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Debt Investing

When Compound Interest Empties Your Wallet

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

– Albert Einstein

Compound interest is a financial concept I really, really wish was emphasized more in the United States’ education system.  Of the many subjects taught in school, all of them with some value and most of them with a good deal of value, personal finance would benefit all students (and probably most teachers).  A good friend and mentor summarized our shared view regarding the lack of personal finance curricula in formal education: “Why do we spend 12 years in first through twelfth grades, then four more years in undergraduate education, and sometimes several more in additional schooling learning to be better workers only to graduate and have no idea how to manage the money we make?”

The first time I recall a teacher in a formal school setting emphasizing the power of compound interest was in graduate school in an MBA finance class where the teacher, thankfully, spent his first class providing students two hours of personal finance education.  While I was well aware of the power of compound interest by the time I entered the MBA program and had also spent many years investing by then, I was also aware that many people see personal finance as overly complex, so I was glad the rest of the class was getting this lesson.

Compound Interest Giveth

As I wrote previously in Part 4 of the Personal Finance Foundation series, compound interest is a powerful tool for growing wealth over time. Investing money at a given interest rate over a given amount of time can produce huge growth.  Increase either the interest rate or the amount of time the money is invested, or, better yet, increase both, and you’ll see enormous transformations.

Example 1: Roth IRA, $6,000 contributions, 30 years, 6% interest

The 2020 IRA contribution limits allow you to contribute $6,000 annually.  If you were to contribute $6,000 annually for 30 years and receive a return of 6% annually, in 30 years you would have $508,810.06.  Note that of this amount, $186,000 are contributions you made and the remaining $322,810.06 is interest earned.  I want to emphasize that the $322,810.06 is money your money earned for you, and is not money you traded time, energy, sweat, or tears for.

Example 2:  Roth IRA, $6,000 contributions, 30 years, 8% interest

Holding all things equal (maintaining the $6,000 annual contribution for 30 years) and raising the rate of return to 8% would result in you having $740,075.21 at the end of 30 years.  This is $231,265.15 more than the amount you would have in the previous example.  The power of even a slightly larger interest rate invested over time is clear in this example, as just a 2% increase in the rate of return results in a huge difference.

If you use recognize that the maximum allowed contribution to IRAs has increased over time, it stands to reason that in the future you could increase the $6,000 contribution you’re making, resulting in larger returns over time.  Further, the 6% and 8% interest rates I used are below the average rate of return for the S&P 500 stock index for the past 30 years.  With dividends reinvested, the 30 year annualized return for the S&P 500 is 9.4% as of May 10, 2020.  I purposely chose the more conservative 6% and 8% rates of return because I prefer to estimate my returns conservatively.  In other words, I’d rather play it safe in estimating how much money I may have in the future rather than relying on too high a rate or return and then finding myself without enough cash in the future.

While compound interest can grow your net worth immensely over decades, it can also be an immense drain on your financial health.  Here’s how.

Compound Interest Taketh Away

A prominent financial voice and personality has often spoken of the ease of finding investments that reliability generate 12% interest.  While I find his claim questionable, there is a financial liability that can drain you of money at a much faster rate than 12%, guaranteed:  Credit cards.

I use multiple credit cards that give rewards for spending and they have a range of interest rates from 9.9% on the low end to 17.99% on the high end.  The card charging 9.9% was issued by a credit union and the 17.99% interest rate belongs to a Chase cash back credit card.  While we as savers and investors seek saving and investment vehicles that produce the largest interest rates, it’s also important to consider what we do when we carry credit card balances:  We choose to pay credit card companies interest rates that are much higher than we can (most likely) find on our own in investment vehicles. I’m going to walk through a couple of examples to demonstrate the amount of money you hemorrhage by carrying balances on credit cards from month to month.

Example 1:  A credit card with a 9.9% interest rate, a $10,000 balance, and an $84 minimum payment

If you have a credit card with a 9.9% interest rate, a $10,000 balance, and pay an $84 minimum payment until you pay off the credit card, you’ll get the following results:

Expected payoff time:  490 months (about 41 years)

Interest paid:  $31,154

Insane!  $31,154 of interest.  You can see how people trying to get out of the credit card debt hole by making minimum payments, or close to minimum payments, often feel like they’re on a hamster wheel, barely able to make progress.  Also, look at all that interest paid to the credit card companies that, alternatively, could have stayed in your pocket had you either paid off your balances immediately or had you paid them off much sooner.

Example 2:  A credit card with a 17.99% interest rate and a $10,000 balance

If you have a credit card with a 17.99% interest rate, a $10,000 balance, and pay a $150 minimum payment until you pay off the credit card, you’ll get the following results:

Expected payoff time:  504 months (42 years)

Interest paid:  $65,558

Again, if you only pay the minimum payment on a credit card, you’re going to spend a very long time paying off the balance.  Granted, the examples above use a static minimum payment while you pay off the balance rather than adjusting the minimum payment based on a percentage of the balance, but the takeaways are the same:  You need to pay more than the minimum payment on credit card debt, otherwise the interest you’ll pay will be outrageous.  In this second example, consider that the $65,558 in interest is cash credit card companies are earning in their “investment” with a rate of return of 17.99%, all at your expense.

Getting Out of Credit Card Debt

Call your credit card company, explain your situation, and ask if you can have a lower interest rate.  Especially during the pandemic, credit card companies are more likely to be empathetic, as they’d rather have customers providing them cash flow rather than customers unable to pay.  Even if the credit card companies aren’t able to lower your rate, you’ll only have expended a short amount of time to call them, so make the call.

Identify spending that isn’t needed.  If you’re not doing so already, track your spending with a budget or cash flow plan.  I have a cash flow plan template you can download here in Microsoft Excel format.

There are plenty of other tools you can use for budgeting or cash flow planning, but your end goal should be to identify spending that isn’t needed.

Stop using credit cards and start paying the balances down.  There are two popular strategies for paying down credit cards:  Paying off cards with the smallest balances first in order to generate quick wins and to generate the associated emotional rewards (this is often referred to as “The Debt Snowball”), or paying off credit cards with the highest interest rates first (this technique is often referred to as “The Debt Avalanche”).  Mathematically, the second plan of attack is best, but humans aren’t purely mathematical creatures, especially when it comes to personal finance.  Both strategies have their merits.

Takeaways

  • Pay off credit card balances every month.  This prevents interest from accruing at enormous interest rates.
  • If you’re working on paying off credit cards, strongly consider paying off credit cards with the highest interest rates first.
  • Interest you’re paying toward credit cards is lining the pockets of credit card companies.  Consider how you can pay yourself instead, namely through saving and investing, and grow your net worth.
  • Once you’re done paying down credit card debt, build a habit of saving cash for large purchases so that you don’t jump on the hamster wheel again.
  • Even better:  Once you build up cash savings for large purchases, consider how you can start using excess cash for investments so that you can reap the benefits of compound interest.
References

I used a calculator from Credit Karma’s web site to calculate payoff times.  This web site also provided the great visuals.

Categories
Investing Retirement

Personal Finance Foundation – Part 4 – Invest, Invest, Invest

Having examined how you can grow net worth by reducing spending and growing income, we now come to the most powerful tool for growing net worth: Investing. Reducing spending produces quick wins in growing net worth, but there’s only so much cost cutting you can do until you are living on a bare bones budget. Increasing earned income is a great way to increase your net worth that, theoretically, has no ceiling, but we all know that raises don’t come easily. Also, even if you do get that raise, you’re still trading time for money.

What if there was a path for you to augment employment income by having your assets work for you and earn money for you?

The Miracle of Compounding Interest

I started investing when I got my first full-time job out of college. I put 5% of my salary into a 401(k) and, following my older brother’s advice, I maxed out a Roth IRA. For better or for worse, I socked money away in both accounts and didn’t spend much time looking at them except to rebalance occasionally. I say this was “for better” because shortly after I started working full time, the subprime mortgage crisis contributed to the stock market crashing and, as a result, my 401(k) and IRA accounts lost almost half their value. Had I been more attentive to my retirement accounts, I would have seen them hemorrhaging value which likely would have caused me grief. While I’m very committed to leaving my retirement accounts alone until retirement, I’d rather not test my resolve.

You may be thinking, “you’re not much of a personal finance person if you only put 5% of your salary into your 401(k).” If I remember correctly, I received a 3% match on this contribution but, you’re right that 5% is less than I’d recommend anyone invest. Over time I gradually increased my contributions so that now I contribute over 20% of my gross income to my 401(k) and also max out IRA contributions. Now I have well over a decade’s worth of compounding interest rewarding me for my efforts.

What is compounding interest? A plain English example: You start off with $1,000 and earn 10% interest annually. The first year you earn $100 in interest, which leaves you with $1,100 total. The second year you earn $110 (10% of $1,100) in interest, which leaves you with a total of $1,210. Keep repeating this math (or, even better, use this great compounding interest calculator: http://www.moneychimp.com/calculator/compound_interest_calculator.htm) and you’ll have $1,610.51 at the end of five years.

The beauty of this $610.51 growth (the difference between the red line and the blue line in the picture above) is that you didn’t trade time for money to gain the $610.51. Instead, your money sitting in an investment account worked for you to earn more on your behalf. Extend your timeline to 15 years and your initial $1,000 turns into $4,177.25. Mind you this growth is happening without you adding a penny extra. Change the initial $1,000 to $5,000 with the same 15 year timeline and 10% interest rate? You wind up with $20,886.24.

If you use your imagination a bit, you’ll see how you can leverage compounding interest in a very powerful way. It’s not very likely that you’d make contributions to your retirement accounts only in your first year of employment but never again, right? If you make the first year contribution of $5,000 then add $5,000 every year for 15 years at a 10% interest rate, at the end of 15 years you end with $179,748.65. Not bad, huh? Key takeaway: $29,748.65 in growth that occurred (your $150,000 of deposits subtracted from the $179,748.65) didn’t require your time, sweat, energy, or tears. Instead, your money worked for you.

One of the most powerful variables in growing wealth via compounding interest is time. If you extend the previous example from 15 years to 30 years, you witness astounding growth.

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein

The Basics: How to Invest in the Stock Market

You may be thinking, “OK, great buddy. I want some of this stock market action and having my money work for me. Where do I start?” A common place to start, and where I started, is in an employer-provided 401(k) retirement plan. Think of the 401(k) retirement plan as a wrapper for investments, and stocks as an investment you can put inside this wrapper.

A significant benefit of the 401(k) retirement plan is the tax advantages that come along with it. When you invest in the 401(k), your annual taxable gross income is reduced by the amount you invest, and the invested money is not taxed until you withdraw it. If your employer, for example, uses Fidelity to manage their 401(k) plan, you would create an account on Fidelity’s web site or use the account created for you by your employer. Once you log into the account, you’ll be able to select from likely a variety of investment choices.

One very common selection to make in 401(k) plans is a target date retirement mutual fund, which automatically adjusts the mutual funds holdings (think stocks, bonds, and cash) as you approach your targeted retirement date. In general, it’s a good idea to move gradually from riskier investments (think stocks) to less risky investments (think bonds and cash) as you approach retirement.

The volatility of stocks could cause the loss of a significant amount of your nest egg as you enter retirement, so it’s best to have some protection against this volatility. A great example: Retirement portfolios immediately after the sub prime mortgage crisis lost almost 50% of their value. It took roughly three years (until 2012) for the stock market to recover the lost value. How would you feel if you planned on retiring in a given year and then observed almost half your nest egg evaporate?

I’ve just described investing in the stock (often referred to as the equities) market, but there are many, many other types of investments. An alternative investing technique I’ll discuss next is real estate, specifically rental property, investing.

A Second Investment Vehicle: Real Estate

A brutal reality I observed during the subprime mortgage crisis were retirees needing income from their 401(k) accounts while seeing almost 50% of their balances evaporate. Hindsight tells us that the stock market recovered these losses within a few years, and then entered a very long bull market, but I could empathize with the fear and anxiety experienced by retirees who depended on their 401(k) to navigate retirement.

About the same time, I learned of a concept I found fascinating: The multi-legged retirement stool. In short, what if your retirement income didn’t solely depend on a 401(k), with its commensurate stock market volatility, but was also funded by another source of income? A three-legged stool has stability not by relying on one or two legs but on three legs. Similarly, your retirement income could have more stability if it didn’t only rely on income from the equities market.

While I love the simplicity of investing in index funds within a 401(k) and and a Roth IRA, I also love the dependable income stream produced by rental residential properties. People will always need a place to live, so there will always be a demand for residential real estate. Though we’re certainly witnessing significant disruptions of rental income streams during the COVID-19 pandemic, I sleep better at night knowing I have three disparate sources of potential income: Employment, retirement accounts, and rental property.

My long-term plan for bear markets (significant stock market downturns) is to rely more on rental property income to fund my lifestyle while simultaneously leaving my 401(k) and IRA accounts untouched so as to not make paper losses real losses. In other words, while the stock market may be down and your retirement account balances may be down, these losses aren’t realized until you withdraw money from retirement accounts, thereby selling shares at lower prices when it would be better to sell at higher prices.

In the worst case scenario of both the stock market being significantly down and your renters not paying their rent, a scenario that is highly unlikely but that is occurring with some landlords in the country as renters lose employment during the pandemic, take advantage of your emergency savings to tide you over until either the stock market or rental income stabilize.

Categories
Debt Investing Saving

Personal Finance Foundation – Part 1 – A Starting Place (Calculating Net Worth)

So you’re on the journey to get your financial house in order.  You first need to know where you’re starting.  You do this by measuring your net worth.  Net worth is calculated by adding up your assets and then subtracting your liabilities.  A very, very simple example: You have a savings account balance of $10,000 and have a credit card balance of $2,000.  Your net worth would be $8,000 ($10,000 in assets minus $2,000 in liabilities).  It’s certainly possible to have a negative net worth (think of the recent college graduate with student loan debt but no assets to their name), too.

As you can see, one way to increase your net worth is to increase the value of your assets.  Another way to increase your net worth is to decrease the value of your liabilities.  Often, though, and especially in the world of personal finance loud mouths, an extreme emphasis is placed on either increasing assets or decreasing liabilities, as if both can’t be accomplished simultaneously.  Both can be accomplished together and you’ll find positive movement in your net worth by focusing on both initially in your journey to a healthier financial state.

Here is a screen clip of an Excel spreadsheet I use to track my net worth:

Net Worth Spreadsheet
Net Worth Spreadsheet

You can download the spreadsheet here.  As you enter assets and liabilities, the spreadsheet automatically adds up both categories and automatically updates the resulting net worth value.  I update my spreadsheet monthly in order to keep tabs on my financial health and, more importantly, to see if something is out of whack and needs to be addressed.  Frequently updating your net worth will provide you with encouragement when you’re taking the right steps and seeing net worth grow, but it will also alert you if you’re slipping into bad habits.  It’s better to catch a bad habit a month or two in rather than realizing years later that the bad habit has caused you major financial damage.

Here are some challenges I’ve encountered while tracking net worth:

Challenge 1:  Accurately valuing certain assets and liabilities.  The value of a given asset or liability may not be black and white.  For example, when including a home’s value in net worth calculations, you should use the going market price for your home and avoid using values that may inaccurately inflate or undershoot the actual value.  This means that your home’s taxable appraised value may or may not be near the home’s market price (i.e., what you’d get if you sold the home).

Challenge 2:  If you have an asset that you’re financing, like a home or a car, make sure to include both the asset and the accompanying loan on your net worth statement.  Again, make sure you’re valuing the asset accurately (hint:  Kelley Blue Book is a great way to value cars).

Challenge 3:  Even though you’re enthusiastic about a collection you have (American Girl dolls, stamps, coins, etc.), they may not be nearly as liquid (i.e., easy to sell) as you think, and they may not be worth nearly as much as you envision.  I don’t include collectibles or jewelry in my net worth statement because I don’t see them as liquid assets.  This is an arguable point, though.  If you choose to include collectibles or hard-to-value items on your net worth statement, try to be accurate with their valuation.

Challenge 4:  You’ll encounter ups and downs in your net worth if a sizeable portion of your asses are in volatile categories, like stocks.  You’ll notice the ups and downs even more if you track your net worth monthly.  This is OK, as stocks (I’m thinking index funds when I say “stocks”) appreciate over long (10+ years) periods of time.  Just make sure that if you’re net worth is declining in value that you’re not contributing to this with reckless spending, overloading credit cards, or buying that Corvette you probably can’t afford right now.

Now that you know your net worth, you have a baseline from which to measure progress or regression.  If your net worth increases, this shows financial progress.  If your net worth decreases, this shows regression, and you should be especially aware of what’s causing the decline.  Your goal should be to increase your net worth over time.

Personal Finance Foundation – Part 2 – Easy Money:  Spend Less

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Investing Retirement Saving

What Can You Learn from the Subprime Mortgage Crisis?

It’s hard to believe time has passed so quickly.  Ten years ago the subprime mortgage crisis led the U.S. economy into a severe recession and carnage ensued.   Many people lost their homes along with huge portions of their retirement savings.  Credit markets froze and taxpayer money was used to purchase toxic assets from the very banks that facilitated the crisis.

A decade removed from the great recession, what takeaways can help you succeed financially and prepare you for the next economic downturn or recession?

  • Only you have your best financial interests in mind.  Banks were more than willing to lend money to under-qualified borrowers, and this resulted in skyrocketing foreclosures when interest rates increased on adjustable rate mortgages (ARMs).  Some argue that banks were negligent in persuading under-qualified buyers into taking on supersized mortgages.  This certainly could be the case, but it hammers home an important lesson:  Understand your financial choices and don’t rely solely on someone else’s opinion to guide you, especially if they are in a position to make money off of you.  Educate yourself before you pay someone for their financial guidance, as this will better allow you to see if your adviser is pursuing your best interests or his.
  • Diversify your investments.  Plenty of folks who planned to retire in 2008-2010 had to delay retirement due to seeing their 401(k) plans shrink drastically as the equity markets plunged.  This meant several more years of work for this group.  What if, though, this group had rental property as an additional source of income for their retirements?  The recession economy saw an increase in renters, resulting in increased income for rental property investors.  These rental property investors could choose to withdraw a smaller amount from their 401(k) plans while relying more on the increased cash flow from rental property investments.  While I’m not advocating only for rental property investments as a source of retirement income (it certainly is a great option), I am advocating for a multiple-legged stool for your retirement portfolio that does not leave you in an anxious place should an investment class take a plunge.
  • Invest more than you need.  I’ve never heard anyone complain that they invested too much.  In the case of workers who had to postpone retirement due to the Great Recession, many of them could have continued with their retirement plans had their nest eggs been larger.  While this may go into the “thanks for the insight, buddy” category, your savings and investment rate is a better determinant for your success than rate of return:  http://www.thesimpledollar.com/five-most-important-factors-for-investment-success/
  • Follow your plan, not your emotions.  The S&P 500 lost about 57% of its value from October 9, 2007 to March 9, 2009, the day the index bottomed out during the Great Recession.  Thankfully, I didn’t check my retirement account balances much during this time, mainly because I had barely entered the workforce after graduating from college.  My plan, though, was to continue working for at least three, if not four, decades more until I retired, and equities with all of their volatility were the foundation for growing a large enough nest egg.  The S&P 500 took four years to reach its value on October 9, 2007 and has grown much more in the current bull market.  Investors who made an emotional decision to sell during the recession likely missed much of the growth during the subsequent recovery and likely missed the opportunity to purchase shares of the S&P 500 while they were on sale.  Recessions and downturns in the economy can be very anxiety inducing if you don’t remember that these are terrific opportunities to buy shares on the cheap and that the market provides substantial returns in the long run.  The past 30 years saw the S&P 500 return 11.66% (10.19% geometric return) with dividends reinvested.
The S&P 500 has returned 11.66% (arithmetic) and 10.19% (geometric) the past 30 years.  Courtesy of http://www.moneychimp.com/features/market_cagr.htm

For a terrific read about the subprime mortgage crisis and its causes, read The Big Short by Michael Lewis.  The book will hammer home my first point regarding educating yourself on financial decisions, especially major ones like taking out a mortgage.  While I think the majority of people in finance are well-intentioned, great people, The Big Short shows that there are individuals who will seek to take advantage of you (as there are in any industry).  While the financial industry may or may not be in a better position to avoid a similar crisis, you can certainly prepare yourself to not only avoid making bad decisions during a recession, but to take advantage of the opportunities presented by an economic downturn.

Categories
Debt Investing

Is College Worth It?

The cost of a college education and the associated debt that often accompany a college degree were both hot topics during the recent presidential election cycle.  The price of college tuition has soared and greatly outpaced both incomes and inflation.  One fringe presidential candidate even campaigned on promises of “free” college education for all (rant:  We’ll be taxed all the more to pay for this “free” college).

There is a camp that believes all people should go to college no matter the circumstance.  This view, though, doesn’t address the financial implications of attending college and also discounts various nuances, including whether a person would like to pursue a trade or career that does not require a college education. Additionally, some individuals may not succeed in a traditional classroom or school environment. They may benefit much more from an apprenticeship or hands-on training environment where substantial education costs are not incurred.

Tradesman can expect to make respectable salaries, too. Salary.com indicates a plumber earns, on average, in the range of $36,568 to $51,610 annually as of January 30, 2017. Welders make on average $32,409 to $42,798 as of January 30, 2017 according to salary.com. US median household income is $55,775 as of 2015 according to census.gov, the United States Census Bureau, so these salaries are certainly competitive when considering they are earned by individuals (as opposed to households).

I have an undergraduate degree in a STEM major and a Masters in Business Administration with an emphasis in finance and real estate.  My undergraduate college was a liberal arts college and, while as a student I questioned the value of all those “useless” electives, I now value all the writing practice, communications skills, and soft skills I gained.  My MBA was 85% paid for by my employer and provided me with a ton of business, finance, and investing knowledge that I am leveraging to continue investing in equities, start real estate investing, and potentially start a business with a colleague.  Was an MBA needed to continue investing in index funds, start investing in real estate, and open a business?  Certainly not.  Having the MBA 85% paid for, though, by my employer made this a great opportunity and helps me understand most aspects of running a business, and this knowledge was conveyed to me by terrific professors and the learning was facilitated by classmates who had expertise in many fields, including investment banking, real estate, energy, supply chain management, and management.

So, is college worth it?  It depends on many factors.

If you’re going to college, here’s how you can increase your return on investment:

  • Advanced Placement Exams.  Take advanced placement (AP) courses while in high school. You can then sit for AP exams in various subjects.  Depending on how well you score you will earn a corresponding amount of college credit.  Each hour of credit you earn will save you hundreds of thousands of dollars.
  • CLEP Exams.  College Level Advanced Placement (CLEP) exams function similarly to AP exams and allow you to earn college credit.  As with AP exams, CLEP exams can save you hundreds or thousands of dollars in tuition.
  • Get Community College Credit.  Community colleges have tuition that is much cheaper than 4 year universities.  If you’re already attending a 4 year institution, look into their transfer credit policy and see which hours (especially basic credits) can be taken at the local community college and transferred.
  • Finish College.  According to a recent LinkedIn article, graduates with a bachelor’s degree earn over $1 million more in their lifetimes relative to those who only hold high school diplomas.  If you start college but don’t finish, and if you also incur student debt, you’re putting yourself in a hole that will be difficult to escape.
  • Choose Your Major Carefully.  Certain majors are more in demand by employers and certain majors typically result in higher starting pay.  It’s one thing to finish school with $200,000 in debt but a $100,000 starting salary as an analyst at an investment bank.  It’s a completely different ball game finishing school with $200,000 in debt but starting your career making $30,000 as a social worker.  Notice that I’m *not* saying don’t become a social worker (or any other major, for that matter).  Before you choose a given major, know reasonable starting salaries and how long it would take to pay off debt if you choose to carry debt. Educating yourself on your degree’s financial ROI will help you save yourself from the potential surprise and grief of monster debt when you graduate.
  • Have Your Employer Pay For It.  Many employers will subsidize part of your college education, especially if it relates directly to your job, while other employers, especially universities, will pay for your entire education.
  • Choose a College with Successful Career Placement.  I credit esimoney.com for this great, and often overlooked, idea.  A college education is a step toward employment, so visit the career services offices at your prospective school and ask the placement rate for students in general and, more importantly, for students in your major.

There’s no easy answer regarding whether college is worth it for a given individual.  If you’re considering a trade as a profession, college may not be the route you choose.  If you decide to attend a college or university, there are many factors to consider that can help you increase your return on investment.

Categories
Debt Investing Saving

Three Lessons from The Millionaire Next Door

The Millionaire Next Door is my favorite personal finance book because of three life-changing lessons it imparts, all supported by mountains of research data gathered and analyzed by two professors, Thomas Stanley and William Danko.  These lessons provided me with a financial enlightenment when I was first learning the basics of personal finance, and I suspect many of you will find at least one of them encouraging, challenging, or both.  These lessons taught me to have a new attitude regarding personal finance, and I hope they do the same for you or your loved ones.

Lesson 1:  The majority of millionaires differ radically from what the media and marketers have you believe.

I grew up on a steady diet of TV and, as you know, advertisers and marketers feed you a stream of images and depicting what the rich are supposed to look like.  Of course, their message equates buying their products and increasing consumption with living like a millionaire.  The Millionaire Next Door shatters the notion that the average millionaire consumes the latest and greatest.

In reality, the average millionaire lives a nondescript life and lives in an average neighborhood. This is logical, as over-consuming would lead one to have less money to save an invest.  Stanley and Danko acknowledge that deca-millionaires, the extremely rich, can afford to consume and live up to the images portrayed by advertisers, but this segment of the population is extremely small.  You are more likely to find the ex-millionaire who has spent their fortune away than you are to find a deca-millionaire who can afford to live an extravagant lifestyle.

Lesson 2:  You will not acquire financial independence as long as your sole source of income involves trading time for money.

Many Americans grow up with the idea that working an 8-to-5 is the only way to pay for life. This mentality is one I grew up with and fails to consider what happens if injury, chronic illness, or another circumstance interrupts your employment.  More importantly, this mentality forgoes any consideration of financial independence, as it assumes one must be an employee their entire life in order to sustain a lifestyle.

You will never acquire financial independence without acquiring assets that appreciate without realized income.

-The Millionaire Next Door

Having assets (savings, investments, businesses, etc.) work for you allows you to achieve financial independence as these assets working for you reduce or remove your dependence on realized income (income you earn via employment).  The more assets you have working for you, the more likely you are to achieve financial independence more quickly.  Think of Dave Ramsey’s debt snowball here, but instead of debt, consider an “asset snowball.”

Lesson 3:  The American dream is alive and well.

We’ve all heard in the media many times that it’s impossible for the little man to get ahead, with stagnant wages, a tepid economy, and any number of other reasons.  The Millionaire Next Door provides all Americans with hope:  The vast majority of millionaires are first generation millionaires, having built their fortunes without the benefit of an inheritance.  That’s right, most people who become millionaires are not trust fund babies and do not have a leg up on the rest of us.  The majority of them live below their means, save, and then invest their way to wealth. The American dream is indeed alive!

Categories
Debt Investing Retirement Saving

Psychology and Fear in Personal Finance

Be fearful when others are greedy.  Be greedy when others are fearful.

-Warren Buffet

Warren Buffet is one of the most successful investors of recent times and provided this great quote in 2008 during the height of the subprime mortgage crisis.  During the 2007-2009 bear market, the S&P 500 lost over 50% of its value and many people close to retirement had to delay their exit from the 9 to 5.  In hindsight, as we sit in the middle of a bull market in 2016, Buffet’s quote is great advice, but how are you supposed to separate yourself from emotion when your nest egg loses over 50% of its value?

S&P 500 2007 - 2009 Bear Market
S&P 500 2007 – 2009 Bear Market (courtesy of Yahoo Finance)

There is no easy answer here, as personal finance is indeed personal, but you can certainly make good, informed decisions in the middle of emotionally charged circumstances.  Buffet was right about the subprime mortgage crisis and the need to buy while prices were low (i.e., while the market had lost lots of its value).  He likely looked at the history of the market and understood that it would bounce back.  As of September 16, 2016, the S&P 500 sat at 2,139.16 versus its lowest value during the subprime mortgage crisis of 676.53 on March 9, 2009.  As you can see, the market has more than returned.

S&P 500 - 2007-September 16, 2016
S&P 500 – 2007-September 16, 2016 (courtesy of Yahoo Finance)

How do you disarm fear and anxiety in personal finance?  Educate yourself.

Peace I leave with you; my peace I give to you. Not as the world gives do I give it to you. Do not let your hearts be troubled or afraid.

John 14:27

How should you manage fear and anxiety when making financial decisions?  Start with education, then don’t stop educating yourself.  Read personal finance books (I highly recommend The Millionaire Next Door), visit personal finance blogs (Afford Anything is my current favorite), and listen to personal finance podcasts (Marketplace is great for keeping up with current financial events; Afford Anything has a great podcast, too).  I’ve found that I pull pieces of information from each of these sources and, as a result, have molded a personal philosophy.

The key lesson here is that education will help you see that American equity markets have more than recovered from the multitude of previous crashes and bear markets.  Buffet understood this and saw that equities were simply on sale.

How else do you disarm fear and anxiety?  Understand risk and reward.

I recently listened to a personal finance podcast where I heard an interesting anecdote involving fear.  A caller indicated they hadn’t invested in the stock market for retirement due to their fear of losing money.  While the caller certainly is correct that avoiding the stock market and investing in something safer, like CDs or cash, will help you avoid risk and the large losses that can accompany risk, he is also missing the other half of the equation:  In finance risk is necessary for growth.

While the caller will seemingly preserve capital by avoiding the volatility of the stock market, their capital will erode over time due to the effects of inflation.  The eroding power of inflation will decrease buying power if not offset by gains.  One option for generating more gains than cash but experiencing less volatility than the stock market is the bond market.  The bond market, though, experiences a good amount of volatility, too.

While someone can certainly go to sleep peacefully knowing they will avoid the volatility of the stock market and keep their money safe (at least until inflation eats away at it), it would be rash to do so without being aware of the rewards that accompany carrying risk.  Over the past 30 years (specifically from January 1, 1985 through December 31, 2015), the compound annual growth rate of the S&P 500 was 8.2% with dividends reinvested and adjusted for inflation.

S&P 500 - CAGR for past 30 Years
S&P 500 – CAGR for past 30 Years (courtesy of MoneyChimp.com)

As you can see, $1 invested in an S&P 500 index fund on January 1, 1985 would have returned over 1,100% in 30 years.  While I can see how avoiding significant losses would allow someone to sleep peacefully, avoiding a significant amount of the S&P’s gains during this time period would cause me to lose sleep at night.  My advice to the caller:  Educate yourself about risk and reward, then understand how accepting additional risk could result in your nest egg multiplying in size.

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Investing Saving

Investment+Savings Challenge

One of my personal financial goals is to become financially independent.  For those unfamiliar with the term, I define financial independence as follows:  A state in which financial assets generate sufficient income to pay for a chosen lifestyle.  In layman’s terms:  More assets = good, combined with fewer expenses = better.

Financial Independence = Passive Income Generated by Assets > Expenses

I am seeking financial independence so that I will have the freedom to walk away from my current or future job should I need or want to in the future.  One example of when I would potentially want to walk away from my job:  My spouse and I have a baby and we decide that my staying home with the child is our preferred option for care taking.  While I absolutely love my job and my career, financial independence allows for many options in the future that being tied to a 9 to 5 does not.

One key step in achieving financial independence is increasing investment and savings rates. Not only does this increase the amount of assets you have working for you by generating passive income, but you decrease your expenses, thereby accelerating the journey to financial independence.

I’m going to start tracking my investment and savings rate on this site, starting with August 2016.  My investment+savings rate is based on my *gross* income.  Also, I’m including in gross income my employer’s 401(k) contribution, as they give me a portion of my salary each month.  This isn’t a match, but a contribution to my 401(k), so I view it as income and include it in my gross income so that my savings+investment rate isn’t disproportionately inflated by this contribution.

August 2016:  40.29%

 

 

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Investing

Considerations for Investing as a Catholic, Part 2

In my previous post regarding things Catholics should consider when investing, I spoke about one mutual fund family (Ave Maria Mutual Funds) as an example of a fund family that offers investments that abide by United States Council of Catholic Bishops (USCCB) guidelines.  There are certainly other fund families that abide by USCCB guidelines and I wanted to mention some of them here.

Note:  I do not currently have money invested in Ave Maria funds nor in any of the other fund families I am about to mention.  Yes, you’re right:  As a good Catholic, I should strongly consider moving my money to somewhere other than the Vanguard funds where my IRA money currently sits.  I am searching for a good Catholic mutual fund with low fees, so if you know of any, let me know!

Luther King Capital Management (LKCM) has the LKCM Aquinas Catholic Equity Fund (AQEIX) that abides by USCCB investment guidelines.  The fund, though, has consistently under performed its category average.  Its expense ratio of 1.50% makes it a very expensive fund to hold.

Epiphany Funds has three funds to choose from, all of which have high total expenses.  These funds are very small and this is likely the reason for the high expenses.  The Epiphany Fund family

Index Fund Advisors provides a list of Catholic index funds on its web site.  I do not see ticker symbols for these, so I am not able to judge their performance very well, although they appear to perform relatively well.  The expenses for investing with IFA appear to be significant (0.90% annually for accounts with less than $500,000, plus quarterly fees), so be aware.  I like the variety of target date funds IFA provides, as this makes it easier for investors of any age to find an index fund suitable for their stage of life and risk tolerance.

As I mentioned in Part 1, high expenses are the norm for Catholic mutual funds and are the price we pay, at least for now, to abide by USCCB guidelines. Until these Catholic funds gain more assets under management, these high expenses will likely continue.  In the meantime, if you choose to invest in any of these funds, give yourself a pat on the back.

USCCB Socially Responsible Investment Guidelines:  http://www.usccb.org/about/financial-reporting/socially-responsible-investment-guidelines.cfm

Categories
Investing

Considerations for Investing as a Catholic

In a previous post I recommended investing in index funds in order to minimize expenses and better increase your nest egg.  Unfortunately, though, many of the companies contained within a standard index fund conduct activities that are in opposition to Catholic teaching.  For example, the owner of Rick’s Cabaret strip clubs, RCI Hospitality Holdings (RICK stock ticker), is held by, among others, Vanguard Total Stock Market Index Fund (VTSMX and VTSAX).  When you purchase shares in VTSMX or VTSAX, you purchase fractions of shares in the owner of Rick’s Cabaret.  So what is a Catholic to do?

Educate yourself regarding Catholic investing guidelines and make informed decisions.  The United States Council of Catholic Bishops (USCCB) released “Socially Responsible Investment Guidelines” in order to provide guidance on this topic:

USCCBhttp://www.usccb.org/about/financial-reporting/socially-responsible-investment-guidelines.cfm

In summary, we have a moral responsibility to avoid investing in organizations that operate in opposition to Catholic teaching.

But, how is a person supposed to navigate through the hundreds or thousands of funds an index fund, much less multiple index funds, invest in?  Thankfully, Catholic mutual funds exist and do this work for us.  Ave Maria Mutual Funds is an example of one of these companies and Ave Maria has two funds, the Ave Maria Rising Dividend Fund (AVEDX) and the Ave Maria Growth Fund (AVEGX), that are rated well by Morningstar.  The 0.92% expense ratio for AVEDX and the 1.17% expense ratio for AVEGX are very high, though, in comparison to Vanguard’s fund lines.  Working against Ave Maria in this case are the active management they have to perform for both funds, as fund managers must weed out non-Catholic organizations, and the sheer size of Vanguard funds, as Vanguard can drive their expense ratios lower (VTSAX has an extremely low expense ratio of 0.05%!!!) due to VTSAX’s $141 billion in holdings versus AVEDX’s $789 million in holdings.

Catholic investors can look at the 0.85% difference in expense ratios between VTSAX and AVEDX and know that the extra money they are paying is helping to build the kingdom.  That being said, I really wish Ave Maria would consider lowering their expense ratios, as the extra 0.85% in expense makes a huge difference over time.

If you were to invest $10,000 into VTSAX with no future investments, a 7% rate of return, and the 0.05% expense ratio, in 30 years you would have $74,989.  (Calculations done on calcxml.com)

Investing in VTSAX

 

If you were to invest the same $10,000 in AVEDX with no future investments, a 7% rate of return, and the 0.92% expense ratio, in 30 years you would have $57,689.  That’s a difference of $17,300 when your investment compounds over 30 years.  That extra 0.85% in expenses wasn’t so small after all.

Investing in AVEDX

 

Unfortunately, until Ave Maria Mutual Funds has more money under management, it will likely not be able to leverage economies of scale in order to reduce expenses.  We meet our initial goal, though, of putting our money into investments that comply with Catholic social teaching, and this is certainly worth some extra expense.