Pondering Money

Happy Thanksgiving, I hope you have a lot to be thankful for today!  I’m going to take some time to try to appreciate all of the the people and things I have.-Rick

Save Money.  Live Better.   Good advice, right? Normally I would agree, but I bet the last time you read that was on a Walmart advertisement that all about you SPENDING not SAVING!   I’m sure you have seen dozens of adds proclaiming SAVE! in anticipation of Black Friday.  The truth is that making purchases at lower prices will only become savings when:

• You can sell the item for more then you paid for it.
• You were ready to buy at a higher price with cash.

The first case is extremely rare because most used items lose 50% of their value, still there are sometimes opportunities- just don’t forget to factor in the cost of your time to buy and sell the item!  If you fall into the second case- you decided on your own to make a  purchase, saved the cash needed for it, and just happened to find a better price.  Then you have real savings go for it!   Just be wary of the lure of the bigger/better version that will eat up all your savings!  In any other case don’t fool yourself you are really just spending more.   Before you part with your hard earned cash, ask yourself: Couldn’t I live better by keeping my old TV/DVD player/iPod and REALLY saving that money?

A truly wise person learns from other people’s mistakes, so I’m going to share another of my mistakes so that you don’t have to experience it yourself.My wife and I bought a new home in 2002 with a 6.75% 30 year mortgage. That was a good rate at that time and we never had trouble affording the payments.  We love our home, but I never loved having a mortgage!  Over the next couple of years I made some additional payments toward the principle to try to get rid of the mortgage quicker but I completely ignored interest rates.  That was a pretty big mistake because I missed not one but two great opportunities!  In 2003 and again in 2004 I could have refinanced to a 15 year loan in the mid 4% range.  My monthly payments would have been about the same, but refinancing would have helped me in two ways:

• I could have saved over $10,000 in interest.
• I could have been mortgage free 4 years earlier!

I did eventually correct my mistake and refinance down to a 5% 15 year loan in 2007.  Today rates are really low again- according to Bankrate.com a 15 year fixed mortgage is at 4.56%!   If you have a mortgage at a higher rate shouldn’t see if refinancing could save you thousands?   Don’t make the same mistake I did and ignore the opportunity from low rates!

Are you interest in investing, but feel overwhelmed with information? You might want to delay starting until you figure it all out, however that would be a mistake! Let’s consider two investors Motivated Moe and Cautious Carl that want to start investing. Both will invest $1000 a year once they start. Moe does not know what to do but wants to start right now. Cautious Carl decides he will wait and figure out the best investment path before starting. Carl studies and after a year decides to invest in a portfolio of bond and stock index funds which returns 8% each years of investing. Moe starts out with a very conservative fixed investment and decides he will find better alternatives later. Moe has two years where he only earns 2% then he adds some bonds and has two years of 4% returns. Next Moe adds some stocks and ups his returns to 6%/year for another two years. Finally Moe discovers Carl’s portfolio and sticks with it. Who does better?

• Moe (blue) is always ahead for starting earlier!

Remember that time is money so even though it took Moe 6 years to find the right solution, starting one year earlier still puts him ahead of the game.  So, how much did Moe miss out from his 6 years of experimenting?  Only 4.5%, Carl’s caution cost him about 8%.   Time is your most precious ingredient for investing, so it’s better to start conservatively today than it is to wait until you have the perfect plan.

Tired of increasing credit card debt, or overdraw your checking account?  Would you like to be the one to fix your family’s finances?  Here is a simple system that can help you do it!

Eliminate the Invisi-bill

It’s easy to overspend if you don’t have any idea that you are doing it!   Do you know how much money you can spend today without getting into trouble this month?  I’m going to share the system I used in college to really know exactly how much I could spend:

• I always carried my checkbook.
• I immediately recorded any expenses.
  • Not just checks or ATM transactions but also credit card charges.
• If I ever wanted to spend I could check the balance to see if I could afford it!

Yes, I realize some of these expenses won’t clear immediately, but if you assume that they do then you never risk overdraft fees!  Also, when that credit card bill comes in the mail you will have the money available to pay it off.

But My Finances are too Complex!

I bet you are thinking that this could work for a college kid but your finances are too complex you have lots monthly bills, and some of them you don’t know the amount ahead of time.  Well there is good news; it isn’t hard to extend my simple system to work by:

• Recording any fixed monthly expenses at the start of the month
• Building up a reserve for variable monthly expenses

If you always enter the fixed monthly expenses at the start of the month they will never be a nasty surprise at the end of the month.   As for variable expenses- you probably already have a good guess of the range a bill could be.  For example your electric bill may be 2-3 times more in the summer when running the AC, but you know it isn’t 20-30 times more.  If you put aside some amount of cash reserve you can cover the variable part of your variable expenses.  Also, once you know how much you really have to spend you will want to have some reserve cash anyway…  Otherwise you can’t take advantage of life’s opportunities because you are broke!

But I Hate All that Math

Do you like trying to manage credit card interest payments and overdraft fees better then tracking your expenses?  I certainly don’t!  However, there is some good new because once you increase your reserves enough and have the  habit of not overspending then you don’t have to watch your balance as closely.  I haven’t kept an exact total for years and haven’t overspent in years either!  These days I just keep a large enough reserve that I know I’m not going to over draw it in a month.  Then if I see my reserves dropping I spend less the next month(s), until my reserves increase enough so that I feel free to spend a bit more.

While reading Large Amounts Matter Too a quote from JD really got me thinking: “You rarely make financial decisions involving tens (or hundreds) of thousands of dollars.”    I agree people generally don’t spend huge amounts every day, but are the big opportunities really that rare?How many opportunities don’t we recognize?  Or just barely miss?  How many start small but turn into big wins over time?  Finally how many big wins are really summations of many small actions?

Unrecognized Opportunities

How can you take advantage of a big win unless you recognize it?  I’m very guilty of missing big opportunities.  I’m sure I missed at several million dollar opportunities.  I used the Mosaic Browser in ‘92 and I recognized that it was revolutionary compared with text based Gopher clients… but I didn’t recognize that the company to commercialize it would make a fortune and try to get in early with Netscape.. or even try to get some Netscape stock.

Missed Opportunities

I was at Stanford for most of the 1990es, ground zero for a lot of internet startups.  I knew people in the CS PhD program too.  Did I miss some chance encounter that would have put me as an early employee of either Yahoo or Google?  I wonder how many big opportunities we all just barely miss?

Small Seeming Big Wins

Some big wins seem are very small in the short term, but it the long term become huge.

• Choosing to Invest Early - When you choose to start investing early it may not feel like a big win, but consider if you invest $1 for forty years it becomes:
  • $21.72 @ 8% interest
  • $31.41 @ 9% interest
  • $45.26 @ 10% interest
• Investing with Index Funds - Saving a few percent in fees doesn’t seem like a big deal… unless you understand that interest rates really matter, and a 0.75% difference in fees could cost you over a quarter million dollars!  You also won’t waste time trying to outperform the market, especially if you don’t have the half million dollars to make it worth your time… even if you are the next Warren Buffett!
• Diversification - Instead of chasing after the latest hot sector you can own them all and let rebalancing automate buying low and selling high.

Big Wins that Require Small StepsSome big wins are really the result of a multitude of small steps.

• Investing - Most people save a bit at a time, small steps but those steps can lead to financial freedom over time.
• Successful Marriage - The I Do is just the start!  It takes a lot of small (and some large) efforts to really make a marriage work.  That has to be one of the biggest wins in terms of both happiness and finances.
• Practice - To be a master at anything takes years of practice- and those individual practice sessions are small actions with small effect but the sum is an incredible win.

Maybe the big wins aren’t really that rare, we just have to be more aware so we don’t miss all of them.  What do you think?

My title sounds like very strange- who wants to see their investments crash?   However, if a crash is going to happen it is much better for you for it to happen sooner and for the recovery to happen later! Let’s explore a few graphs to see when and how much it could matter.

Lump Sum

Let’s first consider a lump sum starting with $10,000 what happens in three cases:

• Blue - Uniform 8% Returns
• Red -  Boom (133.3% gain) then Crash (-50%)
• Green - Crash (-50%) then Boom (133.3% gain)

• All 3 cases end with exactly the same amount

This isn’t an accident because multiplication is commutative, the order you multiply doesn’t matter: 3*5 = 5*3 = 15.   However, most of us don’t do all of our investing in one giant sum.

Periodic Investments

Most of us put away some amount every year over a long period of time; let’s look at an example where we invest $1000 each year for 10 years with the same returns as above:

• Totals Very Different:
  • $26,812
  • $7,317
  • $13,486

Multiplication with addition (or subtraction) is NOT commutative, for example (5+1)*2+1 = 13 while (2+1)*5+1= 16.  The order matters!  It matters a lot in investing- if the crash happens first then the boom the total is over three times more than the boom first and then the crash.   So when you start investing you should pray that the biggest crash happens immediately!

How would you feel about a 20% reduction in pay for forty five years! Unless you start contributing toward your retirement early that is a very real possibility!  No one wants to see a huge cut in their standard of living when they retire, so how much do you need to contribute toward retirement to keep your standard of living?

Social Security

The Social Security Administration has a web site to estimate your benefit.   Using that calculator I found that my estimated benefit could range from 20-40% of my salary per year, depending on when I retired.  I also suspect that the benefits will have to decrease as Social Security may need a bailout.    However, I can’t see Social Security disappearing completely either.   For my calculation I assumed it will cover 30% your salary.  Now most of us would be eating cat food if we had to make it on 30% of our salary so what do we do about the rest?

Investments to the Rescue

What you invested over the years must provide the rest for you.  You can’t reasonably expect to make more income when you are 90, so you better not withdraw too much or you will be forced to live on only social security.  The rule of thumb is that a 4% withdrawal rate is very unlikely to deplete your investments.  Say that you wanted to prove 70% of your salary from your investments, how much money would you need? When 70% Salary = 4% investments then your investments need to be 17.5 times your salary.  As an example if you make $50,000 that means you need $875,000 to reasonably provide 70% of your salary.

But You Haven’t Been Spending 100% of Your Salary!

If you have been saving 10% of your salary to invest before you retired, then you are used to only spending 90% of your salary.  You shouldn’t need a 10% raise when you retire to keep your standard of living the same!  To keep the calculation simple I’m not including inflation either.  This is the same as assuming that the only increases to your salary are cost of living increases.  Since time is money and interest rates matter both are big factors to how much you need to save:

• Saving 10% of your income just won’t cut it unless
  • You start very early
  • You get good returns
• The returns in this example are after inflation,  so 8%  is a very good return!

It’s also interesting to see how much you contribute versus how much your investment returns contribute.   If you get 8% returns the following graph shows the following breakdown:The It’s the wonderful power of compound interest at work!  When you start early not only will you contribute less, but you will live on more in retirement:So do yourself a big favor- start contributing toward your retirement today rather than cutting to the bone tomorrow.

Yearly Really Beats Never!

You don’t get compound interest if you never reinvest, and the difference between never and yearly reinvestment is huge!  Increasing the reinvestment frequency is always a bit better but if you are already reinvesting monthly there just is not that much more to gain.

Don’t Forget!

You don’t want to forgo compounding because you forgot to reinvest- so why not look into automating the process?  Are you receiving dividend checks or are they going to a money market account?  How long does that money sit before you invest it?  Does it ever get reinvested at all?  There are automatic options called Dividend Reinvestment Programs (DRIP).  These programs re-invest the dividends as soon as they are paid out and usually do so with very low transaction costs.  It’s easy to sign up for a DRIP but the enrollment process varies between brokers.  For example E*Trade has an online form to enroll your stocks- while Ameritrade requires a call their customer service to enroll your stocks.
If you have a CD Banks are usually happy to automatically reinvest a CD into another CD of the same term. Just make sure that you know what time frame you could withdraw without a penalty.

Shopping Time

If you have to delay reinvestment a week or so won’t make much of a difference in your overall return- but higher rates of return will.   Take a bit of time to shop around for better alternatives.  The internet is a great resource for comparison shopping for investments.  I found a lot of sites by searching “compare CD interest rates”.  Keep in mind that as long as you are under the FDIC limits any FDIC insured bank is just as safe.
If you invest in ETFs or mutual funds it is a good idea to check that the fees haven’t changed or that there aren’t other lower cost alternatives.  Again all of this information is available on the internet- for example if you own a Vanguard EFT the prospectuses are available here.  I found that page searching “Vanguard Prospectus”