One of the ideas that has become quite pervasive within the minds of investors is the notion of a “good stock” or a “good property” to own.  This notion stems from a general desire on the part of most people to own things of quality.  In our personal life, this frequently manifests itself as a desire to own a comfortable home, and a reliable automobile.  Quality gives us a feeling of safety and security.  Thus, it seems completely natural to want our investments to be the stock of a high quality company, the bonds of a high quality corporation of government, or a property that is desirable in both its quality of construction and location.  The problem with this view is that it only provides one half of the information that you need to determine whether an investment is a good deal.

The second half of this investing puzzle is price.  Put bluntly, the quality of a stock, bond, or property investment only matters in relation to its price.  This means that a ram shackled, blighted property can be a phenomenal deal at a certain price.  The stock of media darling companies such as Apple, Google, and Amazon can all be terrible investments at a certain price.  It is certainly true that high-quality investments can frequently justify a higher price than lower quality investments.  However, it is equally true that any investment can be a spectacular deal if the price is right.

The key for investors is to determine when the price of a high-quality stock, bond, or property is over-valued, or conversely when the price of a lower quality stock, bond, or property is under-valued.  Any investment is a good deal at one price, and a poor deal at a different price.  Unfortunately, it is frequently very difficult to determine exactly where these two boundaries are drawn for any particular investment.

When estimating the appropriate price for a particular investment, there are two relevant factors that need to be considered.  The first is the expected future price, the second is expected future cash flow, and the third is taxes and inflation.  When combined, they will create a holistic picture of the value for any particular investment.

Expected Future Price

• In the world of stock and real estate investing, this is referred to as appreciation.  Fundamentally, it represents the expectation that the future price of an investment will be higher than the price you paid to purchase it.  This is frequently referred to as the ‘buy low, sell high’ philosophy.  For most investors, this is the primary source of value that they see.  Stock market tickers report the price of securities, and the Multiple Listing Service reports the price of properties.
• However, the ubiquitous availability of price information frequently causes people to over-emphasize price appreciation as a source of value.  It is most certain that price appreciation is an important source of value for investments, but it is certainly not the only value vector.  The fact that so many people focus on market prices has made them become very volatile over the past few years.  Values for stocks, bonds, and real estate have all fluctuated significantly.  This has made future price appreciation very difficult to predict.
• In addition to all of this, there is one further characteristic of price that investors must take into consideration.  In order to capture the benefit of price appreciation, you must sell the investment.  This means that watching the value of your stocks or real estate skyrocket means absolutely nothing unless you sell and lock-in the gain.  Thus, in order to realize the full gains from future price appreciation, it means that you must sell at the right time.  In practice, this is very difficult to do and frequently results in selling while values are still going up.

Expected Future Cash Flow

• Another key characteristic of what makes a good vs. bad deal for investors is the cash flow that is produced.  In the case of stocks, this comes from dividends.  In the case of bonds, this comes from interest payments and the future return of the bond face amount.  In the case of real estate, this comes from rents that are paid by tenants for the use of your property.  The importance of cash flow to the value of an investment is that it represents a current, tangible return.  Typically, investments that produce the best cash flow don’t always have the best appreciation.  However, they also tend to be less volatile since the price tends to be more highly correlated with the rate of cash generation than the market expectations for future price increases.
• The way that most investors articulate the future cash flow of an investment is through its yield.  In simple terms, the yield of an investment represents its annual cash flow divided by the price paid for the asset.  In the case of stocks, the “dividend yield” is the annual dividends divided by the current market price.  In the case of rental real estate, the “capitalization rate” is calculated by dividing the annual net operating income of the property by the purchase price.  In the case of bonds, the discounted future value of all payments is compressed into an internal rate of return, which is articulated as the bond yield.
• In most cases, the rate of cash generation for an investment is much less volatile than the market price of that investment.  Stocks that pay dividends tend to adjust their dividend rate at a much slower rate than the market value gyrations of its price.  Rents from income properties tend to shift much more slowly than the value of the property.  Bonds typically feature a fixed interest and repayment price, with their market value being determined by the movement in yield rates for similar instruments.  When market yields increase, the price of bonds currently on the market go down.  When market yields decrease, the price of bonds currently on the market go up.

Taxes and Inflation

• The final key characteristic that differentiates good vs. bad investments is inflation and taxes.  Inflation represents the erosion of you investment’s purchasing power and taxes represent the amount of your gains that need to be paid to the government.  One of the oldest and most important concepts in finance is that “It’s not what you make, it’s what you keep” … fundamentally, this means that the “real” rate of return for your investments is much more important than the “nominal” performance.
• Starting with inflation, it is important to understand that when the amount of money in circulation expands more quickly than the amount of goods and services being traded, it creates upward pressure on prices.  For some asset classes, the effect of inflation is relatively benign, for others it is beneficial, and for some it is devastating.  By and large, property values tend to be lifted in proportion with inflation, while cash flows from dividends and rents are also increased by inflation.  Some stocks move up with inflation, but certainly not all.  On the other hand, bonds with a fixed interest rate are destroyed by inflation since it de-values the interest payments.  Conversely, fixed-rate debt that you owe is wiped away by inflation as the dollars you use to re-pay the loan become less valuable.
• Another key characteristic to understand is taxes.  Different types of income are subject to different rates of taxation.  Generally speaking, income that is earned from a job encounters the most taxes.  Income that is earned passively encounters less taxes, and income earned from capital investment encounters the least taxes.  Astute investors also understand the impact of legitimate business deductions, non-cash expenses such as depreciation, and deferring capital gains through a 1031 exchange to reduce their tax burden down to the legal minimum.  In many cases, it is tax advantages that turn a good investment into a great investment.

Ultimately, it is the responsibility of each person to determine what constitutes a superior investment deal.  Since people have different appetites for risk, there will always be a variety of investors bidding for a variety of assets.  What is most important for the individual investor to do is take an honest assessment of their personal investment tolerance and make decisions that incorporate all of the major value factors.  By balancing the future price, future cash flow, inflation risk, and tax characteristics, it will allow you to build a strong portfolio of optimized deals.

 

It can happen to the best of entrepreneurs. While a new business owner is putting in long hours to build a business, a marriage can fray. The next thing the owner knows, his or her spouse may be filing for divorce.

This scenario is all too common. Forty percent to 50 percent of all first marriages in the U.S. end in divorce, according to a 2010 report by the National Marriage Project at the University of Virginia. The divorce rate for second marriages is even higher.

For those whose marriage is in trouble or who are about to begin a divorce, a few strategies can help preserve a business. Once the divorce proceedings start, entrepreneurs won’t likely be able to implement some other legal maneuvers that, if accomplished in happier times, could keep their business from landing in a soon-to-be ex’s possession.

A typical scenario, according to family-law attorney Robert Kornitzer, at Pashman Stein, a commercial law firm in Hackensack, N.J., is: “You get married young with no prenup and you have a $100,000 business. . . not anticipating that, 20 years later, it’s a $5 million business, and now the spouse has some stake in the growth of the business.”

If you’re not careful in a divorce, you could find your ex is your business partner — or you could be fighting to keep your enterprise from being sold to raise cash.

Or you might lose the business to your ex. That’s what happened to Tereson Dupuy, founder of FuzziBunz, an online cloth-diaper business based in Lafayette, La.

Dupuy launched the company three years into her marriage after seeking better diapering options for her second child. But in 2005, close to the couple’s 10-year anniversary, the marriage unraveled. Dupuy discovered FuzziBunz would be considered a joint marital asset. Louisiana is one of a handful “community property” states, including California, which assume each divorcing spouse owns half the property accumulated during the marriage.

Dupuy says the stress of the divorce drove her into a nervous collapse and within 24 hours a judge put her husband in control of the company.

It took Dupuy a year and a large lump-sum payment to her ex — plus $15,000-a-month payments to her ex over many years — to regain ownership. The payments drained cash, and bankers considered her need to pay them outstanding debt, making it hard for her to borrow needed growth capital.

Is your marriage headed toward a breakup? Here are seven strategies to consider if a divorce is threatened or already underway and your company is considered a joint asset.

1. Maintain good records, and keep the family’s finances separate from those of the business. “Don’t borrow out of the house [account] to buy company trucks,” Kornitzer says.

2. Pay yourself a good salary. If you starve the family’s cash flow to build the business, a lawyer might later make the case that your ex is entitled to more of the company’s assets, according to Jeffrey Landers, founder of Bedrock Divorce Advisors LLC, a divorce financial strategy firm based in New York City.

“If you paid yourself $80,000 a year instead of $300,000 and were hoping on retirement to sell the business and enjoy the proceeds together and now that’s not happening,” he says, “then your ex will want [his or her] share” of the company.

3. Fire your spouse. If your spouse is actively involved in your business, ease him or her out as soon as possible, says divorce lawyer Daniel Clement, principal of New York City family law firm Clement Law. The more prominent the ex’s role and the longer he or she worked in the business, the stronger the case a lawyer could make that this spouse helped build the enterprise and should profit from its growth.

4. Sacrifice other assets. In a divorce settlement, a couple’s total assets are added up and then divided. Try to retain 100 percent ownership of the business by forfeiting other assets instead, such as retirement accounts, the family’s home, vehicles or collectibles, Clement says.

5. Get a fair valuation. Use a neutral, court-appointed valuation professional and then arrange for another outside party to review the figure before you agree to it, Clement says. Dupuy wishes she had challenged FuzziBunz’s valuation, which was based on a projection of 10 years of future growth rather than current revenue, she says.

6. Arrange to make any payments over time. It’s common to pay an ex for a share of a business gradually, as Dupuy did. The monthly payments can come from the business’s cash flow or a bank loan.

7. Raise capital by selling a stake. You could sell a minority stake in your business to employees through an employee stock ownership plan, Landers says. Or find an angel investor or two who will pay cash in exchange for an ownership stake.

One bright spot for entrepreneurs: It’s rare that a business ends up being sold off to satisfy a divorce settlement, Clement reports. That’s because it would deprive the business owner of the future income needed to pay support payments.

Preventive Moves

Take action while your relationship is still rosy and you may greatly increase your odds of surviving a divorce with your business intact.

Here are five pre-emptive strategies from attorney Jeffrey Landers that can help protect you from losing your business in a divorce.

1. Sign a prenup. If your business existed before you wed, designate it as separate property owned by only you.

2. Secure an early postnup. This is much like a prenup, except the agreement is signed after the wedding. If a postnup is done long before the marriage disintegrates — ideally more than seven years before a breakup – it might be useful in defining a business as separate property. But judges often view postnups skeptically.

3. Place the business in a trust. This keeps the business from being counted as a marital asset as you no longer personally own it. The move also protects the value of the company’s growth.

4. Create a buy-sell agreement. It defines what happens to a business should any owner’s status change, as is the case in a divorce. The agreement might limit a spouse’s ability to acquire ownership, deprive a divorcing spouse of voting rights, or give you or other partners the right to buy at a low, preset price any interest awarded the ex.

5. Have insurance. A whole-life insurance policy that builds cash value can be liquidated to provide the funds to buy out a spouse’s share of the business, if need be.

Article source: Entrepreneur.com

 

By JEFF D. OPDYKE

Generating the most income in the safest fashion from a nest egg is the holy grail of retirement income planning. You obviously want your dollars to stretch as far as possible without taking on much risk.

The proper mix of stocks and bonds and cash is the mix that allows you and your parents to sleep at night. That may sound trite, but it is the only true gauge that works. Mom and Dad can look at all the charts and all the probabilities, but if at the end of the day the mix of assets has them paranoid that a market correction will wipe them out or leave them unable to afford their cost of living, then it is clearly the wrong mix. Thus, telling you what an appropriate mix might be for your parent is largely impossible. But there are a couple of generalities and rules of thumb around which you should begin helping your parent structure a nest egg.

Do not put all the money into CDs, savings accounts and bonds. Inflation will decimate those assets over time and that will not help a parent maintain financial security later in life.

Depending on a parent’s age, put between 20% and 60% of the nest egg into high-quality, dividend-paying U.S. and global stocks to provide the necessary growth as well as income. Where your parent should be on that spectrum between 20% and 60% largely depends on age.

And remember: While we’re focusing on managing the finances of elderly parents, many of the issues apply to your own retirement planning as well.

U.S. Stocks

Too many retirees tend to shy away from stocks for fear of losing their principal. Better to be ultrasafe than devastated by a dramatic downturn in the financial markets. However, given the potential length of time a retiree will spend in retirement these days, a nest egg really demands some exposure to stocks in order to survive for as long as a retiree does.

This is not an argument for investing in high-growth Internet stocks or biotechnology companies with unproven medications. No retiree needs exposure to the market’s riskiest stocks.

Adapted from “Protecting Your Parents’ Money: The Essential Guide to Helping Momand Dad Navigate the Finances of Retirement” by Jeff D. Opdyke. Copyright 2011 by Jeff D. Opdyke. Published by Harper Business, an imprint of HarperCollins Publishers. Used by permission.

However, it is an argument for owning stable, blue-chip companies, particularly those that pay dividends. These are big, brand-name firms that have a long history of growing their business year after year and that in many cases have an equally long history of spinning out a healthy stream of dividends — companies like Pfizer, McDonald’s, Wal-Mart Stores, Johnson Johnson, Exxon Mobil and Coca-Cola. Mind you, those aren’t recommendations of stocks you should go buy for your parent’s portfolio. Rather, they’re examples of the kinds of companies that make for relatively stable, dividend-earning investments.

Indeed, the best advice for the bulk of retirees is to own blue-chip stocks through a mutual fund, where the portfolio manager’s aim isn’t to shoot out the lights in the quest for capital appreciation but, rather, to own investments that along with modest growth prospects pay out a stream of dividends or other forms of income.

Foreign Stocks

A retirement portfolio should have a small exposure to overseas stock markets, particularly for retirees early into their retirement. While foreign stocks are often considered riskier assets than U.S. stocks, when you narrow your focus to developed markets like Japan, Australia and Western Europe, those shares are, statistically speaking, no more risky than what you find in America.

But they offer retirees some advantages. First, they typically pay meatier dividends (as a percentage of the stock’s price). And they offer exposure to the growth happening in other economies, which can offset weakness in the U.S. economy. And potentially more important, putting some money to work in foreign markets exposes a portfolio to other currencies — especially important when the U.S. dollar is weakening against other currencies.

Bonds

Even more than with stocks, you’ll largely want your parent’s bond portfolio in a mutual fund; bonds can be much more challenging to research individually because there are just so many of them. In general, stick to a broad-based, intermediate-term bond index fund (intermediate-term because bonds of between five and 10 years in maturity tend to deliver decent rates with only moderate risk).

You also should give some consideration to municipal bonds sold by the various counties, cities and agencies within your parent’s home state. Most of these are tax-free at all levels, meaning parents owe no income taxes at a city, state or federal level on the interest income received.

One caveat you should understand about bonds and bond funds is that, generally speaking, owning individual bonds tailored to a parent’s specific situation is preferable to owning a bond mutual fund.

But building a portfolio of individual bonds typically requires at least $100,000 in cash to adequately diversify across at least 20 different bonds in various sectors of the economy. Such a sum implies a much larger overall portfolio when you consider that your parent still needs exposure to stocks and cash. As such, individual bonds are out of the question for most retirees.

Certificates of Deposit

A CD ladder is essentially a series of certificates of deposit, each maturing at a different point in time. CDs are standard fare for retirees, and with good reason. The cash is in a rock-solid institution and will never accrue losses.

You don’t need a specific amount of money to ladder CDs. You could, for instance, put $100 in three CDs, maturing respectively in one, three and five years. In practical terms, however, laddered CDs tend to make the most sense when a parent has several thousand dollars to spread out. That’s where you’ll see the biggest impact in terms of income.

With a $50,000 lump sum of cash, a parent has the option to put all of it in a one-year CD so that the money is available fairly readily, or the cash can go into five $10,000 CDs laddered across one-, two-, three-, four- and five-year periods, with some of the cash fairly readily available, and some of the cash locked up for a number of years.

—Email: forum.sunday03@wsj.com.

Article source: Wall Street Journal

 

The financial planning profession has a long history of demonstrating the power of compounded growth to clients who are looking to invest for the future.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically produced a high rate of return so that you will be able to enjoy a happy and comfortable retirement from your compounded returns.

Unfortunately, there is one question that never seems to enter into the conversation.  This question is whether the historic rates of compounded growth for the stock market will continue into the future?  If the returns produced by the stock market in the past do not extend out into the future, there will be many hundreds of millions of people who have their entire financial lives decimated.  And the shock will be even more severe, as many people have not even considered that it could happen.  For many years, it has been assumed that the stock market can continue to grow faster than Gross Domestic Product (GDP) indefinitely.  However, that assumption may be faulty.

Currently, the ratio of total US Stock Market Capitalization compared against GDP stands at approximately 95%.  This means that the total value of all US stocks adds up to 95% of total US economic output for one year.  This ratio is consistent with the 10-year average from 2000 through 2010, but is higher than the 20-year or 30-year average for the stock market to GDP ratio.  This disconnect raises an interesting question.  How much longer can the stock market continue to grow faster than the economy?

It is important to consider that the overall stock market can only grow if new capital is invested.  Individual stocks will go up or down in value as people switch from holding one company to holding another, but there is only one thing that can propel the entire market upward, and that factor is additional investment.  However, that additional investment must come from economic activity.  What happens if the level of investment required to continue driving the stock market upward at historic rates is larger than the amount of economic growth?  The answer should not come as a surprise … if the money to invest isn’t being generated by the economy, it won’t be invested, and the stock market won’t grow at it’s historic rate of appreciation.

To illustrate this point, both total stock market capitalization and GDP have been projected out at historic growth rates over the next 15 years, starting with actual data from 2010.  Over the last 30 years, the total stock market capitalization has grown at approximately 9% per year, while GDP has grown at approximately 5% per year.  When these assumptions are extended out to 2025, the infinite compounding fallacy becomes quite clear.  in order to maintain the historical rates of appreciation that are used in almost every financial planning model, the stock market will need to be $17.4 Trillion dollars larger than US Gross Domestic Product by the year 2025.

When one considers that this gap represents approximately 57% of Gross Domestic Product, it becomes increasingly evident that the total stock market capitalization simply cannot continue to grow at its past rates because there is not enough additional output being generated to fund the incremental investments that would be necessary to continue driving market values upward.  Thus, the answer to the question of what will happen to stock market capitalization is very apparent.  Unless the economy grows dramatically faster than it has in the past, there will be insufficient capital to propel the stock market values upward at previously experienced rates of appreciation.

Upon further analysis, the problem grows even more complicated.  Since the ratio of total stock market capitalization to GDP is currently equal to the 10-year average from 2000 through 2010, and is higher than both the 20 and 30 year averages.  This means that if the ratio between stock market capitalization and GDP regresses back to historical levels, the growth in stock market valuation will not only be constrained by GDP, but may actually grow slower than overall economic output.

Over time, it is not possible for the stock market to grow nearly twice as fast as the economy.  Eventually the capital required to drive further value growth equal to past rates of appreciation will not be available.  In this way, the fallacy of infinite compounding becomes strikingly apparent.  Financial planning models have been built on the assumption that one can passively generate a rate of return significantly higher than the growth rate of the overall economy.  Over time, this assumption will prove to be faulty, and spell ruin for the traditional models of investment planning.

So what can a person do?  It’s one thing to point out the problems with compounded appreciation assumptions built into financial planning models, but it’s another thing entirely to plot out a new course that overcomes these challenges.  The truth is that this course will be different for every person.  However, there are a few guiding principals that will make finding this course much easier.  These considerations are that cash is king, and leverage amplifies results.

Cash is King

This is the oldest and most hallowed of financial axioms.  Cash stands and the fundamental basis of investment value.  The ‘real’ value of an investment is the cumulative discounted value of all future cash flows it produces.  This can come in the form of dividends from a stock or rent revenue from an income property.  When evaluating an investment based on the cash it produces, the value is easy to see.  However, if the value of an investment depends solely on selling it to somebody else for a higher price in the future, it can result in tremendous volatility and risk … especially if the investment does not produce any cash flow.  Thus, the paradigm of the future for investors should be to seek cash flows.

Leverage Amplifies Results

Another fundamental consideration for astute investors is the power of leverage.  This can take the form of both financial leverage and organizational leverage.  In either case, the leverage will allow you to amplify the results produced by your efforts.  In the case of financial investments, borrowing at a low rate of interest and investing at a higher rate of return will allow you to amplify your returns much higher than could be earned with cash alone.  Similarly, leverage will amplify any losses that are incurred from your investments.  This is equally true with organizational leverage for business owners.  Amplifying your time through the efforts of others will allow you to generate better results if you are highly effective, or will create chaos if you are disorganized.

In the end, future investors will need to rely on their ability to create value.  The days of infinite compounding from perpetually escalating market values are reaching an end.  The people who survive and thrive in this environment will be the ones who focus on fundamentals and create value.  It is important to understand that every difficulty carries an opportunity, and that each person is responsible for capturing that opportunity to create the best future that they can.

 

Silicon Valley has a new case of “sudden wealth syndrome.”

Bloomberg

This week’s stratospheric public offering of LinkedIn Corp., the social-networking company whose shares more than doubled on Thursday, turned company founder Reid Hoffman into the nation’s latest tech billionaire, with a stake valued at more than $1.7 billion. CEO Jeffrey Weiner, who joined the company in 2009, is now worth more than $200 million.

With more IPOs in the offing, from Zynga Inc. to Groupon Inc. to Facebook, the social-media craze has become America’s latest supernova of wealth creation, launching a new generation of millionaires and recalling the instant riches of the 1990s dot-com explosion. Terms like sudden wealth syndrome and “affluenza,” which had largely vanished from the offices of Palo Alto, Calif., and the cocktail parties of nearby Atherton, are back.

Yet when it comes to investing and spending their newfound fortunes, Silicon Valley’s newly rich are likely chart a different course from their predecessors. In the wake of the dot-com bust in 2001, which left many dot-com millionaires with massive mortgages and worthless stock, the new tech magnates are likely to take a more cautious approach to their money. Advisers say the new class of dot-commers is likely to sell as much of their holdings as possible and protect their cash.

“We’ve been through such a number of watershed events over the past decade, and those lessons are writ so large,” says Chris Sheldon, director of investment strategies at BNY Mellon Wealth Management, which has a number of wealthy tech clients. ” I think people seem to have a better chance this time around of starting out the right way.”

Of course, some of the suddenly wealthy of 2011 may end up making the same mistakes as the last group. Tech entrepreneurs often pursue their corporate visions with missionary zeal and are loath to sell company shares, even if it is financially prudent. And loading up on social-media stocks has proved highly lucractive for investors like Russian billionaire Uri Milner, who invested with Facebook, Groupon and Zynga, and recently bought a $100 million house in Los Altos Hills, Calif.

Yet Silicon Valley’s top wealth managers are telling their newly rich clients to cash out as much as possible. If the old message was “risk and returns,” the new message is “protect and preserve.”

“The folks today don’t have the sense that the world will keep getting better and everyone will keep getting richer,” says Keith Whitaker, a wealth counselor and president of Wise Counsel Research in Boston, which studies wealth. “There’s a desire to be liquid, and less trust in financial markets and less of an appetite for risk.”

Here are a few of the tips advisers are giving to the Valley’s freshly minted millionaires and billionaires.

• If it’s not cash, don’t spend it. Mr. Hoffman may be a paper billionaire, but he sold only about $5 million of stock in the IPO. He is still rich, of course. But advisers are telling the instantly wealthy to limit their lifestyles to their cash rather than their paper wealth, which can vanish overnight.

While LinkedIn, Groupon and the other companies have enjoyed steadily higher valuations in the private market, they are likely to endure a more volatile ride in the public markets.

“There’s a temptation to start spending the money right away,” Mr. Sheldon says. “But the lesson from recent history is that your stock doesn’t always have the same value in six months that it does today.”

• Hedge, pledge and sell. Advisers recommend that founders and executives sell large chunks of their stock so they don’t have so much of their wealth tied up in one investment—especially one as volatile as a tech stock. Katherine Ellis Nixon, a regional chief investment officer at Northern Trust Corp., says she advises clients to create a “barbell,” with their company stock on one end and ultrasafe investments (like short-term Treasurys) on the other.

Many times company chiefs are subject to lockups that prevent them from bailing out of all their shares. Mr. Hoffman, for instance, has a six-month lockup. Advisers are telling those clients to create “stock collars,” which are options trades that limit the downside and upside of a stock movement.

They also are recommending hedges using options that would involve, for instance, betting on a decline in broader tech stocks to offset an executive’s ownership in his own company.

The goal, Ms. Nixon says, is to “offset the high volatility and concentration of their company” shares.

• Give it away. The government is offering attractive terms for gifts, raising the lifetime gift-tax exemption to $10 million from $5 million for married couples. Advisers also say today’s newly rich—often in their 20s and 30s—are highly philanthropic. Many of them (like Facebook’s Mark Zuckerberg) are giving away millions already.

• Stop and listen. Wealth psychologists say instant wealth can be highly disorienting.

“When you suddenly cross that boundary like these guys just did, it’s like going to another country,” says Lee Hausner, a psychologist who works with many wealthy families and entrepreneurs in California. “It’s like getting dropped in a rural village somewhere. You have to stop and do nothing. Just get the lay of the land and try to learn.”

She tells clients to initially avoid wealth managers and park their money in cash until they can get educated in the peculiar customs and rules of investing, spending and giving away large wealth.

“You need to start with the big questions, like what are your life goals and family goals before you start picking an investment strategy,” Ms. Hausner says. “You can’t just run to someone with a vested interest in selling you something.”

By ROBERT FRANK

Article source: Wall Street Journal

 

Anybody who has taken accounting classes in school is familiar with the terms asset and liability.  Typically, assets are things you own that have value, and liabilities are obligations that you owe to pay for your assets.  This definition is very consistent with how accountants view the world, but Robert Kiyosaki has advanced a different way of viewing assets and liabilities that may be very enlightening.

Kiyosaki advocates classifying ‘assets’ as things that generate cash flow and ‘liabilities’ as things that cause a cash outflow.  This perspective throws a large monkey wrench into the personal ‘balance sheet’ of many people, because it pushes many things such as boats, cars, ATV’s, etc out of the ‘asset’ category and into the ‘liability’ category.  (Some even advocate that your personal home doesn’t even fully count as an asset, because it does not produce any rent income)

The revelation this creates is showcasing the relatively small share of our possessions that are actually working to make us wealthier.  The impact of this revelation is that many of the things we had previously were building our net worth are actually hindering our ability to build wealth.  The overwhelming majority of these items tend to be ‘status symbols’ that we buy to project an image of success.  I won’t attempt to editorialize the relative value of these purchases, but I will point out the simple fact that they do not make us wealthy.  If the purchaser is fully aware of this fact and wishes to do it anyway, it isn’t necessarily the wrong decision.  It is simply a decision that needs to be made with a realistic view of the facts.

The most obvious next step is to shift more of our possessions from ‘liabilities’ to the ‘asset’ category.  The next level of analysis is to determine which types of assets comprise the best wealth creation opportunity.  Factors to consider are the income/appreciation opportunity, the ability to use other people’s money/time (leverage), and relative tax efficiency.

 

One of the most important factors influencing our financial lives today is the notion of volatility.  At it’s basis, volatility is the rate at which the value of an investment or stream of cash flows will vary over time.  People who owned real estate in California, Las Vegas, Florida, or the Northeast over the last few years are very well associated with the notion of volatility, since the values of their properties shot up like a rocket and then crashed back down to earth like a rock.

The principal is critically important to our investing life, since the value of most people’s portfolio is based on the value of its underlying securities (mostly stocks), which have a tendency to fluctuate on a regular basis.  In the not too distant past, this fluctuation was relatively light.  However, recent years have seen an acceleration of price volatility up to unprecedented current levels.

The important thing to consider in regards to volatility is that when asset price volatility increases, the timing of when you buy or sell becomes more important.  This stands in contradiction to the traditional orthodoxy of ‘buy and hold’ for long-term investors, but the vast swings of market values in recent years is providing an increasing amount of resistance against this conventional wisdom.

In contrast to volatility, you have stability.  In the context of investments, stability generally takes the form of cash flows from dividends, interest payments, or rent revenue.  As the volatility of stock, bond, and real estate values continue to increase, the stability of cash flow will become a more important part of prudent investing strategies.

In the context of earnings, most people acquire cash flows from a job.  Some people have volatility in their income from commissions, but many people have relatively stable cash flow that they earn and relatively volatile values when they invest.  As the trend of value volatility continues to impact the financial markets, the time for a new model of financial investment to emerge is drawing near.

The most likely vehicle for this new model of investing is in the realm of investment real estate and income properties.  The reason for this is because income properties are fragmented in local markets that do not fluctuate directly with the financial markets.  Furthermore, income properties can be financed with leverage and produce regular cash flows.  This gives prudent investors who pursue income properties an opportunity to realize a level of stability in their investments that is no longer available in the financial markets.

 

Source: Standard & Poors

Most people are very familiar with the traditional investing axiom of ‘buying low’ and ‘selling high’ that is rooted in experience with the stock market.  Because of this, many equity market investors choose to hold their capital on the sidelines waiting for prices to hit a cyclical bottom before buying-in.  We understand this sentiment in regards to stock market investments, due to the increasing volatility of market values in recent years.  The orthodoxy of ‘buy and hold’ worked very well for stocks through the 1990’s, but has subjected investors to large downside risk in the last decade if they bought at the wrong time.

Source: Standard & Poors

The stock market movements of the last fifteen years are a testament to the growing volatility and flattening long-term rate of appreciation for the stock market.  The compounded growth rate for the S&P 500 over the last 20 years look much more modest than most financial planning models assume after the effect of two market bubbles are backed-out.  This leaves us with the inescapable conclusion that success in the current stock market is achieved by the strategic buying of stocks when their values are depressed and systematic liquidation when values expand.

By graphing the index value, earnings per share, and dividends per share of the S&P 500 index over the past 20 years, it becomes quite apparent that the major source of returns after backing out the two market bubbles has been dividends.  Another thing that becomes quite apparent when comparing the stock market against its fundamentals is that market values are much more volatile than the underlying data that is the ultimate basis of market valuations.  These gyrations in market prices have prompted many investors to diminish the importance of fundamentals and cash flow in favor of trying to pick stocks that are about to go up in value.

Unfortunately, experience with financial assets like stocks and bonds have caused many investors to treat income properties similar to stocks or bonds.  The unique aspect of income property is the cash flow generated by rent income.  Since the returns from income property are not solely dependent on gyrations in market prices, there is a much greater cost associated with waiting for the perfect buying opportunity.  The reason for this is because waiting for conditions to be perfect for buying could cause us to miss out on profits from cash flows on deals that we didn’t execute because we were waiting for something better.

Analyzing the cost of waiting shows that every year you delay taking action increases the effective rate of return that is required to achieve the same-compounded results as if action had been taken earlier.  For example, if you can earn a 15% compounded rate of return today and wait for 2 years, you would need a 16.2% rate of return to be in the same place after 30 years.  If you decide to wait for five years, the required return increases to 18.3%.  After ten years, it increases to 23.3% and after 15 years, it stands at 32.3%.

As we can plainly see, waiting too long requires that we earn impossibly high rates of return simply to match the compounded impact of starting today and growing our wealth steadily.  This is where the true power of prudent income property investing comes into play.  Since much of the value comes from cash flow, which is much more stable than market values, returns are less dependent on buying right before the market rockets up and more dependent on finding deals that are attractively priced relative to their cash flow.

Many people in the ‘baby boom’ generation are in the midst of this problem.  They waited too long before beginning to plan for retirement, and had much of their wealth wiped away in the financial crisis of 2008 and subsequent economic recession.  For many of these people, their previous vision of retirement is no longer a reality.  It is not possible for them to earn enough to retire comfortably before reaching what was previously thought to be ‘retirement age’ . . . this will ultimately mean that they must work much longer than they had previously imagined would be necessary.  It is frequently commented; “luck favors the prepared” . . . it is equally true that “luck favors those who take action.”  By taking decisive action, it allows us to harness the power of compounding and create a bright future for ourselves and the people we care about.

Action Item:  Do not wait to begin investing.  Once you have access to the necessary capital and have become sufficiently educated to make an informed decision, take action!!!  When your investments begin to bear fruit, continue to take action by re-investing your profits until a holistic wealth portfolio has been constructed.

 

One of the oldest and most important notions in Finance is the statement that “Cash is King”. The purpose of this cliche is to focus examination for a business deal, product decision, or prospective investment on cash flow. This is especially important when the accounting profit & loss is different from the cash flows.

Consider the difficulty of running a business where all of the value comes from a future sale of the business to somebody else? What happens if large losses must be absorbed until the future sale? What happens if the future price is lower than your projections? How much of your future are you willing to stake on anticipated gains that may not materialize?

This is not to say that all focus should be on short-term results, with no thought of the long term. Quite to the contrary, we should view the future as an opportunity that is waiting to be discovered. However, we should avoid the trap of vague ideas about value or gains. If a deal or investment is a sound decision it must produce results. (Typically measured in terms of cash)

Consider the paradigm shift of stock market investors away from dividends (cash flow) toward capital appreciation. During the bull market of the ’80′s and ’90′s, values climbed and people simply assumed that they would keep going up. After the tech and credit bubbles, values have become highly volatile. In order to capitalize on value gains, you must know when to sell. Since nobody knows when markets will break up (or down), market timing has become a very risky proposition.

In the end, each of us must learn to incorporate the lessons of cash flow into our investment and financial decisions. This frequently requires that we move contrary to most other people, since fads are what create (and destroy) market bubbles. By maintaining an even focus, it will allow us to achieve ever greater heights of success.

 

Earlier this year, news was made when the current cash flow for social security went negative for 2010.  This has prompted many politicians to make the statement that Social Security is not in danger because of its “Trust Fund” balance that has been built over the years when it ran a surplus.  These statements represent either ignorance in regards to the flow of government funds or deceit on the part of the politicians.  (Possibly Both)

The important consideration when talking about the Social Security “Trust Fund” is to understand the cash flow and accounting behind government funds.  When the social security administration receives taxes, it deposits them into a fund.  (Frequently referred to as the “Social Security Trust Fund”)  This fund subsequently invests the assets of this fund into government treasuries.  Effectively, this results in an I.O.U. being swapped out for the aggregated Social Security Tax Receipts.

In order for the Social Security Trust Fund to cash in its loans to the US government, it would require that same government to go an write new debt to make good on those loans.  This is what ultimately dooms the so-called Social Security Trust Fund.  In order for the government to make good on its entitlement promises, it will need to incur so much debt that it will drive up interest rates and possibly collapse the economy.  In effect, the Social Security Trust Fund is a circle that feeds back in on itself.

This reality will not restrain free-spending politicians from attempting to use this fictitious “Trust Fund” as a propaganda tool for avoiding the spending restraint that is necessary for a sustained economic recovery.  Understanding the true state of government finances should prompt individuals to understand that they cannot depend on government benefits to finance their retirement.  The money has already been spent, and the cupboard is now lying bare.  Astute investors should seek to become financially self-sufficient so that the inevitable disruptions in government programs do not drag them into the abyss.