Tag Archives: financial education

Buffett and Munger For Familes – My Wife’s Cats

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Two Cool CatsWhat can a family learn from one of the most successful investment partnerships of my lifetime?

Last month, I read Tren Griffin’s book on Munger and re-read Warren Buffett’s Owner’s Manual for Berkshire Hathaway.

I read them NOT to figure out how to make money. I read them for ideas to make myself more useful to my family and make less mistakes in my decision making.

A successful partnership is characterized by:

  • Shared responsibility and shared benefits
  • Trust and open communication
  • Confidentiality, only when necessary, rather than secrecy

The role of the managing partners:

  • Allocate capital
  • Structure incentives
  • Seek to embody shared values
  • Communicate via stories
  • Resist the urge to seek an edge

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Financial Strategy, for capital allocation

This is important. Even financially-sophisticated families get caught up in the noise that constantly surrounds us.

Keep It Simple

  1. Focus on sustainable cash flow divided by capital employed
  2. A fundamental reference point is the 30-year rate on US government securities
  3. Treat deferred tax as a valuable, unsecured, non-recourse loan from the government

My recent article on the Boulder real estate market used the above.

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Understand the value of deferred taxation

If you sold everything you owned (right now) then how much tax would you have to pay?

Many would be proud of a low number. I know that it would make me feel safe.

Buffett and Munger would argue that you want this number as high as possible.

In my family’s case, we would have to pay 6% of family assets, on a portfolio with an average investment age of less than five years.

Historically, we’ve earned ~15% per annum on family capital. I don’t expect that to continue, so let’s assume the family earns 7.5% going forward.

What’s the value of NOT selling and letting the 6% deferred tax asset continue to compound?

7.5% of 6.0% is an extra 0.45% per annum.

Let’s make that number real.

Express it in dollars and compare to your family budget.

  • In our family, it’s equivalent to our federal income tax bill
  • In a friend’s family, it’s equivalent to what they pay for professional advice
  • In another family, it is more than they save each year

If your advisers churn your assets then they are costing you much more than their fees.

View percentages in dollar equivalents.

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Berkshire has bought sub-par business in the past. However, so long as the businesses have decent management, good labor relations and generate a little cash… they stick with them.

It’s like my wife’s cats.

  • When she goes out of town, they pee on our bedding and furniture.
  • Most weeks, they barf a few times around the house.
  • However, the kids love them and are aware of their faults.

By sticking with the cats, despite their faults, I demonstrate loyalty to the entire family.

That said, I’ve made the point…

We’re not replacing the cats.

 

 

 

 

Small, Negative Suprises

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Sneaky SquirrelPart of being human is a tendency to over-react to small losses.

As this error has cost my family (big) money, I’m going to share a case study that illustrates the point.

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One of my jobs is to manage a small portfolio of local real estate. From time-to-time items come up that need to be sorted. Each of those items represents a small dose of unexpected pain.

In most years, there will be a dozen items that require action. Total cost of these items is on the order of one-month’s living expenses.

To give an idea on scale of the “pain”, the portfolio is worth ten-year’s living expenses and, annually, it generates cash equivalent to seven-month’s living expenses.

Combining the above, you could calculate that the portfolio has a cash yield of ~5% on net realizable value.

When compared to all of the alternatives, this investment is one of the best places to invest.

But the random, little bits of pain hurt — jammed sewer lines, flooded basements, six-foot high marijuana plants, missing tenants, leaking toilets… none of this is unusual, or unexpected.

The small doses of pain hurt so much I’ve been considering selling the portfolio and switching into a less attractive investment.

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To escape the small and random pain, I am willing to accept certain, large and immediate pain! A discount on market value and payment of significant tax liabilities. The total cost would be more than two-year’s living expenses.

In a fantastic investment, with less attractive alternatives, I’m willing to pay 25x more than the cost of the pain to make it go away.

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Rather than pay two-years living expenses to make the pain go away, I’ve hired a property management company to insulate me from the pain.

Annual cost is 0.6% of net realizable value and less than a month’s living expenses.

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Beware of quick reactions triggered by small, negative surprises.

They are often irrational.

 

 

Wealth Habits: Capitalizing Luxuries and Time

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IMG_4160Over the last year, I’ve sold two paintings and a piece of jewelry. My family had owned these items for a long time and they have given us a lot of pleasure. However, each September, an insurance bill arrived and gave me a fair amount of pain.

So now the items are gone and last week my insurance bill arrived. I noticed that my insurance savings are enough to take my wife to visit any museum in the world, annually, forever.

By getting through the pain of change (the sale)… I created a situation where we could share experiences together (future trips).

The cost of the status quo is often hidden.

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Similar story.

I’ve been thinking about buying a boat, a sprinter van and/or a truck.

Despite evidence to the contrary, at some level, I think these assets will make it easier to spend time with my kids.

These assets are expensive to own, depreciate and require time to maintain.

How to counter the urge to purchase?

Assume depreciable assets are free to own, lease, keep receipts and track total time/spending in a year.

Cat SailAn example for the boat:

  1. As a teenager, I spent many summers working on the water. In those years, what was the total number of days that I would spend on the water? My peak days were 60 per annum. This year was closer to 25 days.
  2. Based on my rental history for the last two years, what’s the average cost per day of renting, rather than owning? Let’s assume it is $1,000 per day.

Based on actual days on the water, how many years expenditure would I capitalize with a purchase? In my case, it is 10-25 years of expenditure based on how you slice the numbers and the size of vessel. Also, worth noting that I was on seven different vessels in 2015.

The above analysis is essential before you buy a vacation home, consider becoming a ski-family or purchase a large depreciable asset.

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Think back one decade, or two… have your preferences changed? Mine have changed tremendously and I have discovered that I am a lousy judge of what I’ll want in ten years’ time!

How might a large capital purchase impact the freedom you have to allocate your time?

By staying variable in the family budget, I can:

  1. free significant time in my daily schedule
  2. finance childcare
  3. budget for shared experiences
  4. immediately ratchet down spending, when required

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2015-09-20 17.53.02The final step is to pay attention when you are enjoying a “luxury” expenditure.

Notice the changes (if any) with your inner experience.

My benchmark is the way I feeling during a walk in the forest that’s ten minutes away from my desk.

Live where you don’t need to leave.

Real Estate – Should I buy or sell?

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2015-09-14 13.55.37

In May 2014, I shared a template for reviewing your real estate. Let’s revisit that property – (prior values in parenthesis).

  • Today’s Zillow value $1.2 million ($850,000, +26%)
  • Recent Assessment value $1.05 million ($830,000, +27%)

Zillow and the county assessor have revised values up by more than 25%. You’re wondering if there is a bubble. You receive an offer of $1.1 million, should you sell?

In the article from May 2014, the “owner’s value” was $925,000. This offer is ~20% higher. Seems straightforward to sell, but pause to consider…

  1. How has the investment changed over time?
  2. What are you going to do with the money?
  3. What are the tax consequences of selling?

2015-09-11 15.25.11Investment Review

The big story in Denver/Boulder real estate has been increasing rents. The current rental income for the property is ~$60,000 per annum. Taxes, insurance and repairs cost $10,000, so the net cash flow is $50,000 per annum.

Previously, cash flow before interest and depreciation was closer to $25,000 per annum. So there has been a near doubling in the annual cash flow from this investment, but pause to consider…

Is the cash flow sustainable?

In this case, the cash flow is not sustainable. Houses wear out, roofs need replacing, plumbing needs repair and appliances break down. So let’s adjust the $50,000 per annum to $40,000 to reflect sustainable cash flow.

The offer is $1.1 million to buy $40,000 of sustainable cash flow. That is an implied yield of 3.6%.

How does that stack up?

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Alternative Uses of Funds

US Treasury Yields

  • 5 year, 1.6%
  • 10 year, 2.3%
  • 30 year, 3.1%

Vanguard Select Fund Yields

  • VTSAX (US Equity) – 2.0%
  • VBTLX (US Bond) – 2.2%

If you are the seller then you should ask yourself “What am I going to do with the sales proceeds?”

If you sell real estate that yields 3.6% to buy bonds that yield 2-3% then the value of your investment is likely to be eroded over time. Most obviously, because rental income tends to increase over time, while interest payments are set for the duration of the bond.

High-quality assets with growing income streams are attractive.

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Taxes

If you sell at $1,100,000 (to a buyer without an agent) then what’s your net realizable value?

Using numbers consistent with the May 2014 article, you would net about $1,025,000 (before any mortgage pay off).

You’d also want to adjust the sustainable cash flow from the property to reflect taxes you pay on the income. To make things simple, let’s assume a sustainable cash flow after taxes of $32,500 (yielding ~3.2% after tax).

The above numbers would change, possibly significantly, based on the size of mortgage payoff and your personal tax position.

It’s worth having a professional walk you through the detail.

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Overall

When I look at the above, I see a market that has increased 25% in value. Seems like a lot.

  1. Rental growth is in line with the increase in value.
  2. Alternative investments are yielding less than this asset.
  3. The asset is located in a zip code with real-economic growth that is higher than the US average.

So the market seems fairly priced – at least to me, today.

What should the buyer and seller do? In these market conditions, they are likely fine either way.

What’s going to happen to future rents and prices? I would be suspicious of anyone that claims to know.

Family Financial Review

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2015-09-10 11.53.28August/September is the time of year when I do my life review. I’ll be writing about the various components over the next few months.

2015-09-04 19.00.49Fear Impairs Judgement – you’ve certainly felt financial fear in the last three weeks. However, the lesson runs deeper than short-term volatility.

The financial media tempts me to:

  • frequently tweak strategy
  • aim for the perfect asset allocation
  • act impulsively to avoid future losses
  • seek superior returns

Strategically, I want to avoid all of the above.

Tactically, I want to manage family expenditure and execute a reasonable long-term financial strategy to the best of my ability.

Being good enough is good enough.

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Sell Illiquid Assets Into Late Bull Markets – in 2014, I decided to sell land, art and jewelry.

Our illiquid assets cost money to hold and I realized that the cash would be better spent on childcare and pre-K education.

Despite selling for less than expected, the net result has cut the family’s core cost of living by 4% and enabled my wife (and me) to work less.

The question to ask yourself is not “is this my best price?”

The question to ask yourself is “are we in a late bull market?” If the answer is “yes” then it’s a good time to sell illiquid assets.

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2015-09-06 17.06.43-1Asset Allocation is often a distraction from what matters – with good wealth habits, you can ignore the small stuff.

Here’s a post from December 2010 on asset allocation. Five years along, I’m making progress at following my own advice.

This post from April 2012 (about my future asset allocation) reminds me of the folly of forecasting.

For the benefit of my future self, here’s a snapshot from 2015.

  • 30% – investment real estate
  • 25% – low-cost, diversified equity funds
  • 25% – fixed income in home currency
  • 15% – family home
  • 5% – cash and other

There are historical and family-specific reasons for the above. Not a recommendation to your family.

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2015-09-06 20.04.16Time and Health – Am I acting in harmony with my mortality? with my values?

If you find that a self-serving bias isn’t generating satisfaction then consider shifting your focus towards taking better care of your health.

The shift towards health will surface conflicts between your values and how you allocate your time.

No step is too small with regard to positive self change.

 

Can’t Be Bought

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bearLooking forward to 50, I will find myself with 10, 7 and 6 year olds living under my roof. Those are great ages to accompany a 50-something man as he explores the world.

There remains a lot to look forward to.

The key advice that I give myself, and offer you, is to approach life with the understanding that you can’t be bought.

The reality is, often, we can be bought. If that describes your current position then keep your mind open to the possibility of increasing your price until you remove it all together. That’s what I’ve been working towards for the last 20 years, or so.

What’s your price?

I must remember the dissatisfactions have come from letting money influence my life choices. I’ve taken on assignments because I thought I should, rather than because they fit my principles. I’ve sustained a double-whammy when those assignments took me away from the people closest to me.

What are better principles to guide my thinking?

  • Lean towards marriage, family, friends, local community – let’s call these Core People
  • Share experiences with Core People
  • Pay attention to spending that has an immediate beneficial impact – my highest utility spending is childcare that enables me to share experiences or spend time alone
  • Aim to help all people – keep broadening my circle of altruism
  • Set aside time for continuous simplification – automatic bill pay, empty time in my schedule, reduced admin, streamline possessions
  • Don’t pay for luxury – adversity makes fond memories

Every day offers a chance to turn toward my principles.

When To Review Strategy

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dad_axI’ll start with my answer… now is not the time to change strategy because I know…

  • The more often I change, the greater my opportunity for error and increased costs
  • The more changes I make, the worse I’ll do

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Q2-2015 marked the completion of the five-year plan that I put together at the end of 2008.

When to consider change?

A major life event is a good time to consider change.

  • In 2008, I was faced with unemployment.
  • In 2000, it was a divorce.
  • I’ve seen friends face criminal charges, bankruptcies, health emergencies and deaths.

A crisis can be a sign that, absent change, things are likely to deteriorate. It can also provide a nudge to endure the discomfort of change.

In my case, a high-spending rate combined with unemployment to tip me off that I was heading towards a major problem.

The plan required us to move (twice), establish new careers, achieve a dramatic reduction in spending and change the allocation of 95% of our balance sheet.

I expected the changes to be costly and forecast our balance sheet to decline by 20%. I was wrong. In reality, the balance sheet increased by 2% per annum.

Why?

  • I’m good at cost control – we made changes early, and severely.
  • We maintained exposure to favorable events – things like promotions, bonuses, babies, cheap mortgages, new friends, equity options.
  • Despite my fears, the world tends to improve.

I was also wrong about the price that we would achieve for the assets we sold. On average, we sold 10% under my estimate of “fair value.”

The Endowment Effect shows that we overvalue what we own. It’s valuable knowledge to be reminded that I’m prone to the standard forms of human misjudgment.

These two lessons are important to remember:

  • Things are likely to turn out better than I expect
  • I overvalue what I possess (jobs, assets, habits, the status quo)

I paid close attention to my “good days” since 2008. They were nothing like I expected and have influenced my thinking in how best to spend the next 1,000 days.

Effective Wealth – Legal and Strategic Considerations

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alvinIn my first piece on effective wealth, I laid out…

  • Individual wealth => 5 to 10 years cost of living
  • Generational wealth => 10 to 25 years cost of living
  • Multi-generational wealth => 25 to 40 years cost of living
  • Surplus (excess?) wealth => beyond 40 years cost of living

We hold our individual wealth in Living Trusts – these have the benefit of being fully revocable (assets in and out easily) and transparent to the IRS (easy for taxes and administration).

TIP – five years cost of living in a debt-free balance sheet will change your life and make you far less susceptible to corruption and influence. Once you hit ten years cost of living (in a debt free balance sheet) then you should consider cutting expenses and working part time. At a minimum, 5-10 years worth of wealth should trigger a sabbatical to consider personal wellness and how you allocate time.

Generational wealth is held in an irrevocable Grantor Trust that benefits my spouse and kids. I can’t get the assets back nor can any creditor or petitioner. In my lifetime, I retain the obligation to pay taxes on the trust as well as the ability to swap assets in/out for fair consideration. Admin is about the same as managing a partnership/LLC with similar assets/earnings.

TIP – once you are nearing 20 years cost of living in a debt-free balance sheet you are close to the breakout point where you can stop working, forever. Now is the time to shift towards personal wellness!

Multi-generational wealth – this is small part of my family balance sheet, because I followed my advice at each of the above segments. We use a Private Trust Company (in a state without income tax) that oversees a trust that benefits my descendants. We also use 529 (college) accounts.

TIP – the first time you realize that you might be making money for your adult children STOP and undertake a life review that focuses on how you allocate time and personal wellness.

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What does all this cost? Charging market rates for my work, I oversee the structure for less than $5,000 per annum. Living Trusts/Will were $5,000 to set up. Grantor Trust was $5,000. Private Trust Company and Family Trust was $10,000. These are Boulder, not New York, rates.

How does this give you peace of mind? My personal assets are the smallest of any adult in my family tree. By value, I own less than 1% of the above structure. I am free to give my family the gift of service.

I’ve said what needs to be said.

I’ve done what needs to be done.

I’m free to focus on loving those that love me.

 

The legal and tax consequences of an error in your family structure can be severe. Take expert, local advice. Nothing on this site should ever be considered professional advice.

Effective Wealth – Due Diligence Results

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tulipsThis series started with a definition of effective wealth and a due diligence exercise for your family.

I’ll share the best tips that I received from my due diligence work:

A general liability umbrella policy can be an effective way to insure against ruin – in my life, hosting events (where athletes might die) was the source of my greatest liability. Due to my other insurance coverages, $5,000 per annum bought me $5,000,000 of coverage.

Have an expert read your insurance contract to ensure you’re covered for your key risks. I’ve reviewed draft policy documents that specifically ruled out the only reason I was buying the policy!

Paying $5,000 per annum got me thinking that there might be a better way to structure my life. There is a better way and I’ll share my family legal structure in a future post.

Hosting athletes is a low-margin business and my need for multiple insurance policies greatly reduced the profitability of the events. So I handed the events off and removed myself from their promotion and management.

In speaking with successful families, three things stood out.

#1 – the advice to share information widely and control the structure narrowly. As much as possible the family is involved and consulted on family matters. However, not more than two individuals from each generation are involved in governance. Write out the process for a family member to become a fiduciary, or trustee.

#2 – each generation must decide their own values. It’s impossible for elders of the past to influence third and fourth generation family members. The best tip here is a reminder that no matter what you do, what you decide, what you structure… there will be aspects of life that you find disappointing – in yourself, in your spouse and in your kids.

#3 – young family members should be given the opportunity to learn from mistakes early in life. No family member should be given the opportunity to bring down the entire family and individuals should experience the impact of their poor decisions.

How To Make Money At Real Estate

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taxiEffective last month, my family owns a house in North Boulder for a net cash cost of US$100,000. It took me a decade to get that deal done. I did a similar one in New Zealand in 2001.

When I buy, I look for a good asset, at a fair price, with built-in options that can create upside.

If you’re going to make superior returns then it will be due to an option embedded in the deal.

For example:

  • Excess land gives the option to subdivide (Boulder 2010)
  • Buying outside my “home” currency of US dollars gives the ability for international arbitrage (New Zealand 2001)
  • Buy homes for less than their cost to build (Tucson 2010)

The goal is not having a property that you would be proud to show off to your friends. Until recently, I owned a “pride” property. A 6,000 sq. ft home that earned my family nothing for the time we lived in it. Truly fantastic house, mediocre investment.

Likewise, the option should not be created by using a ton of leverage. High leverage is appropriate only when you’re using other people’s money in a non-recourse vehicle. More here.

When should you buy?

#1 – Buy when you need the asset. You rarely need the asset! Be patient.

#2 – Buy when the cost to own is FAR less than the cost to rent – see my free ebook for how to do this calculation.

#3 – Buy when banks are foreclosing – banks, governments and trustees often sell for less than fair value.

#4 – Buy when the local debt market has collapsed – a cash buyer in a liquidity crisis will receive favorable terms.

Note, these tips apply to every asset and you’re going to need substantial liquid assets to take advantage.

All of the above, imply that you should study your target market for a decade before you buy. I also recommend that you limit your equity investment to 15% of your family’s balance sheet.

Right now, we’re in a bull market and you probably feel like you will never get another chance to buy at distressed prices.

You’re wrong.

In my working life, I remember bear markets in 1990 (UK), 1997 (Asia), 2000 (US) and 2009 (Global).

Take your time and remember you don’t need to do the deal.

Once a decade, the patient investor will be sent a fat pitch.