Incentives! One of the key laws of economics.
We act in a certain way because we are incentivised to do so.
So back to incentives…
Generally people don’t turn up to work purely for the enjoyment of so doing, although they might say that they do.
Instead, the primary incentive is usually financial reward.
Some older folk elect to keep working beyond the retirement age for the incentive of keeping active or sociable.
Coles and Woolies offer us shopper-dockets in order to incentivise us to come back to their store instead of another outlet.
Incentives don’t only apply to financial and economic decisions.
In almost every decision humans make we consciously or unconsciously weigh up the incentives of each of our options.
This is the origin of the phrase…
“There’s no such thing as a free lunch”
Let’s take the example of…well, why not the example of an actual free lunch?
Let’s say I’m 21 again (sigh) and I wander down to a pub in Sydney tomorrow (sigh!) and meet a beautiful lady who I find funny and great company.
I offer to buy her lunch next weekend.
Obviously the lunch would not be free for me.
Nope, certainly no free lunch there!
But would it be a free lunch for her?
Her assumption would be that I would be expecting something in return as an incentive (even if that incentive was simply her time and company) and would intuitively weigh up her own incentives.
She’d balance up the mediocre quality of the suggested restaurant, the inane nature of my moribund 21-year-old conversational skills and – the clincher – my woeful requirement for a haircut, before politely declining.
Whether we think about it or not, we weigh up incentives in this way all the time.
Blokes spend more time getting ready to go out on a hot date than they do for a day at the footie due to the incentive of a potential romance.
Even when we are apparently giving something for free such as a charitable donation, we often expect to feel good in return as our incentive.
This is why we choose charities that have a meaning to us and is why I donate to cancer charities in in preference to other deserving causes.
Governments use tax cuts and parking or speeding fines to incentivise us to behave in certain ways, and so on, but can we…
Find a free lunch in investing?
Unfortunately, the law of “no free lunches” also applies to all types of investment and particularly property investment.
Investors who gave money to Allen Stanford thought they’d found a free lunch.
Consistent, high returns with remarkably little volatility!
But they forgot to ask what the cost was.
In this instance, sadly, the cost was one of the greatest frauds ever committed, a gigantic Ponzi scheme which ultimately collapsed.
No free lunch – and the cost many investors suffered of not having diversified was immense.
In The Intelligent Investor Ben Graham cautions readers not to invest in junk bonds.
The incentive is a higher yield but you must always ask: what is the cost?
The cost is a higher risk of the bond defaulting and loss of your capital, which to Graham is unacceptable.
Today, of course, you can invest in a diversified junk bond fund.
Again, a potentially higher yield.
Always ask: what is the cost?
The cost is that by holding a diversified portfolio of junk bonds you can be almost certain that a percentage of them will default.
And the fund manager’s incentive?
The cost is that they will siphon off a percentage of your investment to compensate for their management time and expertise.
Personally I wouldn’t go near bond funds at this stage of the interest rate cycle; others might argue they represent a decent deflation hedge.
Something for nothing
One of the problems in the world today is that too many people want something for nothing.
This is why many leap into trading leveraged CFD contracts or currencies, or buy speculative mining stocks.
They might make some gains but more often end up losing them and back to where they started…or worse.
The incentive of building wealth for a prosperous future has a cost and that is sacrificing luxuries today for a better tomorrow while shunning unnecessary risk of investment loss of capital.
Incentives in property
Similarly, be wary of rental guarantees.
What is the cost of a guarantee?
Is it that the developer wants to sell you a property based upon a multiple of the high rent?
What happens when the rental guarantee ends?
What if you buy a property via a property investment club?
Are they helping you to buy just to be nice?
Perhaps, but you need to fully understand their incentives.
It may be 6% of the property purchase price.
What of the developer’s incentive in this case?
They may be selling via a club because it is a simple way for them to find buyers.
At other times, they may be offloading properties they simply can’t get rid of.
Does that mean that all properties bought via clubs are sub-standard?
Of course not, some might be excellent investments.
You simply need to understand the incentives and the costs and to always do your own due diligence.
The incentive of yield
Property investors today are constantly being lured to invest in regional markets.
The incentives are always listed as the same.
Higher yield to lower your risk!
Higher capital growth! More affordable and “room to grow”!
If anyone had designed a free lunch, this juicy trifecta must be the veritable entrée, main course and dessert.
Might you get both positive cash flow and growth?
Actually you well might if you choose your market well.
But always ask, what is the cost?
Go back to basics.
A yield is high because the market value is low.
Prices are usually low because…demand is low.
A property which is in low demand is a bad investment.
Be especially wary of investing in small cities or towns where there is vast acreage potentially available for new property development – if prices do go up it could become swamped with dwellings and prices may retrace.
The best property investments are those you own forever.
Remember that by investing counter-cyclically in cities which are at the nadir of their cycle investors can get some pretty darned good yields anyway.
If you think you can outsmart the market in today’s climes by getting in and out a mining town with expert timing (materially beating stamp duty, legal fees, sales costs and capital gains taxes) you’re probably wrong.
And remember the law of incentives.
There’s no such thing as a free lunch and always ask yourself: “what is the cost?”