Not Rich Yet | Managing higher incomes

CAT | Invest well

Personal income tax rates in the US are at relative lows.

Over the past 50 years, income tax rates have been much higher. See the following chart from Wikipedia:

Based on recent government spending as part of the bailout and other programs to stimulate the economy – regardless of your political opinion on whether this was right or wrong – taxes have nowhere to go but up. The government needs income to balance the budget, and like it or not, higher taxes are will come.  And guess who they will hit? Not the poor, not the “middle class”, not the ultra-rich, but the folks with higher incomes (doctors, lawyers, professionals, etc.) that earn enough to labeled rich by politicians, but not rich enough to really defend themselves.

So let’s just assume for a second that my assertion above is correct. What should you do differently if you anticipate (much) higher tax rates within the next few years?

Here are my ideas:

  • Accelerate taxable events
    • If you own a house or some other asset with a lot of appreciation, you may want to sell earlier rather than later to avoid a higher capital gains tax
    • If you want to pass on your wealth to the next generation, you may want to give extra thought to estate planning and vehicles that allow you to maximize the impact of your inheritance for your heirs
  • Reduce your reliance on tax breaks
    • One popular way for the government to increase taxes is by doing away with tax breaks or lowering the bar at which the tax breaks phase out. If you heavily use tax breaks, you should think of ways to reduce your reliance on them
    • This includes relying on tax-deferred accounts such as 401ks and IRAs.  Just because those are tax protected now, doesn’t mean they will be in the future. One day all of us who invested diligently in 401ks will be the new bad rich people that politicians will strive to tax.  So don’t put all your chickens in one basket and diversify amongst different tax-deferment strategies and keep a healthy chunk in good old-fashioned taxable accounts.

What would you do? What would recommend?



Under contract!

So we just signed the contract to buy the rental property I mentioned in my post The math behind buying a rental property!

This means we are under contract, but still need to arrange for financing, survive the due diligence by lawyers, underwriters and inspectors and then close on the property.

Mortgage rates are at historical lows currently so it was a good time to strike.

There are several pros and cons of investing in rental real estate that we have been weighing before embarking on this journey.


  • Good hedge against inflation – when inflation kicks in it will raise rents and property values but my mortgage will stay constant. This way I will have hopefully some protection against inflation of my cash and other inflation sensitive investments
  • My rental income is relatively independent from the volatility of the stock market and allows me to diversify away some more risk
  • It provides a decent return of 8-15% (decent because it is not risk-free compared to cash sitting in a savings account)


  • Requires active involvement (hey landlord, my toilet is clogged)
  • Not risk free (real estate prices, tenant damages, ability to rent out property 100%)
  • Emotionally taxing (aggravation over tenants)

Next we need to figure out our financing – how much to put down? buy down the mortgage rate with points or not? escrow or not?

I will keep you posted…

Image by NobMouse


We were featured on on the Carnival of Personal Finance today.

Check out the whole list: MoneyRelationship

Our featured article: The math behind buying a rental property

Today I am kicking-off a multi-post series on Angel Investing. This is an interesting avenue for high income individuals with tolerance for risk.

The topics I intend to cover in this series are:

  • What is angel investing?
  • How angel investing works
  • What the requirements for angel investing are
  • What to look out for as an angel investor
  • How to become an angel investor

Angel investing – what is it?

In 1998, Andy Bechtolsheim, a successful entrepreneur and co-founder of Sun Microsystems, was approached by the founders of Google. Larry Page and Serge Brin pitched their idea to Andy, and he consequently wrote them a $100,000 check as a seed investment for their brand new idea. Fast forward a decade, and Andy’s investment in Google is worth more than $1.5B.

Angel investing is a high-stakes, high-risk form of investing by one or a few investors into promising ventures. Typically these investors are expected to contribute more than just money, but also facilitate contacts, provide expert knowledge and generally be helpful. In return, they are allowed to invest at “basement” level, and can achieve amazing returns – if unlikely as spectacular as those of Andy Bechtlolsheim – if the venture does well.

Typically, such investments are equity purchases (stock or stock options) or convertible debt (loans that convert to stocks). Pure debt deals are rare as they don’t allow the investor to profit greatly if the company does well.

Typical investments

Most importantly, angel investors typically invest in companies that will have some sort of “exit” or liquidity event. Internet start-ups or biotech companies will typically have an IPO or be acquired by another company if they succeed. Such an event allows the investor to convert his or her initial stake into cash or tradeable shares. Before the event, the investors shares were illiquid since the company was not publicly listed and tradeable.  An angel investment in a company that never intends to have a liquidity event is a moot point – why sink money in a deal that you can never sell?

Companies most attractive to investors since they will likely follow the route above typically follow the profile

  • Technology or biotech focus
  • Own strong intellectual property such as patents that will afford them a defensible advantage
  • Are not “life-style” businesses but instead highly scaleable businesses that can drive tremendous revenue and profit with a small base of employees
  • Organized as C-Corp or more rarely as LLC
  • Are for-profit

What this means is that businesses that do not meet the criteria above are unlikely to be attractive to angel investors. Restaurants, bars, ice cream shops, consulting companies, advertising agencies and other businesses that rely on people instead intellectual property are unlikely to attract angel investors.

The risk

Angel investing is risky. One angel investor I know mentioned that only a handful of the over 50 investments he made were doing well. In fact the risk is at multiple levels

  • First, the company has to do well overall and turn an idea into a roaring business
  • Next, most companies need to change their business model a couple of times in their life. During such changes, esp. if they involve near-death experiences for the company, new investors may force unfavorable terms onto the company, often “cramming down” older investors. What this means as an angel investor is that while the company may be doing well overall, your personal investment could be doing horribly
  • Finally, you need to have a liquidity event that is successful. Many a dot-com start-up was bought up in the hey day giving their angel investors huge returns on paper – e.g. through stock swaps – only to find after the 12 month waiting period that the buyer negotiated that the stock market tanked and their shares are worthless

For this reason, the US government actually requires angel investors to meet certain requirements. The government wants to avoid that innocent and inexperienced investors get suckered into such deals, so they require investors to have a minimum networth or income (to be discussed in detail later).

Given the risk discussed above, most investors I know only invest a small percentage of their portfolio in angel deals, often 5% or less.

My experience

As a disclaimer, I am not an active angel investor myself but have received angel investments from others as an entrepreneur. I have negotiated over 15 such investments and have assisted investors in their due diligence in other transactions.


In my next post in this series I will explain how the nuts and bolts of angel investing work.

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We are currently considering buying a rental property as an investment. It turns out, there are many different ways to “skin that cat”.

But how do they all compare?

So I ran some IRR (internal rate of return) calculations for them. The IRR essentially tells me what the expected return on my investment will be. Investing in a rental is no different than investing in a CD or a stock – you expect to earn a positive return on your investment.

Here are the facts

We would pay roughly $200k for the property, and get a gross rental income of about $1700 per month. The gross “cap rate” of the property would be about 10%, the net cap rate of the property would be about 5.5%. This means that we would have an annual gross income on the property that equals 10% of the purchase price and after accounting for all expenses except for mortgage costs, an annual income of 5.5% of the purchase price.

Further then property would be cash flow positive on a monthly basis – the rental income would (slightly) exceed my mortgage payments, taxes, insurance and expected maintenance costs.  Sounds great, right? I buy a property and the tenants pay my monthly bills while my equity grows.

But there is a catch. I still need to make a down payment (no more zero down payments in today’s market).

So what is the return or IRR I earn on the down payment investment?

Base case

Lets assume I buy the property with a 20% down payment, and I own the property for 10 years after which I sell it. I assume that the property value increases every year by 2% (roughly with inflation), and rent increase each year 1% (slightly slower than inflation).

Under that base case, I would earn an IRR of 9.6%.

Not bad, right? Better than what I would get if invested in a CD. But hold on, isn’t this riskier than a CD? Shouldn’t I be getting a higher return to make a riskier investment worthwhile?

Value evolution

So what happens if the value of the property doesn’t evolve the way I assumed and doesn’t grow with 2% as assumed in the base case? Lets keep everything else equal and change that assumption.

  • 2% p.a. value growth (base case): IRR = 9.6%
  • 5% (market peaks): IRR = 15.8%
  • 1% (slower growth): IRR = 7.2%
  • 0% (flat market): IRR = 4.4%
  • -2% (market declines slowly): IRR = -3.1%
  • -3% (market takes a beating): IRR = -9.1%

Ouch! So if the real estate market grows or does well I get a nice or even very nice return. But if the market stays flat or starts declining I very quickly have less attractive and even negative returns.  I better be sure the market doesn’t tank!

Rent evolution

So what happens if rents don’t evolve the way I assumed and don’t grow with 1% as assumed in the base case? Lets keep everything else equal and change that assumption.

  • 1% p.a. rent growth (base case): IRR = 9.6%
  • 3% (rents grow quickly): IRR = 10.3%
  • 0% (rents flat): IRR = 9.1%
  • -2% (rents decline): IRR = 8.1%

Okay, so rent growth has some influence on my return but all in all it doesn’t move the needle much. My IRR is still reasonable even if rents start to decline  a bit.

Down payment

So what happens if I plunk down more or less of a down payment compared to the 20% in the base case? Lets keep everything else equal and change that assumption.

  • 20% down (base case): IRR = 9.6%
  • 0% down (no money down – not realistic): IRR = 17.0%
  • 10% down (hard to get for investment deals): IRR = 11.7%
  • 25% down (being required more and more for investment deals): 9.0%

Wow, this really illustrates why 0% down was so lucrative back in the old days.  You could nearly double your IRR by not putting anything down. In essence your renters would pay everything for you and you wouldn’t have to invest a thing but reap a big return when you sell.

Buying it out right

So many people like to pay-off their rental properties quickly, and then think they have a wonderful investment. That is a lot like putting 100% down or just paying cash. What is the IRR then?

  • 100% down (pay cash): IRR = 6.0%

So all else being equal, if you pay for cash for the property, your return on investment is a low 6%, nearly half of what you what have gotten with 20% down and a third of what you would have gotten with 0% down.


Frankly, from my perspective, the risk posed by fluctuations in property value are quite substantial.  So I would want to see an investment return of at least 9%. That means I should pay no more than 25% down, and not pay off my mortgage early. In addition, I should try to make sure I am able to increase rents over time.

I am still mulling this one over and will keep you updated as it evolves.

Image by TheTruthAbout

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Across my and my wife’s various investment accounts I recently instituted a new portfolio allocation.

The concept here was to be:

  • Well diversified across multiple asset classes (8)
  • Have a good representation of international stocks (20%)
  • Slightly more conservative approach by weighting bonds heavier than I have done in the past (30%)
  • Not invest in asset classes I currently consider overheated – delay that investment until prices come down: this means currently avoiding investing in gold, although I do want to invest in that once the gold price cools down

Source of inspiration for my approach was the book The Intelligent Asset Allocator by William Bernstein, one of the best books on the subject IMO.

As you will notice, we have all our account with Vanguard. I am a huge proponent of investing in indexes vs. mutual funds, and therefor prefer Vanguard to most all other providers.

And here is my portfolio:

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Yesterday the market took a major nose-dive – whether computer glitch, gremlins or human error was the cause isn’t quite clear yet.

Some of the trades that happened during that very scary nosedive were canceled after the fact. However, the vast majority were not. So if you owned shares in P&G and had a stop-loss order, you may have lost up to 37% of your investment.

What is a stop-loss order?

A classic stop-loss is a kind of insurance you can use with your stock investments. You can set a “panic” threshold so if the price of your stock drops below the threshold, your holding in that stock are sold at, theoretically preventing you from incurring even greater losses.  E.g. if you own Goldman Sachs shares, that trade for $150, you could set a stop-loss at $130. If the price drops beneath $130, your shares are sold. Traders often use stop-loss orders as a kind of insurance against a stock tanking in a big way while you are not paying attention.

However, a stop-loss order can also ruin your day.

It is important to understand how a stop-loss order works. A stop-loss order is a dormant order that is converted into a market order when a price threshold is met. This does NOT mean you are guaranteed that the stock will sell for your stop loss price. Instead, it well sell at the next best price. That may be your stop-loss price or a couple cents below it. It may however sell for far less than your stop-loss price. In the case of P&G, Apple, Sam Adams and a bunch of other stocks yesterday, the best next price may have been far below your stop-loss price. Sam Adams for example went from $56 to $0.01 in a heart-beat. If you were unlucky your converted stop-loss may have sold at the very trough of that decline. In the case of Sam Adams, the SEC decided to undo the trades, but for P&G and others, people weren’t as lucky.

What does this mean to me?

Stop-loss orders tend to do fine with high-volume stocks – there are enough trades happening so that prices evolve more smoothly, and that your sell price will be close enough to your stop-loss price. However in low-volume stocks prices tend to move in jerks they only move when bid and ask prices meet, so the risk that your sell price will be far below your stop-loss price is much higher.

So know that using stop-loss with random small stocks is risky.

Next, you could use a stop-limit order. This means that your stock sell order is triggered when a threshold is met – same as a stop-loss order – except you choose a limit price. This means that the stock is sold for a minimum price, typically your stop-price. This means the stock only sells if price is above the limit. If the price is in free fall, no-one will offer a price greater than the stop price that the price just rocketed past, and you end up not selling your shares – no-one offered you a price that met your limit.

So both stop-loss and stop-limit orders are helpful insurance policies, esp. for large stocks, but they are not fool proof and can end up hurting you bad if the market or your stock tanks.

Buyer beware!

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How much should I save?

One of the toughest questions you need to answer – regardless of your income – is how much of your income you should save?

5%? 10%? 50%? What is the right answer? If your “hard” expenses are close to your net income, you won’t have much choice in the matter, but if dialing your “fun” spending up or down moves your savings rate a lot, you should take a look at the graph below.

This is a simple analysis I ran to see how many years it would take assuming a fixed savings rate, inflation and investment return rate to build up a nest egg that exceeds 20 times of your annual net income adjusted for inflation. Why 20 times your net income? Well, that is a reasonable rule-of -thumb value for a retirement nest egg that has a good chance of not running out of steam before you do.

This graph shows that saving early and a lot is a good thing.

Under a moderately conservative scenario of 2% inflation and 8% pre-inflation investment return

  • Saving 10% of your net income per year will take you 44 years to save up that 20x income nest egg
  • Saving 40%, will take you 23 years
  • Saving 60% will take you 18 years
So if you can only save 10% of your income, you better start at 21 so that you hit the magic number by 65. But if you have an higher income, cranking up your savings from 40% to 60% by reigning in your expenses, would allow you to retire 5 years earlier.
What is the right answer? That depends on your goals and circumstances. But think about it carefully…

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