Free-quent Flyer
Blogger
Access to capital is an interesting dilemma for most people. Financial institutions offer a small number of secured loan products, as far as I can tell for historical reasons: car loans, mortgages, and secured credit cards. Leaving aside secured credit cards, the key problem with car loans and mortgages is that they're secured by the asset they're taken out to buy, and those are depreciating assets (houses and cars). So while they may be useful for buying houses and cars, they're not useful as a means of accessing capital.
You can take out a personal loan, either from a peer-to-peer lender or a bank, but the interest rates on those products are extortionate.
You can also borrow from friends or family, which can be a great way to get low-cost capital.
Besides those options, which are limited, expensive, or personally risky, you can also access capital through saving unspent income, the personal version of corporate "retained earnings."
How to allocate your capital
The current fad in designing an investment strategy/asset allocation is to ask in a variety of ways, "what is your tolerance for risk?" People with higher tolerance for risk (and long investment horizon) are assigned a riskier asset allocation with the hope that they will earn a higher investment return (and if they don't, well, they're the ones who said they had a high risk tolerance!). People with a lower tolerance for risk (or short investment horizon) are assigned to safer assets that are expected to have less volatility, but lower returns.
A different investment strategy would be to ask, "what is my desired investment outcome?" You might say something as simple as: "I want $1,000,000 in assets by the end of 2036." Then you can think about how to get there: you can save $50,000 per year for the next 20 years in a savings account with negligible interest. You can save $40,000 per year at 2.08% APY compounded annually. You can save $17,000 (deductible workplace contribution limit) per year at 9.44% APY compounded annually. You can save $5,500 (IRA contribution limit) per year at 18.39% APY compounded annually. (All figures calculated with this pretty crappy compound interest calculator: http://www.moneychimp.com/calculator/compound_interest_calculator.htm).
The point is simple: the more money you save, the lower an interest rate you can afford to earn. Meanwhile, the higher an interest rate you can earn, the less money you have to save.
Subtracting the cost of capital
If you're investing unspent income, your cost of capital is logically 0%. If you're investing borrowed money, however, your investment returns are decreased by the amount you have to pay your lender for their money. If you're investing $40,000 per year that you've borrowed at 1% APR, you need to earn not 2.08% to reach a goal of $1,000,000 in 20 years, but 3.08% — the same 2.08%, plus the 1% cost of capital.
What if your cost of capital is negative? If you're investing $40,000 per year that you've borrowed at -1% APR, you need to earn not 2.08%, but just 1.08% APY in order to reach the same goal. Alternatively, you can continue investing at 2.08% APY, but invest just $35,811 instead of $40,000.
If you're trying to meet an investment objective, rather than accumulate as much money as possible, then lower, safer returns should be preferred to high, riskier returns: 1.08% guaranteed returns are preferable to 2.08% risky returns if you are still able to meet your investment goals.
Find your true cost of capital
In this framework, if you don't know your cost of capital, you can't make appropriate investment decisions. You'll either take on more risk than necessary or save more money than necessary. Now, travel hackers are generally a risk-seeking, upper-middle class bunch, so "investing too aggressively" and "saving too much money" may sound like good problems to have, or not even problems at all.
But that's not right: increasing the riskiness of your investments also increases the chances of a permanent loss of capital, which can lead to a permanent decrease in your quality of life. You should take the smallest risks you can afford to take, consistent with your investment goals!
Ironically, that means being more aggressive with manufactured spend and other methods of receiving negative-interest-rate loans from banks. Investing capital borrowed at negative interest rates decreases the amount of risk you have to take with your capital and increases your chances of meeting your investment goals.
You only get one lifetime of savings and investment. Minimizing the risk of loss consistent with your investment objectives should be your first priority when allocating capital. Very cheap access to borrowed money, combined with a moderately safer asset allocation, increases your chances of meeting your investment objectives and reduces the risk of permanent loss of capital.
You can take out a personal loan, either from a peer-to-peer lender or a bank, but the interest rates on those products are extortionate.
You can also borrow from friends or family, which can be a great way to get low-cost capital.
Besides those options, which are limited, expensive, or personally risky, you can also access capital through saving unspent income, the personal version of corporate "retained earnings."
How to allocate your capital
The current fad in designing an investment strategy/asset allocation is to ask in a variety of ways, "what is your tolerance for risk?" People with higher tolerance for risk (and long investment horizon) are assigned a riskier asset allocation with the hope that they will earn a higher investment return (and if they don't, well, they're the ones who said they had a high risk tolerance!). People with a lower tolerance for risk (or short investment horizon) are assigned to safer assets that are expected to have less volatility, but lower returns.
A different investment strategy would be to ask, "what is my desired investment outcome?" You might say something as simple as: "I want $1,000,000 in assets by the end of 2036." Then you can think about how to get there: you can save $50,000 per year for the next 20 years in a savings account with negligible interest. You can save $40,000 per year at 2.08% APY compounded annually. You can save $17,000 (deductible workplace contribution limit) per year at 9.44% APY compounded annually. You can save $5,500 (IRA contribution limit) per year at 18.39% APY compounded annually. (All figures calculated with this pretty crappy compound interest calculator: http://www.moneychimp.com/calculator/compound_interest_calculator.htm).
The point is simple: the more money you save, the lower an interest rate you can afford to earn. Meanwhile, the higher an interest rate you can earn, the less money you have to save.
Subtracting the cost of capital
If you're investing unspent income, your cost of capital is logically 0%. If you're investing borrowed money, however, your investment returns are decreased by the amount you have to pay your lender for their money. If you're investing $40,000 per year that you've borrowed at 1% APR, you need to earn not 2.08% to reach a goal of $1,000,000 in 20 years, but 3.08% — the same 2.08%, plus the 1% cost of capital.
What if your cost of capital is negative? If you're investing $40,000 per year that you've borrowed at -1% APR, you need to earn not 2.08%, but just 1.08% APY in order to reach the same goal. Alternatively, you can continue investing at 2.08% APY, but invest just $35,811 instead of $40,000.
If you're trying to meet an investment objective, rather than accumulate as much money as possible, then lower, safer returns should be preferred to high, riskier returns: 1.08% guaranteed returns are preferable to 2.08% risky returns if you are still able to meet your investment goals.
Find your true cost of capital
In this framework, if you don't know your cost of capital, you can't make appropriate investment decisions. You'll either take on more risk than necessary or save more money than necessary. Now, travel hackers are generally a risk-seeking, upper-middle class bunch, so "investing too aggressively" and "saving too much money" may sound like good problems to have, or not even problems at all.
But that's not right: increasing the riskiness of your investments also increases the chances of a permanent loss of capital, which can lead to a permanent decrease in your quality of life. You should take the smallest risks you can afford to take, consistent with your investment goals!
Ironically, that means being more aggressive with manufactured spend and other methods of receiving negative-interest-rate loans from banks. Investing capital borrowed at negative interest rates decreases the amount of risk you have to take with your capital and increases your chances of meeting your investment goals.
You only get one lifetime of savings and investment. Minimizing the risk of loss consistent with your investment objectives should be your first priority when allocating capital. Very cheap access to borrowed money, combined with a moderately safer asset allocation, increases your chances of meeting your investment objectives and reduces the risk of permanent loss of capital.