I’ve been thinking about advice lately, about advice I’ve been given, or that I’ve given to other people. Or just things that I’ve said that I think people might take to heart and act on. I’ve started thinking that little tidbits of advice and rules of thumb really do no good. And I’ve come to the conclusion that you shouldn’t take anything anyone says to heart – even what I’m writing now – without first thinking about it for yourself. Let me explain.
The most important question I think anyone should ask themselves when they read or listen to anything from someone else is: “Is this true?” I think it should even be asked when you say or write something yourself.
Asking this question will eventually, after some practice, have you automatically evaluating why what you are being told might not be true.
I think this is one of the first steps in learning to learn. The way I see it, we don’t often learn things the right way – we want quick answers to things: rules of thumb, sound bites of advice.
Let’s run through an example, and let’s use financial advice, because (1) I like finance, and (2) I think bits of financial advice are often the most heinous of all forms of advice. People are inundated with so much silly financial advice, and they make ridiculously important decisions based on this poor quality advice. Here’s one: your home is your most valuable asset.
Wow, doesn’t that sound great? It’s short, sweet, and so easy to understand. It just brings to mind thoughts of sitting around a warm fireplace, or eating steak at your nice dinner table. Or lounging out in the sun in your backyard deckchair.
Great. Wonderful. Except that none of the feelings you just had above have anything to do with assets, which is what that advice says. Yet those feelings may have a whole lot to do with purchase decisions. So, “is this true?” Well have a seat (if, for some reason you aren’t already), and let’s figure it out.
First of all, an asset is something that, in expectation, produces cash flow for you – now, sometime in the future, periodically, indefinitely, or for a finite number of periods, or some combination of these. By contradiction, a liability is something that consumes cash flow in expectation. So is a house an asset?
By this definition (and right now you should be asking “is this true?”) I’d have to admit that yes, houses are assets. If you bought a house today, you could undoubtedly sell it in the future and it would generate some cash for you. Hopefully more cash than what you paid, since that’s kind of the purpose of assets (but in reality, it depends on the price you paid to buy it in the first place).
Ah, but is it a valuable asset. Here’s where it gets fun. From a purely financial standpoint, for a house to be valuable to you, you must obtain more cash from it in present, discounted dollars than you pay for it today. If you don’t like math, now’s your last chance to run away.
Since we’re talking about the house you’re going to live in, I’m going to assume you aren’t renting it out. You pay some money today to buy it, and you sell it at some time in the future down the road. Supposedly to live in a new house, and hopefully not on the street.
So say you buy a house for $300,000 today, and in 20 years you sold this house for $600,000. If your sole goal was to outpace the rate of inflation (say, 3%), so that you preserved your purchasing power, then you did just that and you made money. Had the house instead appreciated to only $542,000, then you were no better off than the day you bought it – the money you spent on that house can afford you the same number of cheeseburgers today as it will buy in 20 years. But by selling it for $600k, you created $32,000 in value in today’s dollars. Since we’re using inflation as the opportunity cost (discount rate), this means you can now afford more cheeseburgers in 20 years.
“Is this true?” Why yes! But only if you bought that house in cash. Well you did, right? You didn’t? Oh. Well of course not, nobody does that these days. You took on debt – a mortgage.
Now a bank is in the business of making money (in fact, most businesses are really just in the business of making money, if you think about it – but money is especially a bank’s business). So let’s say this mortgage costs you 5% (the interest rate). It has a 20 year term, over which period inflation is 3%, and you buy the home for $300,000, selling it for $600,000 in 20 years. Let also assume that you just make annual payments (the answer is roughly the same for more practical payment frequencies, but this makes my spreadsheets shorter). You make a 20% down-payment.
So, the price you paid today is $300,000 with $60,000 down and $240,000 in debt. If you crunch the numbers on this one, you’ll find that the present value of the mortgage payments you make are negative $287,000, and the present value of the home when you sell for $600,000 is $332,000. Thus, the value this transaction creates is negative $14,000. To break even on all the interest you’re going to pay, you’d have had to sell the house for $626,000, meaning it has to appreciate at 3.75% per annum. “Is this true?” Easy, make a spreadsheet and try it. If the house had appreciated at 3% per annum (perhaps a more likely scenario) instead, the transaction would create -$47,000 in value.
So there you have it, given the assumptions above, a house is not always a value-creating asset. And this doesn’t even consider costs like moving, bills, etc… Excluding these, in order to break even, the house will have to appreciate at a rate somewhere between inflation, and the interest rate on your mortgage. The somewhere depends on the down-payment you make and the mortgage payment frequency. But can houses appreciate at above the rate of inflation for the long-term (“is this true?”)? I don’t know for sure, but I wouldn’t bet on this. Inflation is related to income, as are home prices (you can only buy what your income can afford you). Can two things with the same economic driver both diverge indefinitely?
However, it happens to be that both renting and owning a home may both be value-destroying activities, it’s just a matter of calculating which is more destructive, and choosing the lesser of two financial evils (“is this true?” build a spreadsheet and prove it!). Of course, there are non-financial reasons for owning/renting a home: because you like it! Ultimately, I personally think people should live somewhere because they like it (and can afford to live there without stretching themselves), not because they want to get rich. But this choice largely depends on one’s other goals in life.
To sum up: it can be pretty dangerous to just agree with something you see or hear without actually having an understanding of the underlying concepts yourself, or without proving empirically that what you’ve learned is correct or not. You can apply this concept to literally any topic you hear about, and believe me you’ll find that examples of misconceptions about the world abound.
Here’s another quick piece of false general knowledge: the flanges on a train’s wheels keep it on the tracks. Right now, you might be thinking: “no way, there’s no way this one can’t be true, come on”. Well it isn’t. Let’s let Richard Feynman do the talking.
Finally, I think you should always make the following assumption about everything you ever read about or learn from someone else: everything in life is far more complicated than it seems. Simple answers to concepts are not adequate in helping you to gain a thorough understanding of something. If you choose to accept a simple answer, always be aware that you run the risk of not knowing what you’re doing, and that you can be burned for this. You ultimately do yourself a disservice when you accept a simple heuristic or rule of thumb as a method dealing with something important – at least until you understand the reasons behind the rule, and in what situations that rule may or may not be true.
Obviously you can’t live your whole life questioning ever little thing about everything – no one has time for this – but I think you should be able to identify what’s important to yourself and what isn’t, and then go about making sure you know the right answers to the more important questions. Think for yourself.
 What I just did to you is called substitution. When most people are asked a difficult question, or hear a concept that is difficult to understand, they (automatically and without awareness of it) substitute the difficult question for an easier one. We’re talking about whether or not your home is your most valuable asset, but the substituted question you might have asked is “would I enjoy owning a home?” I bet you didn’t even think about the price of the house. If you want to learn more about substitution, which I think you should, I recommend reading Thinking, Fast and Slow , by Daniel Kahneman (2011). In fact, I think if you don’t read this book, to loosely paraphrase Charlie Munger: you might go through life a little bit like a one-legged man in an ass-kicking contest.
 I hope you’ve figured out by now that you can just Google/Wikipedia all the concepts I’m hyperlinking that you don’t understand, because that’s all I’m doing, too. There’s really no secret trick to learning new things.
 $300,000 * (1 + 0.03)^20 = ~$542,000
 $600,000 / (1 + 0.03)^20 = ~$332,000. $332,000 – $300,000 = $32,000
 Everything is discounted at your opportunity cost of 3%, which is the rate of inflation you need to overcome to be able to afford the same number of cheeseburgers tomorrow as you can today.
 $332,000 – $60,000 – $286,000 = -$14,000, or ($14,000) if you’re an accountant. $60,000 is the down-payment (20% of $300,000). By the way, even if the bank was crazy and gave you a 3% loan and the rate of inflation was 3% (essentially the bank is giving you money for free), this home transaction is worth $32,000 just like above – because the money from the bank is free in real-dollar terms. But no bank is going to charge you the same rate as inflation over time. That bank won’t be around for very long.
 Renting something does not guarantee value destruction, even though you build no equity in the thing you are renting. If you think about this long and hard, and you really understand the concept of opportunity cost, you’ll find that there are situations in which renting is quite valuable, and these situation all arise for the same single reason. Ask yourself why a filthy rich person might still lease a car instead of paying for it in cash, or why none of the Canadian banks own the office buildings they’re headquartered in.