Principles of Financial Intelligence      

I.  How does money relate to civil society?
    A. Well, it is not really about money--it is about assets, and liabilities, and the stability that comes from long-term investment in a community.
    Money is only a convention, an idea, a way for people to trade on an even basis. 
        1. For example, until very recently, countries in Europe had no easy way to buy and sell between themselves. A German shopper had to convert his local deutchmarks to French francs if he wanted to buy something in France.  And he was at the mercy of several central banks and local intermediaries to provide him this service, with each one of them taking a fee for their services.  Now, with the coming of "modern money", the German can directly carry or send Euros to a French seller, with no intermediaries and no bother about differing rates of value.
        2. In the same way, "money" is used as a transportable item of value for trading hours of work for square meters of land, or an auto, or gold.  Gold also works, but is less "normal."

    B. Civil Society, as I will use it here in the balance of article, will mean a community living mostly in compliance with two primary laws summarized by Richard Maybury.
        1.  Do all that you have agreed to do
        2.  Do not encroach on others' person or property

    C. In these terms, stability comes when there is expectation that there is security because others's behavior can be predicted, trusted, and rewarded.  Without confidence in the future, treasures are kept liquid and easily moved to another place, not invested for the welfare of the community or one's descendents.  Where confidence in the future is growing, there seems to be an:
     increase in affordable housing for lower income citizens
     increase in business opportunities, small business startups, and employment rates
    increase in safety and security
    increase in civic participation for the common good of all
    increase in savings
    increase in sports, arts, and leisure activities
    increase in education at all ages
    increase in outside money entering a community for investment and charity

II. What is financial intelligence?
    A.  Financial intelligence, or financial wisdom, or financial literacy, is the idea that there are solid differences between assets and liabilities, income and expense, saving and spending, wealth and poverty.  This article is an attempt to clarify these terms, and work towards increasing personal and community stability and wealth.

    B.  There are many intelligences, such as those presented by Howard Gardner, not just IQ (intellectual quotient).
    Each of us has  MUTIPLE  types of intelligence, even though we each may have one or two favorites. 
    *Verbal-linguistic--the intelligence of words (mostly written words)
    *Logical-mathematical--the intelligence of numbers and reasoning
    *Visual-spatial--the intelligence of pictures and images
    *Musical--the intelligence of tone, rhythm, and timbre
    *Bodily-kinesthetic--the intelligence of the whole body and the hand
    *Interpersonal--the intelligence of social understanding
    *Intrapersonal--the intelligence of self-knowledge
    *Natural--the intelligence of relating to the natural world

    Gardner stressed how most formal education is focused on the first two types, but that these can all be learned. 

So can Financial Intelligence--the intelligence of how personal property is valued, traded, stored, and increased.  Unfortunately, financial intelligence is usually not learned in formal education, and most people only learn bad habits about finances, and most people trust the wrong people for financial advice.
    For example, this week I was advised to consult a financial planner to analyze my income, my expenses, and my "assets", and to get professional advice on how to become more secure for retirement.  I found a (long) list of certified financial planners and began checking on their credentials and experience.  Very interesting...they were all certified as financial planners, but all were certified in a very narrow range of specialization.  All of them were only credentialed in dealing with artificial assets, that is, pieces of paper that promised potential exchange for something of value.  ( I will discuss this fallacy later on in this document).  None, that is, none of these highly-skilled "professional advisors" showed credentials to give advice on trading in real assets such as real property (land, houses, apartment buildings, etc.).  In their experience descriptions, they only listed work selling insurance or stocks, bonds, or mutual funds. They seem to only have one solution, and they happen to sell that solution.  This is not meant to be disrespectful to the profession of financial advisors, but is illustrative of the need for each of us to learn for ourselves what we need and to go to the specialist able to solve a specialized problem.
That is what I mean by financial intelligence:  for paper assets, go to a paper asset broker; for real assets, go to real assets broker.  And, remember that a broker will sell you their solution and not "the other guys' solution."

For example, look at the return on a stock market investment.
http://www.fidelity.com

Historical Return Scenarios*
Based on a Hypothetical Portfolio of $100,000
     Best Return                   Worst Return
1 Yr.     154.59% Jun. 1933    -65.75% Jun. 1932
5 Yr.     34.7% May 1937    -16.3% May 1932
10 Yr.     20.57% May 1959     -4.44% Aug. 1939
15 Yr.     19.02% Jul. 1997    -0.15% Aug. 1944
25 Yr.     16.81% Dec. 1999    5.56% Aug. 1954
Average Annual Return over 25 years: 10.03%
     
About Historical Return Scenarios
This chart shows the broad market performance during several given market periods.
Performance numbers are based on a hypothetical portfolio with a market value of $100,000.

Market Decline Scenarios with initial Market value of $100,000
              Return          Ending Value
  Aug 1929-Jun 1932    -81.86%     18,136
  Dec 1972-Sep 1974    -39.85%     60,154
  Mar 1981-Jul 1982    -14.09%     85,913
  Aug 1987-Nov 1987    -26.49%     73,506
  Apr 2000-Sep 2002    -40.43%     59,568
         
About Market Decline Scenarios
The market decline scenarios table shows the hypothetical returns for the asset mix
(stocks, bond, and short-term) for five selected stock market declines from 1926 through 2002.

http://www.nationalresidentialinvestments.com/comparing%20investments.htm
Let's take a moment to determine the wealth accumulation potential of savings accounts, investment in stocks & bonds,
and investment in real estate:
 
Savings:   If we invest $40,000 in a certificate of deposit (CD) at 5%, compounded yearly, our investment will grow to $42,000 by the end of year one. $40,000 x .05 = $2,000 interest. $40,000 + $2,000 = $42,000. If interest is compounded monthly, the original investment will grow to $42,046. If it is compounded daily, it will grow to $42,051.

In 15 years, an original investment of $40,000 with interest compounded daily will grow to $84,675.
Would you consider this to be a good investment?

What if the average rate on inflation during this 15-year period was 6%? Adjusting for inflation, the original investment of $40,000 would not be able to purchase as many goods in 15 years as it would today.

Mutual Funds: Now let's invest $40,000 in a mutual fund growing at 10% annually.  Our investment will grow to $44,000 by the end of year one. $40,000 x .10 = $4,000 interest.  $40,000 + $4,000 = $44,000.

In 15 years, an original investment of $40,000 that increases 10% each year will grow to $176,090. As you can see, there is a significant difference in the yield of a mutual fund earning 10% and a CD earning 5%. The increase in yield in this case explains why investors will take on the increased risk associated with stocks, bonds, and mutual funds.

Real Estate:  For this example, we will invest $40,000 (as 20% down) in a $200,000 real-estate investment. The property will be financed using a fully amortized 15-year loan. After payment of the taxes, insurance, maintenance, property management, and mortgage payments, let's assume that the income and expenses of the property break even.  This allows us to focus on the increase in equity that results from paying off the mortgage along with the increase in equity resulting from 5% annual appreciation.

The value of an investment property appreciating at 5% a year for 15 years will grow from $200,000 to $415,786. Let's take a look at the future equity potential of this investment.

  Future value of property in 15 years $415,785
- 7% overall cost of sale  $29,105
- Loan balance        paid in full
= Net proceeds from sale before tax $386,680

Review:  In the above examples we determined that if we invested $40,000 for 15 years, we would be able to accumulate wealth (before tax) in the following amounts:

1) Certificate of Deposit $84,675
2) Mutual Fund $176,090
3) Real Estate $386,680

If we compensate for 6% average inflation per year, then our accumulation at the end of 15 years for our $40,000 investment would show a much different yield for each type of investment!




Traditionally, the stock market has netted investors 4% annually (10% gross return less 6% inflation) over the long haul. Let’s look at an investment of $10,000 in the stock market compared to the same investment in real estate that is held for a period of 5 years. Your $10,000 investment in the stock market will purchase $10,000 worth of stock. That will represent your entire investment portfolio for that purchase.  If you average 10% per year, you will receive a return of $1,000 the first year, and at the end of 5 years, your portfolio will be $16,105. If you sell the portfolio at that point to invest in something else, you will have a capital gains tax of 18% which will net you $13,207. You would have achieved a $3,207 net return on your investment.
 
Now let’s take a look at the real estate investment. First let’s preface with a philosophy I heard a long time ago that made perfect sense. “If you want to
become a millionaire, the easiest way to do it is borrow one million dollars and pay
it back with someone else’s money”.   In a nutshell, that is what you are doing with the real estate investment.   With your $10,000 to invest, you purchase a single
family rental house for $100,000 in a growing market that will appreciate 10% per year.  You now control a $100,000 investment portfolio.  At the end of one year your investment has gone up by $10,000.   A whopping 100% return on your investment. At the end of 5 years, your rental house would be worth $161,051. If you elected to sell it, you would pay off your mortgage balance of $84,249 and closing costs and commissions of approximately $12,884 leaving you with $63,918. If you back out your original investment of $10,000, you would have achieved a net return of $53,918 before taxes!
 
Clearly,  there is no comparison between the benefits of real estate as an investment
vehicle and the stock market. In the example above, you would have the choice of deferring your taxes via the 1031 tax exchange. Further, there are huge tax advantages. You can deduct your maintenance expenses, interest, as well as taking depreciation on the property. In this example, you could have taken a $3,636 deduction the first year on a depreciation schedule of 27.5 years.


http://realtytimes.com/rtcpages/20020211_investment.htm
What Was The Best Investment Of The Past Decade?
by Peter G. Miller


If you were an investor in the 1990s would you have done better with stock or real estate?

No doubt a lot of money has been made with stocks. At the same time, the last few years have been a blow-out on Wall Street. Between dot-coms, cable firms and Enron, predictions that the Dow Jones Industrial Average would one day hit 36,000 now seem far removed. Indeed, the Dow has fallen nearly 15 percent in the past two years, from 11497.12 at the end of 1999 to 10021.50 at the end of 2001.

But what about real estate? Has it done any better?

Speaking before the National Press Club, Fannie Mae Chairman and CEO Franklin D. Raines offered this analysis:


It's January 1990. Three individuals have just received a $10,000 year-end bonus. And they're trying to decide what to do with the windfall.

John decides to invest his $10,000 in the stock market, and being conservative with his finances, he puts the money in an index fund of S&P 500 stocks.

Bill is excited by the possibilities of the Internet and all the new technology companies, so he puts his $10,000 in a Nasdaq index fund.

Mary has never invested in the stock market. But she's tired of paying rent every month with nothing to show for it. So she put her $10,000 down on a bungalow listing for about $80,000.

It's about 12 years later. Assuming they all had to pay for shelter every month, how would you say John, Bill, and Mary did on their $10,000 investment? Who came out better?

Since 1990, the value of the S&P 500 more than tripled. So from his initial investment of $10,000, John made about $22,000, pre-tax.

During the same period, the value of the Nasdaq quadrupled. So Bill's gain was roughly $30,000, pre-tax.

What about Mary? During the same period, home values increased roughly 4 percent per year nationally. At that rate, the house that Mary bought for $80,000 is now worth about $126,000. And if she sold it, she would have a profit of about $46,000. And that gain would be free of capital gains taxes.

"It is extraordinary," said Raines, "that after the longest, strongest bull market in history, the average American built more wealth owning a home than she did in the stock market."

"Most Americans invest and earn more in their homes than they invest and earn from their savings accounts, IRAs, stocks, bonds or other investments," he said.

"During the past ten years, the average stockholder earned $23,000 in the stock market, while the average homeowner earned $44,000 in home equity. Home equity remains the cornerstone of most family wealth."

But even if the returns from stock market investments and homeownership were the same, real estate would still yield a better net result. Why? While profits from the sale of stock are generally taxable, profits of up to $500,000 for a married couple (and as much as $250,000 for single owners) are typically shielded from taxes when a prime residence is sold.

============

by Jon Gresham.  2002.