Think Like An Investor

I came up with this post after meeting with a favorite client today. She's a charming and intelligent woman with a good career and a 401k who, until recently, had never thought of herself as an investor. Investments were complicated things designed for wealthy people. And then she realized that she wanted to buy a home. Part of our problem with the term "investor" is that too many of us picture this when we hear it:

There is some kind of vague understanding out there that "real" investors have special access to a supply of financial jargon, legal tricks and overpriced cuff links that somehow make sense of those relentless scrolling stock prices on CNN. And let's face it, throwing in tax references (tax-deferred, capital gains, tax efficiency) isn't helping. It's enough to make any reasonable person throw her hands up. And it's no surprise that so many of us, even when we actually have investments, don't think of ourselves as investors.

Watching the determination with which my client approached her goal of homeownership really brought home what we are doing wrong when it comes to investing. Buying a home is a form of investing, but where talk of 401k's and index funds makes people feel overwhelmed and anxious, talk of mortgage calculations and down payments has a completely different effect. People who feel empowered as they approach home ownership. And that's important. Because while I am the first to point out that homeownership isn't a good investment for everyone, the real estate industry has done something right by making clear that every buyer should feel like she belongs at that proverbial homeownership table just as much as any coiffed businessman in navy suit.

Since the great home building boom of the 1950's, Americans have understood that our economy depends on the willingness of  "average" middle-class people to buy homes. But we seem to have forgotten that our economy depends on those same people to hold up everything else, as well,—grocery chains, cars, professional services, restaurants, charities, and yes, stock markets. Because no matter how wealthy our wealthy class gets, they are never going to make, hold or spend enough money to sustain a modern economy (feel free to ask me why "trickle down theory" was a clever illusion).

All of this leaves us with a dilemma. Most of us believe that we are cut out to be investors in housing, even if we aren't quite ready, yet. And we believe (even if we have temporarily forgotten) that we, in fact, are the U.S. economy when we work and when we spend. But we don't seem to realize that we are also the "public" behind publicly traded corporations and the only reason that stock markets are worth tracking. The hard truth is that we depend on these markets to ensure that we have funds to live on after 65 and that we have the money to buy homes (or to help our children buy them). So how do we convince one another to demand a little more clarity around the retirement plans and investment accounts on which we depend? How do we claim our places at this other table?

Are You An Accredited Investor?

I considered calling this post "What The Heck Is An Accredited Investor?" But unless you are hanging out with stock brokers,  you probably don't even recognize the term. That's a problem, because the SEC's accredited investor rule often dictates what you are allowed to invest in and what sort of businesses can afford to ask you for an investment in the first place. The rule has kept our money flowing in certain directions since the aftermath of the Great Depression. And for the first time since then, we are seeing serious efforts made to change it. So what is it and why should it matter to you?

So, are you an accredited investor?

Accredited Investors are the holy grail of ambitious start-ups and private fund managers. If you fall in the Accredited Investor category, the SEC assumes that you can look after yourself (financially, anyway), so many of the careful protections they put in place to keep us all from being squirreled out of our money don't apply to the deals you can make. You would think, then, that you'd have to be very rich or very sophisticated to be an Accredited Investor. The fact is, though, that a lot of well-off but not necessarily "wealthy" people are starting to fall into this category. And it's hard to see where we get the idea that they are all that financially sophisticated.

There are two ways that someone usually qualifies as "accredited":  1. you have at least $1,000,000 in assets (not including your home), OR 2. you made at least $200,000 a year for the past two years and believe you will earn that much next year (the number is $300,000 if it's you and your spouse jointly).  (SEC Reg D, Rule 501).

That first category pulls in quite a few retirees whose pension funds grew over the decades or who inherited retirement funds or property from their own parents. Some of these folks are very sophisticated about money. Most of them probably are not. And while earning $200,000 a year is a great thing, that's not exactly rare or a sign of financial sophistication, either. Sophisticated or not, though, if you are an accredited investor, private businesses, start-ups, hedge funds and other sometimes murky investments are out there looking for you.

Does That Mean I Can Invest In the Next Tech Start-up?

Why, yes it does—maybe. Your Accredited Investor status matters because it means companies can ask you to invest even if they haven't gone through the paperwork and review process that the SEC usually requires in order to sell an investment to the general public.  This can be a very good thing. With SEC public investment filings costing hundreds of thousands of dollars, smaller but equally worthy companies often just can't afford to the process. Limiting themselves to accredited investors means that they still have to follow some basic laws related to what they tell you (and don't tell you), but they don't have to come up with the independent audits and elaborately detailed paperwork. Note, though, that this also means they don't have to make all of that information public for inspection. In other words, it's up to you to make sure you ask the right questions.

What Should I Ask?

You should always ask questions about any investment before handing over your money. But if you are thinking of investing in an unregistered investment as an accredited investor, it's up to you to avoid the Ponzi schemes and the half-baked business plans. You need to ask some extra questions:

1. Who is selling you this thing? Make sure you research the person or company selling you the investment. That might be the company you are investing in, but it might also be an advisor, a hedge fund manager or a broker. Every day the SEC brings charges against people selling fake investments or giving misleading information to investors. Not everyone is caught, but a lot of these names end up on publicly available databases. Start with FINRA's Broker Check site and the Investment Advisor Public Disclosure website to find out more about a broker or advisor;

2. How much will I be charged? A start-up probably won't charge you for giving them money, but a hedge fund definitely will. Be sure you understand any fees you are paying to buy the investment (keep in mind that there might be two layers of fees if there is a broker and a fund involved);

3. How long do I have to leave my money with you? Ask whether your money will be locked in for a period and under what conditions you could sell the investment to get out. Hedge funds almost always require you to leave your money in for a period of time to ensure the manager can follow her long-term strategy. If you invest in a start-up or private business, the only way out will be if someone wants to buy your stake—never a certain event!;

4. How will it make money? Be sure you understand the plan for making money. An investment fund should have a clear, understandable strategy for bringing in returns. A business should be able to show you reasonable (and readable!) estimates for when and how it will make a profit. Make sure you figure in the fees and liabilities to this calculation in case your broker/founder/fund manager doesn't;

5. What can go wrong? If someone tells you there is no risk to an investment, walk away immediately—no such investments exist. Make sure you understand all of the ways your investment could lose value so you can decide how comfortable you are with that risk;

If, after you've asked those questions, you still don't understand something, get an expert. Don't let company representatives, brokers or even your own advisor gloss over the important facts about what you are buying. If the expert in front of you can not make these things clear, or if you are worried that he or she has a conflict of interest, bring in another expert review the materials. Ask an accountant, attorney or financial advisor who is not involved in the deal review the particulars.

For more questions that every investor should ask, check out the SEC's online investor guide.

Is Your House A Home Or An Investment?

Ask this question of just about any American and they will happily tell you that it is both. And why not? From home improvement centers and real estate agents to government programs and tax breaks, the clear message is that it is always better in the U.S. to own a home. The reality is a little trickier, though. And if you plan to use your home as an investment—that is, to actually get additional value out of it at some point in the future—you need to think more clearly about the limitations of living in one of your biggest savings accounts. Here are a few key points to consider:

1. You don't buy a house for the land.

We have a tendency to think that buying a house is somehow a more "stable" investment, as if the fact that we can still touch and see the land means that it's value is not going anywhere. Sure, you can probably still grow potatoes on the land  even if the economy tanks. But let's face it, you didn't pay a quarter of a million dollars so you could grow veggies and no one else is going to either. The value of property, like the value of any other investment, comes from only one factor—what someone else will pay for it at the moment you want to sell;

2. Home values can be just as unstable as stock markets.

Our most recent U.S. Census data shows that median household net worth went up by about 30% between 2000 and 2005 (an increase from $81,821 to $106,585)! This was great news, and it was almost entirely due to the fact that people's home values went up during those years. But when home prices dropped in the 2008 crash, Americans' net value also went down...by about 35% as of 2011. That crash wiped out almost a decade worth of gains, and it left many homeowners with mortgages that were more than the home's value. We haven't all recovered, yet. According to Zillow's 2014 report, 16.9% of U.S. homes were still "underwater" (worth less than their home loans) as of the end of October, 2014. Which brings me to my next point—

3. You can't live in a mutual fund.

Generally speaking, this is a point in favor of buying a home as an investment. Since you were going to pay housing costs anyway, why not put it toward an asset of your own? But if your stock prices crash, you can usually leave them be and wait it out until the market recovers. If your home price crashes and you can't afford your mortgage or you have to move for a new job, you just don't have that luxury. That means you may be forced to "cash in" at the worst possible time, making you a lot more vulnerable to losing all of that money you've put in and possibly more;

4. Your mortgage is someone else's investment.

In our rush to celebrate the great American home-buying dream, we often forget that the reason economists love home buyers is because home owners borrow so much money. Home owners not only tend to take out large mortgages (which can be bundled and sold off into all sorts of investments by financiers), they also borrow more through auto loans, education loans and credit cards because of the sense of safety provided by their home values. It's great for the economy, but it might not be so great for you. If we assume that the average U.S. mortgage is a 30-year fixed rate at about 4.5% interest on a $222,000 loan, then the average home owner is paying a total of about $183,000 in interest for the privilege of being rent-free. This, of course, does not include any of the closing costs, maintenance, taxes and upgrades you choose to do on your home (not to mention the added temptation of new sofa cushions, shelving, curtains, etc...);

5. There's no profit until you sell.

All of us are happy when we get word that our home price has gone up. And thanks to refinancing, we can access some of that money (for a price) by borrowing against the new value. But nothing will change the fact that investments don't make you any money until you sell them, and this applies to your home, as well. If you are counting on the value of your home to help you in retirement, keep in mind that without some creative help from family members, this will mean a reverse mortgage or a sale. And if you choose the latter, you are going to have to find somewhere else (somewhere less expensive) to live.

All of this is not to say that your home in not a good investment. It may very well be! The mortgage tax deduction can offset some of those interest payments, and if you buy in the right time and place you could make a lot of money when it is time to sell. What all of this does mean is that averages will do you no good in determining whether you should by a home. You need to do the calculations based on things like how long you plan to stay in the area, what other resources you have in case of a downturn, what the rental market looks like in your area and what other financial and familial obligations you have.

Most importantly, though, you need to account for the fact that what you are buying is not a house...it's a home. If flexibility, adventure, ease or mobility are what you need at this point in your life, there are probably better investment options for you. If, on the other hand, buying a house ensures that you can keep the kids in school with their friends or that you can finally set down roots in a community, well, that is another kind of investment—one that doesn't come with a calculator but makes a world of difference.

Who Needs an Annuity and Why?

My clients might well be surprised to see this post—I spend a lot of time railing about the over-selling of annuities and the hefty commissions that go to the advisors who sell them. But the annuity has a long, respectable history and can actually be a good financial tool for the right situation. So what is that situation?

First, it helps to know how annuities work. They aren't quite as dreary as they sound. Way back in the 17th and 18th centuries, annuities were a great way for a very wealthy person to fund the retirement of a widow, an artist or a beloved servant. For that matter, they were one of the original prizes in government lotteries. Essentially, an annuity is a contract that gives the beneficiary the right to receive a certain sum of money every month or every year for the remainder of his or her life. Sounds great, right?

There is a little more to it, though. These days, annuities are insurance products. Like any insurance policy, the insurance company has used statistics about people's life spans to predict how much they need to charge you (and how much they could pay to the beneficiary) in order for the insurer to make a profit on the deal. So, for instance, Wholesome Life Insurers, Inc. are happy to sell you an annuity that costs $100,000 up front and pays $20,000 per year to your Aunt Betty for $100,000 if they think she'll drop dead after the second year of payouts.

And there are necessary costs. In addition to paying the people who sell you the annuities, the insurance company needs to pay people to file the required reports, process the applications, run the office, etc... That isn't all, though. In point of fact, your insurance company is hoping to make most of their profit by investing your initial $100,000 until it needs to be paid out. For that, of course, they need to pay investment managers. All of these costs are built into how much the annuity costs you.

So why not just invest the $100,000 yourself and skip the other costs? This is the question at the heart of the matter when it comes to annuities. In most cases, it is cheaper to fund your own (or your Aunt Betty's) annuity. But relying on your $100,000 investment to grown enough that it can pay you back the money you need in retirement is a gamble—a gamble on the investments and a gamble on your lifespan not going longer than planned.

In the Bloomberg article with which I started this series, David Little, Director of the Retirement Income Planning Program at the American College of Financial Services, chose to take care of most of his own investing, trusting that he would do better than the relatively high fees and low returns that an insurer would get. But he also purchased an annuity as a supplement to the investments. The annuity offers him a baseline amount that he will get every month during retirement to prop up his social security benefits in case the investments disappoint or in case he lives to, well, 103.

As Little's plan suggests, annuities make sense in those instances when security matters to you much more than cost. Whether it's being able to insure a comfortable living for your Aunt Betty, or locking in a baseline for yourself, annuities are about covering a basic need—often psychologically as much as financially.

Just one last note on annuities—there is no such thing as a "guaranteed" investment. Make sure you feel as confident about the insurance company you buy from as you do about your choice to buy. If you want to learn more about the types of annuities out there, check out the SEC's online guide to annuities.