Why My Alpha Bias is Towards Entrepreneurship
“Business opportunities are like buses, there’s always another one coming.”
I have run the gamut of investing successes and failures. I’ve had some pretty hairy failures in investing (spec home building, option spread trading) to reasonable success (value cost averaging in index funds and rental real estate investing) to a big hit (co-founding and selling a company). Even though I’m a serial entrepreneur (this is company number five that I have founded, and I’ve worked longer for myself than I have for someone else), I generally like to think of myself as more financially conservative than the average person. In most cases, it doesn’t take much of a loss for me to crinkle my nose and try something else.
Yet, every time I think of ways for my clients to get ahead, I come back to the same set of recommendations and assumptions. I could be clouded in my thinking because I did manage to hit a home run (or at least a long triple) with entrepreneurship, but, for people who have the constitution to do it and the luck to get some traction, starting up a small business is, in my mind, a great way to get ahead.
However, before I get too far into explaining my (obvious) bias towards entrepreneurship, I need to explain a term for readers who might not be familiar with it. The term is called alpha.
Alphas and the Stock Market
Alpha is an investing term that means your investment return on a risk-adjusted basis. If everyone has the same amount of risk, then alpha would explain individuals’ deviations from the average.
The most common usage of alpha is looking at mutual funds. Mutual funds have a benchmark for overall risk – the stock market itself. Investment professionals use volatility as a measure of how much risk you’re taking. That volatility is called beta. So, if you’re in a fund which is twice as volatile as the overall market, your beta is 2, and you should receive twice the return of the overall market to account for that risk. Alpha is a measurement of how far you’ve deviated from that expected return.
The reality with stock market investing is that, if you’re willing to go after very risky options strategies or you’re going to try to catch a penny stock on its way up, and you put all of your money into the investment and get it right, then you could get incredible returns. You’d also probably be exceptionally lucky. There are people who, for example, invested in Apple at its IPO and are sitting on 15,000+% ROIs…for that investment. How many of them risked it all on that investment to get the super outsized returns? Every time you diversify your investments in your chase for improved alpha, you have to get just that much more in returns from a single investment, assuming the rest perform on par with the market or the expected return, to change your life.
While alpha is measured in the stock market, the concept can apply across a broad range of investments.
Let’s take a commonly used example: using a mortgage to buy rental real estate.
The Alpha of Real Estate
Lots of rental real estate investors take out mortgages on their investment properties, and I do not. Because the tax system allows for deductions of mortgage interest, the expected return on a mortgaged rental property, all things being equal, should be higher than one that is purchased outright. I’ll walk you through an example.
Houses A-F are all on the same street and all worth $100,000. They will rent for $1,000 a month, and, since this is imaginary world, they don’t need any maintenance or have other issues, and there are no property taxes (hah!).
Investor 1 and Investor 2 have $100,000 in cash. They are both in a 25% tax bracket, which means that depreciation recapture will net out depreciation taken.
Investor 1 is risk averse and pays cash for House A. He gets $12,000 in income in the year. One year and two days later, he sells house A for $110,000. He has $9,000 in after-tax ordinary income, and $8,000 in after tax capital gains (assuming a capital gains rate of 20%). His return on his investment is 17%.
Investor 2 has a higher risk appetite and doesn’t mind getting mortgages if he can put 20% down on the property. Since they’re rental properties, he doesn’t quite get the sweetheart mortgage deal, but he gets 5% on a 30 year mortgage. He buys houses B through F for $100,000 each, getting an $80,000 mortgage on each of them.
He gets the same rents and makes the same sale. At the time of the sale, his mortgage for each property is $78,819.65, and he’s paid $3,973.17 in interest on each mortgage.
His taxable income on each house was $8,026.83 since he got to write the mortgage off. His cash flow was $7,200.47 per house, although the amount which accounts for the difference went towards principal on the loan.
So, Investor 2 paid $2,006.71 per house in income taxes, compared to investor 1, who paid $3,000. He pays the same capital gains tax on the sale, and when he sells, he gets $31,180.35 back in cash per house.
Let’s look at the results.
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Jason Hull is a Fort Worth fee only, hourly financial planner who serves clients in Fort Worth, TX and Dallas, TX as well as serving clients nationwide.
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