Category Archives: Investing

Fiscal Cliff Resolution’s Impact on Taxes and Investing

Given the large US budget deficits of the past several years, tax increases were inevitable. No doubt, this will be a drag on economic growth going forward. For starters, those earning wages will experience an increase in payroll taxes. The withholding for Social Security taxes will revert back to 6.2%, the amount it was before the financial crisis.

The Bush-era tax cuts will remain in effect for those earning less than $400,000 per year with the top tax bracket being 39.6%. Long-term capital gains and dividends will remain at 15% for those earning less than the $400,000 threshold. The top rate for long-term capital gains and dividends has risen to 20%.

Most importantly, however, is the permanent patch to Alternative Minimum Tax (AMT). Previously, AMT had to be patched every single year, leaving an element of uncertainty for many filers. Had this not been resolved this year, many taxpayers would have been caught by surprise with a stiff tax increase.

Although this resolution will be a fairly minor drag on the economy, it will not be sufficient for solving our budget problems. Our budget deficits are too massive and spending cuts will still be needed to bring our budget to a reasonable level. Simply put, the government will still spend far more than it receives in taxes.

One of the buggest dangers is a sharp increase in interest payments for the national debt. Interest alone on the national debt is around $29 billion per month. A spike in inflation and interest rates could make this amount multiply. Currently rates on US government bonds are near zero with the 30 year bond being around 3%. This is why any increase will be huge. These rates are historically low and cannot get much lower. That being said, the risk involved does not favor US taxpayers.

The Fiscal Cliff consisted of mostly media hype. The real problem involves the mushrooming amount of debt. If this is not dealt with, then we will experience a real crisis. According to Reinhart and Rogoff’s This Time is Different, once debt-to-GDP rises to over 90%, it becomes a significant drag on the economy (We have already passed this level). In most cases cited by the authors, governments eventually default. Currency devaluations, resulting in inflation from printing money, are considered to be an indirect form of default. And is the most common method used by governments with fiat currencies.

Slower Growth Impacts Equities

Currently, the stock market is priced with the assumption of GDP growing at the rate of its historical trend. This is roughly 3% per year. Since the Great Recession, we have not been anywhere near that. Corporate earnings for the majority of S&P 500 companies have been disappointing for the last 2 quarters. This suggests that earnings are near their peak for this business cycle.

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On Time and Money

Simply put, we are a nation of instant gratification. That said, it may not be such a bad thing. We should spend the bulk of our time doing what we’re best at. Just because you can do something doesn’t always mean that you should.

If you’re putting in long hours at work, it’s more feasible to get a sandwich from Subway than to cook at home (going to McDonald’s is a different story). Convenience goods generally cost more. Like getting a gallon of milk from 7-Eleven.

Many people are do-it-yourselfers. I’m not one of them. Why go through the trouble of learning how to fix something that you’ll likely deal with just once?

Changing you own oil for your car is the perfect example. Why do this yourself when you can take to a shop, and get it done within minutes? The cost for this service is low. In addition, you don’t need to worry about getting dirty and disposing the oil when you’re done.

Doing a task in which you’re not good at is a mis-allocation of resources. If your time is worth more in your primary business, you should seek to outsource tasks that are not your core business. These generally include tasks that are redundant in which you can write a simple to-do list for. These tasks require little or no creative thought. If you cannot completely outsource them or automate them, you may need to hire an employee to perform them.

Ultimately, the value of your time and specific situation will dictate what things you spend your time on. When I was younger, my time was worth less than it is now. So, it was a rational decision to carry out a few of the tasks that I wouldn’t do today. Back then, I have more time and less money. Thankfully, things have changed now.

We have limited room for how many tasks we can handle. We can’t focus on a long laundry list of high priority tasks. Therefore, reality eventually forces us to prioritize. Knowing where your critical path lies and staying on it are critical elements of being successful.

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Why Real Estate is a Good Investment Choice

Real estate allows an investor to control a valuable asset with only a small commitment. For investment purposes, an initial investment consists of a 20% down payment plus some closing costs. If you are buying a fixer, then your investment will be higher. That said, your initial investment is much smaller in relation to the value of the asset you are purchasing. Few investments allow this kind of leverage.

Indeed, leverage can be a double edged sword. It can magnify your investment results when things go well. It can work in reverse as well. That is why a margin of safety is vital. A margin of safety is a principle typically associated with investing in securities. It can also be applied to real estate.

Margins of safety for real estate can include the spread between your income and expenses. This is where you only settle for properties offering good, consistent cash flows. For example, a residential property in a distressed market is likely to be underpriced. Your mortgage payments are low in relation to what you’re getting for rent. Being a residential property, there are also plenty of people to rent the property to. Compare this with a commercial property with a greater return on investment but is attractive for only certain types of businesses. You have a much higher risk of vacancy loss. This simply means the property is sitting empty while you are paying the mortgage, taxes, and upkeep. This is why the residential property is the better investment choice despite having a lower ROI.

Another metric that is useful is the market’s price to medium income ratio. This is an important metric to avoid getting caught up in manias and bubbles. When the price for a median home is much more that three times the median income, the overall market is overpriced. As Warren Buffet has said, there are times in which it’s best to do nothing. Opportunities will eventually come.

In addition to getting positive cash flow, real estate is a good inflation hedge over long periods of time. There will be bubbles and panics again in the future. However, real estate will always revert back to its intrinsic value. Investors are best off when they don’t get caught up in the highs and lows. Instead, only buy properties that offer positive cash flow while you wait for price appreciation to accumulate.

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How We Make Financial Decisions

Financial decision making is simply more tricky than it seems. When we make our decisions, they always seem rational at the time. In addition, economists mistakenly have looked for ways to justify our decisions as being rational. Obviously, this cannot be the case.

We often buy things on emotion. Economists would rationalize this by saying that the item we bought gave us the most utility at the time. In reality, the thing we bought could have been a snickers bar or a soda. Something with no real value, in other words. But it gave us a feeling of satisfaction. Does this qualify as a rational decision? I think not.

Many irrational decisions people make involve those that provide the most pleasure or the least pain. This casuses even the most disciplined of people to slip every once in a while. For instance, a motivated health guru doesn’t eat healthy 100% of the time.

Another decision making problem we have lies with our illusion of being able to predict the future. We are hardwired to look for patterns. Then, we take those patterns and expect trends to continue indefinitely. Obviously, very few trends continue indefinitely. Most of these trends are nearly random and regress to the mean over time.

Bull markets start once everyone has given up on a particular asset class. This makes it undervalued. Anything that’s undervalued will begin attracting savvy investors. A new trend is born. When a new asset establishes a track record of rising prices, it attracts more investors. The trend strengthens and becomes psychologically reinforcing. Usually, the asset is at or above its intrinsic value at this point.

When prices get unreasonably past their fair values, a bubble is born. A crash becomes inevitable. But its difficult to stop and cash in. This is because it’s impossible to know when prices peak. A rational investor could stand to miss a big portion of the upside because a bubble could persist for longer than one would reasonably assume.

Governments also play a big role in bubbles. In fact, they will do anything to keep the party going. Keeping interest rates low is the perfect example. Lax lending standards and rising debt levels are a red flag that a bubble exists. Examples of this include buying stocks on margin and leveraging real estate.

The nature of bubbles reflects that most investors buy near the top. If an upward trend doesn’t exist for an asset, no one talks about it. Out of sight, out of mind. Gold simply wasn’t discussed in the 1990’s. The law of large numbers would show that the asset pool was too small at the beginning of the bull market in order for the majority to have owned it. If the masses were holding any particular thing, the prices would have been higher. And no new trend could get any traction.

We make our decisions based on what others are doing. In order to achieve long term success, try looking for the assets no one else is buying or discussing.

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Virtues of Contrary Thinking

“When everyone thinks alike, everyone is likely to be wrong.”
— Humphrey Neil

Simply put, the best investors are contrary thinkers. It pays to be contrary. Investing with the trend only gets you caught up in financial manias and bubbles. Human nature is what causes us to replicate the thoughts and actions of others. Despite the achievements in technology, human psychology has remained constant. Because of this, we still have the boom and bust cycle which is no different today than what it has been throughout history.

It makes little sense to copy what everyone else is doing when it comes to investing. If everybody is chasing a single asset class, that asset class has to be overvalued. When everyone was buying dot com stocks, other assets, including precious medals and other commodities, were ignored. This demonstrates that the best time to buy something is when nobody is talking about it.

Over time, these cycles repeat. A bull market begins when savvy investors begin buying an asset that is unloved and has been forgotten about. The first stage of a bull market flies under the radar and gets little to no media attention. As that asset class gets more traction and eventually shows a track record of rising prices, it attracts more investors and more media attention.

Eventually, a third stage unfolds. The real mania begins once that asset price has passed it’s fair value yet investors keep pouring money into it. You see magazine covers showing it off and it’s on CNBC all day. When that happens, it is a bubble and you should lay off of it. The day of reckoning will eventually come and the price of that asset will usually drop by 70% or more.

If you’re like most people, reflect back at your own history with mutual funds. As the saying goes, mutual funds do really well until you put your own money into them. This is true among the best performing mutual funds. This is because a mutual fund’s assets are in that third stage when you buy it. Otherwise, it would not have had the track record of being a top performer.

A mutual fund that has a great ten-year track record most likely holds assets that were undervalued when the fund manager first bought them. Over time, they kept rising in price until they were overvalued. At that point, those funds are featured in every magazine, on every financial website, and other media sources. If you choose to buy that fund, you either think it can continue going up while holding the same assets. Or, you think the fund manager is savvy enough to sell one set of assets and invest in another while getting the timing right. History suggest this is highly unlikely.

One of the most frustrating things is knowing when a bubble has peaked. When you get to a point at which prices seemingly couldn’t go any higher, they double. This is usually how it goes. Meanwhile, you hear from family and friends who claim they are making tons of money. And you realize you’re wasting your breath by explaining that a bubble is about to burst. At the same time, you don’t have 100% trust in your own judgment and are tempted to jump in yourself. Prices never get so high to the point at which they can’t go higher. On the same token, no boom ever eludes a bust.

For instance, consider gold prices. Many of the talking heads in the media are declaring the end of the bull market for gold. How can they be so certain? In previous bull markets, gold prices dropped 30-50% at certain points. After that, the bull market resumed and then doubled or tripled in value. In real estate, many people were calling for a bubble as early as 2002. In many localities, prices more than doubled from there.

If only it were that easy to buy low and sell high. It’s such a simple concept yet so few can pull it off.

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Tough Economic Times Call for More Liquidity

Liquidity is one of the most important factors when deciding on how to manage your financial assets. Tough economic times are usually temporary. During times like these, you should err on the side of caution and have plenty of liquid and non-volatile assets. This does not mean you need to turn into a gold bug. However, when deciding to pay down your mortgage, think twice. Should you need access to that money within 5 years, you should find a more liquid investment for your capital instead and keep making the minimum monthly payments.

The equity in your home is not liquid. This means that you simply cannot withdraw and use it anytime as if it were money in the bank. You must plan for the unexpected. You should always maintain some liquidity because there will inevitably be times in which you need cash fast.

There was a time where people believed that equity was almost equal to cash. In a healthy market, you would indeed be able to refinance or sell quickly to extract your equity. This is not the case anymore. It is much harder to quality for a refinance even if you have positive equity. Your credit must be very good and you need to prove your income has been steady for the last few years. In the current environment, you cannot assume that all of your home equity is readily accessible.

When the economic environment is good, people seldom need cash. And cash is much easier to borrow. This is especially the case when asset prices are rising. When the economy is contracting or at stall speed, it is a different story. Lending will often seize up and the capacity you had to borrow will also be gone. Most people take this for granted during the good times.

The harder times generally present the best opportunities. The real catch is that they are difficult to take advantage of. For example, real estate is a great buy in many regions today. At the same time, how many people can afford it right now? How many people are lendable especially for investment purposes? So, despite the enormous opportunities that exist, they are out of reach for many. The statement that bear markets present great opportunities for investors is only a half truth. This is only true to either a new investor or an investor that is buying that asset class with no prior holdings of it. This also assumes that you both have the ability to recognize the opportunity and the means to be able to afford it.

A cynic usually says that a bank will only lend you money when you can prove you don’t need it. This has been quite true at times.

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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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The Reality of Wheelin’ and Dealin’

Making deals sounds fun and exiting, right? Not so fast. If you’re survival always depended on making deals, how stressed out would you be?

Imagine you had a period of success. In fact, you had several months in which you had deals that gave you a surplus of money. Also, this was your only income from a business in which you owned. Therefore, you had no steady paycheck. Eventually, things tend to even out. You have a slow month or two. At first, you do not worry because you accumulated some extra cash from previous months.

Yes, you were stressed out a little bit at the very beginning. But things came together and money was flowing in. Then the dry spell came. Within the first month, you changed none of your habits and were not worried. You assumed that since you had some recent success, more deals must be around the corner.

Then the second month passes and things are still slow. You start to get nervous and begin to wonder when things will return to normal. You still have some money left so there is no need to panic yet. However, things start to get stressful. In the back of your mind, you start playing the ‘what if’ game. You ask what if I cannot make the mortgage payment or buy food a couple months from now. You wonder if the last few successful months were just an anomaly.

After considering that, you look at your average income over the last year. Not bad. But, what if you had a steady income and every two weeks you were guaranteed to get paid? It would seem like you got a raise.

If your income relies on your investments or by collecting commissions, you will not have a steady income. A steady income is simply worth more than making an equivalent amount that comes in bursts. It is also much more stressful.

This is a big reason why most successful investors place more emphasis on risk than on returns. Managing risk first will relieve much of the stress that comes from deal making. The more erratic your income stream is, the more cash you need to have as a reserve.

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Things You Should Consider when Investing with Partners

Investing with a single partner or as a group is a challenging task. This will involve structuring the right entity as well as understanding the goals of every stakeholder. Having said that, investing as a group can be a success. You can take advantage of opportunities in which you would not otherwise have access to. Investments that require a huge capital investment would be completely out of your reach if you had to go it alone.

When investing with a group, you have more bargaining power. For example, let’s say the group enables you to bring a larger down payment to the table. With a larger down payment, you can take a tougher stance on negotiating on price and other terms. You will, in addition, have more alternatives simply because there are far more properties within your reach. Many of these properties are such that most competing investors cannot afford them because they are acting alone. Another important facet of this idea is that larger properties often have much better cash flow than a single family residence that you convert into a rental. As a side note, when economic conditions are healthy, it can be difficult to find a single family residence that offers good cash flow for a reasonable down payment. Multi-family properties, on the other hand, typically offer good cash flow.

Partnering with other investors can also help you diversify. Instead of using all of your own money in a single property, you can spread your money across different properties with your partners. This would protect you from an unanticipated occurrence wiping out your entire investment.

Next, you should consider the goals and motives of your partners. Everyone has slightly different expectations, so it’s vital that you continuously communicate with your partners. This is important not only before you decide to pool your funds and invest but also you need to maintain the relationship over time. No partnership is without legal risk. However, with good communication and relationships, you can reduce this risk considerably.

Finally, you need to decide on what business entity to form. You generally have three choices which are a partnership, limited liability company (LLC), or a corporation. A partnership, meaning the business entity not the act of forming a group, generally offers no liability protection. Therefore, it is best to either form a LLC or a corporation. A LLC is generally the easiest to form and has the fewest requirements with regards to formalities and record keeping. This is the best entity choice for most investors. However, the best choice will ultimately depend on your specific circumstances including your income tax situation. You should seek professional advice from both a legal and tax advisor.

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Leverage is Your Friend Given that the Finance Industry is Returning to Normal

A smaller down payment and a loan sounds threatening, right? Not necessarily, as you are going to discover. The last boom-and-bust cycle was unmatched in the history of residential real estate. Within a typical market, leveraging is an excellent thing, particularly if you are a real estate investor.

By using leverage, you may build a large return on your investment. This is due to the fact that you have much less money tied up initially. If you purchase an investment for only twenty percent down, you’ll be able to possess a great deal of value.

In today’s market, there are numerous regions where it’s much cheaper to purchase rather than lease. In many of these places, it’s actually not unheard of to discover people getting more than 20% yield on cash flow alone. Throughout the bubble years, the opposite was the case. If you obtained a rental property as an investment during this period, then you know upfront that the rents you were paid failed to even take care of the loan payment. You needed to “feed” the property every month since you didn’t receive enough revenue to pay all the costs.

When it is less expensive to buy than to lease, there’s something wrong with the current market. Down financial markets are wonderful possibilities with regard to investors since the slow market will work to your advantage. In the present environment, lots of individuals are not able to get financing or have zero dollars for a down payment. Therefore, investors step up to help make up for them.

Purchasing real estate is an effective hedge against long-term inflation. In the long run, the real value of all paper currencies will proceed to depreciate while real estate will maintain real value in real terms. Right now, we’ve got very low interest rates that offer the opportunity to secure a lower rate. When inflation goes up, and it eventually will, you can raise rents while repaying the loan with cheaper money.

Also, does this imply that real estate investing is easy or that you should try to buy without a down payment? Definitely not! A 20% down payment is now an absolute minimum unless you locate a seller that’s willing to carry the note. In fact, too much leverage can be dangerous as many of us have discovered. You should aim for at least a five percent return on cash prior to investing. This consists of all obligations connected with the asset. A lot of inexperienced buyers leave out vital expenditures including vacancy loss and routine maintenance. You must think about all obligations. When you run the numbers, you’ll find that a bigger capital investment can often be necessary to clear the 5% cash flow yield benchmark.

In conclusion, you should utilize leveraging to your advantage. Nonetheless, you need to be practical and cautious about it. It’s also wise to reduce your risk by making sure that you will have favorable profit from leasing the property.

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