Why Becoming Debt Free Is Not A Great Idea!

 

We Don't Need No Medicine!

We Don't Need No Medicine!

I’m pleased to bring you a guest post by faithful reader and commenter, Larry Ludwig (bio below).  He writes a thought provoking piece about challenging the norm of becoming debt free.  You’ll be smarter after reading this, guaranteed!  Enjoy, and as always, feel free to debate away!  Rgds, Financial Samurai

You’ve heard the financial gurus like Dave Ramsey perform pasectomies on his show and Suze Orman with her numerous “I have 50k in debt” guests.  The gurus all say, debt is bad, credit is evil, and being debt free is nirvana, yada yada yada.  While I do think as a whole Americans have too much consumer debt, the goal of being completely debt free is actually a terrible idea. Let me be specific: buying things that depreciate with debt is bad, that big screen TV, new clothing or car.  Most of the financial gurus do not make this distinction and make all debt to be “evil”.

I believe Rich Dad/Poor Dad Robert Kiyosaki has said it best, “There is good and bad debt and being debt free is more risky than having good debt.”.  Now before you go off on my recommendation of Robert and his questionable background, I believe his statement is sound and correct.

The primary reasons are:
•    Opportunity Cost
•    Asset Allocation
•    Inflation
•    Tax Deductions
•    Arbitrage
•    Leverage

OPPORTUNITY COST
In my case my wife and I just refinanced our house with a 30-year fixed rate at 4.875%.  A great rate and will be probably not see rates lower in our lifetime.  While we could pay off or accelerate the payments it does not make sense to do so.  Why?  Our actual mortgage rate after taxes is 3.26%, a very easy rate to beat with investments (especially pre tax) and in addition the average rate of inflation is also 3.26%.  With both taxes and inflation are expected to be higher in the future and it’s possible the actual mortgage rate will be even lower.  It’s better to take the freed money that would have been tied into the house, and invest in other assets.  In today’s environment you still can beat the above-mentioned rate.  Another way to look at, with inflation we will primarily paying only principal in real dollars with very little in interest payments.  Your primary residence should not be looked at as an investment and if the numbers make sense take mortgage pre-payment dollars into other assets.

ASSET ALLOCATION
Let’s assume you take the financial guru’s advice and either pay off your home mortgage or accelerate payments.  You will then have the proverbial “too many eggs in one basket” being your house.  Most families that take this advice then cannot afford to build up an emergency savings or put money in pre-tax or after tax investments.  You’ll have too much of your dollars tied into one asset.  Should pricing go down like we have seen in the past 2 years than you’ve lost real money.  If you lost your job it would be much harder to get the equity out of your house to use in an emergency.  Pre-payment of your home mortgage should always occur last after any pre-tax deductions (IRA, 401k), or emergency savings.  Even then, depending upon your real mortgage rate, it may not make sense to ever pre-pay.

INFLATION
Inflation has been called the “silent tax” and lurks at night eating away at your money.  With our fiat currency and monetary policies, inflation is something our government wants to ensure always happens and at all cost.  You not only want a ROI (return on investment) but a return OF your investment in real dollars.  An example of this is a bank CD generating 4% a year interest, yet inflation is at 5%!  While it’s great you have a safe investment, you are loosing %1 of your real money buying power.

Now you say what does savings have to do with borrowing?  Everything.  In general our government’s monetary policy is punishing savers, while helping debtors every way it can.  This has become painfully obvious in the past year.  You see this in every news headline and policy our previous and current administration has done.  Inflation is especially obvious with people on fix incomes (i.e. retirees).  By having low fixed rate loans you are paying with future dollars that are worth less than currently.

The $64k question is what will happen 10 – 20 years in the future?  Will we have a Japan style deflation?   Will stagflation of the late 70’s come back again?  Will hyperinflation like Zimbabwe occur?  There are a number of factors to consider:
•    China and Japan will keep buying our debt?  Will they just stop or slowly decrease their purchases since a devaluation of our dollar will hurt their exporting.  The latter situation is more than likely
•    Foreign countries that are buying our debt are now only buying short term debt.  (less than 10 years).  When this debt comes due, this could have massive issues for us.
•    How with our government pay off the existing debt?  Based upon interest alone we getting close to 40% of our yearly tax revenue.
•    Will our government stop spending like drunken sailors with debt expected to pass 100% GDP in 2011?  Unlike Japan, we do not have a country of savers to fall back upon.
•    Will our government stop creating policies that will hurt small business?
•    We are base currency for other countries, but for how long?  If dollars start coming back to the U.S.A what would that do to the value of our currency?
•    For the time being forget about the new health care bill, how will our government be able to fund the existing programs Social (In)Security, Medicare and Medicaid?

While there is no assurance of what the future holds, the question is do you want to ignore the risks, or hedge your bets? I choose the later with some assumption inflation will be higher than what we’ve seen for the past 30 years.  Even so since 1914 the average inflation rate has been 3.26% and since 1971 (the year we completely came off the gold standard) it has averaged 4.48%, so always keep these numbers in the back of your head when debt taking on debt AND investing.  By taking on low fixed rate debt, this is one simple method to hedge against inflation.

TAX DEDUCTIONS
The Government wants you to be in debt. That’s right, why else would they have tax incentives like “Cash for Clunkers”, first time home purchase, and for businesses deductions on equipment purchases?  The only logical reason is they want you to take on debt.  This is related to the government’s monetary policy mentioned previously.  So if you are in the higher income brackets it makes more sense to use the tax deductions to your advantage.  This is especially true on assets that generate income or increase in value over time.  It’s also important to note, don’t take on debt just for the tax deduction alone.

ARBITRAGE
Arbitrage is just a fancy term making a profit from the difference in market prices.  I just received a credit card offer for 0% interest for one year, with check writing expenses it was 2.99% fixed for one year, much lower than any other of the current credit card rates we have.  In the next year it’s expected all credit card transactions are going to go up dramatically.  With that said if I take a one-year low interest loan and make 6% in a safe investment I’ll come out ahead with a 3% difference.  This example assumes inflation and taxes paid are 0%, not completely realistic but you get the idea.  While there is some risk involved (as with any investment) the risk is somewhat low and will take my chances on this type of arbitrage.

Let me also add another form of arbitrage we saw in the previous years with one of our credit cards.  We had a 4.99% “fixed” rate credit card that also offered great card rewards.  I recently calculated any interest we paid, minus all of the gift cards we received.  It turns out the credit card company paid us over $600.00 in the 3 years we used it and this is after any interest payments incurred!  So our interest real rate on this credit card was negative.  Not a bad deal if you ask me.

LEVERAGE
I’ve seen articles that state rental housing is a poor investment compared to stocks or bonds.  They use the typical statement of housing matches inflation or slightly less.  While this is true, it does not take into account the use of leverage.

Lets use an example of putting down 20% on a $100,000.00 rental house.  We’ll assume over time the house increases in line with inflation, and use 3% a year.  So in the first year it increased from $100k to $103k, assuming the property is cash flow positive, the property increased in value 3k without doing anything.  With your $20k investment, just increased to $23k or a 13% increase.  So with leverage you made more money with the assistance of inflation.

Using leverage while does increases risk, it can be used to your advantage.  Too much leverage (like many of the failed banks) can destroy you.  So the question becomes how much leverage do you take on?  For housing the typical 20% down payment makes sense and should be the bare minimum.  For other assets it really depends upon your risk tolerance, asset allocation and long-term goals.

IN SUMMARY
I’m not saying go out to Macy’s and Best Buy max out your credit cards on deprecating assets.  I am saying use debt to your advantage. Leverage assets that in the long run increase in value and/or generate passive income, while using cash to purchase deprecating assets.  Don’t assume that all debt is “evil”. When using debt and risk management properly, it is one of secrets of becoming wealthy.  If used improperly can enslave you for the rest of your life.

Larry Ludwig - Started Empowering Media in 2001, a managed hosting provider offering system administration consulting and web hosting services.  He lives in Long Island, NY is married to Jeanne and has two children.  His “hobby” is investing and reading personal finance books.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Lulu says

    Most of the points make sense but what if you inherited your house or car? And you don’t have to carry a balance on a credit card to make the card work for you…..

  2. Larry L, New York says

    @Lulu
    for inheriting a house or car, I assume you also inherited the debt? What’s the difference if you bought it or someone else did?

    I’m not suggesting we carried a balance, almost all months the debt was fully paid back so it was interest free for net 30. For most credit card balances completely paying off monthly makes the most sense. If we had any decent debt on that specific card we either would have broke even or a slight loss, not bad either way. I suspect credit card points will not be a generous as they have been in the past 5-10 years.

  3. says

    Hi Larry – The real risk is knowing when to stop taking on debt it seems. Once you start, it’s hard to stop given how easy it has been to access credit.

    I used to abhor debt. Now I love debt if used properly like you say. It’s almost like a bell curve, where you have no debt, ramp up debt, and spend the next couple decades paying it off by the time you retire.

    I’ve never really worried about inflation and its erosion effect. It’s either trying to be be in the green and make a lot or protecting assets by not going in the red. Maybe I should focus more, but i don’t really care as inflation has been going down hill for 20 years already and we’ve got a big output gap. Should I worry about inflation?

    Living beyond one’s means is the American way for many if we compare your savings ratios to those of many other countries. It may take generations to change the way we consume debt. But, it’s probably not possible, even after this crisis.

    Best, FS

  4. fredct says

    Larry, you can’t inherit debt. Debts do not pass from person to person upon death (unless you were a co-signer to begin with, of course, in which case it was yours all along).

  5. Geek says

    I’ve always thought the nicest way to look at inflation is that it increases the value of your house, while decreasing the value of your mortgage.

    FS – a lot of Larry’s points on inflation indicate that the fed may be printing more money soon. If you think this is going to happen, then you should worry about inflation. It is important to take inflation into account in retirement planning and savings. The rule of 72 with inflation (divided by 3.26) says my savings value halves every 22 years.

    • says

      Geek – I hear what you are saying, and agree. I know there’s a previous post somewhere where I talk about loading the boat on assets b/c they will inflate by definition, and take on debt, which will become cheaper…. but I forget where it is for now :) I remember now, it’s in my “Note to Self: Buy More Rental Property Post”. Check it out!

      I don’t believe inflation is on the horizon despite all this monetary expansion b/c of the output gap. Money is going to be cheaper for longer. There may be some headfakes, but there will never be double digit inflation in our lifetimes in the US. FS

  6. Larry L, New York says

    @Geek

    If you look at all of the stats the Fed has printed more money than ever. It’s not a matter of this, the velocity. If/when banks start loaning the money and can the Fed take the punchbowl before it becomes an issue. Based upon the evidence the Fed wants inflation, not deflation so they would rather error with inflation.

  7. Larry L, New York says

    @admin

    While we disagree about how high inflation will be, I think it’s safe to say the next 30 will be higher than the previous 30 years.

    • says

      Larry – I would frankly love to see high single digit inflation, so we can inflate away our debate, and inflate higher home prices. But, in the long run, it’s all the same. High inflation = higher wages = higher goods and services, no big deal. But, since many of us have locked in fixed rate debt, i’m hopeful inflation will come!

  8. says

    I really love this article.

    I tell people all the time that debt can be used to your advantage. The truth is… the shortest distance between to points is a straight line. If you want to be rich (meaning have the most money), then your strategy should revolve around accumulating the most money the fastest. And Debt if used correctly can help you do that.

    I am not on a debt crusade. I’m on a financial independence crusade. You can be debt free and BROKE! Don’t be distracted from the true goal, which is wealth.

  9. Charlie says

    I try to limit the amount of debt that I have at any given time and always pay off my credit card to avoid fees and interest, esp. since my rate is rather crappy. If I had a 0% credit card though I can totally see how it’s great to take advantage of that as long as I could discipline myself not to overspend beyond my means.

  10. Lulu says

    @Larry L, New York
    I have not inherited anything…I was just saying since you seem to think that not having debt is bad…then if someone inherits a house they have no mortgage payment….so is that bad?

    I have debts and I am paying them off…………..my comment was not meant as a personal attack…………just a what if?

  11. Larry L, New York says

    @Lulu
    Hi Lulu, never took it as an “attack”, just not sure I understood what you were trying to convey.

    As far as inheriting a house with no debt, you CAN always get a new mortgage for it.

    IMHO it all comes down to opportunity cost. If you feel the money taken out can be better invested in other assets then do it, if not no. Current fixed mortgage rates of around 5.00% and for most people that’s below 4% after taxes. So beating that rate is pretty easy to do, without subject to high risk. This would change if we see mortgage rates like we saw in the early 80′s. Some people were paying 12%+ interest rates. In that case you more than likely better off paying the mortgage first before investing in other assets.

    For my family, we can do better than our after tax rate. In addition, I can pay my mortgage in the future with cheaper dollars. This of course assumes inflation will be similar or higher than the previous 30 years. That situation seems the most likely out of all others.

    The other thing to mention is you can always take the freed money and use it to make a lump payment back into your house. This would make sense if disinflation or deflation occurs instead of inflation. Right now nothing shows this is occurring, if anything signs of inflation are starting to take hold.

    Taking money out of a house is much harder than putting it into and also subject to interest rates at the time you take money out.

    Hope this clarifies things.

  12. Larry L, New York says

    @Charlie

    A few years ago you would see true 0% interest rate for X months for new and/or transfers. Today it’s usually only for new purchases only and usually less than on year. Transfers are typically not offering true 0%. You must run the numbers with their “check writing fees” to get the true rate.

    The only areas I still see 0% interest is in technology (Best Buy, Apple) and furniture. These are offering 12+ months at 0% rate. Keep in mind both these areas the assets can decrease quite a bit. So use these wisely.

    As I stated in the post, I expect traditional CC rates to increase dramatically. Even with our excellent credit and long term relationships we had with our banks, they stripped us of our ‘fixed’ rates (what the f*$k is up with that?) and now have variable rates. The interesting thing I see with also owning a business, they haven’t done the same to any of the business credit cards. I still have some very low (sub 5% interest rate) credit.

    So if you can afford it, now might be the time to use this debt to your advantage.

    I play the game so we win, not them. Worst case for my family we go back to completely playing via cash, which I have no issue with. If you have the discipline, why not us their services to your advantage?

  13. says

    @Larry L, New York
    One thing to realize about all these 0% temptations though is that their cost to allow a customer to finance at 0% is baked into their price.

    You may get a great TV deal for $1,000 with 0% financing but the reality is, if there wasn’t 0% financing, the TV would probably cost the consumer $925!

  14. KK says

    I agree with the main thrust of the post — that debt used wisely and responsibly is not a bad thing. However, I read Ramsey’s book, and his point is that debt does increase risk. I think it is a point worth remembering. If one is paying 30% (or more) of one’s income toward mortgage debt and gets laid off, will the person be able to keep making that monthly mortgage payment. Also, Ramsey advocates first saving for retirement and then paying down the mortgage.

    Also, there are many favorable assumptions in your section on leverage. If those assumptions are true, then I agree about the retirement property. However, likely some would not.

  15. Larry L, New York says

    Ramsey and Suze financial advice are more for the “working joe” than say for someone like me who owns a biz, likes to invest and who have higher net worth. A little tidbit bout Suze and her own investing:

    http://www.maxfunds.com/?q=node/260

    So should I get advice from someone herself does not invest in the stock market?? She considers it throw away money. I consider her advice fitting for me for when I first came out of college and knew very little.

    What also matters is not only is the debt ratio but also free cash flow (like any biz). No cash flow, no biz and the primary reason why new biz fails. Cheers!

    • says

      The funny thing Larry is that there are a ton of people who don’t practice what they preach. Before starting this site, I was reading so much junk online about PF. Guys would blog about how to buy a home when they have never bought a home in the first place! It’s all one big sham, especially those who’ve gotten rich off their marketing.

  16. XtraCrispy says

    I think I’m following this post…

    I do have a CC card that I pay off monthly, and use it for everything to get the most $ back in rewards. I have 2 sets of student loans, and a car payment…is it more wise to try and pay the car off (keep the student loan debt for tax purposes) and put money in CD’s, emergency fun, house fund etc…or is it more wise to snowball money onto the car not, student loans…and maintain a current savings rate? (currently $300ish a month).

    Any opinion is appreciated…cause I’m stuck at the moment! haha. Thx

  17. Larry L, New York says

    @XtraCrispy

    Hi I’ll try to answer since it’s my posting…

    I assume the car payment rate is higher than the student loans? I would pay the car off first compared to the others. Cars depreciate at a rapid rate and are usually higher than your student loan rates (even before taxes).

    As far as emergency savings, depends upon what you have currently, how stable is your job and how much expenses you have. The primary question is what would happen if you lost your job and out of a job for 6-12 months? After unemployment runs out what would you do? In my case I don’t have unemployment insurance, since I own my own biz, and have more than the norm (1 year of emergency savings). Employees in most cases won’t need that much, and 6 months should be fine.

    If you don’t have one I would suggest that first, at least something, so you aren’t living paycheck to paycheck. It’s harder to take money out of an asset once it’s been put into it.

    After that it depends upon your investment return rate and the rate of the loans. If say your car loan is 10%, then trying to beat that with investing will be pretty hard to do without getting into very risky assets. You would be better to pay off the car loan first.

    In my case we are looking for a new car and some of the offers are at 2.9% rate. I should be able to beat that with investing pretty easily and with somewhat secure investments. So in our case I might not want to pay cash for the car.

    Hope this helps.

  18. XtraCrispy says

    @Larry

    I definitely don’t have 6 months worth of income saved…so I should probably look into getting that setup first. I have some money saved, but not enough to cover me if I were to become unemployed. I believe I’m “safe”, and I use that lightly for another year or two before I have to worry about a re-compete for a contract.

    Car note is at 8.09%, one student loan is at 6.75%, and the other is a Parent PLUS loan(big mistake) at 8.25%. Paying off the car first was what I had in mind initially, while continuing to move at least 300 a month toward savings as I have been doing for about a year now. I would be able to pump up the savings a lot faster if I don’t pile extra $ on the car note, but I guess that’s a toss up.

    Thx for your response though. It did open up some ideas on what I might consider doing.

  19. Steven Francis says

    Definitely there are some benefits of being in debt, but what I suppose is the mental piece can be achieved only if we are debt free. I have seen many people really eager to get out of debt by any means. So I always prefer having no debt.

    • says

      Steven – Thnx for your thoughts. I donno, I’m really used to being in debt and using it to my advantage at the moment. Perhaps I forgot the feeling of what it’s like to be debt free. I hope I know in 15 years!

  20. Jana says

    Be careful of maxing out balances on the 0 interest cards. Those practices are ruining credit scores as the FICO scoring system punishes you for using more than 35% of any one credit card. That could affect your ability to get low interest credit on other items (housing, small business LOC, etc) in the future.

    Maxing out 1 card could lower your score by 100 points, seriously I’ve seen it happen.

    • says

      Jana – Interesting stat on not using more than 35% on any one credit card. Folks really get punished for that? I’ve never heard of such a thing.

      What about the scenario where your credit limit is $10,000, and you use $10,000 of it to buy something but pay it off in a month, then buy something else for $10k and so forth? There can’t be punishment, can there?

      FS

  21. Larry L says

    I have heard about your FICO score gets adjusted but not to the degree you’ve mentioned. I’ll have to check it out with our next FICO check.

    FS, as far what they count against is your balance at the moment they get your balance from the credit card company. If it’s a constant rotation, it will show a balance of something. What the credit reporting does not show is your credit turnover (payments vs charges) That’s something I’m sure the credit card company themselves keep track of though.

    • says

      Larry – Interesting. Ok. Well I guess i never really carry a balance, so I don’t know too much about credit cards. I have one personal card, one corporate card, and that’s it. Don’t need no more! I also don’t need to be giving some big bank 8%+ in interest when the 10-yr treasury is at 3.5%. What a crock. FS

  22. says

    @John DeFlumeri Jr

    True in a financial sense. However assume you have a mortgage on a house. As long as the debt is not paid, the bank will probably have some special rights on that house. Honestly I would have a problem on the long-term, knowing that my assets could be claimed by a third party during a crisis or perhaps when I have a moment of finacial instability. Perhaps it’s a matter of how much security and stability an individual wishes in his/her life…

  23. says

    @Aleks: Keep in mind you always will pay taxes on your house regardless if it has a mortgage or not. Two items to consider:
    1. Try not paying your property taxes and see what happens to your house.
    2. Eminent domain is whole other discussion.

    So at minimum someone will ALWAYS have “special rights” to your house. You’ll see how much you really “own” your house.
    .-= Investor Junkie´s last blog ..Mint Review: Should I Use Mint.com? =-.

  24. Karl says

    I think debt should be used for your own mortgage and education and nothing else- yes, have nil debt after these two.

    The article is a clever yet dangerous, as it offers the ‘candy’ of debt but fails to mention what often happens next with borrowing to buy growing assets.

    What happens next is you get greater monetary returns, so you take on more debt to achieve even greater returns, you get greedy and overstretch further and then… boom! either revenues slump, recession hits, business has cash flow problem, factory has a fire, porperty market crashes, you have a sudden medical cost, lost job or whatever many reasons for a temporary weakness.

    And with debt, there is a high probability that such a moment of weakness for you will *coincide* with the lender pulling the rug from under you with a capital repayment demand.
    So you start back at zero with fewer working years left so more of a hurry so seek more debt and, you get the idea.

    A guy I know has studied business and investing for a decade and can compound money at 30% per year. So he should borrow money at 5% interest rate and invest to achieve 30% p.a. right? Certainly not.
    He achieves 30% p.a. returns because 1. he rarely loses money due to avoiding companies saddled with debt, 2. he is rational enough to know that a little personal debt+ short term success will only lead to him feebly succumbing to using more debt and 3. he knows the simple math that ten years of growth multiplied by zero in the 11th year- thanks to leverage- gives a net worth of zero.

    If you’re smart enough financially*, you have no need for debt.
    If you’re not financially smart, you should avoid debt at all cost.

    * by “smart enough”, I mean you’ll know the difficulties in trying to value a company’s equity when it has a D/E ratio above 0.5, prior to deciding whether to invest.

    Beside a mortgage and any loan for your education (good debt), do not borrow and reach your financial goal with 100% certainty… or borrow and have a 5% chance of failing to reach any goal.

    Financial services companies want you to take on lots of debt. Companies with over 20% director ownership rarely use debt. Don’t these two facts tell you something?

  25. says

    @Karl:

    Over leverage yes is VERY bad. How much is over leverage? Depends upon a few factors. Debt can amp your returns, but it can also destroy you. exhibit A: banks from 2 years ago. The author never states over leveraging. A good portion of debt is personal debt is consumer debt, not in investments. You are 100% people should not purchase assets that always decrease in value with debt.

    I call BS on your 30% return guy. For how many years consistently??? Investing in what? If this “guy” you state gets that amount every year he has to be one of the best investors to ever live! Better than Buffet, who has averaged 23% (if memory serves me correct) Is it possible to get 30% in one year (don’t forget last year the S&P was 22% up YOY) but consistently… ah no.
    .-= Investor Junkie´s last blog ..How Much is 1% Costing You? =-.

  26. Karl says

    Sorry, maths mistake. The risk of bankruptcy may only be say 1% a year, but over 20 years = (1-0.99 to the power of 20) = 18.2% probability of bankruptcy at least once in 20 years (not 20% chance as mentioned before). Still, too risky.

  27. Karl says

    @Investor Junkie
    Re. 30% p.a. returns, to be clear this is average return. Some years were less (1% in 2008) and other years were more (56% in 2009, 48% in 2004). So it’s 30% p.a. average return since 2003.
    He achieves this by:
    1. investing in small to mid cap equities
    2. only in industries he understands (excludes 4/6ths of the stock market).
    3. managing $500k and that relatively small amount of capital is his structural advantage over investment institutions, as he can invest in small companies off the radar of the professionals
    4. runs a focussed 7 stock portfolio- he splits the capital into 1/7th portions and invest one chunk when a dirt cheap company appears, and that only happens a few times a year, so the 30% returns are best achieved via part-time investing (months of no trading and the occasional 12hr research into one company)
    5. he avoids debt like the plague- both portfolio leverage and individual company debt- because we know that a capital loss through borrowing can ruin the compounding process.
    6. he works hard at being rational; he understands that a little side bet on the golf course can lead to more gambling in his life and exactly the same happens with a ‘harmless’ bit of debt to juice returns leading to more and more debt.
    7. finally, occasionally a holding of his might fall by 50% shortly after purchase and so he buys more, but leverage would not allow him to stomach such short-term volatility.

    If that capital was $10m, the average returns would drag down to say 20-25% p.a. average. I agree with you that Buffett’s returns are phenomenal on $100bn+.
    Google “50% per year Buffett return”- Buffett says it’s possible to achieve 50% p.a. average return with sub $1m, but that’s a full time job and you have to be really fanatical about the process.
    So these returns follow a power law distribution curve, with average returns on the y axis and capital sum being invested on the x axis. The more capital, the lower the average returns.

  28. Karl says

    @Investor Junkie
    (continuing from the the above post)…

    Note- the more volatile the asset, the greater the return so it’s tempting to borrow at 5% and invest at 30% p.a. average return. But a cash call from a lender at a weak point in the volatility could permanently cripple you. Alternatively, borrow at 5% and invest at 8%… but there is still asset volatility simply due to earning that extra 3% spread, so you’re still vulnerable to collapse but this time earning less returns.
    This risk of bankruptcy may only be 1% a year, but add that over 20 years= 20% probability. Too risky.

    Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.

    Certainly, playing with “credit card 0% interest” and credit ratings is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.
    It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. Could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?

  29. Karl says

    (continuation from post above…)

    Note- the more volatile the asset, the greater the return so it’s tempting to borrow at 5% and invest at 30% p.a. average return. But a cash call from a lender at a weak point in the volatility could permanently cripple you. Alternatively, borrow at 5% and invest at 8%… but there is still asset volatility simply due to earning that extra 3% spread, so you’re still vulnerable to collapse but this time earning less returns.
    This risk of bankruptcy may only be 1% a year, but add that over 20 years= 20% probability. Too risky.

    Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.

    Certainly, playing with “credit card 0% interest” and credit ratings is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.
    It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. Could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?

  30. Karl says

    Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.

    Certainly, playing with “credit card 0% interest” and credit rating games is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.

    It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. In other words, could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?

  31. says

    @Karl

    Ok approx 7 years of returns you are stating. A sub 10 year, especially starting the first year of a bull market is most definitely possible to achieve 30% in that short of a time frame. My point is, if your friend or you think he’ll continue this trend for year 10, 15, or 20 in the future. The trend is not a realistic, he’ll be assimilated closer to more typical averages. Especially with some of the possible headwinds and unknowns coming down the pipe. I would congratulate your friends returns, if in fact they are real. Like I stated before if he’s able to pull this off in the long term, he’ll be on course to be one of the greatest investors of all time!

    If you haven’t proof (ie a statement) it becomes more of “the big fish I caught” story. I assume this is an active trading strategy in order to achieve the returns he got. I suspect real returns after expenses (let’s for now not even discuss taxes) it’s much less than the 30% mentioned. If he’s done it more via buy and hold and value investing methodology, his return wouldn’t jive with what professional value investor returns we saw in 2008 (to use a known benchmark). Value investors saw some of the worst returns during that period.

    To circle back to why I commented on your original reply. Your friends investment returns is an outlier and not typical returns MOST people achieve, even the “professionals” who aren’t chained by certain rules (ie mutual fund managers and the amount they can invest per company) To say an investor shouldn’t use debt to help amp returns, if the debt pricing and ratio isn’t right is just plain silly. Debt, just like investing, has risks. Both should be used appropriately and wisely.

    If your expand statements and it were applied to all businesses and investing some very interesting results would occur. Not using debt in business or investing would lead to more stable but below our historical normal returns. Just what I believe we’ll see in the next 10 years of below optimal returns on the flip side. Too much debt to pay down also leads the same path. My point it should be balanced. To attribute to FS theme there, a yin and yang of debt and investing. Cheers!
    .-= Investor Junkie´s last blog ..How Much is 1% Costing You? =-.

  32. Karl says

    Investor Junkie-
    You say “starting the first year of a bull market… it’s possible”. FTSE All share index (he’s a UK investor) rose just 40% between 2003-2010 = 7% p.a. minus 30% p.a.= 23 percentage point difference. This is very doable when managing under $1m for a rational value investor. Buffett did 22% point difference to the Dow in the 1960s and Munger did 19% point difference in the same period and incredibly with far, far more money than <$1m in 2010.

    You say “he will regress to typical averages”.
    I agree that, in c.15 yrs from now, his $10m will have lower average annual returns of around 20% p.a. instead (and 15% p.a. on $100m will be excellent).

    You say “I suspect real returns after expenses… it’s much less”.
    These returns are after expenses: the portfolio has a 65% turnover rate, so each stock is held for 1.5 years on average and this is for a 7 stock fund only. So the trading cost is around 0.3% of the portfolio net asset value p.a.
    The capital is pension money, so it’s pre tax. At 20% capital gains tax, the returns would conservatively be 25% p.a. average.

    You say “if he’s done it more via buy and hold… his return wouldn’t jive with what professional[s]… saw in 2008”
    Yes, the style is entirely value investing and his returns do not jive with the pros dire results in 2008 because a. he held up to 40% cash in 2007 (due to being unable to find cheap stocks), whereas the pros often have to remain fully invested and b. he did not suffer clients making panic redemption calls on the fund that would lead to forced selling of stocks at the lowest prices.

  33. Karl says

    Back to debt, the article author wrote “Using leverage while does increase risk, it can be used to your advantage”.
    This notion that debt increase returns but also risk is illogical- risk of permanent capital loss *erodes* returns. Yes, an investor may enjoy 20% returns due to debt leverage, but if it leads to –40% or more in one year, then the net worth is crushed.
    And the temptation to ramp up the debt once started is too great, so don’t start.

    Just save the income and teach yourself how to maximise returns whilst keeping the risk of a loss greater than 10% in any year on your investments to a tiny probability… and you’ll be 100% guaranteed to reach your goal.
    Why leverage your assets (beyond education debt, own mortgage, start-up or investment property) in an attempt to reach your goal say 5 years earlier, but with a small chance of utterly failing?

  34. says

    Full disclosure: I am a die hard dave ramsey fan. Please consider these thoughts:

    Larry, you do have some excellent points here. It is true that debt can be used to one’s advantage. However, to do this properly, interest rates must be to one’s advantage and to do that properly takes some very careful calculation.

    Additionally, we must absolutely remember to distinguish personal debt from business debt. Here is where I completely disagree and my Ramsey-ness comes in. I believe the facts show that all personal debt is not good, because individuals are usually subject joint and several liability, when it comes to real estate at least.

    The simple fact of the matter is that the vast majority of the working public does not possess the proper understanding of finance to use debt to their advantage. This is the genius of gurus such as Dave Ramsey. His program strives to simplify finance by the use of cash and cash alone!

    Readers, please do not misunderstand me. Anyone, and I do mean anyone, can learn the proper principles to use debt to their advantage. But this takes times and much study and a level of math knowledge many people do not care to have.

    Thus, readers, please consider carefully what Larry is saying here. He is correct, debt can be used to one’s advantage, but the best decision and safest decision is always to have no debt, period.

    The way the American culture and the vast majority of us think about debt is very far from the correct way to use debt in a business. I urge anyone who might be open to learning and study to truely study the nature of debt versus zero debt, and I truely believe one will find that zero debt anywhere at all for anything is always bad debt.

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