Monthly Archives: November 2011

Hope and Gambling are not Strategies

Hope does not make for a great strategy, as any biography of Ben Franklin will remind us. But, many people do hope for such luck. This is reflected by the number of people who play the lottery, slot machines, or any other activity where the expected value of the payoff is far less than their bet. With a good, carefully planned investment, the expected value of the investment (or money put down) is far greater than the capital they’re tying up.

The chances of achieving wealth through luck alone are almost nothing. Sure, there are those who earn wealth ethically where luck was part of the equation. The point here is that luck is only part of the story. Abe Lincoln once said that if I prepare myself, perhaps my chance will come. Preparing yourself will reveal the “lucky” opportunities. In reality, people seldom build wealth from chance alone.

Good financial planning is a practical way to accumulate wealth over time. This is a slow, steady, and boring process. Yes, boring. Building wealth in a sensible manner doesn’t mean flipping houses and buying “dot com” stocks. This is just another form of gambling. Instead, it consists of having a plan that incorporates investing with regularly, diversification, and limiting risk.

As we have seen from the housing bust, it is important to take all assets into consideration. People traditionally thought of their house as being an investment. The reality is houses are a depreciating asset just like any other consumer item. These items get used and wear out. Therefore, there is considerable expense to owning a home. Inflation, over time, distorts housing prices.

In nominal (meaning not adjusted for inflation) dollars, real estate prices tend to rise over very long periods. This refers to spans of 20 years plus. However, when you adjust for inflation, resale value for the home remains fairly steady. The only exception is the recent real estate boom and bust cycle. Although the resale price is roughly the same after factoring in inflation, remember all the costs associated with maintenance and repairs. This equates to a large sum of money over a period of time.

When looking at all your assets, it’s vital to understand which ones are long term investments and which are consumer items. Although buying a home is often a great choice, it should not be classified as an investment. If you rent it out in the future, then you can re-categorize it at that point. Until then, it’s important to recognize it for what it truly is.

If you reach a point where that particular home gets rented, and it meets all the expenses, then you have a real investment. If you keep it hoping for the price to go back up or are looking for capital appreciation, then it is only a game of speculation.

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Why Almost Everything is a Numbers Game

We always think of business as being a numbers game. However, numbers apply to almost anything, especially sports. In football, Bill Walsh developed a system that resulted in scoring more points and reduced risk by limiting turnovers. In baseball, Billy Beane used statistics to find undervalued players to fit his team’s tight budget. This shows that you can find an arbitrage and increase efficiency in almost anything.

Michael Lewis, a financial writer, wrote two great books on applying numbers in sports. The first was Moneyball. In this book, Lewis uncovered how batting average was a statistic that was over used. This has traditionally been the biggest statistic in which a player’s performance would be judged. Billy Beane, having to replace key players that left the team for more money, had to find a way to maintain production (scoring runs) without these major stars. He found that batting average wasn’t a perfect indicator as to how many runs a team would score. Of course, the higher the batting average, the better in general. But, there were other stats that did the job more accurately.

The key point here is that slugging percentage, walks, and on-base percentage are better metrics than batting average at estimating runs scored. However, the market (other teams), were using batting average as their key metric. This created enormous opportunities in the marketplace. Baseball has long been a game of tradition. And those working within the game were reluctant to change. This included everyone from owners to general managers and coaches. Billy Beane was able to replace stars with low budget players while the team kept winning.

In the investing world, we see examples of this all the time. Quarterly and annual earnings are an over used statistic, not to mention the fact that they’re also heavily manipulated. Also, there are those who only buy securities based on recent price performance. Stocks that have been going up generally attract more buyers. We’ve seen Benjamin Graham and Warren Buffet take advantage of these arbitrage opportunities by separating the real value of the company from the price of the stock. They care more about the business’s fundamentals than the stock.

In The Blind Side, Michael Lewis described the evolution of football over the last few decades. When Bill Walsh took over the San Francisco 49ers in 1979, he revolutionized the game. He introduced an offense that consisted of shorter passes. Not only did this new offense score more points, it also reduced risk. Shorter passes get intercepted less often. Plus, the quarterback gets rid of the ball quickly which reduces the likelihood of getting sacked. Replacing the traditional approach with higher percentage plays, Bill Walsh would win 3 Super Bowls.

Sports is a numbers game just like any other business. We can learn quite a bit from the competitive world of sports. The first is that most people favor the traditional ways of doing things which creates opportunity for you. The second thing is that we should always strive to maximize productivity while reducing risk. Many games are won or lost based on how many mistakes were made.

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Filed under Finance, Small Business