Too many choices. Using automation to reduce choices and dominate your money.

I have known Ramit Sethi for several years now, first through PBWiki, which he co-founded, and later as someone I turned to with questions about the world and workings of finance. In a world of gurus who promote one method of investing and then follow another, it was refreshing to talk with someone who was willing to share real numbers and case studies from their experiments.

Ramit and I have also able to share a bottle (OK, many bottles) of wine and laugh about the downstream effects of titles we’ve tested and chosen, as both of our book titles sound like scams to most people: The 4-Hour Workweek and I Will Teach You To Be Rich.

Despite this self-imposed handicap, Ramit’s blog and advice have been featured in media such as NPR, The New York Times, and Fortune magazine. I specifically asked him if I could excerpt a few of the diagrams and call scripts from his new book. He and I both share a love of templates that enable us (and others) to duplicate results without reinventing the wheel…

Enter Ramit.

The Psychology of Automation – by Ramit Sethi

Think about the 50+ money decisions you have to make today: Should you save more? What should you cut down on? What about investing — real estate or stocks or index funds? Pay off debt? Did you send in that Comcast bill on time? Is it time to rebalance your portfolio?

Faced with an overwhelming number of choices, most people respond in the same way: They do nothing. As Barry Schwartz wrote in The Paradox of Choice: Why More is Less,

“…as the number of mutual funds in a 401(k) plan offered to employees goes up, the likelihood that they will choose a fund — any fund — goes down. For every 10 funds added to the array of options, the rate of participation drops 2 percent. And for those who do invest, added fund options increase the chances that employees will invest in ultraconservative money-market funds.”

Why do so many people believe that personal finance is only about willpower? The idea goes like this: “If I just try harder, I’ll start saving more, pay off my debt, stop spending all that money, keep a budget, learn about investing, start investing, rebalance ever year…” Unlikely. In fact, go ask your friends if they’re taking full advantage of their employer’s 401(k) match. The vast majority of people are not — even though it’s literally free money. Their answer? “Yeah…I really should do that…”

It’s not about willpower. More than anything else, the psychology of automation is critical to successfully getting control of your finances.

In one study, researchers found that making 401(k) accounts opt-out instead of opt-in — in other words, making employees automatically participate, although they could stop at any time — raised contribution rates from less than 40% to nearly 100%.

Defaults matter. We’ve all read The Four Hour Workweek so you know about the benefits of doing less. Today, Tim’s given me the opportunity to show you the details of the personal-finance system I’ve built over the last five years. It’s a way to automate the day-to-day decisions you have to make — paying bills, investing, rebalancing, cutting down on spending, increasing spending on things you love — and focus on the things you care about.

Using “The Next $100″ Principle, which I’ll show you below, your automated money flow will automatically route money where it needs to go — investments, paying bills, savings, and guilt-free spending.

And you can focus on the things that matter to you, instead of being a slave to your personal finances.

Case study: Michelle’s Automation System

To see how this will work, let’s use Michelle as an example:

Michelle gets paid once a month. Her employer deducts 5 percent of her pay automatically and puts it in her 401(k). The rest of Michelle’s paycheck goes to her checking account by direct deposit.

About a day later, her Automatic Money Flow begins transferring money out of her checking account. Her Roth IRA retirement account will pull 5 percent of her salary for itself. Her savings account will pull 5 percent, automatically breaking that money into chunks: 2 percent for a wedding sub-account, 2 percent to a house down-payment sub-account, and 1% for an upcoming vacation. (That takes care of her monthly savings goals.)

Her system also automatically pays her fixed costs like Netflix, cable, and insurance. She’s set it up so that most of her subscriptions and bills are paid by her credit card. Some of her bills can’t be put on credit cards—for example, utilities and loans—so they’re automatically paid out of her checking account. Finally, she’s automatically e-mailed a copy of her credit card bill for a monthly five-minute review. After she’s reviewed it, the bill is also paid from her checking account.

The money that remains in her account is used for guilt-free spending money.

To make sure she doesn’t overspend, she’s focused on two big wins: eating out and spending money on clothes.

She sets alerts in her Mint account if she goes over her spending goals, and she keeps a reserve of $500 in her checking account just in case. (The couple of times she went over her spending, she paid herself back using her “unexpected expenses” money from her sub-savings account.) To track spending more easily, she uses her credit card as much as possible to pay for all of her fun stuff. If she uses cash for cabs or coffee, she keeps the receipts and tries to enter them into Mint as often as possible.

In the middle of the month, Michelle’s calendar reminds her to check her Mint account to make sure she’s within her limits for her spending money. If she’s doing fine, she gets on with her life. If she’s over her limit, she decides what she needs to cut back on to stay on track for the month. Luckily, she has fifteen days to get it right, and by politely passing on an invitation to dine out she gets back on track.

By the end of the month, she’s spent less than two hours monitoring her finances, yet she’s invested 10 percent, saved 5 percent (in sub-buckets for her wedding and down payment), paid all of her bills on time, paid off her credit card in full, and spent exactly what she wanted to spend. She had to say “no” only once, and it was no big deal. In fact, none of it was.

Starting off: Scripts for negotiating with banks and credit cards

We’ll get to creating an automatic personal-finance system for you in a second. First, we need to iron out a few wrinkles to make sure your banks and credit cards aren’t screwing you.

The first steps are setting up the right financial accounts (saving, checking, investing), which I detail in chapters 1-3 of my book, but I’m just going to give you some core negotiation scripts to use against your financial institutions. With a customer-acquisition cost that’s typically between $300 and $1,500, financial companies don’t want to lose you — especially since most Americans are horrible negotiators and are afraid of using the phone. If you do it, you’re one of a select few who get preferential treatment.

First, I recommend you create a simple spreadsheet where you list all your accounts. Without it, you’ll activate a passive barrier that will make automation and negotiation far less likely to succeed. Download a spreadsheet here.

Next, I recommend you call up each account and negotiate like an Indian:

Script #1: Negotiating overdraft fees from your bank

You: “Hi, I just saw this bank charge for overdrafting and I’d like to have it waived.”

Bank rep: “I see that fee . . . hmm . . . Let me just see here. Unfortunately, sir, we’re not able to waive that fee. It was [some B.S. excuse about how it’s not waiveable].”

Bad Things to Say Here:

• “Are you sure?” (Don’t make it easy for the rep to say no to your request.)

• “Is there anything else I can do?” (Again, imagine if you were a customer-service rep and someone asked this. It would make your life easier to just say no. As a customer, don’t make it easy for companies to say no.)
• “Well, this Indian blogger dude told me I could.” (Nobody cares. But it would be cool if a thousand customers called their banks and said this.
• “Okay.” (Don’t give up here. Despite what you learned in sex ed, “no” does not mean “no” when it comes from a bank.)

Try this instead:

You: “Well, I see the fee here and I’d really like to get it waived. What else can you do to help me?”

(Repeat your complaint and ask them how to constructively fix it. At this point, about 85 percent of people will get their fees refunded. I have hundreds of comments from people on my blog who have taken this advice and saved thousands of dollars in fees. But in case the rep doesn’t budge, here’s what you can do.)

Bank rep: “I’m sorry, sir, we can’t refund that fee.”

You: “I understand it’s difficult, but take a look at my history. I’ve been a customer for more than three years, and I’d like to keep the relationship going. Now, I’d like to get this waived—it was a mistake and it won’t happen again. What can you do to help?”

You: “Hmm, one second, please. I see that you’re a really good customer. . . . I’m going to check with my supervisor. Can you hold for a second?”

(Being a long-term customer increases your value to them, which is one reason you want to pick a bank you can stick with for the long term. And the fact that you didn’t back down at the first “no” makes you different from 99 percent of other customers.)

Bank rep: “Sir, I was able to check with my supervisor and waive the fee. Is there anything else I can help you with today?”

Script #2: Negotiate your credit card APR

Your APR, or annual percentage rate, is the interest rate your credit card company charges you. The average APR is 14 percent, which makes it extremely expensive if you carry a balance on your card. Put another way, since you can make an average of about 8 percent in the stock market over the long term, your credit card is getting a great deal by lending you money.

So, call your credit card company and ask them to lower your APR. If they ask why, tell them you’ve been paying the full amount of your bill on time for the last few months, and you know there are a number of credit cards offering better rates than you’re currently getting. In my experience, this works about half the time. It’s important to note that your APR doesn’t technically matter if you’re paying your bills in full every month—you could have a 2 percent APR or 80 percent APR and it would be irrelevant, since you don’t pay interest if you pay your total bill in each month. But this is a quick and easy way to pick the low-hanging fruit with one phone call.

Script #3: Get your monthly/annual fees waived (credit cards and all bank accounts)

You: “Hi, I’d like to confirm that I’m not paying any fees on my credit card.”

Credit Card rep: “Well, it looks like you have an annual fee of $50. That’s actually one of our better rates.”

You: “I’d rather pay no fees. Which card can you switch me to that doesn’t charge fees? I’d like to make sure my credit score isn’t affected by closing this account, too. Can you confirm?”

The vast majority of people don’t need to pay any annual fees on their credit cards, and because free credit cards are so competitive now, you rarely need to pay for the privilege of using your card. The only exception is if you spend enough to justify the extra rewards a fee-charging account offers. If you do pay an annual fee, do a break-even analysis to see if it’s worth it. Hundreds of my readers have either (1) had their annual fee refunded, or (2) switched to a no-fee card.

Script #4: What to do if you miss a credit card payment

You: “Hi, I noticed I missed a payment, and I wanted to confirm that this won’t affect my credit score.”

Credit Card rep: “Let me check on that. No, the late fee will be applied, but it won’t affect your credit score.”

(If you pay within a few days of your missed bill, it usually won’t be reported to the credit agencies. Call them to be sure.)

You: “Thank you! I’m really happy to hear that. Now, about that fee…I understand I was late, but I’d like to have it waived.”

Credit Card rep: “Why?”

You: “It was a mistake and it won’t happen again, so I’d like to have the fee removed.”

(Always end your sentence with strength. Don’t say, “Can you remove this?” Say, “I’d like to have this removed.” At this point, you have a better-than-50-percent chance of getting the fee credited to your account. But just in case you get an especially tough rep, here’s what to say.)

Credit Card rep: “I’m very sorry, but we can’t refund that fee. I can try to get you our latest blah blah marketing pitch blah blah…”

You: “I’m sorry, but I’ve been a customer for four years and I’d hate for this one fee to drive me away from your service. What can you do to remove the late fee?”

Credit Card rep: “Hmm . . . Let me check on that. . . . Yes, I was able to remove the fee this time. It’s been credited to your account.”

You don’t believe me that it can be so simple? It is. Anyone can do it.

There are other advanced negotiating strategies and tactics, including optimizing your debt-to-credit ratio, but I’ll leave those for another day.

Finally, if you decide to switch accounts, which ones should you use? I cover this in detail in the book, but here’s what I use ING Direct for savings and Schwab Investor Checking, where I earn interest and get 100% of ATM fees refunded from anywhere.

“The Next $100″ Principle Applied: Automating your Finances

Too many people try to save money on 50 things and end up saving 5% on everything — and causing themselves a huge amount of stress that makes them give up entirely. Instead, I prefer focusing on my top two discretionary expenses (for me, eating out and going out), and cutting 25%-33% off over a period of six months. This generates hundreds of dollars of extra cash flow that I re-route to investing and travel.

To show you how automating your accounts works, I’ve prepared a 12-minute video that shows you how to build a personal-finance infrastructure that automates your money so you can spend less than 1 hour per week monitoring your money. Everything will be done automatically — investment, savings, bills paid. Everything.

Ramit’s 12-Minute Guide to Automating Your Finances

First, you’ll need to log in to each account and link your accounts together so you can set up automatic transfers from one account to another. When you log in to any of your accounts, you’ll usually find an option called something like “Link Accounts,” “Transfer,” or “Set Up Payments.”

These are the links you need to make:

Examples: Your 401(k) should be connected to your checking account via direct deposit (talk to your HR rep about setting this up — it takes 10 minutes to fill out a form). Then log into your Roth IRA, savings account, and credit card, where you can link your checking account to them. Finally, there are some bills that can’t be paid through your checking account, like your rent. For those, use your checking account’s free bill-pay feature so they automatically issue your landlord a check on the precise date it’s due. Now, you never have to manually write a check again.

Set up automatic transfers

Now that all your accounts are linked, it’s time to go back into your accounts and automate all transfers and payments. This is really simple: It’s just a matter of working with each individual account’s website to make sure your payment or transfer is set up for the amount you want and on the date you want.

Most people neglect one thing when automating: dates. If you set automatic transfers at weird times, it will inevitably necessitate more work, which will make you resent and eventually ignore your personal-finance infrastructure. For example, if your credit card is due on the 1st of the month, but you don’t get paid until the 15th, how does that work? If you don’t synchronize all your bills, you’ll have to pay things at different times and that will require you to reconcile accounts. Which you won’t do.

The easiest way to avoid this is to get all your bills on the same schedule. To accomplish this, get all your bills together, call the companies, and ask them to switch your billing dates. Most of these will take five minutes each to do. There may be a couple of months of odd billing as your accounts adjust, but it will smooth itself out after that. If you’re paid on the 1st of the month, I suggest switching all your bills to arrive on or around that time, too.

Call and say this: “Hi, I’m currently being billed on the 17th of each month, and I’d like to change that to the 1st of the month. Do I need to do anything besides ask right here on the phone?” Of course, depending on your situation, you can request any billing date that will be easy for you.

Now that you’ve got everything coming at the beginning of the month, it’s time to actually go in and set up your transfers. Here’s how to arrange your Automatic Money Flow, assuming you get paid on the 1st of the month.

2nd of the month: Part of your paycheck is automatically sent to your 401(k). The remainder (your “take-home pay”) is direct-deposited into your checking account. Even though you’re paid on the 1st, the money may not show up in your account until the 2nd, so be sure to account for that.

Remember, you’re treating your checking account like your e-mail inbox— first, everything goes there, then it’s filtered away to the appropriate place. Note: The first time you set this up, leave a buffer amount of money—I recommend $500—in your checking account just in case a transfer doesn’t go right. And don’t worry: If something does go wrong, use the negotiation tips above to get any overdraft fees waived.

5th of the month: Automatic transfer to your savings account. Log in to your savings account and set up an automatic transfer from your checking account to your savings account on the 5th of every month. Waiting until the 5th of the month gives you some leeway. If, for some reason, your paycheck doesn’t show up on the 1st of the month, you’ll have four days to correct things or cancel that month’s automatic transfer.

Don’t just set up the transfer. Remember to set the amount, too. Use the percentage of your monthly income that you established for savings in your Conscious Spending Plan (from Chapter 4 of my book; typically 5 to 10 percent). But if you can’t afford that much right now, don’t worry—just set up an automatic transfer for $5 to prove to yourself that it works. The amount is important: $5 won’t be missed, but once you see how it’s all working together, it’s much easier to add to that amount.

5th of the month: Automatic transfer to your Roth IRA. To set this up, log in to your investment account and create an automatic transfer from your checking account to your investment account. Refer to your Conscious Spending Plan to calculate the amount of the transfer. It should be approximately 10 percent of your take-home pay, minus the amount you send to your 401(k).

7th of the month: Auto-pay for any monthly bills you have. Log in to any regular payments you have, like cable, utilities, car payments, or student loans, and set up automatic payments to occur on the 7th of each month. I prefer to pay my bills using my credit card, because I earn points, I get automatic consumer protection and little-known benefits, and I can easily track my spending on online sites like Mint, Quicken, or Wesabe.

But if your merchant doesn’t accept credit cards, they should let you pay the bill directly from your checking account, so set up an automatic payment from there if needed.

7th of the month: Automatic transfer to pay off your credit card. Log in to your credit card account and instruct it to draw money from your checking account and pay the credit card bill on the 7th of every month— in full. (Because your bill arrived on the 1st of the month, you’ll never incur late fees using this system.) If you have credit card debt and you can’t pay the bill in full, don’t worry. You can still set up an automatic payment; just make it for the monthly minimum or any other amount of your choice. (Incidentally, paying your bills on time is the one of the top factors in determining and improving your credit score.)

By the way, while you’re logged in to your credit card account, also set up an e-mail notification (this is typically under “Notifications” or “Bills”) to send you a monthly link to your bill, so you can review it before the money is automatically transferred out of your checking account. This is helpful in case your bill unexpectedly exceeds the amount available in your checking account—that way you can adjust the amount you pay that month.

Tweaking Your System: Freelancers, irregular income, and unexpected expenses

That’s the basic Automatic Money Flow schedule, but you may not be paid on a straight once-a-month schedule. That’s not a problem. You can just adjust the above system to match your payment schedule.

If you’re paid twice a month: I suggest replicating the above system on the 1st and the 15th—with half the money each time. This is easy enough, but the one thing to watch with this is paying your bills. If the second payment (on the 15th) will miss the due dates for any of your bills, be sure that you set it so that those bills are paid in full during the payment on the 1st. Another way to work your system is to do half the payments with one paycheck (retirement, fixed costs) and half the payments with the second paycheck (savings, guilt-free spending), but that can get clunky.

If you have irregular income: Irregular incomes, like those of freelancers,

are difficult to plan for. Some months you might earn close to nothing, others you’re flush with cash. This situation calls for some changes to your spending and savings. First—and this is different from the Conscious Spending Plan—you’ll need to figure out how much you need to survive on each month. This is the bare minimum: rent, utilities, food, loan payments—just the basics. Those are your bare-bones monthly necessities.

Now, back to the Conscious Spending Plan. Add a savings goal of three months of bare-bones income before you do any investing. For example, if you need at least $1,500/month to live on, you’ll need to have $4,500 in a savings buffer, which you can use to smooth out months where you don’t generate much income. The buffer should exist as a sub-account in your savings account. To fund it, use money from two places:

1. Forget about investing while you’re setting up the buffer, and instead take any money you would have invested and send it to your savings account.

2. In good months, any extra dollar you make should go into your buffer savings.

Here’s an example of how I set up my sub-savings accounts:

Once you’ve saved up three months of money as a cushion, congratulations! Now go back to a normal Conscious Spending Plan where you send money to investing accounts. Because you’re self- employed, you probably don’t have access to a traditional 401(k), but you should look into a Solo 401(k) and SEP-IRA, which are great alternatives.

Just keep in mind that it’s probably wise to sock away a little more into your savings account in good months to make up for the less profitable ones.

If you have an irregular income, I highly recommend using YouNeedABudget as a planning tool. It uses a forward-looking system that’s very helpful if you don’t know what you’re going to make next month.

Your money is now automatic

Congratulations! Your money management is now on autopilot. Not only are your bills paid automatically and on time, but you’re actually saving and investing money each month. The beauty of this system is that it works without your involvement and it’s flexible enough to add or remove accounts any time. You’re accumulating money by default.

Most importantly, whenever you’re eating out, or you decide to buy a new pair of shoes or fly out to visit your friends or get the “Pro” version of that web app you’ve been eyeing, you won’t feel guilty because you’ll KNOW that your finances are being handled — automatically.

Excerpts from Ramit Sethi’s new book, I Will Teach You To Be Rich. Used with permission.

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Note from Tim on the next 48 hours only: I think optimizing your finances is so important that anyone who buys this book (no-purchase option available here) in the next 48 hours will get: (1) An exclusive invitation to attend a private webcast where Ramit and I will answer your questions about automation, money, and entrepreneurship, and (3) a grand prize of one roundtrip ticket from anywhere in the United States to meet me and Ramit for dinner in San Francisco. Just get the book and forward your receipt to fourhourworkweek@iwillteachyoutoberich.com by 6pm PT, this Saturday, 3/28/09.

LOS ANGELES, MID-JUNE 2008

Sitting on a plush couch in the neon-infused nightclub, I asked again:

“What’s it about?”

Neil Strauss glanced around and looked nervous, which I found strange. After all, we’d known each other for close to two years now. In fact, he was – as New York Times bestselling author of The Game and others – one of the first people to see the proposal for The 4-Hour Workweek and offer me encouragement.

“C’mon, dude, give me a break. Don’t you trust me?”

“Guilt. That’s good. Use guilt,” Neil said. But the Woody Allen approach wasn’t working.

“I can’t let the meme out early” he said, “I trust you—I’m just paranoid,” he offered to no one in particular as he downed another RedBull. So I fired a shot in the dark.

“What, are you writing about the 5 Flags or something?”

Neil’s heart skipped a beat and he stared at me for several long seconds. He was stunned.

“What do you know about the 5 Flags?”

I was in.

The 5 Flags

Neil’s new book, Emergency, teaches you how to become Jason Bourne.

Multiple passports, moving assets, lock-picking, escape and evasion, foraging, even how to cross borders without detection (one preferred location: McAllen, Texas, page 390)–it’s a veritable encyclopedia of for those who want to disappear or become lawsuit-proof global citizens…

I proofread the book months ago, and it’s been torture to keep some of the content from you, as I find the topics endlessly fascinating. For example, let’s take the concept of “geoarbitrage” to it’s natural but extreme extension: The 5 Flags. I was first introduced to the 5 Flags approach by a deca-millionaire in San Francisco, but here is Neil’s explanation:

“The way to break free of nationality, according to Schultz’s pamphlet, was to follow a three-flag system. The three flags consist of having a second passport, a safe location for your assets in another country, and a legal address in a tax haven. To these, Hill added a fourth and fifth flag: an additional country as a business base and a number of what he called ‘playground countries’ in which to spend leisure time.”

I never implemented the 5 Flags, but I fantasized about getting a second passport and the infinite options it could provide. Neil actually went out and did it.

I’ll get stopped at the airport in a lock-down; Neil won’t. If the FDIC collapses and bank withdrawals are blocked (as happened in Argentina in 2002 when the currency collapsed due to hyperinflation), I’m out of business; Neil has assets elsewhere.

Do I think the US banks are all going to collapse? Not at all. Do I think it’s intelligent to have a lot of options? Indeed. Do I think it’s fun to read about what billionaires and money launderers do, even if I don’t imitate them? Most definitely.

I’m very happy to offer you an exclusive first look at Emergency. Get this book. The following excerpts will set your mind spinning. Ellipses indicate skipped passages.

Lesson 22 – The Gone With the Wind Guide to Asset Protection

If you wanted to withdraw your entire life savings and move it to a bank in Switzerland, what would you do?

Now that I’d decided to hide my assets offshore, the information from the Sovereign Society conference about the government tracking withdrawals and transfers of more than $10,000 applied to me. It seemed impossible to get the money from my American bank to the Swiss bank Spencer recommended without ringing alarm bells. Even if I moved it in small increments, there would still be a paper trail detailing exactly how much money I’d transferred.

So I did what any resourceful American would do: I bought a book on money laundering.

After all, it isn’t a crime to move money secretly as long as the income’s been reported to the IRS and any other necessary reporting requirements are met. And my intention wasn’t to hide my earnings from the government, customs, or creditors, but to protect it from bank collapses, inflation, seizure, and lawsuits, which required leaving few traces of where it went.

Securing money overseas is not a new idea. Even in the novel Gone With the Wind, Rhett butler keeps his earnings in offshore banks, enabling him to buy a house for Scarlett o’Hara after the Civil War—in contrast to his Southern colleagues, who lose their fortunes due to blockades, inflation, and financial collapse.

For more practical, non-fictional inspiration, I bought Jeffrey Robinson’s 1996 book The Laundrymen. I’d always wondered how empty video stores renting movies for $3 a day could stay in business, and why I’d see Russian thugs running clearly unprofitable frozen yogurt stands on deserted side streets. According to Robinson, it’s because, in order to make illegal funds appear legitimate, crooks will slowly feed the money into the cash registers of a normal business.

“It’s almost impossible to spot an extra $500 coming in daily through the tills of a storefront stocked with 15,000 videos,” he writes. “Nor would anyone’s suspicions necessarily be raised if that same owner ran a chain of twenty video rental stores and, backed up with the appropriate audits, awarded himself an annual bonus of $3.96 million.”

Buried elsewhere in Robinson’s book was the answer I was looking for. The best legal way to surreptitiously move money, it seems, is to buy something that doesn’t lose its cash value when purchased. For example, there’s a black market for people who transfer money by buying expensive jewelry, art, watches, and collectibles, then selling them in their destination country for a small loss—usually no greater than the percentage banks charge for exchanging currencies.

So once AIG private bank in Switzerland returned my phone call—assuming that, unlike Spencer’s [a billionaire who appears earlier in the book] lawyer, they were actually willing to work with me—I planned to go shopping for rare coins.

But if it was all so legitimate, why did it feel so wrong?

While I waited to hear from the Swiss bank, I drove to Burbank to meet with the asset protection lawyers Spencer had recommended, Tarasov and Associates. The receptionist led me into a room with black-and-silver wallpaper where Alex Tarasov sat at a large mahogany desk with a yellow legal pad in front of him. With this pad, he would rearrange my business life forever.

“You did a very smart thing by coming here,” Tarasov said. Twenty- five years ago, he had probably been a frat boy. Maybe even played varsity football. But a quarter century spent sitting at desks scrutinizing legal papers had removed all evidence of health from his skin and physique. “By taking everything you own out of your name, we can hide it from lawyers trying to do an asset search on you.”

“So if they sue me and win, they won’t be able to get anything?”

“We can make it very difficult for them to find the things you own and get at them. It’s not impossible, but the deeper we bury your assets, the more money it’s going to cost to find out where they are. And if we can make that time and cost greater than the worth of the assets, then you’re in good shape.”

Like Spencer had said, this was just insurance. The cost of setting this up would be like taking out a policy against lawsuits.

“So what do you own?” he asked.

I laid it all out for him. “I have a house I’m still paying for. I have some stocks and bonds my grandparents gave me when I was a kid. I have a checking and a savings account. And I have the copyrights to my books.” I paused, trying to remember if I owned anything else. I thought there was more. “I guess that’s about it. I have a secondhand Dodge Durango, I guess. And a 1972 corvette that doesn’t work.”

In truth, I didn’t own that much. But ever since my first college job, standing over a greasy grill making omelets and grilled cheese sandwiches, I had started putting money in the bank. Since then, I’d saved enough to live on for a year or two if I ever fell on hard times or just wanted to see the world. I didn’t want to lose the freedom that came from having a financial cushion and not being in debt for anything besides my house.

“Here’s what we can do,” Tarasov said. He then sketched this diagram on his legal pad:

The stick figure was me. as for the boxes, I had no idea what those were. “These are boxes,” Tarasov explained. I was clearly getting the asset-protection-for-dummies lecture. “Each box represents a different LLC”—limited liability company. “If we can wrap everything in an LLC, and then all those LLCs are owned by a holding company, and that holding company is owned by a trust that you don’t even technically own, then you’re safe.”

I liked that last word. But I didn’t understand the rest of it.

“So we’re just basically making everything really complicated?” I asked.

“That’s the idea. We’ll even put your house in a separate LLC, so that if someone trips and falls, they can’t get at anything else you own.”

When Tarasov was through explaining everything, I couldn’t tell whether I was protecting myself from being scammed or actually being scammed myself. But I trusted Spencer, because he seemed too rich, too smart, and too paranoid to get taken in. So I told Tarasov to start wrapping me up in LLCs until my net-worth was whatever spending money I had in my pocket.

“Once we have these entities set up, we can talk about transferring them to offshore corporations,” Tarasov said as I left.

…

Lesson 54 – Secrets of Escaped Felons

Kelly Alwood didn’t say a word as he handcuffed my hands behind my back, opened the trunk of a rental car, and ordered me to get inside. With his shaven head, which looked like it could break bottles; his glassy green eyes, which revealed no emotion whatsoever; and the .32 caliber pistol hanging from a chain around his neck, he didn’t seem like the kind of person to cross.

As he shut the trunk over my head, the blue sky of Oklahoma City disappeared, replaced by claustrophobic darkness and new-car smell. Instantly, panic set in.

I took a deep breath and tried to remember what I’d learned. I curled my right leg as far up my body as it would go and dipped my cuffed hands down until I could reach my sock. Inside, I’d stashed the straight half of a bobby pin, which I’d modified by making a perpendicular bend a quarter inch from the top. I removed the pin, stuck the bent end into the inner edge of the handcuff keyhole, and twisted the bobby pin down against the lever inside until I felt it give way.

As I twisted my wrist against the metal, I heard a fast series of clicks, the sound of freedom as the two ends of the cuff disengaged. I released my hand, then made a discovery few people who haven’t been stuffed inside a trunk know: most new cars have a release handle on the inside of the boot that, conveniently, glows in the dark. I pulled on the handle and emerged into the light.

“Thirty-nine seconds,” Alwood said as I climbed out of the trunk. “Not bad.”

I couldn’t believe classes like this even existed. In the last forty-eight hours, I’d learned to hotwire a car, pick locks, conceal my identity, and escape from handcuffs, flexi-cuffs, ducttape, rope, and nearly every other type of restraint.

The course was Urban Escape and Evasion, which offered the type of instruction I’d been looking for to balance my wilderness knowledge. The objective of the class was to learn to survive in a city as a fugitive. Most of the students were soldiers and contractors who’d either been in Iraq or were about to go, and wanted to know how to safely get back to the Green Zone if trapped behind enemy lines.

The class was run by a company called onPoint Tactical. Like most survival schools, its roots led straight to Tom Brown. Its founder, Kevin Reeve, had been the director of Tracker School for seven years before setting off on his own to train navy SEALS, Special Forces units, SWAT teams, parajumpers, marines, snipers, and even SERE instructors. As a bounty hunter, his partner, Alwood, had worked with the FBI and Secret Service to help capture criminals on the Most Wanted list.

…

As the sun set, we drove to an abandoned junkyard, where Reeve let us practice throwing chips of ceramic insulation from spark plugs to shatter car windows, using generic keys known as jigglers to open automobile doors, and starting cars by sticking a screwdriver in the ignition switch and turning it with a wrench.

As I popped open the trunk on a Dodge with my new set of jigglers, I thought, This is the coolest class I’ve ever taken in my life.

…

Over a barbecue dinner later that night, Reeve asked why I’d signed up for the course. “I think things have changed for my generation,” I told him. “We were born with a silver spoon in our mouths, but now it’s being removed. And most of us never learned how to take care of ourselves. So I’ve spent the last two years trying to get the skills and documents I need to prepare for an uncertain future.”

I’d never actually verbalized it before. I’d just been reacting and scrambling as the pressure ratcheted up around me. Reeve looked at Alwood silently as I spoke. For a moment, I worried that I’d been too candid. Then he smiled broadly. “You’re talking to the right people. That’s what we’ve been thinking. Kelly has caches all over the country—and in Europe.”

Lesson 28 – Calculate the Odds That You’re In Jail Right Now

ST. KITTS, EASTERN CARIBBEAN

In a few days, I’d be committed to an expense of over half a million dollars, which was more money than I had.

And what was it all for? Symbolic paper. A passport, which is just a teeny little booklet that means nothing to the universe. Realistically, the world wasn’t likely to end in my lifetime. And if it did, everyone on St. Kitts would be just as dead as everyone in America.

If there were a smaller-scale world disaster, things would probably be even worse on an island in the Caribbean, where I was more likely to be a victim of food shortages, droughts, hurricanes, blackouts, and tsunamis. There’s nowhere to run and nowhere to hide on an island—especially one in the smallest country in the Americas. I’d become so focused on my search for a passport—so consumed with escaping the blowback of American politics—that I’d forgotten the survivalist lessons I’d learned on Y2K and 9/11.

Soon, the whole endeavor began to seem like the biggest travesty ever. If something horrible happened in America, would a St. Kitts passport even get me out during a state of emergency? What if it was confiscated by customs agents? Or what if Victor, Maxwell, and Wendell were in collusion and just ripping me off? I didn’t have anyone to protect me here.

Once I’d ridden out that wave of anxiety, a new one formed. I began worrying that I’d blabbed my name and occupation to too many people. If they Googled me and saw the filth I’d written, they might not sell me the apartment or give me a citizenship. And then I’d be stuck in America if anything bad happened.

And so it went, all night, one wave of anxiety after another—half of them spent worrying that I wouldn’t get a passport, the other half spent worrying that I would.

I fell asleep around dawn for a few fitful hours, until I was woken by my cell phone. AIG Private Bank was finally returning my call.

Every day, my small savings were dwindling as the dollar dropped relative not just to the euro, but even to the Caribbean currency here. I never thought I’d see the day when Eastern Europeans came to the United States for the cheap shopping.

“I’d like to inquire about opening a private banking account,” I told the woman.

“Great,” she said, with barely a trace of a Swiss accent. “Let me ask you a few questions.”

“Sure.”

“Are you an American citizen?”

“Yes, I am.”

“We don’t deal with American citizens for a few years now.”

“But my friend Spencer Booth is American, and I think he has an account with you.”

“It’s likely an older account. We don’t do business with American citizens anymore. Sorry, good-bye.”

Before I could respond, she had hung up. I felt like an outcast. I couldn’t believe a bank wouldn’t take my money solely because I was American.

I’d noticed that many of the banks I’d researched had special policies for dealing with United States citizens. Even some of the online companies selling vintage travel documents said they no longer shipped to America because U.S. customs agents were opening and confiscating the packages. The government seemed to be sticking its nose everywhere.

In the meantime, I’d discovered a few other interesting facts: according to a report issued by Reporters Without Borders, the United States was ranked as having the fifty-third freest press in the world, tied with Botswana and Croatia. According to the World Health organization, the United States had the fifty-fourth fairest health care system in the world, with lack of medical coverage leading to an estimated 18,000 unnecessary deaths a year. And according to the Justice Department, one in every thirty-two Americans was in jail, on probation, or on parole.

Rather than having actual freedom, it seemed that, like animals in a habitat in the zoo, we had only the illusion of freedom. As long as we didn’t try to leave the cage, we’d never know we weren’t actually free.

That phone call was all it took to let me know I was doing the right thing.

Before going home, I had dinner with Wendell at a restaurant called Fisherman’s Wharf [in St. Kitts, not San Francisco] and thanked him for his help.

After the meal, he patted my shoulder and smiled. “Next time I see you, you’ll be a citizen of St. Kitts and Nevis just like me,” he said. “When you get married, your wife will be a citizen. And when you have kids, so will they.”

He stepped into his SUV, started the engine, then unrolled the window and concluded his thought: “One day,” he said, beaming, “when you come back to America, no one will recognize you. You’ll be a Kittitian.”

At the St. Kitts airport the next morning, I felt like I was returning not to a country but a fortress. “Your country is so tough to get into,” the ticket agent complained as she checked my documents for the flight home. “They make it so hard for us.”

She looked up at me and said it louder, almost with venom, as if it were my fault. “They make it so hard for us.”

She wasn’t alone in her opinion. A survey released the previous month by the Discover America Partnership had found that international travelers considered America the least-friendly country to visit.

“That’s why,” I told her, with the newfound pride that Wendell had instilled in me, “I’m moving here.”

Lesson 59 – Iceland is the New Caribbean

Maybe it was when Bear Stearns became the first brokerage house to be rescued by the government since the Great Depression.

Maybe it was when IndyMac became the fifth American bank to fail in recent months.

Maybe it was when the government gave customs agents authority to confiscate, copy, and analyze any laptop or data storage device brought across the border.
…

Maybe it was the unshakable sense that the worst was still to come.

But I was no longer alone.

It was a hot summer, and pessimism hung thick in the air. Most people I talked to felt as if they were inching closer to some darkness they couldn’t understand, because they’d never experienced it before and didn’t know what it held.
…

Even Spencer’s housemate Howard, who had once made fun of us for taking precautionary measures, was now looking into Caribbean islands. As it turned out, he would beat all of us there when his company collapsed and he had to hide from possible indictment.

“I’m so glad we started preparing ahead,” Spencer told me over dinner at the Chateau Marmont, where he was staying in Los Angeles.

Having struck out with the Swiss, I took Spencer’s advice and opened an account with a Canadian bank that had a branch in St. Kitts. Since both Canada and St. Kitts are part of the British Commonwealth, he’d explained, I would have easy access to my money if anything happened in America. Unfortunately, in the process, I discovered that keeping international accounts secret is now illegal: the IRS requires Americans with over $10,000 in foreign accounts to file an annual report disclosing not just the amount of money and the banks it’s kept in, but the account numbers.

Meanwhile, Spencer was moving forward with his ten-year plan. He started an Internet business in Singapore, enabling him to open a private banking account in the country, which he claimed was fast becoming the new Switzerland. Though he hadn’t gotten his St. Kitts passport yet either, Spencer had done more research into buying an island.

“I’m looking at islands in the north, around Iceland, because no one will think of looking for anyone there,” Spencer said, his thick lips spreading into a self-satisfied smile. “If I can get some other B people [billionaires] to go there with me, we can build underground homes and use geothermal energy.”

“What about your submarine?”

“It’s a great way to move between islands undetected, but we’re running out of time. We need to move faster. This is only the beginning.”

“How bad do you think it’s going to get?” Spencer seemed to understand the economy at a higher level than most people did, perhaps because he knew so many of the people who ran it.

“I don’t think the whole country’s going to collapse, but we’re looking at the worst economic disaster in America since the Great Depression. What I’m also concerned about is the increase in violent crime that’s going to accompany this.”

Everywhere I went that summer, the demon of Just in Case seemed to follow me, growling in my ear louder than it ever had, its jaws terrifyingly close to my jugular. I’d learned so much, changed so much, tested myself so much. It now was time to stop preparing, turn around, and face the demon—and my fears—head on.

And a musician would lead me there.

###

Exclusive first-run excerpts from Neil Strauss’ Emergency: This Book Will Save Your Life. Used with permission.

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The unanimous conclusion after stockmarket pundit Jim Cramer appeared on The Daily Show with Jon Stewart last week was: Jim got his ass kicked.

Be that as it may, were the facts straight? I will defer here to Mark Hanna, Trust Officer at Clayton Bank and Trust in Knoxville, TN. I first met Mark at the 2008 Berkshire Hathaway Annual Shareholder’s Meeting, where he was wearing a manager badge and discussing complex financial instruments.

Clayton Homes was sold to Berkshire Hathaway in 2003, and founder Jim Clayton hired Mark to start a Trust Department within his bank — Clayton Bank and Trust — to manage proceeds from the sale. Mark didn’t want me to share his personal annualized track record, but trust me: it’s phenomenal…

Here is his interpretation of the Daily Show interview, bolding mine:

—

The stock market tends to capture public attention primarily for two reasons: irrational exuberance or disappointment in misplaced faith.

Today the stock market is on the minds of many because the belief that the market goes up over time has again been called into question. Capitalizing on this attention, Jon Stewart has given Jim Cramer a public scourging in a now viral video from the Daily Show. Mr. Cramer may have deserved at least part of this flaying, but Mr. Stewart, representing the lay view of the current situation, falsely implies that investing in stocks is as safe as “betting it all on red”.

Mr. Cramer’s fault lies not in poor advice to buy or sell specific stocks, industries, or the market as a whole. His sin, and that of the media in general, is stirring the emotions of those who hold stocks as a long-term investment, turning them into short-term speculators. CEOs have lied, and people will always lie to further their own self-interest, as is the nature of man. We have been led astray, believing falsehoods that have caused loss of investment. Now in our panic we are guilty of believing the lie that stocks are, by nature, gambling.

Mr. Stewart asserts that as 401k investors, we are “financing the adventure” of hedge funds; that short-term traders HURT long-term buy and hold investors. This view is incorrect, and to paraphrase Buffett, here’s why: if you are a long-term investor in stocks, you want prices to decrease over your buying period so that you are able to buy more at better prices.

Still, Stewart’s thought that managers rewarded themselves for short-term performance at the expense of shareholders is right on. There are significant problems with corporate governance and a general lack of shareholder rights. Too many times management and rainmakers are incentivized to take great risk while not held accountable for losses. Some firms evolved over time into enterprises whose business was to employ speculators and “send them to the casino every day”. In addition, many banks were excessively leveraged, and this was obscured through Enronesque accounting. Off-balance-sheet arrangements that blew up at Enron were criminal, but a “mistake” at Citigroup.

However, there has always been sound business activity in the financial sector. Loans to support creditworthy businesses and individuals have always been profitable activities in the western system of finance. By now it is clear that most of the gamblers within the banks are leaving the table, either of their own accord or by demand, which may slightly reduce profit but will also dramatically reduce risk. While there are some financials today that remain speculative, it is certain there has been an overreaction: many babies thrown out with the bathwater.

Investing in stocks is provably not speculation. If one were to own all of the stock of a company with positive earnings, cash flow, and net worth, this ownership would have value. Thus, there is also value in a partial ownership stake in this same business. Purchasing any asset at a price less than its value is not speculation. Perceptive investors realize that they are not investing in “the market”; they are actually investing in the companies in which they hold ownership shares.

The bottom line is this: gambling is never investing, and investing is never gambling. The trick for the savvy investor is to recognize the difference.

-Mark Hanna
Trust Officer, Clayton Bank and Trust

Related and Suggested Posts:
Picking Warren Buffett’s Brain: Notes from a Novice
Rethinking Investing – Part 1: Common-Sense Rules for Uncommon Times
Rethinking Investing – Part 2: Information Advantage, Best Books, and More
Things I’ve Learned and Loved in 2008 – Recouping Losses, etc.

“If the market felt fidgety, if people were scared or desperate, he [senior Salomon Brothers bond trader] herded them like sheep into a corner, then made them pay for their uncertainty.”
-Liar’s Poker, Chapter: A Brotherhood of Hoods

Connecticut, 2003

There were 4-6 screens per person, and chairs were lined up at a single 30-foot desk in hierarchical pecking order. Commands would come down the line and trades were made.

“Who the f*ck are you?” asked one of seniors, swiveling back to his glowing screens before I could answer.

It was my first time inside one of the largest investment banks on the planet, and I was just observing a friend in the hopes of learning something. Before I knew it, lunch had arrived and a 20-minute break was announced in a poetic slew of 4-letter words.

“Name a company.” It was a voice I didn’t recognize, but it was clearly directed at me.
“Uh… sorry. Excuse me?” I asked to the room and no one in particular.
“Name a company.”
“Uh…”
“Any company — doesn’t matter.”
“OK. Ah… Genentech.” It was a shot in the dark with no rhyme nor reason.
“F*ck Genentech!!!” came the chorus.

“OK, we just sold 100,000 shares of Genentech. F*ck those guys. Lost a ton on them last week.”

100,000 shares of Genentech sold because a no-nothing guest had pulled the name out of thin air.

That was my introduction to how truly rigged the stock market is…

Information Advantage

“One trader remembers that Lewie [head of Salomon Brothers' mortgage department] would say he thought the market was going up, and buy a hundred million [dollars' worth of] bonds. The market would start to go down. So Lewie would buy two billion more bonds, and of course, the market would then go up. After he had driven the market up, Lewie would turn to me and say, ‘See, I told you it was going to go up.’”
-Liar’s Poker, Chapter: The Fat Men and Their Marvelous Money Machine

I currently have less than 10% of my net-worth in stocks. Why? I don’t have an “information advantage”. If other words, I’ve seen the sharks in this ocean, and I want no part of it. They’ll eat my Barron’s-reading ass alive. I’d rather put my capital in angel investing and the few industries I understand, two areas where I have insider knowledge and connections that others don’t.

To quote billionaire Mark Cuban (great blog here) in his short interview with Young Money (YM) magazine:

YM: Do you have any general saving and investing advice for young people?

CUBAN: Put it in the bank. The idiots that tell you to put your money in the market because eventually it will go up need to tell you that because they are trying to sell you something. The stock market is probably the worst investment vehicle out there. If you won’t put your money in the bank, NEVER put your money in something where you don’t have an information advantage. Why invest your money in something because a broker told you to? If the broker had a clue, he/she wouldn’t be a broker, they would be on a beach somewhere.

Here’s the deal — to beat the market consistently, you have to: 1) have better information than most people, 2) have superior analysis of the same information, or 3) have better luck than a Leprechaun.

Discarding luck as a strategem, and personally discarding better analysis because I don’t want to spend my life poring over annual reports or evaluating algorithms, there is a simple conclusion: don’t invest in anything that you don’t know inside and out better than most of the world.

From David Swensen, who ended 2007 up 28% as the investment manager of the Yale University endowment:

“You have to diversify against the collective ignorance… I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.”

Having come out of Princeton and the land of Burton Malkiel, I agree with efficient market theory insomuch as “information advantage” is a prerequisite to consistently getting better returns than average.

If you don’t know something the rest don’t, don’t gamble.

Period.

The Weasel Word: “Investing”

In part 1 of this series, I promise my favorite picks for investing books. Though I’ve read several dozen based on recommendations from self-made millionaires (I try not to take advice from speculators), here are the few I’ve found most useful:

The Essays of Warren Buffett: Lessons for Corporate America (Buffett)
The Smartest Investment Book You’ll Ever Read (Solin)
Liar’s Poker (Lewis)
Seeking Wisdom: From Darwin to Munger (Bevelinl; Parts 2-4)
Less is More: An Anthology of Ancient and Modern Voices Raised in Praise of Simplicity (VandenBroeck)

What?! It seems like philosophical books have been mistakenly put on this list, no? Here’s the rub: after all the research and mind-numbing number crunching, I’ve decided that the philosophical decisions take precedent over the tactical ones. For me and those whose lives I most admire, at least.

One qualified commenter on the last investing post said:

“I don’t think you’re going to figure out investing in a matter of weeks or months.”

Well, this brings up an interesting question, doesn’t it. What the hell is “investing”, exactly?

If you have the potential to make 30% per annum in a given stock, but it keeps you up with sweaty palms at night, is that a good “investment”?

Is a stock with a projected 25% annual growth rate over 10 years a good “investment”, even though it will lose value every year except for one undetermined year with a 259% increase?

I sat in on another friend’s job once. He was a day trader, and his boss made more than $50,000 per day in most cases. But, this boss also carried divorce papers in his briefcase 24/7 “just in case he’d had it with the bitch.” Do you want his life? Is he a successful “investor”? Be careful with that term.

In the 100+ comments on the aforementioned post (some of the commenters manage 9-digit funds–hundreds of millions of dollars), definitions of “investing” range from “gambling” to “asset allocation.” In other words — “investing” as a term is so overused as to have become meaningless.

I propose that we define investment as a broad concept and then separate it out. First, the broad definition:

Investing = “Allocating resources to improve quality of life.”

This applies to financial investment as much as it does time management and all other resources. How much would your behavior and results change is you just replaced the concept of “time management” with “time investment” in your head?

Using this definition of investment, I would not chase the moving target of pure ROI (after all, there is always a more speculative vehicle with potential higher gains), but choose the vehicles that offers the greatest ROI with the least insomnia. More cash with constant sweat in the palms is hereby defined as a poor “investment.”

Moving from conceptual to tactical, we can also separate “investment” into three categories of actions, which I’ve found useful:

Investment =

-Asset/wealth creation
-Asset/wealth allocation
-Asset/wealth preservation

[To be continued...]

Did you miss Part 1 of the “rethinking investing” series? Read it here.

###

Odds and Ends: The Presidential Election

I’ll keep this short and sweet. Regardless of whom you’re voting for, get out and vote tomorrow, Tues. Find your closest location here.

If you care about your future and believe in a democratic process, it is your DUTY to get out and vote. I voted last week in San Jose, and — to be honest — I was not overwhelmed by the brain power I saw around me, all due respect to those who actually made the effort.

The best-informed people, for some reason, seem to sit on the sidelines playing armchair critic while elections happen. That’s bullsh*t.

This country is hanging on by a thread.

Make it a priority and vote on Tuesday. No excuses. Let the boss get a little pissed, let the co-worker whine for a few hours. Screw ‘em — they’ll get over it within 48 hours. The future of this country, and every person you know in it, is at stake. Gird up your loins (metaphorically) and get to your closest voting location.

Who am I voting for? Since the word got out last week, here it is: Barack Obama. I’m not an Obama maniac, and I don’t think he is a panacea. I think all politicians are liars — it’s in their job description to win public office. Either candidate will get more things wrong than right.

I actually agree with McCain on many issues, but this is an A-or-B choice. Despite some misgivings, I am certain Obama is far better than McCain for the long-term prospects of the US, and I know advisors to both candidates.

The minds I most respect, including people like Warren Buffett and Marc Andreessen (his reasons here) and those who will be taxed most under his administration, all support him. If you want to see a video where I explain some of the reasons, here it is. Disagree if you will, but make no mistake: I’ve done a lot of homework.

Here’s the point, though: I don’t care much who you vote for, despite my preference. But I do care that you vote.

Get out and make yourself heard. Find your closest voting location here. No excuses. What could be more important?

DonorsChoose winners:

I haven’t forgotten! Lots of good news coming soon on winners and even more winners…

I’ve learned quite a few things in the last 18 months of exploring—and experimenting with—the world of investing. This post is my first attempt to share the findings.

The lessons have come from not just reading books, but trial and error, and picking the brains of some diverse and fascinating people:

-Warren Buffett, the richest man in the world, and CFOs/financiers at Berkshire’s portfolio companies
-Chief economists at top investments banks
-Dot-commers who have turned $40,000 into $2,000,000 in stocks using massive leverage
-Conservative entrepreneurs (still self-made millionaires) with all-bond portfolios
-Money managers of the ultra-rich and ridiculously famous
-Ivy league professors who not only trade options exclusively but also bet up to $500,000 per night as no-limit hold ‘em poker players.

In all cases, excluding blog reader feedback (how could I know?), the principles I will offer are from people who have made millions in their respective investments, not armchair quarterbacks (advisers) who take a management fee from the people willing to take real risks…

Total read time for this post: 6 minutes.

I’ve lost a little money, made more money (with “risk capital,” about 28% annualized over the last three years), and preserved almost all of my money. I’m terrified of certain things, but I build my irrational decision-making and temporary stupidity into the planning.

To start, here is a snapshot of my total current asset allocation in retirement accounts. I’ll come back to this. Notice the dates:

Let’s start off with some smart observations from readers of this blog, who commented on my post where I described Warren Buffett’s answer to my question, which recentlymade it into Berkshire’s new annual report! Here it is:

“If you were 30 years old and had no dependents but a full-time job that precluded full-time investing, how would you invest your first million dollars, assuming that you can cover 18 months of expenses with other savings? Thank you in advance for being as specific as possible with asset classes and allocation percentage.”

The observations I have picked out for discussion follow, and I’ve tested most of them. Some will sound complex, but this series will reduce it all to simple conclusions anyone can use:

From Lee:

For someone so risk seeking in your personal life, I’m surprised at your risk tolerance rate of 10%. From reading your blog, it seems like you live your life experiences with a 50% risk tolerance rate.

[Tim: This is a common misconception. I actually consider myself very conservative and risk-averse in both life and investment, and my close friends can confirm this. As we'll see, the phrase "risk tolerance" is hugely problematic, but behind the scenes, I micro-test the hell out of options to determine what has the best chance of a high return-on-investment (ROI), but this isn't transparent to most observers, who assume I regularly roll the dice and hope for the best. Not true.]

Patrick Clark [Tim: if you take nothing else from this post, re-read the bolded portion a few times and memorize it, especially the last sentence]:

I am going to make a few assumptions here:

1. You are an accredited investor.
2. Your businesses will continue to run themselves and create cash flow income for you.
3. This $1 million is true risk capital.

That being said, I am a investment advisor. I create portfolios for clients in both traditional asset classes (stocks, bonds, cash, and real estate) and non-traditional asset classes (raw materials, energy, metals, and currencies). This provides a mix of investments that are uncorrelated to one another.

Without getting into specific investment vehicles, an asset allocation will look something like this:

US Equities – 24.5%
International Equities – 19.5%
Real Estate – 3%
Raw Materials – 12%
Energy – 12.5%
Metals – 12%
Currencies – 6%
Cash – 10.5%

The goal is to produce an absolute return. For my clients, I am not interested in having the following conversation, “The market was down 40% this year, Mr. Jones, but we only lost 18%. We did a great job!” No. A loss is a loss. By setting up a portfolio for absolute return, not relative returns, your chances of forwarding the ball every year is much greater.

Remember, a 50% loss requires a 100% gain to get back to even. Don’t lose.

Luca:

cash IS an asset during bear market.

From D:

Find an investment style that fits your personality, then backtest that strategy [Tim: for those of you mathematically inclined, search for "Monte Carlo simulation"] over long & varied starting/ending periods to see if you can stomach the maximum drop (”drawdown”). And stick with it…forever. No one can predict the market, you never know if you’re about to buy before a big dip.

It’s true that growth stocks outperform a helluvalot of other asset classes over the long haul.

But, someone who put all their money in the S&P500 index on 1/3/2000 lost about -50% (by October 2002) and is still losing money eight years later! Most might throw in the towel at that low point, when they should have been adding. The pain of losing is alot stronger than the hope of winning.

Superstar investor via phone:

92% of your return is determined by asset allocation, 6% my manager/stock selection, and 2% by timing.

Russ Thornton:

Once your target allocation among the chosen funds had been determined, I would rebalance back to your target allocation when any single asset class deviated 20% from it’s target. There is meaningful data supporting this rebalancing trigger. You could also rebalance with additional savings which is a much more tax efficient approach and will reduce your capital gains realization. Rebalancing forces you to buy more of the relatively less expensive asset class in a classic “buy low” discipline [Tim: versus selling the higher-priced asset].

That’s about it. Buy when you have money and only sell when you need the money, but not before.

Lee:

I like Taleb’s idea of 90% in government bonds and 10% in highly speculative stocks.

More conventionally, I’d follow a highly diversified strategy as suggested by Swensen (Yale) in his books, adjusting the bond percentage up or down as dictated by risk tolerance:

stock funds:
large blend index (S&P 500)
small value index
International index
Real estate Index
Commodities (PIMCO real return)

bonds:
TIPs
Short term treasuries

Bex:

You can have a pretty diversified portfolio, even if you only own 10 stocks.

Henrik:

So basically, for the most stable returns, invest in a set of assets that do not go up or down at the same time. That means you need international as well as US exposure, and debt (bonds/money mkt) as well as stocks. [Tim: these are also called "negatively-correlating asset classes," common in pair trading, which Buffett did quite a lot in the 1970's and 80's]

Oliver:

Your allocation should be approximately as follows:

90% TIPS
10% Call options on the S&P500

This means you’ll lose almost nothing if the market tanks but you’ll still get a lot of the return of the S&P500 on the upside.

The first lesson is: you don’t know what you think you know.

Think you can predict your risk tolerance? I bet you can’t.

Let’s try another question that will drive the point home:

Would you call yourself a racist? I bet you wouldn’t, and I bet you are.

Take the Harvard Implicit Association Test (IAT) for race as many times as you like. I’m not a betting man, but I’ll bet you come up as racist, regardless of race.

Surprising? Perhaps.

I’ve come to realize that the questions most investment advisers (and investors) ask are the wrong questions, or incomplete. Even if you have only $100 to invest, this is important to explore.

Most advice and decisions center on one question: what is your risk tolerance?

I had one wealth manager ask me this, and I answered honestly: “I have no idea.” It threw him off. I then asked him for the average of his clients’ responses. The answer:

“Most answer that they would not panic, down up to 20% in one quarter.”

My follow-up question was: when do most panic and start selling low? His answer:

“When they’re down 5% in one quarter.”

Unless you’ve lost 20% in a quarter, it’s hard—neigh, impossible—to predict your response. It’s not to dissimilar from a common boxing maxim: everyone has a plan until they get punched in the face.

False assumptions about your future decision making almost guarantees failure, so either 1) dial back your supposed “risk tolerance”, or 2) simulate the loss with smaller amounts but higher risk investments before betting the farm. I use angel investments in tech start-ups for this purpose.

It need not be $100,000—go to the horse track and make conservative bets (high-probability, low pay-out) at $25 a race until you lose $200 (FYI: here’s how I learned to bet on horses). How do you feel? That’s the starting point: accurately gauging emotional responses to gain or loss.

Your decisions, and investment future, depend on calibrating accurately.

—

Continued in Part II, which includes best books, redefining “investment”, and more…

Suggestions for topics in this series? Please let me know in the comments. I still consider myself a novice and this is a work-in-progress. If investment advice, please give an example from your personal experience whenever possible. Real-life anecdotes are more interesting than opinions, though opinions can be helpful.

Suggested reading:

Picking Warren Buffett’s Brain: Notes from a Novice
The Karmic Capitalist: Should I Wait Until I’m Rich to Give Back?
Lifestyle Investing: “Compound Time” Like Compound Interest?