This article was posted on Sunday, Nov 01, 2015

We’ve been accumulating new readers with both hands it seems, and for that I’m very grateful. But it’s not all campfires and S’mores. Frankly, it’s difficult for new folks to step into the middle of an ongoing conversation like we’ve been having. Recently, one of my longer-term clients asked me to introduce his nephew to some of the principles we’ve been discussing in these pages for over a decade. Sally thought it might help the young man develop an investment mindset. After a little reflection it seemed the discussion might be useful to others, if only as conversation starters for their children or grandchildren.

What follows is not a transcript. It is largely from memory, and some things that were talked about are not included. On the other hand, I’ve added a few of things that I should have said, and would have if I’d thought of them in time. The discussion has been reformatted into sections so things that belong together are more likely to be found together.

It might be useful to open the conversation with one of the emboldenated heading questions and see how close the student comes to figuring out the answer. You don’t have to ask the questions in the order provided. Use the question you think would be most appropriate at the time.

Disclosures:     (1) I find mortgages for people. I am not a financial planner. If you want financial planning advice, hire a financial planner. (2) Examples used are illustrative only. (3) Numbers are appropriately rounded. (4) Friends and family know him as Sally. Only his mother called him Salvador. 

Why Invest?

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I’ve never asked Uncle Sally exactly why he invests, so I can’t respond to his personal reasons. But I can tell you in general terms how investing might change your life, and then you could decide if you are willing to pay the price. Perhaps you don’t buy that new dress until it goes on sale. Or you may have to work a second job and thus miss meeting the Love-of-your-Life and die an old – but rich – spinster who leaves individual annuities to each of her cats. There is always a cost. We don’t always know what it might be, but it is usually deferred gratification of one sort or another.

Let’s begin by establishing what a reasonable person might hope to get from just investing in general. In other words, why would someone want to do it?

Easy peasy. They do it to have a better future.

As people go through life they check off certain costly milestones. First car? Check. College? Check. Marriage? Check. Orthodontics? Check. Retirement? Check. These are costly monetary milestones and they clock by whether or not you are financially prepared for them. Most people are not. If you are like most people you won’t be ready for your milestones when they appear. You’ll borrow money to buy your cars. You’ll borrow money to pay for college. You’ll marry at the Elvis Drive-Through Wedding Chapel, just off the strip. Your honeymoon will be a few hours at Bowlerama. Orthodontics? Just teach your daughter not to smile. Retirement? Sigh. Sadly, this pretty much outlines how most folks muddle through life.

Although everybody knows milestones are going to happen, very few people prepare for them. We think everybody does, because that’s the circle we’re in. But most people don’t. Over half of retirement aged (65 – 74) people have no savings at all. Their jobs may have earned them a decent or even a good income over the years but at the end they have nothing left because they mismanaged their money.

Take a moment and reflect on just one example of fiscal mismanagement. Assume your new boyfriend buys a fishing boat with dual outboards and a trailer, borrowing $30,000 at 8% interest, payable over 15 years at $287 monthly. By the end of those 180 months he will have paid a total of $51,600 for a (now) old smelly fishing boat with sick motors and a broken trailer. There is no resale value. 

Total Interest Percentage (TIP) –  Over the fifteen year loan the total payments will be $51,660 ($287 x 180 months). The original amount borrowed was $30,000, so the interest charge was $21,660.  ($51,660 minus $30,000). The TIP was 72% ($21,660 divided by $30,000).

His total hard cost (excluding insurance, licensing, gasoline, worms) was $51,660 for a boat used an average of six or 8 weekends a year for 15 years. That’s 105 weekends for $51,660 or $492 for each weekend he used the boat.  

At $246 a day, couldn’t he have just rented a fishing boat? Was owning it a proper use of funds? Would you make that same purchase decision if it was you? Is he really husband material?

The biggest reason good people enter retirement age with no retirement money is because they’ve spent their working years buying depreciating assets on credit. There may be other reasons people wind up broke, but no bigger ones.

If you buy depreciating assets with money you haven’t yet earned, you are spending your future (money) to enhance your present condition. That is the exact opposite of what investors do. Investors push money into the future where it will grow and be ready for them when a milestone is reached. Instead of paying interest, they receive interest from bonds, or dividends from stocks, or rents from income properties. Maybe all of the above.

Takeaway:  Don’t borrow money to buy things that depreciate. If your boyfriend does it, he’s a loser. Try to discover why you’re attracted to loser boyfriends. If you need help, ask your girlfriends. They probably know already. 

What is an Investment? What is an Investor?

An investment is a stream of net income. An investor is anybody who buys stream(s) of net income.

Net income is what you can put in your pocket after all expenses are paid. You want that number to be positive (“Look what I made!”) rather than negative (“I can’t believe I’m still feeding that sucker!”)

Not all purchases are investments.

Commerce is not an investment. A businessman who purchases a piece of cloth for $10 might tear it into two pieces and sell each piece for $7. But it’s not an investment because there was no stream of income while he owned the cloths. It was not an investment. It was commerce.

Speculation is not an investment. Someone may buy an Alfred Sisley painting for what she thinks is a favorable price, hoping that one day she’ll be able to sell it to someone on Craigslist for a nice profit. The gain comes at resale but she doesn’t really know when (or even if) that will ever happen. In the meantime there are storage costs to be paid and insurance to buy. That purchase has not only brought the speculator no stream of income, it has burdened her with a negative cash flow. It is not an investment.

When you make your money on the buy-side by buying under market and selling at market, it is commerce. When you make your money by buying at market and hoping to sell over market, it is speculation.

Contrast commerce and speculation with investment. The investor buys at market and sells (if she ever does) at market, albeit sometime in the perhaps distant future. The investor purchases things (again, almost always at full market value) that generate a positive cash flow during the holding period. If it appreciates, fine, but in any event if the investment is kept long enough its cash flow will return the entire purchase price to her without having to sell it. Such investments are valued, both when buying and when selling, by capitalizing their stream of income (more about that next month). 

The 4% Rule

Of those that have saved for retirement, and you’ll remember that’s less than half, the median value of their holdings is $148,900. That may sound like a lot to your boyfriend, but it’s not much considering that most retirement consultants suggest employing the 4% Rule. That’s the withdrawal rate that is currently expected to provide a minimum of 30 years of sustained withdrawals from a 60% stock / 40% bond portfolio. The 4% withdrawal rate has been successfully backtested over every rolling 30 year period since the 1870’s, so it’s pretty robust.

Using the 4% Rule, the retiree lives off 4% of his savings annually (with the dollar amount increasing at a 3% annual inflation adjustment). Four percent of $145,900 is $496 monthly. And the next year, after a 3% inflation increase, it’ll be $511 a month. Add a little social security if you qualify, and you have what most retired people (at least the ones who have savings) are required to live on for the remainder of their probable lifespan.

Takeaway: Monitor how your potential retirement is progressing by using the 4%Rule. You may be able to retire early. 

When you invest, you are moving money across time, from “now” to some point in the future. That requires deferring gratification, but not just on the day you write the first check to your discount broker. You will keep deferring gratification until you die. A long time ago my husband’s mentor told him that the greatest challenge to investing is when you sell a successful investment and receive your first check for $10,000. (Just for a little perspective, back then $10,000 was a down payment on a six unit apartment building.) His mentor said “If you can reinvest that entire check, you have become an investor. If you can’t, then you aren’t and will never be.”

One purpose of investing is to make your money grow during the holding period. For example, if you reinvest your stock dividends over an extended period then both your original principal and the reinvested dividends continue to compound. Then the newly compounded amount subsequently compounds. Repeat. The result is that you may only have to invest a portion of little Mitochondria’s university costs now because the investment will grow over time. When she’s ready for college the deposits you’ve made over the years (and their reinvested dividends) will have grown into a meaningful sum, perhaps four pre-paid years of college.

While it’s a fact that when people buy a depreciating asset (especially on credit) they are changing their future in a bad way, what you have just done is the exact opposite: you have paid cash for an appreciating asset (perhaps a wide spectrum stock ETF) and thus altered your future in a good way. When the time comes for you to pay Mitochondira’s college expenses you smile, press speed dial, and tell your stockbroker where to wire the funds.

So, why do people invest? They invest to proactively manage their future. They invest to make their future better than their present. They invest to prepay life’s milestones. Managing his future is probably one of the reasons your Uncle Sally invests.

Takeaway: The opposite of borrowing money to buy a depreciating asset is to invest discretionary funds to buy appreciating assets. The former almost always results in a loss. The latter usually results in a win. 

Why Are We Talking About Stocks?

We’ll get to income properties in a later article. This month we’re talking about stocks. The reason is twofold. First, it’s a place to start, and folks have to begin somewhere. It’s a lot easier for a new-investor-in-training to begin their investment life by depositing $1,000 at a discount stock brokerage and maybe buying a good market-wide EFT.  If you try to tell him (or her) about the glories of apartment buildings you are sure to lose their interest when you get to the down-payment part. The young investor-in-training can start mostly with stocks. When he or she has built an adequate capital base, the next step might be a small income property. You can talk about down payments then.

Secondly, even the biggest income property investors should have a portion of their assets in liquid funds because you just never know what might happen. There could be real benefit in having a place to store excess capital (Excess capital: it’s not enough to buy another building, but keeping it at home makes the mattress too lumpy), and the stock / bond market might be a place to consider.

More next month. We’ll continue with Synergism.           

 This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at