High Return Investments

An professor and his student were walking. The student notices €50 lying on the sidewalk and says, ‘Look! €50 on the street!’ The professor replies, ‘Rubbish. Markets are efficient. If there were really €50 on the sidewalk, someone would have already picked it up.’
So both keep walking

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

Reductions: “I will try going out to eat less often.”
Eliminations: “I do not need to take a trip this year.”
Substitutions: “Maybe I can find a cheaper mobile phone contract.”

Eventually, however, you will exhaust all the low hanging fruits. If you attempt to hold your budget steady, you will need to continue to make routine cuts in order to combat inflation. It will not 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 we have lost our mind, so please allow us to explain. No, we do not 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 we are talking about is a high internal rate of return (IRR) on a specific project, and believe us, 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 is not scalable.
2. It is 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 do not mean there is not money to be made. It just means you cannot 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. We 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 €50 lying around on the sidewalk. So why do we find the account humorous? While we are unlikely to find money lying on the sidewalk, it becomes funny when we assume it is impossible. And by the way, for those of you who love to argue about the Efficient-market hypothesis, keep in mind that efficiency is a ratio, not a boolean!

So from a practical standpoint, what does this mean to us? It means that we do not expect to find a €50 on the sidewalk as we walk downtown, both literally and figuratively. We also do not spend time looking for them on city streets. And we surely do not buy books that explain how we can get rich by looking for money on city sidewalks. But we do believe it is possible that we can stumble onto them, and if we see them, we are going to pick them up.

Now where is the most likely place for us to find money on the ground? The most likely place is on our sidewalk on our property. It is the most likely place because we probably dropped it there and because other people do not often walk there! So in general, if you are 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 “€50 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. Do not 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 like restructuring projects, with the expectation that you will lower your budget by initiating the project and lower your fixed expenditures.

Sources and Costs of Capital

Unlike a corporation, you cannot 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? We 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.

We would also point out that the “hurdle rate” in many situations is quite low. It pains us to see conservative investors attempt to save 30 or 40 times their spending to achieve retirement withdrawal rates of 2% 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 us 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, we are 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 we 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 we have used or have seen friends use:

  • Spending money on roadside assistance associations to allow you to drive carefree an older car.
  • Spending money on newer appliances like compact fluorescent lamps or insulation that saves you money on your water, gas or electric bill.
  • Spending money on a community college course to learn how to do automobile or plumbering 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 Amazon, education is not always a college or online course, and insurance is not always something you buy from an agent. Here are some less traditional examples:

  • A friend of us wanted to tackle a lot of plumbing work himself, but did not feel he could do it correctly. Because he was a teacher and did not 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, friends wanted to tile the bathroom. They had read a lot about how to do it, but in the end, they were too afraid that they would mess it up. Instead of giving up, they spent €25 for a piece of plywood and some tiles. They practiced setting, leveling, and grouting the tiles on the board for a few days. After they had gained some experience and confidence, they were able to move ahead with successfully tiling the bathroom. They saved approximately €3000 from the €25 investment by doing it themselves.

Examples and Workload

If you are reasonably creative, we do not 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. We think a lot of people are wired to dismiss ideas that seem offbeat, have an immediate cash outlay or need some workload. Just think of the examples above. A quick back-of-the-envelope calculation should show you, that the return on investment of the last example was just amazing, with little risk! We routinely look for such investments and find them, and we believe it is one of the reasons we are able to keep our budget constant year after year.


2 Responses to High Return Investments

  1. All my real estate investments were as result of inefficient markets. Buying when no one else was buying made a lot of sense to me. To others, they could not see the future and realize that housing was an essential commodity.

Leave a Reply!