- The difference between capital gains and cash flow…
- If you like stocks, it is still best to first invest in a stock that does this…
- The lesson about investing that my rich mentor was drumming into my head…
Years ago, when I was just starting my real estate investing career,
I considered a condominium in Delhi as an investment.
The problem was that the investment would have cost me
about $300 a month.
Back then, a $300-a-month loss would’ve been the same f
or me as $300,000-a-month loss would be today.
When I ran the numbers past my rich mentor, he asked, “Why do you want to lose $300 a month?”
In other words, my rich mentor wanted to know why I
wanted to pay money to invest.
“Well,” I told him, “the real estate agent said the condo
would go up in value and I would make a profit.”
Rich mentor chuckled and asked,
“How many condos can you afford that cost you $300 a month?”
“But it will probably go up in value, and then I can get my money back when I sell it.”
“You’re probably right,” said rich mentor, “but you didn’t answer my question.
How many investments can you afford that cost you $300 a month?”
At the time, my net after-tax income was only about $2,000 a month,
and my expenses were about $1,800 a month, so the reality
was that I couldn’t afford even one condo that cost me
$300 a month — even if it went up in price sometime
in the future.
So my answer was a sheepish, “I can’t afford even one
that loses me money.”
With a smile on his face, rich mentor said,
“Remember what I’ve been teaching you.
Any fool can lose money on an investment.
That doesn’t take much financial intelligence.”
This advice may sound simple, but if you think about it,
millions of investors invest their hard-earned money
every day and receive little to nothing in return.
In other words, their investment costs them money
rather than makes them money.
For example, millions of workers put their money in 401(k) plans,
hoping that someday in the future there will be enough in the
account for them to retire on.
And millions of people put a little money aside, either in a bank or under the mattress, and receive little to nothing in return.
They all pay to invest rather than getting paid to invest.
The lesson my rich mentor was drumming into my head, and I mean to drum into yours, is that investing should make me richer every month, not poorer. It should put money in my pocket every month, not take money out.
To him, it was a miracle that so many financial services salespeople
could convince financially naive people that it was smart to
pay money to invest.
He wanted people to learn to look harder for better investments —
to be professional investors rather than naive investors.
When he asked me, “How many investments can you afford
that cost you $300 a month?”
he was also asking, “How many investments can you afford that earn you $300 a month?” The obvious answer is, “As many as I can find.”
The Difference Between Capital Gains and Cash Flow
Most people invest for capital gains.
That is why they get excited when the stock market goes up or their home appreciates in value. That is how my Hollywood friend and most real estate flippers invest. It is also what most workers do when they invest for their retirement in the stock market.
People who invest for capital gains are gambling. As Warren Buffett has said, “The dumbest reason in the world to buy a stock is because it is going up.”
Investing for capital gains is also why most investors get depressed when the stock market drops or their home declines in value.
A person with a financial education invests for both cash flow and capital gains. There are two main reasons why.
Reason #1: A currency must flow from an asset that produces cash flow, or it loses value.
In other words, if your money is just parked waiting for appreciation or an increase in the share price, your currency is not productive and not working for you.
Reason #2: Investing for cash flow takes most of the risk out of investing.
It’s hard to feel like a loser as long as cash is flowing into your pockets—even if your asset price has depreciated.
On the other hand, if your asset appreciates, it’s an added bonus since you are already collecting cash flow.
My friend and I are partners in an oil company.
We invest in oil for both cash flow and capital gains.
When we first drilled for oil, it was about $25 a barrel.
We were happy with the cash flow every month.
When oil hit $140 a barrel, our wells increased in value
due to capital gains, and we were even happier.
Today, with oil at $65 a barrel, we are still happy because cash continues to flow into our pockets regardless of the oil well’s value.
If you like stocks, it is still best to first invest in a stock that pays a steady dividend, which is a form of cash flow.
In a down economy, when stock prices are low, it is a great time to buy stocks that pay dividends at bargain prices.
A stock investor also understands the power of cash flow, or dividend yields, as cash flow is called in the stock market.
The higher the dividend yield, the better the value of a stock.
Stocks and Dividends
For example, a dividend yield of 5% of the stock’s price signals
a great stock at a great price.
A dividend yield of less than 3% of the stock price means
the stock is priced too high and will probably fall in value.
In October 2007, the stock market hit an all-time
high of 14,164.
Suckers jumped into the market, betting on stocks going
higher (capital gains).
The problem was that the Dow had a dividend yield of
only 1.8% of its total value, which means that stocks were
too expensive, and professional investors began to sell.
In March 2009, the Dow hit a low of 6,547, and many
people jumped back into the market, thinking the worst was over.
The problem was that the dividend yield was still only 1.9%,
which to a professional investor meant the price of stocks
was still too high and the stock market would probably go lower,
and long-term investors would probably lose even more of
their money as cash flowed out of the market.
To me, investing for both cash flow and capital gains makes
more sense than worrying about the ups and downs of any market.