Finance Blog

Vancouver Housing Market Blog: More on the tenacity of neg-cash flow investors
Very Interesting "clip" off Van Housing Blog.
http://van-housing.blogspot.com/2006/02/more-on-tenacity-of-neg-cash-flow.html

So where should I stick my money now, Smart guy (Freako)?
"

No offense meant, just a difference of opinion. I probably laid it on too strong, and I must admit that much of the literature in the genre irks me. I haven't read the Millionaire Next Door, but will when I get a chance. The book is inspirational, and I applaud that aspect.

And I know it is easy to be armchair quarterback know it all, and pick others apart.

The main beef I have with many of these books is that they are written to make money by playing off people's desire for wealth the way acne remedy commercials play off teenagers insecuraties. It is pretty obvious to me that Kiyosaki is pitching to a crowd long on ambition and short on sophistication (that is not meant to be deragotatory, this is complext stuff). Clearly he has cut his teeth with being involved in Amway and having been on the self-improvement seminar circuit for some time, probably knows the target market of the eternally hopeful inside out. Usually these guys prey on each other like one of those ads in the paper that says "Want to make thousands of dollars? Send $5 for detailed instructions". Of course the instructions are to place the ad yourself and do the same thing. Rich Dad Poor Dad broke out and went mainstream, however.

Do I have a better answer for how to get rich? Not really. But I think the goal is too black and white, is misleading and can lead to excessively high expectations.

Being rich is great, but being just "well off" is pretty good. Don't need a secret for the latter.

To become filthy rich from nothing is not easy. I can only really think of three possibilites:

1. Creating huge value (inventing something, starting a successful business etc.) Easier said than done. This category also includes active investing which earns superior risk-adjusted returns. Requires skill, and carries risk of losses or opportunity cost of your time.

2. Passive investing in risky ventures and taking huge risks. Requires luck.

3. Fraud/crime/unethical business practices. Examples would be manipulating penny stocks, or selling get rich quick schemse. Requires low ethics, and may involve risk.

If one desires nothing else in life than to be rich at all costs, one has to pick one or more of the above. There are consequences, not unlike leaving a promising career to pursue a dream of sports or music or what have you. That decision is individual preference. However, those making the plunge should clearly understand the payoffs. That may not be the case due to survivorship bias. We are much more aware of those who succeed than those who fail (unsuccessful athletes don't appear on the cover Sports Illustrated, just as failed investors don't appear on the cover of Fortune and so on), so our perception may be skewed. In Freakonomics, Levitt notes that crack dealers made minimum wage and had about a one in three chance of being killed. Why bother? The chance of being kingpin.

However, if we lower the bar to "well off" instead of filthy rich, the chances of success are much higher, and the risks are much lower. While not entirely mutually exclusive, a passive investor aiming to be rich is essentially going for broke, and risks being less than "well off".

It is individual preference, of course, but I believe that most people are risk averse in that sense. If offered a million dollars guaranteed or a coin flip wager for 4 million dollars, most people would avoid the gamble even though the expected return is twice as big. Why? A million dollars will make you happy. But 4 million won't make you 4 times as happy. Diminishing marginal utility of wealth in other words. Yet it seems as if risk taking is on the rise. That implies that the risks are not understood.

In (mostly) plain English, it's not that complicated. Assuming that you are a normal person, earning a typical income:

1. You have an income stream that rises, peaks, declines, and stops over your lifetime.
2. You have varying needs throughout your lifetime.
3. By foregoing consumption of your income stream you will be rewarded by a return that depends on risk taken.
4. You can supplement consumption with borrowed money, but this involves a cost.
5. You can also borrow money to invest in risky ventures which will earn you the difference.
6. As mentioned, the utility (pleasure) of consumption decreases as your spend more money (diminishing marginal utility).
7. As per 6, it makes sense to even your consumption over your lifetime. Hence borrow in your early years, save invest in your middle years, draw down in your later non-working years. Very rational.

Based on the above we can conclude the following:

1. There is a tradeoff between early and late consumption. Individual preference. Most people fall somewhere in the middle. I don't think it is rational to live like a pauper so that you can die rich. Nor is it rational to retire in poverty because you lived beyond your means in midlife.
2. We can push the envelope by taking on more risk, but must be mindful of the consequences. There really are two risks.
- bankruptcy (very bad)
- underperforming investments for a given time period. This risk drops dramatically as you increase the time horizon. Hence, the younger you are, the more risk you can take on.

Diversification is "free" risk insurance and should be utilized.

So what should one do?

1. Decide on your preference between present and future consumption and act accordinly. May be hard to predict what you will want in the future, but if you thought about it, your chances of regret is smaller (regret is a huge negative factor in "enjoyment of life"). If nothing else, choose the middle road.

2. Decide on your risk preferences and adjust accordingly. If you can't handle a bankruptcy, don't take any risks that can put you there. If you can handle risking in a moderate retirement in return for a crack at riches, then act accordingly. If the lowest you want to go is "well off" then take those risks into account.

3. Combine your choices above with your age and make your decisions. How much to consume. How much to invest. How much risk is acceptable and the return desired. Place your money.

For most people, I'd recommend sticking with the lowest cost index funds available, and buy your own home. Perhaps look for investment property if the numbers make sense, but watch overexposure to real estate.

Fairly passive in other words. The only active advice, would be to consider offsetting if the "herd" becomes too big. In other words, if everybody is talking about it, reduce exposure. That would have meant selling tech stocks during the Nasdaq bubble. It would mean being wary of real estate right now. And whatever the next best thing is, act the same way. This little bit of caution will protect against falling victim to the latest greater fool fad investment.

There you have it. Not very exciting.