wealth. No longer are we betting on the appreciation of mutual funds, but instead accumulating assets that will yield cash for us in retirement with protection from the tax man.

    Throwing out old advice that didn’t build much wealth

    We recently moved. My family needed a bigger house, and we looked for some time before finding the perfect place. In the process of packing for the move, I came across an old book. I had bought it just a couple years after finishing college and entering corporate America.

    At the time, I was into the full blown, set aside the max 15% in your 401K deferred savings plan. In fact, I had increased it to 18% and was reaching the max annual set aside.

    Advice I read years ago

    I had read this book to learn all about stocks, bonds, mutual funds, futures, options, REITs, gold and real estate. As I was now sifting through all my books and deciding which ones to throw out for this up-and-coming move, I leafed through it, remembering when I had first read it.

    I quickly scanned the section on investment real estate. I was shocked out of my mind! It never mentioned rental property. Instead, it covered the idea of buying real estate with the idea that it will appreciate over time, and then eventually selling it. Not one iota talked about rent, cash flow, landlording, the famous 1%-rule, 50%-rule, etc. I felt the book was really lacking. Essentially, it said that buying a piece of property and waiting for it to appreciate was risky, not very diverse, and pretty much a no-go.

    They quickly moved on to REITs, which are a type of stock holding where they invest in real estate and distribute earnings to the share holders. It quickly pointed out how this was much less risky, didn’t tie up your investment capital for years, and let you avoid the expense of closing costs if you had bought the property yourself.

    Costs again?

    The focus on costs is nothing new. Some people drop the idea of real estate in a heartbeat simply due to the closing costs. That is sad, because real estate is one of the biggest ways that the rich become rich. Things like REITs and MLPs are regulated to pay out 90% or more of their earnings in order to maintain their tax advantaged status. That’s nice, but at the end of the day, they are just stocks. Unless you are buying on margin, you can’t get the same leverage as you can with real estate. When you consider that real estate grows at around 5%, that doesn’t seem like much. But if you purchase rental property with 25% down, then you’re cash-on-cash growth rate become more like 20%. Show me a REIT or MLP that beats that.

    Another important thing to know when comparing real estate and REITs is that just because you own a REIT, doesn’t mean you escaped closing costs. You might not have to show up at a closing with a check in hand, but who do you think pays the REIT’s closing costs? They are part of the bottom line in earnings, so you are still paying for them.

    By dodging the closing costs, the property really isn’t yours, and you don’t get the direct rent or cash-on-cash return of buying the property yourself. You didn’t take the risk so you don’t get the profit. Instead, you get what’s left after the REIT pays its manager, staff, promotional materials, managerial fees, and a dozen other things needed to maintain their structure. You are, as they say, at the bottom of the food chain. You receive a fragment of what’s left. If you invest $25,000 in a rental vs. $25,000 in the REIT, the outcome will be very different.

    Talking about investment property without rent is incomplete

    To have a section where all they talk about is appreciation is only half of a conversation. It would have been fine to mention that rent may bring in money, but there is the risk/cost of landlording. That would have been better. But that was completely left out.

    I really appreciated how the book had a running theme of mentioning risk. For example, in the chapter about futures, they clearly describe how you can make money. But they are quick to point out that it’s very risky and is one of the things you really can lose your shirt. In the section on margin trading, that is also risky. It is the sort of thing where you may start with putting in $10,000, but it’s not hard to get a call from your broker indicating you have to either pony up another $30,000 or lose your original investment.

    Back then, I liked learning more how those markets work, but I always appreciate that they said these more “exotic” investments were only for experts. Now, after having read “Where are the customer’s yachts?”, I have sincere doubt that there are any experts in these exotic investments. They are rare and hard to find. Ben Graham and Warren Buffett are the exception, not the norm. So whenever I read stock news, I take it ALL with a grain of salt. The only advice I read closely is from those who have made millions and billions over the decades

    Time to throw it out

    Since this was about packing, the question in my mind was, “Will I ever read this book again?” Seeing that this book was written for people that are worried about market risk and want to avoid exotic investments, I could tell I had outgrown it. Anyone who read it would be steered towards mutual funds and tax deferred savings plans. I wouldn’t recommend it to my dearest friends. I think reading many of the columns by Jeff Brown would be more constructive and lead to better wealth building. Hence, I threw it out instead of packing it up.

    Personal reserves vs. rental reserves

    There are a handful of blog sites out there that feature what I call non-traditional advice. What is non-traditional advice? To describe, let’s look at what comprises traditional advice.

    • You should be paying out less than you earn on each paycheck.
    • Build up some small emergency fund. Later on, build up 3-9 months of income in savings.
    • Any extra cash you receive must first target any and all debt. Often home mortgages are put last in line, but still eventually targeted.
    • After paying off non-mortgage debt, max out your 401K, 529 plans, IRAs, and any other tax deferred vehicle.
    • Investments should target mutual funds to avoid taking on too much risk.
    • Never buy individual stocks.
    • Only buy real estate if it’s cash only, and still profitable and you are willing to learn how to be a landlord or hire a property manager.
    There may be variances, but that is what most people on TV and radio talk about when they give financial advice. Well, there is a whole body of web sites that focus on wealth building using different principles than what’s listed above. People that stumble onto them are shocked when any of the above points are called into question. Heck, I saw one site where the blogger posted his net worth worksheets for several years, and one of the comments hastily stated was that the author’s posted debt was flat out “stupid.”
    Pay note, the man had a net worth of over $1 million, was cash flow positive on the order of $15,000/month through a combination of business income, rental income, and other means. If needed, he could sell everything and pay off his debt, and be debt free, but then he would be asset free and cash flow free as well. But none of that seemed to matter to the debt-is-evil commenter.
    Cash vs. stocks to store reserves

    One thing I have noticed that several sites are talking about is that cash reserves are dead money. The principle point is that cash reserves are either in checking accounts that yield no interest, or savings accounts that yield little interest. Either way, the money is expected to suffer bad losses over the long term due to inflation and taxes.

    While the point is sound, in my opinion, we need access to some amount of liquidity. My rental properties are currently 75% occupied. If that dropped down to 25% through the loss of two tenants, my cash reserves in place would cover the cost of the rental mortgages until new tenants are found. My property manager could call me tomorrow and tell me there are major damages caused by a tenant who was just evicted. The unit needs to be repaired before it can be shown to new potential tenants. These are items of risk I must be ready to handle on short notice, and I was already geared up to handle before I bought them.

    It’s possible I could stash that money in other places, like dividend kings that have a solid history of growth. This would probably have a longer term benefit to my cash reserves, but it introduces short term risk. Let’s assume that instead of keeping my reserves in cash, I instead invest it in one of my current stocks like Vanguard Natural Resources (VNR). VNR is currently yielding 9+%, so it would definitely outpace the interest of my savings account. When that emergency call comes and I find out that my units are currently vacant, it appears I need to withdraw $1500 to pay the monthly mortgage. It’s possible that VNR could be in a down cycle, causing me to lose money since the time I invested the money there. I may have gained some money in distributions paid out on a monthly basis, but it could be entirely offset if VNR is in a downcycle. This would be the time when I should be BUYING, but instead circumstances require I SELL. That is the short term risk I would be taking on if I stored my money there.
    This makes the cash used to back my real estate investment no longer a reserve, but instead an investment of its own. This introduces systemic risk, which I don’t need at this point. Mortgage debt is fixed, except for taxes and insurance, which is just a piece of the monthly payment. This means that my reserve cash doesn’t have to compensate for inflation. Repairs can rise with inflation, so my reserves should probably rise as well in the future, but not as fast a real investments. Just enough to reasonably cover my rental units.

    Or a HELOC to bail you out

    One of the articles I spotted addressed this issue squarely and had a solution: open a HELOC (home equity line of credit) on one of your properties, possibly your primary residence. That way, when there is no panic, you don’t draw the money. But if something goes haywire, you can easily pull money to deal with the situation. As soon as the situation permits, perhaps through recovering rental income or distributions paid on the VNR stock I mentioned earlier, you could repay the outstanding balance of the HELOC and get back on track.

    This is a strategy that could work, if you have the fiscal and psychological makeup to handle it. It would require that you not be tempted to use the HELOC for other things, like buying toys. It also means you might pay some amount of interest charges, but the advocates of such a plan would say that is washed out by the opportunity costs in not investing your money in a real wealth preserving vehicle.

    To be fair, the articles visit the concept of risk. Essentially, they point out the likelihood of using your reserves, and showing that in the long term, investing the money has a bigger payoff. But in my opinion, you can’t serve both long term and short term needs at the same time. My portfolio needs a certain amount dedicated to the short term, and that is what my reserves are for. The sacrifice is their lack of long term growth.

    Or an EIUL to borrow against

    One avenue I have evaluated and may yet pursue, is to buy a small EIUL using my cash reserves. In the span of five years, I could fully fund a cash value life insurance policy, and whenever I need the cash, I can borrow against the surrender value of the policy. When things are restored to balance, I can then start to pay back the EIUL and eventually put everything back on track. Since the borrowing costs of an EIUL are around 0.1% (yes 1/10%), it sounds like a good plan. That’s even better than the current 4% rates on HELOCs.

    If you are not aware, $10,000 at 4% incurs a monthly interest charge of $33. At 0.1%, that interest charge be just $0.83. Like the difference? To be fair, even the $33 isn’t much.

    Of course, in the first five years, my total amount of accessible money would be less than what I started due to the front loaded expenses, but the estimate I have already previewed shows that by the end of the sixth year, I would have caught up and passed my initial cash outlay. In 15 years, my cash value will have doubled, providing an internal rate of return of around 5.6%. Assuming I make it to retirement age, and have been able to effectively pay back any loans, the fund should yield around 7%. Not bad for an emergency reserve of liquid cash, ehh?

    How much does maxing out your IRA go towards your retirement?

    I just received an email from my discount brokerage firm. Most of the emails I receive from these financial houses are oriented towards mutual funds and IRAs, because, of course, that is what they sell. It’s only natural. The only other emails I get is when I perform some transaction.

    Today I got one that read “Even if you are only 10-15 years from retirement, you can still save a substantial amount in an IRA.” Is that true? What would the evidence suggest?

    Looking at the table they included (as well as checking the IRS web site), contribution limits for 2013 are $6500. It’s possible to save up to your total earned income, but it’s capped at $6500, so let’s assume we manage to do that. Let’s also assume we get that maximum window they are telling us of 15 years. What is $6500 x 15 years? $97,500

    But don’t forget, the increase the contribution limit each year to compensate for increased cost of living. They increased it by $500 from 2012, so let’s assume they will do that every year. Using a spreadsheet, you will find that saving $6500, then $7000, etc. for 15 years creates $150,000.

    First of all, how useful would $150,000 be if we were just entering retirement? At first blink, that sounds nice. But when talking about retirement planning, which hopefully would last at least 20 years if not more, it just’s not that much. If you factor in a 4% inflation, in 15 years, that chunk of money would be equivalent to $83,000 plus a latte in today’s dollars. Yikes! That kind of sinks the party.

    Next, let’s think about the magic of compound interest. Everyone likes to mention that in financial articles, because it’s the most powerful tool every invented! Whether or not Einstein actually referred to compound interest as the most powerful force every created, financial advisors like to make you comfortable in your progress to retirement by making it sound as if it will always be there to catch you up at the right time.

    In the article I saw they said that “you’ll benefit from time and the power of compounding to significantly grow your retirement savings.” That is a killer soundbite. Except your performance according the financial laws of compound interest can swing wildly either in your favor or against your favor.

    If you restrict yourself to only investing in mutual funds and index funds, then you’ll have to be happy with averaging around 4% in annualized growth according to the Dalbar report, which won’t cut it. I took the liberty of punching the numbers up above into my spreadsheet, multiplying the total cash saved each year by a fluctuating growth rate of mostly positive growth with only one loss in that entire 15 year stretch. Considering we have historically suffered a market correction about every ten years, this should prove somewhat conservative.

    You know what I got? A total cash value of $210,000. That may sound better, but it’s not a huge return after investing $150,000. In fact, that it’s only a measly 2.2% annualized growth rate!

    Click on the image to zoom

    You could potentially do better than the mutual funds if you invested that money into some dividend kings and reached retirement with a nice 4% yield in stocks. But don’t fool yourself into thinking this is all you need to do to retire. That kind of yield would only produce $8400 annually, averaging $700/month.

    I don’t think $700/month, or $388/month in today’s dollars, counts for “significant” in retirement savings as that article implies. When these articles wave the magic wand of “compound interest” and “dollar cost averaging,” watch out. They are attempting to cast a spell on you to make you think this can grow HUGE.

    Dividend kings may help you grow the net worth of your equities better than mutual funds, but make no mistake. Limiting yourself to setting aside $6500 in an IRA just won’t cut it. For example, if life interrupts and causes you to miss any of these contributions, your end results will only diminish. This is the best, and it doesn’t and consider what happens during the worse, such as a market correction the year before you retire or two corrections in the same span of time.

    If you already have something else that will provide your main source of income in retirement, then I wouldn’t object to having this IRA to use as fun money. But consider this: is your other source of retirement an order of magnitude bigger in the amount of money being saved, or is it similar to this? If it’s relatively the same in total dollars saved every year, the best you can is double the outcome. Is that really going to be enough?

    By all means, I encourage you to create your own version of the spreadsheet up above. Don’t like the rates I picked? Punch in your own percent growths. Try the last 15 years in average S&P 500 performance and see what you get. You may find that things don’t quite work out as well as you heard about in articles and on the radio. And feel free to contact me if you have any questions.

    Is your net worth built to survive inflation?

    Two big factors that can impact your net worth are taxes and inflation. In this posting, I want to discuss inflation.

    Essentially, the government pumps out a certain amount of money periodically. The Big Idea behind this is to smooth things out by having a steady increase in money supply. You can debate whether this works or not in some other forum. I only want to discuss how this impacts your net worth.

    If your money is invested in fixed instruments like treasury bonds, CDs, or fixed interest bank accounts, then inflation can be very hard on your net worth. A pile of cash can lose its purchasing power when it grows at 1% (or less) while inflation grows at 3-4%. Inflation is a complicated concept. There are a couple of ways to look it up. One is the base rate that the Federal Reserve lends money to banks. Since banks make money by adding a little profit on top of this, all other interest rates are above this. Given that you can borrow money today at rates like 3.5%, you can imagine how low the Federal Reserve rate is.

    Another is called the Consumer Price Index (CPI). The CPI is essentially a basket of goods whose purchase price is tracked periodically. As the prices rise, an estimated rate of increase is derived, i.e. inflation. But going back 20-30 years, we find that this basket of goods has been altered on multiple occasions. For example, in recent years, beef and oil have been removed from the CPI. Official inflation metrics may report somewhere in the neighborhood of 4%, but the price of beef has risen much faster than that in recent years.

    Suffice it to say, the subject of inflation can be talked about to death. But it’s real and here to stay. Which means we must deal with it when it comes to retirement investments. Take a real example. Imagine you own a home and need to replace the roof. If you do it right now, there is a certain cost. What if you need replace the roof again 25 years from now when you are retired? The price will have certainly risen. Other home maintenance costs will slowly rise as well. Fixed income instruments don’t lend themselves well to handling this rise in home repair costs. Other things that increase in cost is groceries, medicine, and gasoline. All these things are good you will need in the future when you are retired. Simply paying off your home mortgage won’t shield you adequately from needing to deal with this.

    Assets that weather the storms of inflation

    Some tools we use for investment purposes are ravaged by inflation while other things tend to compensate. One asset that can handle inflation is rental property. In times of inflation, rents tend to rise along with the value of the property itself. They may not grow at the same rate, but generally, rents rise. Now in past articles, I have presented numbers on the value of real estate based on NO rent increases. That was to make sure things were sound without depending on these increases. Sometimes rent doesn’t increase when inflation grows. Or at least it might not rise immediately. But in the long run, and real estate is a long term investment, rents rise and that’s a good thing.

    Do you know what else weathers inflation pretty well? Dividend aristocrats. These are long term companies that have been paying increasing dividends over decades, some more than 50 years. These are from companies that are producing quality goods that are able to raise the prices of their goods in line with inflation. By owning positions in some of these companies, you can keep receiving increasing dividend payments that tend to compensate for inflation.

    The strategy to building up an inflation-proof plan

    Okay, that headline is misleading. Nothing is inflation-proof. Maybe inflation-resistant. Every time this country has suffered high levels of inflation, the reasons have varied. Some people think we are poised to enter a high level of inflation, or even hyperinflation. I’m not sure I agree with that. Those opinions have to be counterbalanced by whether the ones making the boldest predictions are selling.

    To get this conversation on track, the question should be, what strategy must I use to handle future inflation?

    1. Develop a good reserve fund. This is where I agree with the many pundits who are talking about building up a 6-12 month reserve of liquid cash, like in a savings account. 
    2. Eventually, owning a home with a fixed-rate loan is a good thing. While property taxes and homeowner’s insurance may rise, a fixed payment of debt will tend to shrink as inflation grows. This also helps you avoid rising cost of rents. It’s no reason to buy a home RIGHT NOW before having your cash reserve built up, but eventually, a fixed house payment will help reduce the risk of being on the wrong side of rising rents (your own rent!)
    3. Start acquiring cash flowing rental properties and dividend paying stocks. As dividend payments come in, reinvest them periodically, and as extra rent comes in, use it to pay off investment debt.
    4. Plan to increase your inputs in various investing vehicles each year to compensate for lost power of the dollar.
    This list, while seemingly detailed, is very non-specific on when to do each, or how much time it should take, etc. That’s because everyone is different. You can send me a note if you want to chat a la email, skype or on the phone to talk about things in more detail. There are no promises to be made when it comes to dealing with inflation, but certain approaches are better than others. The bottom line is that investing in real estate and cash yielding stocks are good tools that have a long history of helping to compensate for inflation. Both of these things are better than gambling on mutual funds being able to match or exceed inflation through the pure appreciation of mutual funds.

    One man’s panic is another man’s opportunity

    While scanning the latest performance of my stocks on my iPhone, I noticed a curious news article linked to Berkshire Hathaway.

    Apparently, CNN Money was granted tour of the Oracle of Omaha’s office. I watched this short clip, and noticed how he keeps certain inspirational news stories framed and hanging on his walls. One was what looked like a stock certificate. It apparently involved a company that went into a panic.

    During the tour, Warren Buffett indicated that he keeps his eye on when companies enter a panic, because that is the best time to buy.

    You see, this investing philosophy he has demonstrated for decades shows that a company’s business may be solid. Their products may be good. But certain circumstances can make stock investors panic and try to dump their stock. When the herd is evacuating, it may be your best buying opportunity.

    When everyone is buying up a certain equity, that may be a sign that it’s stock price is becoming overvalued, and would actually be time to sell.

    There is more to this than just buying low and selling high. Some companies nosedive right before they dive. This is where you have to do your homework and understand the fundamentals of the business before buying. And I said fundamentals of the business, not fundamentals of the stock. Stocks suffer from a lot of human emotion. There are many companies out there that are solid and doing well.

    You can say as much about Apple. But in the past couple of months, their stock price has swung between $700 and $500, with news reports about people predicting the best to the worst. I think Apple is a solid company with plenty of cash reserves to weather many storms. They have built pipelines of popular products, several which I use, and continue to develop newer pipelines leading to continued sales. Whenever I visit an Apple store, it isn’t empty. Instead, they are full of customers. I have been there to get my laptop fixed, and the service was excellent. I have also been there to buy the latest iPhone 5, and again the service was excellent. These are all the hallmarks of a top notch company, catering to their customer’s needs, and selling valuable products. These types of companies last a long time.

    To step back from this high level analysis of their business and instead look at the historical trend of their stock, it is clear Apple has had strong growth at least since the 80s. This is what leads me to believe that they will continue to show good growth for many years to come. They didn’t reach this level of quality overnight. They have been building it for years.

    When I see the stock panic, I evaluate whether I have enough cash on hand to invest in more Apple stock vs. my other holdings, or if I should route that money towards my real estate portfolio. I have a strongly armed set of rental properties that are already paying me well, even though I have 75% occupancy. This is a good position to be in, and I look forward to next year and tracking my net worth, to see it grow. I hope to be able to buy up more Apple next year. The key is to have enough reserve cash standing by to buy up when a big drop strikes.

    Is your portfolio well armed with solid companies and solid real estate investments? If not, then recheck your assumptions. Are you just following the herd of investors that are throwing money at their 401K and hoping it will work out in the end? If so, you may be in for a rude awakening. I just hope your awakening comes sooner rather than later, so you have time to do something about it. Drop me a line if you want to discuss what’s in your portfolio.