The Leverage Equation Page 3

  How To Convert Uncertainty into Opportunity!

  Now that you know expectancy determines the growth of your wealth, let’s switch gears and connect all the logic blocks I’ve shared so far into a single picture that shows you how it all fits together and ties leverage into your wealth planning strategy.

  Expectancy analysis is how you estimate outcomes that are uncertain. The fact that all your investments and business plans to build wealth are a bet on an unknowable future is, by definition, an uncertain outcome. That’s why expectancy analysis is required. It’s the scientific, reliable way to manage the risk of the unknown.

  Expectancy analysis is how you make smart financial decisions when all outcomes are uncertain. It gives you a scientific, rational way to reduce risk and maximize reward using leverage that converts unknowable outcomes into the closest thing to certainty you can get (without a crystal ball).

  The formula is really nothing more than probability times payoff. This stuff isn’t complicated, but it’s counterintuitive because we all think in terms of the odds of something occurring. Introducing payoff to the equation literally changes how you play the wealth building game. Yes, it’s that important. It becomes a two-part, dynamic equation where unlikely events with very large payoffs, either negative or positive, have a disproportionately outsized influence on results.

  Disproportionate results have make-or-break impacts on the compound return equation. The key principle of risk management is to control your plans so you can control outsized negative payoffs, commonly known as losses, from destroying your expectancy, and consequently your wealth growth. Leverage is how you maximize the gains from your winning decisions.

  Designing your wealth plan to maximize gains through leverage while minimizing losses through risk management is how you tilt the payoff portion of the expectancy equation. If you can favorably tilt the payoff portion of the equation enough, then you can still profit even if you lose more often than you win. That’s how you create reliable profits out of unreliable, unpredictable future outcomes.

  Seek large, positive investment returns using leverage so you can win big when you succeed; but learn how to control risk for adverse losses during the inevitable failures by using risk management strategies. (This is taught in a separate book in this series, Risk Management – How To Make More By Losing Less, and it’s also taught in the risk management mini-course found at https://financialmentor.com/educational-products/risk-management-course.) When you shoot for large positive outcomes when you’re right, while controlling risk to small negative outcomes when you’re wrong, you effectively tilt the expectancy equation to result in wealth. It’s literally as simple as that; but of course, the devil is in the details, which is what we’ll get to in the remaining chapters of this book. But your overriding goal for leverage is to tilt the payoff dimension of the expectancy equation, which is the dimension you have the most control over.

  Understanding all the implications of expectancy, and mastering the required skills of leverage and risk management as implied by expectancy analysis, are central to your financial success. It’s the single best way to take back control of your financial life from all the uncertainty inherent in putting capital at risk in an unknowable future.

  I’m sure that’s a mouthful if you’re not familiar with these ideas, but I wanted to give you a step-by-step flow of how the logic connects – from uncertainty about an unknowable future to risk management and leverage strategies that control losses and maximize gains, thus tilting the payoff part of the equation to result in positive expectancy, or wealth growth. Again, here’s the equation:

  Manage Your Payoff To Master Your Wealth Growth

  The counterintuitive realization is that disproportionate payoffs can make you rich if you maximize gains through leverage when you’re right and manage the risk tightly when you’re wrong. Even if you’re wrong 9 times out of 10, or even 99 times out of 100, you can still profit by tilting the payoff portion of the equation. My suggestion is that you highlight that sentence in gold because it explains how you can reliably achieve your financial goals when facing an uncertain future.

  Equally as important, you’ll want to realize how a strategy that produces mostly winning investments can still be a loser with negative expectancy if the average loss is larger than the average win. In fact, many investing strategies are notorious for that problem.

  THE TRAP OF NEEDING TO WIN

  But focusing on payoff is counterintuitive to most people because it’s not how we’re trained to think. I believe it’s a major reason that wealth eludes most people. We all have a natural bias toward winning with high reliability.

  You want to be right. It feels good to win, and nobody likes to lose. We’re taught in school that high accuracy gets an A, and mediocre accuracy equals failure. Nothing below 70% correct is even acceptable, which is absurd. Even worse, many people mistakenly view failure as a measure of self-worth.

  Everyone is looking for high reliability because we’re trained to think in terms of probability, but the percentage of winners versus losers is not the most important factor to your financial success, and it’s the thing you have the least control over. The real key to expectancy is how you control losses and maximize gains – through risk management and leverage.

  It’s irrational to focus on winning versus losing because, as I said earlier, the future is uncertain, so it’s not really within your control. You should always try your best to win, but the reality is: if you play the game, losses are inevitable. It’s just a fact of life when the future is unknowable.

  For example, I lose all the time. It’s a regular part of every week of my life. I never really get used to it because I’m human like everyone else, but I’ve trained myself to accept that putting capital at risk into an unknowable future means that losing is an inevitable part of the investment process and I have to accept that.

  But payoffs are different. I actively manage my payoffs because that’s the part of the equation that’s controllable; and fortunately, the math is clear: if you do a good job of controlling losses, you can get rich relatively easily. It’s just a question of sample size.

  The bottom line is: successful wealth builders are fine with losing more often than they’d like, but they’re very attached to the relative size of those wins and losses because that’s what’s really important to your financial outcome in life.

  Think of risk management as the defensive half of your wealth plan to tilt payoff in the expectancy equation; and think of leverage as the offensive half of your wealth plan to tilt payoff. They each tilt payoff favorably, but in opposite directions.

  When you put both leverage and risk management together in your wealth plan, the net effect is to radically tilt your payoff to such an extreme degree that your success becomes a matter of sample size. It’s not a question of if; it’s a question of when. All you have to do is implement both disciplines with persistence.

  IN SUMMARY

  Mathematical Expectancy can be somewhat counterintuitive because most people are conditioned to think in terms of probability, not expectancy. Expectancy is probability times payoff, and adding that payoff component to the equation changes everything.

  Your wealth compounds according to expectancy, not probability. Introducing the payoff component to the equation emphasizes the essential role that risk management and leverage both play in your wealth growth. Risk management minimizes losses, and leverage maximizes gains. Together, they can create positive expectancy and wealth growth even if you lose far more often than you win (low probability of success).

  Payoff is particularly important because the future is unknowable, so controlling probability is difficult. You can guesstimate probability, but it’s ultimately unknowable. However, you can control payoff.

  Smart wealth builders focus on those things they can control so they can produce a predictably profitable outcome regardless of circumstances. Mathematical expectancy gives you the framework to achieve that object
ive, and leverage is the tool you use to create large wins, thus tilting the payoff equation and creating positive mathematical expectancy.

  EXERCISE: EXPECTANCY ANALYSIS

  Imagine you’ve accumulated a $50,000 “war chest” and set it aside to launch your dream business. You’re presented with quite a few business “opportunities” to consider. They all look promising, or you wouldn’t be considering them, but the future is always unknown so every one of them could fail.

  Your task in this exercise is to flex your expectancy analysis muscles so you can get in the practice of maximizing your expectancy with every decision. Analyze each deal both in terms of probability of success and in terms of potential payoff versus loss. Also, notice the overall risk to your entire nest egg from a single deal versus situations where risk can be controlled so you can try multiple deals in a series should any one deal fail.

  The first business is a local sandwich shop. You can buy it from the current owner for $25K, and this includes all equipment and inventory. The owner’s records show it earns $100K per year after paying employees, but that doesn’t include paying the owner. The owner’s sole revenue is the profit from the shop. Additionally, nearly all of the profit comes from lunch rush hour during the business week when there is a line-up out the door and the shop is producing all the sandwiches it’s capable of producing. At other times the shop has limited business.

  The second opportunity is your dream coaching business. Good coaches make $150 to $250 per hour, with top coaches fetching higher rates. The problem is that most coaches starve for lack of clients because they have no marketing system. To figure your real income potential, you have to include all the costs, both time and money, for marketing your practice when no revenue is produced. The good news is you have $50K to survive on until you get it working – if you work at it full time. Assuming you figure out, in that limited time, a marketing model that converts clients, remember that your coaching income is limited by the hours you can work, given that the revenue model is trading time for money.

  The third opportunity is an innovative new product created by your gadget buddy. He just came up with an idea that seems like a breakthrough, and you’ve guesstimated that it will cost $50K to take it from idea to fully proven prototype ready for manufacturing. (What a coincidence! It’s the exact amount of money you’ve saved). You’ve already identified the ideal target market for this product and you’ve run the idea past five people in that market with all of them asking: “Where can I buy it?” The profit margin on the product would be large, but there are a lot of unknowns since you’re starting from scratch with no proven business model.

  The fourth opportunity is an options trading course claiming that you can make a full time living by trading options. After buying the course, you’d still have enough money left over to fund your options trading business (according to the salesperson). You’ve asked for referrals, and they all seem like good people, but none of them are making a fulltime living yet. In addition, you were researching the basic premise of the course and you came across a very negative article on the subject, built around the idea of infrequent, but regularly occurring, “fat-tail risk” issues with these strategies. The course salesman says they’ve got it handled, but the article implies there’s more to understand and the references you were given don’t seem to have any clue about these issues.

  Analyze each opportunity above by answering the following questions:

  What exactly are you risking? Time, money, other resources?

  How much are you risking? Can the risk be carefully controlled?

  If it fails, will you have enough resources to get up to bat again, or will it take you out of the game?

  How would you measure “failure”? Is it losing money; is it failing to meet your goals in life; or what?

  What’s the probability for success? (Be practical. You’re not looking for an exact number, but you can at least tell which choices are high probability versus low probability.)

  How do you measure “success”? If financial success, is it the degree of fulfillment, or what?

  Could the opportunity ever result in a life-changing “big” win that tilts the payoff equation, or is it inherently limited?

  Could the opportunity ever result in a life-changing loss that tilts the payoff equation negatively, or is it controllable?

  Success for this exercise is not coming up with the “right” answer, because (just like in life) there is no right answer that’s knowable from analysis alone. Only in the fullness of time is the “right” answer known with 20/20 hindsight.

  Success for this exercise is to train your mind to habitually think in terms of expectancy, and to begin viewing all life decisions through mathematical expectancy – because it has life-changing consequences. And if this challenges you to complete on your own then download the companion bonus package you get with this book. It includes a free audio recording where I analyze each business with a group of fellow students. You can download the entire bonus package for free at https://financialmentor.com/free-stuff/leverage-book.

  For example, expectancy analysis can change your eating habits, exercise habits, prioritization of relationships, work projects, occupation, and much, much more. Yes, it’s that big of a deal. The outcome of your life will be determined by mathematical expectancy at many levels. You can either develop the habitual thinking pattern that makes it work in your favor, or you can endure the negative payoff.

  THE PRINCIPLES TO LEVERAGE LIMITED RESOURCES

  When a man tells you that he got rich through hard work, ask him: “Whose?”

  – Don Marquis

  Now that you’ve got the math fundamentals out of the way, it’s time to dive into a few principles that will be intuitive. These are the ones that are easier to see and feel the truth of. This chapter is going to explain how leverage can overcome limited resources to create exponential growth.

  PRINCIPLE 2: TRADING TIME FOR MONEY LIMITS WEALTH GROWTH

  What’s the most valuable non-renewable resource you have?

  Obviously, it’s your time.

  You aren’t making more. You can’t buy more. When it’s spent, it’s gone.

  And if you’re trading that ultra-limited resource for money, you’re limiting your economic life to reciprocal forms of exchange, which is the hidden problem in most wealth plans.

  But it’s not just trading time for money. Reciprocal exchange also includes trading your money for a product or a fixed interest rate of return. It means you exchange one thing of value for something of equal value.

  There’s nothing wrong with reciprocal exchange when you have average goals, but it limits your ability to achieve financial independence.

  For example, wage-earning W-2 employment can provide a nice income and lifestyle, but unless there is scalable upside potential through equity options or income growth participation, there is no leverage, which limits your ability to create a big win that tilts the payoff portion of your expectancy equation.

  The problem with reciprocal income is that you’re limited to your personal resources because that’s all you have to exchange. Unfortunately, you can only work so many hours per day for so many weeks per year before you run out of years, and somewhere in between you’re supposed to enjoy your life.

  Similarly, conventional asset allocation in paper assets (stocks, bonds, and mutual funds) is governed by strict mathematical limits to growth that is unfortunately beyond the scope of this book to explain (but is fully explained in both my Expectancy Wealth Planning course and my Expectancy Investing courses). For the purposes of this book, one of the drivers behind that limited growth is the lack of leverage involved. Sure, there’s some leverage in stock ownership, since you own a share of the company that, over time, will hopefully grow due to inflation and employee skill; but bonds offer no real leverage because they’re a form of reciprocal payment where you exchange value for value (in this case, you lend a fixed amount of capital for a fixed amount of i
nterest).

  Notice how these reciprocal exchanges of time and money – your two primary resources – are not benefiting from leverage? That’s the problem with traditional wealth plans that lack leverage. They’re based primarily on reciprocal exchange.

  That’s why the traditional plan typically takes a lifetime to achieve financial independence (with the sole exception of extreme frugality); but a leveraged plan can work much faster, without resorting to extreme frugality, by applying principles that increase the mathematical expectancy.

  PRINCIPLE 3: THE OPPORTUNITY COST PROBLEM

  The core problem with reciprocal exchange is that your resources of time and money are limited.

  Time and money spent in one place cannot be used elsewhere. There’s an opportunity cost to choosing to spend it in one way and not in another. At some point, your financial growth hits a wall.

  The way it works is: you trade a unit of time for a unit of money, and then you add those units together to get a paycheck. Then you exchange this paycheck for the limited version of goods and services you can afford from the unlimited supply that you have to pick from. The more you make, the more you spend, and your savings gets what’s left over (if anything) after taxes and lifestyle spending take their cut.

  When you limit yourself to your own resources, you’re without leverage. You have to rely on your own time, contacts, experience, money, and other resources. That’s why the three most expensive words in the English language are: “Do it yourself.” Relying on yourself only hinders your success.

  Leverage gives you access to time and resources other than your own so you can produce greater results faster using less of your own time and money.