How to BE the Insurance Company

I wrote a few weeks ago that the economics of writing options (i.e. selling options that you intend to let expire or buy back at a lower price) are a lot like those of an insurance company. Yes, there are risks, and insurance companies do take losses from time to time. But those risks can be managed, and — let’s face it — insurance company failures tend to be extremely rare. So long as people are willing to overpay to protect themselves from disasters, insurance will be a profitable business model.

Well, my friend and colleague Lee Lowell picked up the torch and took those comments a little further last week in the Rich Investor. Below is an excerpt from his article. Enjoy!

How to Pull in Cash Just Like an Insurance Company

by Lee Lowell

Do you ever think about all the money you pay to insurance companies each year? I wouldn’t blame you if you didn’t.

I mean, there’s car insurance, home insurance, renter’s insurance, life insurance, medical insurance…

It adds up. We just assume that’s part and parcel of living in the modern world, so we grin and bear it.

Fact is, I’m pretty sure that in your lifetime, you’ll never make a substantial claim from your insurance company. (Here’s hoping!)

Sure, you might get into a minor fender bender or have a leaky roof that can cost a few thousand dollars to fix. And, if that happens, it’s almost a guarantee your premiums will go up.

You’ll fork over even more to your insurance company each year.

But where does all that money go?

Right into the insurance companies’ pockets, and whatever’s left over heads to their shareholders.

Again, insurance companies are insuring you for things that almost certainly won’t happen. They’re banking on low-probability events, and they’re raking in the cash.

I was thinking about insurance when my colleague Charles Sizemore recently answered a question from one of his Peak Income subscribers.

The reader asked Charles’ opinion on whether the timing was right to start buying put options on the Dow Industrials.

Here’s how Charles replied:

As a general rule, I don’t buy options because they’re too speculative for my style of trading.

Due to the time decay of options, you have to get the timing just right to make money buying call or put options.

Some investors choose to buy put options as portfolio insurance. As a general rule, I do not.

I think about it like this: I buy homeowners insurance because my house is a large piece of my personal net worth, and I have no other practical way to hedge the risk of a disaster.

The insurance is expensive, and I hate paying it. It irks me that my insurance company profits off of my fear.

But, again, I pay the insurance because I don’t really have a choice.

Portfolio insurance is different. I have choices.

If I’m worried about a market crash, I can set a stop-loss or simply sell some of my stocks and raise cash.

I don’t need to buy expensive put options that will nearly always expire worthless.

But while I don’t buy put options, I do often sell them.

If done correctly, selling out-of-the-money put options can be a conservative income strategy. Rather than paying insurance premiums every month, I’m more like the insurance company that collects them.

Charles hits the nail on the head.

Over the years, I’ve seen this same question and given the same answer many times. Charles also echoes everything that I’ve been writing in these pages so far in terms of selling put options.

Remember: Insurance companies are insuring you for things that almost certainly won’t happen.

That’s the secret sauce!

But, as Charles says, he pays it because he has no choice.

And that’s true. We have to pay it, right? We just can’t take the chance of being without it if disaster strikes.

What if you could turn that dynamic on its head so that it’s you collecting cash?

I’m here to tell you those same principles are at play when you sell out-of-the-money (OTM) put options – and doing so can bring in lots of money in the process.

How so?

When you sell an OTM put option to someone, you’re collecting their premium upfront (just like insurance companies) while offering them insurance against an event that most likely won’t happen – specifically, a very large fall in the stock price.

But as long as the stock doesn’t fall to the put-option’s strike price (a very unlikely occurrence), you keep the whole premium at expiration.

Take Amazon (AMZN), for example.

It currently trades at $1,880 per share. I recently wrote about how you could get paid upfront premiums – and keep them – as long as Amazon doesn’t fall to $370 per share.

The odds of that type of fall happening? Practically nil.

Still, someone who owns the stock is looking for some kind of insurance against it falling in price, even all the way down to $370.

How do they do that? They buy a put option that allows them to sell the stock to someone else at a price of their choosing.

It’s peace of mind for them. So, they buy the insurance.

Who’s the insurance company in this case? The put-option sellers! Put-option sellers offer the insurance and collect the premiums. And they can do this year-round.

The key to making consistent money from this strategy?

By deciding where the stock is most likely not going to fall to.

It’s a much different concept to ponder. Most stock and option buyers are always trying to figure out where the stock is going.

But put-option sellers are basing their trades on where the stock isn’t going. Huge difference, and the odds are well more in their favor.

Better yet, you can sell these sorts of options on hundreds of stocks each month and collect thousands of dollars in the process.

The key is picking an area where the stock has such a low probability of falling. That’s how you decide which put option to sell.

You’re in complete control. You choose the stock and you choose the strike price level.

But how do you know where a stock most likely won’t fall to?

You do your research just like any other investor. You look at stock charts, you check the stock’s fundamentals, and you use a secret weapon like a probability calculator.

Pick a point where the stock has very little probability of falling to. And then sell the corresponding put option. You’ll collect the premium and if the stock doesn’t fall to that level by expiration, the money is yours free and clear. Wash, rinse, and repeat!

And what if the stock does in fact fall to the level by expiration?

Well, this might be the best part – if you picked a high-quality stock to begin with, that means you’re scooping it up a ridiculously low price. Can you imagine getting your hands on Amazon for $370 a pop? Do you think it’d stay at the level for long?

My best advice for anyone wanting to sell put options: only execute this strategy on stocks that you feel would be great to own at below-market levels.

That way, if you do in fact end up owning the stock, it’s still a win!

In short, stick to your favorites, and stay the heck away from companies you don’t care about.

When you concentrate on selling put options on levels where the stock won’t fall to, you’ll see your win rate skyrocket.

This is how the insurance companies play the odds. It’s about time you did, too.

This first appeared on The Rich Investor.

Tiny Houses, Tiny Wallets

This post originally appeared on The Rich Investor.

My buddy Ari was a self-made millionaire by his early 30s. But he didn’t earn his nest egg the way you might expect.
It seems like most of the young and well-to-do hit the jackpot by writing a popular app or creating a viral YouTube video.
That’s not Ari. For a young guy, he made his money in a surprisingly old-fashioned manner: building an empire of mini-storage units, strip malls and other steady income-producing properties.

(Ari looks old fashioned too, by the way. Despite being a Millennial in his mid-30s, he wears a three-piece suit and wingtips to the office every day. Give him a fedora, and he’d look like my grandfather circa 1940.)

Ari is my go-to “real estate guy,” the person who can reliably give me a boots-on-the-ground account of what’s happening in the property market. So I asked him the other day about the health of the Dallas apartment market. Everywhere you turn, there are cranes and construction crews throwing up towers full of luxury apartments.

“It’s a joke,” Ari deadpanned. “Most barely break even. They’re just looking to sell to a private equity fund and take the money and run.”

That might sound like a flippant answer, but Ari was just getting started.

“This property market is a house of cards, bro. Look at the trend of microapartments. Do you think anyone actually wants to live in one of those? They do it because they can’t afford anything bigger.”

Ari’s phone rang, and that was the end of the conversation. But he left me with some good food for thought.

In case you’re not familiar with them, “microapartments” are tiny one-room apartments of 50 to 350 square feet. Your toilet doubles as living room chair. They’re that small. (I’m only slightly exaggerating.)

Microapartments are billed as a great option for the young and trendy. They are tiny and thus eco-friendly. You’re not cooling or heating a lot of unused space. They tend to be located in urban areas close to public transportation and close to bars and other entertainment options.

All of that sounds great. But again, your toilet is doubling as a living room chair.

And living within walking distance to your job and to your local Starbucks matters a lot less when you can actually afford a car.

I think Ari was on to something.

So much of what is viewed as eclectic Millennial behavior – microapartments, not owning a car, the “sharing economy,” no immediate plans to marry or start families, etc. – has a lot less to do with the fickle preferences of the young and a lot more to do with them struggling to stay afloat financially.

Let’s look at the broader housing market.

Since 2000, the Case-Shiller 20-City Composite Home Price Index is up 111%, and this includes the major collapse in home prices starting in 2006. In most markets, home prices are at new all-time highs.

Average wages, in contrast, have risen a little over 50% in that same period (neither data series is indexed for inflation).
You don’t have to be a math whiz to see that it’s a real problem when housing prices have more than doubled while wages of the would-be buyers of those houses have risen by barely half.

Given this, it’s not surprising that something as ridiculous as a 50-square-foot apartment is now fairly common.
Most of our readers tend to be professionals that are well advanced into their careers, so if you’re reading this it’s pretty unlikely that you’re living in a microapartment and taking the bus to work.

But if you also want to save your children and grandchildren from that fate, teach them to save and invest early. They don’t have to swing for the fences. Regular, disciplined investment into a portfolio yielding 6% to 10% will grow a nest egg quickly, at any age, really.

Investing just $200 per month will grow to a nest egg of well over $30,000 in 10 years if invested at 6%. That number jumps to nearly $40,000 if invested at a 10% annual return.

If you can convince your child or grandchild to start saving like that at age 20, they’ll have plenty of cash on hand to make a nice down payment on a proper house.

I can’t make your kid save. But in Peak Income I can help them (and you) grow their savings steadily and conservatively through some of my favorite long-term income producers.


Competing with the Quants

I was having a drink a while back with my friend and fellow Rich Investor contributor John Del Vecchio, and we were reminiscing about how much this business has changed since we started our careers.

John is a forensic accountant who knows exactly where to look in the financial statements for accounting shenanigans; where “the bodies are buried,” so to speak. I call him the “Horatio Caine of finance” after David Caruso’s character on CSI: Miami. John has the same no-nonsense demeanor.

The late 1990s were a fantastic time to be a short seller. With the internet bubble entering the final blow-off stages, a disciplined forensic account had an almost unlimited supply of short candidates.

But you had to know what warning signs to look for. This often meant spending hours digging through the footnotes of a company’s income statement, cash flow statement and balance sheet.

Back then, John spent 10 hours per day on the LexisNexis database, pouring over every line of a short candidate’s financial statements. And often, it would all be for naught. Not every investigation ended with a perp walk.

Today, John presses a button and his system does the heavy lifting for him in a matter of seconds.

When the system finds irregularities, John still has to roll up his sleeves, put on the green visor, and dig into the books. But his quantitative system saves him hours (if not days) of exhausting research.

And the 1990s weren’t all that long ago. Let’s go a little further back in time.

Benjamin Graham – Warren Buffett’s mentor and the man that invented value investing as a discipline – made a fortune in the 1930s and 1940s by doing painstaking research.

He’d dig through the financial statements and calculate valuation ratios (price/earnings, CAPE, etc.) by hand.

As early as the 1950s, after Wall Street had starting hiring armies of analysts to do the same work, Graham had started to question whether he could still find bargains using his old methods.

By the 1970s, Graham has more or less given up and converted to an efficient market advocate.

Warren Buffett is most famous for owning large positions in household names like Geico and Coca-Cola. But earlier in his long career, Buffett literally walked door to door in Omaha asking little old ladies if they were interested in selling their paper stock certificates to him.

In today’s world of instant stock trading on your smartphone, that seems ridiculously quaint and old timey.

Fundamental investors have flocked to quantitative tools to help them pick through mountains of data faster than their competitors.

Forbes even coined a term for it – “quantimental” investing.

But is more data always better?

That’s a lot less certain. Last week, Bloomberg reported that quant funds are “reeling from the worst run in eight years.” AQR – considered one of the best quant managers in history – is down nearly 9% this year in one of its flagship funds after suffering a miserable June.

There are so many points to be made here, it’s actually hard to know where to start. But here we go…

1. You can’t realistically invest today without using at least some basic quantitative tools.

There are simply too many stocks to research and not enough hours in the day. Not all of us are crunching numbers using computers designed for NASA, of course. But even something as basic as a simple screen or ranking system can narrow your universe to a manageable size.

If Ben Graham were alive today, he wouldn’t be calculating ratios by hand after digging the numbers out of a quarterly report. It’s also highly unlikely he’d be using the same screening criteria that he recommended using in the 1930s.

Graham was a smart guy, and he would have evolved with the times, probably coming up with new ratios we’ve never heard of.

2. You’re never going to be able to compete with the big boys in technology investment. 

The biggest Wall Street banks and hedge funds really do use computers that were designed for NASA and have teams of PhD eggheads to run them. You can’t realistically compete with that, so you have to play a different game.

Look for opportunities in small- and medium-sized companies that the big boys can’t realistically touch. (A large fund can’t take a meaningful position in a smaller company without moving the market.)

3. Beware of false correlations. 

I wrote a couple months ago that butter production in Bangladesh was statistically proven to be the best predictor of U.S. market returns.

Now, this is obviously a quirky coincidence. No rational human being would really believe that dairy production half a world away makes a dime’s bit of difference to the stock market here.

But quantitative investing is full of little traps like these. So before you trade, your screen needs to pass a “smell test.”

If the criteria seems farfetched (seriously, Bangladeshi butter?) it’s likely that you’re mistaking statistical noise for worthwhile information.



Why Would You Live Stream Dental Surgery on Instagram?

My sister-in-law, Malu, is the baby of the family. We love her to death, but she’s a walking stereotype of a millennial.

Well, sort of. She has no face tattoos or stretched earlobes, and I don’t believe she subsists on a diet of avocado toast and LaCroix.

But she’s just now finishing college – at the age of 26 – and is so wrapped up in social media, I’m nearly certain she would go through the cold sweats and seizures of withdrawal if you took her iPhone away.

This is nothing new. We’re used to it. But what I saw last week took even me by surprise.

Malu had an appointment to get her wisdom teeth removed, and my wife was busy at a kiddie birthday party. So, I volunteered to drive her to the dentist.

Midway through the surgery, I decided to peep through the window to make sure everything was under control. I didn’t understand at first what I was seeing. She was awake and had her arm outstretched with her iPhone in hand.

She was live streaming her dental surgery on Instagram.

There are so many questions here that begged to be asked.

Why would you broadcast that? Who would want to watch it? And why on earth didn’t the dentist crank up the nitrous oxide to knock her out and stop that nonsense?

We may never have answers to these questions.

But this incident does remind me of a relevant study I saw published last month.

TD Ameritrade commissioned a survey of 1,500 American millennials aged 21 to 37. More than half (53%) expected to be millionaires someday, and the median expected age at retirement was just 56.

Among the millennial men surveyed, the expected age of retirement was 53. TD Ameritrade didn’t specify whether males with their hair pulled back into manbuns qualified as “men.”

Oh, and it gets better.

The average age at which they expected to start saving was 36. So, apparently, they intend to hoard a lot of cash in a 17- to 20-year window in early middle age.

Good luck with that.

That particular stage of life also corresponds to your child rearing years, and every parent knows your expenses go through the roof when children come along.

So, unless you become an overnight YouTube millionaire (from streaming your wisdom tooth extraction, of course), reaching those financial goals is going to be a challenge.

It’s easy to poke fun at the unrealistic expectations of young(ish) people, though we’ve all been there.

I was in high school and college during the dot-com bubble years and fully expected to be a millionaire long before 30. That didn’t happen. (When I was 10, I also expected to be the started point guard for the Los Angeles Lakers, taking over for Magic Johnson once he retired. That, alas, also didn’t happen.)

Not all millennials are delusional. Fully 28% admitted that they don’t expect to retire at all.

Unfortunately, this is a lot more likely to be realistic.

A different study published earlier this year by the National Institute of Retirement Security found that 95% of millennials were not saving adequately for retirement and that 66% had not saved anything. And roughly half of the millennials with access to a 401(k) or similar plan at work don’t currently contribute to it.

It’s not completely their fault. Millennials really have had a rougher start in life than most of us due to the exploding cost of education, low starting salaries at the beginnings of their careers due to the lingering effects of the 2008 meltdown, and ridiculously expensive housing costs relative to incomes.

If you’re reading this, you’re probably not a millennial. We know the demographics our readers, and chances are good that you’re a baby boomer or a gen-Xer.

But it’s likely that you have millennial kids, grandkids or even younger siblings that are struggling to save and accumulate wealth. Here are a few things you can do to help:

  1. Encourage them – in fact, nag them incessantly – to stuff as much money as they can into their 401(k) plans. At a bare minimum, they should be contributing enough to get the full employer match (generally 3% to 5% of their pay). Ideally, they will get close to maxing out their contributions at $18,500.
  2. If you have the means to do so, incentive them to save by offering to match. For example, for every $5 they put into a savings account, you kick in an extra dollar. This is obviously more appropriate for teenagers or college kids than young adults with careers, but you get the idea.
  3. Teach them the importance of diversified income streams. Yes, the market “always” goes up over the long-term (or at least it has thus far). But if you really do want to retire at 56, you need to have the income to pay your bills.


Can You Trust the Social Security Trust Fund?

Did you see this bit of news recently?

The Social Security Administration announced earlier this month that it would have to dip into its trust fund for the first time in 36 years.

With the Baby Boomers retiring in droves, the Social Security system is now paying out more in benefits than it’s taking in as tax revenue.

And if current trends hold, the trust fund will be completely depleted by 2034.

That sounds bad. Really bad.

But it’s actually worse than you think.

Social Security is dipping into a trust fund that doesn’t actually exist. There is no trust fund.

No, it wasn’t stolen in some Ocean’s Eleven-caliber heist. And no, I’m not a conspiracy theorist who believes it was an elaborate plot by our government to lie to us.

But I’m 100% serious when I say the Social Security trust fund doesn’t exist, nor has it ever existed – at least not in the way you or I would understand a “trust fund.”

Let’s start with the basics.

What is the Social Security trust fund?

The Social Security Administration essentially has two accounts at the U.S. Treasury: The Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund. We’ll call both collectively the “trust fund.”

You and I and every other working American contribute to these funds through our payroll taxes: 6.2% of your paycheck (up to the first $128,400) goes to Social Security, and your employer chips in another 6.2%.

For the past 36 years, tax revenue coming in was greater than benefits going out. The accumulated surplus makes up the trust fund.

That sounds straightforward enough. At its heart, it’s not too different than the way all of us save for retirement.

There’s just one big problem. The surplus cash might go to the trust fund, but it doesn’t stay there. It gets sucked into the current expenses of the U.S. government and replaced with an IOU.

The trust fund’s assets are “invested” in U.S. Treasury bonds, and the cash is used to fund the current expenses of the government.

If you or I buy a U.S. Treasury bond, that debt obligation of the government is an asset to us.

But that’s not exactly what is happening here. Remember, Social Security is the government. So, the government is lending to itself and calling it an asset.

That doesn’t work in the real world.

I can write myself a check for a million dollars, but that doesn’t make me a single penny richer. I’m just shuffling the money from one pocket to another.

So, when I hear that Social Security is having to dip into its trust fund, I roll my eyes.

The so-called trust fund was never more than an accounting trick.

The idea that there was cash set aside for our retirement by the wise mandarins running the government was a convenient fantasy.

Keeping the fantasy alive actually isn’t that hard. If Congress raises payroll taxes, raises the retirement age or finds other stealthy ways to reduce benefits, such as by means testing or tinkering with inflation assumptions, we can rebuild the “trust funds” in a hurry.

For that matter, the U.S. Treasury could create a quadrillion-dollar superbond to prefund the trust fund from now until the end of time, and then promptly lend the money back to itself.

But what difference would it make? It’s all just accounting.

The reality is that the retirement of the Boomers is going to force the government to make some uncomfortable choices.

A current deficit (benefits going out being larger than payroll taxes coming in) means that the money has to come from somewhere else.

That means that taxes go up, other spending goes down or we simply borrow more. None of those options are desirable.

I don’t know about you, but I don’t feel comfortable depending on accounting gimmickry to fund my retirement needs or those of my family.

And, if anything, this just reinforces my belief that you must create your own income streams in order to have the type of retirement you want.

That’s why I started writing Peak Income, my newsletter dedicated this exact idea. Click here to learn more about it.