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CHAPTER 26 – MEASURING ECONOMIC PROGRESS
How can an investor who wants to increase wealth for generations measure the performance of his or her success? Typical the answer I hear is to look at the return he or she receives based on all assets that are under his or her management. The return on investment is obviously a major indicator. But will it be enough to measure economic progress in the long-run? There must be additional information that measures the success of an investor who manages wealth for generations. This exact questions has been researched for over a decade and answered in a book called Capital in the Twenty-First Century by economist Thomas Piketty in 2014. Thomas Piketty is a Professor at the Paris School of Economics, and he published his so called First Fundamental Law of Capitalism. Thomas Piketty analyzed economic data from many countries going back many centuries. He has developed in my opinion the most important formula since Albert Einstein’s relativity theory E=mc2. I believe what Albert Einstein has achieved for the world of physics, Thomas Piketty has achieved for the world of capitalism. In Thomas Piketty’s formula are only three components that determine exactly the success of the economic progress, and these components are: the sum of all assets someone owns, the total income and the rate of return from all assets. The formula is as follows: 195
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α=rxβ Reads: α = (return on capital) x (capital/income ratio) Whereas: β = capital divided by income r = return from all capital (assets) Please note: • the word capital is a synonym to assets as I use it in this book • income in this formula is income from labor plus income from capital returns • income is considered to be net income: • total income = earned income – living expenses + passive income – investment related expenses • return r is only income from capital returns, not income received from labor as salary or wages and not government or company retirement income. • return r is only the monetary return in form of income from capital (assets) and not theoretical income received from capital gains when assets might be sold. • capital is the total value of all assets minus all debts associated with these assets (net assets). 196
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• The value for α falls always between 0 and 1 (except for the case when capital returns are negative and the earned income is higher than the losses from capital. In this case α is negative and the outcome a financial disaster. • The higher α is, the better is the financial situation for the entity measured. • All calculations in this book are based on annual financial data. Based on Thomas Piketty extensive analysis he concludes that a typical country achieves a number for α of about 0.3. If you use this formula to calculate an average family’s financial situation, you receive very different results for α. Let’s assume the financial situation of family A looks as follows: Capital C = 100,000$ (average 2014 family net worth) Income I = 66,666$ (from salaries + capital returns) r = 1% (capital returns, e.g. interest from savings) Then: α = r x β = 0.01 x (100,000$ / 66,666$)=0.03 or 3% The numbers used for this family A seem to be typical for an average American household. As the formula shows this results in a very low value for α 197
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of only 0.03. Their return on capital in this example is the best case scenario for an average family and with 1,000$ (1% from 100,000$) not achieved by most families. An average family has typically very little financial capital and receives none to very low return on capital. In case a family has zero return on their capital, which in my observation is rather the norm than the exception, α for this family would be zero. As a reminder, Thomas Piketty’s analysis on the other hand reveals that a typical α for countries or nations is around 0.3. In other words, this simple equation shows clearly that nations have been for centuries and are still today managed to be financially successful over time, and generations of families are typically not. For me, this is a strong indicator that Adam Smith’s theory in his book The Wealth of Nations has been applied very successfully to make nations rich, but families have been left in the financial dark age. So, how should the numbers look like for a financially successful family? Lets look at family B with the following financial data: Capital C = 2,000,000$ (net assets, incl. residence) Income I = 50,000$ (salary, wages, capital return) r = 2% (from all assets)
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Then: α = r x β = 0.02 x (1,000,000$/66,666$) = 0.3 or 30% This family with α of 30% has the same income of 66,666$ as family A and a slightly higher return on their capital. But due to their higher net worth their α is considerably better than the one of the first family. Also, the return (income) from their capital is 20,000$ (2% from 1,000,000$), a considerably higher amount than in the case of family A. But a family does not need to own much capital to have a high α as demonstrated in example for family C: Capital C = 100,000$ (net assets, incl. residence) Income I = 66,666$ (salary, wages, capital return) r = 20% (capital return from all assets) Then: α = r x β = 0.20 x (100,000$/66,666$) = 0.3 or 30% Family C has the same value for α since this family is able to receive 20,000$ (20% from 100,000$) return from its much lower capital base of just 100,000$. The family wealth manager(s) have done a much better job to invest the family capital than family B 199
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and A. Which family do you believe has a higher chance of building wealth for generations? Family A, B or C? Lets conclude: Family
Capital
Return
Income
α
A
100K$
1%
66,666$
0.02
B
1M$
2%
66,666$
0.3
C
100K$
20%
66,666$
0.3
Figure'50:'α'for'three'different'families
The typical American family A has the absolutes lowest value for α, in other words family A is financially absolutely dependent on their earned income. Family B and C have the same α but are financially in a very different situation since family C seems to have a superior financially education and receive much higher passive income from their capital than family B. Members of family B might represent the lucky heirs of a rich relative or are happy lottery winners. Members of family B seem to be financially relatively illiterate, and their expenses will hence eat up all their capital over time. However, the value for α of both families A and B are comparable to the α of most countries, and both 200
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have a great chance of building wealth for generations. I encourage you to find the financial numbers that represent your family and plug them in the formula. An extreme situation The following scenario might look somewhat strange to the reader: Capital C = 10,000$ (net assets) Income I = 10,000$ (salary, wages, capital return) r = 100% (returns from all assets) Then: α = r x β = 1 x (10,000$/10,000$) = 1.0 or 100% A value for α of 1.0 or 100% is the perfect financial situation. Imagine you own 10,000$, which you borrow to a friend in London for one year. You have no expenses while you live on a south-sea island, and when you come back to London after that year, your friend was able to start a successful business and pay you back 20,000$. You received 100% return on your capital, while having no expenses. While this scenario is highly unrealistic, based on this first fundamental law of capitalism you should aim 201
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to lower your expenses and invested your capital in the best way possible. Lowering expenses is good budgeting practice, and it should be mastered by every investor.
Credit Ratings Every investor, in fact, every individual and family is rated also for their ability to handle money they owe. Credit ratings are important measurements for every individual when they need money. Rating agencies like Standard & Poor rate companies and countries, credit bureaus rate consumers. The three important bureaus in the United States are Equifax, Experian and TransUnion. All three agencies use the most common three digit score ranging from 300 to 850, called FICO Score. FICO stands for Fair Isaac Corporation. It is a public 600 million dollar revenue company listed on the NYSE. The company FICO which created the industry standard credit scores used by almost all lenders. Fair Isaac Corporation has been in business since the mid 1950s. They started building and introducing the famous FICO score in the mid 1980s. The basic idea is that if someone applies for credit, a quick number, the credit score will determine if this individual will receive the credit and under what terms. Similar scores are used in other countries like Germany, where a publicly traded company named 202
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Schufa Holding AG provides credit information about individuals to contracted partner companies. Today, the credit score is also widely used for rental applications, cell phone contracts and even indirectly at car rental places. It is a very useful tool when doing business. Based on a study by Charles SCHWAB taken in December 2012, 13% of the population have a credit score over 800; they are seen as financially flawless, 27% have a score between 750 and 799, which is considered excellent, 18% are between 700 and 749 and seen as good borrowers. 15% are in the mediocre range of 650 to 699. 12% have 600 to 650, which is seen as not good. 8% have a poor credit rating from 550 to 599. There are even 5% of the people with a 500 to 549 rating. About 8 million people, which is 2% of the population in the United States have a credit score lower than 499. But what does the credit score number really tell anybody about their investor sophistication? Really not much or rather nothing. It could sometimes even give a quite deceiving picture of someone: a bad credit score might sometimes mean that the individual took some drastic measurements to cut him or her self clean of liabilities - dead cows - that he or she has been burdened with due to his own mistakes in the past or other people’s faults, and now has a lower credit score. Or sometimes people have not used any credit in the past or moved from another country and has not built a credit history yet. 203
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There are wealthy investors who will not qualify for loans due to a their credit history. I have a friend from Europe who recently came to America. He is fairly wealthy and never buys anything on credit. He immigrated years ago but he never really built a credit history in the Unites Sates. He would not even be able to get a cell phone contract with a wireless carrier if he did not pay for his own phone. Of course, he got a phone without a plan and otherwise does not need to proof to anybody how great his credit worthiness is because he does not need to borrow any money to invest or to buy any consume items. If you have your spending habits under control, and if you don’t have the need for huge capital investments, you might consider trying to live and work with less or even without a credit line. If my wealthy friend however were to be rated with an investor score instead of a credit score, he would score much higher than most of all of the average investors. In fact, he is an accredited investor and plays in the league of level 5 and 6 investors. But what about all other investors on lower levels? How is their ability to invest rated? To give these investors, which are the great majority of this modern society, a way to tell them where they are in terms of investor sophistication, I will describe a way to rate investors by introducing an investor score. The Investor Score The following investor score rating can rate every 204
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investor’s ability to invest and manage their assets. The components are payment history, amounts owed, length of credit, new credit and types of credit used. These measurements have been used from the FICO score and reversed from a liability viewpoint to an asset based view. The same score ranging from 300 to 850 as for credit ratings is being used to increase readability. People with an investor score above 800 are investor level 6 investors, individuals with an investor score below 550 are on investor level 0, they don’t have anything to invest. The following formula will give you your financial independence. It is equal to passive income over the sum of your salary plus your passive income: Financial Independence = I = P / (S + P) If you are used to the numbering system of the credit score rating, you can use the following formula to calculate an investor score IS that uses the same range from 300 to 850:
IS = 300 + (b x 350) + (I x 200) IS = Investor Score b = if you have at least one income producing asset, b=1, otherwise b=0 I = Independence (I = P / (S + P))
Lets say you receive monthly $4,000 from your salary and $2,000 monthly from passive income with two income producing assets. In this case your 205
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independence is: Independence I = $2,000 / ($4,000 + $2,000) = $2,000 / $6,000 = 0.33 IS = 300 + (1 x 350) + (0.33 x 200) = 716
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! Investor Score
Investor Level
Investor Sophistication
Population
800 - 849
6
Mint
1%
750 - 799
5
Excellent
5%
700 - 749
4
Good
10%
650 - 699
3
Mediocre
20%
300 -649
1..2
Insufficient
74%
Figure'51'Investor'Rating'and'Investor'Levels
The investor score of 716 is considered good. You still need a paycheck from a salary to cover your personal expenses but you have income generating assets that you can grow to achieve the maximum score of 850. How can you use the investor score? The investor score is primarily for your own information. The score is a daily measurement that shows you if you are on the right track? Did you consider downshifting? There is no easy way to increase your wealth overnight. But if you are able to lower you expenses a little and maybe take a voluntary time-out from work or just a weekend off to re-focus, you could go a long way towards increasing your investor score. Which of the following gauges would you fit in? Are you the typical average investor, the elaborated 207
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investor, a sophisticated investor or a typical elite investor? On the following page you see some examples of different investors and their passive income over expenses gauges. The lower diagram shows typical investor mistakes and how they will decrease your investor score.
Figure'52:'non;investor'and'unsophisticated'investor:'0%'to'100%'of' personal'expenses'are'covered'by'passive'income'
Figure'53:'sophisticated'investor'cover'more'than'100%'of'their' personal'expenses'by'passive'income' Investor Mistake
Down from 780 by
Owning a Dead Cow for too long
25 to 45 points
Owning too many Over-leveraged
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25 to 45 points
THE WEALTH OF GENERATIONS Assets Irregular asset income
90 to 110 points
Debt Settlement
105 to 125 points
Clamp Down of an asset
140 to 160 points
Strategic Default of an asset
140 to 160 points
Figure'54:'Examples'for'negative'investor'points'affecting'your' investor'score
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CHAPTER 27 – IS MY HOME AN ASSET?
How much do you pay each month to live in your house? If you pay to live in your house, your house is an expense item in your personal budget, not an asset. As Robert Kiyosaki in his book Rich Dad says: “If you stop working today, an asset puts money in your pocket and a liability takes money from your pocket. Too often people call liabilities assets. It’s important to know the difference between the two.” Robert Kiyosaki is referring to the concept illustrated in the asset grid. In the grid you see the two axes income and value. We are all too focused on asset value and not on asset income. Your house you live in is either a Young Cow, or if it is “underwater”, your house is a Dead Cow. It will never ever be a Cash Cow or an Old Cow. We as a society got used to certain language that makes us feel good. Life is good is one of them. Homeownership is another. Officially, we might own the house we live in, but it is really only a form of rent we pay for a long time. A mortgaged house we live in is just another consumer toy that we have to pay for each month. It is very risky to hope or speculate on selling the house at a later time with a profit. But did you really buy your home to make money? Even if you rent parts of your house to tenants, your house is still not an asset. Even if you outright own 210
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your house without a mortgage, that house is still no asset since you have to pay taxes, maintenance and other costs. So, when you buy a house, which you intend to live in, you typically will not generate any income. Instead it is an expense. Most people are focused on the value of the house. They look at one dimension of the asset grid: the asset value axis. They are traders. Traders are one-dimensional investors. They try to buy low and their goal is to sell high. Now, when you buy a home for you and your family you might not think that way. But your house is at best a one-dimensional asset. Remodeling What about upgrading your house with new energy saving appliances, new windows or a new heat pump? Remodeling your house can lower your personal expenses and might increase the value of the house. It could save you a lot of money, but it would not make you any money. Your house is still an expense. Buy your home with the right down payment! A home is a residential property, which you and your family intend to live in. It is not an investment. It is an expense item as your car or any other item you use. But when you buy your home you will have to apply some investor thinking to reduce some financial risks. If you intend to buy a home for example for 228,000 dollars, take a loan of 200,000 dollars and put down 211
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28,000 dollars, you will pay at current low rates of 5% about 1,200 dollars a month for a 30-year mortgage plus other monthly costs like taxes and maintenance. Let’s assume that that property shows a rent estimate between 1,200 and 1,600 dollars (You can find out rent estimates on many popular websites like zillow.com).
Figure'55:'Calculation'for'the'right'down'payment'for'your'home'
If you do the math, you can determine a range for your down payment that allows your monthly costs to stay below the amount that the place would rent out for. Then you have the freedom to move somewhere else at any time, start renting the place out and receive a monthly income. Whereas if you financed in this example more than 200,000 dollars you might have to pay some money each month when you rent it out because the mortgage would be higher than what you will receive in rent. Every investor will need to plan for an exit strategy. And you as home buyer should do the same thing before buying your home. It is for the case when the unforeseeable happens: imagine the price of your home drops below the amount you owe the bank, 212
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and you need to move out of state due to a job change, or as many people you get divorced and need to sell the home. So, when you buy a home be sure you have an exit strategy. One way to do so is to get a loan with the right down payment. That way you will not only have the home you want but also you have an insurance in case you need to move or sell. You have always the option to move somewhere else because you can either sell your home with a profit if the housing market went up, or you you will receive monthly income by renting it out if the house is underwater. You cannot lose when buying a home with the right down payment, and it is also a good compromise between being a home owner and an investor. You should never consider your home to ben an investment, but you still have to crunch some numbers to lower financial risks. Having the right down payment will lower the risk of financial loss or default dramatically. It will very likely prevent you from going through a short-sale procedure or foreclosure, which would impact your credit score dramatically. When you purchase your home do your homework and calculate the right amount for your down payment and stick to it. Even if banks offer you a lower down payment or you would like to go for the bigger more expensive home, stick to your plan. A higher down payment increases your payment upfront, and you might not even be able to buy the house you really want. But, believe me, the right down payment will save you from huge trouble. 213
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Remember: The job of mortgage departments in banks is to sell loans. So, if you ask them if they can give you a loan for a home, they will say ‘sure’, and they will try to make it work for them no matter how good or bad your credit score is. But be careful! Before you sign make sure it will work for you!
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CHAPTER 28 - YOUR ACTION PLAN
“Stay hungry, stay foolish! “ Steve Jobs The proper amount of the following three ingredients are required to build wealth for generations: your passive income, your financial literacy (sophistication) and the right size of your personal expenses. This section will tell you how to manage these three components. The transition from an average investor to a sophisticated investor will not happen over night. Only when someone’s wealth W is greater than 1, that person can be considered a sophisticated investor. Wealth W is passive income P over expenses E: (W = P/E). In my experience it takes at least ten years to reach this goal if you start from zero, or as an average investor. In general, the younger a person is the faster someone will be able to become a sophisticated investor. It certainly is a life changing process, it means a lot of sacrifices and willpower at first but it also involves a lot of fun and excitement, and eventually one will look back and ask how he or she ever could have lived differently. The only goal on your path to a successful investor is to increase your wealth to be greater than 1. Written as a formula: W > 1 or P/E > 1. This means your passive income P will have to be 215
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Figure'56:'Decision'Tree'to'build'your'Wealth'of'Generations'
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higher than your personal expenses E at all times. To achieve this goal you will have to build your solid fundament of income producing assets like real estate and businesses but also the right mix of money market assets, securities and commodities. If your wealth is lower than one, you still need a salary to pay for your personal expenses like rent or mortgage. To increase your wealth you can lower your personal expenses or increase your passive income, or both. Working harder to increase your salary S will not improve your wealth. Quite the opposite: increasing your salary S will only lower your independency I = P / (S + P) and will do nothing to your wealth W. However, increasing your passive income P will increase your independence. There are certainly huge changes going on in America. Today, 1% of the American people own more than 30% of all assets. In 2007, the average annual income of the 1% was 1.3 million dollars, and the income of the lowest 20% was 17,800$. 0.1% of the Americans make in average every one and a half days as much as 90% in an entire year. Before the crisis in 2008, 65% of the GDP gains reached the 0,1% richest of the country, thereafter 93%. And those who call them self middle class lose their savings and houses. What is happening? Does it maybe pay off to be a sophisticated investor. A resent article in a European daily newspaper recently wrote that less and less young people believe that hard work alone will pay off. It seams only logical that there needs to be more 217
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sophisticated investors to increase checks-andbalances between the average people and the elite. Would you agree? Not everybody has the capacity to become a sophisticated investor, but everybody who can ought to try. The bigger the gap between the elite and the average the greater the risk of the rise of tyranny and undemocratic behavior. Many people are frustrated with the financial industry, the available investment products and the never ending financial scandals popping up worldwide. The riches are getting richer and all the rest is getting poorer by the day. Have you asked your self where you can put your hard saved money without the ever increasing worry about the value of it and the fear of high fees, taxes and inflation? Do you feel your are only getting screwed by a big investor machinery, the elite, cheated of your savings, retirement funds and your ever decreasing buying power? As the average investor, it is now time to wake up, start to build your own financial foundation. The times have changed since the dawn of the new century. Natural resources are becoming more scares, economic growth is increasingly in jeopardy and the form and availability of employment is changing. The Massachusetts Institute of Technology MIT published a very interesting e-book about how information technologies are affecting jobs, skills, wages, and the economy. If you hope the old boom times will come back soon, think twice. Many reputable economists, former CEO’s and politicians are screaming it already from the rooftops: the times 218
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of endless conventional economic growth, endless social welfare and cheap resources are over. A mega long-term Kondratieff Shift is under way. Everybody who wants to maintain a certain lifestyle will have to rely increasingly on their own creativity, sophistication and their own financial assets. This book provides all the knowledge and tools to start acting and thinking like a sophisticated investor on level five and six. Take action today, come up with a 10-year plan to become financially free, and follow the below steps: 1) Start increasing your and your family’s financial literacy, learn how to consume less - decrease your personal expenses 2) Continuously improve your financial education in all asset classes 3) Invest only in income generating assets; use paper assets to pay for your expenses and to store income from your investments for short-term 4) Continuously increase your passive income 5) When your passive income is greater than your expenses, stop working as an employee 6) Maintain all your assets as your new job I hope this book has given you some ideas for how to change your life to become a financially free person, and how you can build wealth for generations. I am working on Edition Two of this book, which I plan to publish end of 2014. Thank you for spending your valuable time to read this book. 219