Category Archives: Investing

The legendary Margin of Safety

I have an opportunity to read Margin of Safety, the 1991 investment book by Seth Klarman that’s long out of print and regularly sells secondhand for hundreds, if not upwards of a thousand dollars.

Suffice it to say, I feel a certain obligation to read it since it’s highly regarded enough for people to pay those prices. Continue reading The legendary Margin of Safety

How to invest without a financial adviser

I’m not a big fan of financial advisers. Their job is to sell you financial products, not to look out for your own best interests. I learned that the hard way, after sending most of what I made in my early 20s to one. He doubled my money in a year or two, but erased the gain and then some just as quickly. So I had motivation to learn how to invest without a financial adviser.

There’s a pretty easy formula you can use to outperform 90-95% of financial advisers.
Continue reading How to invest without a financial adviser

401(K) Paperwork

So I’m filling out 401(K) paperwork. I don’t like everything I see, but can live with it. I guess it’s what I don’t like that’s important. Or why I don’t like some things I see, that is.

Then again, some people may be wondering why I’m even investing at all.I wish I had a nickel for every time I heard someone say, "I’m going to reduce my 401(K) contributions because I’m not getting anything for them right now."

It’s when the market isn’t giving anything back that you want to be buying. Eventually it’s going to bounce back. Nobody knows when, or how high. This is a simplistic way of looking at it, but right now stocks cost about 2/3 what they cost a couple of years ago. There is no historical precedent for stock prices staying where they are now forever. Eventually they’re going to come back.

So we might as well enjoy being able to buy stock at 1997 prices while it lasts, then enjoy the big gains even more, when they eventually come.

The biggest quick gains are probably behind us, given that the Dow rallied about 50% already earlier this year. Fortunately, I was making 401(K) contributions at the time, so I got in on some of that action.

So the first question is when to invest. The answer is, continuously. Trying to time the market is a fun game, but you’ll be right just as often as you’re wrong–if you’re lucky. The problem with most investors is trying to be smarter than the market. The reality is that somewhere in the neighborhood of 90% of people who try to outsmart the market end up underperforming the market over the long term.

So if you’re willing to settle for average returns, you’ll automatically be in the 90th percentile. That’s not a bad place to be.

So, buy when you have money. Don’t worry about whether the market is up or down on payday when your contributions get deducted from your paycheck. Some days it’ll be up, some days it’ll be down, but you’re in the game. You’ll be right more often than you would be if you were trying to time things.

The second half to getting average returns is choosing what to invest in.

Most mutual funds are run by managers who are trying to outsmart the market. Some of them can give very good results in the near term. But they can just as easily lose your shirt for you.

Index funds mimic the market. Index funds invest in precisely the same companies that appear in the major market indexes, so they do whatever you hear on the news. As such, they need no managers, so none of your investment goes towards paying managers. That saves you money. And there’s a 90% chance those managers wouldn’t outperform your index fund anyway.

I invested my money in four funds: an index fund that tracks the S&P 500, a second fund that tracks the other 4,500 or so stocks that aren’t big enough to be in the S&P 500, an international fund, and a bond fund.

My best performer? The fund with the 4,500 pipsqueak companies. But next year it could be completely different.

The international fund is there to give me some aggressiveness. For most of my lifetime, the biggest growth has been happening outside of the United States, and that gives me a chance to benefit from it. Some years I’ll get big returns from it. Some years I’ll lose my shirt.

The bond fund is there for balance. Bonds are boring. They usually give slightly better returns than parking your money in CDs in the bank. The idea is that in years when stocks are down, having some money in bonds ensures you’ll get some growth. How much to put in bonds depends on how conservative or aggressive you want to be. The younger you are, the less you should park in bonds.

The next trick is to rebalance the portfolio. It’s only something you should do once or twice a year. But the idea is that you should decide how you want your investment to be allocated. 25% S&P 500, 25% other 4500, 25% international and 25% bonds may not be the ideal mix but it keeps things simple for this example. They’re not all going to perform equally. If you rebalance them, then you’ll end up naturally buying low and selling high. This builds in profit and keeps your portfolio from becoming too conservative or too aggressive.

This is a good thing, because our natural tendency with stocks and other investments is to buy high and sell low.

Rebalancing means you can benefit from volatility in the market. You’ll never be able to predict which is going to be your best investment and which will be your worst, but if you’re rebalancing, it doesn’t matter.

Follow this strategy and you aren’t guaranteed to double your money in roughly 7 years, but the odds are very much in your favor. You may even do it a little bit faster.

My dad had a very different philosophy. He tried to outperform the market, and took pride on the years that he did. But there were two problems with that. He spent hours every night watching investment shows and reading investment newspapers. It was like having a second job. Even Warren Buffett says you’re better off spending your time doing things that increase your earning power, so that you have more to invest, rather than trying to eke out a slightly higher return on investment.

The second problem is that he didn’t outperform the market every year. I don’t know all of the details and nobody does, but Dad had at least a couple of catastrophic losses in the years just before he died. I don’t know all of the details because it would be inappropriate–I was 17 years old when one of the losses happened. What I do know is that Dad wouldn’t let me invest in whatever he was investing in. That tells me he really knew better.

Settle for average, and you won’t make dumb decisions when you really know better.

I made my dumb decision in my 20s. A friend of Dad’s introduced me to a money manager soon after Dad died. At first the guy looked like a wizard. I sent him pretty much every spare dime I had for the first three years of my career. It wasn’t much, because I wasn’t making much, but the guy doubled my money in less than three years. I was convinced I would be a millionaire by 35.

The bottom fell out sometime in 2000. I didn’t lose it all, but I lost enough. Unfortunately, along the way he parked what was left in something that tied it up until age 59, and the returns don’t keep up with inflation. Swell.

The state of Missouri took away his license.

So I’m done trying to get better-than-average returns.

So what is it that I don’t like about my new company’s 401(K)? The investment options are more limited, and my pipsqueak 4500 fund isn’t one of the choices.

So I just do the best I can, mixing it up between the S&P 500, a bond fund, and an international fund. They’re paying me more than my former employer did, so Warren Buffett would approve.

And… bailing out.

Scratch one investment property.

Running the numbers, it might have still been possible to make it work. But a lot would have to go right, and this particular property didn’t have an especially good track record.We had a plumber come out and look over the biggest problem. He came back with a best case scenario of $5,000. He called this morning with what he thought was a more realistic figure: an eye-popping 15 grand.

Well, there’s a problem. The property easily needs another 15 grand worth of work. And most of it isn’t stuff that a do-it-yourselfer ought to be doing. It was overzealous DIY work that got the house in this mess in the first place.

According to the books we’re reading, we could afford to put $33,000 worth of work into the house, based on what it should rent for. But it’s easy to see how one project going over budget could blow the whole thing out of the water.

And, frankly, doing that much work would cause more debt than I’m comfortable carrying.

We’ll lose some earnest money. But the risks are starting to outweigh the benefits.

We’ve learned some expensive lessons. But at least we’ve learned. We’ve gone and looked at a couple of other houses already. And we noticed things we hadn’t noticed before.

Not only that, in one case we liked what we saw. The question is, how many other people have seen it and liked it too?

End of the innocence

Honeymoon’s over. The purchase is getting rocky. I’ll tell you about my troubles so you hopefully don’t repeat them.Mistake: We used the mortgage broker our realtor recommended. She got us preapproved quickly enough for us to get our bid in… barely. The rest of the process to get approval went at a sloth’s pace. And then? She slapped us with a 5.625% interest rate and $2,600 in closing costs. She had a vaguely plausible explanation for both, but the closing costs were highway robbery and the interest rate was half a percent higher than it could have been.<p>

Having been lectured by my accountant once about closing costs, I tried to negotiate. Everything’s negotiable, he said. Nothing’s negotiable, she said.

"So I really should just pay cash for this house?" I asked.

She laughed. "If you can." She thought she had me over a barrel and she was going to take advantage of me.

Hopefully she learned a lesson, but I doubt it. Don’t give a Scotsman reason to reconsider parting with money, because once you do, you’ve lost him.

I was out of fight at that point, but my wife called the bank we use most of the time. She told the agent about our 5.625% interest rate and $2,600 closing costs, and asked if she could beat that, and if she could, how we get out of the bad deal.

She talked to us about our goals and our finances and suggested a Home Equity loan. The rate would be low, the payments would be flexible, we could get approved quickly, and there would be no closing costs.

It’s an unconventional answer to the problem. But for a first property, with uncertain expenses, it gives some flexibility. Let things stabilize for a year or two, then get a conventional mortgage if need be. The conventional mortgage gives long-term flexibility, but a HELOC gives short-term flexibility.

So it pays to call around until you find a loan officer with some creativity.

And true to her word, we had approval on the HELOC in three days. That’s how long it took sloth lady to get us just a preapproval.

The house: Now I know why the house was cheap. Superficially, it looked good. But when we started poking around with an inspector, we found out the house was an Uncle Louie Special. Uncle Louie re-did the wiring, the siding, the plumbing, and almost everything else in sight. Uncle Louie did a reasonably good job of laying tile and painting, but when it came to anything else… Well, the inspector said, "He sure didn’t let not knowing what he was doing get in the way of him finishing a project."

He said a few other things too, but it’s probably best not to repeat them.

Unfortunately, it’s going to take professionals to fix most of Uncle Louie’s work. And it won’t be cheap.

The inspector’s advice: Make the decision with the numbers, not with your heart. Which is good advice. The realtor’s job is to make you fall in love with the property. The inspector’s job is to bring you back to reality.

Sometimes the reality isn’t what it first seems. But sometimes you can still make it work anyway.

That’s what we have to learn next.

Diving into real estate

You’re not going to believe this. This week my wife and I applied for a mortgage.

Not on our primary house. We’re buying an investment property. I’m still struggling with the mortgage bit.The greatest real estate investment books of all time (for mere mortal working class people, at least) were written by a man named William Nickerson, starting in the 1950s. Nickerson took one and only one shortcut in his investing. He saved up 25% for a solid downpayment, and bought property. Usually property with something wrong with it. He liked small apartment buildings and humble single-family houses.

Then he fixed the property up. Depending on the situation, he’d sell it if it made sense, or more likely, he’d rent it out, then sell when the right opportunity arose.

And when he had enough money to buy another property, he’d buy another one. An outright sale usually would yield enough to buy multiple properties. Or if he could make a trade that made sense, he’d trade properties.

His initial $1,000 investment (which would be more like $10,000 in today’s dollars) grew to $1 million in property by the time he wrote his first book, to $3 million by his second edition in the late 1960s, and $5 million by his final edition in the mid 1980s.

Nickerson argued that his method was the safest investment in existence. He had a point. Land is the one thing God isn’t making any more of, but God is still making new people. People who need land to live on.

But how do you find tenants? What if the house sits empty for a long time? After all, my Dad rented out a property for several years and it was a nightmare. It sat empty a lot, and his tenants trashed the place.

A couple of months ago, I saw a house for rent two miles from me. The asking price was $900. Two days later the sign was gone. Now there are cars in the driveway. So someone rented it. I looked up the house on Zillow. You could buy the house for less than that, if it were available at current market value.

I kept watching. Rentals in my zip code don’t stay vacant long. So when a HUD-owned home a couple of miles away came up at a price we could afford (my wife found it), we went and looked at it. We liked it. It needs work, but that’s why it was cheap. We made an offer, and now we’re a few steps away from buying.

We have some luxuries Dad didn’t have. We’re in a hot market, so we don’t have to rent to the first guy who asks. We can get a family with references. We live close, so we can keep an eye on the place. We can use a management company to help keep everything smooth. We’ll pay more for that privilege but it’s probably worth it. And the mortgage payment is low enough that if it sits for a few months here and there, it won’t break us.

Where house flippers–at least the ones you see on TV–seem to get into trouble is dealing in big, expensive homes and being too leveraged. If the market for $200,000-$500,000 houses goes south, they’re stuck.

This house will never be on TV. Well, the Extreme Makeover guys would love to tear it down and build a sprawling, awkward castle on its L-shaped lot. It’s a low-end house, the kind of place a young family would buy or rent, live in for a few years, and then probably vacate once the kids are done with grade school–if not a bit sooner.

People want large houses in outer-ring suburbs, but they don’t need them. But a young couple that’s outgrowing an apartment does need an affordable house for a few years, and when they outgrow that, there’ll always be another family in the same situation, ready to move in.

So why don’t they just buy the house we had our eye on instead of us? I’m sure some do. But not all of them can afford the downpayment and the money it will take to fix it up.

A friend and I discussed the ethics of buying a down-and-out person’s house, back when Robert Kiyosaki was at his peak in popularity. Kiyosaki appears to have no qualms about it. We were less comfortable about that.

As far as I can tell from the records easily available, this house finished up the foreclosure process in May. A bank somewhere in New York had it for a couple of months. Then HUD ended up with it. I don’t completely understand the process yet.

As it stands now, the house is no good to anybody. HUD’s doing the bare minimum to keep it from getting much worse. It’s eating up taxpayer dollars and making the neighborhood look worse.

The best thing for the house and the neighborhood is for someone with money and who knows what he or she is doing to come in, make it inhabitable again, hopefully make it look a little better, and get someone living there just as quickly as possible.

In my wife and me, they got someone with a little money. We’ll have to learn what we’re doing on the fly.

We’re taking advantage of the former owners who got in over their heads, but when I go to work every day, I’m taking advantage of whoever made the decision to replace a working, reliable computer system based on VMS and Unix with a sprawling monstrosity based on Windows. And my wife would argue that they take advantage of me.

By buying a fixer-upper below market value, fixing it, and renting it at market value, we’re taking advantage of the house’s situation and the future tenants. But the future tenants are taking advantage of us, because they get to live in a house they couldn’t otherwise afford.

I’m not crazy about all aspects of the situation but I’m comfortable that I’m doing more good than harm.

Now, back to that mortgage question. I’m still arguing how quickly and how to pay that off. The math suggests I could ultimately pyramid at least seven properties, using rents from the first two to pay the mortgages on all of the others. And a few short years ago, a bank would have been more than happy to lend me the money it would take to do that.

One latter-day follower of Nickerson makes it his goal to pay off one of his properties per year.

I like the idea of fixing a property, holding it for as long as the tax code encourages you to hold it, then selling and using the proceeds to pay cash for more than one property to replace it. The growth is theoretically smaller, but I really don’t like debt.

But that’s really a question for another year.