Part 2 – Death of the Millionaire Next Door and the “secret sauce” that leads to financial security
By: Daniel Harris, RIA, Tuesday March 21, 2017
Coming back to the article. The article touched on two people, the prototypical millionaire in Thomas Stanley’s millionaire next door (written in 1996) who was a family of 50 years olds, who ran businesses, where professionals, or were self employed, were married to the same spouse their whole life, lived in a nice neighborhood with good schools but older homes, was a good earner and a good saver (they saved around 20% of their income), hired wealth mangers, attorneys and accountants at much higher rates than the general public, and paid proportionally less in taxes then many other families.
Taleb’s position was it all could have been random and the winners were just lucky. You can’t help yourself by doing what they did – it was all plain luck. According to him there could be plenty of people who invested in their own educations and those of their children, saved their money, hired professional experts who didn’t succeed. Technically he is right. Nothing in life is guaranteed and we all know even if you do everything right, things may not work out for you. It’s a risk we all take, and one we can’t really get away from. But it makes a critical logical mistake – it assumes that because you can’t guarantee an outcome that you can’t your probability of getting your desired result by making certain moves. That I think is both logically and empirically not accurate – and I think deep down we all know that.
The other person profiled with much skepticism, was a guy named Richard Reed who was a fastidious saver and investor and was able to die a multimillionaire even though he was only a janitor and a gas station attendant.
The right lesson to take out of Richard Reed’s story, is that the securities market is so productive that someone with a meager income can still end up in the top 1% of America if they really focus on their investments, are wired right for it, and are an exceptionally good saver (I think he probably saved 50% or more of his income). But of course, that wasn’t the lesson the writers took out of it. They said Richard Reed was lucky because he likely entered the workforce around 1940, saved and invested consistently until 2014, when he passed away. The problem with this argument is that Richard Reed lived through 2 of the 3 worst bear markets in the last 100 years (1973-1974), and (2008). He had plenty of tough markets to make mistakes in; he just made fewer mistakes than the average investor.
Before I started this firm, I worked at a big brokerage firm and one of our clients was a guy just like Richard Reed. This guy worked for some kind of agricultural products company and never made more than $36,000 a year in his life, and he retired with more than $2 million in his brokerage accounts at our firm. So this guy was in the bottom 41% of income in the US at the time, but ended up in the top 4% in assets. His behavior was almost identical to Richard Reed – he was really frugal in almost every other area of his life but he did not skimp on hiring a financial advisor and you can see how it worked out for him.
I’m going to kind of summarize what the Millionaire Next Door said of the behaviors that were consistent amongst those who become financially secure. I view this as kind of like the formula that doesn’t guarantee a good outcome, but certainly raises your odds of success. See how many of these apply to you…
1) They value education and invest in it. 80% of millionaires in 1996 were college graduates. At the time the book was written, less than 26% of Americans were college graduates. 18% of millionaires had graduate degrees in 1996, compared to just 10% of the U.S. population at that time.
2) They tried to get themselves into position where they were valuable in society and could earn a good living. Many are self employed (partners or owners in professional firms) or entrepreneurs. Others have special skills and knowledge that have value and are fastidious savers and know the value of investing well and pay for professional help.
3) They save fastidiously, investing about 20% of their after tax income.
4) They pay professional advice at much higher rates than the general public. While they may be frugal in many ways, they see investment and tax advice as an investment, the same way they saw their educations, and they make sure to give it the resources it needed to succeed.
5) The invest heavily in their children's education – they save for their children’s college and deliberately live in neighborhoods with good school districts so their children can always have the option to go to a good school.
Death of the Millionaire Next Door and the “secret sauce” that leads financial security
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By Daniel Harris, RIA, Monday March 20, 2017
Part 1
The other day I read a column written by Michael Hilstik, a columnist for the LA Times.
The article discusses who a seminal book on how people achieve financial security, “The Millionaire Next Door” by Professor Thomas Stanley isn’t accurate any more because life has gotten tougher and doing well in your life is now a “loser’s game.” Here is the link to the article in case you are interested: http://www.latimes.com/business/hiltzik/la-fi-mh-the-death-of-the-millionaire-next-door-dream-20150310-column.html
These articles are what I like to call “statistical pessimism.” Statistical pessimism is the idea that because you don’t know something for certain, it’s bound to fail. My biggest criticism of this approach is that it fails to recognize the fact that we have make guesses all the time in our lives and nothing is really guaranteed for us.
Whenever I read these articles I like turn to my wife Linda and joking say:
“I shouldn’t have gone to college because less than 36% of the population graduates from college so going to college must be a loser’s game”
“I shouldn’t apply to Stanford since only 13% of the students got in when I applied, so it’s a loser’s game to apply to a school like that (unbelievably they let me in)”
“I shouldn’t try to graduate Phi Beta Kappa from college since less than 20% of Stanford students can pull that off, so it’s a loser’s game”
“I shouldn’t apply to Berkeley law since less than 30% of applicants get in, so it’s a loser’s game to try to get into a school like that (they let me in there too!)”
“I shouldn’t sit for the Bar exam since the majority of exam takers fail ever year, so it’s a loser’s game to even try (another time where I defied the odds – must be survivorship bias”
“I guess we shouldn’t try to retire one day, help our kid pay for college, try to help out community, my clients or do well at our jobs, and try to live a nice life because having a hope and delaying gratification is a loser’s game according to the columnist”
Of course, what none of these things consider is the role of effort or discipline. I wanted more than the average kid in my school to make good grades and get into a good school. I wanted to make good grades in college and get into a good graduate school. I wanted to pass the bar exam and I studied for it. I wanted to own my own firm as soon as I understand the advantages of being an owner and how our tax code favors owners compared to employees. One day, I want to be able to retire and to help pay for my kid’s education, since I think it is very valuable.
I bet if you looked at your life, there are tons of things you did, the statistically had a less than 50% of chance of working for all people who tried. How did you get there? How did you outcompete other people for those spots? Did you do anything differently than they did?
What should a small business plan retirement fees look like?
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By Daniel Harris, RIA, Sunday March 19, 2017
401(k) plans are absolutely the best option for small business retirement plans in most cases and the reason is the fees are reasonable, are mostly paid for by the participants, and contributions by the employer are voluntary.
The Simple IRA which is the main alternative to the 401(k) has most of the same costs of a 401(k) plan – the business still has to match employee contributions (the main cost of a 401(k) plan) if the owner and other highly compensated employees want to contribute to their own accounts, but the amount you can put in is only $12,500 compared to $18,000 in a 401(k) plan.
The big challenge is getting your plan set up and getting reasonable expenses on it while also shifting some of the personal liability away from the business owners. You might be inclined to use a payroll or insurance company plan, and for many years this was the only alternative, but now much better alternatives are available.
To set up a 401(k) plan it can cost as little as $500 these days, of which you can usually deduct $250 of that as a legitimate business expense. Most if not all other costs are generally paid for by the participants since they are the ones benefitting from having the plan structure.
The three ongoing costs of most 401(k) plans are 1) the investment advisor 2) the mutual funds companies and 3) the recordkeepers or third party administrators.
The benefit of a 401(k) plan is that you get to defer or eliminate taxes on your investment gains – something no other instrument provides at this scale. The downside is that it creates personal liability for the plan sponsor to follow the rules and procedures of ERISA, the law that governs tax protected retirement plans.
The first rule is that a plan sponsor (you) must provide ongoing investment advice to the participants (your employees). The advice must be customized to them and you have to make yourself available to give them advice on what to buy or sell in the plan. Most business owners are not experts on the securities markets and don’t want to complicate their relationships with their employees especially if the employees lose money on their investments as a result of the employers advice.
So they hire an investment advisor paid for by the participants of the plan, not the business, to do this function. This helps shift risk for investment decisions away from the business owners and towards the investment advisor. Some firms don’t charge much for this on new plans. We charge around $200 a quarter to the entire plan to serve in the investment advisor role and shift risk away from the owner. Our fee is paid by the participants (your employees) on a proportional basis depending on how many assets they have in the plan. So if you have 5 employees and they each put in $5k in the first year of the plan, each employee will be paying $40 a quarter (deducted directly from plan assets) for us to be available to answer investment questions they have about the plan and to help them select investments that are appropriate for them. It’s an all or none system – either the investment advisor is shared by the whole plan or the employer is the investment adviser and takes personal liability and responsibility for carrying out that function (i.e. your incorporation documents will not protect you, the employees can sue you for your personal assets if you violate ERISA).
It sounds scary, I know, and that is why up to 75% of small plans, and 50% of plans generally hire an investment advisor. Of those that don’t many are large corporations that have in house staffs to provide financial advice to their employees. Obviously, small business cannot bear those fixed costs, so they generally outsource it to an investment advisor, which is more efficient for them.
The second cost of a 401(k) is the underlying costs of the investments. This breaks down two ways. Investment can be from independent third parties (the best option) or they can be from the company that serves as the investment advisor (a vastly inferior option in our view). In the first case, the investment adviser like us help you select the best funds on the market and give your employees ongoing investment advice about how to use their 401(k)s to reach their goals. We have an incentive to provide broad coverage and low expense ratios for these funds, since we will not collect more in fees no matter which underlying investments you select and we want you and your employees to be happy. Unlike for insurance or payroll providers, the expense ratios or a not a fee bonanza for us, but just the lowest price available to access these assets. We can generally get the fund fee portion alone down to an average of 0.20% per fund but the exact price depends on the mix of investments and your recordkeeper.
The second option is to wrap everything in the mutual fund expense ratio. At first this sounds like a good idea, but it really isn’t. These expense ratios can be anywhere from 1.5% to 5% and in general they don’t go down much as your plan adds assets. These high expenses are destructive over time to your employees and and they don’t reflect the actual risk the insurance or payroll company is taking. It’s inevitable, a small, brand new plan is going to have a lot of fees due to fixed costs, but growing plans should have falling fees. If your does not, then that is a problem.
The third cost is the recordkeeper or third party administrator. These terms are used interchangeably because they do similar rules. A third party administrator is generally a fiduciary under ERISA whereas a recordkeeper is generally not a fiduciary. The benefit of using fiduciary is that it does a better job of shifting liability away from the company. The company has to supervise it’s fiduciaries but ERISA does not require the company to act with any sort of expertise in those areas where responsibility has been delegated to a fiduciary. However, when the party is acting as a nonfiduciary, like a recordkeeper or a broker (not an investment advisor) on a 401(k), the company is responsible for the actions of those people. So hiring a fiduciary providers extra protection, but generally doesn’t cost much more than hiring a normal service provider who isn’t willing to serve as a fiduciary.
Recordkeepers cost as little $1,500 a year for a small business and this cost is paid for by the plan participants generally on a pro rata basis. For this, the companies will usually prepare your filings with IRS, handle the payroll transfers, make sure the deposits get invested in the participants investment selection, make sure dividends are reinvested etc. Insurance companies and payroll providers generally wrap this fee into your fund expense ratios.
The final cost to budget for is compensation. Almost all plans we work with are “safe harbor” plans which basically means that 3% of the employee’s compensation is automatically put into the plan. You need to budget for this when you allocate money for raises. In general, if you don’t give your employees this 3% then you won’t be able to contribute to your own 401(k) account. It’s unfortunate but it is just the rules.
So in short 401(k)’s are some of the best tax savings out there and they aren’t really that expensive to set up. If your business is consistently profitable, you can generally afford one and the tax benefits are very good. If you’d like some objective advice on how to set up one of these plans and what your options are we’d be more than happy to talk to you.
The five things that matter the most when pursuing financial comfort – a few tricks of the trade
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by Daniel Harris, RIA, Saturday March 18, 2017
The five things that matter the most when trying to grow your money to be financially secure in my view are 1) your savings rate, 2) tax protection, 3) a global approach to investing, 4) sensitivity to market conditions and 5) deep knowledge about the habits and preferences of the opposing parties in the securities market.
Early on we have carefully manage how much of our savings do we give to each of these goals. The truth is most peoples’ saving for financial security are somewhat suppressed in the first five years of their career because other goals take precedence, but by your 30’s saving for your security has to be a key priority for you to succeed. If you wait until late 40s or early 50s it will probably too late and you’ll struggle more to have a chance to attain financial security. So focusing on these issues in your 30s is key to being financially secure, in my view.
The second issue is tax protection. Taxes will take at least 25% of your investment gains away and possibly quite a bit more. They are far more important in how your long term outcome will turn out than investment fees or expenses, which are de minimis when compared to taxes most of the time. You always want to have a deep understanding of the tax code and how to use it to get what you want. If you don’t know it well you can always hire a firm like ours that spends a lot of time working on the tax code and taking advantage of every long term we can find in it for our clients.
The third issue is a global approach to investing. You’ve probably heard rules of thumb like you should have x or y asset allocation based on your age (50% stocks/50% bonds if you are 50). The truth is this type of lazy allocation is almost always universally bad investment advice and really squanders your potential in my view.
The market is made up of people and their preferences, it’s dynamic and in the short term it is unpredictable. You can look at what’s for sale today and say what relatively the best deals are but you can’t look into the future and know what people will do in advance with much precision, because too many factors are at play. People who make their investment decisions years in advance inherently have inefficient portfolios compared to the available alternatives, and in my view, are much worse off as a result. My advice is put effort into understanding the current environment well or pay someone who already has that understanding to guide you.
Additionally, it’s important to keep an open mind in what you are willing to invest in for two reasons. First, assets don’t have a fixed or static expected return or volatility – these things vary quite a bit over time. Investing is like a game of blackjack, you can count the cards and give yourself a mathematical advantage by varying the size of your bets but off how many face cards are left in the shoe – but you can’t count how many face cards are left in the shoe until they start dealing the cards on the table. This is why prospective asset allocations are expected to do far worse than one that takes into account the price of things currently.
The second reason is that options to invest within the financial field aren’t static either. All the things we take for granted now: the mutual fund, the index fund, the exchange traded fund, the real estate investment trust, the high yield bond – were at one point financial innovations. Also the old rules tend to be in constant flux. This is why the job is so hard and the average person doesn’t come anywhere near reaching their potential unless they really focus on the things that matter.
Fourth, it is incredibly important to be highly sensitive to market conditions at all times. Many people invest like a blind bull in a china shop and as a result the average investor typically only earns about 1% above inflation over 30 years, according to Dalbar. That study has some built in flaws, but I think their conclusions are about right, from my experience client outcomes at a large brokerage firm. By contrast, we expect a typical client at our firm to earn somewhere between 6.5% and 7% after fees and inflation on their portfolios (but nothing can ever be guaranteed and every client is different because of their preferences, goals, and tolerance for volatility – so you should not necessarily expect this return if you choose to work with us).
So if the average investor who earns 1% after inflation and costs on their investments who has $50k and puts in $18k a year for 30 years will end up with = $699,781 in today’s money.
Our typical client who we expect to earn say 6.7% after inflation and fees on their investments who has $50k and puts in $18k a year for 30 years will end up with = $2,069,043 in today’s money.
The spread between the $2 million and the $700k is our potential area to create a value add for our clients (our an individual’s ability to create it for themselves if they are really willing to do the work). Even charging a fee for our services, the spread between what is possible and what people actually achieve is so large that people can frequently pay our fee and still end up better off. The thing is to do this really well is a lot of work, and it’s competitive, so you need to have the free time to do it and the interest to really do the intensive research consistently without ever burning out.
The fifth factor is deep knowledge about the preferences and habits of opposing parties in the market. Certain products like a municipal bond have a natural market (high income earners, older people, people who are on fixed incomes and adverse to risk) and then if the price moves a certain away they attract other people into that market. The demand for one security fluctuates quite a bit based off the recent experience of previous investors in that security (which can either raise or decrease demand depending on whether their experience was good or bad) as well as what is happening in the price of other securities on the market.
The best way to think about this is a grocery store analogy. Some people will always buy salmon because they need it for their products. Other people frequently will buy salmon but if the price gets too high they’ll switch to halibut or tuna. Still others don’t usually buy salmon but if the price gets low enough and the product is attract enough some people who don’t normally might decide to cook salmon for dinner that week. The securities markets work the exact same way and to do well it’s helpful to be prepared and to know the preferences of other investors because when you buy a security you really aren’t acting like a customer of a grocery store, you’re acting like a grocery store and you should know whether there is likely adequate demand to sell you salmon (security) at the price you’d like when you think you might want to sell it. If you aren’t an expert on the demand for fish, you might want to hire someone who is to help make sure that you don’t end up losing money when you try to sell your salmon back into the market.
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Actionable or Interesting?
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By Daniel Harris, RIA, Tuesday February 14, 2017
With politics seemingly in the news all the time these days, I’m often asked by clients what sorts of impacts Washington might have on their portfolios?
The truth is most of what happens in Washington is kind of unpredictable. The Federal Reserve meets in secret and only tells you of their decisions after the fact. The two houses of Congress have to work things out amongst themselves to get legislation through. And of course the President can make decisions that sometimes catch people by surprise.
The things that move security prices in a more permanent way tend to be much bigger than any one country’s or person’s politics. They rely on a number of factors of which politics are only a tiny one.
So while politics may be endlessly interesting, or exhausting, to observe these days for the most part it is not actionable. I’ll sometimes talk with clients about politics and what they think will happen but that rarely results in a change in portfolio strategy for us.
In the long run, it’s very important to know what factors are actionable and what typically moves security prices over time. It’s very important to be an expert on what you are buying and what it is likely worth to other buyers at different points in time. They key to this whole thing is to buy something inexpensively and sell it to someone else at a profit. In order to do that you really have to be an expert on the thing you are buying and the person you plan to sell it to.
As always, if you want to know what kind of things are actionable today and likely to impact your portfolio, I’m always happy to talk to current and prospective clients. I’m even happy to talk with you about politics if you like, although that conversation is more likely to be interesting as opposed to actionable :)
Fundamentals of Investing, Being an Accredited Investor and the Myth that the big players get a much better deal than you
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By Daniel Harris, RIA, Sunday February 12, 2017
In this post I’m going to talk about three things that are fundamental in investing and that have been coming up a lot with my clients. They are 1) the inverse relationship of investor size and competitiveness in the markets in which they invest, 2) whether investments for accredited investors actually are better and 3) the myth that the big guys have a much better deal in the market.
The inverse relationship of size and competitiveness in investing
Investing is incredibly competitive because people who have better information may be able to obtain significant wealth simply by putting this information to use. Information and knowledge is extremely valuable in this field, especially when combined with the magic of compounding.
As a result, large investors tend to acquire huge teams of analysts. A typical large pension fund may carry a staff of 50-300 analysts. You’d think they’d have a huge advantage over you, but in truth they operate at a huge disadvantage to you. Why is that?
The reason is the only investments that they can invest in also are being looked at by all the other funds with 100-300 person staffs and they are in a vicious zero sum game with each other. These opportunities may make up as little as 7-8% of the investible market. As an individual investor, you can compete in those markets too if you’d like but you’ll be up against people who know how to discount cash flows, properly value companies, and perform sophisticated financial analysis. If you don’t know how to do these things at a professional level, you’ll be at a big disadvantage in my view.
But my question to you is why would you want to compete with them? You want a good outcome – does it matter how you get it? These funds are beating the crap out of each other to earn a 2-3% returns above inflation, which might be the best you can do if you have a $200 billion fund. In my view, they aren’t going to stop doing that because the funds have swollen in assets and they have to invest in things that can handle $5 billion or $10 billion in inflows without moving the asset prices too much. You don’t have to do that, and there is a better way.
In investing small size is a huge advantage since you can invest in almost anything. There are some investments you can’t make after you have $10k or $100k saved up, but most of the time you wouldn’t want to make those investments anyways. I’d argue that up to 70-80% of the market stays open to you until you have more than $100 million to invest, which obviously the vast majority of people will never have. I would say that you should focus on wide open spaces that are less competitive and that are miles away from what the large pensions fund are necessarily doing at this time. I’d be happy to show you how to do this if you are a client of our firm.
What about accredited investor investments – aren’t those better because you have to have $1 million to invest in them?
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Let me disabuse you of the myth that buying something through the accredited investor loophole leads to better investments. Accredited investments can be better for the investment managers because they allow for multiyear lockups and keep you from having to show all your cards to the SEC every quarter. Some legitimately good investments exist through the accredited investor loophole.
The downside is that they are generally aren’t being watched by the SEC or very many other people so if someone wants to commit fraud this is an area in which they can do it more easily. Additionally, from a capital raising point of view the public markets are the cheapest way to raise capital in bulk, in my view. Doing a bond underwriting or a stock IPO or secondary doesn’t cost as much in fees as a percentage of the amount raised, provides for mostly standardized terms, and is an extremely inexpensive way to raise money. Under Sarbanes Oxley it may not be as cheap as it once was but it’s still a pretty good deal, which is why a lot of the really big companies in America are in fact public or raise money on the public markets.
Private markets can be useful for their lockups but they generally are much more expensive to operate in and are a much less protected way to invest money. I’ve seen a number of these things over the years and they’ve basically been illiquid black boxes where the promoter will say I’ll take your money and do x, y or z but there is no way to check to make sure that they actually did what they said they would do. Additionally, in these investments you typically can’t get your money out whenever you want to. I’m sometimes okay with these things if they truly can produce exceptionally high returns and make sense for all parties involved (including being the lowest cost of capital for the borrower), but not that many of these investments that I see would pass my test.
To give a brief example, venture capital worked in the 1980’s and 1990’s because no one would lend to these companies who didn’t have earnings are were in unpredictable industries so the VC was the lowest cost of capital for the borrower because it was the only source of capital available to them. Today we live in a different world and everyone is throwing money at startups (including public mutual funds) and so it’s important to make sure that whatever private vehicle you use – it’s the lowest cost of capital available for the borrower in addition to producing a good return for you.
Do big investors get a much better deal? Not really
The final issue is the myth that the big guys get a better deal than the little guy. The brokerage business has become so insanely competitive that the companies practically pay you money to do business with them (an unsustainable business model, in my view). Occasionally, in 401(k)s and things like that small players have to pool together to get a good deal, but basically anyone with $10k to invest will get a good deal from a brokerage house on a non 401(k) account. Even within 401(k)s the brokerage window has completely undercut fees in the industry (which is a good thing in many cases) by freeing people from having to invest more than 5% of their 401(k) into the more expensive mutual fund options in their plan.
It might cost you $200-$300 a year in commissions to do all the trades you’d ever need to maintain a properly responsive portfolio to market conditions and to your goals. This is true whether you have $10,000 to invest or $10,000,000. The price of commissions just doesn’t go up when you have more money. It’s a low, fixed cost of investing. The fact that someone got this service for free and you had to pay $300 isn’t meaningful over your lifetime. For a good investor these $300 in commissions might cost you 15 thousandths of one percent per year when averaged over your lifetime.
The big difference in outcomes, in my view, comes from access to information. As a small investor, you can create a huge advantage for yourself, in my view, by having better information than your competitors. This usually comes from hiring an advisor, surprise, surprise, that I would say something like that – but it’s also completely true. They’ve studied people and often those who end up with more money are more likely to hire advisors. This is similar to the fact that people who invest in valuable educations from good schools often end up making more than the population generally. It doesn’t mean that they are better – it just means that they made an investment in something productive and thus tend to reap good rewards from that.
The point is that you invest your time and resources in things that have the potential of generating a return. Because most smaller investors aren’t that knowledgeable, if you can get someone who knows how this works to help you, and compete against those investors, I think you have a good chance of being a lot more productive than your peers with you money. Of course, this involves a commitment to yourself and a little bit of delayed gratification.
Those who make in the investment, have a high chance of prospering in the future, in my opinion, and those who try to skimp on this area usually have to save more to get to the same spot of spend less in retirement than the otherwise would have.
So my recommendation is to compete in the less competitive parts of the market and to hire someone who can give you a knowledge advantage over others in this highly competitive space. If you do that, and stick with it, I think the rewards can be immense.