Pondering Money

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”

Dave Ramsey advises people to not contribute to retirement accounts while repaying credit card debt.  This advise seems sound because credit cards charge high interest rates and your investments may not make 10 or 20%.  But is this idea still correct when there is a company match, after all an immediate 50% or 100% return is pretty hard to pass up?

Your Choices

To simplify a bit I want to look at two choices: You could put $1000 dollars in 401K with a 50% match or you could take the $1000 pay 25% in taxes and put the remaining $750 toward your credit card.  After your credit card is paid off you take the monthly payment and contribute that much to your 401K and getting the employer match and a tax deduction.  Because of the tax break you can afford to contribute 25% more without lowering your income.  After five years which option earns you more?

And the Winner is…

It depends on the interest rates, but here is a graph that simplifies a lot of complex math:

It turns out that the expected interest rate on the credit card has to be a few percent higher than the expected interest rate from the 401K.    I tabulate the numbers below, an example if you expect to get a 6% return on your 401K investment then you should pay off a credit card that is 8.72% or higher.

What about 100% Match or 0% Match?

The results are the same- I was actually a bit surprised but the match % cancels out of the calculations.  The above chart does not depend on how much your employer matches- or if they match at all!

The Math

For anyone interested, I can send you a spread sheet with the calculations.  It’s a bit of a mess because the solution can’t be solved algebraically.  You make an initial guess and do repeated iterations that get an ever improving result.

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!

Buying a stock on a hot tip is exciting, but it can be very expensive excitement don’t make the same kind of mistake I did…

Turning Back the Clock

In 2000 I sadly followed a hot tip and bought 15 shares of Sycamore Systems for about $1000. Pure speculation and not very wise on my part I was caught up in the irrational exuberance of the Internet bubble. It was pretty exciting, especially when the stock more than doubled!

What goes up…

The internet bubble popped sending stock prices through the floor. As it plunged I could have at least my original investment back… but I hung on, and on, and on… Hindsight is 20/20, so I know I should have sold, but who knew at the time that it really was the end of the bubble? Today, it’s a stock I’m likely to never sell. Don’t misunderstand, it isn’t that that it’s a wonderful investment. It’s that it is worth so little now (~$42.30) that it is worth more as a reminder to NEVER again buy a stock on a hot tip!

A Saner Alternative

What if instead I had bought $1000 of the S&P 500? Today it wold still be worth $760. Yes, that seems like a pretty big loss but when you include nine years of dividends I would actually be pretty close to break even… That’s even after buying at a truly terrible time to buy stocks!

Don’t Try This at Home

Being older and wiser, I’m not planning on repeating this folly. I’ve realized that I don’t need to get 100% yearly returns to reach my goals.   Slow and steady is far more likely to get me there- even if it is boring!  Please take my advise- forget the hot stock tips, buy low cost index funds and reap the rewards of owning a piece of capitalism.  The alternative is that you have your own $1000 reminder.

Even if you are the next Warren Buffett unless you have about half a million dollars you are still better off investing in index funds.  How could it be that the worlds greatest investor should still buy index funds?  Picking an index takes almost no effort and thus virtually no time, while finding superior stocks is a LOT of work!

Just Supporting Yourself is Costly

Let’s pretend that you are just as good as Warren at picking stocks.  But don’t fool yourself it will be a full time job for you- he didn’t become a billionaire by lounging around!  Since finding superior stocks will take all your time it must provide all of your income.  According to Berkshire Hathaway’s 2008 annual letter to the stock holders, their average compound annual gains are 20.3% which beat the S&P500 index by an impressive 11.4%.  If you can’t pay your salary from that 11.4% premium you would be better off with some other job and investing in a S&P500 index fund.   How much money do you need to invest to make it worthwhile?   Let’s just assume you are so good that you can do everything all on your own- no research staff, no special software, no special databases, just your time.  If your salary is $57,000/year, then you need $500,000 to invest to pay yourself and still match the returns of the S&P500!   Of course if you are that good at picking stocks you then go work for a mutual fund company earn a lot more than $57,000/year and invest in your own fund!

What About Dumb Luck?

I’m sure that someone reading this post will say- I didn’t need any work I picked stock XYZ and make an outrageous amount… That’s called luck, I’m happy for you but do you really think you are going to be lucky each and every year for thirty years?  If you really are that lucky forget the stock market- go to Vegas and win your fortune in a weekend it will be a lot more fun!

Reality Check

In reality we are almost certainly far less skilled than Warren Buffett, we don’t have millions to invest, we aren’t incredibly lucky, and we have far less resources than a mutual fund manager and the majority of actively managed mutual funds fail to beat the market.    Doe you still think it makes sense to try picking individual stocks?

 A seemingly small change in interest rates makes a  huge difference in the long term returns of your investments.  To get the most from compound interest you need to pay close attention to the rates of return of your investments.  There are so many possible ways to increase returns that I only want to touch on the major factors here.

Reasonable Risk

If you speculate wildly or stuff your money in a mattress you are likely to end up with far less than taking calculated risks.

Safety in Numbers

Buying individual stocks is always riskier than buying a group of stocks. What are the chances that a single company will fail and lose all of it’s value? Now consider what are the chances that a group of 500 companies will?  The down side is that a single company may grow by leaps and bounds while the average of 500 aren’t nearly as likely.  If you bet all your retirement savings on the fortunes of one company you may end up very rich… you may also end up eating cat food during retirement.  I think most people are better served accepting the average market return rather than gambling on a single company.   Mutual funds offer a way to buy large collections of companies, without the trouble and expenses of hundreds of transactions.

Thinking Long Term

The last few years have been pretty brutal for the stock market, but that is over a short term.   If you look at longer terms say- 20 years or more diverse collections of stocks have done very well. Take a look at this table at All Financial Matters, showing the returns from the S&P500, a group of stocks of the 500 largest companies traded in the US.  Note many of the 20 year periods the returns from the S&P500 have had average compound returns of 10% or more. Even considering the terrible performance of stocks in 2008, over the last 20 years the SP&P500 still had a 8.41% average growth rate. The future is never certain, but I don’t believe the economy is in a death spiral and will never recover.  I think it makes some sense to invest in both stocks and bonds.

Don’t be Taxed by Taxes

Is there anything worse than making sacrifices to invest then giving a large portion of the return to the tax man? If you don’t consider the impact of taxes on your investments you could lose a quarter or more of your yearly returns! Fortunately there are strategies that will help you minimize your taxes.

Tax Shelters

The US government wants you to invest for both your retirement and for your kid’s college expenses.   It have created special accounts for these purposes that give you tax breaks as an incentive.    The gotcha is that they also impose fees if you use the money for other purposes!  You probably have heard of at least some of these accounts- 401K, Roth IRA, 529 Plan, 403B, or SEP.  The exact rules differ from account to account but the purpose of all of them is to avoid or at least delay paying taxes.

Tax Efficiency

Not all investments are taxed equally, for example the gains on corporate bonds are taxed at the higher ordinary income rate while the gains of stocks are taxed at lower capital gains rates.  If you can’t put all of your investments into a tax sheltered account, then you want to put the tax inefficient investments in the tax sheltered account and the tax efficient investments outside of the tax sheltered account.  You may even choose an investment that has lower pre-tax return such as a municipal bond in order to get a better after tax return.

Cut Investment Costs to the Bone

Would you be willing to examine your mutual fund fees for a quarter of a million dollars?  Could it make that big a difference?    Say you invest $5000 per year in a mutual fund that returns 8% over 40 years with a 1% fee, how much would you have?  Over a million dollars ($1,093,898)- compound interest is a wonderful thing! However, if you could invest in a different mutual fund that returns 8% over 40 years but has a 0.25% fee then your total grows by 23% to $1,351,458.93. That’s a $257,560 increase for a 0.75% lower fee! Every penny paid in fees or transaction costs is money that isn’t going to grow for you.  In many area of life you get what you pay for, but in investing you get what you don’t pay for!

I always find that I get much better deals when I first decide what I want to buy then hunt for a price rather than letting someone else sells me something, but would you believe it could be a 90% difference?About either years ago two Kirby Vacuum cleaner salesmen came and demonstrated their g-six vacuum.   I have to give them credit as they showed off their product very well- or I wouldn’t remember this story!   It was an impressive cleaning machine - it picked up the Carpet Fresh that our vacuum had left over a year of weekly vacuuming!  I was convinced that it was a nice vacuum- but the price was just too high.  They starting at $1000 and the best I could haggle down to was $800.  In the end we didn’t buy it.  I also remember being very happy we didn’t as finances were a bit tight in the next few months and would have been a lot harder with $800 less.  I actually feel a bit guilty though…  The salesmen went to the extreme of eating some of the carpet shampoo to demonstrate that it was non toxic.  I really feel someone willing to eat carpet foam should get some compensation!This summer I was looking to replace our old vacuum and I remembered their demo.  I did my own search and found an even newer model Kirby selling for $150 on craigslist.   I asked if the buyer would take $100- it never hurts to ask for a discount and I noticed it had been posted for over a month.  She agreed, so I showed up with $100 cash and picked it up that day.   She told me that she was willing to accept only $100 because several people already expressed interest then never show up to finalize the deal.In the end I discovered a few things I didn’t like about the vacuum; it weighs a ton and is too big to get under some furniture but for $100 I’m satisfied with my purchase.  The next time someone is trying to sell you something- think about how much you could get selling it in a few years.  If you do still decide to buy ask for a discount- the worst they can do is say no!