Gambling or Investing?

Bernie Madoff ran a Ponzi scheme but, before he was revealed to be a fraud, he posted some of the most impressive financial gains in the industry. This is how he attracted so much capital and was able to keep the pyramid going for so long. Madoff’s net annual returns were around 15%. Here’s how this was described in an SEC report:

…industry professionals "marvel at [Madoff's] seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative and the related ability to buy and sell the underlying stocks without noticeably affecting the market." It further described how "experts ask why no one has been able to duplicate similar returns using [Madoff's] strategy."

For the last ten years, the S&P 500 – a broad indicator of stock market momentum – has returned around 9% annually. This happened during one of the most bizarre and distorted time in market history, where low interest rates and central bank intervention have fueled what many have called an “asset bubble”.

Contrast these returns with the person going to the casino. Or playing the lottery. What kind of returns is that person seeking? Hopefully they recognize they are gambling – a form of entertainment, not investment – and therefore are very comfortable with losing everything, something they are likely to do. If they do consider it an investment, however, they are seeking instant returns in the thousands of percentage points. Back in college when I would sometimes visit the casino I would consider wild success turning my $20 (I’m cheap) into $40 or $60 over the course of a wild night of gambling.

Screenshot from Trulia.com of a Peoria neighborhood.

Last week I was in Peoria, Illinois, and spent some time touring some of their distressed neighborhoods. They are looking at how to make millions of dollars of investment in these places to correct a combined sewer problem (where the sanitary sewer and the storm sewer run together). The engineers initially recommended a big pipe solution; spend a lot of money underground but don’t change anything above ground. The very smart people of Peoria are rightfully rejecting this idea and demanding that they get more for their money.

So what would a good return on investment look like in this situation? As we were touring these neighborhoods, I was looking on my phone at Trulia to see the house prices for those that were listed. There were many neighborhoods dominated by homes in the $20k to $30k range. While the natural inclination of some – and I heard this a few times – is to demolish these low value homes and replace them with new homes that would be valued well into the six figures, is that really success? Is that more like investing or gambling?

Let’s consider this house with an asking price of $22,500. In a city where the gross median rent is $700, this would be extremely affordable. Let’s say that the city is not looking for Madoff-like returns but will settle for gains that would beat the S&P 500, let’s say 10%, a feat that would be nothing short of amazing and would earn any broker bonuses beyond most of our lifetime earnings. Here’s what that would look like for this little house:

In other words, wild success would be this house appreciating in value from $22,500 to around $58,000 over the next decade. That’s a 259% increase in value and a corresponding 259% increase in property taxes. What a windfall!

And not just a windfall for the city coffers – although it would be that – but a huge windfall for the property owner as well. Yes, they would be making investments, but those investments would be paying off in a neighborhood on the rise. This is how you avoid gentrification and build wealth among people who have little. It’s the first component of a Strong Towns approach:

A Strong Towns approach relies on small, incremental investments (little bets) instead of large, transformative projects.

There is no need for Peoria to be gambling with their neighborhoods. They should not be seeking windfall payouts. They should not be trying to orchestrate a Bernie Madoff-like return. They should be defining success in a way that means success for everyone.

The question the city of Peoria should be asking – and every city around the country should be following their lead – is this: What’s the next smallest thing we can do right now to make this neighborhood a little bit better? For Peoria, the urgent need to address their stormwater problem provides the perfect context to work incrementally.

Do that day after day, week after week, year after year and not only will the city be building wealth, it will be improving the lives of the people who live there.