Teaching Personal Finance in School


A dyed red-haired rapper criticizes the public education system in a viral YouTube video, “Don’t Stay in School“.  Looking back at my education, I remember learning the capitals of the states for no apparent reason.  Other than watching Jeopardy, I’ve never used this information.  Now my children are also learning the capitols, again for no reason.  With search engines this information is even more useless than when I was in school.

If we replace the teaching of useless and pointless things like this, or maybe the learning of the three types of rocks (igneous, sedimentary, and metamorphic), we would have time to teach children a lot of really important things for their lives like personal finance.  Much of the information about personal finance that keeps people from making bad decisions was not taught to their parents, which is one reason we see so many people buying new cars every three years or running up debt on 19% interest credit cards.  Here are some lessons that should be taught in schools instead of, say, the types of clouds.

The rule of 72.  If you take 72 and divide by an interest rate, that will tell you how long it will take an investment to double at that rate.  For example, if you put your money into a CD paying 4% interest, you will double your money about every 72/4 = 15.5 years.  Double that rate to 8% by investing in bonds and you’ll double your money about every 72/8 = nine years.  You get a better return because you’re taking on a little more risk since the bond issuer could default.  Go into stocks, which have a variable return, but one that averages around 12% annualized if you hold them for at least 20 years and you will double your money every six years or so.  If you invest your money for 30 years, $1000 will turn into $4,000 in bank CDs, $8,000 in bonds, and $32,000 in stocks.  That’s something worth learning.

The rule of 72 works the other way as well.  If you are taking out a home mortgage at 8%, you will pay in interest about every nine years about the amount of principle that is not paid off during that time. Because you pay back very little of the principle during the first two-thirds of a mortgage, if you have a $200,000 30-year mortgage, you’ll pay about $160,000 in interest during the first nine years and still owe about $180,000 on the loan, as if your payments just vanished.  Over the life of the loan, you’ll pay about $530,000 for that $200,000 mortgage.  If you use the rule of 72 and assume you’ll owe about the full loan value for the first 18 years and then a little over half of the mortgage value for the last twelve years or so, you would estimate paying $200,000 for the first and second nine-year period, then a little of $100,000 for the last 12 year period, which is pretty close to the $530,000 paid.  If you get a 15-year loan instead, you could estimate about $200,000 for the first nine years and then a bit more than $100,000 for the next six years.  The true amount you’d pay would be about $344,000 – fairly close to your estimate of a bit more than $300,000.

Note if you keep a credit card balance and are paying 15% interest, the rule of 72 tells you that you’ll be paying the full value of the balance in interest every five years.  If you keep a $10,000 balance on your cards, you’ll be paying $10,000 every five years or about $2,000 per year in interest.  That is a paycheck or two for many people, meaning you’re working a month of your life per year just to pay interest on your credit cards.  Maybe if people learned this in school, they would be more leery of whipping out the plastic for a vacation.

The power of extra payments.  And speaking of home mortgages, here’s a little trick that is not taught in school that would be very valuable.  If you look at your mortgage pay-off plan, you can determine how many payments you could remove from the loan by making an extra payment.  For example, in year one of a 30-year loan on $200,000 at 4% interest, you’ll be paying about $3,500 in principle and $8,000 in interest.  Monthly this is about $300 in principle and $670 in interest each month, for a payment of about $970 per month.  If you paid an extra $300 in a month (the amount of the principle paid each month), you would be eliminating one mortgage payment, saving yourself $970.  Pay an extra payment, and you’re eliminating about three payments, or $3,000.  If you make an extra payment during the last year of the loan, you’d only be saving about $60 since at that point your payments are going mainly to principle.  By looking at the amount of principle you are paying off each month, you can see how powerful making extra payments is.  Early in the loan (and the higher the interest rate you’re paying), extra payments are very powerful and well worth the money.  Later on, not so much.  Maybe if people knew this, they would try to hit the loans hard during the first several years and save hundreds of thousands of dollars.  People often get serious about paying off their loan at the end, but by that point, most of the damage has been done any you might be better off to invest the money.

Small amounts add up.  Let’s say you run by Starbucks every working morning and drop $6 on a sugary coffee drink.  If instead you made a cup of coffee at home for essentially free (compared to $6 per cup) and invested the money, you would be investing about $150 per month or $1,800 per year.  Invested in mutual funds, making 10% annualized over 30 years, you’ll have about $330,000.  That is enough to send a child or two (or three) to college.  So, just by changing your morning routine and making expensive coffee drinks an occasional luxury rather than a daily routine, you can pay for college.  Imagine how different things would be if almost everyone did this.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Sample from the Cash Flow Book: The Cash Flow Diagram.


As I’m working on the second book, Cash Flow Your Way to Wealth, I thought I would put out some samples from the book.  Here is part of Chapter 1, which presents the basic idea of personal cash flow and the cash flow diagram.  Look for the book to come out in a couple of months.  Enjoy!  SI

Most people mistake income for wealth, but the two are very different things. Income is the amount of money that you have coming into your household – the size of the stream entering your canyon. Wealth is the storage of money that you have – the level of the lake in your canyon. Huge amounts of water flow through the Grand Canyon in the Colorado River each year, yet there is far less water in the Grand Canyon than there is in Lake Mead behind the Hoover Dam. The difference is that in one case the water is allowed to flow right through, where in the second it is stored.

People who have high incomes tend to drive fancy cars, have big houses, eat at expensive restaurants, and wear expensive clothes. People who have large amounts of wealth tend to drive modest cars, have modest houses, eat at home a lot, and wear average clothing. There are a few extremely wealthy individuals who do display their wealth somewhat, but even then the cost of their lifestyles are well within their income level.

Luckily, you don’t need the income of Bill Gates to become wealthy. You just need to start storing some of your income, then invest to increase your income. This is not an overnight process – it takes time. Decades, in fact. But with a bit of persistence and patience, most people can join the ranks of the wealthy. Because most people spend all that they make and then borrow more, it isn’t that difficult to become one of the top 10% or even top 1% of wealthy individuals, currently around $1 M and $8 M, respectively.

Now let’s get to the heart of the matter – the cash flow diagram. A lot of people create budgets. Budgets are fine, but a budget is a flat canyon with no dam – you balance inflows and outflows with nothing saved and stored up when you’re through. A cash flow diagram directs your money into investments, which in turn create more income, increasing the size of the stream entering your canyon. In this chapter we’ll introduce the diagram and give an overview of each of the boxes that comprise it. Then, for the rest of the book we’ll go into each of the boxes in detail and show how to setup your own cash flow to build wealth.

A basic cash flow diagram is shown in Figure 1. Income flows in through Box A, rests briefly in Box B (Cash on Hand), then is distributed to various expenses or savings/investments. Income includes your paycheck, any income you make from side jobs, investment income, alimony, and gifts from uncle Bob. Cash-on-hand is your bank account or checking account – money that you have readily available for use whenever you want. Expenses are money flowing out of your bank account, never to be seen again. Investments are places where you put money at risk in order to generate more income.

Cash flow through your cash-on-hand is required to follow the familiar PISO equation:

Production + Inflow = (Change in) Storage + Outflow.

This says that all money produced by your investments, plus any inflow from salary and other sources, must equal the change in your cash-on-hand plus outflows to expenses. Rearranging we have:

(Change in) Storage = Production + Inflow – Outflow.

In other words, if you want to increase your storage of money (your wealth), you need to make the sum of your production of money (investment returns) plus your income (salaries, etc…) exceed your outflows (expenses). Or, as your grandma used to say,

Spend less than you make.”

What a simple concept: If you want to increase the amount of wealth you have, spend less than you make. And yet few people ever build any real wealth over their lifetimes, so few people follow this principle. In fact, most people spend more than they make, so they are destroying wealth before they ever have the chance to earn it. No wonder the fiscal health of society is so poor!

OK – so this all makes sense, but what does it have to do with Figure 1, the cash flow diagram? Well, your inflows – your income – is given in Box A. Box B is your change in wealth storage. Boxes C, D, and E are expenses, which are outflows of cash. Finally, Boxes F and G are investments, producers of wealth.

Notice that there is an arrow from Box A to Box B. This means that Box A increases Box B – your income increases your cash on hand, just as inflows increase the storage of wealth. There are arrows from Box B to boxes C, D, and E. These are the outflows, which decrease the amount of wealth you have stored. If the cash flowing in from Box A exceeds the cash flowing out through to Boxes C, D, and E, your wealth will increase. If the opposite is true and the flows to Boxes C, D, and E exceed cash flowing in from Box A, your storage of wealth will decrease. When everything is balanced, such that inflows from Box A exactly equal outflows to Boxes C-E, then your wealth will remain constant.

Going back to our vision of the river and the canyon, the canyon is Box B. The water flowing into the canyon is the arrow from Box A into Box B. Water flowing out of the canyon are the arrows to Boxes C-E. If you have a small salary, the money flowing from Box A to Box B will be small – a creek. If you have a large income, it will be substantial – a raging river. It doesn’t matter how much money is coming into Box B from income, however, if the amount flowing out of Box B to C-E is equal to or greater than the amount flowing in – the water in the canyon will never rise, it may  even decline. The amount of wealth stored in Box B will never increase or it will even decrease until there is no more stored wealth.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Financial Options for Paying for Retirement


So perhaps you’ve been saving and investing for years, and now retirement is in your sights.  The question now is, “How do I use the money in my retirement accounts and other savings to pay for things in retirement?”  Today I thought I’d discuss some considerations and ideas.

How much income can I receive each month?

The first consideration is how much spending money will you have in retirement.   This information might also point to the need for a part-time job or other source of income in retirement.  A fairly good rule-of thumb is that you can withdraw about 3-4% of your net worth per year from your retirement account without the value declining in value in real-dollar terms.  (Here “real dollar” means dollars adjusted for inflation so that you’ll have the same amount of spending power as the years go on.)  If you withdraw more than this, you will be spending your portfolio over time and eventually run out of money, assuming you live long enough.

For example, let’s say you have a portfolio (401k, IRA, savings, etc…) totaling $750,000.   You would be able to spend about 0.03*750,000 =  $22,500 per year without seeing the value of the portfolio decline and be able to leave your heirs about the same amount of money when you died.  Monthly this would be about $1875.  If you were just paying for a family of two, had the house paid off, drove old cars, and didn’t do much, this might be sufficient.  If you wanted a bit more of a lifestyle, you might need to work a part-time job to help with expenses.  You could also consider options such as selling your home and downsizing to increase the investment portion of your net worth.  If you pulled out $40,000 per year, the value would decline over time, meaning you might run into an issue in your 80’s or 90’s.

How can I generate the income I need?

The second aspect is how you use the money in your portfolio to generate the cash needed to pay for living expenses.  Here there are basically three options:  1)  Invest a portion of the portfolio in income producing assets to generate regular payment, 2) Sell some assets each year to raise cash, and 3) Buy an annuity to pay the income you need.  Let’s look at each of those options.

1.  Invest a portion of the portfolio in income-producing assets to generate income.

This is the traditional way of generating income for expenses.  It works well in times when interest rates are fairly high (not the current period).  Many people simply invested in bank CDs to generate income, but while the dollar value of bank CDs remains constant, value will be lost to inflation each year, plus the rate of return will always be lower than other options like bonds, real estate, and dividend-paying stocks.  You can choose this option if interest rates are sufficiently high to generate the income you’ll need and you’ll have enough left over to invest in growth assets like stocks to prevent inflation from reducing your rate-of-return in the future.

Typically the percentage of income investments when you retire should be around 50%, so if you can generate enough income from bonds and dividend-paying stocks using about half of your portfolio or less, while investing the remainder in growth stocks that will increase in value with time. this could be a good option.  Note that as you age, you would shift a greater percentage of your assets to income assets to increase the amount of income you receive each month to account for inflation.  When you were 80, you might be 70-80% in bonds and 20% in growth stocks.  You could buy individual. stocks and bonds, but it is usually easier to buy an income fund.  Also note that the higher the return you’re receiving, the higher the risk you’re taking.  It is generally a good idea to spread the risk out between safer, lower paying bonds and more risky, higher paying bonds.

2.   Sell some assets each year to raise cash.

The first strategy is probably best if you have just enough money to generate income for retirement.  If you have more than enough, you might still put a portion in bonds to help smooth out the volatility (having about 20% in bonds will greatly reduce the price level of value fluctuations in your portfolio without greatly affecting your total return), but plan on selling assets each year to raise cash for expenses.  Because growth stocks will provide greater returns than bonds and income stocks over long periods of time, this will provide more money to use in retirement and/or pass on to the next generation.  There will be volatility, however, so you need to have enough of a cushion to weather most market downturns that may occur.  This means you really should have at least twice the portfolio value required to generate the income level you really need since a 50% decline in stocks over a short period is not common, but it does happen once-in-a-while.

Part of using this strategy involves using cash to provide the money you need during the years when the market declines and you need to wait for the market to recover before selling more shares.  Since the market usually recovers within a year or less (although there are exceptions like the Great Depression), having a cash cushion will usually provide the time you need to avoid selling shares too cheaply and locking in losses.  Since having a loss over a five-year period is almost unheard of, having between three and five years’ worth of cash is a conservative strategy.  (Note “cash” here means bank CDs and money market funds – not $100’s in your mattress.)

If using this strategy, some level of opportunism should be used.  If there are years when the markets do really well, use the opportunity to raise some cash.  In years when the markets decline, maybe wait to sell unless your cash drops below some threshold, for example, 2 years’ worth of expenses.

3.  Buy and Annuity to provide a monthly payment.

When you buy an annuity, an insurance company invests your money and pays you a guaranteed amount per month for the rest of your life (or some other period depending on the terms of the annuity).  Because the insurance company wants to make money, they will always pay you less than the amount you could have received if you had just invested it yourself using strategies 1 or 2 above.  The difference is that the rate-of-return each year would vary if you invested yourself, where it would be guaranteed (provided the insurance company didn’t default) with the annuity.  The insurance company would get variable returns by investing your money, but make a higher return overall, where you would get a lower, but fixed (guaranteed) return.

Clearly, annuities have drawbacks.  The income they pay is often fixed in dollar terms, so your buying power may decline over the years due to inflation.  If you die young, your money may be gone so you may not have anything to leave heirs.  As stated above, you will not, on average, do as well with an annuity as you will do investing yourself (assuming you invest appropriately).  The exception may be if you live a really long time, but for everyone who lives exceptionally long, someone dies exceptionally early.

If you do choose to buy an annuity, avoid the fancy annuities that promise things like additional returns based on the market performance or other bells and whistles.  Just buy a simple annuity that pays a fixed amount (perhaps indexed to inflation), either immediately or at a certain age (if you’re worried about running out of money late in life) .    If you want to also get some market returns, hold back some cash and invest it yourself outside of the annuity.

Note finally that there is no reason to just choose one of these strategies.  You can mix and match them.  You could buy bonds and income stocks to generate some income, but also sell some stocks to raise cash to supplement what the bonds were paying, particularly in times like now when bonds aren’t paying much.   You could also buy an annuity to pay for something critical like food and basic necessities, then use bonds and growth stock sales to pay for luxuries like travel and home improvements.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.