The last line in my previous post touches on something I come back to now and then to plan my finances. I first heard of this idea from Robert Kiyosaki, who wrote something like “whenever I want a fancy car, instead of just going out and buying it I buy a property that will pay for it”. As usual it’s not quite that easy but there is an element of truth.
A lot of writing about personal finances is about moving from the lowest level of stability (borrowing to buy things) to the middle level (saving so you don’t have to borrow). This lowers your total spending since you pay less interest. But when you do this you still need to earn the money to pay for what you want to buy. Not that there’s anything wrong with this but I always like to do a little better 🙂
When you take this idea further you could call these the 3 levels of leverage:
- Borrowing to pay for things: this is leveraging other people’s capital and comes at a price (more time working to pay for your expenses)
- Paying from your savings/earnings: this is the minimum financial leverage, relying on your work to pay for things
- Paying for things with investment (“passive”) income: this is using reverse leverage, putting your capital to work to minimize the work you need to do
Of course the highest level is what people think of as retirement. Sometimes they plan to skip the middle level entirely. I prefer to stay out of the lowest level as much as possible though. In reality we get a mix of these. It’s hard to live completely in the middle if you’re doing things like buying a house. And with my businesses I have opportunities to do things that are in between working and passive income. Staying out of the lowest level is an accomplishment but it’s not the end. My goal is to get as close to the third level as soon as possible.
Even being able to pay for minimal survival expenses from investment income and working for the extras would be a big step up. As mentioned in the last post, one of the simplest ways you can do this is to be invested longer. If you put off spending and invest more instead, you can spend later while your investments are growing. Delay an expense long enough and the investment income can take over paying for it.
This takes a bit of time though. I recently calculated that if you invest as much as you spend it could take 10-15 years for the investments to reliably pay for the spending. Many expenses can’t be delayed that long. Trying to reduce the time for your investments to cover your spending is hard since the power of being invested for a long time is so strong that there are few alternatives. The best thing you can do is maximize the time you give yourself, in any way you can. And if you have an expense that’s more than 10 years away it can be much cheaper to pay for it through investments rather than just saving up the full price in cash.
A recent post at Million Dollar Journey explores the message of a new book on “Lifecycle Investing”. The idea is that it’s risky to build up a traditional portfolio which is expected to be at its biggest and get most of its returns in a short period of 5-10 years before you retire. If those years aren’t so good, everything you did up to that point doesn’t make much difference. And if you’re moving to bonds in that time it will further reduce your returns at a time when you could be making more than ever before. Instead of doing this you really want a larger equity portfolio when you are young and a slightly smaller equity allocation when you are old. This can be balanced by borrowing at the start and increasing bond holdings at the end.
The blog post compares a borrowing strategy (borrowing enough to double your initial investments) to a fixed allocation (75% stocks) that give you the same average amount invested in stocks over your lifetime. The results show that the borrowing strategy has similar returns with less risk based on 140 years of historical data. However, keeping higher stock allocations at older ages seems to increase your returns without a lot more risk.
I’m practicing a slightly different form of this. While we have many opportunities to improve our finances right now, I’m focusing a lot on increasing our investment portfolio. For example we could pay down our mortgage a lot faster and then invest when it’s gone, but I prefer to invest most of it now and only take slight increases in our mortgage payments.
For some people it may seem simpler to do one thing at a time and pay out the mortgage first then invest more. I’ve even thought of this at times. But this assumes that it’s safe to build a portfolio in 20 years instead of 40 because investment returns are steady and consistent. If you know financial history before 1985 it’s obvious that would increase the risks. It’s not impossible to have a 20-year period of high and rising prices when you’re buying, followed by 20 years of stagnating and falling prices when you’re living off the investments. It reminds me of when I really started learning about personal finance in early 2007 and everyone was talking about how you could select a few uncorrelated stocks and the total return would be as safe as bonds (oops).
One thing I’m doing wrong according to this idea is still carrying some bonds. The formula calls for maximum leverage and no bonds until you have a significant portion of your planned lifetime savings put into stocks. However I live by the idea that there will be bad years when we don’t expect it, and I currently carry just enough bonds to attempt to increase the returns a bit through re-balancing.
I don’t borrow to invest because my business income is uneven. That provides us with enough risk and also comes with the potential rewards of higher income or receiving a lump sum from selling a business in the future. If I manage things well I can get higher returns by focusing on my own businesses first. But by investing in our portfolio and my businesses while keeping a mortgage balance we are doing something similar to borrowing to invest. And the mortgage gets us a very low interest rate. Directly borrowing to invest can make sense if you have a very high probability of getting a certain income far into the future, but you would still need to get a low long-term interest rate to make it worthwhile.
One thing that’s not mentioned in the blog post (I’ll read the book soon) is that borrowing early on increases the length of time you are invested in the stock market since an investment made 20 years earlier has 20 more years to grow. Unless you’re buying at a peak, the length of time you’re invested is one of the most important factors in your portfolio growth so it’s natural this would increase returns.
It’s absolutely true that the right plan for when to invest, and how much, matters more than getting a slightly higher return. But borrowing comes with its own risks of poor planning that can be costly. Overall it’s not surprising that being invested longer and taking advantage of the difference between borrowing costs and investment returns can be profitable. The claim that this works almost 100% of the time is surprising but that depends on precise math and history that we can’t relive.
You don’t need to follow this exact strategy and borrow as much as you save. This is a useful reminder that it’s sometimes worth doing unusual things to increase the length of time you are invested in stocks. Even if you’re playing it safe, is there anything you can delay to give yourself more to invest now? Do this well and the investments might even pay for the expenses you delayed.
The difference between what you earn and what you spend is how rich you are. The difference between what you have and what you want is how poor you are.
That gives us 4 things that we have some control over. The funny thing is that many people spend their lives focused on the 1-2 hardest things and let the others get out of control even when they would be easier to change.
I recently heard from someone wise that good generals constantly think about a few timeless strategic questions including “where’s the battlefield?” and “who’s the enemy?”. These sound too simple but many people don’t take the time to ask themselves the questions. And then they’re surprised when they don’t win the battle. There is always an obvious answer to the questions but there are other less obvious answers that can make it far easier to win.
What are your strategic choices that will lead you to wealth?
As I noted earlier this week, there’s a chance that us stock investors will be lucky enough to see a return of prices similar to 2009. What’s funny about this is the thinking that drives the prices. The last 3 months of data apparently form a solid trend when it comes to the news. But this is just watching shadows and trying to guess what’s creating them.
I know from running a business that measuring on the wrong time-scale is just crazy. I can project that I’ll get $X in a certain month, but if one person delays a decision by a few days a substantial part can move into the next month. Am I going down just because it was a few days late? In my business a quarter starts to give me an idea of a trend and a year tells me what’s really happening.
In the real economy it’s not unusual for a large number of people to decide to delay certain types of activity such as buying a car by 1-5 years. That might make one year bad but it doesn’t make a trend because they’re adding to the future economic activity. People will have kids, grow old (so far all attempts to prevent those two have largely failed), look for somewhere to live, try to go places, eat things, and entertain themselves. They may put it off when forced to do so by extreme pressure. But as soon as they figure out a way they will continue to do it.
Most things that have an impact on the economy will affect when people do things, not what they do. Real changes take a long time to happen. And when they do they usually create demand for new businesses that can make a profit from them. As an investor I see economic news as entertainment. And you can get both better news and entertainment.
Lately the news about the stock market has been giving me more and more hope. Not that the economy will recover and nothing bad will happen again. I’m hopeful because we might actually get to enjoy some of the low stock prices we haven’t seen for a couple of years!
The north american markets are looking stable, but if the news out of Europe is believable there’s a chance that it will go through some disruption in the markets. This could once again lead to people desparate to unload stocks at any price, giving buyers a rare opportunity. And if there is a brief contagion that affects other countries we might get excellent prices everywhere. I’ll be standing by to step in and support the market!
While browsing financial headlines recently I was surprised to hear that Lehman Brothers is bidding on an apartment company, a bold move for a company that no longer exists. Ok, that sounds more dramatic than it really is (I should write financial headlines). The estate of Lehman brothers owns 47% of the company including a contractual right to buy out the rest, and claims that the other owners are selling it for too low a price. It only makes sense to maximize the assets of a bankrupt company and try to recover a bit more. But you have to wonder how long it will be until the estate of a bankrupt company makes a bad trade and goes bankrupt itself…
In a link post this morning I came across The Digerati Life’s post 7 Ways to Run Your Household Like a Business. Things like avoiding procrastination are always good (except when they aren’t). But discipline isn’t the real difference between businesses and households. As Thomas Stanley points out in The Millionaire Next Door series, many people get wealthy by running a business and applying the same concepts to their personal life. It’s definitely worth learning how more about how to do it.
Not everyone needs to do this. Running a business well takes a lot more creativity and responsibility than doing what people tell you to. But the rewards if you do this are more control, freedom, and options. Since I study management intensively to improve my own business, I apply similar concepts at a personal level and this made me think about what I do.
Households that are not economically productive are mostly guided by what sounds fun and what needs to be done to avoid losing things. The essence of a good business is to find an advantage involving exchanges between people, and magnify it as much as possible in order to create an increasing value over time. Ok, this post is done! Oh wait, if you don’t have 40 years of management experience to tell you exactly what that means maybe I should add some details 🙂
A lot of good, strong, and successful businesses look kind of dumb and boring. They usually don’t involve a lot of special tricks, just something that seems completely obvious once you hear about it but no one bothered to do it before. It typically involves doing something that isn’t too hard, but someone else gets a much bigger benefit by paying for it instead of doing it themselves. Spending time on anything else is not profitable. The businesses that seem like they take a genius to run or constantly do lots of different things usually have a high failure rate.
The personal application is obvious. Any financial plans that can only be accomplished by the smartest person in the world, like figuring out which stock will have the highest growth rate in the next decade, are not right for you (sorry but you may only be the second smartest person in the world). If it works it doesn’t matter if others laugh at how simple it is.
You should find what you are good at and work with that. If you have capital and you’re patient, you can make money by letting others use it. If you have a unique skill and not much else, you can focus on increasing your income. It’s all about finding what you have that others don’t and figuring out how you can be rewarded for helping others.
Good businesses are boring because they mainly involve doing simple things as consistently as possible by establishing a system. There are endless debates about how smart and creative your employees need to be, but a business creates value by giving employees rules to do things they could not do on their own. The rules represent the ideal way to do something that avoids waste and increases profit. They can be adjusted from time to time but changing them too frequently or not following them will ruin the business. Some people succeed through creativity alone, but they have a job and not a business because they can’t teach anyone else to do the same thing in less than 20 years.
For your personal finances systems and rules are good. If you know the best way to do something there’s no reason to do it differently every time. With systems in place you don’t need to think and remember as much (if you set up automatic transfers you don’t even have to do anything). And even if you’re unable to do something you can set out rules for a trusted person to follow to get the same results. If you don’t want your personal finances to be your full-time job, systematize as much as you can.
The final thing that a business manager must do takes this idea a bit further. The one thing the manager should never do is the actual work. Now this isn’t just to be the big man with all the power over others (at least not with good managers). A business needs to get many people doing the work so they can create more value. The manager is there to help them and remove any obstacles. If the manager is doing the work it’s limited by one person’s time (bad) and they can’t help everyone else who’s supposed to be doing it (even worse). If you’re a business owner, the best way to grow your business is to always figure out how you can get someone else to do what you’re doing now (often better than you) so you’re free to do other things.
In your personal finances this starts by automating simple things that shouldn’t take a person to do. Then you need to get help from advisers who can save you years of mistakes in a couple of hours. At a higher level you want to reduce the difficult and time-consuming parts over time. For most people earning an income takes up a lot of time, so you want to take steps that will reduce that time in the future such as building your investment income.
If you follow these rules it won’t look like you’re doing anything special at first. But they give you an advantage that compounds over time, until people start wondering how you got so far and looking for the secret to your success (they probably won’t believe how simple the truth is). When things change you do need to adjust, but most of the time maximizing the advantages you have (as consistently as possible) will take you a long way. And you might even be able to use the same ideas to start a business and increase your income.