The Stock Market Cash Flow Read online

  When house flippers and weekend-warrior real estate investors speak, they always talk about the houses. They talk about re-habing and foreclosure auctions and such. When I hear professional real estate investors like Kenny McElroy and Robert Kiyosaki speak, it’s almost always about debt, the decline of the dollar, and taxes. They almost never talk about housing! Why? Because a person who buys real estate with all cash is a LONG position in real estate. But a person who uses debt to buy real estate is in a SHORT position on the dollar! Many real estate investors fail to see that other side of the coin! So the fundamentals and technicals of the dollar are as important to them as the fundamentals and technicals of the real estate market.

  Perhaps a better word to use than “sell” might be the word “trade.” When you sell, you are trading something you have for dollars.

  The worst thing that can happen to an investor in a long position is for the item they are holding to lose value. Conversely, that means that the worst thing that can happen to an investor in the short position is that the item could increase in value during the time they have borrowed it.

  Imagine what would happen to our real estate investment if the dollar were to increase in value. That means prices would fall because dollars would have more purchasing power. In a situation where it takes one thousand “weak” dollars to purchase one month’s rent, it might only require five hundred “strong” dollars to purchase one month’s rent. Why? Because a strong dollar has more purchasing power than a weak dollar. Yet the monthly payment for the mortgage remains constant. Thus, a strengthening dollar could place the real estate investor in a position of negative cash flow if he’s using debt as a lever.

  We take a short position in the stock market by simply borrowing shares of stock from our brokerage and then selling them on the open market to receive cash. Once the stock falls in price, we can then buy those shares at a lower price on the open market and then return the borrowed shares to the brokerage and pocket the cash we earned.

  Short positions have their own risks, of course. If you are in a long position and the stock goes to zero, it can be devastating. But if you are in a short position, the stock has no limit on the upside—which could be even more devastating. Remember: if you want to go deep into short positions, then visit my website and view the free online class on short positions.

  Take an Inventory of Your Assets. How Are You Positioned?

  As you ask yourself the question about what kind of money you want to generate from your investments, I recommend looking at your income statement and balance sheet for guidance. Use the understanding you have gained in this book to do your own personal fundamental analysis. Then you will better understand what kind of investments you want and how you want them to change your financial statement.

  How you position yourself in your investments will have a bearing on the numbers in your financial statement based on what kind of investments you acquire. Do you want to grow your net worth as shown on your balance sheet? Or do you want to increase the monthly cash flow on your income statement?

  As you set your goals you might examine where you are currently in terms of your paper assets and whether or not your goals are dependent on capital gains. Are you buying stocks today and then hoping to sell them later at a higher price? Or are your paper assets positioned to deliver steady cash flow month in and month out?

  The long-term strategy of buying and holding stocks or mutual funds is all about hoping for growth. This may help your net worth in the long run if the market accommodates you, but doesn’t provide you with reliable cash flow to add to your income statement every month. Keep in mind the difference between a golden goose and a golden egg. A golden egg strategy is to gather lots of golden eggs and hope the eggs increase in value. A golden goose strategy is to focus on assets to create new golden eggs all the time.

  Obviously, this book is about showing you how you can gain a steady cash flow from the stock market. It’s a different way of using the market to your advantage that your friends and family probably don’t talk about—simply because, in most cases, they just don’t know.

  Go back to those goals you set earlier. You probably set a goal of having steady cash flow every month. Odds are you want at least enough cash to cover all your bills. If that’s the case, you need to set a target number to shoot for every month.

  So let’s determine how to create enough cash flow to pay all of your bills every month. Take a moment and write down that number—the amount you need every month to live on. If you don’t know that number, stop now and figure it out.

  This is your expense number—the dollar amount you need to match or exceed with monthly cash flow to gain your financial independence. This is a much more intelligent way to set your goals for financial freedom than just pouring money into some retirement account and hoping there’s enough there to live on when you reach a certain age!

  Most people use a job to generate the income they need to meet that expense number every month. Go ahead and challenge that way of thinking. That’s what the wealthy do.

  If you can identify your investing goal now, then you can make major progress toward building the cash flow you’ll need to meet that amount. As your monthly cash flow from the market grows, you will rely less on a job and be confident in your own abilities to generate the money you need.

  Imagine how it will feel to free yourself from a 9-to-5 job. All it takes is enough cash flow to replace that employment income and pay your expenses. At that point, you’ll see your life in a very different way. Instead of thinking of retiring in 20 years when you have a big pile of money saved, I want you to focus on increasing your cash flow to the point where your assets give you the passive income that meets whatever number you desire.

  For our purposes, let’s suppose that your monthly number is $10,000. That’s what you need to meet your expenses every month. With that goal clearly set, you can then develop a plan to go out and buy some stock and make $1, and then $10, and then $100 dollars…and then keep building your assets to provide you with income from your assets. As you keep following this plan of building your assets, one day you can have a cash flow of $10,000 a month, or more. Suddenly, you realize you’ve achieved financial independence. At $15,000 in monthly cash flow your lifestyle improves drastically!

  Note that your net worth is not depicted, at all, in the figure above. Why? Because financial independence isn’t about having some massive amount of money in the bank. It’s not about having a huge net worth. Instead, financial independence is about having enough cash flow from your assets to live without having to worry about money.

  The traditional way of thinking about wealth building is to try and have x-number of millions of dollars at retirement—golden eggs. But there is a better way, a more intelligent way. If you develop the skills to acquire income-producing assets, and then continually learn how to make those assets give you more and more cash, then it doesn’t matter what number you are aiming for. At that point, it’s simply a matter of growing your assets to reach the number you want. It’s essentially the same skill focused on a bigger target.

  By thinking about it as a cash-flow goal instead of a net-worth goal, you are fundamentally changing the structure of your financial life. Instead of saving up a lot of money to retire at age 65, you can essentially do whatever you want starting on the day when you have more than enough passive income to cover your expenses. Some people call it early retirement. I call it freedom to live the way we have always dreamed.

  Using Leverage

  In the market, we use contracts to help us gain leverage. These contracts give a person the choice to buy or sell a stock at a set price, or to simply walk away from the deal completely. In the market, this type of choice is called an option.

  We can use an option contract to accomplish any of the three investing goals: capital gain, cash flow, or hedge—or any combination of the three.

  Rate of Return

  Whenever investors put money into an investme
nt, they expect to see their money grow. This growth is called a return, and it’s simply the profit gained on that investment over a certain period of time. Here’s how we calculate it:

  In fancy mathematical terms, we can write it like this:

  (Vf – Vi) ÷ Vi

  Vf = Final value of investment

  Vi= Initial amount invested

  For me, a simpler way to calculate this is to break it up into two simple parts that I can do on a calculator.

  First, I count the money pulled out of an investment and then substract the amount of money put into the investment to start with.

  Money out – Money in

  Then divide by ‘Money in’:

  Money out – Money in

  Money in

  Let’s do an example and start the investment by buying $100 of stock.

  Money in is $100

  Then later on you sell it for $110 and get all your money out of the stock.

  Money out is $110

  To calculate your profit, subtract the money you put in ($100) from the money you pulled out ($110), which gives you a return of $10 on your initial investment.

  To calculate the rate of the return, you simply divide the return ($10) by the initial amount you put in ($100) to get a return of 0.1 or 10 percent.

  When we are comparing the returns of various investment opportunities, the rate of return gives us a good way to evaluate different investments. If one investment generates a return of $300 and another investment has a return of $500, which one is better?

  It’s hard to tell from those numbers alone because we don’t know how much money was initially invested. Seeing the return as a percentage allows us to make apples-to-apples comparisons of different investments.

  Increasing the Rate of Return

  When people who rely on jobs want to increase their income, they must ask their boss for a raise or look for a different job. Investors, on the other hand, can increase their income by growing the rate of return they get from an investment.

  There are two ways to increase the rate of return on an investment:

  1.Have a bigger gain. This looks simple on paper, but in real life it’s not that easy. To double your return, it’s unrealistic to think that you can simply double the money you invest on every trade you make. And since you are somewhat at the mercy of what the market chooses to do, it’s impractical to rely on this approach for a regular boost in income.

  2.Reduce the initial investment amount. Based on the rate of return calculations we just looked at, we can see that if you can find a way to reduce the initial investment as close to zero as possible, then the rate of return can grow very large. In fact, it’s possible to grow your rate of return to infinity.

  Some Amazing Math

  We can see that as we reduce the initial amount of money we risk in an investment the total amount of money we can lose goes down and the potential return goes up. In fact, the ideal amount of money to risk in an investment is actually zero. So what happens to your potential return when the amount of money you put in is zero?

  When I explain this concept of infinite returns to people, I usually get very puzzled looks. Most people believe there’s no such thing as an infinite return. Let’s look at an example to show you how it works:

  Scenario #1

  Initial investment = $100

  Final value = $110

  ($110 - $100) ÷ $100 = 10 percent rate of return

  Scenario #2

  Initial investment = $10

  Final value = $110

  ($110 - $10) ÷ $10 = 1,000 percent rate of return

  Scenario #3

  Initial investment = $1

  Final value = $110

  ($110 - $1) ÷ $1 = 10,000 percent rate of return

  Scenario #4

  Initial investment = 10¢

  Final value = $110

  ($110 - 10¢) ÷ 10¢ = 109,900 percent rate of return

  Scenario #5

  Initial investment = 1¢

  Final value = $110

  ($110 - 1¢) ÷ 1¢ = 1,099,900 percent rate of return

  For all these scenarios, you can see that it is essentially the same investment that grows to $110 for the final value. The difference among the five scenarios is the amount we put in as our initial investment. As we push our initial investment down as low as possible, you can see that the rate of return skyrockets to over one million percent. If we go all the way to zero we get infinity.

  Scenario #6

  Initial investment = 0

  Final value = $110

  ($110 - 0) ÷ 0 = ∞ percent rate of return

  Based on these example scenarios, we can see that it’s theoretically possible to get a huge rate of return on an investment by reducing the initial investment as low as possible. But the logical question we must ask is this: Is it really possible to get into an investment at such a low investment amount? The answer is yes! You can do it by using the principle of leverage.

  The Principle of Leverage vs. Hunting for the “Ten Bagger”

  Some investors spend a lot of time doing fundamental analysis in the hope of finding a diamond in the rough. They dream about buying a stock for just pennies and then having the stock skyrocket in value. They dream about hitting a big home run that sets them up for life.

  Peter Lynch was a famous mutual fund manager for many years with Fidelity. Before his retirement he became known as one of the most successful mutual fund managers in history. I don’t know if Peter Lynch would agree, but I feel that being a mutual fund manager was much easier in the bull market of the 1990s than it is today.

  In the mid-1980s to the mid-1990s there was a huge influx of capital in the stock market because of legislation that incentivized people to dump money into their 401(k)s. Combined with a robust economy and sensationalism about the birth of the Information Age, computers, and the internet, an individual investor could practically throw darts at a list of stocks on the wall and pick winners. Some of these stocks doubled in price. Others tripled. And some even increased ten-fold. In referring to these companies whose stock prices increased by ten-fold, Peter Lynch coined the phrase “ten bagger.”

  Today’s investor can still occasionally run across a ten bagger. But it seems that they’re not nearly as common as they used to be. And in today’s volatile market, stocks that achieve ten-bagger status often struggle to stay at those lofty heights. Like a child’s toy rocket, they tumble back to earth as fast as they were thrust into the sky.

  While it would be nice to think about being able to use fundamental and technical analysis as a crystal ball to tell us which companies are about to become ten-baggers, it’s not really a practical way to become a successful investor.

  Another way to approach this would be to use leverage. Let’s use another real estate example to illustrate this, because it’s so easy to understand.

  Two friends decide they’re going to become real estate investors. The first investor’s name is Mr. Cash. He’s very afraid of going into debt. He doesn’t understand debt very well, so he avoids it like the plague. Mr. Cash purchases a home for $100,000. He puts in $100,000 in cash so he doesn’t need a mortgage. Six months later there is a boom in the value of real estate and someone offers Mr. Cash $110,000 for the house. He accepts the offer and sells the house for $110,000. Now let’s do our calculation:

  Money in = $100,000

  Money out = $110,000

  ($110,000- $100,000) / $100,000 = 10 percent

  The second investor’s name is Mr. Credit. He’s actually just as frugal as Mr. Cash, but he understands how debt works. He has a financial education. He is not frivolous by any means, and he is a man of integrity who keeps his promises. So he has proven himself worthy of being extended a lot of buying power and a high credit score. Because he has a great command of credit, he only needs to put $10,000 of his own money into the home as a down payment and he allows the bank to provide the other $90,000.

  When the market offers him $110,000 for h
is house, he can give the bank back the $90,000 he borrowed and he gets to keep additional $20,000 for himself. Let’s see how his transaction compares to Mr. Cash’s:

  Money in = $10,000

  Money out = $20,000

  ($10,000- $20,000)/$10,000 = 100 percent

  What is so powerful about this simple example is that we began with two homes purchased at the same price and later sold for the same amount of profit. The key point here is to understand that one investor received a 10 percent return on his money while the other investor doubled his money. This illustrates that if an investor can learn how to position himself with leverage, he can receive an extraordinary return on his money based on the same market moves. You are about to see how this can be done in the stock market without using any debt.

  In the case of real estate, professional investors use debt as the lever. But there’s an important distinction to make here. It wasn’t the fact that the investor used debt that created the leverage, but the fact that he decreased his initial investment. If you can find a way to decrease the initial investment required to take control of an asset, you’ve achieved a position of leverage whether you use debt or some other means.

  The options market allows investors to reduce the amount of money required to take control of an investment. A bonus benefit is that this leverage does not require us to take on any obligations of debt. Like debt, many people mistakenly attach a negative connotation to options. But the key is not to approach options with fear, but with respect.