The Market Crash: Another $2Millionblog.com Blunder

I know. Choose my words carefully, because a lot of people lost money last week when the US major market indexes dropped 5%. But I think this can be a great teaching moment for all of us. The first quick thought I’d like to throw out is this: when you look at stock charts like the ones below, realize that stocks are no different from houses (or any real estate for that matter). What this means is that there will always be market corrections to account for previous over/under valuing of that asset. Over the past 2 months, all major market indexes have been at record highs, so what does that tell you? There was a correction coming. You could either succumb to greed and attempt to ride out the bull market, or be content with your winnings and back into some certainty. Which did you choose?

The Facts: The $2Millionblog.com posted on Wednesday that he lost $9,000 the day of the 4% drop (do a little math, carry the one and it looks like he had about $225K at risk). It can be assumed that he lost another $2K over the next two days as the indexes continued to drop an additional 1%.

The Critique: Mr. $2M was invested 100% in equity securities. No bonds, or fixed income securities (dividend paying stocks). His logic? Stocks outperform bonds, and he’s right… over 10 year periods. I’ll disclaim the remainder of this post with the following statement: my personal bias is that the stock market should not be considered a means of generating wealth, but rather of preserving capital.

If you were to take a survey of millionaires (if you haven’t yet read the Millionaire Mind, buy it tomorrow), you may find that .000001% of them would attribute their success and fortune to the wonders of the stock market. To generate real wealth, a market investor would be forced to invest in a number of long shots, and hope for the best… The equivalent of heading to the race track and stacking all of your cash on the horse with the lowest odds. True, every investor must take risks, but a smart investor will attempt to maximize his risk to return ratio.

So what does this all mean? As always, I can answer this question with a quick glimpse into my own investment portfolio: 70% bonds, 15% international equity, 15% US equity. Mr. $2M would say, “your portfolio will only yield 6%, whereas mine could push 12%.” The key word here is could. Again, whereas Mr. $2M is looking to make money in the market, I’m just looking to earn a modest return on my idle cash while I wait for a real opportunity to present itself (i.e. real estate, start-up company, etc.).

In the stock market, the term “risk” often refers to the volatility in value. For example, it is very likely that after a year, my conservative 6% $1,000 investment will still be worth $1,000 (in addition to the $60 dividends paid out), whereas there is no telling where the value of a more risky portfolio might be. The below graph illustrates the differences in volatility between your standard equity and fixed income / bond securities.

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The graph is deceiving at first because it appears as though the stock index (red) has greatly outperformed the bond funds. Over a 10 year period, this is true (and I conceded to as much above), but if you break the graph into smaller intervals (2-5 year periods), the volatile nature of equity securities vs. bonds becomes much more evident. For example, if your portfolio consisted of 100% equity stocks from 2000-2001, your portfolio would have dropped 50% in value. Now imagine it’s 6/1/2003, and you’re approached with an amazing opportunity to invest in a piece of real estate, but you can’t do it because you just lost 50% of your capital.

The Moral: 12% market returns are chump change compared to real estate and other active investment opportunities that will present themselves. Use the stock market to maintain your capital, not to generate it.

Real Estate IRA: The Loophole?

I know I promised to focus on critiques, but real estate is my passion and this topic was too good to pass up. As I mentioned in my Mission post, I would never condone a strategy or transaction that I would not pursue myself. That being said, I am currently MAXING OUT my Roth IRA contributions in order to increase my tax free buying power. Enjoy.

Most investors are unaware that real estate may in fact be purchased using monies in their Roth and Traditional IRA’s. If the strategy and accounting (crucial) are executed correctly, the results can be phenomenal. Let me preface this discussion with the following: I’ve read the books and done the research, but research alone does not measure up to practical experience. Over the past few months, I have worked with a number of clients who have used this strategy to shelter their real estate gains from federal taxation. Note: most people equate shelter with illegal, but the two have no relation, and I can offer pages of IRS code which support the legality of these transactions.

This strategy has picked up steam with the housing boom over the past 5 years as illiquid (little cash on hand) investors searched for new ways to add real estate to their investment portfolios. That being said, the majority of individuals using this strategy are individuals who did not have the resources to make a real estate purchase without the help of their IRA; but what if you do have the resources to buy outside your IRA?

The short answer is simple: if you have the opportunity to buy in a Roth type IRA (one where all qualified distributions of principal and earnings are tax free), do it. Why? Say for example you have $200K in your Roth IRA which you subsequently use to buy a rental property investment. Over your ownership term, your investment income (rent, etc.) is completely tax free (this income is typically taxed at your highest marginal rate, up to 35%). In 5 years when you sell that property for $300K, you will avoid paying the capital gains tax of $15K (15% x $100K = $15K). One caveat however is that if you plan to operate your property at a loss, your losses will not be deductible for tax purposes (it’s only fair since they don’t tax your gains)

Sounds great right? Whenever researching a potential investment or strategy, your first question should be: if it’s so easy, why isn’t everyone doing it? To execute this strategy, your IRA funds must be held by an IRA custodian who allows Self-Directed IRA’s. Essentially, the difference between a Self-Directed IRA custodian and most commonly known custodians (Vanguard, Fidelity, etc.), is that Self-Directed custodians allow more flexibility in your investment choices. It takes little more than a phone call to transfer your funds from one custodian to another, but most people are content with the 7% return generated by the 5 mutual funds offered by their current custodian.

For those investors who want to play a more active role in determining the success of their investments, a Self-Directed IRA is for you. It may take a little more consultation with knowledgeable individuals (at your service), but the time is well worth the return.

I know that this post is going to generate a plethora of technical questions, and I welcome them, so please feel free to ask.

The Maiden Voyage: Target = 2millionblog.com

The Facts: At the 2Millionblog.com, the author speaks of his “credit card balance transfer” strategy. For those of you who are not familiar with the concept, it is most quickly summarized as follows: investor A receives a credit card offer in the mail from the Bank of America offering $10,000 at a promotional APR of 0% for 12 months. Investor A subsequently takes an advance for the entire $10,000 and invests the money in a low risk money market fund at 5%. At the end of the year, Investor A has earned $500 on his “free” money and it is time to pay it back to the bank (or owe ALL of the back interest). Instead, Investor A opens another credit line with a 0% APR promotional period, and pays off the old balance with the new card. The author at 2Millionblog.com ($2M) has perpetuated this cycle and currently has $60K rolling from one credit card to another. His logic is that he is generating free capital. In reality, his capital is very costly indeed.

The Critique: There are no shortcuts to becoming a millionaire, and more often than not, your “shortcuts” will get you lost. Interestingly enough, debt (leverage) is absolutely imperative to your success as an intelligent investor. Take for example a billionaire such as Donald Trump, or even a corporate cash giant such as Microsoft. Both are similar in that they have millions (and billions) of dollars sitting around in cash, and short term investments, yet they continue to carry debt balances. Your question is this: why maintain debt and continue paying interest when you have the cash to pay it off? The short answer is flexibility. You’ve heard the adage “the rich get richer and the poor get pooer”, and for the most part, it’s true. Why? The rich have the means and the flexibility to seize the best opportunities as soon as they present themselves.

So why is $2M’s free money so costly? Every time he opens a new account and maxes out a line of credit, his credit rating takes a hit. Now imagine that he is presented with an extremely lucrative offer to invest in a blooming start-up, or a piece of real estate, that would require $500,000 in additional financing. When he goes to the bank to ask for money, his battered credit score may cost him up to 3% in interest rate! The result is him paying an additional $15,000 (3% x $500,000) to borrow that money. So what happened? He put a few extra dollars in his pocket in the interim, but it ended up costing much more in the long run.

The Moral: Begin with the end in mind, and understand that there are no shortcuts. If shortcuts existed, everyone would take them.

The Mission

I’ve spent the past 3 months perusing hundreds of personal finance blogs. The one unifying element was that not one of these individuals was qualified to give financial advice. The next time you read a personal finance blog, ask 3 questions: 1) do you hold a business degree, 2) what practical experience have you accumulated, and 3) would this guy give the same advice to his mother? Often there will be no mention of formal education, and they have no practical experience, because they are not financial experts… they are entrepreneurs. What do they do for a living? Your looking at it. They’re trying to get something together for themselves, and this (a blog) is often the beginning. As the custodian of my mothers finances, the third question is that which guides my investing philosophy, because every investing decision I make for myself, I make for her as well.

I’m a Washington State Certified Public Account (CPA) who graduated from the University of Washington School of Business with a degree in Accounting and Finance. I started my career as an intern and then full time Associate in the Audit practice of KPMG, LLP, one of the remaining Big 4 Accounting Firms. At KPMG I focused primarily on clients within the Real Estate Industry, the largest of which owned 6 of the largest homebuilding subsidiaries in the United States. I later left KPMG to join the Tax and Wealth Advisory practice of a slightly smaller firm, where I spend the majority of my time with Real Estate and High Net Worth clientèle.

When I was 18 years old, I started reading biographies of successful individuals, and I haven’t looked back since. Investments, and the financial markets fascinate me like nothing else on earth, and I have an unprecedented passion for explaining financial concepts to all those interested.

My goal is for this blog is two fold: 1) to help to mitigate the damage done by other reckless authors, and 2) to function as a true learning forum. On a daily basis I will offer a critique of another bloggers attempted wisdom. At times, I hope my commentary may merely serve to supplement the words of the original author; however, I have a sneaking suspicion that this will seldom be the case. I also hope that my readers will indulge me with questions of their own. If I don’t know the answer today, I can guarantee one by tomorrow, so please, ask away.