Risk Evaluation Part 1: Secured vs Unsecured

-- If you can cover the downside and let the upside take care of itself, wealth creation is easy....George Antone

When evaluating an investment opportunity, there are many characteristics that one can use to evaluate risk.     A savvy investor needs to understand the quote above from a very wise mentor when evaluating investments.     Reward is easy to measure.  It's typically stated or promoted quite a bit.  

Most novice investors focus on the reward alone, and with rose colored glasses ignore the downside risk of a particular investment.    This is a very immature approach to investing. 

There are several characteristics to consider when evaluating an investment.   One of those is to evaluate whether the investment is secured or unsecured.    A secured investment is when there is a lien on some underlying collateral.  This makes recouping your investment much easier.   

An unsecured investment means there is no underlying collateral to protect your investment, and you'll have to sue in order to collect.  This obviously causes delay and additional expense. The better and more valuable the collateral the safer your investment.

Many people ask me if investing the stock market is unsecured or secured.  That's a good question, and the answer is, the investment is secured.  It's just secured to a volatile asset.  

So ask yourself, would you prefer a secured investment or unsecured investment?   It's up to you, there's no wrong answer.

Landlord vs. Investor

What’s the difference between a landlord and investor?  

A landlord is someone who buys houses and rents them out.   They do this for the purpose of cash flow and wealth creation.   

The landlord typically looks to build their portfolio one building at a time, starting small by maybe buying a house or duplex, and living in one side.  They’ll maybe set the goal of buying a new house or small apartment building every year or two. 

It’s the slow boat to China for wealth creation, and it’s not an active business.   It’s a passive business for the landlord.   The landlord typically has another source of income through a regular job.   This is the client the banks serve.   Banks love to make loans to landlords because typically they have good credit and they have another source of income besides the property.  

The landlord will use their own cash to fund their purchases and down payments.  It oftentimes will take them 20 or more years to amass enough equity and cash flow to replace their income to afford the lifestyle they want.  

There’s a difference between a landlord and an investor.

An investor is an active pursuit to become an expert in the niche.   Investors want to be the best home-flippers or best buy-and-hold real estate professionals in their selected market.  They are either dedicating full time resources or are rapidly moving toward full time to their craft.  Investors spend hours analyzing the market in order to know better and more than any other professional the values in their market.   

Investors don’t rely upon agents to find deals, because they know the best deals aren’t privy to most agents.   They find deals on their own.   Investors own their success.  Landlords rely on others for their success.   Investors use other people’s money for their investments.    And to that end, they have a fiduciary responsibility to their capital partners.   The quality of their relationships with their investor clients defines their success, and they protect those investors at all costs.     

The Power Of Tax Free Wealth

Einstein once said the power of compound interest was the 8th wonder of the world.   What is compound interest?    Let me answer this by way of illustration.

Here’s a question I’d like you to consider.   Which would you like more? $100,000 cash or a penny doubled every day for 30 days?  

Let’s look at the penny doubling every day example:   
Day 1 0.01
Day 2 0.02
Day 3 0.04
Day 4 0.08 
Day 5 0.16 
Day 6 0.32 
Day 7 0.64 
Day 8 1.28 
Day 9 2.56 
Day 10 5.12 
Day 11 10.24 
Day 12 20.48 
Day 13 40.96 
Day 14 81.92 
Day 15 163.84 
Day 16 327.68 
Day 17 655.36 
Day 18 1,310.72 
Day 19 2,621.44 
Day 20 5,242.88 
Day 21 10,485.76 
Day 22 20,971.52 
Day 23 41,943.04 
Day 24 83,886.08 
Day 25 167,772.16 
Day 26 335,544.32 
Day 27 671,088.64 
Day 28 1,342,177.28 
Day 29 2,684,354.56 
Day 30 5,368,709.12 

After 30 days, you’ve accumulated over $5 Million dollars!  However, this assumes a tax-free environment.   Let’s look at a more realistic environment of 15% tax.    This is a conservative tax bracket and represents a short term capital gains tax, such as if you bought and flipped a house (you’d be subject to this capital gains tax).   In addition, since it’s income you’d be taxed on the income later as well.  However, for now, let’s look at how this realistic tax environment has an effect on your bottom line.   
Day 1 0.01 
Day 2 0.02 
Day 3 0.03 
Day 4 0.05 
Day 5 0.08 
Day 6 0.14 
Day 7 0.24 
Day 8 0.41 
Day 9 0.70 
Day 10 1.19 
Day 11 2.02 
Day 12 3.43 
Day 13 5.83 
Day 14 9.90 
Day 15 16.84 
Day 16 28.62 
Day 17 48.66 
Day 18 82.72 
Day 19 140.63 
Day 20 239.07 
Day 21 406.42 
Day 22 690.92 
Day 23 1,174.56 
Day 24 1,996.76 
Day 25 3,394.49 
Day 26 5,770.63 
Day 27 9,810.07 
Day 28 16,677.11 
Day 29 28,351.09 
Day 30 48,196.86 

Look at that 30-day number!   It’s only $48,196 after 30 days.   This is in a tax environment, not tax-free or tax-deferred.   This is well over $4.9 Million less than the example above.  

If you do some quick research on the Internet, you’ll soon realize that taxes will be the largest expense and have the largest effect on your wealth over the course of your lifetime.  In fact, the bureau of statistics claims that American’s will spend 30%-40% of their entire lifetime’s income on taxes.   From the above example, you can see how detrimental taxes are on wealth creation.  

The solution is to invest tax free or tax deferred is to use a qualified retirement vehicle such as a 401k or IRA or Roth IRA or HSA.   

However, most people just think that “investing” means investing in the stock market only.  However, there are 100s of different types of investments, and the IRS allows you to use any of these qualified accounts for these investments, including investing in real estate.    That’s right, you can invest in real estate using your IRA, and it’s quite simple actually.

The most challenging part of investing in real estate with your IRA is finding a custodian that will allow this type of investment. 

If your custodian is Fidelity, or Charles Schwab, or Edward Jones, or UBS these are traditional custodians and they will only allow investment in the equities market.   This is so sad really because there are so many more profitable investments outside of the equities market.  

So the first challenge for you will be to find a custodian that allows investment in the asset or investment that you’d like to invest in.  This can be real estate or anything else that you can think of such as startup companies, joint venture partnerships, commodities, and really anything you can think of in the world.   

Each self-directed IRA custodian will have their own investing forms and protocols.    Companies such as Equity Trust Company, New Direction, Qwest and others will help you roll over your IRA into their company, of which then you can invest in anything you would like to invest. 

There are many ways to do it wrong.  We’ll discuss these pitfalls in an upcoming blog post.  

The Wall Street Gamble

Growing up with a stockbroker for a father gave me a unique perspective of the equities market.  My financial education started at the kitchen table each night at 6pm, after my dad came home from the firm.  "Do you know what makes money?"  he would ask me,  "it's money that makes money.  And the money that money makes, makes more money".

That idea that money as a product, is the foundational premise behind our business.  Money sells itself because everyone needs it.   

The challenge for the Managers of that money is to invest it wisely.    The old idiom, a fool and his money are soon parted, is true.  You must be wise, prudent, skeptical, and cover the downside in order to survive and thrive.   Too many investors just look at the potential; however, the prudent Manager must first look at covering the downside.   Remove the risk and let the profit take care of itself. 

Each year, Dalbar publishes a research paper on how investors underperform as compared to the index fund for the S&P 500.  Once again the 2015 study shows that the average mutual fund investor makes 8% below what the index fund makes.   The average return is close to 5.5% APR.    

Two things.  
#1) That's an incredibly low return.  How can investors stand for that?
#2) This does not take into account inflation, opportunity costs and taxes. 

What's the current level of inflation?   According to our government it's closer to 1.5%-2%.    According to ShadowStats.com the rate is closer to 10%.   

In either case, you're either barely keeping up with inflation, or you're purchasing power is falling behind.  

How do we solve this?   We need to move to what my friend George Antone calls the right side of the equation.  

We'll talk more about these next time. 
Marc