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The theory has proved to be remarkably accurate. When Dow Theory says we’re in a bull market, stocks rise by an average of 35 percent. Dow Theory has made only seven incorrect bull-market calls over the entire 100-plus years of the Dow Industrials. And most of those wrong calls were not wrong by much. When Dow Theory indicates a bear market, stocks lose an average of 6 percent.
At the beginning of this chapter, I said that what I liked most about equity investing in stocks is that you could do it without a lot of active work.
You can’t say that about investing in small private businesses and real estate. Most of the time, you have to monitor, analyze, and often direct the operations and activities of the business. That extra work, though, can bring you significantly greater returns. Whereas 12 percent to 15 percent is the target I set for my stock investments, 25 percent to 100 percent is what I look for in real estate and small businesses.
Let’s talk about real estate.
THE POTENTIAL OF REAL ESTATE
There is sometimes an argument among real estate investors about what’s better: buying and holding properties or buying and flipping them. There are pluses and minuses to each. But there’s no point in arguing. If you want to acquire wealth quickly, you need to do both.
You need to buy rental properties for equity appreciation and buy-and-fip properties for income. This statement may sound confusing to the inexperienced. Aren’t rental properties for income? And isn’t the idea of buying and flipping to take advantage of the increased equity you create?
184 AUTOMATIC WEALTH
SIX STATEMENTS YOU MUST PROMISE YOURSELF YOU'LL NEVER SAY—ESPECIALLY TO YOURSELF
If you hear these words coming out of your mouth, brace yourself for a loss:
1. "It's only $3 a share. What can I lose?" You can lose your entire investment in this stock, same as if you were investing in a more expensive stock.
2. "Eventually, they always come back." As if all companies emerge from bankruptcy filings intact and healthy. Do you remember WorldCom, Enron, Global Crossing, and all the dot-coms?
3. "When it rebounds, I'll sell." When your patience is finally being rewarded and your stock is worth more with each passing day, who's kidding whom? You're more likely to keep it than sell.
4. "What, me worry? Conservative stocks don't fluctuate much."
Even blue chips can get hammered. They're worth at least a little attention.
5. "It's taking too long for anything to ever happen." Stocks that inch their way to higher value can be fine medium-to-long-term investments. A stock that grows 1 percent a month won't dazzle you, but it will make you good money on an annual basis.
6. "Look at all the money I lost because I didn't buy it!" Peter Lynch, who managed the ultrasuccessful Fidelity Magellan Fund and wrote a book about it, titled One Up on Wall Street: How to Use What You Already Know to Make Money in the Market, says this thinking "leads people to try to play catch-up by buying stocks they shouldn't buy, if only to protect themselves from 'losing' more than they've already 'lost.' This usually results in real losses."
Yes and no. Yes, rental properties will eventually give you equity. But this won’t happen—or shouldn’t happen—until you have become financially independent and are ready to shift your lifestyle and investment profile into a retired or semiretired orientation.
While you are building wealth (for the next 7 to 15 years), you should treat your rental real estate portfolio as an equity play. You will
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want to use leverage (by taking mortgages) to get the maximum appreciation on your cash. Remember, if a property appreciates 6 percent a year and it is mortgaged at 20 percent, you are getting, in effect, a 30 percent appreciation (6 percent X 5).
To take advantage of this enormously beneficial, wealth-producing effect, you need to use debt to your advantage—by having each property mortgaged. As your equity increases in each property, you should consider taking some of that money out of it and reinvesting it in other properties.
If you follow this program, you won’t be making any income from your rental properties. And that’s why I am categorizing rental real estate as an equity play.
When your wealth increases and you reduce your debt, income will start coming in. Eventually—and certainly when you’ve reached retirement age—you will want to reduce your leverage by paying down your mortgages. As you do that, your income will increase. Eventually, you may have a very nice income stream from your rental properties.
Buying and flipping real estate—however much it relies on equity appreciation—is an income play. Or at least you can approach it as such during your wealth-building career. You should think about this activity as a sort of business unto itself. You capitalize the business with an initial down payment, and every profit you make from a sale can be plowed back again into the business.
This, again, should be thought of as an income play. And that’s how I’ve arranged it in this book.