Diversification or Diworsification?

Diworsification
“Diversification is the only free lunch in investing” 

This is a common refrain in the world of financial advisors (we at Richucation of course don’t think much of what financial advisors (more accurately financial salesmen) have to say since they generally don’t know much if anything about good investing and beating the market).


What do they mean?

They follow the statement up with “it’s the only way to decrease your investing risk without decreasing your expected return”.

In other words, let’s start by recognizing the theory of diversification isn’t to boost your pure returns but rather to boost your risk adjust returns.

It’s worth noting what they define as risk probably isn’t what you or I define as risk.

Are they right?

Let’s start by defining diversification.

In simple terms diversification means splitting your investment up between multiple investments rather than just one.

There are whole ranges of diversification strategies for good reason as we’ll soon see.

It might include buying multiple investment properties rather than just one.

It might involve buying multiple stocks instead of just one.

It might involve buying multiple asset classes instead of just one.

There’s a literal gradient of just how diversified your portfolio actually is since you could apply one or all of these and you could diversify between one or hundreds of potential assets and strategies.

The theory is predicated on two assumptions:

  1. The risk (either measured by the odds of losing money or the volatility) is lower when you diversify
  2. Your expected return remains the same

The first of these is perhaps the easiest to argue. After all, if you’ve got one company what’s the odds it goes bankrupt? On the flip side what’s the odds two companies go bankrupt? It’s like the odds of flipping heads on two coins rather than just on one.

Likewise, in theory the more diversified your portfolio is the more the ups and downs of individual assets will level each other off smoothing out the volatility.

Makes sense right? Indisputable? Not so much as we’ll see in a minute.

What about the second assumption?

The second assumption presumes the future expected returns of all investments you’re diversifying between is the same and this probably isn’t true.

Consider for example using CAPE by country as a measure of the future expected returns of given stock markets over say 10 years. Diversifying between them would in theory lower your volatility and decrease the chances of any one country going down dramatically but the future expected returns between these assuming a return to the mean over time isn’t even remotely similar.

But wait there’s something else…


A Return Booster They Aren’t Telling You About

There is actually an increase to returns outside of decreased risk most people are unaware of but does something to validate the idea that diversification might be a free lunch after all.

Assume you had average annual returns in a portfolio over 6 years adding up to 60% of 10% per year.

Assume this could come in two forms:

  1. 10% per year for 6 years
  2. 20% per year every second year and 0% per year every other year for 6 years (the order of years doesn’t matter the math works out the same)

The first case represents no volatility and the second case represents much higher volatility.

On a compounded basis what does this do to our returns. You’d expect the returns to be identical right?

After all, whether you earn 10%/yr for 6 years or 20%, then 0%, then 20%, then 0%, then 20%, then 0% the average is still 10%/yr and the total simple returns are 60% so you end up the same right?

Wrong, let’s look at the math:

1.1 * 1.1 * 1.1 * 1.1 * 1.1 * 1.1 = 1.77 or 77% actual return after compounding

Vs

1.2 * 1 * 1.2 * 1 * 1.2 * 1 = 1.73 or 73% actual return after compounding!

Say what?

How can one yield 4% more over 6 years when the average returns are the same?

You take some time and redo the math for yourself changing the order and playing around with alternatives if you like. I did when someone first showed me this and I couldn’t believe it.

What this shows is without rebalancing, without any fancy strategies, on the exact same average returns over time lower volatility boosts ACTUAL returns and higher volatility hurts ACTUAL returns.

This is one of the biggest fallacies in the financial sales and investing community. They’ll tell you average returns as opposed to actual returns.

Why is this a bunch of nonsense?

Let’s take a look at a more extreme but real example.

Say you had an investment where one year you lost 50% and another year you made 50% your average return is 0%. Let’s compare this to a portfolio that did nothing it had an actual return of 0% how do they compare?

Assuming $100k invested if you lose 50% in year 1 you’re down to $50k now you grow this by 50% and you’re up to $75k…your actual return is -25% but your average return is 0%.

Once again it doesn’t matter what order these years come in and the effect gets magnified the more you increase the volatility, which you can see clearly if you assume one year (doesn’t matter which year in a series) you have a 100% loss. You could have had 1000% gain five years in a row and it still wipes you out and your actual return drops to a -100% even though your average could be thousands of percent.

So in this sense simply decreasing your volatility is actually a free lunch.

This is one of several reasons we recommend the small initial part of a person’s portfolio go into close to zero volatility investments when building wealth until you leave to invest well.


The Counter Argument to Diversification

Lowering volatility mathematically increases returns assuming returns average out the same but herein lies the big gap.

Returns generally aren’t the same between assets or asset classes.

Proponents of diversification argue it’s extremely hard to successfully choose assets or timing that will outperform the market but this is a question of investing method not the underlying theory or math.

Diversification is a protection against ignorance.

– ​Warren Buffett

I’d expand this to suggest diversification is a protection against rare unexpected events especially Black Swans much like insurance.

For example, say I purchase two properties. There’s always a risk of a fire or a bad tenant, etc. Although we can improve our odds of these things not happening they are mostly outside our control and this is a great example of where diversification up to a point can help you.

The problem with diversification is you can’t take advantage of big winners either.

For example, say you split your portfolio between 10 different assets and one of them does incredibly well posting a 1000% return.

Instead of this giving you a 1000% return across your portfolio it will only give you a 100% return across your portfolio because you’ve only allocated 10% of your capital there.

In this case diversification didn’t help you it hurt you. Diversification was actually diworsification.

Concentration is required to beat the market and achieve optimal returns

Logically if you could completely diversify across the entire market your returns would equal exactly the market returns minus fees so it would be impossible to beat the market.

Matching the market is better than not investing and an ok place to start when you don’t know anything and are focused on building income but eventually you need to move away from this strategy if you’re going to do truly well.


The Second Fallacy of Diversification

Additionally, we should revisit that assumption that diversification decreases risk (either odds of losing money or volatility).

If you’re simply picking assets blindly this is true meaning on average with no skill it will achieve this result but saying so completely misrepresents the drivers behind risk and reward.

While it’s common to cite average returns, average volatility, etc. the truth is hundreds of assets every year outperform the average and hundreds have lower than the average risk or volatility, it’s the nature of averages that they include both the highs and the lows.

Your objective as an investor is to minimize risk while simultaneously maximizing returns, so called asymmetric risk reward.

If you understand how to do this you can actually decrease your risk by concentrating. This is essentially what Warren Buffett has done both radically outperforming the market over 40+ years and experiencing fewer losses than the market in general.

Diversification once again is diworsification if you know how to pick the assets and/or the timing well.


So, is Diversification a Free Lunch or Diworsification?

It depends.

One point is fair, diversification is a way to lower volatility and risk virtually without any knowledge so in this sense it is free.

So, compared to completely random concentrated bets yes it is a free lunch.

But compared to someone who knows what they are doing diversification isn’t only not a free lunch it’s diworsification and you’re better off to concentrate your holdings intelligently, it’s the only way to beat the market.

If you’d like to learn more about investing well, beating the market, etc. check out some of our other articles, take our trainings and reach out to us to collaborate, for investment ideas, deal flow, and consulting.

The 7 Types of Diversification to Decrease the Risk of Uncertainty

There’s lots of talk about diversification to reduce your risks and consequently boost your risk weighted returns.

On the other hand, in conversations with people recently I’ve noticed a significant lack of understanding about what this means and how to do it well.

The primary reason for this is because of the subject of correlation.

To avoid correlation, we’re going to discuss the 6 areas to diversify to deal with any market condition.


What Does It Mean When Assets Are Correlated?

Essentially this means they behave similarly at the same time.

For example, stocks tend to go up with the market and down with the market.

Bonds tend to move together.

House prices in a given area tend to go up or down together.

Crypto currencies tend to go up or down together at least for now.

The list goes on.

When you can look at a list of assets and see they are mostly all up or down by a similar amount on the same day or week you know they are probably fairly heavily correlated.

Note, just because they move together doesn’t mean they are correlated, non-correlated assets could happen to move together by pure chance but over time this pattern won’t hold.

I recently had some people telling me they were diversifying between 10 crypto currencies to decrease their risk but this is nonsense because mostly they tend to perform very close to identical posting double digit gains or losses on the same days, etc. and if you look at the charts they show approximately the same shape.

This is a horrible example of how to diversify intelligently.


If You Want to Decrease the Risk of Uncertainty…

Diversification protects you from the effects of uncertainty by limiting your exposure to any given unit of uncertainty.

In other words, you can decrease the impact of things you might not be sure about by limiting your exposure to them and splitting between them.

Understand then there are a variety of factors, which might cause investment performance to correlate.

As we’ve mentioned, diversification is often diworsification so where you can apply logic, intelligence, good judgement, research, etc. to gain an edge concentrate. But where you don’t have this understanding diversify in those areas.

For most people they aren’t even aware of the areas where their investments are likely correlating or what to do about them.

What follows then is an overview you should consider based on your scale of wealth. When you’re very small your portfolio might not justify diversifying in all areas but the more you grow the more it might help.

This will also help inform you how to concentrate and make more money aside from simply the asset or asset class you’re choosing.


The 7 Areas of Correlation & Uncertainty

Correlation isn’t random it comes about because of common drivers, which work together and apply similarly to multiple investments.

More importantly though there are multiple areas where you might be uncertain and as a result wish to protect yourself from those uncertainties by limiting exposure.

What’s critical is understanding these are all areas where you could be blinded.

As always, concentrate when you have an edge then level out your risk by diversifying in these areas where you don’t:

  1. Assets – diversifying between assets themselves is the most basic form of diversification. It’s worth considering diversifying not only by specific asset but also by asset class for example not buying all stocks of companies exposed to similar drivers like oil prices.
  2. Asset classes – next most common is diversifying between the classes of assets, which might tend to move up and down together.
  3. Regions – because of common regional drivers (government and bank policy, immigration, economy, etc.) regions tend to correlate. This is especially important when the drivers of your particular investment performance are largely regional such as with real estate.
  4. Timing – this is one of the easiest areas to diversify, dollar cost averaging your investments by flowing money into investments and markets as you build it up and as you sell other assets. You can also achieve this by rebalancing.
  5. Currencies – although this is not a fundamental driver in the long term for all asset classes (real estate and stocks in particular stocks of international companies tend to be less correlated with currency fluctuation than say bonds) it is a very important area of uncertainty and correlation if all your assets are measured in the same currency.
  6. Strategies – are you long or are you short? Are you capitalizing on cashflow or growth? Are you relying on leverage or not? Etc. Strategies can correlate to one another and often you can gain an advantage sticking with the same asset or asset class but varying your strategies.
  7. Managers – people tend to follow similar behavioral patterns so leaving all your investments with one manager will tend to produce more correlated returns than varying across managers. As usual this can work for or against you so whether to concentrate or diversify depends on your expertise in selecting managers.


Conclusion – A Place to Look for Opportunities Not Merely Avoid Uncertainty

We’ve often spoken about how diversification is diworsification if you know what you’re doing and you’re far better off being concentrated with skill than diversified with ignorance.

As a result the above shouldn’t simply be a place to look for opportunities to diversify. It should also be a place to look to gain an edge.

You could gain an edge in the asset you choose, the asset class or mix you choose, the regions you choose, the timing you choose, the currencies your investments are denominated in, the strategies you’re employing and managers you’re picking.

Some of these will overlap with one another, which is fine. The objective isn’t to be isolated the objective is to beat the market increasing your returns while decreasing your risk.

To learn more, becoming someone who is betting on an edge rather than diversifying against ignorance explore some of our other articles below, enroll in some of our training, reach out to us for consultation and join our network of investors and investment experts.


The Flaw in Ray Dalio’s Investing Strategy

Ray Dalio

I’m a huge Ray Dalio fan.

Ray is one of the most famous investors in history, the founder of Bridgewater the largest hedgefund in the world with around $160 billion in assets under management as of writing this article.

He’s a brilliant thinker and one of the thought leaders when it comes to asset allocation and portfolio construction.

His firm is perhaps most famous for accurately predicting the 2008-2009 financial collapse as well as the European debt crisis, gaining positive returns when most lost money in 2008-2009 then having phenomenal returns in 2010 and 2011.

But history lies to us and it’s easy to focus on those big wins ignoring the 4.5%/year returns Bridgewater has produced between 2012 and 2017 when the world markets have enjoyed an incredible bull run.

With all the talk about Ray it’s worth examining what works and what doesn’t work, not so much for Bridgewater but for people like you and I in looking at them for investing lessons.


They’ve Got a Terrible Record of Macro Calls

It’s worth noting that as much as I love Ray and love his thinking you should be aware of what he’s good at.

He’s got very solid research into the transactions behind markets.

He’s got excellent logical thinking.

On the flip side his calls about what the broader market (not necessarily the economy) would do have been way off. For example, Bridgewater predicted a huge drop in the stock market if Trump won the election…the opposite happened.

He said they wouldn’t continually raise interest rates referring to “one then done”. They’ve raised over and over.

The list goes on. At least recently his calls about what would happen haven’t been great and it reflects in their investing performance.

Most recently at the Davos Conference 2018 he said anyone who was in cash over the next little while would feel stupid because the market was going to surge. We’ll see if he proves right or not.

A lot of very smart people including some of our hedge fund manager and investor clients think he’s way off.


Be Aware Dalio Prioritizes Risk – Meaning Volatility

Before we get into the specifics of where Dalio has taught me a lot and also where his system breaks down for most investors, it’s worth considering the angle he comes at it with.

His background is largely in helping companies hedge against risk.

He’s done some great work in this regard and his strategies both in the Pure Alpha fund and his All Weather fund are designed to minimize risk.

When he says “risk” he actually means “volatility” or “beta”, which is different from what most people think of when they think of risk as we’ve discussed in previous articles.

So, his strategies will inevitably have lower peaks and lower valleys in their returns. In the abstract this means they’ll take 40% return instead of 70% return, so they can have 5% return instead of 20% loss in another year.

Their clients are mostly very large institutions, corporations and governments who value this investment profile and of course it pays off big in times of crisis…we just haven’t seen one of those in a while.


What I Learned From Dalio

Dalio famously created the video How the Economic Machine Works, which is brilliant and fantastic though incomplete in its overall explanation and therefore not overly useful to the average person, though it remains fascinating and I recommend it often.

He was also famously interviewed in Tony Robbins book Money Master the Game talking in particular about portfolio theory, asset allocation and something called Risk Parity, which they created and has now become very common within the fund management world.

Prior to Dalio I was much more anti-diversification than I am today. He really was a dominant force in helping me to understand the value of asset allocation and diversification though I’m still far more bullish on concentrated portfolios than financial advisors and other people who I generally consider pretty useless because they can’t beat the market.


Dalio’s 3 Ways to Beat the Market

Dalio’s approach is to suggest you can beat the market in 3 ways (you’ll notice these are different from the 4 ways to beat the market we discuss at Richucation though if you dig deeper they tend to overlap):

  1. Beat on selection – pick assets that outperform
  2. Beat on timing – buy and sell to take advantages of ups and downs better than the market
  3. Beat on asset allocation – by leveling out the volatility you multiply your compounded returns over time

His argument is the first two of very hard to do because in the markets you’re competing with the big guys who have more resources than you. 

We of course disagree with this assessment because:

  1. Just because something is hard doesn’t mean it shouldn’t be done especially when the long-term gains are massive
  2. Individual investors have structural advantages over major investors that allow them to not have to compete with those big players. For example you’re not competing with Warren Buffett because Buffett can’t do a deal under $1 billion

His argument is it’s easier to beat the market on asset allocation.

I’m not sure this is true in terms of the “easier” part but it is certainly true that by choosing the right asset allocation mix you can level off returns, multiply returns and do very well.

This also has a huge psychological advantage since psychology kills most investors.


The Advantage We Love About Non-Correlated Asset Allocation

A major advantage to non-correlated asset allocation and the reason we work with larger clients on it is because it puts you in a position to take advantage of opportunities that aren’t available if you’re using a concentrated strategy.

What does this mean?

Well there are often times when an asset class, region, etc. is down and it’s a great opportunity to buy.

The problem is a big part of the reason to opportunity exists is because people don’t have money because it’s down.

If you diversify across non-correlated assets then when something drops a lot you can sell something else that’s up in order to take advantage of the asset that’s down.

This is super beneficial not just in investing but also in business, which is why we pay a lot of attention to it in Stage 4 and especially Stage 5 businesses.


Correlation Between Asset and Asset Class Performance

Dalio points out the majority of the returns in any given asset are mostly explainable by the asset class itself anyway.

For example, stocks tend to move up together. When the stock market is in a bull market 70% or so of stocks will go up not so much because of how great an individual stock is but they get swept along in the “rising tide raising all ships” approach.

Because the majority of the rise or fall in a stock can be explained by the class it’s in Dalio would argue it makes more sense to focus on the asset class than the individual asset (note this is fundamentally the opposite of Buffett who makes highly concentrated picks looking for companies that will outperform their asset class).

There’s a more important consideration when it comes to risk though.

People tend to diversify by say buying a basket of stocks rather than a given stock.

But the basket tends to do roughly the same thing as the individual items anyway so you don’t gain much of a diversification advantage operating that way.

What’s much better in terms of leveling out returns is to choose non-correlated (meaning they don’t more together) assets.

This is central to Dalio’s premise and also where his system breaks down for average people who want to beat the market. You’ll see it fits with our argument that Diversification is often Diworsification.

This isn’t to say there isn’t an advantage of diversifying within a region, asset class, etc. there can still sometimes be an advantage against certain rare events for example by having multiple houses you decrease your risk of a fire taking any one of them out because you’ll have others to protect you in the meantime.

What it means is your houses in the same city are likely to perform more or less the same so the volatility in your portfolio is likely to remain about the same as if you had just one.

Certainly, the argument is beyond some basic diversification you do little to decrease your volatility by diversifying within a given class.

What Ray shows is because risk has a dramatic affect on your overall portfolio returns by choosing a few non-correlated investments rather than correlated ones you can dramatically improve the performance of your overall portfolio without decreasing the returns.

Whereas if you bought a series of correlated assets you wouldn’t gain anything in terms of returns or decrease your risk.

At least on the surface this is true…it doesn’t always work that way for most people though and not even for Bridgewater, which will explain in a moment why Buffett gets better returns consistently than Dalio does.


Where Dalio’s Strategy Breaks Down

Dalio’s theory of boosting portfolio returns by decreasing volatility by choosing non-correlated assets is based on one very important underlying assumption that’s almost never true.

It assumes each of those non-correlated bets has the same returns as the correlated bets.

Think of it this way.

If I can choose between 10 options all of which have roughly the same returns but 2 are non-correlated and the other 8 are correlated what’s my best approach?

I should choose one of the 8 plus the other two so I end up with 3 non-correlated assets.

This is because they’ll level each other out decreasing volatility, which increases return, it will dramatically decrease risk and yet my returns won’t suffer because their returns were all roughly the same anyway.

The problem is how often do you have a bunch of non-correlated strategies with the same expected returns?

Almost never.

There’s two reasons for this:

  1. Markets tend to operate in cycles and what assets do well will be based in part on what stage they are at in the cycle. Since non-correlated assets tend to be at different stages in their respective cycle you’ll usually have to take a hit in returns to diversify out of one cycle and into another.
  2. People generally get superior returns by having expertise in a particular area for example in a particular region, asset class, etc. Virtually no one is an expert in many asset classes. So to diversify into different asset classes means moving away from areas where you’re an expert and into areas where you’re not an expert, which has a high likelihood of decreasing your overall returns.

Note, these observations aren’t based on the Wall Street theories these are based on the cold harsh realities of how real returns work in the real world not how some academic has generalized that they work.

This is where Dalio goes wrong.

In his book Principles he states he’s got hundreds of non-correlated strategies with similar expected returns and therefore they can diversify between those strategies decreasing risk, boosting returns without hurting returns.

But this hasn’t been true based on their real-world portfolio performance where Bridgewater has radically lagged the S&P 500 from 2012 to 2017…that’s a lot of opportunity cost and probably has meant even with their superior performance in 2010 and 2011 they probably don’t have a real edge in fact there’s a good chance they might be down relative to the general market.

Granted they might have done so with lower volatility, which might meet the mandate of their clients but it doesn’t do a lot for the average person working to get superior returns.


What Can You Do About It?

This isn’t merely a discourse in vanity we want to identify flaws in arguments in order to make better decisions.

So, what can we learn from this process?

First, we could argue concentration still beats diversification if you know what you’re doing.

Second, and perhaps more importantly you can still gain advantages similar to what Dalio is talking about by broadening your investing expertise.

What do I mean by this?

Start by mastering one asset class, one approach, one market.

But then rather than sticking to that one start mastering another that’s not correlated with the first.

So often someone who has expertise in real estate will expand by going into real estate in another market. Of course, they need to learn that market, network there etc. and usually it correlates fairly tightly with the first.

Or maybe they do something similar with companies and stocks.

Instead of doing that, which has diminishing returns anyway take the time to learn to master 2-3 other strategies, other markets, other asset classes not correlated to the first.

This way you’re in a position to invest in non-correlated assets without compromising your overall returns.

You can practice a great asset allocation strategy where you sell off what’s up to buy what’s down in cases where you can predictably find great opportunities and benefit from the best of both worlds.

This is why in our Multiply Ownership training we explain details of how the various major asset classes work so you can take advantage of multiple of them.

Some of the same fundamentals apply but you get to learn the nuances.

Taking this training is a great place to start but alternatively reach out to us take advantage of our network, our expertise, our deal flow to maximize your non-correlated returns.

​Where Are You In the Wealth Journey and What’s the Highest Impact Objective For You Next?

Wealth Scales Map

The Barbell Strategy – Limit Risk While Taking Advantage of Upside

Limit Risk

What’s the big fear of a lot of people about becoming an entrepreneur or investing?

Risk of course.

On the flip side what drives us to take this risk?

Upside.

What is upside?

Upside is the potential of something better happening.

Entrepreneurs are often perceived as risk takers but really the best entrepreneurs aren’t big risk takers.

The same is true of others who do well who are seen as not being risk takers they find ways to capitalize on upside.

If you want consistent success the objective is to simultaneous protect your downside while at the same time taking advantage of upside.

This won’t mean you always win as much as you could but it will mean over time your consistent wins will work out very well in your favor.

The strategy is what we call The Barbell Strategy courtesy of Nassim Taleb for the name.


What’s the Worst That Could Happen?

This is an important question to ask not just because it could be crippling but because the downside can pull you back a lot of years.

So the best entrepreneurs identify what could go wrong and find ways to limit those risks.

Having a low risk or risk mitigation strategy is the first half of the Barbell Strategy.

In other words if things don’t work out you’re still not that bad off.

A great example of this is investing in cashflowing real estate.

If you buy solid cashflowing real estate then usually the worst that will happen is you end up with the cashflow.

The cashflow isn’t especially high it’s not going to make you rich on its own but it’s also not horrible. You might consider it similar to what you’d earn by having your money in a bond or the dividends from a stock.

Likewise, you could look at earning a salary at a job.

Whether the company does well or poorly for the most part this salary should remain consistent and you’re fairly protected.

Of course, you could lose the job and could plan for this but even if you lose the job you don’t lose the salary you made along the way.

This is a notable difference between having a job and having a business. In a job you shouldn’t go negative. In a business you can actually go into the hole not only not earning but also losing money you’re putting out for expenses.

You’ve got the two types of risk to consider. Loss of actual value (relationships, money, assets, reputation, credit, etc.) and loss of time.

In other words, you want to be getting ahead regardless and you want to protect yourself against losing what you’ve already got.

What does this mean?

When you’re considering opportunities you want to find at least some protection within your strategy.

There are plenty of examples of people who don’t do this, make lots of money then lose it all and what good is that?


What’s the Best That Could Happen?

People don’t get rich off protecting downside they get rich off upside.

One of the main reasons so few people become rich is because they never pursue strategies with much upside.

The best that could happen isn’t very good.

Look to become rich you’re going to need to earn multiples (typically around 10x) the average annual income or better.

Even with saving and investing and the compounding you get you won’t be able to add up to much without a project yielding you a lot of upside. (Check out The Golden Path to explore how to do this predictably).

The problem is you simply won’t have enough to invest to get you there and especially not within any reasonable period of time.

So, you need an opportunity where the best that could happen (meaning if things go well) the rewards are really great.

If you study billionaires you see this in their thinking.

Steve Jobs famously said, “I like to be involved in projects that affect a lot of people”, hence iPhone, iTunes, etc. this is upside.

Elon Musk said he thought, “what are the biggest threats to humanity?” If you’re talking about a big threat you’re also talking about big rewards, this is upside.

In both cases especially Musk’s case there was lots of downside risk as well but the point is it was the upside not simply avoiding the downside that’s turned him into one of the richest people on the planet.

Having an opportunity with a lot of upside is the second part of the Barbell Strategy.

Note, there’s no guarantee this upside will actually happen, it might well not in fact most of the time it won’t, which is why the downside protection is so important.

Examples of upside strategy would include:

  • Ownership of shares or options
  • Profit sharing
  • Ability to scale a strategy that works
  • Etc.

If everything goes well those shares, options, profit sharing, etc. could be worth far more than your salary but there’s no guarantee they’ll pay off they are simply ways to participate in possible upside.


Putting the Barbell Strategy Together

The Barbell Strategy helps you not only figure out what opportunities to pursue (in many cases a blend of opportunities) but also how to structure them.

For example, should you take all stocks and profits or salary plus shares?

Should you go into a new business with both feet or should you maintain a side income while building the business until the business can replace your side income?

The Barbell Strategy should encompass both a downside “what if the worst happens?” strategy, which isn’t exciting but keeps you safe while at the same time also encompassing an upside “what’s the best that could happen?” strategy, which is exciting and could make you rich.

Here’s the beauty.

The probability of any given upside strategy paying off is usually fairly low otherwise everyone would do it.

The failure rate of businesses not counting MLMs and a lot of the work from home opportunities is around 70% in the first 10 years…those are actual failures they don’t count ones just getting by without exciting results and when you include MLM and work from home opportunities the numbers tend to balloon well over 90%.

Worse, the percentage of those actually achieving the success they dreamed of when they got into it are much lower typically at less than 5%.

From a purely statistical basis this means to succeed at a high level you’re probably going to have to be willing to try 20 or so opportunities (with great training, education, networks, etc. you can improve these numbers of course, hence Richucation).

Well guess what?

Because the Barbell Strategy protects your downside you’re more able to pursue one opportunity after another because you don’t have time spent recovering from big losses.

What are some great examples of the Barbell Strategy at work?

We discuss how investing in properly purchased cashflowing real estate with a reasonable amount of leverage achieves this brilliantly. See How to Buy a House Like a Millionaire.

This is because the cashflow provides the downside protection while the leverage with appreciation provide the upside, which is why so many people have done well in real estate.

Dividend stocks can provide a similar benefit (estimates range from around 40%-70% of returns coming from dividends). This could in theory be enhanced by investing with margin where the dividends pay the cost of the borrowing but this introduces new downside risk due to the high volatility of stocks.

Note commodities, currencies, etc. don’t offer this same benefit because they are non-productive assets, which is one of several reasons our philosophy is to invest almost exclusively in productive assets.

Some strategies with bonds offer this to a lesser extent because the upside isn’t as great as say real estate or stocks but the volatility is also a lot lower than stocks so the downside isn’t as bad.

What about in income building vs investing?

A great example is mastering marketing.

In most careers you’ve got a low income cap. Trades, engineering, nursing, accounting, IT, etc. usually you’re capped around $100k-$200k/yr. depending where you are in the world.

These are great because they protect the downside but horrible because they don’t offer the upside.
On the flip side you’ve got entrepreneurs, deal makers, traders, etc. who have upside but also could make nothing or in some cases lose a lot.

Marketing is one of the rare fields with both.

It’s very easy to earn a regular wage say $5000/mo. depending where you are in the world as an example.

On the flip side if you master marketing because it’s a field that scales you could earn $2 million or more per year.

This is one of the many reasons Richucation puts so much effort into helping clients develop mastery of marketing since it is the #1 game changing skill in financial success if you’re willing to put the time effort into mastering it and what you learn in colleges or universities simply doesn’t give you these results since it’s designed to have you work in a big company where you don’t have the upside you get through learning independent, entrepreneurial, or small business marketing.

There are some other skills with high upside as well such as Leadership/Management but the problem is in most organizations these aren’t careers so you have to start somewhere else then move into this position.


The Key to Upside is Scale

Why do some things have upside and others don’t?

The answer is scale can you put in the same amount of time and energy while producing dramatically greater results?

In fact, is there a decoupling between how much time and energy you put in and what those results are?

The extent to which you can do this determines the scale.

Scale will make you rich.

McDonald’s isn’t the most profitable burger company because they make the most per burger or the best burger but because they sell the most burgers.

Coca Cola is the most profitable and valuable beverage company not because they make the best beverages or sell them for the most but because they sell the most of them.

This is one of the key insights of The Formula – The Essentials of Becoming Rich.

How much can you scale something that works?

Some things are easier to scale than others but there’s also strategy and skill to scaling and especially scaling fast once you’ve got something that works.


Conclusion

Find ways to protect your downside not only your risk of loss but also ensuring you’re getting ahead as much as possible so you’re not losing time.

Make sure you’re pursuing something with upside or leading to something with upside.

There’s one final lesson.

Sometimes people have a low risk strategy to go along with their upside strategy but the upside strategy has big DOWNSIDE and the downside can wipe out everything they’ve got in the low risk strategy.

This can be a big problem.

For example, you might have a job along side a real estate development project you’re running. The real estate development might involve borrowing a lot of money and maybe you’ve got a personal guarantee.

If the development goes bad it could ripple over and result in losing everything you own even if it’s solid in its own right.

This is where asset protection strategies come in and you can address these through proper structuring as well as proper relationships.

Last but not least the Barbell Strategy doesn’t apply just to money and time it also applies to relationships, reputation and assets.

Some relationships have great upside but also huge downside. You’ve got opportunities for lots of attention, which could build great reputation but also go the opposite way. And so on.

Make sure you apply the same principle limiting your risk to relationships and reputation while pursuing high upside.

The wisdom of this strategy doesn’t usually show up in the short term but over time especially as you go through a cycle or two it becomes very apparent and HUGELY beneficial.

What seems slower is often faster in the long run but what’s slower is sometimes just slower. Make sure in pursuing success in particular financial success you have upside in your low risk strategy.

Likewise, what seems faster is sometimes slower in the long run because it will all come crashing down as time passes. The wise thing is to avoid strategies where you can end up with catastrophic loss even if the chances are low because the more time passes the more those chances compound.

To improve your odds of success:

Or contact us for specific questions.

​Where Are You In the Wealth Journey and What’s the Highest Impact Objective For You Next?

Wealth Scales Map

Can You Still Get Rich In Bitcoin?

bitccoin

2017 saw bitcoin surge well over 1000% from less than $1000 to around $20,000 at it’s peak, then settle down to around $14,000 by the end of the year.

Many of our clients made hundreds of thousands or millions of dollars off the rise.

The speculation isn’t over with suggestions of $100,000 bitcoin coming, some saying $280,000 per bitcoin and others suggesting $1 million per bitcoin within 5 years.

On the other side are cries from almost every significant billionaire investor and many to “stay away from bitcoin”, “it’s a bubble”.

Perhaps legendary investor Jim Rogers had the most pragmatic view “I wish I was smart enough to have bought it”.

The truth is, bubble or not if you didn’t invest in 2017 in Bitcoin or a comparable crypto currency (Ethereum, Ripple, Litecoin, Bitcoin Cash, etc.) you missed out on some gains you will almost never find anywhere.

Now on discussion groups I’m seeing people asking about the best business to be in for 2018 and one of the common responses is “crypto currency”.

On the other hand you might be feeling like it’s too late so what’s the reality?


It’s Good to be Lucky but It’s Still Luck

Unfortunately, you’ve got a whole host of self proclaimed crypto currency experts who have cropped up based on their great gains in 2017….nevermind that most of them didn’t make much at all or perhaps even lost money in 2016, 2015, 2014 and could do the same in 2018.

First bubble to burst…MOST PEOPLE WHO MADE MONEY IN CRYPTO IN 2017 WERE LUCKY!

There’s nothing wrong with this but it’s worth considering the wisdom of legendary tech founder Bo Peabody who said “I was smart enough to know when I was getting lucky”.

Luck isn’t predictable it can make you fortunes one day and rob you of them the next so if you want predictable results, which is our mission here at Richucation then you need to realize when you’re getting lucky and learn to develop expertise in what you’re doing.


What to Learn From Crypto in 2017

If you want to be good and not just lucky, in other words to get consistent predictable results rather than not knowing from day to day if you’ll win or lose you need to start by realizing something…

NO ASSET CLASS is good or bad.

People say “investing in crypto” is good.

That’s wrong.

Investing in crypto in 2017 was almost universally good.

2017 showed the power of riding a bull market mania (btw you could have gotten something similar in weed stocks as well).

It’s not crypto that’s good,0p it’s a bull market mania that’s good.

Dotcoms were similar in the late 90s.

Housing was similar up to 2007.

Gold was similar 2010 to the 2012 peak.

Nvidia was similar this year.

A wise trader once said “don’t tell me what to buy tell me when to buy it”.

It’s not the asset that’s good in and of itself it’s the right asset at the right time, which is part of what makes investing hard.

The lesson you can learn from crypto in 2017 is if you can catch a bull market mania you really don’t have to do anything you just buy and sit and gain.

The same wouldn’t be true in a bear market crash.

What do all those earlier examples have in common? While they had their day of blowing up they also had their times of under performance.

If you learn to adapt and shift your strategy you can continue to do well through almost any market but if you’re blindly thinking “buy crypto” or “buy real estate” or “buy internet stocks” or whatever else then you might do great for a couple years and the time will come when you’ll almost surely get flattened or at least not benefit the same way you did during those great years.


The Truth About Crypto in 2018

If you’re expecting 2018 to be a repeat of 2017 in crypto you’re almost surely going to be disappointed.

This is due to simple economics as well as mass psychology.

Consider that Ripple soared 5000% in 2017 to over a $100 billion market cap.

For it to do so again it would need to be worth $5 trillion.

The problem with this is assets grow as more money comes in but the bigger they get the harder it is for them to grow at the same rate because you need more and more money to fuel this growth.

Think about it in terms of people.

Say you’ve got 100,000 people investing in something, a relatively small group. To go 10x you need to increase to 1 million people. Ok, still reasonable. But to go 10x again you need to go to 10x million about the population of NYC. To go 10x again you need to go to 100 million…more than the entire population of virtually any European nation. To go 10x again you need 1 billion people…about the population of China. And to go 10x again? Well there aren’t enough people in all the world for that.

Assets are a bit like this $100 million isn’t much money in financial markets.

$1 billion is a bunch more but still nothing crazy.

At this point crypto currency market caps have collectively peaked around $800 billion to $900 billion. That’s a lot of money. To put it in perspective the big US bailout package in 2008 was $700 billion and that was to bail out the entire banking sector when the whole housing market was suffering massively.

Total US tax revenue is around $6.5 trillion that pays for the entire operations of the entire country for over 300 million people in one of the wealthiest countries on the planet.

Bottom line, although theoretically possible for Bitcoin to go another 10x and years into the future it might do so it’s highly unlikely bordering on impossible for it to do so again in 2018.

This is similarly true of all the major crypto currencies (Ethereum, Litecoin, Ripple, Bitcoin Cash, etc.)

Does this mean smaller alt-coins can’t soar by 1000% in 2018? Not at all, after all it’s comparatively easy to go from $300 million to $3 billion.

There’s two things working against you in 2018 though:

  1. There’s a lot of alt-coins out there so spotting the winners in the sea of noise is increasingly difficult.
  2. Crypto currencies are highly corelated meaning they tend to move together. There’s a good chance because of the dramatic rise relative to adoption 2018 will see a major decline (we’ve already seen a pullback of about 40% in many crypto currencies from their peak in late December). If this happens the smaller coins even if they are good ones, which most aren’t, are likely to go down with them during at least the short term.

Bottom line making similar amounts of money in crypto in 2018 is likely to be much harder than it was in 2017. Luck isn’t likely to carry you so far and there’s a reasonable chance many people without an understanding who flooded in or have been inspired to flood in due to the 2017 rise will see losses.

Chasing returns is a classic investing mistake. What has happened in the past is not a reliable indicator of what will happen in the future. In fact what happened in the recent past is usually a negative indicator of what will happen in the future due to mean reversion.

Funds that outperformed for 3 years tend to under perform in the next 3 years. Fund managers who outperformed in the past 3 years tend to under perform in the next 3 years and vice versa.

This makes sense when you consider most people tend to operate based on a specific strategy, which they execute well and when the environment changes and that strategy is no longer effective their results falter.

The key to consistent success is an adaptive strategy and no particular asset is in itself adaptive so you need to be willing to move between assets and strategies to remain consistent.


Getting Rich Predictably

You can get rich because you’re good or because you’re lucky. Last year was an easy year to be lucky in crypto.

This luck might continue into 2018 but it’s comparatively unlikely (luck never lasts forever) and it could be the opposite, bad luck could hit.

If you want to get rich predictably what do you need?

You need an edge.

My advice to people asking me about crypto this past year has consistently been the same.

“It’s an extremely volatile unpredictable market that could work for or against you. It could double or it could decline it’s impossible to say so the question is ‘what is your edge?’ If you’ve got an edge then work it if not get one or stay out.”

This advice comes in part from experiences of seeing people lose 100% of their investments at the wrong stage in the market or on bad investments and a bias towards protecting against the downside not simply pursuing the upside.

You can read some of our articles on decreasing risk while increasing return here:

https://richucation.com/how-to-decrease-risk-increase-return-part-1/

https://richucation.com/how-to-decrease-risk-increase-return-part-2/

https://richucation.com/how-to-decrease-risk-increase-return-part-3/

https://richucation.com/how-to-decrease-risk-increase-return-part-4/

Having an edge isn’t just for investing.

You want to earn a higher income? Being able to offer something of unique or rare value will help you do this.

Want to work with the people you want? Having a unique edge will give you the ability to pick and choose.

Want to make a lot of money in your business? Having an edge in costs (learn more in Getting Deals) or an edge in marketing (learn more in Profitable Marketing) will make all the difference.

Apple, Google, and Facebook aren’t big doing the same as everyone else there’s something unique, different, and better about them that makes them highly profitable.

Crypto is just a vehicle. It’s useful because it’s fairly accessible, with a large market and a lot of volatility so if you can profit from that volatility you can do well. It can also crush you if you’re not careful.

But you could just as easily use real estate, or private businesses, etc. to find ways to profit. It helps if you’re in a crazy bull mania but it’s not necessary.

People make the same dumb mistake over and over again. They focus on the vehicle rather than HOW the vehicle is used.

Real estate doesn’t make you rich. HOW you do real estate makes you rich.

Stocks don’t make you rich. HOW you do stocks make you rich.

Business doesn’t make you rich. HOW you do business makes you rich.

This is why Richucation provides guidance on how to get PREDICTABLE results in your finances, investing, and most especially business. Building a Profitable Sales and Marketing Machine where you can put $1 in and get $2 out, automating the business so it runs without you and scaling it to 10x.

Want me to prove it to you?

How many people have gone broke in real estate? Take a look at 2008 when the market turned against people and millions lost everything.

How many people go broke every year in stocks? Look at 2001 when the dotcoms busted. Look at how devastated the country was in the Great Depression after the 1929 stock market crash.

70% of businesses fail within the first 10 years and most of those that last barely get by.

Yet some people get rich in each of these things not because the vehicle is different but because HOW they do it is different.


5 Ways Our Clients Are Making Money in Crypto in 2018

There are two types of risk in investing:

  • Value risk – having something where maybe you’ve got the right price but the underlying value decreases.
  • Timing risk – you buy or sell at the wrong time causing you to have to wait too long or when the price goes against you

If you’re insistent on pursuing crypto (and it’s not an especially good vehicle on average because it has a lot of timing risk whereas some other vehicles have a lot less timing risk) here are some ways our clients are gaining an edge in 2018:

  1. Selective ICOs – ICOs or early stage alt-coins sometimes represent opportunities if they are promoted right, if there is the liquidity to exit and if the entry price is low enough. ICOs do not mean automatic wealth quite the opposite but in the right cases they can be very profitable.
  2. Supernodes – essentially it’s possible to receive dividends on certain types of crypto and earn money facilitating the block chain transaction networks. If you know what you’re doing this is a potentially solid way to profit consistently.
  3. Smart trading – trading involves buying lows and selling highs profiting from the volatility as you switch money in and out. Alternatively shorting downs, etc. This game works in any liquid financial instrument but is much easier in some. The advantage with crypto is high volatility and a 24/7 market. It’s also a fairly new market, which means there’s a lot of trading inefficiencies that have long since closed up in major markets like major stock markets, commodities exchanges and forex. On the other hand timing is one of the hardest things to do and the spreads in crypto can be prohibitive. It gets even worse if your time to enter and exit is limited by KYC, slow transaction speeds, switching between correlated crypto currencies to get in and out, etc. Throw in liquidity problems and thin order books on some of the exchanges and you’ve complicated it massively. If you’ve got technical trading skills though crypto can be a great place to profit.
  4. Mining – we’re helping a client right now with a $1.2 million mining deal. Mining is not a no brainer money maker. It’s become much more competitive over the years especially in Bitcoin where you need to know the technology and your costs. It is also dependent on the price of the coins so you’ve got risk of crashes though also potential upside if you hold on to them. There’s increasing supply problems accessing the best chips and cards for mining. The biggest advantage if you can gain one though is the price of electricity. If you can gain an edge here there’s a definite opportunity.
  5. Brokering – whether people are buying or selling if you’re in the middle of brokering transactions you can make money. I’ve seen people charging up to 8% to broker transactions for others who want to buy or sell so if you can get volume this is perfectly viable. Notice this is more of a business than crypto in general but given the high demands and given the massive friction getting in and out of the market it represents an opportunity. I’ve especially noticed for some large purchases of my own as well as those of clients when you’re dealing with multiple currencies, large size transactions or exotic transactions such as between precious metals and crypto there’s definitely gaps to make a mark.
  6. Bonus – Offering their own ICO – once again offering an ICO isn’t an automatic ticket to riches and I’ve previously mentioned how I consider most of the ICO market a scam where I believe a lot of people are going to lose a lot of money before it ends (there’s also a risk of upcoming regulation from the SEC and others). This being said there’s an insane amount of money pouring into ICOs these days and if done well it represents a viable way for a lot of people to make a lot of money. This is much more complex than simply buying an ICO, you need a team, you need to promote, you need something behind it all, etc. But if you’re willing to start a business around it and really drive the technology it’s a big opportunity at least while the window lasts and we’ve got a number of clients doing them.


Conclusion

None of these things are places where you simply put in money and get rich.

There’s an old expression “that which is easy doesn’t last and that which lasts isn’t easy”.

Money in crypto has been easy this past year and that tells you it won’t last.

Just as with any other wave the casuals will surely come through in a while saying “it doesn’t work”, etc. And it’s true it doesn’t work if you don’t work it.

The lesson is gain mastery. Identify an edge. Build a great team. Scale up your success.

The fundamentals of becoming rich in crypto are the same as in anything else:

  1. Identify a profitable opportunity with high upside
  2. Work it to actually be profitable
  3. Scale it up

To be profitable you need to get great value for your money (Get Deals) and have a system of getting a lot of eager buyers (Profitable Marketing).

To scale up you need to be productive, optimize speed by focusing on the next step of the right sequence, avoid the constraints & levelers, and apply accelerators (Grow Impact).

To make all of this work you need mastery so pour yourself into knowing your field and your business (Value Mastery).

You need to work productively with the right people (Leverage Team).

And you need to own the results of what you’re building, ideally building assets and growing those assets (Multiply Ownership).

This is as true in crypto as in anything else.

Contact us to discuss more in crypto or any other business maybe we can help or collaborate ourselves or through our network.


How to Buy a Property like a Millionaire

Buy Property Like a Millionaire

More money has been made in real estate than anywhere else” – common bullshit expression

There’s a lot of crap out there about real estate but real estate can also be a kick ass investment vehicle.

I’m going to share with you about losing lots of money in real estate, making lots of money in real estate, and having dogs that just haven’t done a damn thing in real estate.

In the end, hopefully you’ll know how to consistently make real estate work really well for you and avoid all the common little mistakes people make that keep them from doing well.


The Journey

This story was inspired by a conversation I had with my mum a few days ago while I’d stopped to visit my parents in the middle of some travels.

Back in 2007 I was green, didn’t know a damn thing about investing but my parents had just finished flipping a small property near the city I’d just moved to.

For decades, they’d faced ups and downs in stocks, bonds, etc.

I’d started my journey back into business and was learning how to make my millions.

It was the height of the real estate boom. A former roommate of mine, an average guy made $100k in a year doing next to nothing off a $20k investment simply by buying a condo and selling it the next year. Dumb luck, but I didn’t know it at the time.

Everyone was making money but I wasn’t in the market.

A new friend invited me out to an investment presentation for a land development project at a fancy office downtown where he was working. They showed how land values rose the most during the development phase from raw land into titled lots and you could invest. Best of all you were getting some end of the line inventory so you’d get even better returns than everyone else (beware when you hear words like that it’s usually smoke and mirrors).

The projected return? 100% in a year.

I was learning then about how rich people knew stuff poor folk like me didn’t know and this is why they were rich. While everyone else was investing at a lousy 10% they were getting 100% (total bullshit but I didn’t know that at the time) but this was one of those opportunities finally!

I didn’t have the money needed to invest so I called my parents. I told my mum “look where you’ve done the best over the years investing…real estate so why not invest in what’s worked for you?” They listened to the story and decided to go for it. After all we were told, it’s land worst case scenario it’s not going to zero. WRONG!

It became the first of 4 troubling investments, 2 resulting in 100% loss for investors, a third around 90% loss for investors and the fourth around 20% loss for investors to date.

What went wrong? Glad you asked but the story isn’t over yet.

After some of these dramatic losses my mum commented to me “well maybe I’ll just not invest anymore”. To which I replied, “that’s stupid you’ve got to invest in something and you just paid $100k+ for an education, the question is what did you learn so you can do better going forward…” Then I shared with her what I’d learned watching not just those but many other investments at the time.

Valuable lesson – when possible learn from the mistakes of others rather than having to make those mistakes yourself, it takes less time and costs less money.

That was the last time we lost money on anything like that time and time again those lessons have served to not just avoid losses but make great returns.


Understanding Real Estate

There’s an amateur way of thinking, which is to think about asset classes: stocks, bonds, real estate, etc.

Why is this amateur? Because the asset class isn’t what makes or loses you money. You can make or lose money in any asset class, which is why anyone who says, “the way to make money is in real estate”, or MLM, or online, or whatever else is clueless. Run away from those people.

Every asset class has different characteristics and if you want to do well in it you should understand those characteristics.

Real estate has some distinct ones:

  1. Intrinsic value – no matter what the land will pretty much always be there (the buildings might not). It’s also easy to get a relatively accurate fair market value for it, which can not be said for say businesses, commodities, or intangibles.
  2. Value is driven primarily by use – this is very different from say stocks, bonds, currencies, etc. which get traded actively as pure investments. Most real estate purchase and ownership isn’t speculative or profit driven it’s for people to use it day to day, which means the markets are very local. There is no Canadian real estate market, or US real estate market, or Australian real estate market. It could be booming in NYC and crashing in Detroit or even vary by neighbourhood

There’s lots more we could understand but first let’s explore some natural consequences of those two factors:

  • Slow moving – real estate prices aren’t going to change dramatically like most financial instruments are. Whereas a 50% move in a stock could happen in days real estate will rarely move than much over a few years
  • Easy to leverage – this is super important. Because it’s relatively safe and stable it is cheap and easy to borrow money to finance it

Usually it has four other characteristics:

  1. High transaction fees – this is especially true if you need to use realtors, which doesn’t mean you shouldn’t as they are often worth it though expensive
  2. Productive – meaning you’ve got renters, which are paying you money or crops you’re growing or something. This is very important as we’ll see later and makes it very different from a commodity like gold, silver, oil, uranium, etc.
  3. Doesn’t grow – just as you aren’t going to have less of it you’re not going to have more of it by having it sit there
  4. Needs management but not much – bonds are productive (pay you cashflow) but don’t need management and frankly the management is a pain in the ass. Yeah you could hire a property management firm but you’ve still got to manage them

Alright, I realize this stuff might seem boring but it’s super important if you’re going to make lots of money and making lots of money isn’t boring it’s the new cool!

All of the above is going to help us figure out how to avoid losing money at it and how to make lots of money at it.


It’s SUPER Hard to Predict the Future

Our rules for buying real estate are super simple. You’ll be able to catch them in a flash. But to understand why they are brilliant it helps to start by understanding investing vs speculating, why it’s hard and what to do about it.

I call this The Barbell Strategy (credit to Nassim Taleb), which is a cornerstone of success in any area of life but especially finance and investing and something we talk a lot about as a core principle in Richucation.

To understand let me tell you about my conversation with my mother yesterday.

We sat around the living room, kind of a dreary day, discussing a trip to Portugal and Spain she wants me to go on with her and I’m feeling reserved about because it will mean cutting a trip to the Balkans short.

For whatever reason conversation turned to a property my parents own in a town called Airdrie, outside of Calgary in Canada, and comparing it to the first property I bought a couple years after they got that one.

Please note, both are real estate, one did about a 300% return in 5 years, the other is 0% return in 7 years. Yes, you heard that right, you want to be the former not the later and I’m going to show you how along with showing you what went wrong on the former so you can avoid it.

The property in Airdrie is a townhouse they purchased because they’d lent money as a second mortgage against a development project and if they didn’t buy it they would have lost about $30k of their principal. That’s all fancy talk for saying the amount the project ended up selling for wasn’t enough to pay them back.

Because they lent the money they had the first option to buy it and the developer who we trusted recommended it. At the time, I thought it was dumb but didn’t know enough to say for sure or communicate it. This is great because it’s another lesson learned off someone else’s mistakes.

The developer recommended it saying it was a good property and he figured the values would go up. Turns out 7 years later the values are almost exactly what they paid for it.

Big lesson – it’s hard to predict the future.

Buying based on trying to predict the future is what we call speculating. Buying based on present realities for long term gains is what we call investing.

Back to the Barbell Strategy…

The Barbell Strategy is all about the idea of protecting against low risk, while positioning yourself to take advantage of good luck if it comes your way and real estate is a perfect example of how to do this if you do it well.

The problem with the Airdrie townhouse was it was PURE speculation. How so?

The rent barely covered the monthly expenses so there was zero monthly profit. In other words, if the market didn’t go up there was virtually no return.

There was no built-in equity when they bought it because they paid full retail price.

Both of these things were huge mistakes and big things you’ll want to avoid (more on this later).

Here’s the beautiful thing about properly purchased real estate. If the market doesn’t do anything special you’ve got some built in equity and you get monthly cashflow out of it at a decent rate (probably better than you’d get buying bonds). If the market does go up you can make some big returns thanks to high leverage.

To take advantage of it though it needs to be PROPERLY purchased.


Real Estate’s a Shitty Investment

Say what?

Wait Michael didn’t you just tell us how wonderful it could be?

Yes, yes I did but here’s what you need to know. What makes real estate fabulous has very little to do with the real estate itself and everything to do with the financing.

What?

Alright let me do some boring (but actually kind of exciting) numbers for you.

Let’s say you buy a new rental property and you pay all cash…Cash means no financing, not literally bringing a big bag of unmarked bills down to the seller.

Let’s say you follow Richucation’s buy like a millionaire rules for real estate and buy it for 10% or more less than it’s worth. So, on a $300k property this means it’s worth $330k the day you buy it, a $30k increase to your net worth…I bet you feel pretty good about yourself don’t you?

Well not so fast because remember those high transaction fees? Yeah if you sell tomorrow you’ll lose about 5% in fees (realtor, closing costs, etc.) so there goes $15k of the $30k. Then you lose another bunch on tax, there’s the original purchase fees, the cost of having it sitting there while you try to sell and what you’re left with is probably barely worth the time it took you to buy it.

You’re probably left with $5k-$10k in final profit on a $300k investment. About a 2.5% return, in other words you could have done that buying a government bond and getting back to work.

Now, you might be saying “but Michael what about the rental income?”

Yes, yes, we’re getting there let’s consider how rents might work.

Let’s say you again were smart and followed Richucation’s buy like a millionaire rules for real estate and purchased with at least $750/mo. of rent for every $100k of purchase price. This means you’d be getting rental income of at least $2250/mo.

Sounds good right? No, not good and here’s why.

$750/mo of rental income is equal to a 9% gross rental yield but of course we don’t actually get gross. By the time you pay for property management, maintenance, vacancy, taxes, insurance, etc. (Click to download the free real estate analysis cheat sheet) you’re down to about 5.5% return and we haven’t factored in the smaller risks like being sued, extreme damage, etc.

5.5% isn’t a great return…oh by the way it’s fully taxable in most places.

I could show you very solid bank stocks you could buy for zero effort paying you a 4% dividend (usually this works out to about the same after tax as the 5.5% because dividends are usually taxed at a lower rate) where you can get lots of upside, be fully liquid, and have zero headaches.

Maybe you’re asking, “what about principal pay down?” There is no principal pay down because there’s no mortgage.

Wait, wait, this doesn’t sound right hasn’t real estate created more millionaires than any other asset class?

First, get this asset class nonsense out of your head. It’s not about real estate or stocks or bonds, it’s about how you buy and how you manage and how you sell, these are the things that will make you rich not the asset class itself.

Second, yeah real estate actually has made a lot of millionaires but it’s a super deceptive statement. People tend to become millionaires through their real estate because they own their own home and they’ve got a lot of leverage on it. We’re getting ahead of ourselves though so let’s finish the boring math.

There’s one more way you could benefit from this real estate, which is it could go up in value. Here’s the problem. Remember how we said real estate tends to be slow moving? Yeah well it isn’t likely to go up much in a year. In fact, while a great stock can double or triple in a year if real estate goes up by 20% in a year the market is INSANE and won’t last.

Best case scenario you happen to get lucky and do 20% in a year but it doesn’t happen year after year. In fact, the most comprehensive research of historic real estate prices by Dr. Robert Schiller shows over the long term real estate roughly matches the rate of inflation, which makes sense because where is the money going to come from to pay for people’s increased cost of housing? It can’t grow faster than the money supply for long periods.

Bottom line over the long term you’ll likely get say 3% or so annual appreciation.


How to Make Real Estate Awesome

Alright so we’ve established real estate is a shitty investment on its own now let’s talk about how to make it kick ass.

Leverage – remember we said earlier it’s really easy to get super cheap money for real estate compared with almost anything else? Yeah this is the main game if you want to win big.

To understand how come let’s go back to the boring math starting with the immediate boost to your net worth when you buy for below market value…which is legit awesome right?

Before we said well you got that 2.5% return off your $300k. But if you’re smart you’re not going to buy real estate with 100% down, you’re going to use leverage, without leverage real estate isn’t anything to brag about, it’s all about the leverage.

For all our future examples, we’re going to assume a very normal 20% down payment, meaning instead of paying $300k in cash for the house you’re paying $60k in cash and getting a mortgage for $240k.

Previously we assumed you made $7.5k if you’d actually sold immediately. If you did so again (assuming no mortgage penalties, yes, I know we’re simplifying the equation a little here) you’d make the same numbers and suddenly that 2.5% return has become a 12.5% return ($7.5k/$60k invested). Much more appealing.

This is only the start though.

What about the rental income? Before we said 5.5%. We’ll still get this same return on the first $60k but then we’ll get a slightly different return on the remaining $240k of borrowed money.

For simple numbers, I’m going to assume your mortgage rate is 3.5%, which depending where you are in the world right now might be low or high (generally places with higher interest rates will also mean higher rental rates so to some extent it should balance out). This means you make 2% on the $240k remaining between principal paydown and monthly cashflow.

Did you follow this? Ok, there’s 9% of gross rental income coming in. But we said there’s 3.5% of expenses leaving you with 5.5% of net income, which is paid on the portion you did the down payment on. The remainder you have borrowed money and the money is costing you 3.5% in interest so you deduct the 3.5% from the 5.5% to leave you with 2% you get to keep off someone else’s money.

In other words, your 5.5% has grown to 13.5% MUCH better than before. This is now an attractive rate far better than what most people will get in their investments.

Finally, we’ve got the possibility of appreciation.

Let’s look at both the lucky years (20%) and the long term expected average (remember we suck at predicting the future so it could vary some).

If the market happened to go up by 20% in a year what would your return be with leverage? Let’s do the math (for simplicity I’m keeping out the extra 10% below market value it was purchased for).

20% on $300k is $60k…how much did you invest? That’s right, $60k down payment…in other words you just made 100% in a year! This is crazy good.

Say it wasn’t a lucky year it was just an average year of 3% or $9k in appreciation. On a $60k investment you made a 15% return just off appreciation! Is 15% a good return? Hell yes! It’s a great return and it’s on top of the other returns you already made.

Bottom line – leverage is what makes real estate awesome.


A Word of Caution

Leverage seems great the way I just described it. Leverage can also be the bane of your existence because if the property goes down in value instead of up it works against you.

If the property is vacant longer than expected the mortgage payment is working against you.

This is why BUYING PROPERLY is so critical!

If you follow our rules it’s going to make it safe for you and profitable.

For example, say you bought for full retail value and the property dropped in value by 10% what did this do to your return with leverage? 50% decline!

What if you followed our rules and bought for at least 10% below market value? Your investment is secure at what you paid for it.

What if you did like most people and bought low cashflow properties? Leverage creates negative cashflow and headaches every year.

If you followed our rules you’re making money off that leverage and dancing all the way to the bank now take yourself to dinner because the renters are buying!


What to Watch in Real Estate

You might have heard people rattle off this expression “the 3 most important things in real estate are location, location, location”. Thank god Donald Trump corrected that one…well sort of.

In “The Art of the Deal” Donald describes the three most important things as “Deal, deal, deal”.

In truth, both are partially correct. There’s four quadrants we like to pay attention to when buying real estate:


A great location will correct a lot of errors if you’re lucky but if you’re relying on luck you’ll probably end up broke.

The deal is arguably the most important consideration but a great deal can get sunk by bad management or a crap property. Then again great management means low vacancy and high rents with few headaches.

What do we mean by property? We don’t mean the location of the property we mean what is it you’re getting for your money? Is it great construction? Will it last? Is it attractive? Is it the largest property on the block or the smallest or something in between?

You want to make sure you nail all four of those quadrants to really do the best possible.


The Millionaire Rules to Buying Real Estate

Wow! We’re finally here some great simple rules for you to follow to make it easy or at least avoid the dumb mistakes people make.

Keep in mind you’ve got to put the work into applying these, I looked at 108 properties before I made my first purchase decision so I knew what I was doing and could actually buy right. If you don’t want to put any effort in…

Here we go:

Rule #1 – Buy for at least 10% less than it’s worth with a margin of safety

This means if a property is worth $330k you’re never paying more than $300k for it.

This has a whole range of benefits:

  • Your net worth goes up the day you buy it
  • If it drops you’re usually still safe
  • Easier to get higher rental return on your invested cash
  • Easier to refinance for higher leverage

Note the comment about “margin of safety”, what’s this all about? You’ll never know for sure exactly what the property is worth you’ll have a ballpark range.

When estimating you don’t want to be optimistic. If you think it’s worth $340k you should probably say it’s $330k. Always include a buffer a little below what you think the property is worth as what you’re saying it’s actually worth.

For me, the property was probably worth around $345k-$350k on the high end (assessed at $380k). I estimated it was worth $330k and bought for $300k. It was pretty easy to do well on those numbers.

Obviously, the lower the better as it’s a pure boost to your net worth right off the bat.

Note, this and a couple other reasons almost always mean you won’t buy a brand-new place unless you’re getting a presale because brand new usually means full retail or close to it. NEVER buy retail.


Rule #2 – Buy with $750/mo. of rental income per $100k of purchase price

For a lot of people this number will seem super hard to hit…probably a sign you should keep looking.

This being said there are lots of strategies to increase the rent beyond what it would normally be such as:

  • Furnished rental
  • Short term rental (at the extreme end Airbnb, VRBO, etc.)
  • Adding suites
  • Renting out by the room

Some of these strategies will require more management so you need to factor those costs into your projections and raise your standards accordingly.

Also note, these numbers might need to be higher in higher interest rate environments so keep those in mind. The key is you want your rental income after accounting for all expenses (not just mortgage, etc. but also vacancy, maintenance, management, etc.) to provide you with some positive return on top of the leverage.


Rule #3 – Buy a property where you can force appreciation

This means you should have the ability to renovate and increase the value of the property if necessary.

Significantly, you want to be able to put in $1 to renovate and get $2-$3 back in increased market value.

Once again, this is a reason buying brand new usually doesn’t make much sense since you’re usually talking about immediate depreciation from use.

What’s the idea here?

  • In case the market goes down this allows you to protect your initial investment
  • It allows you to increase the value then refinance for higher leverage
  • If the market is stagnant you can control whether you get a return

You might never renovate but the ability to renovat​​​​e gives you a lot of security.


Rule #4 – Never buy the most expensive/biggest building on the street/area

The value of real estate is typically set by properties around it. This means either the properties around yours can raise yours up…or drag it down.

If you buy the most expensive property on a street the others around your place are bringing yours down. I made this mistake by getting a property almost 50% larger than anything around it. Surrounded by different properties it would be worth a lot more.

You could take this to the extreme by buying the cheapest property on the block but it’s not usually necessary.


Rule #5 – Buy in an area with positive population dynamics

Ok, now you’re just speaking Greek Michael wtf does that mean?

Remember how we talked about real estate primarily being used by people to live in rather than speculate on?

This means the value of real estate in an area is going to have a HUGE amount to do with what’s going on with the population in the area:

  • Is the population increasing or decreasing?
  • Is it stable and sustainable?
  • Is there good long-term job growth?

Look, if the market goes crazy it will be lucky but there are some things you can do to increase your luck and putting yourself in the way of this trend is a pretty good one.


Rule #6 – Buy inline with growth and NEVER after it

You’re confusing me again Michael what’s this nonsense?

Ok, remember how we talked about real estate rarely jumping up by say 20% in a year? Well usually this means if it’s just jumped up by a large amount it at best isn’t going to do so again and at worst could fall back quite a lot.

Take a chart of property prices in an area. If they’ve just gone up dramatically in the last little while stay away from that market. You might miss some wins but you’ll miss a lot more losses and that’s important.

On the other hand, if property prices around where you want to buy have just gone up a lot and where you’re looking hasn’t that’s a great sign because there’s a decent chance the local rising tide will come to your area.

It’s really hard to predict the future but at least stack the odds in your favor.

Tons of people make the stupid decision to chase returns, meaning they see something went up and they go buy, this is a good way to lose money. When things fall a lot that’s a much better time to buy.


Conclusions

There’s lots to this, I get it but that’s only because it seems new. Yes, it’s been deliberately simplified somewhat to make it easier to digest.

What you’ve got here are some very simple easy to apply guidelines and if you follow them you’ll be in a MUCH better position than if you don’t.

These allow you to position for the big upswings without taking a big risk in case you’re wrong.

I’ve watched so many people over the last few years make dumb mistakes and lose tons of money or tons of opportunity off real estate. I don’t want it to be you.

Real estate is remarkable for how comparatively simple it is to learn and apply. By contrast business is a hundred times more complex and more work.

No, not everything is in here. Unfortunately, there’s way too much for a blog post.

If you’re interested in learning more please download the Free Real Estate Investing Cheat Sheet and consider signing up for our complete training masterclass.

I was fortunate enough to learn from the mistakes and wins of others this is your opportunity to learn from mine.

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The Importance of the Rules and Dangers of Breaking Them

There’s a harmful statement many entrepreneurs are fond of listening to “rules are made to be broken”.

If that’s the case you’re following the wrong set of rules.

Effective rules are designed to give you the best results.

Consider traffic laws if you started driving on the opposite side of the street what would happen?  It would create chaos and slow everyone down, it might work in a small situation but on average respecting and following the traffic rules helps traffic to flow better for everyone.  The same is true for business and investing.

At Richucation we make a point of teaching the universal rules.

Lots of sources preach rules that are a bit like “don’t put your elbows on the table”, they might be conventionally accepted by they aren’t truly important in the modern age at least not in most situations.

But there are essential rules in business and investing, rules designed to ensure you are consistently growing and making money, you can break them now and again and get away with it but it’s unwise because in the aggregate you’ll end up losing out.

All too often I’ve made this mistake, allowing an employee to do something that breaks the rules to encourage them to take risks, unfortunately they were risking my money not their own, we lost money and I should have intervened.

Getting involved in a business whose foundation wasn’t solid, at first it seemed great, the lie I’d allowed myself to believe, and ultimately it lost money.

Skipping the process of acquiring security on an investment relying on the integrity of the participants and strength of the venture to move forward.

Or failing to put something in writing for mutual agreement, or proceeding without getting an agreement signed and then discovering the terms I expected weren’t honored.

The list goes on, the point is rules such as these, unwritten and even unknown though they might be for most are designed to facilitate success and it’s unwise to violate them.

What are some examples of these rules?

  • Buy/engage with a margin of safety
  • Don’t get involved in something you don’t understand, increase expertise to expand where you operate
  • Test small then scale
  • Get great quality data and use it to make your decisions

As you explore business and investing, wealth building, you’ll learn there are certain foundational essentials and that you shouldn’t avoid these.

Don’t get involved in a non-repeat business.  Get involved in businesses based on growth first, only then consider price, people with high integrity have no problems putting agreements in writing.

The list goes on, suffice to say there are rules, but more importantly you must stick to these rules, at times there will be emotional pressure or perhaps a sense of rebellion to break them but don’t, they are meant to be followed not to restrict you, but to enhance your success.  When you don’t follow them, the tendency is to lose time, opportunity, and money, you might gain a little in some way that’s easy to rationalize, but it’s nothing compared to what could have been gained if you’d just followed them.

Have a question about the fundamental rules of business and wealth building?  Want to run a question, thought or idea by us?  Feel free to contact us by clicking “Ask a Business Question” in the lower right corner of the screen.

The Worst Question Financial Advisors Ask You

I recently read an article about “what should I do with my extra cash?”

The basic premise here is cash loses value over time so you want to minimize how much cash you’re holding keeping only enough liquidity around to deal with your needs and provide a buffer so you’re not forced to sell investments when they are down.  With this in mind the question makes perfect sense.  Unfortunately, the answer reflected the common nonsense you often hear from financial planners.

Let’s start with the basics.  FINANCIAL PLANNERS ARE NOT INVESTMENT EXPERTS!

What?  You ask isn’t that the point?  Maybe it’s supposed to be but in practice virtually none of them do better than the market investing their own money in fact most do worse.  In other words they aren’t necessarily great sources of information.  Worse, they are USUALLY incentivized by getting commissions based on the products they sell you, hardly an impartial source of information.  This isn’t always true of course there are financial fiduciaries who can be very good but they are the rarity and still aren’t necessarily skilled investors.

That’s a buyer beware.

Now back to the main subject here, which is a question I hear from financial advisors and planners all the time “how much risk are you willing to take on?”  AWFUL!

Why is this question so bad?

Well, we’ve talked before on numerous occasions both in our training and blog posts as well as books, etc. about how risk is defined and how it isn’t defined in a meaningful way.  Technically, the answer to the question should always be “I want the best risk weighted return”.  Here’s an example, it is NEVER sound financial advice to tell someone to buy lottery tickets.  I don’t care what their tolerance for risk is it’s bad advice but that’s what the question implies.  In other words the question comes from a place that is uneducated, which is a good reflection of the investment knowledge of most financial advisors.

Good financial advice should maximize the risk weighted returns for clients, always period there is really no other value or purpose of a financial advisor if they aren’t helping you to get a better return on a risk weighted basis then they aren’t doing their job well after all why would you pay them if not for this?

So let’s talk about what the real question should be when you get into the conversation.  “What is the time horizon in which you’ll need this money and consequently how much volatility is safe?”  In other words if you buy something with a fair bit of volatility there’s a risk you’ll be forced to sell when it is down.  That is the ONLY risk that should be considered in this part of the equation the so called “risk appetite” because all the other risk should be balanced against returns so on a risk weighted basis you’re getting ahead.

Why are other questions about risk nonsensical to ask a client?  Because it implies that there is somehow a correlation between risk and return.  In other words to get higher return you have to take on more risk.  The problem is that’s false.  You might…maybe, have to take on more volatility.  You’ll definitely have to take on greater exposure to the underlying asset but that’s not the same as risk.  Remember the way we define risk that is actually meaningful to people?

“What is the chance of loss and severity of loss?”  That’s risk the way it matters.  In this sense as we’ve noted in other articles increased volatility can actually decrease returns so decreasing risk by that definition actually increases returns.  Likewise for choice of asset class and price of asset class.

Financial advisors should be helping you to simultaenously decrease risk while increasing returns.  To do this they need to consider your financial needs over the next little while and they should educate you about potential investment performance and how to cope with potential events psychologically.  But on no planet should they be guiding you into higher risk weighted investments that’s just bad financial advice.

Invest in Apple now?

At the end of last week based on their worst earnings report in years Apple’s stock tumbled drastically.  Carl Icahn the legendary activist investor announced he’s sold his shares.  There’s concerns about Apple’s ability to grow given the slowdown in China.  But is it cheaper than it should be?  For the first time in over a decade it’s trading for less than a 10 P/E.

Our second rule of investing is to buy something that’s going to increase in value…this is primarily examined by considering a productive asset and at the moment in spite of drops Apple is certainly a productive cash making machine.  But does it have durability?

Our third rule is to buy for less than it’s worth but what is a fair valuation?  For the last several years buying Apply for below a 10 P/E would have been a dream but now?

Let’s consider the fundamentals – when you’re buying a stock you’re not buying it for today you’re buying for the anticipation of what it’s going to provide in the future.  So the question isn’t whether Apple is doing well now (really based on today it’s better value than say most of the banks) but moving forward.

How do we determine whether sales are likely to continue?  We need to look at what are they selling and who are the customers.

The big reason for the drop in sales was due to drops in iPhone sales, which have traditionally been a cash cow.  Are people going to stop buying iPhones?  No.  Could the upgrade cycle decrease?  Absolutely, the value of upgrading is decreasing.  Could the market slow?  Absolutely, it has, which is the issue here.  What about competition?  Yes, Apple’s market share could erode as well.

What about other products?  iPad sales have been declining.  iPods have largely died out.  Apple Watch hasn’t created a meaningful share of their business and it’s questionable whether it will.  Apple TV and similar products make a very small % of their overall sales.  Macs are a relatively declining market or at least not growing.  This leaves the services, iTunes, Apps, Apple Pay, etc. as well as the possibility of new product lines (TV, car, etc.).  Here there’s a reasonable chance for growth, enough to offset losses in other areas?  Perhaps.  There’s also the possibility of reinvesting additional profits, which are substantial, to increase overall revenues and profits.

Based on the strong brand, distribution, relatively established market, etc. major disruption to Apple’s core businesses seem unlikely there will be minor changes of course but nothing too substantial.  The services business is where the greatest potential for growth lies and it is substantial likely doubling or more over the next few years.  This combined with reinvestment are likely to produce modest returns or at least stability over the mid term (short term you’ll likely see an additional decline as reflected by the higher forward P/E ratio).

This means at the current P/E ratio the investment is likely fairly stable over a mid to long term but what about above market returns?

Above market returns on a predictable basis come from one of two things:

  1. Higher than normal growth
  2. Lower price than the value of the company

Higher than normal growth in the case of Apple is nearly impossible.  How come?  Because the incredible market cap means even if they had a huge win in say the car industry the size of the industry and the win relative to their market cap isn’t sufficient to substantially move the needle.  It might result in 10-20% growth but over a few years, which is not impressive.  Apple is not a so called 10 bagger at this stage.

In other words if Apple isn’t under priced you’re probably better off investing in the general market or a diversified holding with greater protection against uncertainty than merely buying Apple.

Is it undervalued?

In this market we typically are basing valuations on a 5% interest rate to provide a margin of safety in other words a fair multiple on a risk free investment would be 20 times…Apple is currently trading for below 10 times, which means the risk premium is decent, probably better than buying bonds.  But is this a fair price or a great price?

At present the projections are earnings will drop over the coming year, which if earnings continued to fall would make the valuation fair to slightly high. but what about looking forward?

The key is to attempt to determine the forward value, which one would expect to include a modest growth rate based on reinvestment of earnings, operational efficiencies and growing product lines/markets.  Unfortunately, most of Apple’s markets in the aggregate aren’t likely to grow substantially, many will likely decrease (services will be the main growth area as well as additional product lines).  The good news is there’s substantial capital available for reinvestment, which can reasonably be invested at a 5% compounded rate of return.

What’s the problem with these figures?  Based on a 10x valuation one would expect a 10% annual rate of return but if the compounding rate is less than 10% this rate of return will over time diminish meaning an 8 times multiple is likely more fair over the very  long term.

What does this mean for us?  Apple’s stock is likely fair to slightly low based on the present value but not low based on the future value.  In other words the likelihood you’ll see substantial appreciation in the stock price within the near to mid term is quite low.

Conclusion – while Apple is likely a fairly safe bet in that it’s unlikely to experience substantial downside it is unlikely to experience substantial upside either and consequently probably not a market beating investment.

Is the stock market going to crash?

will the stock market crash?

I read an article yesterday in a publication that was forwarded to me showing a variety of indicators suggesting the stock market is going to have a major drop in the near future.  This particular publication is constantly putting out articles like this and I provided the following reply.

I’m not a big fan of this kind of thing for several reasons:

 

  1. Lots of groups – like FIR – make their money off constant gloom and doom stories, take a look back over the articles you’ve sent from them for the last few years and it’s a steady stream of warnings about how things are going to collapse (remember our conversation last summer about them saying the big correction was coming in September, we saw that drop in August, which was a great buying opportunity and then recovered pretty quickly and in spite of some little ups and downs has remained relatively flat).  This makes sense because fear sells, but it’s not an accurate world view as measured by what’s really been going on
  2. It makes the fatal mistake of believing the past equals the future but as we know history is not destiny a lot of things are different today from how they were decades ago so the real question isn’t what happened in the past but what are the drivers that will create change right?  If the drivers have changed then we can’t expect the same outcome.  This is arguably why 2008-2009 wasn’t as bad as 1929, because we had a banking system in place with an ability to jump in and prevent things from falling as far as they did back then

 

None of this is to say they are mistaken, they might not be but let’s look at the fundamental drivers and be rational about it.  Here’s where I’m a big fan of Buffett who has frankly far outperformed all of these guys for decades so based on results he might be worth listening to.  Or Ray Dalio who fits the same mould.  Ed Bogle is a pretty good one as well.

 

Let’s start with the basics.  What causes the market to go up?  Money going into it.  Literally, no rise can happen within the market without more money going into it so for it to rise the money has to come from somewhere.  Over the last few years that money has primarily come from quantitative easing, which has now stopped (Dalio believes they’ll have no choice but to initiate QE4 at some time in the not too distant future so we’ll see if that happens).  In a sense they poured trillions of dollars into the system by swapping government bonds for bank reserves on bank balance sheets and this had the effect of driving up the market a lot more than it would have without those initiatives.

 

Now that this has stopped the money can only come from a few places:

 

  1. Government deficit spending – this is the only way the base money supply grows and might happen to a small extent but doesn’t look probable at levels that would make a big difference measured against the scale of the economy
  2. Foreign investment – the question is “from where”?  China?  Not likely, not with the state of the economy over there.  Europe?  Same boat.  Really any amount of foreign investment large enough to substantially move the needle seems pretty slim
  3. Private debt – the credit markets could expand substantially, which is what happened leading up to 2008 but what would drive that?  Normally, you need rising asset prices (not very likely), falling interest rates (virtually impossible), easing lending rules (pretty unlikely), rising household income (not likely to be enough)
  4. Share buy backs – this could happen to some extent but probably not enough to move the meter substantially

 

Bottom line the forecast of pretty much everyone significant that I know of is the market isn’t going to grow much in the next 10 years.  Whether you want to take that timeline or shrink it down a bunch to say 3-5 years I don’t see any drivers baring another round of QE and a significant one that would push the market as a whole up substantially.

 

Let’s look at the opposite is the market likely to drop substantially?  Again the inverse is true here what causes the market to drop?  When money gets pulled out of the market.  Typically, when there’s a rapid collapse it comes from two things:

 

  1. Debt bubbles bursting because people can’t afford to service the debt they’ve taken on – this is what has been happening in China where people are buying on margin rather than with cash and is also what happened with the housing market in 2008.  The problem is there isn’t a major debt bubble in the US markets right now, I just read a report that household net worth is the highest it has been since the 1980s.  If interest rates rose substantially that could create problems but is that very likely?  You’d need to see substantial increases in inflation for this to happen and even then the Fed will be monitoring it closely.  I’d imagine as the price of oil recovers, which it will probably do over the next year or two you’ll see an upward tick in inflation and there’s a reasonable chance of small interest rate hikes but not ones substantial enough to force a lot of defaults especially since most of the debt is amortized long term
  2. Fear – this is what happened in August and again at the start of 2016 people panicked and sold based on what was happening in other parts of the world, this could well happen but if it’s not backed by real fundamentals represents a buying opportunity because it will turn around as it did in both of those cases.  To quote Ben Graham in the short term the market is a popularity measuring machine in the long run it is a weight measuring machine (meaning it measures profits).  I think it’s stupid to speculate on what public sentiment will or will not be it could go in any number of directions but it’s impossible to say in advance.

 

Those are rapid drops but there could also be a gradual decline, which might come from a couple major sources:

 

  1. Decreasing corporate earnings – earnings definitely slowed at the start of the year due to weakening demand in markets such as China.  You could have definite ebs and flows here, at the moment general market P/E ratios are high but not extremely high, they are still within the bounds of reason so I’m not worried about a major correction but also wouldn’t advise buying general indexes.  Realistically, corporate earnings aren’t likely to drop much but they might not continue to rise as much
  2. Slowly rising interest rates – essentially, this means less margin and a more from money away from equities and indo bonds.  This would be a very slow process and wouldn’t likely push the market down so much as keep it flat
  3. People selling for other reasons – for example you’ll sell stocks to buy a home.  This is the biggest concern because as Robert Kiyosaki pointed out 2016 is the first year baby boomers are starting to retire and will begin selling their portfolios to pay for their living and this is going to continue for 15 years.  “Demographics are destiny”.  This will be fairly gradual but will also be substantial and I don’t see enough new money coming in to counteract it

 

If we look at those drivers what does this all tell us?

 

We probably aren’t looking at a massive sustained crash, it’s possible but pretty unlikely in the near future, a lot of things would need to go wrong at the same time.  On the other hand there’s VERY SMALL chance of any major market gains so most of the returns are likely to be in the form of dividends.

 

This brings us full circle to the Buffett insights.  Buffett says don’t pay attention to all that macro economic stuff.  Instead look at a company that’s producing solid earnings for a decent price and is going to continue producing solid earnings.  Buy that company knowing so long as it continues to produce more and more cash you’re going to be good no matter whether the market goes up or down or sideways because ultimately company cash becomes shareholder cash.

 

In this market I think if you want decent returns you need to focus on individual companies at specific times rather than the market as a whole because the market as a whole is pretty likely to look a lot like Japan for the last 2 decades.