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investing

How Counting Chickens Before They Hatch Can Kill You

I recently found out that a house that I had bought in a small town for my mother to run a small business in has since tripled in value since I bought it 12 years ago. (It’s not in America.)

Does that mean I’ve made three times my money? Not even close.

There seems to be a prevailing myth out there that a home is a terrific investment. While it can be ok, it’s certainly not a no brainer. In fact, it is not unusual to only break even on a house EV-wise (expected value… in this case, inflation adjusted profit) even when you haven’t lived through a massive housing correction like America just has.

There are all sorts of expenses that go into the care and maintenence of a house that eat into your “profits”.

For example’s sake, let’s say I purchased the house at 33k, and is now “valued” at 100k. “Gross profit”: 67k.

First, before you even walk in the door, there’s taxes. Depending on what state or province you live in, you are probably going to have to pay 5-15% sales tax to get ahold of a piece of property. Selling with a real estate agent? Tack on an extra 4-7% in commission. Then there’s property taxes and homeowner’s insurance. Typically around 1-2% of the home’s value combined. Paid every year. 12 years. Ouch. Home maintenence. Say another 1% per year to keep everything in shape and keep up curb appeal. Most years will be less, but some will be a lot more.

Finally, you didn’t buy that house cash, did you? Uh oh. Then you’re paying interest, and a lot of it. With a 20 year loan at 4% interest, expect to pay more than 40% than the value of your loan over the period of the loan. Want 30 years? Better bump that up to 75%. And if you need 30 years to pay off a mortgage, believe me, you can’t afford whatever home you’re looking at. You’ll be paying so much interest that even a small increase in interest rate is going to have your mortgage underwater. That’s how the American housing crisis got started in the first place.

Now the wild card in all of this is inflation. It works on several variables of the equation. Let us assume that we will see an average of 3% inflation per year, which over 12 years means that the value of a dollar declines by one third. Your yearly expenses keep up with inflation, which means that every 12 years, you’re going to be paying 50% more for them. So does the value of the house. In fact, it’s a major driver of the appreciation of real estate. If a $33k house is worth $50k 12 years later, it may have “made money”, but it hasn’t appreciated a single iota in real value. So in EV terms, my gross profit is only twice what I paid for the house (before expenses), not triple.

So take a 100% gross profit, and take off say 10% for commission and taxes. Then 3% (proerty taxes, insurance, maintenence) times 12 years, reduced to 1/2 to account for appreciation/inflation (because 3% when it was worth 33k is not as much as now that it’s worth 100k). No, that’s not the exact math. It’s just ballparking, but it’s close enough. That’s another 18%.

Then there’s the interest on your loan. Your payment does not go up over time unless interest rates do. But inflation marches on regardless. A $200 payment per $30k of loan may suck now, (it will really suck), but 12 years from now, it’s going to feel like a $100 payment. Of course, you’re paying an inflated price for your home because of the interest you pay. But when your interest rate and inflation are equal, (which is pretty close to the case these days) they effectively cancel each other out.

But when the interest rate you pay is higher than inflation (most of the time), then you’re losing value by paying more interest than inflation shrinks the value of your payments. Which means you’re losing EV via interest.

So I haven’t really tripled my money. I’ve made anywhere from 20-70% in EV based on how big my loan was.
Wow, what a letdown. I could have made more money just buying 25k worth of gold and hiding it under my bed.
And I GOT LUCKY. If the house was in America, I would have lost a boatload of EV.

So what’s the good news? Well, it’s twofold.

How many assets do you know that would have even kept up with inflation over the last 12 years (50%)? Stocks? Nope. Bonds? Sorry. And did you have 25k just laying around 12 years ago to buy gold with?

Here’s the beauty of home-ownership. It doesn’t have to keep up with inflation. It has function above and beyond that of an investment, unlike gold.

We all need a roof over our heads. Our physical bodies, at least in a financial sense, are liabilities. We have to pay money each month to keep them going. If you didn’t own a house, you’d have to pay rent. That money is going out the door regardless. And let’s say you bought a house 12 years ago, saw it appreciate 3% a year (which works out to a 50% increase… a 50k house would be worth 75k twelve years later), but then lost it all in the housing correction in 2008. Sure, you lost value, because your house is worth the same money as 12 years ago, and a dollar is worth only 2/3 as much as 12 years ago, but you would have had to pay that much EV in rent anyways. It was actually a breakeven situation, not a loss!

But if you were counting on a gain to balance out bad spending habits…. you are effectively floating up Shit Creek.  Paddle sold seperately.  Basically, buying a house is not really an investment. It is ideally a way to turn a liability (needing a place to live) into less of a liability, or hopefully breakeven or even make a little bit of EV over time if you’re lucky.  But if you’re buying a house assuming it’s going to make you money down the road, make no mistake… you are not investing, you are gambling.

Not only that, but if you’re counting on making money on your house, you are almost certainly going to buy more house than you need, (or can afford) and thus unwittingly be taking risk on par with that of derivative traders.

And you ain’t getting no bailout.

What Would the Effect of a Greek Default be on the Economy at Large?

None. Well, not really. Almost none.

The banks holding Greek debt have already taken a 70% loss on the value of their bonds, and are still functioning, albeit with the aid of the ECB (European Central Bank).

Since the lion’s share of the losses have already been eaten without the markets showing any real adverse effects, I would expect the last 30% to go down pretty easily, washed down with a few satisfying gulps of damn-near interest free money from the ECB, also.

Not to say there wouldn’t be a good week or two downswing on the markets, but as more time passes, the more banks and investors are getting themselves positioned in a way in which they can handle the hit.   If anything, I would think it would actually be a great point to do some buying, because the market will essentially be holding a sale.

Thinking Excercise: Age

Have a look at this graph:

US Demographic by Age

There has never been as many old people in the US as there is today, and that number is only going to get bigger. What determinations can you make from it? Women live longer than men, obviously. But go deeper. What other conclusions or questions can you come up with? Can you think of any opportunities? Stop reading now, and think.

How about:

1) Who’s paying the social security? (A: Not enough.) There obviously has to be changes to system to make it viable. (If you’re 20, what do you think the odds are that the retirement age is still 65 when you get grey?)

2) The US funeral business looks to be a growth industry for the next 30-40 years.

3) Before the baby boomers die off, most have to make the process from “middle age” to old to, “I have more wrinkles than a bulldog”. The demand for assisted living, (known as “old folks homes” to the younger set) is set to take off.

4) The amount of (legal) drugs consumed increases with age, doesn’t it? That’s a good tailwind for the pharmaceutical industry.

5) There’s more 45-50 year olds than 0-5. Presumably more people born 45-50 years ago have died than ones born less than 5 years ago. We can reasonably assume that the American population (minus immigration) is shrinking.

What do you have?

Practice “Thinking Outside the Box”

One of the most important parts of being able to live off your wits is the ability to see opportunity where others see nothing but doom and gloom. Through our five senses, we are exposed to over a million individual bits of information every second. And it is up to us to decide which ones we pay attention to.

Many of us prefer to focus on information that shows that the world is a nasty, brutish place. That we are victims, thus absolving ourselves for any responsibility for our situations. I was just born fat. Those greedy CEOs are taking all the money. Those damn illegal immigrants are taking all of the jobs. You’ve heard it all before.

Many of us prefer to focus on the information that shows that the world is a kind, loving place. There’s someone out there for everyone, the meek shall inherit the earth, my chi is strong, but I’m a little indecisive because I’m a Gemini. Certainly a happier world view than the first example, but it requires one to ignore rather a large chunk of reality. The chunk with the problems in it.   But where there’s problems, there’s opportunity.

What we need to focus on is two things:
a) Is there an opportunity hidden here, if so, where?
b) What is everyone else missing?

Truth is, every single thing you see with your eyes except some portions of the night sky, someone made money off of somewhere. Sometimes it was extremely difficult, requiring millions of man-hours of labour. Sometimes it is breathtakingly simple. The grass out front? Someone grew and sold the sod. $$. Someone’s cutting that grass. If that’s not the owner, that’s $$ for someone. Does it need fertilizer or pesticide? $$.

Now let’s practice. Global warming. (If you don’t believe it exists, fine. Pretend you do. Practice getting outside your belief system.) Bad, right? Sure. All bad? If you believe so, you haven’t spent a lot of time examining that belief.

So let’s try this thought excercise. Try to figure out 5 benefits of global warming. They don’t have to benefit the entire population, just some segment of it.

Now along those same lines, try naming some investment opportunities that might benefit or might not even exist without the earth getting warmer.

Global Warming Forecast

Go ahead. Think about it. Cultivating a state of mind that allows you to see positive aspects and opportunities that others miss is absolutely VITAL to taking control… not just of your finances, but of your mind.

Emotional Swings of Investing

As mentioned before, one of the hardest parts about investing is that sometimes, you’re going to do the work… determine the upside, analyse your risk, figure out the optimum investment size, and still lose. Repeatedly.

And it will suck. Statistically speaking, if you flop a coin 10,000 times in a row, you’re going to come up tails 8 times in a row at some point. And if you make enough plays, investments, whatever, eventually you’re going to go on a losing streak. And we are traditionally risk adverse creatures.

How to combat this? As much as we’re not going to like the answer, it’s the same as everything else. Practice. Our default monkey instincts were just not set up for math, or for finance in general. In fact, most of our “gut instincts” are, when it comes to finance, pretty much wrong. You can see it all the time in the stock market. In 2008, the Dow went to almost half of it’s early 2008 value.

Why wouldn’t it stop at, say, 25% down? That’s a good deal, right? The market is throwing a sale. “Buy low, sell high” right?

Wrong. Our monkey instincts are not built upon wisdom, they’re built on survival and procreation. Which essentially equates to fear and greed. When you open your portfolio statement and realize you lost 25% of your life savings in the last quarter, you’re not too likely to start asking the bank for a loan to invest even more. That’s the fear setting in… “Get out now before I lose the rest!”  So it ends up being “buy high, sell low”.

As you may (or probably don’t) know, I am an aspiring poker pro. Not only do I make money from it, it has also helped me grow as a person in innumerable ways. One of those ways is that it taught me how to lose. Repeatedly. Even when it’s at a much lower level, (I play games with $50 buy-ins), you get used to the feeling of losing streaks. Over time, it takes a lot more losses to start getting under your skin. (Notice how I’m not saying it doesn’t get under my skin at all anymore…) With time and practice, you can desensitize yourself to the negative emotions we experience when me take a hit.

I’m not saying that you need to start playing poker to train your mind, but odds are you do need something to instill that kind of mental toughness into you, because it’s not a standard feature of the human brain. Maybe it’s martial arts and a statistics class. Maybe it’s buddism. (REAL Study… not just telling your friends like most “buddhists”.) But you need to develop that mental toughness somehow…. you’ll be eaten alive without it.

And not only will it help you in your financial life, those skills will spill over into your personal life, too.  You’ll find you’ll become much better at keeping your cool in trivial situations that would have made you crazy earlier.  If you have the mental fortitude to forge on despite a 15% downswing in your portfolio (which IS going to happen at some point), you’re not very likely to go into a rage when someone cuts you off in traffic.  And when you smooth the edges off any  temper you may have and increase your ability to keep calm under fire, your relationships will automatically start to improve.