When Maximizing Gains are a Stupid Idea

There are times thinking like an accountant determines how much of your hard-earned money you get to keep and how well your investments perform. Money isn’t the only thing accountants think about either. Time is more important than money by a long shot and plays into the equation every time.

This past week my oldest daughter asked if I would be helping with her tuition for next semester. I lollygagged as I didn’t want to think about it at the time. My daughter persisted, finally mentioning she wanted me to know about her tuition if I wanted to use a credit card to accumulate bonus miles or cash back.

Every year I generate cash and miles equivalents of around $10,000 per year. The whole family knows my love of these bonuses since they are tax-free and nothing motivates a tax guy like a five figure tax-free benefit.

I shrugged at the suggestion of getting another credit card for a bonus. Yes, tuition is nice spend to generate lots of cash back or miles. I did just that earlier this year.  But I didn’t feel like it anymore.

Another credit card with a required spend would be a nice added bonus. However, I only undertake the process when I feel like it. Some days I am in full hack mode and other times I could care less. Since I don’t need more miles and the kitty is full, my desire is based solely on thrill.

It comes down to time. Tracking spending on a certain card takes a small amount of time. The rate of return is high, but I don’t want to do it! Call me a spoiled child (in the comments, please), but there are times my time is worth more than another $400 tax-free.

Earlier this year I went crazy on the system. I used several new cards to generate thousands in cash, free hotels rooms and miles. I hate traveling and business travel will take years to consume all the benefits I amassed this year. Like I said, I went ape.

I also discovered selling tradelines a year or so ago and decided that looked like fun (if not tax-free). After mild research (and a few hiccups) the ride started producing a revenue stream. The numbers were nice, even if taxable income.

Selling tradelines requires more time tracking each card involved and assuring you have at least something on each card involved. It started becoming a pain in the tail real fast. The money wasn’t worth it after a while. (My attitude changes over time. When I stop enjoying the process I go do something else; when my deviant nature bubbles to the surface I am all in. Until it grows old again.)

Danger Zone

There is a danger in the FIRE (financial independence, retire early) community. We tend to research to the nth degree as we seek to maximize results with minimal risk.

But minimal risk may not be acceptable risk! As I went crazy on selling tradelines I ended up with one credit card cancelled. (Don’t cry for me. Plenty more where that came from.)

The danger part of tradelines was wasted time. Owning a business means I have plenty to spend on. Putting a few transactions on a dozen cards started being a real time consumer, however. If I didn’t have a tax practice and blog to manage I might find the time expenditure acceptable.

With tradelines you need to track when an authorized user is added to the card and when to remove them. More time is needed to track your payment so you get paid for the hassle  investment of time.

The money is good, no doubt. Selling tradelines on a few cards can add a few hundred to the mad money account. A dozen cards can reap up to a thousand every month; sometimes more.

A good accountant would milk this thing for all it’s worth. I’m not every accountant.

A bird in the hand is worth two in the bush they say. And they are wrong! Free money from credit cards is a lot of fun, but your time is more precious! I will still harvest tradelines and credit card bonuses when I feel like it, but this is the boy in me playing. It isn’t maximizing results.

Or maybe it is! Picking every bone clean that happens in your path is insanity! Not only is time precious, but what you could do with that time can easily make more. Life is too short to waste on every hack. You must be careful which hacks you pick and choose.

Blood Letting

Harvesting credit card rewards and selling tradelines at least makes you money as long as you don’t increase spending. The real danger comes when you only consider maximizing rewards in other areas of life.

Drugs might provide lots of utility as long as you realize it costs money and a piece of your soul with every purchase/use. An alcoholic drink now and again is fine for most people. But if you get confused with mild stimulants you can get in deep quickly. The jails are full of people who maximized pleasure without concern for long-term consequences.

And now we get to the real risk of maximizing results applicable to everyone in the FIRE community. Every accountant knows (or should know) leverage is the best way to spike results. Public corporations do it all the time. XYZ, Inc. adds a pile of debt, buys back stock and watches earnings per share skyrocket.

Until it doesn’t.

Leverage is a double edged sword with the edge cutting you enjoying the advantage. You see, leverage has a built in cost. Interest is owed on each leveraged dollar, win or lose. Break even is a loss with leverage.

Investors figure this out early on. A thousand dollars can buy $2,000 of most listed stocks. If the stock increases 10%, your return is 20%, minus interest owed on the borrowed money.

Here is where it gets bad. If the investment declines the loss is also magnified! A 10% decline is a 20% loss on your original money, plus interest owed on the borrowed funds.

The worst part is staying power. Everyone knows broad market declines happen. Everyone should know the market always comes back given enough time. When you use leverage you don’t have unlimited time. Interest is accruing every day you have an outstanding balance on the loan. The market can outlast you when you use leverage.

Without leverage, all you need to do is wait. An individual stock might go down for the count. It happens. But the overall market is a reflection of the long-term growth trends of the whole economy. In time the market will reflect the continuing growth in technology, productivity and economic growth.

And only the unleveraged can outlast Mr. Market.

Hidden Leverage

Most people use leverage at a far greater level than what is allowed to buy stocks, bonds and mutual funds.

I can hear your screams of innocents. You don’t buy stocks or mutual funds on margin* (good to hear), sell your tradelines (maybe you should) or use credit cards with or without rewards and bonuses (why not?).

However, I bet you borrowed money at least once in life on an investment virtually guaranteed to lose money: a vehicle loan. Ah, but that’s different, you say. No it’s not, says your favorite accountant.

Leverage is leverage. And leverage accentuates gains and losses. An auto loan creates the same leverage a stock investment does. The only difference is the size of the loan and the guarantee the asset will decline in value.

There is another leverage I bet most readers have used: the mortgage. But how can you afford a home without a mortgage, you protest? You might not. I’m not even asking you to buy your first (or any) home without a mortgage. What I want you to think about is the amount of leverage you are taking on and the potential consequences.

Real estate tends to be a good investment, except for 2008. As bad as the housing market was in 2008 and thereabouts, the only people who lost their home to the bank had a mortgage. Usually leveraged to 100% or more.

Some leverage can be a smart move, but leveraging any asset or investment to 100% or more is begging to have your head handed to you.

Think of it this way. You buy a $100,000 home with $3,000 down. (We will ignore closing costs and other items that muddy the water.) If the value of your new home goes up 3% the first year you doubled your equity in the home. A mere 3% decline and your home has no equity. None. Zero.

In most cases you are okay as long as you are current on your payments. That is a whole different issue. What does happen when you have no equity in your home is it requires you to come to closing with cash to sell the darn place. It removes the selling option for many people.

Massive leverage is common historically in real estate. In my office landlords are the number one group to declare bankruptcy. They are also the same group who has the highest net worth. What’s up with the dichotomy?

It all comes back to leverage. Those who abuse or overuse leverage find themselves in too deep to wiggle. When you lose the ability to move financially you are in death spiral. Even if you survive there will be significant damage done.

The Efficient Frontier

I hear business owners and those willing to cheat on their way to FI brag about a method they discovered to generate massive income and net worth growth. Before the words are out of their mouth I know they read a news article on using leverage to spike returns. The article probably highlighted a major corporation using leverage to maintain and grow returns.

With rare exception it ends badly and our victims need to start over or at least re-walk part of the path toward FI.

Accountants love to talk about efficiency and maximizing returns. And it is true I want you to think like an accountant. But just because thinking like an accountant is a good thing doesn’t mean accountants never have stupid ideas. Abusing leverage is one of these ideas.

I would never, repeat, never recommend a client to borrow funds to invest in the stock market. This includes option strategies to spike investment returns.

(Side bar on options: Options are not bad in and of themselves, but most people use them wrong. I have no problem using an option to buy a stock a lower price and collecting premiums or replacing a sell order with a covered call. However, if you use an option to buy stock you must have all the cash on hand. Otherwise you are only disguising massive leverage. The bad kind.

If you don’t understand options you have no idea what I just said. That’s okay. Someday I’ll write a post on options and the incredible risks to the foolish as well as using options as a hedging tool for your own investments. Stay tuned.)

Back to our show. A car loan is leverage and not the good kind either. I understand a loan is sometimes necessary. When this is the case you must make your leverage a DEBT EMERGENCY! When you have debt on a wasting asset all nonessential spending stops until the debt is gone.

The home mortgage is a bit different. I make exceptions to the rules for mortgaging a property, but only after careful consideration. Once again, remember 2008. It never happens until it does.

If your accountant tells you to leverage your business or investments, take caution. When he (a woman would never recommend such a stupid strategy) explains how leverage maximizes your gains, grab your wallet and run like the wind. Your accountant didn’t lie, but the risk assumed to take such a strategy is insane.

If your accountant, or anyone else, encourages excessive leverage on real estate or business, or any leverage on an equity (stocks, mutual funds, et cetera) position, remember the words of the dearly departed George Carlin:

“Do you know how you can tell if you have a stupid kid? Take him to the curb in front of your house and stand him there. If you come back in two weeks and he is still there you have a stupid kid.”

And a stupid accountant.

* borrowed money