Fuzzy Math.
That’s what the equation in the title resembles.
“There is no conceivable way within our commonly accepted system of modern mathematics and numerology that the above statement could be true,” some of our more scholarly readers may think.
Fuzzy math…this term makes me think of the debates leading up to 2000 Presidential Election in which George W. Bush coined that term. Or so I thought. A brief internet search reveals that fuzzy math really is a thing (see our references).
Let’s talk about investment returns.
Let’s use round numbers (call it Lee Math).
If you place $10,000 of your money into an investment, and at the conclusion of the investment you are handed a check for $10,500, it can be said that you made $500, or 5%, on the investment.
Q: What about the timing?
A: Great question. If only 6 months elapsed from inception to finish, then your annualized rate of return was actually 10%. However, if it took 18 months to get paid, then your annualized rate of return was 3.33%.
Q: What about inflation?
A: Another great question. Lee Math is quick and easy, so it ignores inflation.
Q: Is there anything else important here:
A: Yes – Note that the return referenced above included both a return ON your investment as well as a return OF your investment. Warren Buffet has been known to say, “Return OF your investment is more important that return ON your investment.”
In other words, I’d rather make 0% than lose money.
Q: What does the “8 – 4 = 100” title have to do with anything?
A: Consider what happens if you don’t use your own money. (Fully unpacked below.)
First, consider Investopedia’s methods (don’t take my word for it) for calculating return on investment, commonly denoted as ROI:
ROI = {(Return on Investment)/(Cost of Investment)} * 100%
Or,
ROI= {Final Value of Investment – Initial Value of Investment}/Cost of Investment * 100%
When you use OPM (Other people’s money), a form of leverage, you push your returns exponentially higher:
Say you have a home equity line of credit within which you can access the bank’s money secured by your home equity for 4% annualized interest.
Suppose that you take $50,000 from this line of credit (Lee Math again) and invest in a private placement with a return of 8%. Lee Math also stipulates that this was conducted in exactly 365 days.
You owe $2,000 in interest. Perhaps you paid it along the way.
You made $4,000 in return.
The average person would look at that and conclude, hey, I made $4,000 – $2,000 = $2,000 on $50,000 – that’s 4% rate of return. And since I accomplished this in one year, I made a 4% annualized rate of return.
But that’s the wrong way to look at it.
The reason is that you didn’t invest your own money. Your cost on the investment was $2,000 in interest that you accrued, and after making $4,000 and paying the $2,000 in interest, you were left with $2,000.
(Remember, ROI = Cost/Return * 100%)
The cost was $2,000 and the return was $2,000.
That is a one-hundred percent rate of return.
Having explained this concept many times, I’m ready for the objections. I have them all covered. If I don’t seem to handle yours, fire away.
“But I had to lock up $50,000 to do it and I could have lost it.”
…Yes, if your investment was not collateralized by real assets and if you did not invest with a (syndicator, aggregator, fund, manager, etc.) who has a proven track record, you do expose yourself to more risk.
Remember that if you took $50,000 liquid cash out of your savings account for this investment, your real rate would be 4%, no more, no less.
But you didn’t – you borrowed $50,000 ‘from others’ – you used money that you didn’t have – and if you have the wherewithal and connections to continue this productive effort repeatedly, there is no limit to the returns you could experience.
“If I really made 100%, I’d want to do it again and again…but there seems to be a limit to how much I can repeat this – the limit is how much equity I have in my home!”
Home equity is but one source of OPM. There are many others.
Here are some other sources:
1. Cash value Whole Life Insurance
Q: But they say to buy term and invest the difference!
A: THEY are financially unsophisticated. Uncle Dave and Aunt Suzy give advice that the masses need to hear, advice on par with “don’t use your home like a credit card and tap it for vacations or to pay off toys”, “live below your means”, etc.
My assumption is that those who take the time to read this article are well beyond that level of sophistication/advice.
If you pay attention to the habits of the financially sophisticated, you will see that they tend to store cash in life insurance policies.
In fact, the largest banks and the largest family offices – all store cash in whole life insurance policies – sometimes policies on their own employees! (There are laws that regulate this).
Disclaimer #1: I don’t sell life insurance
Disclaimer #2: I’m not calling you unsophisticated if you do have term insurance. I had to have a term policy once because a bank who was loaning me money required it, with them as the payee in the event of my death.
Disclaimer #3: I’m not referring to any garden-variety whole life insurance policy.
I’m referring to whole life insurance with a PUA. Period. No variable, no universal, and it has to have a PUA. If you don’t know what that means, revisit our 5/2/2021 blog post (“National Life Insurance Day”) or simply ask below.
2. (back to sources of OPM) Hard Money Lenders:
Yes, you may pay a bit more, but if the real estate deal is worth doing, say if you’re making 20%, you may not mind paying 9%.
Q: Can you make a 100% return in other asset classes?
A: I mean, sure, you can borrow money to buy stocks, but that’s risky in general. Banks usually won’t loan money for it – (I’ll acknowledge that I do have margin on my trading account) – but they also won’t stop you from doing it if you extract equity from your home, for example. But in theory, any investment could go up 100%. However, nothing is as safe, tried, and true as real estate.
Q: Are you painting an extraordinarily rosy picture?
A: No, I’m painting a very conservative picture. The reason is that real estate pays you in five separate ways: Leveraged Appreciation, Cash Flow, Depreciation, Amortization, and Hedging Inflation. Click on each topic to learn more. In this specific article, I’ve only discussed one of the 5 ways that real estate pays you (cash flow).
Q: Isn’t what you’re condoning here what banks do with our money anyway?
A: Bingo! And no, I’m not against banks (thanks for asking). I want to learn from them as much as possible to enhance my own returns.
Banks take liquid money that you and I have on deposit and loan out 900% more. (What?!?). Yes, 9-to-1. This is called the fractional reserve banking system and it creates leverage for them to multiply their returns. If I have $1,000 on deposit, the bank can make a $10,000 loan to someone else and collect interest on the entire $10,000.
Q: Can real estate ever provide an infinite return?
A: Yes! Stay tuned for next week’s article. This is where we’ll beat banks at the return game.
As you think about that, always remember to take financial advice from the “experts” with a grain of salt and pay attention to how the financially sophisticated and ultra-wealthy handle their affairs.
I invite your comments, questions, and feedback.
Until next time,
Dr. Lee Newton
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