Pondering Money

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?

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.

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.

You Pay Yourself How Little?

A different way to think of your investments is that it is the salary you give your future self. Consider the following example: Joe makes $50,000/year and invests 10% of his income a ($5,000/year).  There are about 2000 hours in a year of work so that means only about $2.5/hr goes to the future Joe.  That’s about one third of the minimum wage!

Give Your Future Self a Raise

If you find that your future self is working for sweat shop wages consider the following:  If you could cut back some expenses and invest the savings it’s like working a lot more… For example cutting $50/month on cable would be like working an extra twenty hours for your future self.If you are the type of person that always spends any available cash try boosting your investment rate by one percent and see if you really notice, because your future self really will!  If Joe invests another 1% ($41.67/month) his future just got a 10% raise! You will be your future self soon enough, so be kind and give yourself a raise today!

Welcome to pondering money!  My goal is to provide posts that make you think differently about your money and your future.   The key for me to be successful is to get your feedback, if you don’t understand something I NEED to know.   If you don’t like something tell me how it could have been better.  Finally, if you do like something let me know- so I can provide you with the best possible posts!-Rick Francis