How to Make Money and Build Wealth

You’ve all heard of the phrase, “Let your money work for you.” If you’ve saved up enough money and amassed sizable savings, you might be thinking: Where should I invest my money?  While you can invest in stocks or bonds, another alternative is investing in funds.  Funds are typically run by money managers and can be public or private.  Different funds have different risk/return proportions and lockup periods where the fund requires you to invest for a minimum amount of time (months or years).

In the laissez-faire world of investments, money goes to its highest bidder – or place with the highest returns.  With so many funds projecting 8% to 25% returns, how do you determine which fund to invest in?  Technically, there are many criteria you can look at such as track record, risk adjusted returns, upside potential, and collateral.  However, the most important principal to finding the right manager is stated eloquently in the Gospel by Matthew:

“For where your treasure is, there your heart will be also.”

The first question you should always ask a money manager: Where do you place your eggs?  This will screen out 80% of crap investments in your “world of opportunities”.  When money managers hawk their financial wares and ask for your capital, judge them by the placement of their own.  Shakespeare had it right when he wrote, “To thine own self be true.”  If a manager had ten different funds (or opportunities), you can be sure the he will invest his money in the funds he deems most profitable and secure.

However, having a vested interest in the fund alone is not enough.  There are qualifications:

1. Do they have a meaningful amount in the fund?
2. If so, is it a good percentage of their net worth?

To no surprise, these are qualifications that Warren passes with flying colors.  He has more than 99% of his net worth in Berkshire Hathaway, and additionally, many of his family and friends have a significant amount of their net worth in Berkshire.  As I’m sure Warren would agree, there is absolutely no reason why – the prospect of doubling his money, getting 40% returns, hubris, or prestige – he would ever be tempted to jeopardize the money that is so important to those he cares most.

This shows why Warren builds a fortress balance sheet that can weather recessions worse than that experienced in 2007-2010.  As an insurance company, only Berkshire can insure large policies that no other insurance company in the world can underwrite.  When hurricane Katrina, Rita and Wilma struck the Gulf coast they paid out $3.4 billion in losses.  While this wasn’t a happy loss (no loss ever is), it wasn’t much of a hiccup for the company.

Now, some of you may not find it in you to ask about other people’s money.  Asking about where the money manager invests his funds might make you feel impolite – or even rude.  However, if someone is going to manage your money, you have a right to know about “their” affairs – at least to the extent it helps you to make a decision.  Part of a good investment relationship is being forthright on both sides of the coin.  You can be sure when the money manager qualifies you as an investor, he will ask about your affairs.

How to Buy a Short Sale – or a Foreclosure in King County

It’s been a while since I’ve blogged and I apologize for that.  My recent preoccupation with an investment property is to blame.  I’ve been in contract to purchase a short sale in Madison Valley and the negotiators are working with the bank to get final approval before the property goes to auction this Friday.  Meanwhile, I thought it’d be nice to share the process as it’s fresh in my mind, and perhaps you will glean something from it for your next real estate investment project.

My Target Neighborhood

I’ve been targeting a few neighborhoods that I think will yield the best opportunities.  One of them is Madison Valley in Seattle, WA.  In general, if you want to find a “deal”, focus on neighborhoods where there is likely to be mispricing. This is a fundamental principal that all great investors exploit like Warren Buffett, George Soros, Peter Lynch and Julian Robertson.

New neighborhoods or cookie cutter neighborhoods usually present the least opportunities for the real estate investor.  The reason is simple.  If the neighborhood is new, the homogenous homes make it easy to price.  The seller and the listing agent are less likely to misprice so that the property sells at deep discount.  Additionally, newer neighborhoods typically don’t allow you the ability to rehab (hence, newer) and add significant value through fixing up the property.

If you live in a neighborhood and all the homes were built by the same builder in 2004, why sell your home for $200k when the guy across the street with the exact home just sold for $300k?  However, if you live in a neighborhood where most homes were built in 1920 it’s a different story.  Some homes likely have remodels, so don’t.  In some cases brand new homes have been built on old sites.  These types of scenarios allow the intelligent investor to exploit.

Furthermore, in the bank’s approval process, they request Broker Price Opinions (BPOs known as bank valuations) which are frequently subject to flaws when neighborhoods are heterogeneous and not as easy to value.

Seattle is a developed city with a wide range of neighborhoods with many homes built from the early 1900s and on.  It represents an eclectic mix from early 20^th century styles to post-war styles.  Neighborhoods such as Leschi, Madrona, Columbia City, Wallingford, and pockets in West Seattle present great opportunities because range of homes can range widely.  Gentrifying and transitional neighborhoods also create opportunity as well as it requires specific knowledge to accurately value you the property.

Valuation

When investing in real estate, seventy percent of the battle lies in buying at the right price.  The remaining thirty percent comprises fixup, financing, maintenance, permits, etc.  The good thing about determining price is that you don’t have to be exact, but you have to be roughly right.  In fact, it’s almost impossible for two different people to arrive at exactly the same valuation.

When valuing properties in Madison Valley, I looked at three groups of homes: homes sold within the last year with a heavier weight for homes within the last six; pendings sales with a heavier weight on non-short sale homes; and active comparable listings noting days on market.  If possible, I try to think of the distance in terms of “blocks” as opposed to quarter-mile or half-mile radiuses (commonly used by realtors).  This allows more precision and puts you in the shoes of the buyer where a quarter mile makes all the difference.  During preliminary analysis, I pull up Google Street View and “walk” through the neighborhood and make mental notes of changes such as lot size, curb appeal, traffic, and blocks with curbs and blocks without.

When I determine price, I price the property where I think it would be a good deal on the market.  As in, if anyone were planning on buying a home in Madison Valley – in my price range, of course – would definitely buy my property.  After I determine that price, which is already conservative since they’re getting a deal, I build in a margin of safety where I can easily discount 5% and still make money. Keep in mind 5% is a ton when net margin for nationwide homebuilders is about 5%.

Fixup

This project is a large project that will require more money than usual to fixup.  The property is essentially a shell and just has a roof, outside walls, and some interior framing.  The property needs plumbing, electrical, framing in the lower areas, windows, sheetrock, roofing, a new driveway, siding, flooring, kitchen, bathroom, and landscaping.  In addition to budgeting for known items and issues, I built in a buffer for cost overruns.  In this case, $30k.

Putting in the Offer

This step requires lots of persistence and patience from the buyer’s agent.  Many buyers’ agents wince when it comes to working with an investor.  Some agents have investors but effectively fire their clients through lack of service.  Finding investment properties requires much time and commitment on the agent’s end.  The agent needs to screen, drive, analyze and value a ton of properties and neighborhoods.  Finding deals requires casting a large net which in turn burns the agent’s time, their most valuable commodity.

As an investor/agent, I obviously don’t mind spending time looking for deals for myself as success pays off tremendously.  When it comes to investors, I actually prefer working for them because they have a high sense of loyalty to me and my services.  The truth is, investors are likely intelligent enough to do what I do, but don’t have the time nor the desire.  As long as I’m helping my clients make money, this puts me in a good position because I get paid to acquire the property (as the buyer’s agent) and to dispose of it (as the listing agent).

It’s not uncommon to put in seven or eight offers until you get one acceptance. Even then with the acceptance from the seller, if you’re purchasing a short sale, you still need to wait for bank approval.  I put in multiple offers on different properties in Madison Valley before one finally got mutual acceptance.  Since it’s a short sale, the offer is contingent on bank approval.

To my dismay, Bank of America rejected my offer last week and responded with the following:

This short sale was submitted to your [note holder] for approval and was denied due to (insufficient offer, not willing to sign a deficiency agreement, or contributing to the loss). However, if the seller is willing to sign the deficiency agreement or contribute to the loss or have the buyer increase their offer; we may be able to reconsider the short sale. Please send us any updated documents for the short sale to be reconsidered.

This was an automated response sent by the bank which did not take into account, what I believe, as the bigger picture.  The bank will likely get less since buyers have less information at the auction and tend to bid less to compensate for unknown risks.  At this point it looks like the bank will not approve the offer and I will just make my trip to the auction to bid for the property.

The Right Partners

I find myself extremely blessed to have partners that I like and trust. While they say you never know what you’re made of until times are tough, I believe that we will persevere as a partnership.  Why didn’t do this deal myself?  Because this deal requires more than $200k in equity, and the partners bring other value to the table besides cash.  While I could’ve done the project with less money, the equity cushion provides a buffer to absorb losses and decreases the private loan needed – more on that below.

Private Financing

In this market, financing presents the biggest hurdle.  In many cases you can get funds through private loans or hard money loans.  The key, however, is to get the loan and not lose your shirt in the process.  Lenders typically charge you points and interest.   In King County, the fees typically range from 3% to 5% for points and 10% to 12% interest.  Loan terms are usually 6 to 9 months which means cost of funds are about a 20%. While this seems high, investors pay these fees because they lack alternatives.

While I know multiple sources for private lending, I also know some dentists who have money sitting in the bank earning little or no interest.  Why pay high fees when you don’t have to?  I put together a couple buddies that are dentists and told them I’d give them 10% interest instead of the measly 1-2% they would otherwise earn on their CDs.  I drove them by the property so they could see their collateral and see what they would be loaning money on.

While, these individual lenders are my friends, business is business.  This loan will be treated just as if I were getting the loan from BofA or Chase Bank.  We will formalize the loan through three key documents: 1) Loan Agreement, 2) Promissory Note, and 3) Deed of Trust. The loan agreement basically states the terms of the loan, what the interest rate is, late fees, default rate (if any) and when the note is due.  The promissory note is essentially the promise to pay the loan.  The deed of trust is the security instrument that gives the lender their interest in the property and the right to foreclose if the borrower defaults.   

Bidding at the Auction

Last week I went to the auction at 10am in Bellevue familiarize myself.  I’ve been to numerous auctions in Seattle, but none in Bellevue up to that point.  In King County, there are two locations you can purchase foreclosures 500 4^th Ave (Seattle) and 3535 Factoria Blvd SE (Bellevue).  The property is slated to auction this coming Friday at 10am.

Honestly, getting this one deal started has definitely taken more work than I expected.  Every step of the process has been so rewarding, from scrubbing deals to getting into contract; from putting together the operating and subscription agreements for partners to drawing up loan documents for lenders.  This serves as a great learning process, not to mention it pays the bills (hopefully).

Book Review: The Little Book that Beats the Market

What if you heard there was a “Magic Formula” that said you can beat the market.  You were told that the little guy has a chance to outperform stock market analyst and portfolio managers?  No need to just invest in index funds and wait mindlessly while your investment grows (or diminishes).

In his latest piece, The Little Book that Beats the Market author Joel Greenblatt goes through a simple strategy and explains in plain English how to achieve higher returns than average by just running through a formula and adjusting your positions quarterly.   He calls this the “Magic Formula” that would’ve gotten you 30% annual returns from 1988 – 2004.

Before you write-off the “Magic Formula”, let me inform you the person that devised the strategy is the author of You Can Be a Stock Market Genius, a popular and well known investment book.  And even more impressive, he was founder of Gotham Capital that had an annual return of 50 percent from 1985 to 1995.  That’s right, 50 percent.

As a follower of Warren Buffett, I must admit I was skeptical of Greenblatt just from merely the titles of his books, but after reading both I really enjoyed what he had to say.

High Return on Capital

First step: Buy a good business.  A good business has high returns on capital (capital is what you invest, return is what you get).  For example, Business A requires $100,000 of investment capital and makes $50,000 in profits per year.  That’s a 50% return on capital.  Investment B requires the same amount of $100,000, but only makes $2500 per year – a 2.5% return on capital.  While this is a simple metric it quickly helps you determine which businesses are good and which are bad.  It helps show if the business can command higher prices for their products and whether they have a brand they can leverage to create more profits.  Companies in low margin businesses with no brand or competitive moat tend to get riddled with flagging businesses.

Additionally, businesses with high returns on capital tend to mean that management is in the right business and is likely managing the business well.  This “excess” return on capital for good businesses compared to alternative businesses allows flexibility for management to whether storms and return capital to shareholders in the form of stock buybacks and dividends (both highly valuable).

High Earnings Yield

Second step: Buy cheap.  As we saw in Jimmy’s Gumballs example, buying 50% of the company for $3,000 in order to receive $618 in earnings is a worthwhile investment (21% annual return).  However, if Jimmy wanted to sell half of the company for $20,000 what was a great investment now amounts to a measly 3% annual return.

Probably the most widely used shorthand for determining whether a stock is overvalued or undervalued is the P/E ratio – price to earnings ratio.  The lower the P/E, the lower you’re paying for the business and vice versa.

There are many great companies in the world of stocks, but the challenge is finding then at a good price.  One of the biggest mistakes people make when buying a great company is paying a dear price. A great company does not make it a great investment. The quality of the company must correlate with the price you pay.

Magic Formula

The last step: Combine Step 1 (buy a good business) and Step 2 (buy cheap). There are currently 7,000-8,000 publicly traded on the exchanges.  Let’s say you limit yourself to only the 3,500 largest companies in terms of market cap.  Next, rank the 3,500 issues in your “stock universe” from 1 to 3,500 based on return on capital (#1 being the best).  Now do the same for earnings yield.  Finally, add the two numbers and you end up with ranking of the best companies that have high return on capital as well as earnings yield.

A company that’s cheap (high earnings yield), but really low return on capital gets weeded out.  And a company with great returns on capital, but already has the market’s attention and trading for astronomical prices get weeded out.  The formula leaves you with good and cheap companies.

Below is an excerpt from The Little Book that Beats the Market that compares the Magic Formula results to the general market and S&P500:

Click for larger view (image minimized to reduce load time)

According to Greenblatt’s table, if you would have applied The Magic Formula principal from 1988 – 2004, you have returned 30.8% during that time period while market returned 12%. Honestly, it does sound too good to be true, but at the same time the system – while stupidly simple – makes a lot of sense.

A Few Downsides

1. While I trust his stats, I haven’t looked into it and cannot verify the results.
2. Historic returns, while indicative are not conclusive of future returns.  I feel more comfortable buying a stock that I know – see, touch, and feel – like Coke or P&G.  The strict formulaic approach buying whatever the “system” tells me to still does not sit well with me.
3. This requires you to monitor your positions and make quarterly adjustments or “re-balancing”.  Greenblatt rightly suggests you can mitigate taxes by waiting to sell your wins for a year to get long-term capital gains.  And if losses, selling them before the one year mark to get short-term capital losses and current year deductions.  While this mitigates your tax obligation, it doesn’t compare to the tax advantages buying and holding a stock indefinitely.  Even if you pay 15% long-term capital gains (more favorable than short-term capital gains rates typically taxed at ordinary income rates), you’re still remitting 15% back to the government annually.  Alternatively, if you can hold a stock for 30 years and ride the wave (hopefully upward), instead of remitting 15% of your gains annually, you can let that “taxable amount” compound (since you don’t pay the government until you sell, although Obama might change this).  Essentially, you get to invest borrowed money from the government interest free.
4. If this did work and everyone started following it, it would be self-defeating.

In conclusion, I like the simplicity of buying good businesses on the cheap.  You can’t go wrong with that.  However, as an active investor, this should be a starting point not the ending point.  Over time if you wish to beat the market you need to understand what the company does before investing in it; understand the industry; read the financials; and believe the company has a durable competitive advantage.

A look at the greatest investors shows they all have particular trait in common – the ability to have strong convictions and stick with their guns whether or not their opinions are popular.  Ben Graham, Peter Lynch, Warren Buffett, George Soros, John C Bogle, and Julian Robertson to name a few.  These are people who achieved the upper echelons of success in their respective fields by standing out and having the courage to disagree with the masses.

Benjamin Graham’s sums this concept up in his famous allegory called Mr. Market.  Imagine you own a grocery store and you own 50% and Mr. Market owns 50%.  Mr. Market comes to you every day and decides to offer sell you his shares or buy your shares at some price.  Sometimes the price may be reasonable, sometimes unreasonable.  It all really depends on what Mr. Market was out doing last night and what his current mood is.

As you can see, these mood swings have no bearing on the value of the business.  You still own the same grocery store and sell vegetables to local residents.  Remember, value is what you get, price is what you pay. In this case, Mr. Market is there for you to buy at good prices and sell at unreasonable prices.

Same holds true for the stock market.  Recall, if you own a diversified portfolio on average you can expect your portfolio return to swing between -11% and +31%. Stock market swings happen every year – sometimes widely, the SP 500 lost 37% in 2008 and gained 27% in 2009.  In many cases these annual swings do not reflect the underlying value of the stock.  It represents a manic-depressive business owner, Mr. Market, who vacillates between fear and greed.

Though all may lose their minds, be sure to keep yours.

Drastic market swings create opportunity for the intelligent investor.  When it comes to investing, you’re not right or wrong because other people tell you so.  You’re right or wrong because your analysis tells you so.  Having this mindset is the first step towards investment success.

Whether you’re an active or passive investor, you need to understand the premise of the stock market.  That is, allowing the average person to buy and own stakes in corporate America.  In the market, there are winners and losers, and those who understand the market can and ought to stake a claim for themselves.

Let’s take a look at a simple example.

Jimmy’s Gumballs

Jimmy is a financially inclined seven year-old.  He buys gumballs for 20 cents at the grocery store and sells them for 25 cents to his classmates.  Every day, his main priority is to sell gumballs (not grades or girls).  He sells 25 gumballs a day and makes (25 x 0.05 =) $1.25 per day.  Not bad for a seven year-old.  Let’s assume he sells 50 gumballs every day, rain or shine.  When the weekend rolls by or school is on vacation, he can be found at the local park slanging gumballs.  Over a year he makes $456.25.

Money makes him smarter, so he decides to get a gumball machine.  His uncle happens to have one and rather than let it rust in the attic, he decides to make a deal with Jimmy.  Jimmy pays him $10 per month and he lets Jimmy borrow it.  Great uncle huh? Either way, Jimmy decides he’d be making more money with it than without, so he takes the deal.

Jimmy goes back to school and unbeknownst to his principal and teachers, there is mysterious gumball machine behind the back portables.  While the machine costs him $10 per month, it sells 50 gumballs a day. And since it takes no breaks, it earns him money during and after school hours.  For sake of simplicity we’ll assume the machine sells the same amount during weekends and holidays.  Over a month it makes Jimmy ($75 – 10 =) $65 which equates to $780 a year.

Jimmy’s net income is now ($456.25 + 780 =) $1236.25.  Since the government doesn’t require seven year-olds to file tax returns, he doesn’t.  At a young age Jimmy falls in love with Apple (like many do) and wants to buy a MacBook, iPhone and iPad.  In order to satisfy his needs he will need $3000 to purchase the must haves. 

For $3000 he’ll make you a 50/50 partner in “Jimmy’s Gumballs”, do you take the deal?  Half the ownership of the company means you get half the profits.  That’s a return of ($618.13 / 3000 =) 21%.  Better than investing in CD’s or Treasuries by far.  Note: $1000 compounded at 21% grows to $304,481 in 30 years.  Incidentally, Berkshire’s annual return since inception is pretty close to that, 20.3%.

The Stock Market

The interesting part of the story is every day you are presented with opportunities like Jimmy’s Gumballs in the stock market.  While there are certainly great companies – Coke, General Electric, and Apple to name a few – they might not be at reasonable prices.  What if Jimmy asked for $20,000 for the 50% stake in the company?  A 3.09% return might not be so appealing and you might tell Jimmy, I love your business but your price is ridiculous.  And the crazy thing, plenty people buy stocks at those ridiculous prices.

The good news is you have 7000 – 8000 stocks to choose from on the New York Stock Exchange (NYSE), NASDAQ and American Stock Exchange (AMEX).  You don’t have to buy unless you feel like the price is right.  When you buy a stock, you’re not just buying some paper or receiving electronic confirmations.  You are buying pieces of a company that give you rights to profits, dividends, price appreciation and votes (albeit limited at times).

Investing in stocks takes time and at least average intelligence.  These days, much of the research required is available online.  You can find industry research, financials and reports on the stocks listed on the exchange and do your own analysis of whether or not a stock is a good buy.

More on this to come.

A New Focus for The Intelligent Investor

As some of you can probably already tell, The Intelligent Investor has been going through somewhat of a whirlwind since it was started early January.

When I first started I posted everyday about real estate.  Then I got a tip from Jon Morrow (the associate editor of Copyblogger) suggesting that I write one article a week that was at least 1000 words long – again, all real estate focused.  The goal was to write resourceful content that my readers could go back to again, and again.

After leaving my full-time, salaried job (amidst the economic recession) at a private equity firm that built their funds around real estate, I decided to work as a realtor and blog full-time.  I wanted to eat and breathe real estate – and blog about it.  Upon reflection, I realized that I just love making money in general. Whether money is earned through stocks or real estate, it doesn’t matter.  Money doesn’t know its source.

Since Warren Buffett didn’t restrict himself to just Berkshire the textile company (thank heavens), I’m not going to restrict this blog to just real estate topics.

I decided to change gears one day while talking to my pastor’s wife.  She was like, “James, my husband and I have no clue about what to do with our millions savings.  We need like an intro course to investments or something.”  I told her that I’d get back to her and maybe start writing about the basics of investment.

The idea of helping the average person “make money and build wealth” has been on my brain and I haven’t been able to shake it.  It makes sense.  It’s meaningful work.  And I have free range to learn and write about what I love.

So I will continue to be a real estate agent in Washington (all referrals welcome), my focus on this blog will go beyond just real estate, however.  I will likely focus on stocks, fixed income (bonds, treasuries, etc.), real estate and career development. I figure no matter what stage of life you’re in, you’ll likely fit into one of these categories.  If you are working full-time, part-time, unemployed or a stay at home mom (or dad) you should have control and a good understanding of where you are going financially.

As I write, a new design for www.theintelligentinvestor.com is in the works.  It’ll look ten times better and knock your socks off.

Thoughts and feedback are welcome.  Please comment below or email if you prefer.

In Tom Peters’ most famous book, In Search of Excellence, he mentions a great principle: Stick to the knitting. In other words, stick to the business you know.

Warren Buffett often talks about things he’s does not know.  When he doesn’t know something he is apt to point it out.  That seems simple enough, but there is tremendous wisdom in that.  In life, as in business, it’s important to know what you know and know what you don’t know.  As Warren often says, know where your parameter is and when you’re getting close to it.

In the heyday of real estate many general contractors (GC’s) left working for other builders and started developing themselves.  Instead of just making their GC fee (a percentage above cost) why not develop for themselves and get the upside.  That was easy in a bull market – a rising tide lifts all boats.

Low and behold, when the tide goes out you see who’s swimming naked. When the market fell, many builders instantly went bankrupt, even before they filed notice to creditors.  GC’s were faced with lines of credit that were up for renewal, warranty and construction issues, mismanagement of costs, over-leverage, you name it.  Everything can go wrong when you least expect it. And for many people it did in 2007 and 2008.

That happens when you move beyond your competence.

The tendency to resemble lemmings and follow the crowd is a human flaw that will never disappear.  Psychologists call this social proof.  Essentially, you do something for the sole reason that others do it.  If people make money in penny stocks, why shouldn’t you buy 10,000 shares?  Your neighbor just bought ten homes and saw the value of them go up by 15% in one year.  Why shouldn’t you get just a few?

In Search of Excellence, Peters talks about businesses that get an itch to enter new industries and expand for expansion’s sake, a cardinal sin of business management.   Not that businesses shouldn’t be creative and innovate.  Or that companies shouldn’t be nimble and open-minded.  But that businesses should stick to their core competence and expand those competitive moats in which they already have.

Whether you plan to invest in stocks, bonds, ETF’s, private equity, real estate or anything else make really make sure you understand what you’re getting yourself into.  If not, you might as well hire a money manager or financial advisor to protect you against yourself.

When it comes to money and finance, better safe than sorry, know what you’re doing.

Every year citizens of America (and the world) live with the risk of nuclear war.  Ahmadinejad of Iran and Kim Jong-il of North Korea are just a couple of the known risks of an atomic warfare.  The Nuclear Non-Proliferation Treaty (NPT) of 1970 has sought to reduce spread (proliferation) of nuclear weapons in which nearly 200 countries have signed on and so far it seems to have worked.

As it stands, the threat of nuclear detonation year-to-year is likely not 100%.  But at the same time it’s definitely not zero.  But let’s say there is 10% chance of a nuclear bomb detonating every year.  That means within 30 years there is a 95.8% chance a nuclear bomb will explode. If the odds were true and you’re fifty or younger, you will likely live to see a nuclear bomb go off in your lifetime at least once.

Now let’s use the same analogy for your investments.  If you were told to put all your net worth in an investment that has a 25% return annually over 30 years, but ran 10% risk of complete loss annually, would you do it, or not?  A 25% annual return equates to an 80,779% compounded return, however, you run a 95.8% chance you will lose your entire principal.  And remember, when you’re back to zero, 25% of zero is zero.

A small risk compounds incredibly over time.  As Warren Buffett says, “Don’t risk what you can’t lose for what you can’t have.”

Diversification.  One of the most established tenants of investment strategies taught throughout academia and the investment world. If you’ve met with financial advisers (FA) or portfolio managers they probably mentioned this at least a five times in one sitting.  How you need to buy forty different stocks in ten different asset classes and industries – which makes hard for decision making and requires their help to do so.

However, if you study the most successful investors they don’t necessarily follow this mantra.  In many cases, they debunk diversification.

Don’t just take my word for it.  Look at the numbers.  Joel Greenblatt of Gotham Capital earned a 50% return percent annually from 1985 to 1994 while the S&P 500 return 15.1%.  In his book You Can be a Stock Market Genius he says,

[B]ased on past history, [the] average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year’s return falling between -8 percent and +28 percent are about two out of three.  In statistic talk, the standard deviation around the market average of 10 percent in any one year is approximately 18 percent.  Obviously, there is still a one-out-of-three chance of falling outside this incredibly wide thirty-six-point range (-8 percent to +28 percent).  These statistics hold for portfolios containing 50 or 500 different securities (in other words, the type of portfolios held by most stock mutual funds).

And here comes the interesting part, if you own five stocks you have a two-out-of-three chance your return will fall between -11 percent and +31 percent.  Your expected return is still 10 percent like above.  If you own eight stocks your return will likely fall between -10 percent and +30 percent and your expected return is 10 percent.

Diversification hurts performance if you do it just for diversification’s sake.  For example, there are two stocks you are considering to buy.  Stock A is fantastic buy and Stock B is a decent buy.  You fear putting all your eggs in one basket so you put 50% in Stock A and 50% in Stock B.  You have just diversified downwards. Diversifying downwards only hurts performance and is one of the silliest things you can do.

It gets more silly when you dilute your portfolio from owning five great stocks into owning thirty mediocre stocks.  Now you have to find thirty good buys instead of five.  And along the way you might have to move beyond what you know (and are comfortable with) and venture into unknown lands in which your money might not return.

Mark Twain said it best, “Put all your eggs in one basket and watch that basket.”  Next time someone throws around the word diversify, think twice.

There is much talk about how cash is king.  Cash is king when you can’t pay your bills.  Cash is king if you’re starving and need a hot dog.  It is king when you have liquidity problems.

Cash rules when you can’t meet your financial commitments.

The truth is you only want to keep enough cash on hand to meet your obligations – mortgage, ongoing expenses, and a buffer for unforeseen costs.  Having all your assets denominated in cash for long periods is one of the worst things you can do. Especially, with the budget and trade deficits of U.S. which will push up inflation.

Historically, inflation averages about 2.5% per year. Again, could be worse – much worse – if the U.S. government and its consumers don’t get spending under control.  Now if you hold all your money in cash for thirty years and risk nothing, your real return will be -53%.   You might say to yourself, I’m not taking any risk and that allows me to sleep at night (albeit with cash rotting under your mattress).  But however you look at it, stewarding your money for 30 years only to lose more than half of its buying power is not what you would call a value proposition.

An alternative is to invest in certificates of deposit (CD’s) backed by the FDIC.  From 1970 to 1999 the real rate of return (nominal return – less inflation) is +2.5%.  This does not take tax into consideration. (However, make no mistake only two things are certain in life, death and taxes.)  At a 2.5% compounded annual return, your return after inflation is +109.8% over 30 years.  Better than negative return, but by no means great.

Now let’s say you bought a basket of stocks from the S&P 500 and held it for the same period.  Over the last 40 years the S&P has returned 11.5%.  If we take 11.5% as our benchmark and deduct expected inflation of 2.5%, our real rate of return will be 9.0%.  Compounding at this rate will give you a real return of +1226.8% over 30 years.  Now, that’s something to get excited about.

While these examples are simplified (it doesn’t take into account market risk, risk-adjusted returns or other products like bonds, treasuries, or hybrid investments) – it is clear holding cash overtime is a losing currency.

The key is to buy assets intelligently.  Overtime, if allocate your money wisely you can build a nest egg to provide for you now and later (retirement).  You might even leave some behind for the little ones.