MONEY Master the Game: 7 Simple Steps to Financial Freedom (28 page)

When I spoke with Kyle recently, he shared the details of another
asymmetric risk/reward opportunity he had found for himself and his investors. The terms? He had a 95% guarantee of his investment, but if or when the company went public, he had unlimited upside (and he expected massive returns!). But if it all went south, he lost only 5%.

Kyle, like all great investors, takes small risks for big rewards.
Taking a swing for the fence with no downside protection is a recipe for disaster.

“Kyle, how do I get this point across to my readers?”

“Tony, I will tell you how I taught my two boys: we bought nickels.”

“What was that, Kyle?” Maybe the phone was breaking up. “I could have sworn you just said you bought nickels.”

“You heard me right. I was literally standing in the shower one day thinking, ‘Where can I get a riskless return?’ ”

Most experts wouldn’t even dream to think of such a thing. In their mind, “riskless return” is an oxymoron. Insiders like Kyle think differently from the herd. And by defying conventional wisdom, he always looks for small investments to return disproportionate rewards.
The famed hedge fund guru, with one of the biggest wins of the last century, used his hard-earned money to buy . . . well, money: $2 million in nickels—enough to fill up a small room. What gives?

While a nickel’s value fluctuates, at the time of this interview Kyle told me, “Tony, the US nickel is worth about 6.8 cents today in its ‘melt value.’ That means 5 cents is really worth 6.8 cents [36% more] in its true metal value.” Crazy to think we live in a world where the government will spend nearly 9 cents in total (including raw materials and manufacturing costs) to make a 5-cent coin. Is anyone paying attention up there on Capitol Hill? Clearly this isn’t sustainable, and one day Congress will wake up and change the “ingredients” that make up the nickel. “Maybe the next one will be tin or steel. They did this identical thing with the penny when copper became too expensive in the early eighties.” From 1909 to 1982, the penny was made up of 95% copper. Today it’s mostly zinc with only 2.5% copper. Today one of those older pennies is worth 2 cents! (Not in melt value; that’s the price coin collectors would pay!) That’s 100% more than its face value. If you had invested in pennies way back when, you would have doubled your money with no risk, and you didn’t even have to melt the pennies!

I admit it sounded gimmicky at first, but Kyle was dead serious. “If
I could take my entire cash balance of my net worth and press a button and turn it into nickels, I would do it right this second,” he exclaimed. “Because then you don’t have to worry about how much money they print. The nickel will always be worth a nickel.” And his cash would be worth 36% more—and like pennies, likely 100% more in the future, as soon as the government inevitably cheapens the nickel’s recipe.

Kyle was more than an enthusiast. “
Where else can I get a thirty-six-percent risk-free return!
If I am wrong, I still have what I started with.” Sure, it’s illegal to melt down your nickels (for now), but the point is, “I won’t need to melt it down because once they change the way they make the nickel, the old nickels become even more valuable than before because scarcity sets in as they begin to remove them from circulation.”

Needless to say, his boys got the lesson as well as a good workout moving boxes of coins into their storage unit!

Now, you might be thinking, “Well, that’s great for Kyle Bass, who has millions or even billions just to throw around, but how does that apply to me?” Surely it can’t be possible for normal investors to have upside without the downside—to have a protection of principal with major upside potential.

Think again.

The same level of financial creativity that has propelled high-frequency trading (HFT) from nonexistent into a dominant force in just ten years has touched other areas of finance as well. Following the 2008 crash, when people didn’t have much of an appetite for stocks, some very innovative minds at the world’s largest banks figured out a way to do the seemingly impossible:
allow you and me to participate in the gains of the stock market without risking
any
of our principal!

Before you write this notion off as crazy, I personally have a
note,
issued and backed by one of the world’s largest banks, that gives me 100% principal protection, and if the market goes up, I get to keep a significant chunk of the gains in the market (without dividends). But if the market collapses, I get
all
my money back. I don’t know about you, but I am more than happy to give up a percentage of the upside in exchange for protecting myself from stomach-wrenching losses on a portion of my investment portfolio.

But I am getting ahead of myself.

We have come to a point in the United States where most of us feel that
the only option for us to grow our wealth involves taking huge risks. That our only available option is to white knuckle it through the rolling waves of the stock market. And we somehow take solace in the fact that everyone is in the same boat. Well, guess what? It’s not true! Not everyone is in the same boat!

There are much more comfortable boats out on the water that are anchored in the proverbial safe harbor, while others are getting pounded in the waves of volatility and taking on water quick.

So who owns the boats in the harbor? The insiders. The wealthy. The 1%. Those not willing to speculate with their hard-earned money. But make no mistake: you don’t have to be in the .001% to strategize like the .001%.

WHO DOESN’T WANT TO EAT THE CAKE TOO?

In the investment world, having your cake and eating it too would be making money when the market goes up but not losing a dime if the market drops. We get to ride the elevator up but not down. This too-good-to-be-true concept is so important that I have devoted an entire section of this book to it: “Upside Without the Downside: Create a Lifetime Income Plan.” But for now, this brief appetizer below is designed to dislodge your preconceived notions that you and all of your money must endure the endless waves of volatility. Below are three proven strategies (explored in more depth in section 5) for achieving strong returns while anchored firmly in calmer waters.

1. 
Structured Notes.
These are perhaps one of the more exciting tools available today, but, unfortunately, they are rarely offered to the general public because the high-net-worth investors gobble them up like pigeon seed in Central Park. Luckily, the right fiduciary is able to grant access for individuals even without large sums of investment capital. So listen up.

A structured note is simply a loan
to
a bank (and typically the largest banks in the world). The bank issues you a note in exchange for lending it your money. At the end of the time period (also called the term), the bank
guarantees
to pay you the
greater
of: 100% of your deposit back
or
a certain percentage of the upside of the market gains (minus the dividends).

That’s right. I get
all
my money back if the market is down from the day I bought the note, but if the market goes up during the term, I get to participate in the upside. I call these notes “engineered safety.” The catch? I typically don’t get to keep
all
of the upside. So you have to ask yourself if you’re willing to give up part of the upside for downside protection. Many people would say yes. These solutions become especially valuable when you come to that point in your life, close to or during retirement, where you can’t afford to take any big losses. When you can’t afford or even survive another 2008.

For those looking to take a bit more risk, some notes will allow for even greater upside if you are willing to take more risk on the downside.
For example, a note available today will give you a 25% downside-protection “airbag.” So the market has to go down more than 25% for you to lose. And in exchange for taking more risk, it will give you more than 100% of the upside. One note available right now offers 140% of the upside if you are willing to absorb a loss beyond 25%. So if the market was up 10% over the term, you would get 14% in return.

So what are the downsides of structured notes? First, a guarantee is only as good as the backer! So it’s important to choose one of the strongest/largest banks (issuers) in the world with a very strong balance sheet. (Note: Lehman Brothers was a very strong bank until it wasn’t! This is why many experts utilize Canadian banks, since they tend to have the strongest financials.)

Next challenge? Your timing could be way off. Let’s say you owned a note with a five-year term, and for the first four years, the market was up. You would be feeling pretty good at that point. But if the market collapses in the fifth year, you will still get your money back, but you didn’t get to capture any of those gains. You also might have limited liquidity if you need to sell the note before the end of the term.

It’s also important to note that not all structured notes are created equal. Like all financial products, there are good versions and bad versions. Most big retail firms sell you notes that have substantial commissions, underwriting fees, and distributions fees; all of these will take away from your potential upside. Accessing structured notes through a sophisticated, expert fiduciary (a registered investment advisor) will typically have those fees removed because a fiduciary charges a flat advisory fee. And by stripping out those fees,
performance goes up. A fiduciary will also help you make sure you own the note in the most tax-efficient way since the tax ramifications can vary.

2. 
Market-Linked CDs.
First things first: these are not your grandpa’s CDs. In today’s day and age, with interest rates so low, traditional CDs can’t even keep pace with inflation. This has earned them the nickname “certificates of death” because your purchasing power is being slowly killed. As I write this, the average one-year CD pays 0.23% (or 23 basis points). Can you imagine investing $1,000 dollars for a year and getting back $2.30? The average investor walks into a bank and is willing to lay down and accept 23 bps. But the wealthy investor, an insider, would laugh and tell them to go to hell. That’s not enough to buy a latte! Oh, and you still have to pay taxes on that $2.30 return—an even higher ordinary income tax rate (as opposed to the investment tax rate), which historically is significantly lower!

Traditional CDs are very profitable for the banks because they can turn around and lend your money at 10 to 20 times the interest rate they are paying you. Another version of the insider’s game.

Market-linked CDs
are similar to structured notes, but they include insurance from the
Federal Deposit Insurance Corporation
(
FDIC
).
Here is how they work.

Market-linked CDs, like traditional versions, give you some small guaranteed return (a coupon) if the market goes up, but you
also
get to participate in the upside. But if the market falls, you get back your investment (plus your small return), and you had FDIC insurance the entire time. Typically, your money is tied up for one or two years (whereas structured notes can be as long as five to seven years). To give you a real-life example, today there is a market-linked CD that pays the exact same interest rate as a traditional CD (0.28%) but also allows you to participate in up to 5% of the market gains. So if the market is up 8% total, you get to keep 5%. In this example, you earned over 20 times the return of a traditional CD with the same FDIC protection! But again, if the market goes down you lose nothing. Keep in mind that rates are constantly changing in this field. Rates may be more attractive at certain times than at others. In 2008, when banks were struggling and looking for deposits, they had a sweetheart deal that my buddy Ajay Gupta, who is also my personal registered investment advisor, couldn’t pass up. The note had
100% principal protection with FDIC insurance. The value was linked to a balanced portfolio of stocks and bonds, and when all was said and done, he averaged 8% per year with no risk!

I must warn you again, however, that accessing these directly from a bank will often incur a host of charges and fees. Conversely, accessing these solutions through a fiduciary advisor will typically remove all the commissions and fees that a retail firm may charge, and thus the performance/terms will be better for you.

3. 
Fixed Indexed Annuities.
Let me be the first to say that there are a lot of crappy annuity products on the market. But in my research and interviews with some of the top experts in the country, I discovered that other types of annuities are used by insiders as yet another tool to create upside without the downside.

Fixed indexed annuities
(FIA) are a type of annuity that has been around since the mid-’90s but have only recently exploded in popularity. A
properly structured
fixed indexed annuity offers the following characteristics:

• 100% principal protection, guaranteed by the insurance company. This is why we have to pick an insurance company with a high rating and a long history of making good on its promises—often a century or more!

• Upside without downside—like structured notes and market-linked CDs, a fixed indexed annuity allows you to participate when the market goes up but not lose if the market goes down. All gains are tax deferred, or if it’s owned within a Roth IRA, you won’t pay taxes on the returns.

• Lastly, and probably most importantly, some fixed indexed annuities offer the ability to create an income stream that you can’t outlive. A paycheck for life! Think of this investment as your own personal pension. For every dollar you deposit, the insurance company guarantees you a certain monthly income payment when you decide to trigger, or turn on, your lifetime income stream. Insurance companies have been doing this work successfully for 200 years. We will explore this strategy in depth in section 5, “Upside Without the Downside: Create a Lifetime Income Plan.”