The Leverage of Money
May 23, 2008 by Vagabond Investors · 5 Comments
You’re about to discover some über fantastic ways to multiply your returns with the next five minutes that you spend reading this article. Implementing these simple ideas can open a whole new world for you. You might also recognize some adverse behavior you want to get rid of.
The definition of leverage is this: better results with less effort. The most well-known form of leverage is debt. Why is it that most people don’t really know how to use leverage in their favor? After all it’s all about super simple math. You need not be a rocket scientiest, but you have to figure out some basics. First, you have to understand the difference between good debt and bad debt. Second, you need to know how leverage affects your expected outcome in different scenarios. Third, you need to use leverage in a safe way.
Good Debt VS. Bad Debt
Leverage is like a loaded gun. You have to be extremely careful with it and know how to handle it. The reckless use of debt is a financial suicide while the appropriate use of it will catapult your financial future to the orbit.
Here’s the twist. Good debt makes you richer and bad debt makes you poorer. Now what the hell does that mean? In simple terms, everything that puts money in your pocket is good and everything that takes money out of your pocket is stupid. Get the picture?
Here’s an example of bad debt. Let’s say you buy something on credit. That something then depreciates in value and does not put money in your pocket. This might be your car, stereos, boat, summer cottage, consumer debt, you name it. This is the kind of stuff that goes down in value. If you buy it before you can really afford it, you’re using bad debt.
You might say “I get that. Tell me about the mysterious good debt if there is such a thing!” Here it comes. If you use debt to generate more income and wealth for you, you’re using good debt. For example, you buy a nice piece of real estate using 20% of your own money and 80% of your banker’s money. You then collect an annual rent of $8,000. Your expenses before interest payments and taxes are $1,500 and your interest payments are $4,000 per annum. What’s left is a solid $2,500 before taxes (remember, interest payments on real estate are tax-deductable in most parts of this planet). This is cash that you get every year no matter what happens to the price of that property. It might go up or down but you still collect the money!
It’s in the very nature of good debt on real estate that it brings cash in every year. In addition, the formula is not based on any appreciation expectations. So what happens when the price of that property invariably changes in one way or another? Let’s look at some numbers.
|
Equity / |
Price change |
-2 % |
0 % |
2 % |
3 % |
5 % |
6 % |
|
10 % |
-9,2 % |
10,8 % |
30,8 % |
40,8 % |
60,8 % |
70,8 % |
|
|
20 % |
-2,8 % |
7,2 % |
17,2 % |
22,2 % |
32,2 % |
37,2 % |
|
|
30 % |
-0,7 % |
6,0 % |
12,7 % |
16,0 % |
22,7 % |
26,0 % |
|
|
40 % |
0,4 % |
5,4 % |
10,4 % |
12,9 % |
17,9 % |
20,4 % |
|
|
50 % |
1,0 % |
5,0 % |
9,0 % |
11,0 % |
15,0 % |
17,0 % |
|
|
100 % |
2,3 % |
4,3 % |
6,3 % |
7,3 % |
9,3 % |
10,3 % |
The calculations above are based on these numbers:
Ø Interest rate: 5%.
Ø Net rental income: 6 %
Ø Tax rate of rental income: 28 %
Ø No depreciation.
Ø Real estate purchase price: $100,000
Ø Equity: $20,000
Ø Banker’s money: $80,000
Ø Rental income after expenses: $6,000 (6% of $100,000)
Ø Interest rate expenses: $4,000 (5% of $80,000)
Ø Tax expenses: $5,60 (28% of $6,000-$4,000)
Ø Appreciation: $2,000 (2% of $100,000)
Ø Total capital gain and income: $3,440 ($2,000-$560+$2,000)
Ø Return on equity: $3,440 / $20,000 = 17.2 %
Let’s say we have two people we call Julia and Harry. Julia is a sophisticated investor and has 90/10 leverage (90% debt, 10% equity) on his portfolio. Her property does not appreciate in value at all. Harry is a conservative investor and uses 100% equity to finance his purchase. He enjoys a solid 6 % annual appreciation in his property. We can easily see that they both almost get the same return! The difference is in the leverage. This is exactly the reason why it’s so important to finance your investments in an appropriate way. If you do your homework and buy the right investments, debt can be your best friend.
Investment advisors’ advice
However, most investment advisors will say you that you’re nuts if you tell them that your goal is to get around 17 % return on your equity. They will say it’s far too risky. The fact is that investments are never risky. The risk is in the investor that does not know what he’s doing. Do you think you can find a mutual fund that gives your equity a 17% annual return year after year? I wouldn’t bet my financial future on that horse.
Why hasn’t your investment advisor told you about this? That’s because most investment advisors are not good investors. In fact, most of them probably have no investments at all. Be careful whose advice you take seriously.
Personally, I never use debt in speculative investments. I always require a positive cash flow from my assets. Period.
I can’t emphasize enough how important it is to understand the beauty of good leverage. To be able to create financial freedom you must understand the use of good debt in a deep level. Dismiss it and you’re like a race horse with three legs.
The use of debt can make you enormously wealthy or exceptionally poor. The difference is whether you use good debt or bad debt. Do yourself a big favor and don’t shoot yourself in the foot with bad debt.
Find out more about this subject in this Vagabond Investors’ blog.
Matias
The Hall of Shame: King Kong, Godzilla, The Subprime Six…
May 19, 2008 by Vagabond Investors · 3 Comments
I’m happily surprised. I have known for a couple of years that banking will become hilarious some day. What I did not know back then was how obnoxious the entire financial world would turn out to be.
I have had great fun reading the scary news about the bursting of the credit bubble. It’s a bit like watching horror movies from the 70s. You see a monster’s head fall off but you can’t help laughing at the poorly made visual illusions. I have no doubt that is exactly what the professionals of the future will feel like about the banking practices of today.
It’s always a surprise to the market - and especially to newspapers - that something terrible happens in the banking sector. The blow-up of Long-Term Capital Management in 1998, the bursting of leveraged buy-out bubble in the early 1990s, the Nordic banking crisis and the Japanese experience in the same decade… The list goes on and on way back to the bankers’ panic in 1907 and beyond. Let’s just agree that it is characteristic of banks to get into mess like this.
I must admit that there is something good about the ignorance of the masses. If people knew how retail banks work, the society as we know it today would be history overnight. That would make a lot of things awfully difficult. I accept that the masses don’t realize the nature of banks, but I have yet to figure out why most professionals have a hard time getting the point.
I am especially amused of the debate on the timing of risk. Regulatory regimes that are based on market prices implicitly assume that risk goes down when the markets do well. The value-at-risk measure is the most obvious example. It demands less capital from banks when the data show a longer period of calm, and more capital when markets have become volatile. But that (ass)umption makes very little sense. Up until today, busts follow booms like day follows night.
Financial crashes are not that random. In fact, they occur just after the top of the economic cycle. I bet that market participants were all well aware that too much credit was being created too cheaply. Yet models showed that risk-weighted capital ratios were healthy.
It’s nice to see that financial houses rely on mathematical models. The results are amazing indeed. Right at the top of the hall of shame is Citigroup with write-downs of some $40 bn since January 2007. Right behind are UBS (some $38 bn) and Merrill Lynch (some $32 bn).
When the news of Northern Rock arrived I was immediately with a popcorn can ready to watch the show on TV. I was keenly expecting a series of bank failures to entertain me. I certainly hoped for some banks to fail in order to teach the market some discipline. What followed was the tragicomic news: even the smallest investment bank on Wall Street was too entangled to fail. Bear Sterns just had to saved!
Now don’t you think that it sounds like an invitation to moral hazard? If investment banks have access to the same central-bank funding as commercial banks and represent just as much of a threat to the stability of the financial system, shouldn’t they be subject to the same prudential and capital standards? You might think so. Guess again.
It is questionable if re-regulation helps. I believe that the outcome of this mess will be a more stringent approach to liquidity and capital. That makes credit more expensive. Still, higher capital charges should not be used to make up for the deficiencies in market discipline.
It would be healthy to let some banks fail. Line the banks up and shoot the dog. The rest will quickly learn the lesson. However, I’m confident that Mr. Bernanke will get his hands on that somehow and postpone the horror show to a later date. It’s like eventually showing King Kong 1-3 all at once. You might want to have a crap load of popcorn when that happens. It will be a long show.
See you guys!
Jaakko
Market Conclusions May 12th 2008
May 12, 2008 by Vagabond Investors · 5 Comments
The following thoughts of recent market movements and economic conditions might be helpful for you. First, we play with the idea of Fed’s two possible strategies and their consequences. Second, we take a look at some investment considerations. We try to keep this short and easy to follow. So let’s begin.
We think the Fed now have two options.
1) They could continue to pursue their interventionist policy that is obviously designed to support the suffering US housing and equity markets. That will happen at the expense of further sharp decline in the value of US dollar. You can read more about this in WSJ April-14-2008 entitled “The Inflation Solution to the Housing Mess”. That is a staggering article.
A sharply declining dollar would leas the US to suffer from rapidly increasing import prices (appreciating currencies) and inflation. Overseas particularly the EU would suffer from the further weakening of the dollar. We can’t highlight enough that a total of 31 % of the S&P earnings come from overseas. This will easily lead to disappointing corporate profits and nasty surprises in valuations and future guidance. This scenario makes us seriously think about shorting US long-term Treasuries. No doubt that would be the short of the century.
We would like to warn fellow Vagabond Investors not to be overly bearish about US equities in dollar terms. You can find many cases that show that stocks have rallied strongly in local currency even if the country’s economy is going through its darkest era. At the same time, of course, their currency has collapsed. Keep that in mind. You might still find some opportunities out there. We believe that oil and energy related stocks might offset the weakness in other sectors of the stock market in the near and midterm future. Some of you might remember that this was the case in the energy sector in the 1970s.
2) The second alternative is to tighten the monetary policy to support the US dollar. We think that this is not likely, though. Tightening would lead to weaker US asset markets. If it were the case, we wouldn’t be surprised to see the US stock market slide 20-40 %.
The US dollar would be more stable in this scenario than the first one. A stronger dollar would lead to an increasing cost of living in the US. Would that be beneficial for the median US household? Who knows?
Both of these alternatives sound very unattractive for global economy and asset markets. In both scenarios the US stock market is in a great danger to move even lower in dollar and euro terms. The Fed may have run out of right choices.
The rate cuts since September 2007 have set a furious fire under commodities. We have been very bullish on commodities since 2004. However, a weak US consumption means weaker global liquidity and would consequently hurt most asset markets. This includes real estate, equities, art and most commodities.
At the moment, at least for the short run, we are especially looking forward to the end of this liquidity-driven strength in commodities including gold. However, we are looking for gold to correct around $800 before its bull market resumes. We see this level of $800 a very attractive buying opportunity. We would also add our positions in the future weakness in gold.
We really do not see very much upside room for the US dollar under current US monetary policies. The case with Asian currencies is quite the opposite. Most Asian still look very attractive. They have gained strength against the US dollar, but they remain depressed against the euro. You might want to have a look at the Singapore dollar. It looks like a fun future play for us.
Be careful out there. It’s going to be a bumpy ride. With the right knowledge, you can make great investment decisions. Feel free to share them with us!
Victorious investing!
Matias
The Road Less Travelled
May 5, 2008 by Vagabond Investors · 2 Comments
Sometimes it just so happens to be that seeing a tree right in the middle of the road is a surprising thing. Seeing one after another makes me wonder if there are any better ways to make roads. Look at this…
I would understand one tree in the middle of the road. Can you imagine that you can find four of these within a 15 minute walk in Helsinki Finland? Yep, that’s the same country where Nokia came from.
The idea behind the road planning is not clear to me, but seeing these trees on the way leads me to interesting thoughts. The road less traveled can be found astonishingly close to our everyday life. I have walked tens of times these same streets, yet today was the very first time I noticed these trees. It makes me wonder if there’s something else in life that I haven’t seen even when it’s right in front of me.
It’s a very healthy habit to stop every now and then to take a careful look at where you are in your life. At the moment you stop, remember that your best thinking brought you where you are. To progress you have to adapt new and better thoughts and abandon the old ones at the same time.
Spend a minute to think, whose ideas and thoughts you have been taking seriously for the last years. The fruits of the ideas will tell the whole story. If you’re not satisfied with your results, stop doing what you’re doing right now! Find a better approach!
It’s pure insanity to keep on doing the same old things and expecting different results. Focus on the cause instead. Results will follow automatically. It’s not difficult. Yes, it is uncomfortable to change habits and adopt better thinking patterns, but it surely is not difficult.
The fact that something is common doesn’t necessarily mean that it’s intelligent or anyhow a good idea. Many times we just adopt socially reinforced thinking patterns and unconsciously think that it must be the best practice even if it could be the dumbest one ever. Watch over your thoughts. You might be surprised to realize what you find in your everyday thinking.
You probably hate this, but I’m sure you have been face to face with a million dollar/pound/euro opportunity 3 times during the last 12 months and not even understood that. You see only the things that you think are possible for you. Choose a road less traveled and open your eyes to new opportunities that you have never believed to exist.
Wealth is an attitude. Financial freedom is a state of mind. Money is just an idea.
Have an adventurous day!
Matias
Looking those trees keep me wondering which way to pass the tree
Markets Are Not Rational
May 5, 2008 by Vagabond Investors · 5 Comments
Every now and then newspapers argue that markets have changed. Over the past decades massive structural changes have taken place in terms of credit creation, regulation and deregulation, the development of derivative markets and the value of currencies. Leverage and liquidity have led to a bubbly economy with capital flowing from one asset class to another, creating volatility and turbulence.
While massive changes have taken place, there are some things that have not been affected in 100 years. One particular about markets has remained the same. That is the human factor, which is the wildcard of financial markets. It is specifically because of this factor that one should not think investing as a hard science. In fact, it is perhaps closer to art than science. The difference is obvious. One can heat a pot of water in 100 ºC (272 ºF respectively) and it will boil every time, assuming constant pressure. On the other hand, put a human under pressure and it is anybody’s guess what will happen. He/she is unpredictable, irrational and acts in bizarre ways.
It is useless to try to understand an irrational creature with logic. It is vain to expect financial markets to act in a rational way. Humans operate the markets, and the last time the author of this article checked most people were human.
One can tell the where the market is by listening to people’s opinions. At the height of boom, mobs and media invent explanations to why prices are high and will continue to rise. People tend to make personal relationships with their investments and fail to realize that money is nothing more than a commodity.
Tomorrow always comes, at least up until now, and eventually booms turn to busts. Newspapers declare that certain asset classes are dead (Business Week ran an infamous cover in 1979 entitled Equities Are Dead). Amusingly, financial salesmen are busy calling their customers to tell that it is only a momentarily correction. Prices will rise, they say, so investors should diversify and invest for the long term.
Long term is a flexible concept in inflation-adjusted terms. It is easy to be deluded by nominal figures. Yet in real terms, the S&P 500 at its 1990 low of 460 was radically below its real high of 647 in 1968. Moreover, it was just 20% above its inflation-adjusted 1929 peak.
A rational person would avoid the apparent manias at the end of bull markets. Sadly, the masses get blinded by their own thinking and feel that the rainy day will never come. Most people are ill prepared to meet financial shocks. Many are merely relying on the central banks or the government to bail them out. This creates an obvious moral hazard to the market and encourages excessive risk-taking.
As to the people pointing out the rationality of traditional long term strategies in US equities, it is enlightening to realize that US equities have grossly underperformed any other asset class since 2002. In a world of very high credit growth, a rational investor needs to look at asset price movements in inflation-adjusted terms. The long term value of any paper currency is zero. The same law holds true with humans. The mean for human beings is non-existence or death.
In times of irrational exuberance, human strengths morph into weaknesses. One can have too much of a good thing. In excess, most actions take on the characteristics of their opposite. Pacifists become militants, blessings become curses, and help becomes hindrance. Even National Socialism in Germany was initially promoting peace, but it became the most militaristic creed on the planet. More becomes less.
Time and again this is apparent in the markets, which are supposed to be efficient and rational. In reality, the unpredictable human factor is always present. Coupled with mounting and increasingly more complex leverage, left alone the market is liable of over-extending itself and eventually breaking systems down. For example, several countries have experienced two or more banking crises since 1980: Argentina, Indonesia, Malaysia, Philippines, Thailand and Turkey.
Systemic banking crises typically accompany the implosion of economic bubbles. When economic cycles turn, it seems the masses are revoltingly blind to the changes at hand. As to the public’s need to feel right about their opinions, most people get dead right.
Jaakko
