Saturday, October 29, 2011

Budgeting: Part 29: High Return Investments

"An economics professor and his grad student were walking down the street one day. The grad student notices a $20 bill lying on the sidewalk and says, 'Look! A twenty dollar bill!' The professor replies, 'Rubbish. Markets are efficient. If there were really a twenty dollar bill on the sidewalk, someone would have already picked it up.' So the economist and the student keep walking."

- Old Economics Joke

When people need to cut their budget, they generally start the process by attempting straightforward ideas:

Reductions: "I'll try going out to eat less often."
Eliminations: "I don't need to take a trip this year."
Substitutions: "Maybe I can find a cheaper cell phone plan."

Eventually, however, you will exhaust all the low hanging fruit. If you attempt to hold your budget steady for several years as I suggested in my last article, you will need to continue to make routine cuts in order to combat inflation. It won't take long until all the straightforward cuts have been made. Now what do you do?

High Return Investments

One possible solution is to invest money you have accumulated into high return investments that can return far more than inflation and lower your budget.

Regular readers of this blog may wonder if I've lost my mind, so please allow me to explain. No, I don't mean that there are generic investments open to all where you can plunk down any particular amount of money and have a reasonable expectation of a 20%/year return without outlandish risk.

What I'm talking about is a high internal rate of return (IRR) on a specific project, and believe me, this is no scam. Businesses discuss and implement these projects every day, and in many cases, the returns can be very high - much higher than one could achieve with passive investments in stocks and bonds. However, as you might suspect, there is no free lunch. If the rate of return for a project is very high, there is probably a reason for that. Typically such a project will have the following constraints:

1. It's not scalable.
2. It's a small amount of money.
3. It probably means that you are currently wasting money.

Nonetheless, we can often live with these constraints. These limitations don't mean there isn't money to be made. It just means you can't use one project as a template to make a lot of money over and over again in the same way.

Market Efficiency

There is actually more than meets the eye to the joke at the beginning of this article. I think most people assume that in many circumstances, markets are reasonably efficient. The streets of a major city are certainly well traveled and you are unlikely to find $20 bills lying around on the sidewalk. So why do we find the account humorous? While we're unlikely to find money lying on the sidewalk, it becomes funny when we assume it's impossible. (And by the way, for those of you who love to argue about EMH, keep in mind that efficiency is a ratio, not a boolean!)

So from a practical standpoint, what does this mean to me? It means (both literally and figuratively) that I don't expect to find a $20 bill on the sidewalk as I walk downtown. I also don't spend time looking for them on city streets. And I surely don't buy books that explain how I can get rich by looking for money on city sidewalks. But I do believe it's possible that I can stumble onto them, and if I see them, I'm going to pick them up.

Now where is the most likely place for me to find money on the ground? The most likely place is on my sidewalk on my property. It's the most likely place because I probably dropped it there myself and because other people don't often walk there! So in general, if you're searching for easy money in life, the most likely place to find it is in your own life, in your own home, in your own budget -- not in penny stocks and lotteries and random speculative business ideas. Thus, to find these "$20 bills lying on the sidewalk" means searching your personal budget.

Capital Budgeting

Individuals would be wise to learn a thing or two from the capital budgeting process used by corporations. One of the major functions of any business is to allocate capital efficiently. A business has access to capital through startup capital, (retained) earnings, and issuing new debt and stock. Corporations typically rank their sources of capital from lowest to highest cost, and possible projects from highest to lowest return. They then allocate capital from the cheapest sources of capital to the highest returning projects. This continues until there are no more capital sources that can be deployed to a project with a higher return, or until the company feels they have taken enough debt risk or project risk. This process is called capital budgeting.

One of the most financially productive things you can do is to start integrating capital budgeting into your personal budget plan. Don't simply look at your income and expenses as this fixed table that can only be altered by traditional spending cuts. Start thinking about whether you could spend capital to achieve a higher income or lower expenses. In the short run, capital budgeting may not have much effect, but in the long run, it has the potential to completely dwarf your normal spending cuts.

Corporations often classify their projects as maintenance projects, cost reduction projects, or expansion projects. Maintenance projects simply replace existing things that might otherwise fall apart and cause chaos or loss. These projects are done to maintain the status quo or to reduce risk. Cost reduction projects spend a certain amount of money in order to reduce costs on an ongoing basis. These are usually efficiency improvements, implementations of new technology, better ways of doing business, and so forth. If properly executed, these projects can have a high return on investment relative to their initial outlay. Expansion projects are done to expand into new markets or develop new projects. These projects are used to grow the company.

Individuals have these same projects on the drawing board. Maintenance projects need to be done all the time. Appliances wear out. Job skills become obsolete. Cars die. Everyone is familiar with these projects, whether they are planned or not! Expansion projects are also familiar. Do you want to increase your income? Then you know that you must usually spend money and effort to achieve it. This includes everything from additional education to job search costs to better tools to help you do your work. Lastly, and perhaps least common, are cost reduction projects. These are specific projects where you spend money up front, with the expectation that you will lower your budget by initiating the project.

Sources and Costs of Capital

Unlike a corporation, you can't issue stock to raise capital, and your borrowing costs are likely to be higher and involve more risk. Still, you always have one source of capital - savings. (This is similar to the retained earnings of a corporation.) Now one of the first things you would do in the capital budgeting process is to determine the cost of your capital. So what is the "cost" of your savings? I would suggest that a good rate to use is the opportunity cost of that money. For example, if you think you could be earning 8% in the stock market with that money, then that is the cost of using that savings for something else. This means that the project in question will need to return more than 8% to be viable. While 8% is a relatively high number for passive investments, many specific projects in your personal budget will return more than that.

I would also point out that the "hurdle rate" in many situations is quite low. It pains me to see conservative investors attempt to save 30 or 40 times their spending to achieve retirement withdrawal rates of 2.5% or 3%, while not first attempting to reduce that spending by investing in cost reduction projects that might yield 5%, 10%, or even 20% with little risk. It also pains me to see aggressive investors chasing 20% or 30% returns by dabbling in high-beta stocks, derivatives, and commodities, without first considering whether there are any cost reduction projects that could achieve that level of return with much less risk than speculating in volatile markets.

There have been many articles written about how to invest a medium-sized amount of money, such as a $1,000 bonus or a $3,000 tax refund. While these articles have some good ideas, I'm always surprised that they never seem to mention the possibility of spending that money on cost reduction projects.

Cost Reduction Projects

So what is a typical cost reduction project? Often these sorts of projects will involve tools, education, or insurance. These are what I think of as "enablers" - things that enable you to save money in areas you would otherwise not be able to do so. Enablers are highly personalized to your individual situation and you will have to think outside the box to discover them. Here are a few enablers I have used or have seen friends use:

* Spending money on warranties or roadside assistance programs to allow you to drive an older car.

* Spending money on newer appliances, CFL (compact fluorescent lighting), or insulation that saves you money on your water/gas/electric bill.

* Spending money on a community college course to learn how to cut hair or do routine plumbing or automobile work.

* Spending money on a specialized tool so that even an amateur can do the work.

Be sure not to define these ideas too narrowly. A tool is not always something you purchase from Home Depot, education is not always a college course, and insurance is not always something you buy from an agent. Here are some less traditional examples:

* A friend of mine wanted to tackle a lot of plumbing work himself, but didn't feel he could do it correctly. Because he was a teacher and didn't work during the summer, he offered to help a local plumber free of charge for one month. After his "training", he was able to perform the work he needed on his house by himself. Obviously it cost him time and effort, but not cash, and now he has plumbing skills he can use for the rest of his life. He decreased his home repairs budget this way.

* A few years ago, I wanted to tile our bathroom floor. I read a lot about how to do it, but in the end, I was too afraid that I would mess it up. Instead of giving up, I spent $25 for a 4 x 8 piece of plywood and some tiles. I practiced setting, leveling, and grouting the tiles on the board for a few days. After I had gained some experience and confidence, I was able to move ahead with successfully tiling the bathroom. I saved many times the $25 investment by doing it myself.

A Real Example

If you are reasonably creative, I don't think it will be that hard to think of a number of possible cost reduction projects. What might be more difficult is not to immediately reject them. I think a lot of people (myself included) are wired to dismiss ideas that seem offbeat or have an immediate cash outlay. Let me close with a real example from my own budget.

Several years ago, one of my first cost reduction ideas was to save money by replacing our old toilet. Water costs money, and we had an old 3.5 gpf toilet in our main bathroom. My thinking was that the savings on our water bill might be a good return on investment for a new 1.28 gpf toilet. However, when we got to the store, things did not quite go as planned. First, all the high quality toilets were more expensive than I anticipated. Second, my wife made it clear that only some of these high quality models were aesthetically acceptable, and of course, these models were the most expensive ones. Additionally, when I saw the weight of these toilets, I was afraid I would hurt my back trying to install it.

For a few minutes, I wavered. A new toilet plus installation was more than $350. That's a lot of money. How much could I possibly save on water? It didn't seem worth it. This, however, is exactly the sort of emotional thinking that must be avoided if you are to make cost reduction projects work. A quick back-of-the-envelope calculation showed that the return on investment was still an amazing 18% per year! Hence, we made the purchase, and even though the toilet was a lot better than the old one, it actually saved us money to buy it. It was an 18% investment with little risk. I now routinely look for such investments (and find them), and I believe it's the main reason we are able to keep our budget constant year after year.