Chapter 4

The Process of Wealth

Why do some people have a knack for making money? Part of the reason will always be that those people have some God-given talent, such as ambition and self-discipline. But for most who become wealthy, they have had great mentors and guides along the way. Why reinvent the wheel when you can get a head start from someone who has been there and done that?

The process of building wealth is the ability to accumulate and protect one’s wealth. Understanding the fundamental steps will take you down the financial road toward your goals, versus causing you to take a detour. Basics such as consuming less than you produce and saving the difference is just one building block in a pyramid of concepts that serve to move you in the right direction.

I’ve always felt education is the most important block in one’s foundation. The constant desire to improve your understanding of the world by reading what others have to say is crucial. More important than what you read on any given topic is just that you read. You are demonstrating this basic principle by reading this book. You might not agree with everything I say, but if you can pull out a few good ideas, then your time and money were worth it.

Clients always ask me for book recommendations, and I say if someone spent the time to write something and went through the effort to publish it, then there has to be a few good ideas in the book. Just read.

My goal in the following chapters is to define the process of building and preserving wealth as it relates to financial planning and investments in general. Too often, people get in a rut because they don’t know what they don’t know.

They are invested in mutual funds or exchange traded funds (ETFs) because that is all that has been presented to them or all that they know. They don’t realize that there are many other opportunities that may be appropriate for their circumstances, which they should investigate and from which they could potentially prosper.

At my firm, education is priority number one. I am here to teach people who walk in the door as much or as little as they are willing to learn. I never charge for this service or request retainers. Education is always free. Why do I do this? I need to be paid, right? Of course, but from the client’s perspective, most financial advisors work hurriedly to make the sale and then move on. Many people are disillusioned with the idea of working with a financial advisor because most have been burned by the process that Wall Street promotes: the quick sale.

An interesting question sums up most advisors out there. “Would you rather have Tiger Woods’ golf clubs or Tiger Woods’ golf swing?”

If I had his clubs and Tiger Woods had a three-foot long two-by-four piece of wood, Tiger Woods would still take my lunch money hands down.

It is his billion-dollar swing that wins all the money. A billion dollars is the Forbes estimate of what he has earned playing a game with a stick and a ball. Not too shabby.

When you see firms with high net worth minimums, it doesn’t mean you are getting a better, more educated experience. It just means they don’t want to waste time on small fries because they are more interested in selling golf clubs as fast as possible and moving on to the next prospect.

The critical part of financial planning should be education. You need to learn how to swing the club. In my opinion, groups that cloak their activities in secrecy and fast transaction times are the ones with the least to offer or are possibly scams, like the Madoff or Stanford Ponzi schemes—the “just trust us” attitude. Another fundamental block to building wealth should always be a healthy dose of skepticism.

I am not a follower of the cliché, “If it sounds too good to be true, it probably is,” because many of the great investments out there do sound almost too good to be true. With a lot of due diligence and education, you realize they can indeed be good investments. They are just uncommon because few representatives are able to offer them. If you were to presume that few representatives offer them because they are bad investments, you would assume wrong. Many great, uncommon investments are highly conservative in their design and, with time, they may potentially generate great returns and tax benefits. They are uncommon because the commission schedule they pay to the representative is too low for most firms to want to offer them or the type of products they are do not fit the brokerage’s business model of only stocks, bonds, mutual funds, and annuities.

Wealth Bucket 101

Let’s begin with a visual concept we’ll use for the rest of the book. I like to describe wealth using the metaphor of a large wooden bucket. It is a sturdy bucket with a good handle and steel ribbons encircling the tub. However, the bucket is made from wood and, because it is not indestructible, it is prone to springing leaks.

These leaks are the source of most of the frustration people experience with their money. The leaks occur because of higher taxes due to poor tax planning, excessive investment fees, insufficient estate planning and asset protection, and/or limited investment diversification and withdrawing too much money from a nest egg as currently designed.

Chapter 5 goes into great detail about the causes of leaks in one’s wealth bucket.

In the introduction, we made it pretty clear that we believe in using many investment tools other than the stock market. Several leaks are directly related to Wall Street and the motivation to move money from our pockets into theirs.

Other leaks in the bucket are due to not understanding the process of building and preserving wealth. For instance, using cash to buy a liability represents a huge leak in the bucket. We are told to never have debt, to pay for everything with cash to be bulletproof. Yes, paying for everything with cash is stress free and a safe route to take. But it is not a very good route for building wealth, especially when purchasing an item that will depreciate over time. An automobile is a perfect example of something that should not be paid for with cash.

Most people who have a large net worth realize the importance of using other people’s money to add zeros to their bottom line.

What is a liability?

Anything you buy that takes money from your pocket.

A personal residence is a liability. Conventional thinking says a house is a great investment. Actually, it takes money out of your bucket every year for mortgage costs, property taxes, insurance, and repairs. The saying goes, better to buy than rent. Not necessarily. If you had bought a $584,000 median valued home in Los Angeles in 2006, that house as of 2009 would be worth about $319,000. In a mere two and a half years, the resale value would have dropped $265,000. Had you stayed in an apartment and paid rent of $2,500 per month, you would have spent only $75,000. In terms of net worth, you would be almost $190,000 ahead of the homebuyer.

Of course, there are numerous reasons to own your home, from personal enjoyment to pride of ownership, but financially speaking it is not always a black and white decision.

The opposite of a liability is, of course, an asset.

Assets are investments that put money in your pocket.

If people focused on using their wealth to buy assets, they would keep themselves out of a lot of financial trouble. Many who bought real estate between 2004 and 2007 bought a liability-type property, hoping it would appreciate. They now find themselves on the wrong side of a mortgage payment and upside down on the property. Buying for appreciation and not for positive cash flow has them in a financial bind.

Had they bought an asset property that generated positive cash flow each month, they wouldn’t need to worry so much about the value of the property falling because they have time on their side. Worst case, they can buy time by collecting rent checks until the property eventually becomes more valuable.

Unlike the stock market, where time isn’t necessarily the panacea for bad investments, we can agree that with enough time a property will eventually inflate upwards unless it has other really serious flaws.

Let’s clarify that last thought on the difference between time with a stock and a piece of real estate.

If you pick a bad stock and that company goes under, you have nothing to show for your money other than a worthless stock certificate. If you make a bad investment in real estate, and are not forced to sell at any point, eventually the home price will appreciate above what you paid. It might take a long time but at least you have something real to hold on to. If you can collect some rents while you wait, even better.

Another example of a liability that people buy for cash is an automobile. We enjoy our cars, and we need them, unless we live in New York City or San Francisco, where there is great public transportation. At the end of the day, most cars lose value and end up costing money. They are a convenience, not an appreciating asset.

In summary, your wealth will grow as you buy investments that will appreciate over time and not depreciate. It is a key to the wealth-building process and to expanding your bucket of wealth.

Buy Assets to Pay For Liabilities!

Basically, how can I buy an asset that generates a positive cash flow to pay for a depreciating asset (a liability) that I desire?

For example, you see a beautiful Lexus in the window of a showroom. The cost is $50,000. This is your dream car, and you’ve got the money to pay for it in cash. Sounds like conventional thinking, doesn’t it? But, you should ask yourself a question: “Where can I put $50,000 to earn enough positive cash flow to make the monthly payments on a multi-year car purchase loan?”

Applying the principle of using other people’s money, you begin to search for multi-unit small apartment buildings around the country. You find an eight-unit building in a small city in Tennessee for $200,000, and after running the numbers, the net cash flow for this building with a $50,000 down payment is around $700 per month.

Sounds like a lot of work to buy your dream car, right? It is much easier to pull out the checkbook, whip out a check for $50,000, and sail down the road that afternoon with your hair flapping in the wind.

What have you accomplished with this quick purchase? As soon as you drove off the car lot, you lost $10,000 from your bucket of wealth due to depreciation on the car now being “Used.” After a few years, the car might only be worth $25,000 from continued depreciation. Another $15,000 is lost from your bucket of wealth.

The person who spent time and effort to buy the little building in Tennessee now has $700 per month in cash flow from their eight-unit building to cover the car payment on a six-year loan for the Lexus.

The apartment rents probably won’t cover all the expenses of the car for the first year or so, but the beauty of an apartment building is you can raise the rents year after year. Maybe by the third year, your net cash flow from the property is $1,000 per month, and you are now able to cover the expenses of the car, with some extra to pay for gas. By the time the six years are up and your Lexus is paid off, the little building you bought in Tennessee is likely worth the same as you paid for it, if not more, and you still have at least the $12,000 in positive cash flow from rent coming in each year. The value of the Lexus, on the other hand, is much lower than its original cost. Note the comparisons that follow.

Net result after six years:

Impulse buy of the Lexus with cash:

Car	Year 6 estimated value: $10,000
Cash Flow	Negative each year for gas, insurance, and repairs
Lost wealth from the bucket	At least the $50,000 purchase price

Buy the Asset (eight-unit apartment building) to pay for the liability (Lexus):

Car	Year 6 estimated value: $10,000
Cash flow	Positive by at least $12,000 per year
Wealth preserved	$50,000 down payment
Wealth gained	Potential Equity build up in property
Tax Benefits	Mortgage and depreciation deductions against income. More money in your pocket!

The added benefit of taking the road less traveled to purchase the dream car is that after the six years, you could use the positive cash flow received from the apartment building to buy another dream car and renew the hair flapping and smiles of the open road.

What does the person who bought the car outright have to show for it after six years? A beat up Lexus worth about $10,000 and lost wealth and opportunity, at the cost of tens of thousands of dollars.

So much for conventional thinking!

Fortune 400 Secret

What do the four hundred wealthiest people in the world know about wealth building? That it doesn’t come from the stock market. If you look at the composition of the Fortune 400, their wealth has come from tangible investments: real estate, oil/gas, timber, building a business, or the good old American non-tangible way: they inherited it. Only one guy on the list truly made it from the stock market: Warren Buffet.

Now, I know some would argue that there are a few hedge fund managers who made their money from the stock market, but I would counter that they made their money from the fees they charged their clients within the business of a hedge fund. Your response might be, well, of course, they had great returns in the stock market for their clients and received due compensation.

Hedge funds are the biggest rich person scam going. The allure is the exclusivity, almost country club feel, for investors with high account minimums, and the positive spin with which they promote performance fees. Performance fees are the fees paid for those returns a hedge fund makes over and above a common market benchmark. Typically, the hedge fund takes 20–25 percent of the excess profits. The nature of these fees is that they are measured quarterly, thus making them a sucker’s bet for the client and the ultimate Vegas casino for the manager.

The manager is basically swinging for the fences each quarter, and if he or she hits it out of the park one time from sheer luck, the excess above the benchmark is usually enough for the manager to retire many lifetimes over. For example, between August and September 2006, Amaranth Advisors effectively lost 65 percent of their clients’ money in one month, yet the lead manager for the fund had hit homeruns the previous quarters and made almost $100M for himself that year. Not bad for causing so much harm to his clients. Another example would be T. Boone Pickens, the famous oil/gas hedge fund manager. T. Boone made more than $1 billion of income in 2007 and lost 97 percent of his clients’ money in 2008.

When a fund manager comes to our office to tout their excellent performance, I ask two simple questions:

• What is your 10-year average?
• How much leverage do you use?

The reason for the first question is history. Don’t show me one, three, or even five years of performance. Show me at least 10 years. That way, I know they will have seen some bad years, and I can gauge their ability to protect the principal. The second question tells me the real returns of the group. For instance, if the answer to question one is 10 percent and question two is 3:1 leverage, all we need to do is divide the 10 percent by three to equal a real return minus leverage, or 3.33 percent. There are numerous other investments that can earn 3 percent without as much risk.

For the portion of money I do place in the stock market, I believe in using non-margin money managers. Money managers who trade without using leverage. Without the crutch of leverage in the good times, they really have to perform well. In the bad times, the benefit of not using leverage is more apparent. These accounts tend to have much lower volatility or price swings, and fewer of our clients are biting their nails down to the bone.

Brokerisms

Part of the process of wealth building is understanding when you are hearing a lot of baloney, and more importantly, being realistic with your finances. Being able to make changes by addressing investments that are underperforming will serve you well. Wall Street is artful at changing perceptions to make their mistakes look like opportunities so that you will remain invested with them for as long as possible. You may have heard the running joke, “What do you call the advisor who keeps his clients in accounts, even though they have lost 20–50 percent? Vice President!”

Every year millions are spent on marketing campaigns using mumbo jumbo and celebrity voice-overs to grab your attention and grab your money. Part of the campaign is to change perceptions of reality. I’m sure most of you have heard the common brokerisms, or excuses, used to never admit a mistake and give them an opportunity to sell you something else.

“Don’t worry, you’re a long-term investor; you’re buy and hold!”

If you had held stocks between 1881 and 1921 before you made any money, would 40 years count as long term? What about 1929 to 1954, or another famous bear market, 1965 to 1982? I take a very basic view of bear markets. If the stock market revisits a point on the journey, then the current sideway bear market started at the first point. For instance, in early March 2009, we touched levels on the S&P500 not seen since 1997. Thus, for most people, their money had gone sideways for 12 years.

Most would argue that the current bear market started in 2000. Again, I take a simple approach to money. If I had a hundred dollars in 1997, and in 2009 I still have only one hundred dollars, then my money hasn’t grown one penny, and that is a bear market for me. There will always be scientific methodologies to identify when an official recession or bear market began, but again, for most people, they just care that their investments are worth more than in the past.

“It’s cheaper at this price; we should dollar cost average!”

Imagine you are on the Titanic and you’re sailing on the Atlantic at night. Suddenly, the ship rocks violently and lists to the starboard. You ask the captain what happened, and the captain answers, “Don’t be afraid; this is a strong ship. Instead of panicking and selling like other people, why don’t you take advantage of the cheap prices for a cabin suite, spend more money on better accommodations, and ride it out?”

Do you want to listen to that captain or to Captain B who says, “I will admit that I don’t know what has happened. To be safe, let’s jump in a lifeboat, paddle a thousand yards away and watch from a distance. If the Titanic is okay and she starts to right herself and sail away, we will have to paddle hard to get back onboard, maybe spend some time and money, but at least we will know the ship is not going to sink.”

Which captain would you rather listen to? I’d pick Captain B.

Dollar cost averaging is one of the biggest spin jobs on the planet. It’s a way not to have to admit someone has made a mistake by keeping you in a stock as it goes down, but a way to turn the mistake into a positive and get you to buy more and even earn another commission.

You must ask your adviser, “If you are so sure the stock is cheap now, why didn’t you know when it was more expensive and get me out?” Citigroup may have looked cheap when it hit fifteen dollars a share in October 2008, but if you ponied up more cash and doubled down—as in dollar cost averaging—you probably felt sick to your stomach when it dropped another 93 percent and hit $0.97 a mere five months later.

Successful traders have a general rule. Never throw good money after bad. Now I’m not implying everyone should be a stock trader, but if you are in a stock position and that position goes down 8 percent, I would suggest a move back to cash and re-evaluate. If you lose 8 percent, you have to make 8.7 percent to get back to even. If you lose 30 percent, you have to earn 42.9 percent. If you lose 50 percent, you have to earn 100 percent. If the old saying is true that the markets always average 10 percent, losing 8 percent means you’ll wait less than a year to make it back. That sounds better than waiting four to ten years to make back losses.

Percentage Lost	Percentage Needed to Get Back to Even
10	11.2
20	25
30	42.9
40	67
50	100
60	150
70	234

Remember, you can always go back into a stock position. An analogy I use is the one about the forest and the trees. The idea is to pull back from the trees to see the forest, go to cash, and clear your head. Then if you see the forest is burning, you’ll know to go and invest in fire extinguishers.

“Look how much money I made you last year!”

This one is great. When the markets go up, everyone thumps their chest to proclaim their brilliance. At the beginning of 2007, numerous clients came in declaring their advisors made them 10 percent in 2006 and were brilliant. My typical response was, “How much did you pay them? And were they so brilliant as to underperform the S&P500 which averaged 15.86 percent?”

The funny thing, in 2008, generally the opposite was heard.

“It’s not my fault; everyone lost money in 2008!”

We hire mechanics to fix our cars and keep them running. If the car breaks and the mechanic can’t or won’t fix it, we fire him. How many people stay with their financial advisors as their losses mount and their net worth drops?

In Summary

Warren Buffet has two important rules:

“L” Rules said another way:

Following these simple rules has put more millions in more millionaires’ pockets than any other concept. We’ve all read about the guy who leveraged himself 100 percent, bet the farm, and won the lotto on an investment. Some people have come out smelling like a rose even though they took humongous risks, but the majority of us aren’t so lucky. We will be burned far more often than we are willing to admit, and our story probably won’t make the headlines.