Athletic and Business Humility

kona27

When I think about success, I experience the human quirk of self-attribution bias.

In other words, I believe that my failures are due to external circumstances (those damn flat tires) and success is due to my own efforts (my life today).


parade

In athletics, I played the game of Ironman Triathlon (swim 2.4 miles, bike 112 miles and run 26.2 miles). Two observations about the game, at the time I played it:

  1. Very few people were willing to subject themselves to “proper” training
  2. Most winning times (today, any venue) would have been world-records when I raced

Two ideas flow from these observations.

First, if “winning” is important then find a narrow niche where you enjoy working your a$$ off.

Second, in a field where not many people are willing to do-what-it-takes, be cautious with your self-assessment.

World class is a lot easier when you’re not competing against the world!


thegirls

I was able to play triathlon, because I spent a decade playing Private Equity, in Europe and in Asia.

The only way you can lose this game is by going bust:

  • Gather money every five years => each fundraising created a stand-alone “fund”
  • Split each fund into a dozen deals, invested over 3-5 years
  • Use borrowed money as well as equity
  • Wait 4-6 years then sell the deals and keep 20% of the profits

What makes this game interesting is the “house” received an annual commission (2% of equity).

Over the last fifty years the sector went from ZERO to over $500,000,000,000 annual volume => generating a lot of fee income and creating a buyer’s circle where your competition bid up the assets you already own.

If you think you missed out because you weren’t in finance then you might be mistaken. Similar dynamics have been in play in your real estate market (and sectors touched by venture capital).

From 1980 onwards, rapidly increasing assets under management wasn’t the only tail wind.

There was the long term debt cycle (10-year treasury rate from 1/1/1979).

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Chart looks similar if you use 30-year treasury rate…

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…the debt cycle fed into the stock market (y-axis log scale, SP500 from 1/1/1979).

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I started high school (37 years ago) in the bottom left-hand corner of the stock chart. Is it any wonder that I expect things to always work out?

It is human nature to associate my effort with my results. Some will say this association is obvious!

I am not sure. I know that I ignore external factors and hidden evidence:

  • of people who worked hard and didn’t succeed
  • of crooks and bozos that have done very well

My mantra, “Let’s be careful and remember we are far less talented than we think we are.”

How Bad Ideas Get Funded

2019-06-26 14.43.54After a decade of asset price inflation, I’m tempted to shuffle the deck. I remind myself:

  1. Each time I change, I crystalize tax liabilities, pay transaction fees and introduce the possibility for error.
  2. A key benefits of an attractive position is the freedom NOT to change it.
  3. NOT following through on a mediocre idea => can be a great decision.
  4. My greatest investing weakness is the desire for change, for change’s sake.

Against the above, I’ve developed a hunch that assets are going to be cheaper 2 to 3 years from now.

Fully invested, with yields at historic lows, there’s little reason to rush into changing strategy.

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Costly mistakes happen when we overpay late in an expansionary cycle.

Where are we?

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Start with yourself => write out your ten largest items for the last year.

  • Childcare
  • Ski Season Accommodation
  • Food
  • Mortgage
  • Taxes
  • Healthcare
  • College and Retirement Accounts
  • Disney Cruise
  • Ski Passes & Gear
  • Insurance
  • Harry Potter World

How does your current rate of spending compare to 2009/2010? I’m double my bear market rate. Sitting at a 2007/2008 rate of spending (with 3 more dependents).

Are you considering any big-ticket items?

I am:

  1. Vacation property
  2. Trading up my home
  3. New vehicle

There is information in what you are willing to consider. #1 and #2 are rarely on my radar.

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What’s happening locally?

We are doing well in Boulder County, 2% unemployment, significant investment in schools, parks, and recreation facilities.

Some things stand out at the margin,

  1. multi-million dollar homes being left empty by seasonal residents
  2. houses being purchased for ~$1.25 million then torn down
  3. properties selling for double 2007/8 valuations
  4. local governments seeking to borrow HUGE and take technology risk on utilities / broadband

There are many people choosing risks they do not need to take.

There are many people sharing stories about quick money being made.

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Risk being ignored across all levels of society.

State => We have an active State Assembly passing laws and regulations as fast as the Governor can sign => at the margin… they are seeking the repeal of TABOR so they can spend money even faster.

Federal => in the news… medicare for all, national student loan forgiveness and a war of choice with Iran. No constraint on the ambitions of government.

Interest rates => at the top of the cycle, moving away from rate increases and a yield curve showing sub-2% money five years out.

VC to Public Markets => rapid internal dealing to ramp valuations prior to IPO => weak post IPO performance. The smart money is shifting risk, fast.

Every political viewpoint, local to global:

  • acting as if capital is unlimited
  • taking on risks of choice
  • increasing debt burdens
  • agreeing to future commitments of unknowable magnitude

These conditions are how bad ideas get funded.

  • Asset prices at all-time highs => a price umbrella influencing EVERYTHING
  • Cost of debt back at a generational low => easy money

If you are smart then the marginal idea that gets funded might be your own! Right now is THE time to raise money, sell businesses and unload illiquid positions.

If you are concentrated then consider taking money off the table (link is a blog of mine that’s worth your time).

Stay variable.

Cash Holdings in Context

2019-06-09 07.03.52The Algebra of Happiness is a great read. Professor Galloway has a hit on his hands.

In the book (page 83), Professor G says “I’m 80% in cash.”

I am used to hearing about wealthy guys’ portfolio allocations, I didn’t give it much thought.

However, his statement caught my wife’s attention (Big Time) and I spent a while explaining why I’d give the Professor an “incomplete” on this short section (of an excellent book).

Here’s what I said…

Start by laying out your sources of income:

  • Social security
  • Day job
  • Consulting gigs
  • University professorships
  • Unearned portfolio income
  • Rental property income
  • Tech fund consulting
  • Royalties from bestsellers
  • Spouse’s income

The segments, and the total, are useful to review.

These are figures you should know, roughly, off the top of your head.

Now, consider the information against your core cost of living.

I guess Professor G’s core cost of living is well covered by his sources of income. I’d further guess that his balance sheet has his family’s living expenses covered for the next hundred years. He is unlikely to be hurt by any investment strategy he selects.

The spread of your income sources will show concentration and diversification. Concentration can ruin life as you know it. You are likely to have skin in this game.

Addressing concentration can save you from ruin. Tweaking asset allocation, less so.

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Next, consider the areas of your life that hold option value:

  • Youth
  • Education
  • Ownership (bi-coastal real estate, start-ups, portfolio investments)
  • Wealthy relatives
  • Carried interest in tech firm general partnerships
  • Fame
  • Bestsellers
  • The ability to spend less
  • Equity stakes people toss you for being an entertaining non-executive director
  • World-class skills in well paying, niche specialties

When successful people talk about holding a lot of cash, they rarely mention the MASSIVE option value in the rest of their lives.

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What is cash?

As I write this I have six weeks’ living expenses in cash.

Seems really low!

  1. What if I add my US government bond portfolio?
  2. What if I net my unearned income sources from my core cost of living?
  3. What if I take a part-time job in one of my niche specialities?
  4. What if I downsize my house by moving?

In that case, my six weeks of cash should see me through to my 75th birthday.

Incidentally, I did all of the above 2009-2012 after my professional life was crushed.

Thankfully, I had a large cash holding at the time! 😉

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What should you hold in cash?

When allocating capital, most people want to receive a forecast of the unknowable.

Avoid pundits, forecasters and the predictions of others. They are worse than useless.

Each time I make an important decision, I write a file note to myself. Sometimes I publish these notes! Do this for 30 years and you’ll have a written record of your strengths and blindspots.

I use my limited attention to consider the implications of being wrong.

Overweight in cash and I am right:

  • Rich already => no implication, if you’re not satisfied with what you have today then you will not be satisfied with more tomorrow
  • Rest of us => Need to decide when to invest
  • Rest of us => Need to decide what to invest

The track record of “rest of us” is clear. We do an awful job at market timing and dynamic asset allocation.

Overweight in cash and I am wrong:

  • Rich already => no implication, my unborn grandchildren inherit less unearned capital
  • Rest of us => my widowed wife runs out of money in her 80s
  • Rest of us => I become a financial burden on my adult children

Some games you don’t want to play.

 

Effective Real Estate Ownership

When you buy real estate, what’s your goal?

We want to live in a fabulous place, while getting rich on asset appreciation.

It sounds great but the choice of moving into an affluent community increases expectations, and cost of living.

“So what?”, you say.

The hidden cost can be time for our kids and marriage.

In the Great Recession, I changed course…

We aim to create a portfolio of assets enabling us to live for free in an effective public school system that’s close to nature.

In your teens, you will start to make investment decisions… how much to work, spend, save, donate and borrow. You have 50 years to create your portfolio!

Live for free:

  1. In high-school: with your parents
  2. As a young adult: a place where your roommates subsidize your cost of living
  3. Next: a house with many bedrooms — the first place I owned had the capacity to support me via roommates
  4. As soon as I “could afford it” — I made a mistake with a large, expensive to own, flash property!
  5. …but I found myself unexpectedly unemployed and we couldn’t afford it
  6. Eventually, we wised-up, downsized our home, and bought rental properties that covered our mortgage and healthcare.

When my wife is 65, the mortgage will be paid off, the kids will be educated and her retirement self-funded by the residual real estate portfolio.

How much of our cost of living can be permanently covered, or hedged, by this decision?

Most people aspire towards material goods, appearances and spending.

I urge you to patiently buy time, personal freedom and shared experiences.

Most of effective investing is learning, saving and waiting.

 

High Finance

2016-09-24-10-14-55Keep your ears open this week. There will be a rare opportunity to learn about finance.

For my international friends, many of the American techniques (in the news) are available in your home countries. I have been applying finance, across four continents, for more than 25 years.

2016-09-25-18-48-42The overall financial system works great. However, when I try to explain certain shortcomings to my friends, their eyes glaze over and I lose them.

I wish I was more skillful.

Whether your favorite billionaire is a Cuban, a Koch, or a Buffett, we can learn a lot from insiders. A constant refrain from wealthy insiders is “complexity creates opportunity for the system to be gamed for economic benefit.”

Finance is a complex system. The system has been gamed extensively.

  • Offshore accounts (Panama Papers type stuff)
  • Thinly-capitalized investment vehicles, with lots of debt
  • Applying non-cash losses today, while deferring cash gains to tomorrow
  • Receiving preferential tax rates on gains associated with financial work
  • Using trusts to avoid estate and generation skipping taxes
  • Using special accounts to shelter income and gains across generations
  • Income reclassification to avoid income and payroll taxes

If the collective wants to run the system like that then I’ll bow to its will. However, I’m not sure the collective knows what’s up.

2016-09-28-10-43-49-1Like professional sports, my beef isn’t with the system. What irks me is the lack of integrity when insiders pretend the system is different than reality. The politics of the people I named above are different but their observations are often similar.

I’m grateful I can explain my personal reality without fear of banishment or loss.

Living a life you can disclose saves a lot of suffering.

Intro To Margin Finance

snow_mtnBDC asked for an example for my post How Leverage Kills.

If you don’t understand debt then assume that the only time it might make sense to borrow is when your 30-year fixed-rate mortgage payment (including taxes & insurance) is less than your cost to rent. Assume that all other forms of debt will hold you back, prolong being a wage slave and reduce your retirement income.

The people that take issue with the generalizations above are probably trying to sell you something, and working on commission.

My family’s only borrowing is a 30-year fixed rate mortgage. Our mortgage payment is 60% of what it would cost us to rent. I made a calculated bet that our mortgage debt would provide a hedge against rental inflation.

Homeownership isn’t necessary for financial freedom. I bought the house because:

  • I have a young family
  • Don’t mind being geographically restricted
  • Live in a great public school district
  • My youngest won’t graduate high school until 2030
  • Our city is likely to experience above average real economic growth
  • I’m in a better part of town

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Let’s assume our investor has $100,000 and owns an asset that yields 2% after expenses ($2,000 net income).

  • Along comes her investment adviser and offers a portfolio loan – rates are low right now so the loan will cost her 3% per annum.
  • Our investor decides to borrow $50,000 and purchase more of the same type of asset.
  • Now she has $150,000 of assets, still yielding 2%, so $3,000 of income each year.
  • The loan is interest only and costs her $1,500 per annum (3% of $50,000).

Where things get wonky is if the asset’s yield disappears — for example if a rental property is vacant — OR — if the capital value drops significantly — for example if a portfolio of stocks falls 50% in a bear market.

Let’s look at the 50% asset value decline.

  • The value of the asset falls from $150,000 to $75,000.
  • The value of the debt stays the same $50,000.
  • Therefore the net equity value falls to $25,000.
  • The net cash flows stay the same $3,000 from the asset, $1,500 interest to pay, $1,500 net after interest.

If you generate enough cash to pay your interest then you can ride out the bear market and wait for asset values to return to pre-crash highs.

However… a common feature of margin lending is the bank can ask for their money back… ….and they have a habit of asking at the worst time.

Sometimes, they don’t ask, under the terms of your loan they have rights to sell you out of your position.

Let’s have a look at what happens if the bank asks for their money back at the bottom of the market.

In that case, you crystallize a 75% equity loss ($100,000 to $25,000). You are left with $25,000, which will be worth $50,000 (earning $1,000 per annum) when the market recovers to pre-crash levels.

If you didn’t borrow, you earn your 2% per annum through the bear market and end up with $100,000 (earning $2,000 per annum) when the market recovers.

Market Moves

The chart shows major bull and bear markets.

Using your own money, a habit of margin finance could wipe your investment out every 10-25 years.

Some risks aren’t worth taking, especially with money that you can’t afford to lose.


So Why Borrow?

In a bull market, it’s tempting to borrow a much higher percentage of the total investment. Hedge funds, and investment banks, can get over 90% leveraged, against shareholders funds (also known as other people’s money).

When you guess right with other people’s money, the “house” will get rich quick. I worked in a business that received 20% of the profits generated.

When you guess wrong, the clients take the losses.

More on leverage in Part Four of my free eBook Live Long & Prosper – specifically pages 46 to 51.

The Do-Something Investment

Ax_snow1I saw that Clinton’s son-in-law took some big losses at his hedge fund by making bets on Greece. People are speculating that the Clinton family lost a lot of money in the deal.

While the scale might be different, I see this error in every family that I get to know.

We err by making an investment to help someone “do something.”

Some examples from my own investment history:

  • I’m self-employed and have often been tempted to buy myself an office so I can have a place to do something
  • I’ve offered to back friends in start-ups so they can have the funds to create a business and do something
  • I backed myself in a low-return business, where I didn’t understand the market, so I could have something to do
  • I guaranteed the debt of a friend’s business so he could borrow additional money for his start-up
  • I purchased a property so a friend could have a job acting as my property manager

To limit the damage, I have two questions that I ask.

First: What is the purpose of my family balance sheet?

  • Maintain independence and dignity of elders
  • Educate the kids
  • Share experiences with each other
  • Produce a growing stream of cash flow to fund my future living expenses
  • Support a feeling of security and freedom of occupation

You might have a different list. I’d encourage you to write your list down because the checklist might help prevent expensive errors.

Second: How well have I done with predicting my life on a ten-year prospective basis?

While my life has been rewarding, it’s path has been unpredictable on a ten-year rolling basis.

The unpredictability of life means there is value in maintaining a straight-forward balance sheet that isn’t concentrated in any individual, geography or company.

Put plainly, I’m nearly certain to continue to get the future wrong – especially when I try to predict my family’s needs, desires, location…

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Let’s say an investment can get past those two questions.

It is time to keep it real.

#1 – Are we backing the best members of our team?

The best people don’t need the help of connected parties.

Because…

There is plenty of money available for good people with good ideas.

Therefore, by definition, most family investments are focused on the weakest members of the team.

Don’t do it.

#2 – Can we afford to lose our maximum exposure immediately?

Concentration kills.

If you can’t afford to lose your full exposure, immediately, then don’t do it.

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If you’re struggling to say “no” then

  1. say “yes” to spending time to help raise funding from a third party
  2. lease instead of buy
  3. focus on enjoying each other’s company, rather than investing together
  4. make an introduction to an expert in the industry to facilitate a working apprenticeship
  5. pay for expert instruction

These options have had a great rate of return in my life.