Sunday, April 25, 2010

If You Are So Smart Then Why Aren't You Rich?

Are the Rich Smarter Than You?

"Well if you're so damn smart, why aren't you rich?"

I never knew how to respond to this. Still, it ingrained in us the notion that the rich must have a little something extra going on upstairs, otherwise we'd all be rolling in it. Right?

There is, in fact, some evidence to support this.

According to a recent report from the U.S. Census Bureau, there is a strong positive correlation between education and income. Over an adult's working life, high school graduates should expect, on average, to earn $1.2 million; those with a bachelor's degree, $2.1 million; those with a master's degree, $2.5 million; those with doctoral degrees, $3.4 million; and those with professional de grees, $4.4 million.

But here's the rub: Studies show that those who earn the most aren't necessarily the richest. To determine real wealth, you need to look at a balance sheet - assets minus liabilities - not an income statement.

We generally envision millionaires as Lexus-driving, Rolex-wearing, mansion-owning, Tiffany-shopping members of exclusive country clubs. And indeed, Stanley's research reveals that the "glittering rich" - those with a net worth of $10 million or more - often meet this description.

But most millionaires - individuals with a net worth of $1 million or more - live an entirely different lifestyle. Stanley found that the vast majority:

• Live in a house that cost less than $400,000.
• Do not own a second home.
• Have never owned a boat.
• Are more likely to wear a Timex than a Rolex.
• Do not collect wine and generally pay less than $15 for a bottle.
• Are more likely to drive a Nissan than a BMW.
• Have never paid more than $400 for a suit.
• Spend very little on prestige brands and luxury items.

This is certainly not the traditional image of millionaires. And it makes you wonder, just who the heck is buying all those Mercedes convertibles, Louis Vuitton purses and $60 bottles of Grey Goose vodka?

The answer, according to Dr. Stanley, is "aspirationals" - people who act rich, want to be rich, but really aren't rich.

Many are good people, well educated and perhaps earning a six-figure income. But they aren't balance-sheet rich because it's almost impossible for most workers - even those who are highly paid - to hyper-spend on consumer goods and save a lot of money. (Unfortunately, saving is the key prerequisite for investing.)

In his new book, Stop Acting Rich... and Start Living Like a Real Millionaire, Dr. Stanley recalls an appearance on Oprah when a member of the audience asked the question - one he's heard hundreds of times before:
"What good does it do to have all this money if you don't spend it?" She was angry, indignant even. "These people couldn't possibly be happy."
Like so many others, this woman genuinely believed that the more you spend, the better life is.

Bear in mind, we're not talking about people living below the poverty line. We're talking about middle-class consumers and up who have lived beyond their means and have suddenly found themselves under enormous pressure in a weak economy.
Some were overly optimistic. Others didn't realize that they are up against an army of the best and most creative marketers in the world, whose job it is to convince you that "you are what you buy," that you need to outspend - to out-display - others.

The unspoken message behind the constant barrage of TV and billboard ads featuring all those impossibly good-looking men and women is that you are special, you are deserving, and you need to look and act successful now.

According to Dr. Stanley, "The pseudo-affluent are insecure about how they rank among the Joneses and the Smiths. Often their self-esteem rests on quicksand. In their minds, it is closely tied to how long they can continue to purchase the trappings of wealth. They strongly believe all economically successful people display their success through prestige products. The flip side of this has them believing that people who do not own prestige brands are not successful."

Yet "everyday" millionaires see things differently. Most of them achieved their wealth not by hitting the lottery or gaining an inheritance, but by patiently and persistently maximizing their income, minimizing their outgo and religiously saving and investing the difference.

They aren't big spenders. According to Stanley's surveys, their most popular activities include:

• Socializing with children/grandchildren (95%)
• Planning investments (94%)
• Entertaining close friends (87%)
• Visiting museums (83%)
• Raising funds for charities (75%)
• Attending sporting events (69%)
• Participating in civic activities (69%)
• Studying art (63%)
• Participating in trade/professional association activities (56%)
• Gardening (55%)
• Attending religious services (52%)
• Jogging (48%)
• Attending lectures (44%)

You'll notice the cost associated with these activities is minimal. Most millionaires understand that real pleasure and satisfaction don't come from the car you drive or the watch you wear, but time spent in enjoyable activities with family, friends and associates.

Yet they aren't misers, especially when it comes to educating their children and grandchildren - or donating to worthy causes. Although they are disciplined savers, the affluent are among the most generous Americans in charitable giving.

They "give" in another important way, too. According to the IRS, the top 1% of America's income earners pay 37% of the entire federal income tax bill. The top 5% pay 57%. The top 10% pay 68%. (The bottom 50% pay less than 4%.) It's a far cry from the populist complaint that the rich "don't pay their fair share."
Just how prevalent are American millionaires?

According to the Spectrum Group, there were 6.7 million U.S. households with a net worth of at least $1 million at the end of 2008. Very few of them won a Grammy, played in the NBA or started a computer company in their garage. Clearly, thrift and modesty - however unfashionable - are still alive in some parts of the country.

So while millions of consumers chase a blinkered image of success - busting their humps for stuff that ends up in landfills, yard sales and thrift shops - disciplined savers and investors are enjoying the freedom, satisfaction and peace of mind that comes from living beneath their means.

More often than not, these folks are turned on not by consumerism but by personal achievement, industry awards and recognition.

They know that success is not about flaunting your wealth. It's about a sense of accomplishment... and the independence that comes with it. They are able to do what they want, where they want, with whom they want.

They may not be smarter than you, but they do know something priceless:

It's how we spend ourselves - not our money - that makes us rich.

Sunday, April 11, 2010

The Age of Inflation

In this age of inflation, we are all forced to do many tasks that others could do better for us. The fact is that inflation impedes the process of civilization, which is brought about by the division of labor. While, without the central bank's continual monetary infusions, prices would gently fall as technology made all things and all people more efficient, we don't enjoy that luxury. Instead we're mowing our own grass, fixing the flappers in our toilet tanks, and managing our own retirement funds.

Now, pushing a mower requires little skill, is no more than an annoyance, and provides the benefits of fresh air and sunshine. But managing one's retirement funds is a different matter entirely. It is an especially cruel result of inflation that instead of simply being able to hoard money, people must "invest their money into the financial markets, lest its purchasing power evaporate under their noses," explains Jörg Guido Hülsmann in The Ethics of Money Production. "Thus they become dependent on intermediaries and on the vagaries of stock and bond pricing." And unfortunately most of us aren't neurologically wired well for the job.
But we can't just throw up our hands and trust the state to take care of us in our golden years. Saving money isn't enough. The state is continually making what you have saved worth less. And unless you're a government employee, most likely you're left with the assignment of making sure you have enough for when emergencies occur or you're unable to work.

The typical stockbroker went from selling shoes or cars to hustling stocks after passing the Series 7 exam. Your financial future is not his or her concern; generating sales commissions is. Of course there is plenty of free advice out there, from Jim Cramer to Suze Orman. But, you will likely get what you pay for. Finding good investments is very hard work. Buying them at the right price is even harder work. Having the patience to buy at the right time and sell at the right time is nearly impossible.

Austrian business-cycle theory can give investors ideas on when to invest and what to invest in, but the Austrian School provides little in the way of analyzing specific companies and stock prices. What Hayek and Mises are to the business cycle, Benjamin Graham and David Dodd are to value investing. In their famous treatise, Security Analysis, Graham and Dodd painstakingly lay out their method for valuing stocks, looking for deeply depressed prices.

"Saving money isn't enough. The state is continually making what you have saved worth less."

While the average amateur investor may be excellent in their own career field, it doesn't mean they know what to invest in, or how to pick stocks. In fact being very good at your field can give you the false sense that whatever stocks you pick or your broker picks for you must be good, because after all, you picked them and you picked your broker — and you're smart. So, no doubt those stock prices will go up.

But the smart and talented stock-picking neophyte is not investing at all but speculating. "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return," Ben Graham wrote. "Operations not meeting these requirements are speculative." The vast majority of people just don't have the time or possess the patience to thoroughly analyze an investment opportunity. In The Millionaire Next Door, authors Thomas Stanley and William Danko point out that the average person tends to spend more time on purchasing a car than on looking at potential appreciating investments.

So for those who are interested in accumulating wealth and willing to put the time and hard work toward that end, Joseph Calandro, Jr. has masterfully melded the work of Graham and Dodd with Austrian business-cycle theory. The result is a very readable how-to guide for value investing, aptly named Applied Value Investing: The Practical Application of Benjamin Graham and Warren Buffet's Valuation Principles to Acquisitions, Catastrophe Pricing and Business Execution.

One can see by the title that the book is not for someone looking to take the next step after Stock Investing For Dummies, but it's not the handful that the title implies. The beauty of Calandro's work is that he teaches value investing through case studies. The reader can follow along while the author does his own valuations of Sears, GEICO, and General Re. These of course are not made-up theoretical cases, but real-life deals made by value investors Eddie Lambert and Warren Buffett.

Calandro first provides the reader with the basics of Graham and Dodd valuation in order to be "approximately right rather than precisely wrong." The author does this by valuing Delta Apparel, Inc., as a potential investment in 2002. When his analysis indicated that Delta was undervalued, Calandro bought Delta stocks and immediately offered to resell them at a fairer, higher price. This exercise is all about making money, not falling in love with stocks and their stories.

Much of Graham and Dodd's analysis is in assigning different valuations to balance-sheet items to determine what the real value of a company is beyond the accounting. This requires much more art than science.

"Finding good investments is very hard work. Buying them at the right price is even harder work. Having the patience to buy at the right time and sell at the right time is nearly impossible."

A couple of reviewers of Applied Value Investing have taken Calandro to task for the assumptions he makes in his case studies. Although the author doesn't provide much explanation of many of his assumptions, readers should understand that the talent of investing comes through experience and training. Reading one book will not provide all the answers, but Calandro does give us a roadmap. Investors must still make their own judgments.

These reviewers may not have made it to the book's conclusion, where the author reminds us that applied value investing is all about "identifying what you know and what you do not know, and then taking steps to quantify what you do know in a conservative yet rigorous manner so that a disciplined valuation can be formulated."
In chapter 5, the author draws upon an article he wrote for the Quarterly Journal of Austrian Economics to give the reader/investor insights into the best times to buy and sell from a macro perspective. He breaks the business cycle into eight stages by "synthesizing [George] Soros's boom–bust model, Austrian business cycle theory (ABCT), and behavioral characteristics."

In an interesting appendix to the chapter, Calandro writes of Warren Buffett's criticism of the efficient-markets hypothesis (EMH), which is the Rational Expectations School of the investing world. EMH posits that prices on assets traded in the market already reflect all available information. The Oracle of Omaha refuses to donate money to his alma mater, Columbia, because of the school's research in the area of EMH.

After applying Graham and Dodd valuation to make a catastrophe valuation, the author applies his tools to firms' business strategies. Next he circles back and discusses the important aspects of each layer of value-investing analysis, emphasizing that the key to long-term success is "research, checking, rechecking and cross-checking of assumptions."

To conclude, the author tells the reader to ignore economists shilling for newspapers, TV shows, political parties, the government, or financial institutions. Calandro quotes renowned Fidelity Fund manager Peter Lynch, who said, "If you spend 13 minutes a year on economics, you've wasted 10 minutes." However, Calandro recommends, in addition to a number of other books, Murray Rothbard's America's Great Depression, Roger Garrison's Time and Money, Ludwig von Mises's The Theory of Money and Credit, and other Austrian titles. With all due respect to Peter Lynch, Mises — a real economist — wrote that economics "concerns everyone and belongs to all. It is the main and proper study of every citizen."

And while the practice of value investing the Graham and Dodd way is more prudent than throwing money at that stock tip you overheard at the bar the other night, always remember what Mises wrote in Human Action: "There is no such thing as a nonspeculative investment.… In a changing economy action always involves speculation. Investments may be good or bad, but they are always speculative."