Rule #1 Finance Blog

With Investor Phil Town

SAFETY NET NATION

BusinessWeek recently pointed out that the major stumbling block in the President’s attempt to privatize a part of Social Security is that Americans across the political spectrum are afraid to take responsibility for investing their own money. They want the government to keep its guarantees in place … even if the rate of return on Social Security is only 2%.

Maybe people just know intuitively that the market has produced a zero rate of return for as much as 37 years (DJIA 1905-1942), in which case 2% guaranteed looks pretty good. But only compared to zero, right? Compare 2% to a 4% T-Bill, which has the same government promise to pay as Social Security, and 2% pales in comparison. Let’s assume a twenty year time period that the market goes nowhere. With $50,000 in Social Security you’ll get back $75,000. Put the $50,000 in a T-bill and you get $110,000. Same exact risk.

So what are people afraid of? Why not take the money and buy the T-Bill? Well, the President isn’t proposing that you put the money in a T-Bill. He’s proposing that you put it in the stock market and participate as an owner in the amazing growth of wealth that good businesses are capable of. He’s right about that. Compare the rate of return between an excellent real estate investment and an excellent business investment over a 30 year time period:

Let’s buy a piece of raw land in Jackson Hole, Wyoming in 1975 for $25,000. At the end of 30 years we sell the place and get $600,000 (pretax). Pretty sweet investment. The annualized compound rate of return on our $50,000 is 11% per year. By borrowing at a low rate you would do somewhat better, but rates got pretty high, so let’s just do a cash on cash real estate deal to keep it simple.

But you’ve got another $50,000 that you want to invest long term, so you study Buffett and Graham and learn what I learned… and discover that you like Walmart and that, in 1975, it was cheap relative to its growth. Nice call. At least as nice a call as buying Jackson Hole real estate. Your $50,000 piece of Walmart grew at 30% a year average, almost triple the growth rate of a great real estate investment and netted you (pretax) … (are you sitting down?) …$130,000,000. And now you know why NONE of the top 30 richest people in America are real estate entrepreneurs. They all got rich owning great businesses. You have to go to #38 to find the first real estate mogul, Mr. Donald Bren. Donald Trump is the next real estate guy on the list and he doesn’t show up until #74.

Sure I picked a huge winner for an example. But then the Jackson Hole real estate example was a huge winner, too. I could have picked Fairfield, IA, where a house bought in 1985 is worth just about the same in 2005. I know. I bought one! During that same time, Buffett compounded Berkshire Hathaway stock at 25%, in which case a $50,000 investment with a well-known genius investor produced a return of $40,000,000. Walgreen, which did 3% less – 22% – got you $20,000,000. (Are you starting to see the earning power of just 3% points of compounded return?) Coke got you only 13% but still you now have $2,000,000. All of these were obviously good companies in the 70’s. At least as obvious as Jackson Hole, La Jolla, Aspen or Scottsdale real estate.

Look at the difference in how you’re living depending on what you choose: Stick with Social Security and you’re trying to live on $75,000. Go for a T-bill and you’re getting by on $110,000. A great real estate investment got you $600,000. And a great business investment got you $20,000,000.

So why don’t you pick a wonderful business at an attractive price and buy it? Because you’ve been brainwashed into thinking that if the fund managers can’t do it, neither can you. But now you’re here reading about Rule #1. And if you’ll keep coming back, I’ll teach you what you need to know, I’ll answer your questions and you will discover that you can do it.

And then maybe I can convince you that the best safety net of all – safer even than a government safety net – is knowledge of how to buy a dollar for fifty cents.