Ranjit Kulkarni

Book Synopsis: The Millionaire Next Door

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This is the title of a famous book that was a result of multi-year studies and research done by Dr Stanley and Dr Danko to discover the profile, lifestyle and habits of America’s wealthy households and how they became wealthy. The title is intriguing as they say, because initially they started their research by surveying people in upscale neighborhoods across the United States, and in time, discovered something odd. That many people who live in expensive homes and drive luxury cars do not actually have a lot of wealth. And then they discovered something even odder: many people who have a lot of wealth do not even live in upscale neighborhoods.  A lot of people with high incomes who live there actually have a lot less wealth than they should. And a lot of people who are really wealthy – do not look like they are, hence the name – the Millionaire Next Door.

the-millionaire-next-door-book-reviewThe definition of wealthy for the purpose of this research is important to understand. Obviously one criteria is the actual net worth number. The nominal cutoff was households with a minimum wealth of 1 million USD. But their intention was to research not the mega rich, so they dropped the ones with households of wealth greater than 10 million USD. About 95% of millionaire households in the United States had a net worth between 1 and 10 Million USD (in the mid 1990’s when this was published), and that was the focus of this survey. This is typically the level of wealth that, in their view, could be attained by many working class regular Americans at that time. I am sure something like this can be extrapolated to other countries too like India, with the nominal figures a bit different, but broadly similar distribution statistics between the “mega-rich” and the “ordinarily wealthy”, and perhaps, a similar set of findings.

Another way “being wealthy” was defined is one’s expected level of net worth, in comparison to one’s age and income. Multiple your age times your pretax household income from all sources except inheritance. Divide that by ten. This, less any inherited wealth, is what your net worth should be. To be comfortably well positioned as a prodigious accumulator of wealth, you should have twice the level of wealth expected.

So taking both the nominal (absolute) and relative definitions of wealth, this survey was done almost over a period of a decade from the late 80’s to the early 90’s.

So what were the key findings of America’s wealthy households? Is there a typical portrait of a millionaire household? Is there a set of factors that contribute to their being wealthy? The answer is Yes – there is a prototypical wealthy household, and a set of lifestyle patterns they follow that is conducive to building wealth. Here are a few of them:

1. Typically male lead earner of the household (>75% of income), became wealthy in his early fifties (i.e. when he could retire without income), Lived well below means throughout working life, Very frugal towards consumption

2. 65% either self employed professionals or own a small business, <25% from the high income employed group

3. 50% wives do not work (number one occupation of wives who work is a teacher, working wives contributed to 25% of household income), wives are meticulous planners and are prepared to live on a budget

4. Household income is 7-8% of current wealth (so lives on only 7-8% of net worth)

5. 97% are homeowners, and have lived in one or maximum two houses for the past twenty years or more

6. 87% are first generation affluent, their parents did not provide them with anything materially substantial in their adult life till they died (inheritance)

7. Change cars on an average once in 6-7 yrs (79% buy them without lease), Highest spend of income is on children and grand children education

8. Fastidious investors, invest 20% of income for over 10 yrs, 79% have 1 or 2 brokerage accounts, make own investment decisions, 25% of wealth in publicly traded securities and mutual funds, rarely sell (42% did not have any sell transaction in past 18 months, average holding period of 7 years), 21% of household wealth in their business

9. Save 35% of earned income, live in a neighborhood where they have typically 5 times the wealth of their neighbors (non-millionaire neighbors outnumber them three to one)

10. Their adult children are economically self sufficient, and they do not intend to provide any economic support to their adult children till they plan inheritance

11. Are proficient in identifying market opportunities, niches and chose the right profession, that they have been pursuing for long periods of time

In summary, 80% of the millionaire households are ordinary people who have accumulated their wealth over one generation. There is a set of patterns related to their lifestyle and habits that are conducive to wealth building. As they say, while there are a hundred paths to Nirvana, but if one adopts some of these, it is more likely than not, that one will find oneself being a Millionaire Next door – not in a hurry, but slowly and surely!

Guru Speak: Walter Schloss, Truly conservative value investing

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Among the famous investors of Graham-and-Doddsville that Warren Buffett refers to as ‘super-investors’, the most conservative yet in no small measure less successful was Walter Schloss. He was perhaps the closest to what was commonly referred to as ‘cigar-butt’ investing, and someone who perhaps followed the bargain hunting principles in stock picking perfectly and over the longest period of time with highly successful results.

“Over the entire 45-year period from 1956-2000, Schloss and his son Edwin, who joined him in 1973, have provided their investors a compounded return of 15.3% per year…Every dollar a fortunate investor entrusted with Schloss at the start of 1956 has grown to $662 by the end of 2000, including all charges for management.  A dollar investing in the S&P Index would have been worth $118.”*

walter-schlossA lot has been said about the legend and his style of investing – a very simple style based on buying depressed stocks trading close to book value, of companies with some record of reasonable performance and with little or no debt. His famous lack of interaction with management because “I am not a good judge of people” and dependence on buying something that is so cheap that “something good will happen” are largely responsible for his success. The sheer conviction and high degree of comfort that Schloss had on this approach that he consistently followed with his son for over 40 years to give results surpassing most traditional investors is almost ascetic.

“Their office – Castle Schloss has one room – is spare; they don’t visit companies; they rarely speak to management; they don’t speak to analysts; and they don’t use the Internet. Not wanting to be swayed to do something they shouldn’t, they limit their conversation.  There is an abundance of articulate and intelligent people in the investment world, most of whom can cite persuasive reasons for buying this stock or that bond.  The Schlosses would rather trust their own analysis and their long standing commitment to buying cheap stocks.  This approach leads them to focus almost exclusively on the public financial statements that public firms must produce each quarter.”*

* from the book “Value Investing: From Graham to Buffett and beyond” by Greenwald

Their approach to investing is something that any individual investor with conviction in it can follow with reasonable effort and study – with no need to predict the future or understand businesses beyond a point; but with only a single objective of weeding out companies to find price less than value.

Here is a valuable document that Walter Schloss shared a few years ago, when asked about how he goes about making his investing choices –  a clear and simple set of golden rules of the Walter Schloss style of truly conservative investing.

Walter Schloss and 16 golden rules of investment

Is your house an asset?

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Opinion is divided on whether your house is an asset based on who you ask. Some financial planners recommend that you make your investment plan first, save for a house, buy it only when the rent vs buy equation makes complete sense, and treat the monthly payment as a pure expense (after accounting for tax deductions). Some others say that a house is an investment, and even better than stocks as it is not risky and volatile, and you generally will not lose your money there.

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Like most matters in finance, there is no single answer – but here is an attempt to simplify the thought process. In pure accounting terms, a house is an asset on your books, funded partly by the loan liability. The real question that should be asked is whether it is a good investment? In most cases, it turns out to be a good investment, simply because the asset on your books appreciates faster than both the cost of your liability and inflation. But whether it really happens at a rate where it qualifies as a good investment depends on a multiple set of factors.

(a) Price that you paid for it: Like economic cycles, housing goes through boom and bust cycles, though not as severe as stocks. Hence, the price at which you buy a house is paramount, like all other investments, in deciding whether it will turn out to be a good investment. As it is a high value asset that most people hold for a long time, most people pay much more attention to the price they pay for a house, versus what they pay for a stock. But nevertheless, it is still the single most important factor in determining if it will turn out to be a good investment.

(b) Loan to Value ratio: Leverage (or mortgage) has a definite role to play in the house purchase. The higher the loan component, the higher the chances that the investment will be not be lucrative in a short period of time. The more you can put down in payment, the more (and earlier) you are converting your cash into a share in an asset that will eventually fight inflation.

(c) Your cost of funding versus inflation or expected rate of growth: If the expected rate of return from a house is about 1-2% more than the rate of inflation, and the cost of funding is lower, that is a perfect scenario where buying a house using borrowed funds will turn out to be a good investment. Specially over longer periods where the power of compounded asset value will surpass the cost of the loan liability.  And if one regularly prepays it in the initial stages, one will save lots of interest in the long run.

(d) Last but not the least, where does it fit in your asset allocation: Finally, as compared to your income and net worth, the proportion that you have locked in a house will also determine how comfortable you are with buying the house, the more likely it is that you will take a financially sound decision, hence increasing its chances of working out as an investment.

So overall, multiple factors will go into deciding whether a house will turn out to be a good investment. In a best case scenario, buying a house at a reasonable price with less than 75% leverage at a leverage cost less than or close to inflation, and ensuring that it does not account for more than 40% of assets is almost a sure-shot recipe for a house being a great investment. For most mortals, it may not turn out to be that rosy – in which case one or more of these parameters are likely to get stretched, leading to some financial bleeding, at least for a while.

In general, irrespective of the pure financial matters and even discounting the emotional security it provides, a house is definitely likely to be a worthwhile investment for most normal individual investors if they are prudent in ensuring they balance the above factors in their purchase. As most house purchases are held for long periods, they invariably turn out to be good investments standalone.  They may lead to some missed opportunities due to locked capital, but that’s another matter. After all, I never saw a house owner of 10 years saying I really regret having bought my house. And there’s no dearth of stock owners saying that!

How should I select which stocks to invest in?

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In the area of finance and investing, like many other fields, the questions you ask are perhaps more important than the answers to them. But again in this area, even the simplest of questions can have a variety of complex answers. So something as basic as how should I decide which stocks to invest in – can have multitude of answers. In my view, this kind of question will, perhaps, have at least 3-4 questions as its answer to start with, when asked to an expert. When individual investors ask this question (or of a similar kind) to a financial planner or an advisor or an expert, the investor is most likely to get either unclear answers with a number of riders; or a set of additional questions like how long can you hold, what is your risk appetite, etc. And do not get me wrong. These are perfectly valid questions from the point of view of the advisor, as the expert is trying to assess the investor before giving a customized answer. But it will still leave the investor confused – specially the next time he wants to take a similar decision on selection on stocks. So, I am going to try and attempt simple answers to this question in this note.

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My first answer is – if you can help it, do not invest in stocks directly at all. Invest in an index fund instead (or if you like a fund manager – invest in an actively managed well performing fund). Despite that, if you still want to invest directly in stocks, my second answer would be restrict yourself to the Index stocks or the top 50 stocks by market capitalization, and simply construct a portfolio by buying companies that have high return on equity, low or no debt compared to equity, high profit margins over time and consistent dividend paying history; and buy them when their valuations as measured by Price to Earnings or Price to Book are lower or reasonable compared to long term averages. And better still, buy them regularly over time to build a portfolio.

Beyond this, if you still want to expand your universe of stocks, then the only reason you need to go outside the top stocks by market capitalization is if you can beat the index. And for that, you will need hard work, continuous research, adoption of an investing approach that is not followed commonly and lots of patience. Once you decide that you are prepared to do that, I think the parameters you look for in stocks for investment change. You then enter a territory where there is lack of credible historical performance, unpredictability, unproven business models and perhaps low liquidity. You are then buying a promise for the future, and your interests are then best served if you strictly buy value. In such a scenario, you should then look for stocks that are cheap in relation to assets and/or earnings. And cheap would mean different benchmarks depending on margins, growth expectations and debt – but essentially the focus should be on buying cheap.

So in a nutshell, the simple answer to this question of ‘how do I select which stocks to invest in?’ is firstly this – do not do that selection at all, leave it to the index or a fund manager who is smarter than you and the index. If you think you are smart, go ahead and buy index stocks over a period of time – you are then buying into good businesses at reasonable prices. If you think you are even smarter, go ahead and buy stocks outside of the top stocks family, when they are cheap by earnings and asset measures – you are then buying into reasonable businesses, so be sure you get them at a good price.

Using this simple framework, you will perhaps be in a position to answer this question on ‘how should I select which stocks to invest in?’ Though not precise, but at least, I hope, it provides a decent guideline to arrive at a stock selection decision.

Why age based asset allocation is mostly wrong

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I have often heard a lot of financial planners advise an asset allocation strategy based on the age of the investor – something on the lines of invest 100 less your age into equity or similar. While the broad logic of this strategy is that with increasing age, the capacity of an individual to earn himself out of a market crash reduces, purely age based asset allocation might, like many other things in finance and investing, be the right answer to the wrong question.

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A student who has taken an education loan or a young married person saving for the down payment of a house can hardly justify investing 80% of his savings into equity, while a middle aged double income couple with their mortgage paid off or a retired millionaire with 20 more years of life would be foolish to invest majority of their net worth in fixed income. In fact, it would be risky for the youngster to put 80% of his savings into equity if he gets caught in a market crash when he needs the money for his house; and equally risky for the retired old man to depend on his fixed deposits to face 20 years of inflation.

I have found that asset allocation percentages need to be an output determined by life circumstances, net worth, current income, overall risk tolerance and age. Age can be a good determinant of some of the above, but it is too simplistic to assume that it is the only one. In many cases, it is not – and hence, it turns out that portfolios are more conservative or riskier than they should be. Historical data suggests that the possibility of losing money in equities over a 10 year period is quite low. Hence the equity percentage of the portfolio must largely depend on the ability of the individual to, more or less, forget his money and ride out a period of 10 years with no need for the money put in equity (and perhaps, put more into equity, if required during crashes). Now this ability is something that depends on factors like risk tolerance, current income, net worth, temperament and life circumstances, of which age is just one determinant.

The more you have of this ability, the more should your asset allocation be comfortably tilted towards equity. And age has, perhaps, little but not much to do with it.

Is Financial Independence an End in itself?

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I have often wondered, specially when I read a lot of financial planning related articles, whether financial independence is an end in itself. A lot of financial planning is geared towards basically creating a corpus for a goal like retirement which can replace your current income stream in inflation adjusted terms. And it is all good when they profess getting out of debt, preach high rates of savings that are put in a manner across asset types to provide returns that enable oneself to reach that goal.

But I sometimes wonder whether financial independence can really be defined? And while the pursuit of that has been one of the key motivators of my life, I have sometimes wondered whether that pursuit of a financially free tomorrow has left me in chains today.money-vs-happiness

That’s where I realized that, perhaps, the goal of achieving financial freedom is not an end in itself. And while it is good to have a financial plan and work towards it (in fact, highly recommended for most individuals), a blind following of the same, specially without purpose, may be closer to slavery than to freedom. Also, I think the point of financial freedom can, perhaps, be defined to be the one where the marginal utility of having more money diminishes in the eyes of the individual. And this point is likely to be different for different individuals. Basically, from that point, 5 times more money will not make one 5 times happier. You may still continue to chase money beyond that, but in non-financial terms, you are already free from that point. I guess if an individual can carefully assess what that point is for himself, it would serve him well to make financial independence a good journey rather than a destination in itself.

So by all means, the pursuit of financial independence is a very worthy goal, but if one adds to it, a purpose as to why one wants to be financially free, and determines a point at which the marginal utility of money keep diminishing – the journey can be truly fulfilling and make life itself much more rewarding.

The Financial and Psychological Benefits of Rebalancing

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I have always felt that individual investors (or perhaps any investor to some extent for that matter) have never got a complete handle of the decision on when to sell. Traders or speculators mostly have a fixed target for profit or stop-loss, but investors never seem to enter a stock with a clear exit goal.

rebalancing

Rebalancing as a strategy might provide answers to solve this quandary – more than anything else for the individual investor. At a portfolio level, it provides you with a clear answer on when to sell, and, if required, it can be translated and implemented at an individual stock level also by more mature individual investors. Setting asset allocation limits at various levels in a portfolio can provide you with clear triggers on when to sell. So then, you stop asking yourself questions like – should I sell stock A at this price or wait for some time – questions which have no clear answers anyway. On the other hand, that answer is provided at an overall portfolio level, based on allocation limits.

For example, to provide a complex set of rebalancing rules, consider the following: If you determine that equity will account for 60% of my portfolio, and within that, large cap stocks will account for 50% of the holdings, and then no industry will account for more than 25% and no stock more than 10%, then it becomes easier to take decisions on what and how much to sell when these allocation percentages go out of whack. And if you are not a direct stock investor, but take your exposure through mutual funds, it gets much easier than the above scenario, assuming that your fund manager is dealing with the rest. Therefore, ‘I bought stock A at X, should I sell it now at this price Y’ becomes a wrong and somewhat irrelevant question, and thankfully so.

Of course, rebalancing is not a strategy that guarantees the highest returns. In certain cases, you may end up selling your winners, which in hindsight may not feel great. But for individual investors, who may have no particular reason to feel a sense of conviction about a specific stock, it provides a good way to reduce or manage risk. I do not think at a mathematical level, rebalancing has a very high impact on returns, but it sure reduces risk of excessive falls and locks in some of the profits. And if done correctly, it will also ensure that you buy equity at a time when every one is running away from it – in which case rebalancing affects your long term returns too.

An important effect of this strategy might well also be at a mental or psychological level – because an individual investor feels he is in control and has been smart to book profits when his portfolio grows and to buy stocks when they were low in price.

Therefore, less for returns, more for managing risk, and most importantly for the psychological advantage of getting emotion out of buy/sell decisions, rebalancing is a crucial strategy for portfolio management for individual investors.

How to use Diversification to reduce 3 types of risks

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The core objective of diversification is to reduce risk – the idea being that peaks and troughs in a specific investment does not affect overall portfolio return objectives.

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If one defines risk less as volatility, and more as a either a complete or partial, but permanent loss of capital, then an individual investor would be well-advised to consider diversification to reduce risk of a few primary types:

1. Asset Market or Systematic Risk: What if I am invested in the wrong asset class or market? This is best reduced by a prudent asset allocation decision. Investors should identify different types of asset classes that they want to be invested in along with ideal target percentages in each asset class. This will minimize the impact of being invested in the wrong asset class.

2. Unsystematic Risk: What if I choose the wrong stock or bond or property? This is best reduced by investing in a pool of candidates within the same asset class. So if it is equities, it is best to be invested in a bucket of unrelated good businesses, or in commodities or real estate, again try and be invested in unrelated asset candidates. This will minimize the impact of being invested in the wrong securities.

3. Timing risk: What if I invest at the wrong time? Well – you may have a well-diversified pool of securities in a well adjusted portfolio of asset types, but what if you invest at the peak of the markets? This is best reduced by making periodic investments in the assets of your choice, so that timing risk is reduced. This will minimize the impact of being invested in any asset at purely the wrong time.

For individual investors, more than chasing returns, if prudence is exercised in constructing a portfolio with the objective of reducing risk of the above three types, there are good chances that the returns will take care of themselves.

Is direct stock investing worth it or should mutual funds do?

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Assuming that I want to “invest” in the stock market, and not “trade” or “speculate”, getting average market returns is a no-brainer. I just need to buy an open-ended index fund or an exchange traded index fund, and I am done. At the lowest cost, I am guaranteed returns that the market index will give – day on day, month on month, year on year.

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Why, then, should I be even interested in investing in actively managed mutual funds? There can be only a few reasons for that. First – they give returns better than the index after deducing costs.  Second – I want an exposure to companies outside the index in a specific market cap or sector or style that I am bullish about. So it may make sense to supplement my index fund holdings by some actively managed funds that suit these requirements.

After that, why should I directly invest in stocks? Is it really worth the time and effort? There are few reasons when it may make sense. First – I am a better investor and can beat markets consistently. Easier said than done, but if that is the case, there is no reason I need to invest through the fund route. It is likely to take sufficient time and effort, but if indeed one can beat the index, why depend on mutual funds? Second – I want to invest in some businesses that are either small or in under-researched sectors that funds are not allowed to, or not able to invest in. There is a section of the market that institutions are not interested in. An individual investor who understands those businesses and has conviction on a particular company, has an advantage by investing directly. Third – this is perhaps due to the structural constraints of mutual funds. Due to the inherent requirement of funds to keep beating the index, some great businesses cannot be held by funds for long periods of time. For example, a mid-cap fund has identified a great mid-cap company, but once it becomes successful and actually becomes large-cap, the fund has to sell it. Or, during a market crash, a fund has to sell some companies to honor redemptions – so a buy and hold is not possible, even in case of great businesses.

In such scenarios, it may be worth it for individual investors to invest directly in stocks instead of the mutual fund route. But as index returns are easy to get, one has to be sure that these additional investments will actually help better portfolio returns rather than dilute them. Therefore, overall – allotting majority of your equity allocation to mutual funds (index or active based on performance) might be a prudent strategy for individual investors. Investments through direct stock holding can be a small part of your equity allocation – only in situations where there are valid reasons for the same.

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