Which is Safer – Cash or Stocks?


I’m sure there are many out there who are saying the answer to the questions is obviously cash.  Stocks go up and down in value, and you could lose all of your money if you are in individual stocks.  Cash just sits there and waits for you to spend it.  As long as you are safe from robbery, if you have physical cash, or fraud or a bank run, if the cash is sitting in the bank, then obviously cash is safer than stocks, right?  Not exactly.

Put a dollar ten-dollar bill on the table in front of you and stare at it.  Not doing anything, is it?  Believe it or not, that ten dollars is being stolen right before your eyes.  Don’t believe it?  Put the ten-dollar bill away and put a one-dollar bill in its place.  If you kept that ten-dollar bill in your mattress from the time you started working until retirement, the one-dollar bill would be what you would be pulling out when you retired.  It would still look like the ten-dollar bill, but it would buy a soda in some vending machines or maybe a half-gallon of gasoline.   Because of inflation, the value of cash money is being stolen all of the time, even if the bills are physically safe.

And this leads us into the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the sidebar.) Today we cover the fifth rule:

5.  If you need it in five years or less, save in cash.  If it is ten years or more, invest.  If you’re in between, invest but only if you have a back-up plan.

The returns of stocks over one, two, or three years are unpredictable.  You could end up with more money or less.  If you invest in a diversified basket of stocks (for example, you invest in a three different index funds that cover different segments of the market), over most five-year periods, you’ll end up with more (maybe a lot more, maybe just a little more).  Over ten-year periods you’re almost assured of ending up with more and earning a return of maybe 8-20% annualized per year.  Over a fifteen year period of time, things start to settle in and you can almost count on an annualized return of 12-15%.  For periods longer than that, your return will remain in the 12-15% range.

Note you can use the rule of 72 to estimate how much your portfolio will be worth in periods of time more than 10 years.  Simply divide 72 by the annualized return and that will tell you how long it will take for your portfolio value to double.  For example, if you earn 12% annualized, your portfolio will double about every 6 years.  This means in 12 years your portfolio will be about four times what you started with ($10,000 will be $40,000).  In 18 years, you’ll have eight times as much ($10,000 will be $80,000).

If you have money that you absolutely need in a few years, investing in stocks would be very risky unless you have a lot more money than you need.  For example, if you are planning to go to college in two years and need $20,000 for the first year, you would not want to have the money invested if you only had $25,000 saved.  You could just as easily have $15,000 in two years as you could have $30,000.  If you kept the money in cash, your money might only buy what $24,000 bought two years before – meaning college costs may have gone from $20,000 to $21,000 or $22,000, say – but at least you would be assured of at least having that much spending power.

For money not needed for ten or more years, you really need to invest because otherwise not only will you miss out on a much better return on your money than you’ll find in savings accounts or even bank CDs, but you will also see the spending power of your money decline if you don’t.  This decline will probably be fairly gradual, maybe 1-4% per year, but it could be very rapid should we see hyperinflation again as was seen in the 1970’s.

For periods of five to ten years, it really is a crap shoot, although the odds are somewhat in your favor if you invest.  If I really needed $20,000 in seven years and I had $25,000 saved, I might choose to keep it in a five-year bank CD and just work and save more to fight inflation.  If I had $40,000, I would probably invest it, figuring that even if I saw a loss of 50% I would still have the money I needed.  I would invest in mutual funds instead of individual stocks in this case since I could well see a 100% loss in an individual stocks, while even a 50% loss in mutual funds would be unlikely.   I could also put $20,000 away in a bank CD and invest the other $20,000.  That would be the best option because then I’d be assured of having at least $18,000 after inflation, and I’d probably more than the $20,000 I initially invested in the investment account.

So for money that you won’t need for a long time, like children’s college funds when they’re infants or retirement funds when you’re younger than fifty, invest the money.  For money you absolutely need in a few years, put it in a bank and get the best return you can while still staying in safe bank products with assured returns.  For things in between, invest if you have more than enough, and save if you have just enough.  

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave 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.

Live Your Net Worth, Not Your Paycheck


Most people live their paycheck.  If they make $40,000 per year, they spend $40,000 per year.  If they make $150,000 per year, they spend $150,000 per year.  Actually, it is worse than that, since most people are also making payments each month on things they’ve bought before, so they are actually living on their future paychecks as well.  

All of this seems like a perfectly fine situation until the car breaks down.  Or until you get laid off.  Or you get a medical condition and need to take an extended period of time off for a surgery.  Then suddenly cash flow becomes an extreme issue since you really don’t own the things you have.   They are just being rented each month through payments.  The car you “own” is being repossessed.  The home you “own” is being foreclosed upon.  Everything you have is tied up in your income, and any little hiccup in that income is disaster.

What is instead of living your paycheck, you lived based on your net worth?  What if you started out spending no more than 25% of your net worth per year – giving yourself the ability to live for about four years at your current lifestyle should your income stop.  Then, as your net worth grew to the point where you were approaching financial independence, what if you figured out how much income you could reasonably generate from your net worth – 5% would be a reasonable estimate – and limited your spending to that?  Doing so would allow you to continue to live at your current level indefinitely even if your salary stopped.  How would your life be different?  Here’s a hint – it would be a lot more secure.

For example, let’s say that you have the following net worth at age 35, having been working on paying off your home, putting money away for retirement, and putting some money into investments:

Home equity: $100,000

Retirement accounts: $60,000

Car Equity:  $10,000

Savings: $9,000

Investments: $50,000

Total Net Worth: $220,000

Your spending limit would then be = 0.25*$220,000 = $55,000 per year, with the rest being used to fund retirement and build assets.

Let’s now say that your salary is $80,000 per year and grows by 3% per year for the next 20 years.  Let’s say you followed this idea and you limited your yearly spending to $55,000 per year, regardless of your income, until your net worth was four times your income.  At that point you then limited your spending to your income after that and let your assets compound.   Let’s also assume your assets grew by 6% per year, being a mix of mainly stocks and home equity.  Your net worth and spending would then grow as follows over the next 20 years: 

Year Salary Net Worth Spending
0 $80,000 $220,000 $55,000
1 $82,400 $258,200 $64,550
2 $84,872 $291,542 $72,886
3 $87,418 $321,021 $80,255
4 $90,041 $347,445 $86,861
5 $92,742 $371,471 $92,742
6 $95,524 $393,760 $95,524
7 $98,390 $417,385 $98,390
8 $101,342 $442,428 $101,342
9 $104,382 $468,974 $104,382
10 $107,513 $497,112 $107,513
11 $110,739 $526,939 $110,739
12 $114,061 $558,555 $114,061
13 $117,483 $592,069 $117,483
14 $121,007 $627,593 $121,007
15 $124,637 $665,249 $124,637
16 $128,377 $705,163 $128,377
17 $132,228 $747,473 $132,228
18 $136,195 $792,322 $136,195
19 $140,280 $839,861 $140,280
20 $144,489 $890,253 $144,489

Note the effect here is to limit your lifestyle while you build security.  When you are just starting out in a job and you have no savings, you’re continuing to live like a student until you start to build up some savings, home equity, and investments for security.  Once you’ve built up your security blanket to help insulate you from life’s little events, you increase your spending and start living more of the good life.  

Doing this also lets you command a much higher income since while you are working, your assets will be generating income in addition to your salary.  In the above example by the time you were 40 you would be making $93,000 from your salary, but you’re also making $22,000 per year from your investment portfolio and increases in the value of your home.  This means you have a cash flow of $115,000 while your coworkers who’ve spent every dime only have a $93,000 income. They also probably have debt, probably sucking away $10,000-$15,000 of that $93,000 per year, so they have $77,000 in spending power while you have $115,000.    That’s an extra $38,000 per year to out towards college tuition, paying off the home, or just adding luxuries.  Keep this up and you’ll have the spending power of $1 M per year by the time you’re ready to retire while they’re living on maybe $200,000.

So by limiting your spending, between the ages of 35 and 40 you have grown your net worth by more than 70% while most people would simply be treading water.  You’ve seen your available spending increase by $40,000 as well, matching that of your peers even before they pay their credit card interest payments and car loan interest payments, but unlike them, your income has the solid foundation of your net worth behind it.  If you lose your job, you can tap your investments and savings and maintain your lifestyle, at least for a long period of time.

OK, so obviously there is an issue with this strategy and a little tweaking is required.  When you first start working you probably have a zero net worth or maybe even a negative net worth.  Obviously if your only possession is a $3,000 paid-for car, you can’t live on $750 per year.  You could, however, set a minimal amount of spending needed for absolute necessities – shelter, food, utilities, transportation, and clothing – and then limit your spending to that level (or close to it) until your net worth justifies moving beyond it.  This would guide you in controlling your luxuries until you are on firm financial ground.

For example, let’s assume you’re starting out, making $50,000 per year, and have a net worth of $0.  Let’s also assume your salary increases by 3% per year and you get an 8% annual return on your assets (you’re investing almost entirely in stocks at this point because you’re young and bulletproof).   You choose to setup a spending plan as follows:

1.  You estimate that you can get by with $30,000 per year, which includes the bare necessities, plus maybe $80 per month in “frills,” plus a $1000 vacation each year, so you start out at this level, putting the rest away into assets.  

2.  Once your net worth exceeds $30,000, you start increasing your spending to 25% of your net worth.  

3.  You then limit your spending to 85% of your salary until you are age 50 (putting the rest away for retirement).

4.  When you reach age 50, you just start spending your whole salary, letting your assets grow on their own.

5.  When your net worth exceeds 20 times your salary, you start using some of the income from your stocks and bonds as well, until you retire after working for 45 years.

Your budget and net worth would look like the following:

Year Salary Net Worth Spending
0 $50,000 0 $30,000
1 $51,500.00 $20,000.00 $30,000.00
2 $53,045.00 $43,100.00 $30,000.00
3 $54,636.35 $69,593.00 $30,000.00
4 $56,275.44 $99,796.79 $30,000.00
5 $57,963.70 $134,055.97 $33,513.99
6 $59,702.61 $169,230.16 $42,307.54
7 $61,493.69 $200,163.65 $50,040.91
8 $63,338.50 $227,629.52 $53,837.73
9 $65,238.66 $255,340.66 $55,452.86
10 $67,195.82 $285,553.71 $57,116.45
11 $69,211.69 $318,477.38 $58,829.94
12 $71,288.04 $354,337.33 $60,594.84
13 $73,426.69 $393,377.52 $62,412.68
14 $75,629.49 $435,861.72 $64,285.06
15 $77,898.37 $482,075.08 $66,213.62
16 $80,235.32 $532,325.85 $68,200.02
17 $82,642.38 $586,947.21 $70,246.02
18 $85,121.65 $646,299.35 $72,353.41
19 $87,675.30 $710,771.54 $74,524.01
20 $90,305.56 $780,784.56 $76,759.73
21 $93,014.73 $856,793.16 $79,062.52
22 $95,805.17 $939,288.82 $81,434.39
23 $98,679.33 $1,028,802.70 $83,877.43
24 $101,639.71 $1,125,908.82 $86,393.75
25 $104,688.90 $1,231,227.48 $88,985.56
26 $107,829.56 $1,345,429.01 $91,655.13
27 $111,064.45 $1,469,237.77 $94,404.78
28 $114,396.38 $1,603,436.45 $97,236.93
29 $117,828.28 $1,748,870.83 $100,154.03
30 $121,363.12 $1,906,454.74 $121,363.12
31 $125,004.02 $2,058,971.12 $125,004.02
32 $128,754.14 $2,223,688.80 $128,754.14
33 $132,616.76 $2,401,583.91 $132,616.76
34 $136,595.26 $2,593,710.62 $136,595.26
35 $140,693.12 $2,801,207.47 $140,693.12
36 $144,913.92 $3,025,304.07 $151,265.20
37 $149,261.33 $3,260,977.11 $163,048.86
38 $153,739.17 $3,508,067.75 $175,403.39
39 $158,351.35 $3,767,048.96 $188,352.45
40 $163,101.89 $4,038,411.78 $201,920.59
41 $167,994.95 $4,322,666.02 $216,133.30
42 $173,034.79 $4,620,340.95 $231,017.05
43 $178,225.84 $4,931,985.97 $246,599.30
44 $183,572.61 $5,258,171.39 $262,908.57
45 $189,079.79 $5,599,489.15 $279,974.46


So you would live on bare necessities for the first five years, at the end of which you’d have $134,000 in assets.  You could then take maybe $50,000 and make a good down-payment on a home.  You would then start to raise your spending, growing to 85% of your salary by about year 8.  From that point on you’d have 85% of your salary to spend as you please, putting 15% away into savings and for retirement.  

By the time you reached 30 years on the job, you’d have a net worth of more than 10 times your salary, so you could stop saving for retirement entirely (while your coworkers are cutting back on their spending to fund their retirements).  By the time you were on the job for 36 years (about age 56), you would start supplementing your salary with income from your portfolio, adding more than $80,000 to your budget each year by the time you retire.  At the end you’d have a net worth of about $5.6 M and be able to retire with dignity.   This is after living large for the last 15 years

Saving and putting away money early is the key to a secure financial life.  Limiting your spending to increase your net worth makes all the difference.  Put your money towards acquiring assets and security while you are young, and you’ll have a much more secure future later.

Your investing questions are wanted. Please send 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.

How and How Much to Save For Retirement


This is the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the fifth rule:

4.  Put away 15% of your paycheck for retirement as the first thing you do.  Automate all you can.

Retirement.  The word evokes images of sitting in a rocking chair, travelling the world, or sitting on the beach.  For many it is extended visits for time with grandchildren, many of whom are in other states, or perhaps getting time to work on some projects you’ve been putting off.  Few people have images of sitting around, stressing over how to get the next meal or pay for important prescriptions, and yet that is what retirement holds for many who don’t start to save and invest until it is too late.

Saving enough for retirement is a huge hurdle.  If you’re retiring this year, you’d want to have more than a million dollars saved up – closer to $2M would be better.  If you are twenty years old and reading this, you’ll probably need around $4M – $6M saved to afford a comfortable and secure retirement.  This may seem an impossible amount, but it really doesn’t take a great sacrifice if you do a little at a time.  If you wait until you can see retirement around the corner, it is next to impossible.

People long for the days of pensions since they saw it as a much more secure and guaranteed source of income in retirement.  The truth is, you’ll do a lot better in a modern 401k plan, or simply saving and investing for retirement on your own, than you will with a pension.   The reason is that pensions are invested in a manner suitable mainly for people who are going to retire in five or ten years all of the time, instead of investing for long term growth while people are young and then becoming more conservative as they near retirement.  This is because pension plan managers need to be sure that the money will be there for people in the company who will retire soon.  This means that your return from your pension plan will be a lot less than it would have been if you had invested it properly yourself.   Someone who is in her twenties, thirties, or forties should be heavily in stocks and growth assets rather than perhaps half in income and half in growth as are pension plans.  Companies also set payouts low relative to the returns they expect from their investments to build in another margin of safety.  Of course, many pension plans are still underfunded since companies tend to fund the minimum required by regulators and then save their money for other things.  The pension plan investments are also the first thing cut when economic times get tough since they are competing with keeping the lights on and researching for the next products.

Social Security is a form of national pension plan, but it is on even shakier footing than corporate pension plans and the rate of return is absolutely dismal (it may be positive, but it is about on par with a savings account).  The trustees for Social Security (and Medicare) have reported to Congress numerous times that the program will run out of money in a few years and serious decisions will then need to be made.  Unlike a corporate pension plan where at least your contributions are invested, Social Security is a system where everything going in that is not paid out immediately to current retirees is spent on other things, just like other taxes.  Like a Ponzi scheme, this worked fine as long as there were many more people working than drawing benefits, but now that the ratio of payees to payers is changing, something will need to be done over the next ten to twenty years – even sooner perhaps depending on how things go.  This means payouts will be cut and perhaps taxes will be raised.

So why is it that pension plans are seen as safe and secure, and 401ks are seen as risky?  And why are many people not as well off with a 401k as with a pension?  The reason is our own behavior.  With a pension plan, you’re forced to contribute from every paycheck and you cannot take the money out before retirement no matter what.  (Note, even if the company pays for the pension, you’re really the one contributing since they could pay you more if they didn’t need to fund the pension plan.  The money that goes into that pension plan is created through your labor, not some other source of corporate funds that magically appear.) This allows the money time to compound and grow.  Even in retirement, unless the plan offers a lump sum payout, you are forced to leave the money there and take just a small amount out at a time with a pension plan.

With a 401k plan, conversely, people treat it like a giant piggy bank.  They don’t contribute enough, perhaps just putting in whatever the company will match, if that.  They then take loans out against their investments, which effectively become early withdrawals if not paid back soon after leaving a company or being laid off.  Finally, when they get into their forties or fifties and they finally start to see some investment income coming in as their 401k starts to build into that multi-million dollar account they’ll need in retirement, they get the whim to start a business, pay for a wedding or college, or simply pay off debt and break into that piggy bank despite the huge tax penalties.  They then approach retirement and bad-mouth 401k plans.

If you want to have a safe retirement, you need to treat your 401k just as you would a company pension plan.  This means you need to contribute enough and you need to not touch it for any reason until you are retired.  Even then, you need to withdraw the money out responsibly to preserve the balance and let it grow to cover the higher expenses you’ll face later in retirement as inflation and medical bills take their toll.  With a 401k plan you need to:

1.  Contribute at least 10% of your paycheck every month.  15% would be even better.  If it won’t all fit in a 401k, invest in an IRA and then taxable accounts as well.

2.  Make sure you capture all of the company match.  Unless you have a crazy-generous company, investing 10% will do this, but even if you decide not to invest the full 10%, make sure you’re at least investing enough to get everything your company is willing to give.

3.  Automate the investments, right from the start.  As soon as you get home with the paperwork from the HR office, fill out the form for the 401k and setup for your 10-15% contribution.  If you do this right away when you start, you’ll never miss the money.   It is much more difficult to cut lifestyle later.

4.  Select the lowest cost funds you can find in different sectors of the market.  Go with index funds and other unmanaged funds where possible since they will have the lowest costs.  Splitting money between large caps, small caps, and International is a good way to go.  You can also split between growth and value funds.  When you’re young, you have no reason for any significant amount of income investments.

Got an investing question?  Write to me at VTSIoriginal@yahoo.com or leave 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.

Get Started on Your Financial Education Today – On Sale


The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy
The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy

Many people put off getting started on investing because they don’t know what they are doing.  That’s really a shame because every five years you wait cuts your net worth in half when you’re approaching retirement.  It also makes it less and less likely that you’ll be able to reach financial independence by the time you’re forty or even fifty.  Over the last couple of decades, many people who thought they would just work longer since they hadn’t saved up enough to retire have seen themselves laid off at fifty-five and unable to find a new job.  If you are financially independent, that won’t matter because you’ll have plenty of assets, generating more income than your job, so you can retire at anytime.  You could also start another business, for love and not money, do charity work, or do whatever you want to do.  But it all requires that you start saving and investing when you’re twenty or twenty-five.  Not when you’re forty or forty-five.

Your twenties, and even your late teens, is also when you make the bad financial that make it hard to even do normal things like buy a house or start a family, let alone put money away for investing.  You get huge amounts of student loans by going to a college that is way out of your budget and taking too long to go through.  You buy new cars because you can “afford the payments.”  You go on vacation and come home with a timeshare you’ll never have time to use and will never be able to sell.  You start going out to dinner every night or doing take-out because you never learned to cook.  People often say that it was because they didn’t have a good financial education or because they were somehow tricked by the mortgage agent or the timeshare rep.

Providing that financial education is exactly the reason I wrote The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy.  In chapter two I provide information on all of the different types of investments that matter to a small investor, with a focus on stocks since that is where most of your money should be invested.  Chapter three gives the risks of all of the different types of investments – something you should know before investing your money.  It also gives details on how to manage risk to maximize your returns while protecting yourself from life-changing losses.

But the book is more than that.  The rest of the book provides the money management strategy that will help get you to financial independence.  These are the steps that will give you a good chance of getting to a million dollars before you’re forty, and into multi-millions by the time your seventy.  It gives the cash-flow plan of the wealthy and shows you how people who become rich manage their money.  Again, it is much better to start managing your money the right way when you’re 18 – before you ever take on debts or get into a lifestyle you can’t afford – than it is to try to clean things up when you’re 35 and deep in debt.

Starting later today (I’m not sure of the exact time), the electronic version of the book, which you can buy for Kindle, iphones/iPads, etc… will go on sale for half-off the normal price.  It will only cost $1.99 for the next few days, and then go up to $2.99 for a few days after that before returning to its normal price of $3.99.  You can also buy the paperback version for only $9.99 (normally $12.99).  Take advantage of this opportunity to start your financial education so that you can have a more secure, less stressful life.

Even if you don’t buy a copy of the book, I’m glad you’re reading  The Small Investor, because that is also a great way to learn to invest and handle money.  (You just need to search around more and organize the information for yourself.)  I often hear about how people don’t get a good financial education in school, so I’m trying to do my part to give you those skills.  Having people not manage their money well goes beyond you and your own family.  It means that people don’t have the money for health care (leading to the creation of expensive government programs that cost much more and deliver poorer results than could be had if people simply saved up the money themselves) and it leads to society needing to take care of millions of retirees who haven’t saved enough because they were “living for the day.”  While it’s true there are some people who aren’t able to take care of themselves because of physical or mental problems, and there are others who have some great tragedy befall their family that leaves them relying on charity or government programs for their needs, most people make well more than enough during their working lifetimes to pay for their children’s college, pay for their healthcare, and pay for their food and shelter in retirement.  It is just a matter of proper money management that is needed.  And how much better a society would we see if people did so?

Your investing questions are wanted. Please send 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.

The Start of the Debt Spiral – Not Having an Emergency Fund


Cash Flow for Normal People
Cash Flow for Normal People – Don’t be Normal!

People don’t plan to get into credit card debt and other consumer debt.  They start out thinking that they will just use the card to earn cash back or points for an airline seat.  They figure it is just like buying things with cash since they’ll pay off the balance each month.  Or maybe they keep one in case of an emergency, where they need cash fast and a credit card seems like a good way to be ready.

And then the car breaks down and they need a $1000 repair.  They whip out the credit card, even though they don’t have enough money to pay it off in addition to their other bills since their monthly spending equals their monthly earnings.  (Call it the law of the cash flow equilibrium, where your spending will always grow to equal your income, no matter how high your income is.)  They figure, however, that it’s an emergency – they need their car – and they’ll just pay it off over a few months.  Maybe they do, maybe they don’t, but eventually their air conditioner goes, or they need to go to the emergency room, or the car breaks again, or their friends ask them to go on vacation with them, and the balance reappears on their credit card statement, bigger than ever.

Before they know it, that $1000 balance goes to $2000, then $10,000.  Suddenly that silly little $10 per month interest payment becomes $100 or $200.  After a while, debt begets debt and they’re doing everything you can to just pay the debt each month.  Each little event causes them to go deeper and deeper into debt.  This is the debt spiral.  At first, everything is easy and manageable, but as things get worse it gets harder and harder to pull yourself out.  Eventually it becomes impossible and sending in a check to the credit card companies feels like trying to empty a lake with a teaspoon.

The way to prevent heading down this spiral is to be ready for emergencies so that you can handle them without going into debt.  This is the next item in the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to maintain a healthy and happy financial life.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the third rule:

3.  Have a store of cash for a rainy day.  It will rain at some point.

If you were a farmer, you probably wouldn’t sell or eat all of the food you grew.  You would know that some years you’ll have a great harvest, but others the locusts will come, or it won’t rain, or it will rain too much, or you’ll see a hail storm right as the wheat gets ready to pick.  So you would store some in the silos or preserve it in mason jars in your root cellar. And yet most people spend every dime they earn each month, and even get so many loans and subscriptions for things that they couldn’t cut their spending if they wanted to, as if they will never face a financial storm.  This means that they need to go into debt if something happens (anything happens) and they have an unusual expense one month.  Often this is credit card debt, probably the worst kind second only, perhaps, to payday loans.

If instead you put aside some money to handle these issues, what would have been a financial emergency turns into an inconvenience.  Break a leg and need to go to the emergency room?  You just dip into your emergency fund to pay the deductible.  Need a car repair?  The money is sitting there, waiting for you in your emergency fund.  You get out of these potholes in life without taking on debt.  And staying out of debt means you’ll pay a lot less for things since you’ll typically pay about twice as much for things you buy with debt than things you buy with cash.

Some facts about your Rainy Day Fund or your Emergency Fund:

1.  It should be about 3-6 month’s worth of expenses.  Figure out how much it would take to meet expenses for three to six months if you really cut back to the minimum needed, and then save that much up.  This will give you time to find a new job should you lose your current one.  If you have other sources of money like an investment account, you can save less.  If you don’t, then save up for 6 months.

2.  Your emergency fund should be in a combination of a bank money market account and bank CDs.  You need to have your emergency fund available when you need it, which means it can’t be invested in stocks or other things that go up and down in price.  Start out with cash and see how low you tend to dip in your emergency fund when you need it for a couple of years.  Keep that amount, plus maybe another $1000 in a money market fund so you can access it as needed.  Put the rest in a bank CD since you’ll still be able to access the cash if needed, perhaps paying an interest penalty, but you’ll earn a bit more on the money you’ll probably never access unless you have a life event like a long job loss.

3.  If you dip into it, save like a mad man (or woman).  If you deplete your emergency fund for something, you’re now vulnerable should something else happen.  If you need to dip into your fund for any reason, cut way back on spending and investing until the fund balances are back to where they need to be.  

4.  Emergency means emergency.  You don’t dip into your emergency fund to go on vacation or a night out on the town.  This could literally be the food in your children’s mouths should you lose your job.  It is also the only thing between you and the debt spiral.  Guard it jealously and only spend money from it for real emergencies.  If there is a way to leave it alone, do so.

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.

A Simple Analysis that Can Save You Big Time


OLYMPUS DIGITAL CAMERAToday I continue down the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to basically ensure a great financial future.   (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the second rule:

2.  Before you buy something to “save you money,” figure out how long it will take to recoup your costs.

 

There are always people telling us about all of the money we’ll save by buying their product.  Before you take the plunge and buy into something, however, you should spend a little bit of time doing a simple analysis to figure out how long it will take for you to make your money back and then actually start saving money.  By doing so, you might find that some ideas make a lot of sense, while others are really not that much of a bargain after all.  

When approaching this kind of analysis, you should start out simple with gross assumptions, just to see if the numbers are close or tilted far one way or another.  If you do so and the results are really convincing, like it would take you 40 years to make your money back, there is not a reason to continue.  If things are close, however, like you estimate that it will take you three years to make your money back but you will probably only own the thing for 2 1/2 years, then you should improve your assumptions and try again.  This would be referred to as “sharpening the pencil” in engineering and accounting circles. 

For example, let’s say you are looking at refinancing your home and you see that you can cut your interest rate by 1/2 of a percent.  Is this a good deal?  What is a simple analysis that you could do to estimate the amount of time required to make your money back (your break-even time)?

Well, if you have a $200,000 loan, saving 1/2% per year would save you (1/2% * $200,000) plus a little more.  As a first estimate, just assume you save (1/2% * $200,000) = $1000 per year.  Looking on the internet, you might find that closing costs for such a loan would be somewhere between $2000 and $4000.  You might just pick $3000 as a first-cut estimate.  Your time to break even would be:

$3000/($1000 per year) = 3 years.

So, if you are planning to be in your home for 15 years, this would be a no-brainer.  After about 3 or 4 years, you would have made the money back that you had paid in closing costs and you would be saving a thousand dollars per year after that.  If you were only planning to be in your home for a year, you would obviously lose money and should just stick it out with your current mortgage.  If you were planning to be in your home for four years, you would be right ont he line and would need to improve your analysis.  You could improve your analysis by using an online calculator to calculate your payments and to get better information on closing costs, since it could go either way.

You can also do the same sort of analysis if you’re looking at doing something to earn more money.  For example, let’s say that you are looking at going to a technical school and get a drafting degree.  The school costs roughly $15,000 per year and it would take you two years to get the degree.  You are currently making $10 per hour and think you could make $20 per hour as a draftsman from a brief internet search.  

The cost of the education would be: (2 years) * ($15,000 per year) = $30,000.  If you needed to take out loans to go to school, double the estimated costs to $60,000.  If you needed to leave your job to go to school, add ($10/hour)*(2000 hours/year)*(2 years) = $40,000.  So, you education would cost you about $100,000 if you took out loans and went full time.

Once you finished the degree and found a job, you would make ($10/hour)*(2000 hours/year) = $20,000 more per year that you were making before you went back to school.  Based on these numbers, it would take you $100,000/$20,000 = five years to make back your money.  If you are looking at a 20 year career, this would be a great move since you would make around $300,000 more than you would have without the degree.  If you were planning to work for a few years and then stay home to raise children, however, you might want to think about waiting until the kids were out of the home to get the degree since it might be more attractive to employers.

I can guarantee that on certain purchases you will almost never break even.  These include:

1.  Buying a time share, or even a vacation home.  You may think that you’ll get a “free vacation” each year after you make these purchases, but you’ll find that the payback will take forever and little costs you haven’t considered will keep you in the red.

2.  Going to an elite college, especially on loans.  With very few exceptions, such as becoming a partner in a law firm that only hires people who go to Princeton, you will never make the additional money back that you pay for an elite private school versus just going to your local state school.

3.  Buying an electric car or even a hybrid car.    You really won’t save that much money in gas, especially when compared to a comparable diesel car, and you won’t make enough to overcome the higher price tag before you’re looking at an expensive battery replacement.

4.  Any sort of home improvement.  You’ll only get maybe 75% of your money back on even the best projects, such as a kitchen or bathroom upgrade, and it will all disappear in five or ten years as your upgrades become dated.

So what about cases where you will never break even, or at least not break even during a time frame that matters?  In these cases, you should look at it as a purchase and treat it the same way you would treat any other luxury.  If you have a couple million dollars in the bank, you can afford to send a child or two to Harvard so they can proudly wear a maroon sweatshirt the rest of their lives.  If you are willing to eat in most lunches and save up the cash, you can buy a Prius to make all of your eco-elite friends jealous.  Just realize that you are spending money and not saving money.  You are buying a liability, not acquiring an asset, and people who do well financially acquire more assets than liabilities.  Like many other things, it’s about balance.

Your investing questions are wanted. Please send 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.

How the Way You Buy Things Can Make the Difference in Your Financial Life


In 10 Dirt Simple Rules of Money Management, I provided 10 rules to follow to basically ensure a great financial future.  In the next few posts in this series, I’ll provide more information on why they work and how to implement them in your life.  (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list.)  We’ll start with the first rule:

1.  You pay twice as much for something if you borrow money to buy it.  Don’t borrow for things that won’t pay back at least two-fold.

 Many people don’t think twice before borrowing money to do things.  They need a home, so they find a way to put almost no money down, get the longest loan they can find, and get the biggest mortgage for which they can qualify.  They choose a college without thinking too much about the cost and a major without thinking about the future salary, then spend five, six, or seven years taking the minimum number of classes and running up student loans all the while without even thinking about the balance or the monthly payments they’ll be facing.    Need to remodel the kitchen?  Get a home equity loan.  Want to go out to dinner or buy some clothes?  Whip out the credit card.  Need a new air conditioner?  Finance it.  Need a new car?  What will the payments be?  

They do all of this, taking out loan after loan after loan until the payments due each month equal or exceed their take-home pay.  They then spend the next thirty or forty years wondering why they can’t seem so save up any money.  They say it’s unfair that they have student loans to pay.  It’s unfair that the bank has a mortgage on their home and will take it if they get behind on payments.  They think it’s unfair that the loan on their car is more than the vehicle is worth.  It is unfair that the vacation is over and they now need to keep paying for it for the next several years.  

Many also start to blame the lenders, and nowadays they have various advocacy groups supporting them (and really enabling their poor financial decisions).  The lenders are predatory.  Are evil.  Are taking advantage of them.  They shouldn’t need to pay for the things they bought because obviously they were tricked.  They should get to keep their home even though the bank gave them all of the money for it and they’ve only paid back a small percentage.  They shouldn’t have to pay for their car because the payments are too high.  They shouldn’t need to pay back their student loans because they owe way more than their salary will let them pay in their line of work.

 We all make choices, and one smart financial choice you can make is to not borrow money unless you are almost assured of making at least as as a result of taking the loan as you will pay in interest.  At a 5% interest rate, your loan value will double in about 15 years.  At 10%, it will double in about 8 years.   At the kind of rates charged by credit cards, it might double in three or four years, or even two years.  This means that if you have a 30-year home mortgage, you’ll pay more than twice the price of the home when you’re done, even if you don’t take money out along the way.  With student loans, you’ll pay twice as much if you take 10-20 years to pay them off.  That dinner left on a credit card will probably cost you two to three times as much by the time you are done paying for it with minimum payments.

Buying a new car on credit makes no sense because you can buy the same car for half of the price in five years if you save the payments up.  You can do even better if you buy four year-old used cars for cash.  If you buy a used car from your buddy in four years that he bought new with payments, you’ll pay about 1/4 as much as him for the four years you drive the car if you include both interest and payments.  (Just don’t tell your buddy so he’ll buy the car new for you to get later – just kidding.)

It may make sense to buy some things on credit because you do get a better return.  Getting a degree in engineering, law, or accounting, which leads to a good paying job that could not be had without a college degree, can be worth a loan since it will pay itself back in your increased earnings.  Buying a home can save you money on rent and the appreciation on the home can help offset the interest payments.  Even in these cases, however, you’ll be a lot better off minimizing the interest you pay by borrowing as little as you can and paying back the loans quickly.  If you’re buying a home, start out with a smaller, less expensive home, save up a 20% down-payment so you won’t have to pay mortgage insurance, and use a 15-year loan so that you cut your interest payments was down and get it paid off before your kids are looking at colleges.  If you are taking out a student loan, go to an inexpensive school, get all of the scholarships you can and get through as fast as you can.  Then, live like a student for a few more years even though you have a salary so that you can pay off the student loans before you buy a home.

Don’t fall into the trap of believing that you just have to take out loans to get things.  It just means waiting a little longer until you can pay cash rather than using credit and paying the interest.  You can even earn interest while you’re waiting.  

Your investing questions are wanted. Please send 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.