Loan Interest
Similar to bonds, loan interest is money received from notes (or IOUs),
either from institutions or individuals. For banks, such loans are known as CDs,
or certificates of deposit. In lieu of a lump-sum deposit and an agreed term and
interest rate, you can loan money to a bank and receive regular interest
payments. Unfortunately, the last time such an investment held attractiveness
was the Reagan administration. Due to the laughably low rates offered by banks,
CDs aren’t a viable paycheck-pot investment vis-à-vis the systemic banking risk
they pose. In the 2008 meltdown, over fifty banks, some large, went insolvent.
Think a 1.1 percent return is worth this risk?
Another form of loan interest comes from peer-to-peer lending. Peer-to-peer
lending is when you loan your neighbor money, except in this case, your
neighbor is hundreds of miles away. The two big companies in the peer-to-peer
space are
Prosper.com
and
LendingClub.com
. Each offers loan opportunities
diversified among many individuals. Loans to creditworthy borrowers can yield
as much as 6 percent. For riskier borrowers, rates can balloon as high as 25
percent. The great thing about peer-to-peer lending is diversification. Because
1,000 different people are loaned twenty-five dollars, the default risk is
diversified into the expected return. When several people flake out and don’t pay,
returns don’t take a big hit.
Managed Distributions
Managed distributions are payments evolving from a pool of financial
instruments, professionally managed by a financial firm. Such funds can be
exchange-traded funds (ETFs), mutual funds, closed-end funds (CEFs), or hedge
funds.
For example, the Vanguard Dividend Appreciation ETF (VIG) consists of
one hundred-plus dividend stocks, and its managed distribution comes as a
dividend payment. Instead of buying one hundred dividend stocks, you could
purchase the ETF and receive instant income and diversification.
Likewise, the iShares National AMT-Free Municipal Bond Fund (MUB)
represents over 2,000 different municipal bonds. Own this fund and you will
receive a managed distribution in the form of an interest dividend, while
enjoying significant diversification among bonds without the expense of
dabbling in the bond market.
Managed distributions are available from any asset pool you want: dividend-
paying stocks, MLPs, bonds, REITs, long/short plays, option strategies, real estate
—if you have the cash, there’s a financial firm offering it. In lieu of a
management fee from the fund sponsor, buying into these funds instantly
diversifies your holdings amongst hundreds of assets pooled on a particular
strategy. Many of these funds also use leverage to increase their payouts.
In terms of liquidity, managed distributions from ETFs and closed-end funds
are easily bought and sold because they trade like regular stocks on the
exchanges. You can trade them during market hours as well as monitor intraday
price fluctuations. Mutual funds, however, are bought or sold at their net asset
value (NAV), a market price determined after the close of each business day.
Despite this, mutual funds are highly liquid depending on the fund sponsor and
usually can be traded at the next prevailing NAV with just hours’ notice. Be
aware, however, that in rapidly declining markets, an ETF can be exited intraday
at better prices over a mutual fund, which is transacted at a closing NAV.
Examples:
PREMX (T. Rowe Price Emerging Bond Mutual Fund)
FAX (Aberdeen Asia-Pacific Bond Fund)
PFF (iShares US Preferred Stock Fund)
All of these financial instruments represent a capital rental business that
establishes a paycheck pot, a system creating regular, recurring passive income
for the rest of your life. However, before you proceed, no matter if you’re
investing ten thousand or ten million, there are seven rules I incorporate to
ensure my principal is kept safe and the income flowing.
MY 7 PAYCHECK-POT RULES
RULE #1: THE RENT RULE
Consider this for a minute.
You buy an expensive piece of commercial real estate. A prospective tenant
offers this: Instead of paying monthly rent, he offers a tiny ownership percentage
of his new restaurant and its future profits when they arise. The exact duration
and amount of these future profits are unknown and not guaranteed. Oh, and
one more thing: these future profit payments are voluntarily, arbitrarily, and
unconditionally decided by the tenant. A realized profit, or rent, could be
months, decades, or never. In the meantime, the tenant tells you to sit tight and
hope his restaurant succeeds so your ownership shares might be worth more.
Good deal? You probably don’t think so.
And yet this is how people fund their retirement through stock market
investing. They part with their money and, in return, hope to get a piece of future
earnings or price appreciation. Neither is guaranteed.
In effect, any “investment” you make in a stock that carries an unstated
return is nothing but a fifty-fifty coin flip. Stock goes up, you win; down, you
lose. In truth, you are renting real estate, in this case money, and getting paid
ZERO RENT. In lieu of rent, you are paid a hope and a dream—two things that
do not pay mortgages or buy baby’s new shoes.
For those of us who are familiar with stock options (puts and calls), the truth
behind any stock investment is revealed in the mathematical delta of any at-the-
money option. With stock options, the delta correlates the statistical probability
of any option’s chance of being “in the money” or higher than the strike price at
which you bought it. For example, if stock XYZ is trading at forty dollars and you
buy a forty-strike call option (at the money), your probability of having that
option worth anything at expiration (in the money) is fifty-fifty. In other words,
the statistical probability of you making money on any stock purchase is exactly 50
percent
—a freaking coin flip. If you buy ten stocks, your chance remains 50
percent—while your chance at being profitable on every single one of them is
0.09765625 percent (.50 to the tenth power).
Yes, the entire
SCRIPTED
world has laid their retirement hopes on a series of
coin flips. Ever hear the mainstream parrotheads admit this little fact? Of course
not. This factoid brings us to our first rule of the paycheck pot:
the rent rule. The
rent rule states that anytime you cede control over your paycheck-pot money,
demand rent, not unconditional promises and coin-flip pipe dreams.
As for the rent you should receive, it should come every month or quarter in
any of the aforementioned income streams: dividends, interest, or partnership
income.
RULE #2: THE SNAP RULE
When it comes to global economics and the central banking systems that
manipulate them, nothing stays the same. A great investment today will be a bad
investment tomorrow. For example, in several interviews I did years ago, I
recommended Australian government bonds as decent investments. If you took
that advice today, you’d be late to the party. When I did those interviews, the
Australian dollar yielded better interest rates and possessed more purchasing
power.
Since then, macroeconomics have changed. Advice spoken years ago has
become questionable today. In other words, because global economies bend and
flex, the right investments for creating a paycheck pot also bend and flex. I can’t
tell you a good from a bad investment because, by the time this book gets to
print, a great investment will deteriorate into a sour one, and vice versa.
Economic flux is the methodology behind rule #2:
the snap rule. The snap
rule requires that paycheck-pot investments must remain highly liquid, or
recallable back to cash at the snap of a finger.
The “snap of a finger” usually means a simple sell order at a brokerage firm
and within twenty-four hours, sometimes within seconds, you’re out of the
investment and safely back to cash.
When the economics of an investment changes—and it will change—you
want to be sure your principal is not at risk. Remember, our objective here is not
to grow our nest egg but to “rent it” into a regular income. Without the snap rule
in place, your principal investment can deteriorate into an “at-risk” position,
where its income understates the assumed risk.
For instance, in 2008, when the real-estate boom started its slide south,
everyone from the mailman to the dishwasher at Waffle House owned real estate.
When “dumb money” got wind that the ship hit an iceberg and was taking on
water, sellers flooded the market. Liquidity fled the scene, and the real-estate
plunge drowned investors with it. Because real estate can take months to
liquidate, investors could not “cry uncle” and had to endure the abuse.
Without a snap rule to recall your money, a good investment can tank, and
when it does, you have to suck the rotten egg. In this case, some real-estate assets
lost as much as 50 percent of their value, making bankruptcies and foreclosures
the only alternatives. If only those real-estate investors could have snapped their
fingers and been “out” once they saw trouble…trillions of dollars of personal net
worth would have been spared.
The snap rule says that if a cash recall takes longer than a finger snap to
initiate, liquidity could be an issue. Liquidity issues put your principal at risk in
shifting markets. The rule saves you from asset price declines that significantly
outweigh the income received from the asset. $10K in interest from a bond ETF
that has declined $100K in value is not an effective investment, as it takes ten
payment periods to recapture the lost asset value.
A recent snap rule example comes from one of my favorite dividend stocks,
Southern Company, an electric utility in the southern United States. As I write,
its dividend yield is nearly 5 percent. However, in late September 2013, the stock
price accelerated from forty-three dollars to above fifty-three dollars just a few
months later. On 10,000 shares (a likely investment amount for a $10M money
system), this stock appreciation generated a $100,000 unrealized gain (not
including the dividends) and posed a prime example of why you need to “get
out” when the iron is hot. First, the $100,000 unrealized gain represented nearly
FIVE YEARS in dividends. Why wait those five years when those gains could be
captured now by selling? I snapped my fingers, pushed through a brokerage sell
order, and it was done. Years of dividends in a matter of months (although I wish
I owned more and picked the top, I was close enough to be happy).
And then guess what happened a few weeks later? Hear that sucking sound?
That’s the stock retreating to the mid-forties where, once again, I bought. I will
repeat this scenario until I die, or at least until Southern Company gives me a
reason to believe they cannot sustain their dividends.
Similarly, in the summer of 2015, I started to liquidate my bond holdings as
the chatter of interest-rate hikes picked up. When interest rates rise, the value of
bond funds (managed distributions) decline. A 1 percent rise in rates could
translate to a 10 percent decline in asset values. Instead of waiting for it to
happen, I preemptively took action and moved out of my bond positions. While
I wasn’t right on the timing, I’d rather sit in cash earning nothing versus risking
ten to make one.
RULE #3: THE APOCALYPSE RULE
American Greed
on CNBC is one of my favorite shows. The hour-long
program chronicles some of the nation’s worst financial frauds. Ponzi schemes,
investment frauds, money laundering—every scant of financial malfeasance
makes a cameo. Using empiricism, notwithstanding witnessing the nth grandma
swindled out of her life savings, including her Cadillac, I noticed a familiar
pattern: In all the cons, the company perpetrating the fraud is always a small
boutique company that grows from the power of a sham productocracy. Uncle
Joe tells Uncle Bob that Lustig’s Investment Fund is paying 20 percent yearly,
and wham, the company grows.
This pattern underscores rule #3:
the apocalypse rule. The apocalypse rule
holds that the only catastrophic threat to your principal investment has to come
from a global financial apocalypse.
I consider a financial apocalypse to be hyperinflation of our fiat currency or
the collapse of our banking system. On the contrary, a bankruptcy or a financial
fraud perpetrated by a small company is not apocalyptic to the banking system
but apocalyptic for the investor. Such events might not make the evening news
but could headline a financial failure that imperils the rest of your life.
The apocalypse rule means your investments should only be trusted to
largely recognized megalithic companies subject to considerable governance and
rules of transparency. The phrase “too big to fail” comes to mind as a criterion.
And if such a failure does occur, we’re looking at a total collapse of the world
banking system. At this point, we’re no longer talking about a financial
apocalypse but a real apocalypse where societal hyperrealities fall apart.
For example, here is the list of institutions that hold my cash and/or
paycheck-pot assets:
Fidelity
TD Ameritrade
Vanguard
Charles Schwab
JP Morgan
T. Rowe Price
Bank of America
Blackrock
Notice that none of these is a tiny, unknown company small enough to be
shielded from public scrutiny. Each of these entities is large enough where a
failure (or a large-scale fraud) in any of them would inject systemic risk into the
world banking system. In other words, if Vanguard’s umbrella of shareholder-
owned companies fails, I know we’re looking at a worldwide failure in the
banking system and, perhaps, an event so large that the world will never be the
same.
When you trust your entire nest egg to Donald Lapre at a boutique firm
working out of a 1,200-square-foot office in Hoboken, you aren’t afforded such
protection. I invest in peer-to-peer lending, but the apocalypse rule keeps my
investment under six figures because the concept is too new and too untested. A
fraud or failure in these companies might be worth thirty seconds on CNBC’s
Squawk Box
, but for the wronged investor, the impact could last thirty years.
RULE #4: THE “3 YEARS IN 3 MONTHS” RULE
When Southern Company’s stock moved from forty-three dollars to above
fifty dollars in a few short months as mentioned above in The Snap Rule, another
rule is what compelled me to sell. It’s called
the three-three rule
.
The three-three rule says that
if any of your investments, whether they be
stocks or bonds, appreciates unrealized gains greater than or equal to three years in
dividends in any three-month period, SELL and take the profits.
Consider this
appreciation a compressed dividend advance where, instead of waiting three
years to receive the money, you can take the cash now by selling. Money today is
better than money tomorrow. Here are the mathematics behind this rule, using
two different asset classes: Southern Company (SO), a dividend stock; and The
Aberdeen Asia-Pacific Income Fund (FAX), a closed-end income fund.
Southern Company (SO)
Current Dividend: 5%
Share Price Cost Basis: $43.00
Shares Purchased: 1,000 ($43,000 principal)
Annual Dividends: $2,150 (.05 X $43,000)
Three-Year-Rule Scenario: If SO appreciates to $49.50 within (3) months, you
should sell and take the $6,450 (3 X 2,150) gain, which represents 3 years of dividends.
The Aberdeen Asia-Pacific Income Fund (FAX)
Current Dividend: 8%
Share Price Cost Basis: $5.00
Shares Purchased: 10,000 ($50,000 principal)
Annual Dividends: $4,000
Three-Year-Rule Scenario: If FAX appreciates to $6.20 within (3) months, you
should sell and take the net $12,000 gain, since the $12,000 (3 X 4,000) threshold was
breached.
While appreciation is not our objective within the paycheck pot, asset
appreciation happens. When it does, the three-three rule is a guideline for
turning unrealized gains into compressed dividends. If, after selling an
appreciated asset, it reverts down, I use a 66 percent mean reversion as a
potential rebuy flag. Assuming the company’s financials have not changed, the
66 percent criteria is a guideline, not a rule.
For instance, in our Southern Company scenario, a fifty-dollar stock sale (a
move from seven dollars from forty-three dollars) might be worth rebuying in
the forty-five-dollar range (66% of $7.00 is $4.62 [$50 - $45.38]). The 66 percent
reversion flag is based on mean reversion, which is the statistical probability that
stocks mean revert back to averages as opposed to shooting straight to the stars
or down to zero. I dance this little rhythm of buy-sell-rebuy quite often. It
sounds like a lot of work when, in reality, it only requires a daily ten-second peek
at your paycheck-pot investments.
RULE #5: THE ADMIRAL ACKBAR RULE
Ah, the old saying, if it’s too good to be true, it probably is. The same goes for
paycheck-pot investments. If the S&P 500 yields 2.5 percent a year and that oil
refinery MLP suddenly advertises dividend yields of 18 percent yearly, picture
Admiral Ackbar trumpeting, “It’s a trap!”. In the finance world, they call these
stocks
dividend traps
: alluring investments that ping your radar NOT because of
a great balance sheet, but because the dividend yield is eye-poppingly tempting.
The Ackbar rule is the classifying identifier between an income investment and a
speculative one. The rule is not disqualifying (although I avoid them) but
qualitative—such “investments” don’t belong in the paycheck pot but in the
speculative “fuck you” pot. A closed-end fund with an advertised dividend of
21.5 percent is speculative, not an income investment. The paycheck pot should
be boring like C-SPAN on a Monday afternoon.
The danger of dividend traps is widely known. In finance, it is one of the few
things that are predictable, more so than a coin flip. For example, on December
19, 2015, Linn Energy, a publicly traded LLC, traded down to $12.24 from almost
$22 less than a month earlier. At that point, its advertised annualized dividend
was a beefy 22 percent. For an uneducated income investor, a 22 percent
dividend yield might be as tempting as rotting meat to a fly doing a dumpster
buzz-by.
However, for the educated
UNSCRIPTED
investor familiar with overly
obvious
Star Wars
generals, these investments have enough red flags you’d think
you were at a Chinese military parade. You see, the farther you get from the yield
of the S&P 500, the larger the risk. At some point, the teeter between risk and
reward totters to the risk side. Not that the investment can’t succeed, but more
than likely, it turns into a ticking time bomb ready to blow out your principal.
In the case of Linn Energy, had you invested in this company at the time it
boasted its 22 percent dividend, you would have faced an announcement several
weeks later: due to declining oil prices and a subsequent decline in cash flow,
Linn Energy suspended its dividend payment. Your salacious 22 percent
dividend went to zero. And the real travesty? In a few short months, the stock
tanked from twelve dollars to just under two bucks. A $122,000 investment
would have lost more than 80 percent of its value. No “winner winner, chicken
dinner.” This is not income investing; it’s gambling. Remember, shiny big yields
shine bright like the neon lights on Las Vegas Boulevard: they’re exciting and
grab your attention. Unless you’re ravaging your FU pot, such investments
shouldn’t grab your cash.
RULE #6: THE 1% RULE
By the time you reach the
UNSCRIPTED
pinnacle, you will be a part of the 1
percent. Even if you aren’t the richest 1 percent in terms of monetary wealth, you
will be in time. Thus far, the rules are designed to protect your principal
investment, which protects your 1 percent standing. Besides asset devaluation,
there’s another threat to your money that isn’t so obvious:
management fees.
Since we’re not in the business of making Wall Street and Billy Bankers rich,
we find ourselves with another rule: when dealing with managed distributions
from managed funds, avoid any fund with a management fee greater than 1
percent, excluding interest charges.
This rule means you should avoid any investment where the total
management fees, including commissions, front loads, and/or 12b-1 fees exceed
1 percent. This 1 percent, however, should be exclusive of interest fees, which is
common with funds that use leverage. For example, if ZZZ bond fund has total
fees at 1.2 percent, but half this fee, or .6 percent, is an interest expense, this fund
would still meet our 1 percent rule.
In any case where fees, net of interest, are larger than 1 percent, you can
scream NEXT! There are simply too many other alternatives. We’re not
interested in funding some financial dude’s home in the Hamptons. Personally, I
like to shoot for less than .5 percent, but sometimes I dabble in funds that creep
near the 1 percent threshold. I also avoid any investment that carries a front load
or a commission.
Once you remove the +1 percent funds who take advantage of the
uneducated, many options and asset classes remain. For example, here are some
paycheck-pot investments I use now, or have used in the past. (The stated
management fees are as of December 2015 and may be different at print time.)
T. Rowe Price Emerging Market Bond (PREMX), Fees:
.97%
Vanguard High-Yield Corporate Bond (VWEHX), Fees:
.23%
Vanguard GNMA (VFIIX), Fees:
.21%
Vanguard Dividend Appreciation ETF (VIG), Fees:
.10%
Fidelity Municipal Income Fund (FHIGX), Fees:
.47%
BlackRock Income Trust (BKT), Fees:
.88%
Putnam Managed Municipal Income (PMM), Fees:
.86%
RULE #7: THE OSTRICH RULE
In the middle of May 2012, RadioShack, the long-time strip-mall electronics
retailer, sported an attractive 11 percent dividend.
125
At the time, the stock was
trading around five dollars. If you skipped the Ackbar rule, hopefully you won’t
skip the next rule:
the ostrich rule
. Both can save you from calamitous financial
ruin.
The ostrich rule states that you should avoid investments where the business no
longer jives with either the cultural or economic climate.
Don’t bed yourself to a
dividend yield while ignoring the jaguar sleeping next to you. In RadioShack’s
case, the stock had been falling for years, creating the plump dividend. Moreover,
anytime I visited a RadioShack, it was like walking into a mortuary. RadioShack
was clearly dying because retail was transforming; their products were sold
online and cheaper. Despite stock propping attempts through buybacks,
RadioShack filed bankruptcy in 2013, costing investors millions.
With the ostrich rule, you steer clear of potentially troubling investments.
This includes dinosaur investments (RadioShack, Kodak) or fads (Crocs, Krispy
Kreme). For market awareness, here are some questions which cornerstone the
ostrich rule:
Is the company’s industry dying? (RadioShack, Kodak)
Is the company’s industry being disrupted? (Barnes & Noble, Blackberry)
Is the company’s industry going through a cyclical shift that could endanger
the underlying asset? (Linn Energy, Chesapeake Energy)
Is the company likened to a fad or a trend? (Crocs, Krispy Kreme, Mossimo)
Again,
paycheck-pot investing is boring
. If the investment is “hot” or the
dividend is “fat,” you’re probably playing a shell game with a suit who has a big
parachute. Clamoring after fat yields ultimately will have you clamoring after a
box of tissues.
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