Ward Wilsey's Site

Most finance books use the word retirement in their title. “How to Retire”, “Retire in Style”, or some variation thereof. I have intentionally not used that word in my title, and I haven’t used it a ton in the book. That’s because my experience with advising people rarely centers around a specific desire to retire.

Most Americans are not looking to just wake up one day and quit working. I find that most people who “retire” tend to continue working, if nothing more than part time. There is something cosmic about work. It even shows up in the Garden of Eden as Adam and Eve both worked. It’s good for you, and most people who give up on work permanently tend to decline, physically and mentally.

At the very least, older folks tend to manage their investments closely, and follow what they invest in very closely. I think that’s very important as it tends to keep people healthy, engaged, and mentally sharp.

For those reasons, I tend to use the word “liquid” instead of “retirement”. What I mean by that phrase is one’s income from investments produces enough cash to meet one’s living expenses. At that point, a person can do whatever they want, and any income they generate can be used to purchase more assets that will produce even more income.

The first step to thinking about how to become liquid is understanding the difference between growth and income. The relationship between the two must be taken into account, and your investment philosophy can and will change over time. Let’s explore these two.

Growth is the increase in the price of an investment, should someone buy that asset from you. If you buy a stock for $10, and it increases in value to $20, you’ve gotten growth of $10. Growth is a long term benefit, and you shouldn’t count on any investment to grow over a short time frame. For instance, I can’t tell you what an S&P 500 index fund will do next year. However, I am pretty confident that it will grow 8% to 10% over the course of the next 20 years. Maybe a little more, hopefully not a little less, but it should be in that range.

Income is the cash an investment produces for you on an annual basis. When I rent out a house to a tenant, I make perhaps $200 per month, after my mortgage and all expenses are paid. If I divide the cash that goes in my pocket by the value of that asset, I get my income yield. Different assets have wildly different income yields (and growth rates). Usually, rental properties will produce between 6% and 10% of income. I say usually because there’s certain rentals that will produce less, generally very expensive properties in great neighborhoods. Sometimes properties have an even high yield, generally for “value-add” properties. Stocks produce dividends, bonds produce a coupon, etc.

When you add your growth rate and income rate together, you get your total return on an asset. For instance, you might assume a S&P 500 index fund would earn 8% growth and a 2% dividend for a 10% total return. Maybe a rental property earns a 6% income yield and is in an area where real estate typically grows 6%, for a 12% total return.

At all points in your life, you need to be concerned with your total return. For instance, since municipal bonds don’t grow (at the end of the term you get back your principal), you just get your income yield, and the total return is pretty low. Therefore I don’t like the idea of investing in bonds.

That being said, you can’t ultimately live off growth, without having to sell off assets. If you do that, you won’t have the asset any more, and it won’t produce any more income for you. {Insert cliche about killing the goose that laid the golden egg here}. You need income to produce cash for you, and at different points of your life, this need for cash will be different.

When you’re young, and still working, it’s fine to invest solely in assets that produce growth. You don’t need cash, and you’re not going to need to use the cash that your investments produce. In fact, I often find that the income produced by my investments, particularly real estate, gets left in cash, doing nothing for me for months at a time. This is particularly true if I forget to move cash over into my brokerage account and buy stocks.

I’ve also found that my real estate that produces less income tends to grow faster. For instance, my real estate in Austin, TX doesn’t produce as high of a yield as my rental in Little Rock, AR. However, it does grow significantly faster. At my age, 42, I’d rather have the growth.

However, at some point in your life, you’ll need your investments to produce cash. How much depends on your lifestyle needs. Hopefully you’ve saved enough where the income from your rentals and dividends from your stocks will pay for your lifestyle. However, it may be necessary to exchange more growth oriented assets for income assets in order to meet your living needs. With real estate, this is pretty easy, because you can just 1031 exchange into a higher income piece of real estate. With stocks, you may have to sell in order to buy real estate to accomplish the same thing.

It’s important to understand growth vs. income, and how that affects your portfolio. You’ll need to understand how much income you’ll need to meet your living expenses, and if your current portfolio will meet your needs at some point, or if you’ll ultimately need to convert assets into a higher income producing asset. What you don’t need to do is sell growth assets to just buy bonds. You can get the same income yield with assets that also grow, particularly if you invest in real estate. 

I’m a big fan of professional poker. Doyle Brunson, Phil Hellmuth, etc. are iconic figures who’ve made a TON of money from gambling. When you watch them play, it seems so easy, as if anyone can do it. However, there’s a ton of mathematical calculations from various hands these players must be able to intuitively understand in order to compete at a high level. For every poker player who makes money, there’s probably a thousand (or more) who go broke. Unless you’re a genius poker player (and you’d know pretty quickly if you are) it’s best to play just small stakes for fun, otherwise you’re in for a world of hurt. As they say, if you look around and don’t know who the sucker is…it’s YOU!

Investing in individual stocks or any other investment is quite similar to poker. There’s a small percentage of investors who make a ton of money, but the vast majority flounder. If you’re looking to build wealth, your best bet is sticking to index funds and real estate, as I’ve outlined above. Leave gambling to the professionals.

It’s interesting how even professional managers feel the same. In one of his newsletters, famous (and extremely successful) debt investor Howard Marks talks about how much he likes a book written by famous poker player Annie Duke called Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts. He cites several excerpts of the books, with the basic idea that a good investor will get comfortable with making a bet on an uncertain outcome, and the quality of those bets is made when the bet is placed, not based on the outcome. In gambling, Marks writes, you’re trying to make the best guess as to where the outcome is headed, without knowing all the facts. It’s telling that one of the world’s foremost investors is so drawn to ideas consistent with the strategies of gamblers. Certainly Mr. Marks puts in a lot of time researching and working on his bets, and he also has developed an uncanny knack for getting in front of successful investment trends. I’d also be willing to bet that he has an amazing natural talent for investing that can’t be taught.

The point is there are a lot of investors who invest in alternative assets that make returns well above what you can make in index funds and real estate, using the methods I’ve described above. There are however, far more investors who lose everything trying to imitate professional investors. There are also people who earn far less than the S&P 500 because they insist on investing with investment gurus who promise outsized returns, and fail. 

I want to discuss the assets that make some people rich, but that you should stay away from as an investment. In doing so, I’m opening myself up to the criticism that I may be advising you against investing in something that could make you a ton of money. That’s true. But it’s far more likely I’m helping you make good steady returns, instead of losing your money and winding up bitter.

The first type of investment I want you to stay away from is trying to pick individual stocks (or bonds for that matter). For the vast majority of people, this is a losing battle that will cause you to make less than you otherwise would have made had you followed my advice above.

Most people who invest in individual stocks believe that by studying various companies, they can get insight that can allow them to pick winners, avoid losers, and then generate outsized profits. Yet the vast majority of people severely underperform the S&P 500 while employing this strategy. Why is that? There are several reasons.

First of all, people tend to focus on strong companies that have performed well in the past. While logically this is a good idea, those are also the companies that have had their strong performance already priced into the stock, as all investors see the stock has performed well and anticipate it will perform well in the future. The risk is there’s not much upside, but a ton of downside if the company falters.

The other problem is focusing on winners makes you miss the stocks that have not done great, and have a ton of upside. On the whole, it’s going to be the smaller companies that are still growing that have the most room to run (in terms of generating returns). You’ll miss those if you focus on the winners. Investing in the whole market (S&P 500, Mid-Caps, Small-Caps, etc.) will give you exposure to ALL stocks, and you’ll find over time a good portion of your returns are generated by outsized performance by a relatively small number of companies. The chances of you picking these companies on your own (and avoiding the bad performers) is small.

In addition, I don’t feel like you can truly know the condition of a public company nowadays unless you have inside information (which is illegal). With publicly traded companies, you have no idea what’s truly going on at a company by reading its financial reports. First of all, there’s things going on in terms of market shifts, competition, regulation, etc. that are hard for even the top executives in companies to see as they are happening. In addition, the way numbers are reported may be the executives attempt to show a story to investors that’s not 100% true. Accounting is as much art as science, and CFOs will often use tricks to report the story that investors want to hear, while (hopefully) staying within the parameters of the law.

In order to know the true state of a company, you’d need to do a TON of investigation in order to get down to the true financial condition of that company. Professional investors (most of whom don’t outperform the S&P 500) will look into many different items in order to try to verify the reported numbers of companies. For instance, I’ve heard that professional money managers will scour job postings online to see how much hiring a company is doing, in order to see how much growth they are anticipating. My point is that’s what it takes to even have a shot at gathering the information needed to get outsized investment returns. Do you really have the time (and desire) to do that? Doubtful, especially if you are working a full-time job. It’s a much better idea to invest in the manner I’ve described above, using index funds.

I want to turn now to the myriad of other types of investments that are marketed as alternatives to stocks (and by extension real estate). These investment ideas play on the notion that the stock market is “risky” and purport to be alternatives.

The list of alternative investments is large, and seems to grow every year. While I’ll list a bunch here, a good rule of thumb is that you should not invest in anything that’s heavily marketed during stock market downturns. Whenever there’s a stock market correction (the stock market goes down 10% or more) or a bear market (stock market goes down 20% or more), there are a number of investments put forth as a “safe” alternative to stocks. For the bulk of investors, they’re not safe. In general, these are trash investments that will cost you in the long run. Stick with stocks and good quality real estate.

Before we list these investments, I want to start by saying there are investors who will absolutely make a TON of money in the investments listed below. However, they are generally experts in the asset in questions, and have knowledge about the marketplace that you do not, or have access to investments to which you will never have access. Their results are not representative of the VAST majority of people who invest in these areas.

These successful investors could easily criticize what I’m about to say, and I’ll admit they’re right, as it applies to them. If you’re one of those successful investors, worth tens of millions of dollars, you don’t need my book. But for the vast majority of people, the following investments will lose money, so it’s best to stay away.

If you’re willing to put in the work to become an expert at these investments (and are prepared to lose some money in the process) then by all means, try them out. Maybe you’ll be a natural, and make a ton of money with these. But probably not, most of us are better off to avoid these.

Here’s the investments YOU Should Avoid:

GOLD

The most common alternative asset people invest in is gold. The theory is that gold retains its value in any market, and will protect you against inflations and a stock downturn.

In some short-term situations, this is true. When a bear market happens, gold often (though not always) increases. In addition, because gold is a commodity that has an alternate use (jewelry), it will often protect you against inflation.

However, in the long run, stocks perform much better. Any information you’ve read to the contrary usually is cherry-picking time periods when the stock market is down temporarily. Over the long term, while gold has had some huge run-ups (like the 1970’s), it has performed poorly relative to stocks.

I’ve noticed that gold sales, gold stocks, and even gold index funds surge in popularity each time there’s a recession. Generally, this is the result of huge marketing efforts aimed at people who are worried about the temporary dip in stock prices. This is designed to play to people’s fears about the collapse of the US dollar, as inevitably happens when times are bad.

While I’m sensitive to people’s concerns about the devaluation of the US dollar, I must stress that gold is not the answer. Usually people end up buying gold after a significant runup in price, which inevitably reverses once the economy recovers.

If you’re investing in gold because you’re worried that the USA is going under, and we’re going to live in an anarchy environment, can I suggest bullets instead? Small, easily divisible, useful for personal protection, it’s likely that 9mm rounds would perform much better than gold in the event of the end of the world. Just saying!

CRYPTOCURRENCIES (BITCOIN)

One of the hottest investments over the past few years has been cryptocurrencies, led by bitcoin. Based on blockchain technology, crypto has been touted as a game changer, leading to everything from the end of fiat currency to even the end of borders as we know them.

Cryptocurrency is an online form of money, generally tied to the blockchain, which is an independent, decentralized method of virtually verifying transactions. I’m no expert in the tech side, and an explanation is way beyond the scope of this book, but suffice to say that it purports to emerge as an alternative to fiat money, meaning governments printing their own currency for use in financial transactions.

This is an idea I really want to believe in. It serves as an alternative to fiat currency, which is essentially a government monopoly on the idea of money. It would prevent the government from printing money to fund silly ideas, and avoid the inevitable comeuppance of inflation when the world loses faith in the US dollar as the world’s reserve currency.

It also can send transactions without reference to borders, which would prevent much of the manipulation that goes on around the world by restricting currency use and trading by citizens. An example would be South Africa, which limits the exchange by its citizens of the rand into other forms of currency. This government control limits the freedom of citizens, and allows the government the power to manipulate currency (by printing more) without allowing productive citizens the power to opt out by converting that currency into a stable alternative. Cryptocurrency cannot be easily controlled by the government, and restrictions on conversion are much more difficult (if not impossible) to control.

There’s also nothing to say that an alternative to government money couldn’t emerge. In the 1800’s banks would print their own form of money, albeit backed by gold in their institutions. I would suspect that an alternative will emerge eventually. The likely candidate, as I write this, is Bitcoin, which is the most popular form of cryptocurrency in use today. Is Bitcoin going to replace the US Dollar and other currencies?

The reality is much less exciting than the hype. The reality is that Bitcoin, and other cryptocurrencies aren’t a usable form of “money” for a variety of reasons. Rather, as we sit today, they are simply a speculative investment, where people are betting that a certain cryptocurrency will emerge as an alternative. I’m all for using crypto once it actually becomes a currency, but I’m totally against speculative investments, so can’t recommend it in its current state.

Why do I say it’s not currency? First, you can’t buy anything with it. Try to buy a steak at the store with Bitcoin, or anything else. It won’t work. A currency must be usable to be considered an actual currency, and even Bitcoin doesn’t fit that bill. Until some form of crypto is accepted as payment for a wide variety of goods and services, it’s not really money.

Next, it’s too volatile to be considered a currency. Money is often referred to as a “store of value”. This means you can earn it one day, and put it aside until a future time for spending. As long as that future time is not TOO far out into the future, where you could lose value due to inflation, you’ll be able to purchase the same amount of goods as the day you earned it. That’s not the case with any crypto, as the values fluctuate rapidly. A unit of Bitcoin earned or purchased today will likely be worth a significantly different amount one month from now.

Whatever you do, please stay away from Initial Coin Offerings (“ICOs”). These are (as we write) not highly regulated by the SEC, but are similar to Initial Public Offerings (“IPOs”), and involve investment into a particular cryptocurrency. These are marked with fraud, and millions are getting swindled by hucksters as we’re writing this.

Here’s the rub with what I’ve said thus far. Some people are going to make a ton of money from crypto. But unless you have unusual insight into the industry, that’s not going to be you. What you’re essentially doing, when you invest in crypto, is placing a bet on which version (or versions) will eventually become an actual currency. I can’t recommend making bets. As such, it’s best you stay away. Once crypto is actually currency, I’m all for it, but currently it’s not there.

CANNABIS

Cannabis is the latest hot investment de jour, and these things seem to come along every few years. Whether it’s medicinal marijuana, hemp, or CBD oil, pot is hot! But what often happens with these trendy ideas is a few people get in early, get rich, and the average investor gets scammed.

I’m not sure of the health benefits of weed, and I don’t care to debate, but I’m confident that much of the interest and investment dollars flowing into this industry is a trend, probably caused by the allure of a forbidden substance.

What I’m really concerned about is all the people opening CBD stores or trying to sell hemp clothes, who are going to be wiped out when this trend ends. There’s going to be others down the road just like it, don’t get fooled.

OPTIONS

In late February 2020, billionaire hedge fund manager and brilliant investor Bill Ackman invested $27 million to “short” the stock market. This means he purchased an “option”, which would pay off big if the stock market declined in value. When the Coronavirus hit, the stock market fell sharply, and his $27 million bet paid off with a $2.6 billion profit.

Wow! Why don’t we all buy options? The reality is that odds were that the Coronavirus was a non-event, and the market wouldn’t have gone down much at all. That option would have turned out to be an expensive, non-paying off bet on Ackman’s part. But Bill Ackman is an amazing intuitive investor who seems to time these things perfectly. Maybe it’s brilliance, and maybe it’s luck, but it’s definitely not something you and I are likely to profit from.

Options are priced according to what millions of option traders are pricing them at. This mass of traders, some of whom are smarter than others, as a whole, will tend to price options to match the risk involved. This means that if a bad (or good) event is likely to happen, the option to benefit from it will be priced so high that you won’t make much money from it.

A lot of investment professionals like to recommend options to hedge against stock market declines. Please don’t do this! It’s expensive “insurance”, and you’ll lose compared to just riding out stock market declines.

There’s no denying that certain people are great at options trading. If that’s you, hats off. But most people who get involved with options end up losing a lot of money. This is another investment category to stay away from if you want to get rich.

DAY TRADING

Day trading came into vogue when online trading first came around in the 90’s. Places like eTrade, TD Ameritrade, etc. allowed every investor to trade to their heart’s delight, for $10 or so a share (less nowadays). A few people got rich (or said they got rich) buying and selling stocks quickly. These investors were trading on trends, trying to spot the direction that markets or individual stocks were going, and profiting from those short-term trends. Sometimes these investors would hold onto their stocks for less than a day, earning the name “day traders”.

Successful day traders began selling their “programs” often on infomercials, claiming they could teach the secrets of instant riches to anyone. Thousands bought these programs, and lost untold amounts of dollars trying to put them into practice.

Why? Again, with certain investments, some people have the knack for success. Most people don’t. You can’t teach day trading. I’ll admit that some people can be highly successful at this, but it’s because they’re naturally talented, lucky, or both. Again, just like options, you and I will not be successful here, so it’s best to just stay away.

DIRECT LENDING

Direct Lending is another one that a lot of people make great money doing. Direct lending is lending money directly to borrowers, rather than having borrowers go through a bank. Generally, these are for real estate deals, like bridge loans or house flippers, but occasionally these are done for businesses as well.

One challenge with direct lending is making sure you’ve got adequate security, meaning an actual asset, like real estate or business equipment, to back up the loan if the borrower defaults. A lender should never make a loan without an actual asset to secure the money being lent. No matter what anyone tells you, there’s always a risk of default.

Direct Lending is also ripe for fraud. There are countless stories of lenders being duped by crooked borrowers giving security interests in phony real estate or bank accounts. If you’re going to involved in this type of investing, you’d better be able to perform “due diligence”, which is a fancy way of saying know what you’re getting into, and you’d better have an attorney who can help you draft the legal documents to protect yourself (and get those attorney fees paid for by the borrower).

There are some online lending sites like Peerstreet that aggregate lending and due diligence into one place, allowing lenders and borrowers with a ready market place to lend and borrow. The theory is that this will reduce transaction costs and allow creditworthy borrowers the opportunity to get funds for investment deals. 

I have invested a little into Peerstreet deals in the aftermath of the COVID financial crisis, but that was simply because yields were over 10% for a brief period of time. At that rate of interest, it makes sense to me to have the loans as a diversified part of my portfolio. But they’ve already fallen short of that 10% mark, so my thought is that I’d rather invest in real estate or stocks, where I’m confident that I’ll get a return higher than 10%.

Direct lending can be a successful source of revenue for many people, however, absent using a commercial source like Peerstreet, which candidly is still a bit risky, this is an area that most people should not venture into.

LIFE INSURANCE

Life insurance, when purchased properly, is an essential tool you can use to protect your family in the event of your death for a very small sum of money. Life insurance, as sold as in “investment” by the life insurance industry for high commissions, is a waste of money.

I want to start by making it clear that until you are liquid, meaning your assets are enough to cover your living expenses, you need life insurance. The appropriate life insurance is a term policy. This is a policy where you pay premiums for a term of years, and if you die within that time period, your insurance pays out.

If you’re at the beginning of your wealth journey, with no assets and in debt, you need to multiply your income by 15 and purchase that dollar amount in a 20-year policy. It’s that simple. Even if you’re out of debt, as long as you’re fairly young and healthy, this type of policy is the way to go. It’ll be cheap and you can set it up on autopay and forget about it.

The only issue comes if you’re older and in ill health. The term policy will become more expensive at that point, and you may need to limit the amount of the policy to 10 times your income in order to make it affordable. But you really need to shoot for at least 10 times your income to make the policy something that can take care of your family. It needs to be able to pay off your mortgage and provide income to your spouse to replace yours, especially until your kids are out of the house.

With a term policy, an insurance company will send an examiner to do a general medical checkup involving height, weight, medical history, and blood tests. Once those come back, you’ll receive an offer for your insurance and can move forward. Generally, you want to deal with an insurance broker who can shop the insurance among multiple companies, to get the best deal for you.

The reason the 20-year term policy makes sense is that’s the time period you should need to grow your wealth to the point where your assets will provide for your spouse and kids’ income needs should something happen to you. Once that time period is up, your spouse will be able to use your assets to cover your wages, and your kids will likely be out of the house. There’s no more need for insurance.

Because you’re limiting the time period of your insurance to 20 years, in all likelihood, it’ll never pay out. Therefore, the insurance company can afford to charge a price much lower than the dollar amount being paid out. If you need $2 million of insurance to cover 15 times your salary, the amount of the premiums, added up over 20 years will be pennies on the dollar. Why? Because the goal of both you and the insurance company is that the money is never paid out!

Contrast term insurance with so-called permanent life insurance, which is by definition designed to be around at your death. That means it’s definitely going to (in theory) pay out at your death. As a result, it’s going to be much more expensive than term insurance, because the insurance company has to make enough money, over time to pay the death benefit. 

On one hand, it might seem like a plus that the insurance pays out. After all, with term insurance, odds are you and your family will never get anything from all the premiums you pay in. However, you need to look at the difference in the premium costs of term insurance (small) with permanent insurance (high). By purchasing permanent insurance, you’re forgoing the opportunity to invest the large cost difference between the two premiums into investments described in this book, which is a huge loss. Those thousands of dollars in extra premiums you pay into the policy could otherwise be used to purchase stocks or real estate that will help you earn income while you’re alive, rather than ensure a payout at your death.

The insurance industry has tried to hide this problem by referring to their insurance policies as “investments”. These policies are designed so that you pay much more in premiums in the early years of the policy. A small part of this payment goes to providing the actual insurance. This amount would be similar to what you’d pay each year for a term policy. The remainder of the premium is called the “cash value”, and is held within the policy as an investment to pay for insurance in future years. The cash value is actually invested for you into a variety of investment options, often mutual funds, that should grow over time. The idea here is that if the cash value grows enough through the course of your life, you will have enough money in your policy for the insurance company to withdraw premiums each year during your life, ensuring that the agreed upon death benefit will be paid upon your death.

These policies go a step further, by allowing you, through (a) premium payments and (b) the investment growth of those payments as cash value, to actually accumulate more in the policy than will be necessary to make those premium payments over the course of your life. By a quirk of tax law, you can borrow this excess cash value in your policy tax free. Why? Since you will need to pay back these amounts at your death (plus interest), it’s not really like you’re receiving actual earnings, like with a stock portfolio. It’s more like getting a loan to purchase your house, you would not pay tax on those loan proceeds. The idea here is that you would fund your retirement through borrowing money from your insurance policy, and never pay taxes. Sounds great right?

There are several problems with these cash value insurance policies. First, the cost of setting up these policies is staggering. The insurance agents involved make a TON of money from the commissions on the policies they sell, often equal to ½ or all of the first year’s premiums. When your insurance company starts that far in the hole, you can imagine how they’ll need to recoup that over time from your premiums and policy. Also, the agent is really disincentivized to care whether this is the best thing for you. If they sell you this policy, they’ll make a ton of money immediately. If they recommend the investment advice outlined in this book, they’ll make a lot less. It’s really that simple, and that conflict of interest alone should steer you away from this market.

Another problem with these cash value policies is the investment returns are often poor, compared to what you’d get in index funds. Generally, your cash value is invested into mutual funds. These often are owned by the insurance company (or the insurance company is compensated for directing cash value of policies to the mutual fund) and charge high fees. While disclosed (meaning buried) in the paperwork, these fees are not something the insurance company wants you to see, because they’re often as high as 2% of the invested amount. Even if they were invested as I’ve outlined above, your stock market returns would be 2% lower. If your portfolio made 10% over time, you’d actually be collecting 8%, because 2% went to the fund manager. It’s also important to note that if the policy cash value does not perform as expected, you won’t have enough cash value to cover premiums at some point. You’ll be faced with the choice of funding the policy with more premiums, or letting the policy lapse.

Also, the cash value disappears at your death. One of the selling points of this type of policy is that you can borrow the cash value to support your living needs in retirement, but the reality is that the cash value is not yours, it belongs to the insurance company. Once you die, all that passes to your family is the death benefit, not the actual cash value. To make matters worse, many policies require you to pay interest, to borrow your own money.

Furthermore, loans put the policy at risk. The cash value, which you are able to borrow to support your retirement needs, is needed to fund future premiums. Again, you’re paying significant premiums upfront in order to make the policy permanent. These premiums form the cash value, and that cash value needs to grow in order to continue to pay the premiums as you grow older. It needs to grow significantly, because the premiums are going to increase as you get older, because the older you are, the more likely the policy is to pay out.

What tends to happen as people grow older with these policies is due to (a) lower than expected investment performance and/or (b) policy loans, policies get into trouble and the cash value is insufficient to cover future premiums. The policyholder is often asked to put in more premium dollars than expected, lowering returns to much less than initially advertised. Think about it this way. If your S&P 500 index fund performs at 6%, rather than 10%, you have less money. If your cash value insurance policy performs less than expected, you could end up losing everything! Not a good deal.

Are you confused enough at this point? Cash value life insurance policies are one of the most confusing types of investments that exist. There’s so many catches and provisions designed to protect the insurance company. Unlike stock or real estate, which are true assets, all you really own is a contractual obligation with the insurance company. Over the years, I’ve seen so many of these policies go wrong that it’s impossible for me to recommend them to the average person.

I do want to caveat this by saying that I have seen these types of policies be beneficial, in certain circumstances, for the ultra-wealthy and certain highly compensated corporate executives. I want to also say there are some insurance advisors who are very honest and are able to design these policies to meet the needs of their customers. However, these policies are being done for very sophisticated investors who have (or should have) their attorneys, CPAs, and independent insurance consultants review the arrangements to make sure they’re done properly. Unless that describes your situation, it’s best to stay away and stick to term policies. This is another example of how most investors should not mimic the investments of the ultra-wealthy.

ANNUITIES

Annuities have been traditionally marketed to old folks to provide guaranteed income in exchange for a fixed sum of money. The idea is that the purchaser of the annuity is giving up the prospect of a higher return (in the stock market for instance) in exchange for a guaranteed payment for life.

In theory this is all right for older people who don’t want to worry about investing and are willing to trade certainty for a low return. As one gets older, the short-term fluctuations in the stock market can become more unnerving, and an annuity was designed to avoid that stress.

An annuity factors in the amount of money the buyer puts in, called the principal, as well as the buyer’s age and the interest rate the annuity company (usually a life insurance company) is willing to pay. This interest rate is dependent on market conditions, so right now, rates (and annuity payments) are extremely low.

Let’s say an 80-year-old wants to pay $500,000 for an annuity. How much will it pay him per month for his life? According to a simple annuity calculator, the estimate is $4,253 per month, for life.

That seems like a ton of money, $51,036 per year! Why wouldn’t everybody do that? The answer is that the annuity company can pay out so much because 80-year-old men don’t live very long, on average. According to an actuarial table from the company Annuity Advantage, an 80-year-old can be expected to live 8.34 years. 8.34 year of $51,036 per year would be $425,640, which is less than the buyer put into the annuity.

Now, again, annuities are designed for certainty, so maybe that’s alright. In addition, if the 80-year-old buyer lives to age 100, he’d get $1,020,720 of payments for his annuity. Unfortunately, that’s only about a 4.26% return, so not great. But again, certain.

The real problem with annuities comes from the various esoteric varieties that claim to “give you the upside of the stock market without the downside”, where you can “lock in your returns”. Please run whenever you hear this. In reality these are marketing gimmicks that will give you ultra-low returns. Just invest in the stock market, and keep cash on hand to deal with short term needs so you don’t have to sell stocks when the market turns temporarily.

You’ll notice that annuities are heavily advertised in recessions, when people have just seen tremendous short-term volatility in their stock market portfolios. The sad part is that many people will sell their stock portfolio when it’s down, and then invest the cash in annuities. What they do is lock in their losses and give themselves no change to bounce back. Selling while the stock market is down is the only way you can lose money in the stock market. Don’t fall victim to this trap!

You should especially not fall victim to the sales pitch that annuities are “tax protected vehicles”. Yes, you don’t pay tax on growth in an annuity until you take it out. But the growth is so low that you’re much better off in a traditional stock portfolio just paying the taxes as they come. It’s not a good deal to be paying no tax on an annuity with no return.

Once you’ve maxed out your 401K, and invested the extra funds into a regular taxable investment account, at some point you’ll have enough to purchase a single-family home investment property, which is our next recommended investment. 

This means you’d be able to cash out your investments, pay any capital gains taxes, and use them to buy a property. First, you need to decide if owning an investment property is for you. The advantage is that the returns, especially when taxes are considered, are better than stocks. The downside is that you actually have to get involved with tenants, repairs, etc. You will also need to decide whether you are comfortable with using leverage (a fancy word for a mortgage) on your real estate, as debt will increase your return, but add an element of risk.

Stocks are a truly passive investment. You buy an index fund, sit on it, and let it grow. You don’t need to research stocks, and please don’t watch investment shows on MSNBC. Buy and hold, that’s it.

That’s a good thing, because most people who get too involved with stocks buy at the wrong time (when prices are high) and sell at the wrong time (when prices are low) based on “research” that usually is written to sell fear or greed. We’ve taken the path of continuing to buy the same stocks over and over, and it’s worked really well for us, and we’ve gotten great returns. Most people who over analyze stock purchase and performance do worse in the long run.

Investing in Real Estate

Real Estate, on the other hand, is an active investment. There’s no way around it. You’ve got to actively take a part in researching neighborhoods to make sure you’re purchasing the right area. You’ve got to actively take part in managing tenants. You’re going to have periods of time when your houses are empty because tenants leave. It’s not buy-and-hold.

As we’re writing this, we’re in the middle of the COVID-19 panic of 2020. I had tenants who could not pay their rent early on. I was also prohibited from evicting them for several months. I was still in the position of being required to pay my mortgage. This is a major issue, and I never considered the possibility that I might be forced to pay carrying costs, without the ability to evict non-paying tenants. Luckily, I was able to work out favorable arrangements with my tenants, and they are repaying a missed month or two over the course of their tenancy.

So why the heck do I invest in real estate? Isn’t it too much of a headache? Well, I feel that the extra return, especially the income yield, is so much better with real estate that it’s worth the hassle. Because I have cash reserves, I’m able to weather temporary storms that may come up, including COVID-19.

In addition, the tax benefits from depreciation are so great that they help my wife and I shelter all our real estate related income, similar to a 401K. In addition, new laws related to accelerated depreciation help us reduce our tax burden from other income. It’s an overall great deal. So where do you start?

Why Single-Family Homes are the Place to Start Real Estate Investing

My suggestion is that you start with single family homes. Sure, there’s a ton of other real estate investments out there, but the problem with them is that there’s too much room for error, and too much knowledge that must be obtained in order to invest wisely. In addition, single family homes are much less expensive, the ones we purchase are in the low $200K range, and allow you to diversify your real estate holdings much faster. At the beginning of your journey as a real estate investor, it’s best to keep it simple.

You should look for quality homes that won’t need a ton of maintenance. One of the most frustrating things that can happen to a real estate investor is getting calls from a tenant needing to fix leaky toilets, sinks, etc. Make sure you have a quality inspection of a prospective home, and get any issues fixed prior to renting. Buying newer homes, or even brand-new homes (where allowed by the builder) is another great idea. The extra you pay up front will be paid back ten-fold by the lower maintenance expenses and avoidance of headaches. 

Make sure you’re purchasing properties in good neighborhoods with good schools. Those types of properties will always have a line of tenants with kids willing to rent, and who will want to stay awhile. Providing good homes to good people is a great honor.

Speaking of tenants, it’s a good idea to make sure you investigate your tenants thoroughly to make sure they’ll pay the rent and not trash the property. Credit checks, references from prior landlords, and checking to make sure they actually have the job they claim to have are all important factors to ensure you have a successful property. Post COVID, it’s a good idea to get a sense of their payment history during the pandemic. Not so much whether they paid, but the circumstances. Did they still have a job and stiff their landlord? Well, that’s going to be a bad tenant for you. It’s equally valuable to have a tenant like mine, who lost their job and worked out a deal with me to pay their rent on the backside. That doesn’t show up on a credit report, but says a lot about my tenant’s honor and integrity.

Should you borrow money to buy real estate? I do, and I think it’s generally a good idea to do so. However, you can easily get yourself in trouble here. A mortgage on a piece of investment property allows you to buy that property sooner. Since your tenant is paying you rent, in effect they’re paying your mortgage for you. While you do have to pay interest to the bank, your investment property should be appreciating in the long term, and all that appreciation comes to you in the form of equity. Your debt principal stays fixed.

That’s an important consideration, because it’s why so many people make a ton of money in real estate, over time. If I pay $50,000 down on a $200,000 property, and it appreciates 5%, it’s now worth $210,000. But my earnings are not 5%, because I only invested $50,000. My earnings are 20% ($10,000 appreciation divided by $50,000 cash investment.

So, it’s absolutely true that debt will allow you to earn a higher return. But debt also adds risk, and can cost you your investment property if you’re unable to pay the mortgage. As we’re learning in the COVID-19 pandemic, you may not always be able to evict non-paying tenants. You’d better have cash to cover this. When you buy a new property, make sure you have 3 months of mortgage payments and expenses (faucets and toilets break) for each house you own. Now, realistically, after 3-4 houses, you can ratchet down this savings account. Why? Because the law of averages dictates you likely won’t have issues at all your properties, and eventually that cash can be reinvested for a better return. Still, it makes sense to have plenty of cash on hand of problems that inevitably arise.

You can’t get around risk in any investment, and I’ve outlined several risks inherent in real estate investing through single family homes. There are four ways to reduce that risk, as much as is possible:

1. Keep extra cash;
2. Put down a good down payment;
3. Only use fixed-rate 30-year mortgages; and 
4. Never refinance your investment properties. 

Let’s unpack each of these concepts a little further.

First, always have extra cash available. Three months reserves plus some set aside for expenses for each property, like I mentioned above, which can be ratcheted down slowly as you acquire more properties. That’s worth restating. You will have tenants leave, you will have repairs, you will have issues. Too many real estate investors don’t have the cash ready to back themselves up when it comes to their properties. The result is poor tenant retention, unrepaired issues, and a property that won’t sell for top dollar once you want to sell it.

Next, you need to put down a good down payment, at least 25% of your purchase price. Putting down less than that will leave you with razor thin margins, and not much cash flow. True, the less you put down and the more you finance the higher your yield on your invested cash will be. However, you’ll be adding an element of risk that is really not worth it. In addition, as of this writing, most banks will give a discounted interest rate if you have 25% down. They want to see that you have skin in the game, and won’t walk away from the investment if it declines in value, as happened so often during the Great Recession from 2007-2009. Back then, plenty of “real estate investors” bought over-valued properties with no cash down and interest only mortgages. When interest rates rose, their rents no longer covered the mortgage, and they defaulted. Soon thereafter, the economy turned south, and they could no longer even sell their houses to get out of the deal. Many walked away, leaving the bank holding the bag. Banks are now setting terms to make this much less likely to happen in the future.

Third, always used 30-year fixed rate mortgages on your properties. As I mentioned above, back in the Great Recession, a lot of “investors” were caught skinny dipping when the tide came out. There were a couple of reasons for this related to mortgages. First, they bought adjustable rate mortgages that ballooned into a higher interest rate at the end of the initial term, which was often 2-5 years. Once that interest rate increased, their rents no longer covered their mortgage, and they were left with no option other than foreclosure. Second, the Great Recession was a liquidity crisis, meaning that banks were not as willing to lend as they had been before. Prior to the recession, an investor was able to get a loan with less than 20% downs and with very loose credit underwriting standards. A common phrase back then was NINJA loans, meaning No Income No Job. That ended, and a lot of investors couldn’t get a replacement loan. Again, their only option was foreclosure. The solution is to set your loan up front for the long term. If your loan is set to pay off over 30 years, and your property cash flows with a few hundred dollars per month above your mortgage, it’s very unlikely that rents will drop in the future to the point you can’t cover your mortgage. This is especially true if you’ve put down a solid 25% down payment. Make sure you set your loan terms up front, with a 30-year fixed mortgage, so that you don’t get left hanging (and leave others holding the bag) when times get tough.

Finally, never refinance your properties to pull cash out of them, either to spend or invest in other properties. You want your equity in properties to increase in value over time relative to your debt load. Your rents will increase as well, and this will continually create a larger margin of safety in your portfolio, because even as one tenant leaves, and you temporarily lose rental income, you’ll be able to cover that mortgage with other properties. If you constantly refinance as soon as you have some equity, even to buy other properties, you’ll always be in a position where you NEED that property rented full time to cover your mortgage. Let your properties debt-to-equity ratio (what you owe divided by what the property is worth), decrease over time. It’ll make your world a lot less stressful.

WHAT ABOUT OTHER TYPES OF REAL ESTATE?

How long should you stick with single family homes? At some point shouldn’t you look at commercial properties? What about Multi-Family, meaning apartments? Well, I think you should stick with single family homes for a while, for several reasons. 

First of all, other property types require a lot more active management on the part of an investor. With single family homes, you can hire a manager to handle tenants, minor repairs, etc. With other types of real estate, it’s true you can hire managers, but there’s always going to be lots of decisions that need to be made from an investor perspective, such as when major improvements need to be made, tax considerations, and financing decisions. That’s definitely not insurmountable, but single-family homes are very simple, and there’s something to be said for that.

Competition from larger investors is also fierce in the commercial and multifamily world. While it’s not impossible to find good commercial deals, it’s much more difficult, and takes a very savvy investor. Most deals under $1 million listed on loopnet.com or other commercial real estate sites have a lot of issues that require hands on “value-adding”. That’s difficult to do unless you have a lot of experience. Again, I’m not saying that’s impossible, but you don’t run into that as much in the single-family market. There’s a lot of great properties in great shape for much lower dollar amounts than in the commercial world. That takes a lot of risk off the table. Once you have a robust single-family portfolio, if you’d like to jump into commercial, then by all means do so. But learn real estate investing through single-family homes to avoid making major mistakes.

I also like single family because of how easy the lending process is compared to commercial loans. Single-family homes give you a great runway because you can use low interest conventional loans to invest in up to 10 houses (20 for married couples) before you even have to think about non-conventional loans or commercial loans. A conventional loan is offered through a normal bank, but is guaranteed by one of two government sponsored entities, Fannie Mae and Freddie Mac. These loans are “packaged” by the bank along with other similar loans and sold on the secondary market as bonds.

From your perspective as the borrower, conventional loans are very easy to obtain. Banks have a systematic process for reviewing and approving these loans. You’ll provide information like tax returns and W-2’s, and the bank will approve you (assuming you’ve got good credit and otherwise qualify) and quickly fund your loan, because they know they can sell qualifying loans on the secondary market for a quick profit. 

As I mentioned before, I really like the idea of 30-year fixed rate loans, because it takes a lot of uncertainty out of your real estate investing. You’ll be able to know what your mortgage payment will be each month, and it won’t go up should interest rates change in the future. As time goes on, and you’re able to raise rents, your margin between the rent payment and your mortgage payment will grow. Contrast that to lending that’s fixed only for a 5-year period, which is common to the commercial real estate world. Your interest rate could be much higher at the end of your term, leading to a higher payment. That’s a risk and a complication you don’t want to mess with until you’ve got a lot of capital and experience!

My recommendation is that you stick with a single-family until you’ve used up your allotment of conventional loans. By that time, if you’ve followed my approach, you’ll have a lot of experience, cash flow, and equity to weather any storms you face while learning to invest in other (potentially) more lucrative real estate types.

SHOULD YOU MANAGE YOUR OWN PROPERTIES?

The question of whether or not you should manage your own properties gets asked a lot. I think it’s possible to manage your own properties, for a while. I also think it’s a good idea to get some experience managing tenants if for no other reason than to understand how the processes of qualifying tenants, negotiating rents, dealing with repairs, etc.. 

However, at some point, especially if you’ve got a day job, you’re going to need to hire a property manager to take care of your properties. You need to be an investor, and put your capital to work. You want to focus on your career, so you can earn more money and buy more real estate. Don’t make the mistake of letting property management become a second job.

In looking for a property manager, you should ask for recommendations from other real estate investors who have had a good experience. There are all kinds of property managers out there,. It helps to understand how they’ve interacted with other investors so you understand how they work, and the good and bad.

I think a good property manager can be an asset, but you’ve got to train them on how to handle matters in the manner you want, and give them authority to handle issues up to a certain dollar amount. What you don’t want is your property manager calling you every week with problems, because you might as well insert yourself into dealing directly with the tenant. Ask for references of prospective property managers, and be ready to move quickly if they are not meeting your expectations.

In terms of cost, you can expect to pay 8% to 10% of the gross rental income to your property manager. While this cost is high, a good property manager can make sure you’re not really doing anything on existing properties other than collecting rent and making major repair decisions. Generally, day to day decisions can be made by your property manager, and they (instead of you) will field phone calls from tenants.

A good property manager should do more than just manage the property. They should provide you advice on what the likely rent will be for rentals you’re considering buying. They should deal with a lot of properties in your surrounding area, and will be able to tell you (within $25-$50) what your rent will be if you buy a new property. That’s a pretty good resource when you’re looking at a possible new purchase.

WHAT SHOULD YOU LOOK FOR WHEN INVESTING IN A SINGLE-FAMILY HOME?

Now that you’ve decided to invest in single family homes, the question is what should you buy? How can you make sure you’re actually making a good investment? How can you set yourself up for success as a real estate investor?

The answer is that you need to buy good quality houses, in good neighborhoods, at good prices. You need to buy a property that’s likely to attract good tenants, who will pay stable rents. You want those tenants to love the property so they make the decision to stay there for an extended period of time, so you don’t have to continually relet the property.

The first step in thinking about real estate Is understanding how to calculate the returns from your investment. Once you understand that, you can start looking for good quality properties to add to your portfolio. I’m going to first teach you how to first (a) run the numbers in a real estate deal so you can determine what deals would be appropriate, and then (b) how to look at properties to determine whether they might make a good investment. That might seem a little backwards, but I truly feel that looking at properties is useless until you understand whether the property is mathematically a good investment.

RUNNING THE MATH 

The first thing you need to understand is how to estimate the return a property will bring, and then back into a value for the property that will give you the return you’re seeking. In my mind, the absolute minimum you should take for a real estate investment is a 6% cash-on-cash return, although I’m certainly looking for better than that. Personally, if property is under 10%, it’s got to be a really good property in an area that I think will appreciate significantly over time, in order to give me a significant “growth” return above the cash-on-cash “income” return. Remember that there’s two components to a return, (1) growth and (2) income. With real estate, the growth comes from appreciation and the income is the net of the rent above your mortgage and other expenses. 

Cash on cash return is the cash income earned on a property relative to the cash invested in a property. Again, I’m considering the net rental income (after all mortgages and expenses) only, and not any growth in the value of the house over time. While growth is obviously great, and the equity you build in a house increases your net worth, in real estate deals you need to make sure the cash return is adequate, because that’s what’s going to pay your mortgage and eventually provide the income you need to meet your living expenses. You need a minimum standard for cash on cash return in order to make sure you’ll be able to easily cover your mortgage and other expenses related to the property. If your cash-on-cash return is under 6%, it means the property you’ll introduce an element of risk of not generating enough cash to cover your expenses.

However, note that your cash on cash return can be too high, IF you’re using too much leverage on a property. You can raise your cash on cash return by borrowing more on a house. That’s because it reduces the amount of cash you’ve got invested in the property. However, borrowing too much creates less of a margin by increasing your mortgage, and that’s not advisable. So, any cash-on-cash return can only be considered legitimate if you’ve got a minimum of 25% down on the property. Otherwise, it’s not safe.

Let’s use an example to illustrate how cash-on-cash return works. Let’s pretend you’ve looked at a property that is listed at $195,000 that would cost $200,000 after ALL closing expenses. You need to factor in those expenses as they are really a cost of purchasing the property. Generally, closing costs are going to be in the neighborhood of 2-3% of the cost of the house. So, when something is listed for $195,000, you need to tack on an additional $5,000 or so in costs, which brings your cash invested cost of acquiring the home up to $200,000.

The market rental comparisons suggest that the rental property would bring in $1600 per month, or $19,200 per year. You’re paying cash so there’s no mortgage. Taxes are 2% (or $4,000) per year, and you estimate that it will cost around 5% of the rent, or $960 per year, for insurance and repairs. You’ll also pay an 8% management fee, which will equal $1,536 each year.

So, your cash from the property, each year, will be $12,704, which is that $19,200 amount less all the costs I’ve listed. Your cash invested in the property is $200,000. When you divide $12,704 by $200,000 you arrive at a 6.35% annual cash on cash return. For me, that’s good enough, but not great. In order to get a 10% return, I’d need to pay less for that house. Specifically, I’d need to pay $127,040 for that deal to work. Now, in all likelihood, a house listed for $195,000 isn’t going to drop to $127,040.

Let’s think this through. First, you could be looking in an area of town where the rentals don’t justify the costs of the house. That’s a bad market for real estate investors. You need to start by identifying areas that have good cash flow relative to property values.

Another solution could be to use leverage. In our example above, imagine that instead of paying $200,000 in cash, you pay $50,000, and finance the rest. Let’s assume your mortgage will be for $150,000 at a 4% rate of interest. This would mean a monthly payment of $716 per month, or $8,592 per year. This increases your total annual expense to $15,088. Now your net income on the rental, which was $12,704 above, is reduced further to $4,112 per year. However, your cash in the deal is only $50,000, and not $200,000. Dividing $4,112 by $50,000 gives you a cash on cash return of 8.2%, which is almost 30% higher than the 6.35% cash on cash return listed above, which is much better. 

Now imagine if we found a property similar to the one above, but it was in need of significant repairs. Maybe the roof needed to be replaced, the fence line was rotted, there was shag carpet, popcorn ceiling, and avocado green counters that came from the mid-70’s. That’s the kind of property you want to be looking for…if you have some extra cash to rehab the place. That’s because you’ll often be able to buy it at a significantly reduced price, which will increase your cash-on-cash return.

Let’s say that properties in the area that were in good shape, and up to date, would fetch the $200,000 listed above. What’s this property worth? Probably a lot less. Let’s say you could get this property for $170,000, and get it up to the same condition as nice properties in the neighborhood for $20,000. That’s not a stretch by any means.

Now you’ve got a property that you’ve paid $190,000 for total, that generates the same $1,600 per month, or $19,200 per year. However, your mortgage is now less, only $692 per month (or $8,304 per year) because you’ve paid only $190,000 for the property. Your taxes are less, only $3,800 per year. That makes your total expenses $14,600 per year. Note that the total amount you would have put down on the property, 25%, is only $45,000, rather than the $50,000 listed above.

Now we divide your annual net profit from your rehabbed property, which is $4,600, by the $45,000 of cash you’ve got invested in the property, and you’ll come up with a 10.2% return, which is superb.

So, the point of these examples is that you’re often not going to get a great return in real estate by just buying any old property for cash. You’re going to need to use the tools of reasonable leverage and discounted real estate in order to generate great cash-on-cash returns. I would suggest focusing first on getting great deals on properties, so that you need to use as little leverage as possible in order to generate the return you’re seeking. Under no circumstance should you put down less than 25% on a rental property, because (a) your mortgage costs will go up and (b) your risk will go up significantly if rents go down, because you may not be able to cover the mortgage and generate positive cash flow. Don’t be tempted to juice your cash-on-cash returns by taking unnecessary risks.

A quick note about financing rehabs. Generally, you’ll need to do a little more work in obtaining financing for a rehabbed property. The best-case scenario would be that you have the cash to rehab the property first, and then can refinance the property once it’s finished. If you need to get a loan for the deal, you may run into a bit of a challenge getting a loan to cover both the property and repairs. Another alternative is to use a line of credit, but that will only work if you’ve got sufficient equity in your house (or other assets like a stock portfolio) to secure a line of credit of that size. Banks are no longer willing to offer lines of credit on an unsecured basis for most customers, although you will see this happen in some private banks for wealthy customers.

Another common option to the lending problem above is to take out a short term “hard-money” loan from an investor. These loans are at very high interest rates, and are designed to be a short term “bridge-loan” until you complete the project and take on permanent financing. Personally, I think these loans are too risky, and I’d suggest just waiting until you have the financial means to get a normal loan on a property, as described above. 

It’s important to do the math on a potential deal to make sure it makes sense to you, and gives you at least a 6% cash-on-cash return, and hopefully one that’s higher than that. This should form your bottom line offer for the property. Note that you may get into a deal, and find out that there’s more repairs, or it’s more expensive than you thought, so the return is only 5%. Not the end of the world, but make sure you have some margin there. If you made an offer that was only going to net you a 5% return, and those same problems arose, you might be stuck with a negative cash flow property, which is no good.

LOCATION, LOCATION, LOCATION

You’ve heard the phase “location, location, location”, right? Well, that saying is definitely true when selecting a property. One of the big mistakes you can make in single-family homes is buying in a neighborhood where the math works, but the location is awful. There are plenty of neighborhoods like this, and you need to stay away.

The problem with bad neighborhoods is that they are not attractive to the good quality tenants you’re looking to get. You’ll run a greater risk of not getting paid, or your property being damaged. In addition, your property won’t appreciate over time. It’s tempting to jump on one of those $50,000 properties you see when searching the internet, because they seem cheap, and the rents advertised in the area seem like they’ll provide you with a great deal of cash flow for that price. Stay away, you won’t make that much because you’ll have a ton of vacancies overtime, because any tenant worth their salt is going to want to live in a better neighborhood.

But you don’t want to invest in too nice of a neighborhood either. What? That’s crazy, you say! I thought you would want to buy in the best neighborhood possible. The reality is that in really good neighborhoods, the yields are lower. You have less demand for rentals, because so many people are buying their houses. You’ll find that there’s a limit to the rent you can charge, because there’s a limited number of people who will be willing to pay to live in that neighborhood. You’d probably be better off buying four $200,000 houses in a good rental neighborhood than one $800,000 house in a top-notch wealthy neighborhood. It’s important to remember when thinking “location, location, location”, you’re looking for a neighborhood that is the best for investors, not necessarily the best place in town to live.

So how do you know what’s an in-between neighborhood, where you’ll make a healthy profit? You need to do some research to find your targets. Obviously, you have to consider your price point. How much of a down payment do you even have available? That’s going to limit your search to neighborhoods that fall within that framework. Here’s some tips for looking at neighborhoods for investments.

The first thing to look at is schools. Families make great tenants, because they tend to stay longer, have more stability, and pay rent on time. You can look at the greatschools.com rating for a property on realtor.com, to get a sense of how the schools are. Generally, the elementary school ratings are going to be higher than the high schools. I look for elementary schools that are above a 7, and high schools that are above a 5.

In school districts where everything is a 9 or 10, you’ll probably find that home prices are really high. This will probably be more than you want to spend on a down payment, and also the rents won’t justify the extra cost when you calculate yield. However, there are often older subdivisions in these school districts where you can find cheaper homes that make sense. In our neighborhood, where the average home price is around $600,000, there’s a couple of neighborhoods, with older homes, that are in the low $300k range. These make great investments, because there’s a ton of parents looking to rent these to get their kids into the school district.

In addition to schools, you want to understand whether a neighborhood is growing or shrinking. A great indicator is to look at the types of shopping available in a neighborhood. Are there brand-new large retailers, like Target, Walmart, etc.? Does the mall attract great quality stores that bring in a lot of shoppers? Are there brand-new restaurants being built, with national chains going in? Those companies spend a TON of money on neighborhood research. They want to be in growing communities that will have MORE potential shoppers over time.

Contrast that with a community with a lot of run-down commercial properties, with a lot of vacancies, and struggling businesses renting space. That’s probably a good sign that financially successful businesses don’t want to be in that area, because they don’t see growth potential.

Be careful of going into an area with too many luxury brands, as that may (but not always) indicate that the local houses are too expensive and won’t generate great returns. But as a rule of thumb, the better the shopping potential is judged by large retailers and restaurants, the better the neighborhood will be for you as an investor, assuming you can find a good deal.

WHERE DO YOU FIND DEALS?

Once you’ve learned how to calculate the cash on cash returns of a property, and you’ve narrowed down your search to some good neighborhoods, how do you actually go about finding deals? You obviously know the general prices of properties in the neighborhood, presumably from realtor.com or trulia.com, or some similar site.

The next step is to actually look at potential properties and make offers. When you’re beginning, this means you need to find a quality realtor. Realtors are beneficial in a number of respects, first, they have access to the Multiple Listing Service (or “MLS”) in the area. This shows not only what current properties are available, but gives market comparisons, or “Comps”, which will tell you what similar properties have sold for, in order to give you an idea of what potential properties are worth. I find the MLS is more accurate than the websites mentioned above, and will put Comps in a much better format, so you can truly get a good idea of what a property is worth.

A realtor will also benefit you by being able to write the contract on your property. I’m a lawyer myself, and have reviewed and written thousands of contracts, but even I use the advice of a realtor in new locations, because every state and even every city has different local practices and nuances that you’ll only know if you’ve done a ton of real estate deals in that area, like a local realtor.

You’ll also benefit from having a realtor (and more specifically the realtor’s team) handle your transaction. There are appraisals, inspections, repair requests, etc., that need to be done over the course of a transaction. Trying to do this yourself can not only be frustrating, but counterproductive, as you can easily make a mistake, or miss something that will cost you more in the long run.

It’s true that using a realtor will cost you money, even as a buyer. Don’t let anyone tell you different. The fact that the seller, and not you, are paying the realtor is irrelevant. If you were to go without a realtor, you could request a 2.5% or 3% reduction in the fee, as the seller would keep more of the proceeds. Despite this, it’s still a good idea to use a good realtor, as you’ll end up saving money and time, as well as finding good deals. Don’t try to go it alone, especially early in your career as an investor.

So how do you find a good realtor? I’ll first say there’s a ton of bad ones out there. It seems like there’s a million realtors in every city, looking to cash in on acting as an intermediary in real estate deals.  A lot of them don’t know anything about finding deals, running numbers to see if properties are a good investment, and don’t care if you get screwed as an investor!

Moreover, a lot of real estate agents focus on helping buyers find homes as personal residences, or helping sellers sell their home. This is residential real estate, rather than investment real estate. While these agents may understand how to price and sell homes, it’s totally different than helping an investor find good deals. Generally, the best agents in the residential market are going to work with the highest priced homes (so they get paid more), and those are generally not the homes you want to invest in anyway.

You need to find an agent who is focused on finding investment deals for investors. The first step is to ask other real estate investors you know for recommendations. Great real estate investors usually know great real estate agents. Most investors will be happy to refer out their agent, because they know that they can’t close on every deal a good agent can find, and want to make sure their agent is taken care of.

Good investment real estate agents will be out scouring for deals. They’ll look on the MLS daily for potential deals, and work with other agents to understand how the property would work as an investment. They’ll understand rental comps, and be able to determine what a property would likely bring in terms of monthly rental income. They can figure out how much repairs are likely to cost, in order to arrive at the true cash on cash yield a property will bring.

Good investment real estate agents will also own investment real estate of their own. If they truly believe that real estate is a good investment, they’ll be putting their own money into deals. In fact, you want to be with the type of agent who is only giving their investment clients deals when they themselves can’t close, due to lack of funds. Good real estate agents can also give you referrals for lenders, property managers, handymen, etc.

They’ll also try to go directly to potential sellers, cutting out other agents because they know they can save their investors’ money that way. Smart agents will take 2% or 3% commissions, knowing that their investors will close on any property they find quickly if it’s a good deal. This will bring higher yields to their investors.

Many of these agents who go directly to sellers for their clients are referred to as “wholesalers”. That just means that they are looking to connect buyers and sellers in “off-market” transactions, cutting out a listing agent. Generally, this works better for the buyer than the seller, because the price will be reduced due to lack of competitive bidding from multiple potential buyers.

Often a wholesaler will actually put the property under contract with the seller themselves, and then “flip” the contract to an investor for a higher price, the difference being their profit. For instance, the wholesaler might lock in a contract price at $150,000, and then sell that contract to an investor for $5,000, making the investor have $155,000 in the deal. That would still work out for the investor if the yield makes sense, and smart investors would gladly pay for such a deal.

You might be wondering why the seller would accept such a deal? Why would they ever sell off-market to someone, when it’s pretty clear they could get a higher price through hiring a listing agent? The reasons are many, and probably there’s many more than I’m going to list. Maybe they don’t know what their home is worth. Maybe they don’t have the money to put in the repairs that are necessary to get top dollar. Maybe the price offered is the price they had in mind for their house. Maybe they don’t want to go through showings and the hassle of listing their house on the open market. Whatever the reason, these deals are plentiful, and will net you the highest returns.

Once you’ve maxed out your 401K, you should open an account at a financial institution, and buy stocks with the remainder of your savings. In the previous section on 401Ks, I was more focused on the mechanics of the 401K, and the employer match, rather than discussing how to actually invest the money. I want you to invest those funds in the manner discussed in this chapter. Generally speaking, your 401K will have an easy online investment portal that will allow you to choose your investments. Just go ahead and invest as described below.

If you absolutely hate stocks, go ahead and skip to the real estate section. But let me say before you go that you’re missing the boat, and should investigate this further. It’s a great way to easily build long term wealth, without any effort on your part.

I also think the stock market is a good place to invest funds while you’re saving up for a down payment for real estate. With investment real estate, as we’ll discuss, you’ll need to assume you’re going to need at least a 25% down payment on your properties. You’ll also need more cash than that to cover repairs, vacancies, etc. You may even decide that you want to put down 100% on your properties in order to eliminate the risk of not being able to pay your mortgage completely.

What I’m getting at is there’s likely to be a long time between when you start saving to buy a property, and when you actually purchase the property. In the meantime, if you stick the money in the stock market, it will have a better chance of growing, and you’ll reach your goals faster.

Now, I say that with a huge caveat. The stock market goes up, but it goes down as well. There’s been periods in fact where it’s gone down in value for a LONG period of time. For instance, in times of a recession, when real estate prices are likely attractive, your portfolio will have likely declined significantly in value, leaving you unable to buy anything. If you’re not comfortable with that risk go ahead and just save cash for real estate, but understand that your money won’t be earning ANYTHING in the meantime. My personal belief is that it’s worth the risk, as your money will likely appreciate in the interim, and you can wait it out if stocks go down in value. 

The great thing about stocks is that they are a quick and easy way to build wealth. Money will automatically go from your paycheck to your 401K and your non-qualified (non-401K) stock account. You can have your account automatically invest in the stock market for you. You can do all this without any research or effort, and you’ll become wealthy over time. It’s a great deal in that respect.

Don’t listen to people who say “the stock market is risky” or “you can lose everything in stocks”. They’re wrong. If you invest correctly in the stock market, by following the instructions outlined later in this book, then over time you’ll make a ton of money in the stock market.

When I say the “Stock Market”, I mean investing in a large pool of stocks in one or more index funds, like the S&P 500. When “people” say the “Stock Market” in order to put it down, they usually mean investing in individual stocks. Yes, if you invest in individual stocks, and they go down, and you sell, you can lose money in the stock market. Whenever you hear that someone lost everything in the stock market, they were betting on individual stocks. But if you invest in index funds, like I’m telling you to do, and don’t ever sell until you retire, you won’t lose money over time.

Since 1926, the S&P 500, which is the largest 500 companies in the US, has earned about 10% per year. That’s probably going to be about what it’ll make in the future. That means if you invest your $19,500 into your 401K for 30 years, at the end of it you’ll have around $3,673,292. Want to check that for yourself? Go to google, and type “Compound Interest Calculator”. You’ll understand why Einstein called compound interest the 8th Wonder of the World.

Stocks can go down, temporarily. For instance, from October 10, 2007 to March 9, 2009, the S&P 500 went down in value 56.8%. That’s a huge downturn! You know how much you would have lost had you owned stocks but not sold during that period? Nothing! However, had you continued to invest in stocks and buy more during that period, you’d have bought a ton of stocks at lower prices. Downturns in the stock market are really just sales, that allow you to buy more stocks cheaply.

That brings us to “Dollar Cost Averaging”. According to investopedia.com, the definition is “an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase”. That’s a fancy way of saying as the stock market goes up, you make more, and as it goes down, you’re able to buy more. If you invest a portion of your paycheck each month in your 401K, and the excess into a regular stock account, then you are dollar cost averaging.

When you eventually retire, the great thing about stocks is that they pay a dividend. This means that the individual companies in your stock portfolio will pay cash to shareholders, including you, each quarter. For the S&P 500, this amount should be about 2%. While you’re working, you’ll reinvest this stream of income into your portfolio, using it to buy more stocks and grow your wealth fast. Once you retire, you’ll live off this stream of income. Simple.

OK, so what do you actually invest in? If you want to keep things ULTRA simple, and don’t want to research about investing any further, you can go ahead and invest in any reputable S&P 500 index fund. That represents the largest 500 American companies by market capitalization (value of all the stock owned by all their shareholders). Since there’s 500 companies in such a fund, you’re well diversified, meaning if one company does poorly you won’t be out of luck, because you’ll have other companies that are likely doing well.

What kind of a return can you expect? Historically, the S&P 500 has returned around 10%, and that’s probably about what you can expect over any 20 to 30-year period. There’s going to be ups and downs of course, but over the long run you’ll earn a solid return with an S&P 500 index fund, without having to put much thought into it.

Companies like Vanguard, Fidelity, and others have very well-known S&P 500 Index Funds they sell, and these are great investments, even if you owned nothing else. In fact, Warren Buffet himself has said “In my view, for most people, the best thing to do is to own the S&P 500 index fund.” It’s really that simple.

If you did NOTHING but invest in an S&P 500 Index Fund, you’d earn around 10% over time, and that’d be more than enough to make you wealthy over the course of your life. Of course, there are ways to make a little more, with a little less volatility. That being said, you shouldn’t expect gigantic benefits out of spreading your investments far beyond the S&P 500. Still, if you’re interested, it might be worth the effort.

There are several other classes of index funds that offer the stocks of companies outside of the S&P 500. Theoretically, you’d want to spread your investment dollars over every single company in the world, in parts equal to the size of those companies. You’d want to be earning money off the hot dog vendor in New York City and the shoemaker in India, as much as the largest companies in Silicon Valley and Wall Street. The successes would far outweigh the failures, and the smaller companies would actually grow faster than the large ones (because they have more room to grow faster). That’s obviously impossible, but it makes sense to at least look at opportunities beyond the largest 500 companies in the US.

You can start by looking at large companies around the world. A global ex-US (excluding the US) index fund is a great way to invest in the world at large, and makes a great compliment to the S&P 500 index fund. There are gigantic companies around the world that are great businesses, making great products and offering great services, and you should invest in those as well.

There are also other types of business classes in the US that are worth looking at, Mid-Cap and Small Cap companies. Cap, or Capitalization, refers to the total market size of all the stock in a company. Mid-Cap and Small-Cap Index funds allow you to invest in thousands of companies which are not as large as S&P 500 companies, but are still large enough to be public and warrant consideration for investment.

Theoretically, you’d expect Small-Cap companies to grow faster (and offer a higher return) than Mid-Cap, and Mid-Cap to grow faster to Large-Cap stocks on the S&P 500. Why? They have more runway. While certainly there’s more risk in individual Small-Cap stocks, after all they could go out of business, there’s room for some of them to grow and eventually become Large Cap stocks. Companies like Google, Facebook, and Amazon, all started out as small companies.

Emerging Markets are a unique type of stock as well. They reflect all the less developed nations out there, what we used to call the Third World, back in the Cold War days. Now, as globalization has spread, and people are investing in poorer economies, companies within those countries have begun to flourish, and your opportunity to invest in them comes in the form of Emerging Market Index Funds. The most prevalent Emerging Market countries are the “BRICs”, meaning Brazil, Russia, India, and China. Not exactly small economies, but they earn their emerging market status from being less developed relative to Europe, Japan, etc. in terms of financial markets. Note that there’s a TON of risk with any individual Emerging Market stock. Accounting laws are looser, legal systems are not as developed, and governments are corrupt. However, by investing in all emerging market companies through an Index Fund you can avoid the isolated disasters, and take advantage of the market as a whole.

HOW TO CREATE A STOCK PORTFOLIO

Now that I’ve laid out the various types of stock index funds you should consider buying, how do you “build” a portfolio. If you listen to financial institutions, you need to have a well-diversified portfolio. What the heck does this mean? Well, it’s the idea that you need a lot of variety in your investments, so that some zig while others zag, smoothing out your returns over time.

As you read above, I’m a big fan of the S&P 500. It’s made up of the 500 largest companies in the US, so it’s already diversified. The fact that those companies are in the US gives them the protection of the greatest financial powerhouse the world has ever known. It also gives them the rule of law, less corruption than other countries, and accounting rules that give you comfort that most of those 500 companies will report their true condition.

Again, I’m fine if the ONLY investment you choose is an S&P 500 Index Fund. It’s well diversified already, and it’s always a good idea to bet on America. How better to do that then bet on the largest 500 companies in America? The largest part of any portfolio should be this S&P 500 Index fund, and I’d never recommend less than a 60% allocation.

However, I also said above that there is some benefit to expanding into these other types of index funds. Because these indexes contain (on the whole) companies that are smaller than the US S&P 500 companies, they have more runway for growth. However, I would limit the ex-US global index fund to 25%, and the other types (Small-Cap, Mid-Cap, and Emerging Markets) to 5% each.

This would mean that that a good portfolio might look like this:

1. 60% S&P 500
2. 25% Global ex-US
3. 5% Mid-Cap
4. 5% Small-Cap
5. 5% Emerging Market

It’s that simple to create a well-diversified portfolio that will serve you well over the long term.

WHAT ABOUT BONDS?

Bonds are a debt obligation owed to you by the government or companies. They pay you a rate of interest each month, and you get your principal back at the end. The problem with bonds is that all you get is the interest. The principal doesn’t grow. That means the total return, or growth plus income, is always going to be lower for bonds, compared to stocks, in the long run. While there are short periods of time when bonds outperform stocks, this is usually during a bear market recession when interest rates are going down, in the long run you’ll lose with bonds.

Even during retirement, you’ll fare better with stocks than bonds, as long as you commit to never selling. While the dividend yield, 2% for the S&P 500 for instance, is lower than bonds, your income will grow over time, because that yield is based on the total value of your portfolio. 

Bonds will pay out more up front, probably even double, although that’s not true as of the time we’re writing this book. However, the principal never grows, so the overall income payment won’t increase much over time. This is getting confusing, so let’s do an example. Let’s say you’re 60 when you retire. You’ve saved your 30 years’ worth of $19,500 401K contributions and have the $3,673,292 from my earlier example, because you followed our advice and got a 10% return.

If you keep it in stocks, you’ll get a growth component plus an income component, that will equal that 10% total return. Your income component, historically, should be about 2%, so let’s use that in our example. That means your growth should be about 8% a year. It might be a little more or a little less, depending on the market’s performance, but over a full market cycle of about 20 years, that should be about what you get. Also note that growth is not linear, meaning that you might have a lot of growth one year, and no growth, or even negative growth the following. However, even when the market goes down, your dividend amount should hold pretty true, because companies usually try not to cut their dividends, even when the market goes down.

So, in year one, you’ll get dividend income of about $73,465.84, along with growth of about $293,863.36. That growth is important, because it means your net dividend payment should increase by about 8% a year. By year 10, your dividend will be $146,858.55, and by year 20, your income will skyrocket to $317,056.60. All along, your principal will have increased significantly as well, ending the 20-year period at $15,852,830. Again, the wonders of compound interest.

Here’s a chart that shows this in action:

Year	Principal	Growth	Principal Growth	Income Yield	Income
1	$3,673,292.00	8%	$293,863.36	2%	$73,465.84
2	$3,967,155.36	8%	$317,372.43	2%	$79,343.11
3	$4,284,527.79	8%	$342,762.22	2%	$85,690.56
4	$4,627,290.01	8%	$370,183.20	2%	$92,545.80
5	$4,997,473.21	8%	$399,797.86	2%	$99,949.46
6	$5,397,271.07	8%	$431,781.69	2%	$107,945.42
7	$5,829,052.76	8%	$466,324.22	2%	$116,581.06
8	$6,295,376.98	8%	$503,630.16	2%	$125,907.54
9	$6,799,007.13	8%	$543,920.57	2%	$135,980.14
10	$7,342,927.70	8%	$587,434.22	2%	$146,858.55
11	$7,930,361.92	8%	$634,428.95	2%	$158,607.24
12	$8,564,790.87	8%	$685,183.27	2%	$171,295.82
13	$9,249,974.14	8%	$739,997.93	2%	$184,999.48
14	$9,989,972.08	8%	$799,197.77	2%	$199,799.44
15	$10,789,169.84	8%	$863,133.59	2%	$215,783.40
16	$11,652,303.43	8%	$932,184.27	2%	$233,046.07
17	$12,584,487.70	8%	$1,006,759.02	2%	$251,689.75
18	$13,591,246.72	8%	$1,087,299.74	2%	$271,824.93
19	$14,678,546.46	8%	$1,174,283.72	2%	$293,570.93
20	$15,852,830.17	8%	$1,268,226.41	2%	$317,056.60

Now let’s talk about bonds. If you invest in bonds, you shouldn’t really see any growth. Again, with a bond, you’re loaning money in exchange for an interest payment, and getting back your principal when the bond matures. However, due to things like (a) bond prices temporarily rising when interest rates drop and (b) bonds being sold and discounts and premiums, you should see slight appreciation over time in practice. Those concepts are beyond the scope of this book, but let’s assume you should see 1% growth in your bonds over the course of a 20-year period.

You also should see higher income yield with bonds over dividends as well. While interest rates are extremely low right now, it’s a good bet that over a 20-year period your income yield should be around 4% (hopefully).

Let’s return to our example of your nest egg of $3,673,292, but now let’s assume you sell all your stocks and convert to bonds. First of all, note that if this happens in a 401K or IRA, there’d be no tax, because those accounts are tax sheltered until actual distributions are made.

In your first year, your 4% income yield would give you $146,931.68 of income, which is double the dividends you’d get with your stock portfolio. So why wouldn’t you just do that??? Well, there’s also the growth component. Your bond portfolio is only growing at about 1% per year, compared to the stock portfolio’s 8% growth. This means that your income yield with the bonds is growing slower as well.

In fact, the stock portfolio dividend payment overtakes the bond portfolio payment in year 12. By year 20, your stock portfolio is paying $317,056.60, but the bonds are paying only $177,509.48. Worse, your principal in the bond portfolio has grown to only $4,437,736.94, compared to the stock portfolio at $15,852,830.17. 

Here’s the chart showing bond performance:

Year	Principal	Growth	Principal Growth	Income Yield	Income
1	$3,673,292.00	1%	$36,732.92	4%	$146,931.68
2	$3,710,024.92	1%	$37,100.25	4%	$148,401.00
3	$3,747,125.17	1%	$37,471.25	4%	$149,885.01
4	$3,784,596.42	1%	$37,845.96	4%	$151,383.86
5	$3,822,442.39	1%	$38,224.42	4%	$152,897.70
6	$3,860,666.81	1%	$38,606.67	4%	$154,426.67
7	$3,899,273.48	1%	$38,992.73	4%	$155,970.94
8	$3,938,266.21	1%	$39,382.66	4%	$157,530.65
9	$3,977,648.87	1%	$39,776.49	4%	$159,105.95
10	$4,017,425.36	1%	$40,174.25	4%	$160,697.01
11	$4,057,599.62	1%	$40,576.00	4%	$162,303.98
12	$4,098,175.61	1%	$40,981.76	4%	$163,927.02
13	$4,139,157.37	1%	$41,391.57	4%	$165,566.29
14	$4,180,548.94	1%	$41,805.49	4%	$167,221.96
15	$4,222,354.43	1%	$42,223.54	4%	$168,894.18
16	$4,264,577.98	1%	$42,645.78	4%	$170,583.12
17	$4,307,223.76	1%	$43,072.24	4%	$172,288.95
18	$4,350,295.99	1%	$43,502.96	4%	$174,011.84
19	$4,393,798.95	1%	$43,937.99	4%	$175,751.96
20	$4,437,736.94	1%	$44,377.37	4%	$177,509.48

This means that with a bond portfolio, you’ll generate more income in the short run, but you’ll lose out in the long run. In addition, when you eventually pass away, you’ll be leaving a lot less to your family.

The (theoretical) advantage of bonds is that they are a lot less volatile than stocks. So, if you absolutely can’t stand volatility and sell every time the market goes down, maybe bonds are the only thing you’ll be able to handle investing in. In addition, if you started saving late, and don’t have enough dividend income coming in to live off, you may be forced to generate more income through bonds. However, in the long run, you’ll lose out.

VOLATILITY

A constant question in investing is how to deal with volatility. We are told constantly that one needs to be worried about volatility, theories about how to combat volatility. My personal opinion is that the current approach used, hedging, is all wrong. These common techniques will lead you to accept lower returns over time in exchange for less fluctuation in the short term.

The first thing many experts advise when faced with volatility is to hedge your investments with assets that will zig when the market zags in order to reduce volatility. Bonds are a good example. When the economy dips, and the stock market inevitably goes down, the thought process is that bonds will benefit from The Federal Reserve (‘the Fed’) action to cut interest rates. This is because your bonds would then offer a higher interest rate than newly issued bonds (the lower rate set by the Fed). Thus, your portfolio doesn’t go down as much as it otherwise would.

The problem with this theory is that bonds will never earn as much as stocks in the first place, and will hold back your returns the whole time you have them in the portfolio. Especially today, why would you have a bond in your portfolio earning 2%-4% over the next 10 years? Sure, when the market tanks, then bonds will go up a little, because their interest rate will be more attractive than newly issued bonds. But why deal with the constant underperformance over the life of the portfolio?

Financial advisors sell all sorts of investments based on this premise that are absolute crap. Hedge investments are a great example. A hedge investment is designed to invest in assets that don’t correlate to the stock market (I’ll distinguish high return hedge funds in a future chapter). That means these assets won’t go down (at least to the same extent) when the stock market declines. The problem is that most of them won’t go up as much as the stock market in the long term, especially when weighed down by heavy fees charged by the investment managers. These hedges are extremely trendy, but are terrible for the average investor.

The solution to dealing with volatility is realizing that it is temporary in nature, and waiting for stocks to inevitably come back when market corrections happen. For instance, as I’m writing this, in 2020, we had a HUGE market meltdown due to COVID-19 shutting down America. The S&P 500 reached a high on February 19, 2020,of 3,386. Just a few weeks later, on March 23rd, it bottomed out at 2,238, representing a decline of 33%. However, as I write this, it’s currently almost back to it’s high, just a few months later. That’s a quick recovery, but it’s the same recovery that inevitably happens in every market downturn. Sure, maybe by hedging your portfolio you’d only go down 25%, instead of 33%. But given the strong likelihood of a recovery, which spend the remainder of the time getting less than the 10% return you’re going to get over time by investing in the portfolio I described above.

Another advantage of volatility, if you’re investing only in stocks I’ve described, is the effects of dollar cost averaging. In the current downturn, if you were investing in index funds with each paycheck, you’d be buying the stock market on the cheap during the downturn, allowing your portfolio to rocket upwards as the market recovers. Don’t sell yourself short by hedging with low performing investments!

DO I NEED A FINANCIAL ADVISOR?

A question I’m constantly asked, particularly since I used to be in the wealth management business, is whether it’s a good idea to hire a financial advisor. For most people, the answer is no. For people who have less than $5M to invest, you won’t be able to find an advisor who will be able to give you outsized returns in relation to their fee. You will be much better off following the advice above.

Furthermore, the investment industry is in many ways set up in a manner that is actually designed to limit your success. Stated another way, if you get involved with most financial advisors, the way they’re compensated will ensure your returns will be less  according to the method I’ve outlined above. It’s very difficult for financial advisors to justify their fee by following the advice listed above, and they’ll often insert lower return, expensive products into a portfolio in order to justify the fee their charging clients. In addition, the fees associated with “investments” like cash value life insurance, annuities, hedge funds, etc., are where the real money is made in the industry. It’s hard for financial advisors not to convince themselves these items are good investments, because the commissions are so high! The incentives are all wrong!

First of all, many financial advisors fancy themselves as stock pickers. They think they can get returns above the S&P 500 by picking individual stocks they think have great odds of success going forward. I think this is a fallacy, and I further think that if they were so good, they’d be working for a large hedge fund, rather than advising individual investors. Time after time, I’ve seen stock pickers in this vein blow up their clients’ portfolios. 

The reason is companies nowadays have become so complex,  it’s impossible to know their true state without insider information (which is illegal). There are things going on at companies every day that would seriously affect the way market experts look at the company. However, these material items don’t make their way into the news at large, except in quarterly reports and other special announcements. Even accounting is manipulated, to some extent, to deal with timing and recognition issues that, while perfectly legal, allow companies to massage their numbers to meet the short-term predictions of Wall Street analysts.

A common role model for financial advisors is Warren Buffett. They’ll fancy themselves value investors, in the Benjamin Graham model. Indeed, I’ve read Graham’s “Intelligent Investor” and it’s really been insightful, especially as to the valuation of companies. The problem with this approach is that it ignores Buffett’s intuitive genius about the management of companies, which almost every other advisor lacks. I’d also argue that Berkshire Hathaway is much more like a Private Equity company (discussed in a subsequent chapter) than a simple stock picker, and their deals with buying stock are often extra-market transactions that you and I would not be able to execute. Furthermore, early in his career, when his capital was lower, and he was much more of a traditional stock picker, Mr. Buffett was privy to information (by attending shareholder meetings, speaking to executives with companies, etc.) that while legal at the time, would be considered inside information today.

There’s no doubt that there are investors able to generate outsized returns. Warren Buffett is the best example, but there’s a ton of others out there. Howard Marks, Stanley Drunkenmiller, Paul Tudor Jones, these are all famous names that have made their clients lots of money. Often, they invest in asset classes outside of equities and still earn extremely high returns. But they’re investing for institutional investors, like pension funds, family offices, etc. You can’t invest smaller sums with them. Furthermore, if you invest with someone who says they’re going to get your returns higher than the S&P 500, how do you know that’s true? The VAST majority of stock pickers earn returns much lower than the S&P 500, so it’s not a good bet. In all likelihood, if you go with someone trying to out earn the investments I’ve described above, you’ll earn less, and pay a hefty fee for the “privilege” of poor performance.

HERE’S WHEN YOU DO NEED A FINANCIAL ADVISOR

So, I’ve just spent some time outlining why most financial advisors are a waste of money. Now I’m going to discuss when a financial advisor might make sense for you. If you are unable to invest in the manner I’ve described previously without selling out when the market goes down in value, you may need a financial advisor. Let me give some examples.

As I mentioned before, when the market dropped 33% between February and March of 2020, due to COVID-19 concerns, many investors sold all their stocks and went to cash. If this was you, you locked in your losses and killed any investment returns you might have gotten. That’s a huge mistake, and you don’t have the temperament (or discipline) to invest in the stock market on your own. In that case, it would be a good idea for you to hire a financial advisor to invest in substantially the same manner I’ve described above. The 1% of your portfolio value to pay each year for outsourcing your investment management will be well worth the fee. In essence, instead of the 10%-12% returns I’ve described above, your returns will be more like 9%-11%.

In essence, this type of a financial advisor is more like a coach or therapist than a stock picker, and that’s just fine. Instead of trying to beat the market or time the market, they’re just trying to keep you in the market. When the market tanks, it’s very helpful for fearful stock investors not to have the nuclear option of selling and going to cash in their own hands, on an online brokerage platform. It’s MUCH better to be forced to call your financial advisor, who would then have the opportunity to act as your voice of reason and keep you from making a HUGE mistake.

Let me give you a funny example. When it became apparent that Donald Trump had been elected president (a huge surprise in 2016), the overnight futures for equities tanked big time. This overnight futures market essentially lets people bet on how they think the market is going to do the next day, and obviously investors (speculators really) were betting it would do terribly. I started getting texts from a client around 7pm telling me to sell his entire portfolio and go to cash. Luckily for him, the markets were not even open at the time, so I couldn’t sell even if I was willing to follow his bad instincts. We kept texting back and forth, and finally I called him and told him that this was a huge mistake, and we’d talk in the morning. I called him at 6:30am Pacific Standard Time, but couldn’t get a hold of him. Meanwhile, the stock market, which had opened by that time, started going up. Then it kept going up, and up, and up! Finally, my client emailed me around 10am. It turned out he was so distraught by the news of the futures market that he’d drank until he fell asleep and now had a huge hangover. Good thing the only pain he was feeling was a headache and not losing money with foolishness! That’s the advantage a financial advisor can plan, talking you out of a bad decision.

Myself, I don’t really need a financial advisor because I’m immune to worrying about stock market fluctuations. When it goes down, I look to buy more. When it goes up, I leave it alone and don’t think too much about it. I know that over the long run, I’ll get around a 10-12% return, and that’s fine by me. I also know that I’m no stock picking guru, and I don’t try to beat the market, I just try to be the market. I will admit that I have a little side account with about $5,000 that I play around with for speculating. I’m currently reading about merger arbitrage and want to place a few bets in that area for fun. I’m under no illusion that I’ll do well, and the reality is that I’m pretty confident I’ll severely underperform my normal portfolio with that account!

FINANCIAL ADVISORS FOR WEALTHY PEOPLE

Financial advisors for very wealthy people, who have more than $5,000,000 in investable assets, are a bit different than I’ve described above. I want to go over their utility not because I think you necessarily need to find one who offers these benefits. If you have less than $5,000,000 to invest, you won’t be able to get access to the types of advisors I’m speaking about. However, if you follow the general investments principals I’ve outlined, there is a likelihood that, at some point in your life, you’ll qualify for access, and I want you to understand what these financial advisors do.

Generally good financial advisors at the $5,000,000 plus level are referred to as “Wealth Managers” or “Wealth Advisors” to denote that their advice goes far beyond simple investments. In fact, at this level there’s a combination of investments, banking service and estate planning advice that becomes crucial, and the banking and estate planning becomes more and more important as net worth increases.

Very wealthy people typically have a myriad of banking transactions that get more complex. First of all, they often have lines of credit, secured by real estate or investments. Wealthy people will often use these lines for opportunistic investing. Opportunistic investing just means investing in things when they’re temporarily cheap.

Often, an investment opportunity will come about when the stock market is down or there’s otherwise temporary drama about in the financial markets. Well, if the market’s down, you won’t do yourself any good by selling your depreciated assets (locking in those losses) to invest in others. Those assets you already own will eventually come back, and you’ll miss those gains. Waiting for stock market index fund assets to come back is one of the surest returns you’ll ever get, and you don’t want to screw that up.

Instead, wealthy people will borrow for a short period on their line of credit, paying a low amount of interest to the bank, and then settling their debt when the market comes back to life. They not only get the benefit of their original portfolio roaring back, but they’ll benefit from their new investment even more.

Wealthy people will also use lines of credit for opportunistic real estate acquisitions. Often, if you pay cash (a line of credit gives you access to cash) you can close quickly on an undervalued piece of real estate which is worth much less than it would be if it were fixed up. Wealthy people will buy the property with their line of credit, fix it up with their line of credit, and then put permanent financing on the property once they’re all done. Oftentimes, the benefit of doing this is that you’ll be able to pay off the line of credit completely with the permanent financing, or at least have to come into the deal with very little cash. If you are able to pull off having no cash in the deal, you’ve generated an infinite return. More on that later in the real estate section.

Financial Advisors to the wealthy will also offer their clients access to more assets than you will have access. Wait, didn’t I just say above that you don’t need more investments than index funds? Well, yes that’s true, but there’s also other types of assets, like private equity, private real estate, and even private debt, that have high minimums, but offer higher returns than even the stock market.

In addition, wealthy clients who already have their income needs met by their investments are often looking more for safety than additional growth. You NEED growth if you’re ever going to have your investments pay for your living expenses. People who are already wealthy don’t. They have a much more vested interest in protecting their wealth, than enhancing it. They are willing to give up potential returns in exchange for safety, which is something you cannot afford to do if you’re not yet wealthy.

It’s important to note that not all wealthy people choose good advisors, and many get ripped off. Vast fortunes have been lost by advisors who’ve invested their clients’ money in risky investments. Often advisors choose to put their clients into investments that pay the highest commissions, rather than offer the greatest returns. Some advisors outright steal from their wealthy clients, a la Bernie Madoff.

Both wealthy individuals and yourself should understand that the foundation of a good investment plan is similar to what I’ve outlined above. Cash to weather storms and equity index funds will always be the way to go in order to make your assets grow over time. Wealthy people would be wise not to stray too far from that path, and make sure their advisors don’t pull them in the wrong direction.

You should first invest in your company’s 401K plan, up to the annual limit. Currently, you can put $19,500 into your 401K plan each year, with an additional $6,500 “catch-up” allowed if you’re older than 50. This is a great deal for several reasons.

First, it’s easy. You can have the amount automatically deducted each month simply by choosing to do so on your employee portal, or with the help of your Human Resources director. You don’t need to even open an account at a financial institution.

Second, the tax benefits are outstanding. You get to deduct any amounts contributed. They get wiped off your taxable income, and that lowers your tax bill each year. If you have access to a “Roth” 401K, that’s even better. You pay tax up front, but then the money grows tax free, and you don’t pay taxes on the money when you eventually spend it in retirement. You can’t pull ANY of it out until you’re over 59.5 years old, otherwise you’ll get a tax penalty. But that’s a good thing, you don’t need to pull it out, and the tax penalties make sure you have an extra incentive to leave it in there!

If you don’t have a 401K available at work, you can establish an IRA account at a financial institution, and get similar tax benefits. The annual investment limits are lower, $6,000 with an extra $1,000 if you’re older than 50, but the tax benefits work in much the same way, and you have a Roth option. It’s a good approach to investing if it’s your only option, although the 401K is less hassle to set up.

The third benefit of the 401K is the employer match, if it’s offered. Usually your employer will match up to a certain percentage of your income, say 6%. This means if you make $100,000, and you contribute to your 401K, your employer will match the first $6,000 you put in. Think about that! That’s a 100% return on that $6,000, right away. That’s the best return you can possibly get in investing!

Generally speaking, your 401K should be invested just like a normal stock portfolio, which will be discussed later. Your 401K plan should have some easy investment options. If you’re not willing to read the section later in the book where we discuss stock investments, just choose the option for “Large Cap”, which may also be called “S&P 500” in some plans. 

If you HATE stocks, I don’t care. You need to invest in your 401K. The benefits are too great. It’s a shame that so many Americans have access to such a great wealth building tool and never use it during their lifetimes. It’s so simple, and automatic. If you did nothing but invest the maximum amount in your 401K from age 30 until retirement at 65, you’d retire a millionaire. It’s that simple. Do it.

Until you’re a millionaire, investing should be limited to stocks and real estate. That’s it, plain and simple. Those investments are the easiest to get started in, and should be your focus when you’re first investing.

Your approach should be as follows:

1. Invest in your Company 401K Plan up to the annual limit;
2. Invest in a Non-Qualified Stock account; and/or
3. Buy Single Family Home for Real Estate Rentals.

I’m not going to comment, or try to persuade you, about whether stocks or real estate is a better investment. I have both, and they’re both really great investments. I know that some people only like real estate, because it’s a tangible asset they can touch. Then again, some hate it because they don’t want to deal with renters. Some love stocks because they’re easy, some hate them because they’re volatile. It doesn’t matter, and is not an argument worth having.

Whatever you think is fine by me, as long as you invest. Some people have a negative thing to say about any type of investment, and usually those people are broke. People talk about “risk” as if it’s inevitable that you’ll lose all the money you invest to some huckster or market crash. That’s silly.

In reality, risk is what you must take on in order to get a return. There’s a risk that the companies you hold stock in  will go out of business. So, they must earn you a return in order to get you to invest. There’s a risk tenants will leave and not pay the rent. So, you must earn a return in order to invest in real estate. Otherwise no one would invest.

While you can’t get away from risk entirely, especially in the short run, you can eliminate the chance that your investments will evaporate by investing wisely, for the long term, in the manner I’m going to describe throughout this book. Don’t fear risk, but understand it, and realize that most risk is short term in nature. Risk can also be countered completely with your emergency fund, which prevents you from needing to liquidate assets that have declined in value to cover your short term cash needs.

The main point here is that you need to invest, wisely, and accept some risk to get a reasonable return. Your goal should be to generate enough of a net worth so that at some point down the road you can retire, and have your investments pay for your living expenses.

This brings up a great point about how you will eventually live off your assets in retirement. You need to understand the difference between income, growth, and total return for any investment. The income of an investment is the cash it generates each month (or quarter). The growth is the increase in the value of the asset, should you sell it. The total return is the combination of the two.

The optimal scenario is that the income generated from your investments will provide enough cash to meet your monthly expenses. That way, you don’t actually have to sell assets to meet your living needs. This is stressful, because you’re in essence killing the goose that laid the golden egg (to borrow an overused cliché).

Generally speaking, real estate generates a higher amount of income (and less growth), and stocks generate higher growth (and less income). This is not always the case, but will generally hold true for the investment advice I give in this book. This does not necessarily mean you should choose one approach or the other, but you should be aware of both your growth and income for your investment choices, and how that will affect you when you ultimately decide to retire. 

The next thing to do, if you don’t already own a home, is to save for a down payment to buy a house. Houses are a great wealth building tool, and offer a source of security and stability for your family. Now instead of rent going to a landlord, your mortgage payments are going to an asset which you own. However, it’s important to not get overstretched with a house, so let’s discuss some parameters here.

The first thing to know is that you need to invest for retirement, following the principals I’ve outlined in the next few chapters. However, it’s fine to postpone that for up to a year, and no more, while you save up a good down payment for your house. My recommendation is this amount is at least 10% of the purchase price, although 20% would be great.

The reason you need a good strong down payment is to protect yourself against real estate prices going down when you need to sell. You never know when you’ll be forced to sell because of a new job, life change, or just because you want to leave a certain city or state. If you don’t have a cushion of equity, you’ll be stuck. You won’t be able to afford the realtor fees and closing costs, and your home will sit and get foreclosed upon. While it may be tempting to do those low money down loan deals, it’s really dangerous, and you should take the time to sock away some cash to put up a real strong down payment.

You’ll also get much better mortgage terms. When you have 20% down on a house, you don’t have to pay for mortgage insurance, which lowers your payment substantially. More of each payment you make will go towards paying down principal, which is a key component of building wealth through home equity.

How much home can you afford? Well, the more you spend on your home, the less will be available for other wealth building investments. So, you don’t want to spend too much. A good rule of thumb is to make sure you’re not spending more than ¼ of your take home pay on your mortgage. Any more than that, and you’re going to have a tough time stretching your paycheck to cover your bills while still investing in your future.

A lot of people make the mistake of treating their home as equal to their other investments. This is not the case. While a home does build wealth, in the form of equity, it will never provide any sort of income for you to live off. Quite the opposite, as you will constantly be throwing money into your home to fix the roof, replace the water heater, etc.

Your home is simply a place of stability and harmony for raising your family. While I want you to live in a great, safe neighborhood, with great people surrounding you, don’t do this at the expense of your future. While good schools are a plus, your child’s economic future will not be impacted much (if at all) by their school. It’s just not the case. Your child’s scholastic background (this is true even through college) has very little impact on their overall future. Don’t use that as an excuse to get roped into a more expensive home. It’s not worth it.

Your goal should be to pay down your house as fast as possible, because one of the tenets of retirement is that you need to be completely debt free and not burdened with a mortgage payment. That way, your investments don’t need to produce as big of an income in order to meet your needs.

Let’s walk this out. Pretend your income is $100,000, and you spend $25,000 per year on your home (25%) and another $24,000 (24%) on saving. Forget about raises and inflation in our example. The minute you retire, if your home is paid off, you only need to make $51,000 in order to keep your exact same lifestyle. That’s because you’ll no longer need to keep saving, because you’re retired, and you don’t have a house payment. If you retire with a mortgage, you’ll need to have your investments produce $75,000 of income for you. Big difference!

In sum, a lot of people make huge mistakes when buying their home. They buy it before they’re ready, without a good emergency fund to back themselves. Things will go wrong in your home, and you’ll need to have cash available to avoid credit cards. When you’re the renter, the landlord covers it. When you’re the owner, it’s on you. Make sure you’re ready to truly care for your home prior to purchase. Also, remember that if you buy more home than you can afford, you’ll be sorry later because you’re siphoning off money that could otherwise be used to invest in your future. A home is a wonderful thing, it’s part of the American dream, but please make sure you do it the right way!

Ok, now that you’re out of debt, you may be wondering what’s next? Invest in stocks? Buy some real estate? Hold on there a minute! The first thing you need to do is create some margin of safety, or “margin” in your life. This point is the crucial stage of setting a proper foundation for wealth building, and if you skip setting your foundation, you’ll create a house of cards that will fall eventually.

To establish a foundation for building wealth, you need an emergency fund with at least 3 months’ worth of cash to cover your normal living expenses. We talked about having a small emergency fund, equal to 1% of your salary, just in case something happens, i.e., car repairs, medical bills, etc. You need to expand this emergency fund first to make sure you don’t take a step backward should something go wrong.

You need a larger emergency fund than that, once you’re out of debt, to deal with larger emergencies that might happen, like a job loss, before you move on to buying a house and purchasing long term investments. The biggest risk you have of derailing your wealth building is having to raise cash when you fall on hard times. It’s much better to have a good solid reserve of cash to create a margin for you to live off of while you go look for and find another job. That way you don’t have to take the first thing that comes along, but can do a diligent search that will put you in a position for success.

The problem with having a house without cash is that you’re going to be in a world of hurt without cash to deal with a short term job loss. You’ll be unable to pay your mortgage, negatively affect your credit, and the stress will turn your house into a nightmare. In addition, once you own a home (as opposed to rent) there’s things that need to be repaired, with large price tags. You need to sock away cash to make this happen.

It’s also not a good idea to start investing until you have your full 3 months’ worth of emergency fund in place. The problem with focusing everything on long term investments is that you’ll need to raid these eventually to meet the needs of short term emergencies, and that’s not a recipe for success. If you think about it, oftentimes job losses correspond with recessions, when the stock market is down. That’s exactly the wrong time to liquidate your stocks to raise cash. If you’re a real estate investor, often those emergencies will happen when houses won’t sell or drop in value. For example, the temporary restrictions on evictions in the wake of COVID-19 caused many landlords heartburn, as they had to continue paying mortgages, despite tenants not paying rent.

There’s another problem to relying on investments to cover short term emergencies, and that’s taxes. As I’ll mention later, a 401K is a GREAT way to get started investing for retirement. However, the caveat is that there are tax penalties for withdrawing from a 401K prior to age 59.5. So not only could you reduce your investments available for retirement, but you’ll also have to come up with more cash to pay taxes. Not a good deal! 

How much should be in your emergency fund? You need enough to cover your short term job loss needs as a start. This means a minimum of 3 times your monthly take home salary. However, you should try to keep saving some cash even after you reach that amount. First of all, it never hurts to have extra cash on hand to deal with a job loss. More importantly, when other emergencies or large expenditures come up, i.e., replace a roof, a/c, etc., you’ll have sufficient cash on hand. You should also be saving cash towards the purchase of new cars down the road, because your current car will wear out and will need to be replaced. 

There comes a point where you’ve got too much cash, and that’s probably around 6 months of living expenses. The problem is that cash doesn’t earn anything. In reality, it loses money (safely) to inflation. While it is a great comfort to have plenty of cash on hand, there comes a point where it’s overkill.

My recommendation is that you do not invest until you get to three months of salary in your emergency fund. Then set aside 1-5% of your income to keep cash flowing into your emergency fund, so you can have cash available for large purchases. Never drop below 3 months, but shut down when you get to 6 months of your take home pay in that emergency fund.

Assuming you have some cash for an Emergency Fund, you’re ready to start investing. But let’s recap where you’ve come thus far. You started in debt, and now you are debt free. You’ve trained yourself to live off less than you make. You’ve got 24% (or more) of your income that you’ve trained yourself to commit to the future. That’s exciting, because now you’re ready to create a lot of wealth and stability for your family. Keep on the path, it’s about to get fun!

You can’t get rich if you have debt. It’s that simple. If you borrow money for your lifestyle, you’re losing. You’re falling behind, and you won’t be able to catch up. Rich people do not borrow money for their lifestyle needs.

Let me clarify that. Some rich people do borrow money for investments. I personally borrow money to invest in real estate that makes me money. Some rich people do borrow money for things like their house. I have a mortgage on my primary residence. Some rich people even borrow money for things like airplanes and yachts, so they don’t have to liquidate other income producing assets. Let me say before I move on that this last type of debt is a disaster waiting to happen, and no one should borrow money for depreciating assets no matter how rich they are.

But no rich people (at least those who earned it themselves) who are continuing to grow their wealth EVER borrow money for day to day living expenses like food, clothing, cars, etc. Borrowing money to live is a disaster that will leave you poor and falling behind, without exception. I have seen rich people who inherit large sums go on debt binges and lose everything, but I’ve never seen a rich person borrow consumer debt and stay rich. It just doesn’t happen.

Therefore, it’s crucial that you immediately stop borrowing money, and quickly repay any debt you currently have. Let me take that a step further, it’s important that you get out of all debt before even thinking about taking on debt for appreciating assets like a personal residence or investment property. In fact, you shouldn’t even bother investing at all until you’re out of debt, because in the event of a job loss or other emergency, you’ll likely be forced to liquidate your investments, which may be down in value at the time.

Debt is an anchor on your income, and your income is your key to growing wealth. If you have a car payment here, a credit card payment there, a student loan payment over here, suddenly you can find 25% to 50% (or more) of your paycheck eaten up paying for the past. It’s like you’re making 25% to 50% less money at your job or business. You’ll have no future, and you’ll never get rich.

Most people who look rich to you, are in fact not. Most people in your neighborhood who drive fancy cars are poor. Most people who wear fashionable clothes are broke. Many people who have nice houses have less than $1,000 in the bank saved up. It’s crazy, and an important fact to understand and appreciate. There are many people, where you live right now, who are spending an enormous amount of money on things they can’t afford.

Why do people do this? I’m sure many books have been written on the subject by people more qualified than me to cover the topic, but I’m going to take a crack at it anyway. There’s a couple of reasons.

First, I think people get a rush from buying expensive stuff, sort of similar to a high from gambling, drugs, etc. and become addicted to buying more expensive stuff. I have met a lot of people who almost froth at the mouth when they talk about the expensive gadget, piece of clothing, etc. that they just bought.

Second, I think people do it to impress other people. An obvious cliched example is the guy who buys a car just to impress girls, but it goes way beyond that. It’s people making good salaries who buy expensive cars on credit, and give up $1,500 of their income each month to drive a “luxury car” to impress their neighbors. It’s men who buy $10,000 watches on a credit card in an effort to look more sophisticated. It’s ladies who drop $1,000 on a purse or $500 on a pair of jeans in order to look “fashionable”.

Third, I really think people buy stuff they can’t afford because it makes them feel rich. With credit cards, home equity lines of credit, and other means of access to borrowed cash it’s so easy these days, people are tempted to try to feel rich by means of borrowing money, as a shortcut to actually getting rich. As with most shortcuts in life, it doesn’t work, and will leave you worse off if you take it.

Debt always has a reckoning. Credit card bills and car payments take up a higher percentage of a higher percent of your income. Suddenly you’re having to put off paying that medical bill because all of your money is committed to paying creditors. Saving money? Not going to happen.

This cycle plays out over and over during the course of your life. Eventually a shock happens, like an illness or a job loss, and the house of cards falls. Now bill collectors are calling and knocking on your door. Perhaps your car gets repossessed, perhaps your credit cards get cancelled. That’s actually a good thing, because it stops the cycle, albeit painfully, and you might be able to get on the right course.

OK, let’s talk about what YOU can do to change your life and improve your financial security. How do you break the cycle of excessive spending and debt? What’s the secret? How do you shed debt and turn the corner to begin creating wealth?

When you dig yourself into a hole, the first thing to do is stop digging. You need to cut up your credit cards today. You need to stop trading in your car for a new one with a loan. If you’re in school, you should switch to a part-time program that allows you to pay cash over time. The first step to getting out of debt is to stop borrowing.

This is often a hard pill for people to swallow. For some reason the rationale for keeping credit cards always goes to emergencies. What if my car breaks down? What if we have a medical emergency? How can you possibly suggest that I cut up my credit cards and stop all forms of borrowing?

First of all, the vast majority of your credit card debt is due to excessive spending, not emergencies. It’s likely not medical bills and auto repair bills that are driving you under (although that does occasionally happen), it’s TVs, weekend vacations, excessive clothing, etc. You’re growing broke because you spend more than you make, not because of unforeseen circumstances. You don’t have money for emergencies because you don’t have an emergency fund, despite the inevitably unforeseen events that will occur in your life.

Now, candidly, there are a few situations where a medical emergency has caused bills that are insurmountable. In that case, you should reach out to your creditors and work out a long term payment plan. That’s extremely unfortunate, but most medical emergency situations can be worked out over long periods of time.

You cannot use the excuse of emergencies to avoid the need to stop accumulating debt. Cut up your credit cards immediately. In the next chapter, we’ll start talking about your emergency fund, which is cash in a separate checking account needed to cover short term emergencies. For right now, know that you need to save some cash, equivalent to at least 1% of your salary, right now as a first step to getting out of debt.

Wait, I need to save money in order to get out of debt? How does that work? The primary thing that will get you off paying down the debt train is emergencies. Your car goes out, and you pay for the repairs with your emergency fund, not credit cards. It’s a crucial first step to avoid getting thrown off by life emergencies that will definitely happen from time to time.

So, you need to open a separate checking account at a local bank, and you need to allocate as much cash as you possibly can right now to start filling it. The thing is, when you start working to get out of debt, even trying to save 1% of your salary will feel like a stretch. It’s ok to start there and work up over time. Again, open a separate checking account, automatically transfer 1% of your salary there. Do it this week. Then next month, increase that to 2%. Over the course of a year, you’ll be saving 12% of your income. Over 2 years, you could be up to 24%. The fact that you’re increasing your savings a little at a time will make it very easy to digest, but you’ll quickly amass a pool of funds to pay down debt and eventually build wealth. But the first step is to save 1% of your income.

At this point, you may be throwing up your hands by looking at something I wrote in the last paragraph. 24% of my check is going to pay down debt? Are you crazy? That’s too much! I won’t be able to live! Let me provide some perspective. First of all, by working up to that amount, over a 2-year period, you’ll find that it won’t be as much of a struggle as you think. In addition, once you’re out of debt, that 24% is going to be a powerful force that will allow you to grow wealth, and more important security, for you and your family. You’ll be able to use that 24% to save up for a down payment on a house. You’ll be able to use it to invest in your 401K and real estate. You’ll be able to give 10% to church like you should. What you’ll be doing over this 2-year period is changing your way of looking at money little by little. You’ll end up spending your money like a wealthy person, instead of a broke person. What you’ll likely find out is (a) you’ll want to get to that 24% rate in a faster time frame than 2 years and (b) you’ll want to keep going past 24%, especially as you earn a higher income. If you can, try to push your amount to 40% or 50% of your paycheck, and get there as quickly as possible, especially if you’re heavily in debt. The faster you pay off that debt, the faster you can have that money working for you in the form of investments and other items that actually build wealth.

Another question people often ask is why do I recommend a separate checking account?

Why not just send what’s left over at the end of your paycheck to pay down debts from your regular old checking account?

Waiting for funds at the end of your paycheck will never happen if it stays in your regular checking account, you’ll always run out of money because people always find reasons to spend their entire paycheck if it’s there. I’m the same way. But by sending my money allocated to wealth building to a separate account, at the start of the pay cycle, I’m using that account strictly for wealth building. If I’m allocating 24% of my paycheck to wealth building, then when I see that cash in my wealth building account, I know that when I spend it, it needs to be on my future, and not on the present. If you’re in debt, in your case, you’re going to need to spend those funds on fixing the past for a season in your life, and then eventually you’ll transition this account to wealth building, once your debts are paid in full.

I want you to have a separate checking account to instill a system of “paying yourself first”, as Robert Kiyosaki is famous for saying in his “Rich Dad, Poor Dad” book. I believe it also appeared in the famous “Richest Man in Babylon” book as well. The concept is the first thing that needs to happen, whenever you get money, is to pay yourself for your future. I feel the separate checking account concept fits perfectly into this idea, because it happens automatically. You can set it up so at each paycheck, without lifting a finger, money will appear in your wealth building account, ready for you to spend on building your future, and legacy.

In addition to beginning to allocate money from your paycheck, you need to go over every inch of your house and find things to sell in order to get that 1% savings amount. Old clothes, sports equipment, furniture, books, etc. Have a garage sale, get it on craigslist, Facebook, eBay, etc. Just get the stuff sold and get to your 1% savings mark. Most people have enough crap in their house that this figure should be pretty easy to achieve quickly.

Once you get to that 1% savings mark, you need to take a look at all of your debts. Dave Ramsey says to list them out smallest to largest, and start with the smallest and pay it off, while paying minimum payments on all the others. Once that smallest bill is paid off, move on to the next bill, and the next one, and the next one. This creates what he calls a “snowball effect”, which will make you feel like you’re really achieving something as you pay down your debts. I can’t think of a better method, and I’m going to endorse that one whole heartedly.

Now, let me warn you about something that’s going to happen while you’re paying down debt. Emergencies are going to happen that will throw you off course. You’re going to have a car break down. You’re going to have a huge medical bill. Life’s not going to stand still for you just because you want to get out of debt. If anything, the enemy is going to throw curveballs at you in an effort to drive you down to mediocrity like most Americans.

Be aware of this, and don’t let it get you down. When emergencies happen, you need to adjust and adapt. The first thing is to pay them with cash from your 1% emergency fund. You need to limit yourself to this amount. If your car breaks down, and the repairs are more than your emergency fund, you need to tell the mechanic, “I’ve only got $1,000 (or whatever your emergency fund is), can you get me back on the road for that?”. You need to call the hospital and say, “I can pay $1,000 right now, can I put the rest on a payment plan?” What you don’t need when an emergency happens is to grab a credit card. Resist the urge! You’ll be amazed at the ingenuity you’ll find when you limit yourself to your emergency fund, and don’t consider alternatives that involve more debt and interest.

When an emergency happens, the first thing you need to do is replenish your 1% emergency fund. Shut down debt payments (besides your minimum payment) until this is done. Usually, you’ll be able to make another round through the house for things to sell in order to raise the cash. Get back up to that level as soon as possible, and get back to paying off your debts.

Any big chunks of money you get, like bonuses, inheritances, tax returns, etc., should go to paying off debt. Don’t even think about taking a vacation or buying some new toy, just get out of debt. As you increase your percentage of salary towards paying off debt, and as you pay debt down with any windfalls you get, you’ll quickly see the end in sight. You can even calculate the approximate month when you’ll be out of debt. Imagine the feeling when this happens!

There will come a point when you’ll reach the end. All your debts will be paid off and the weight of the world will be off your shoulders. What then? Well, now you have a large amount of your salary that you can transition into wealth building. For those of you who can’t imagine, that you’ll ever be able to afford a house, put your kids through college, save enough for retirement, etc., the secret is positioning your paycheck in a way that helps you get on a path to wealth and legacy building. You’ll still be spending money on food, bills, and stuff, but through the paydown of debt you’ll have trained yourself to allocate a growing portion towards wealth creation. When you reach the point of being out of debt, it’s time to flip that switch and start building wealth for you and your family!