Uncommon Cents

Looking at my pay stubs as my final paychecks of the year approaches, it’s hard for me to believe that I’ve made this much money this year. Despite the economic downturn, I’ll earn more money this year than ever before.

The unfortunate part is that when I look at my various accounts this year, it’s hard to believe that’s true. My investment accounts are all down considerably; my emergency fund was its fine and dandy usual self until I needed to pay for the truck repair.

Looking at the accounts makes me a bit uneasy; were things really okay for me financially when I have tens of thousands of dollars less in my net worth column than I did at this time last year?

The logic says yes, but the emotion doesn’t always agree.

One of the tricks of investing is to check your results less often rather than more often; that way day to day fluctuations don’t make you overly excited–or overly afraid. Unfortunately, this year, once a year was still once too many (that said, I’m still not making any changes!).

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

Here’s some of my favorite posts as of late in the personal finance blogosphere:

The Simple Dollar is right on the money (no pun intended) on investing in yourself. This post discusses exercise; I don’t talk about it much on this blog, but in 2002 I weighed (according to my doctor’s scale) 272 pounds; today I’m right around 180, so I do believe that this is something that can seriously pay off!

Lynnae over at BeingFrugal.net talks about something I preach to parents regularly: read to your kids! Talk about investing in your family; this is something I believe pays off big. Nothing is equal to the amount of time you spend reading to your kids.

Debt Free looks at reasons why most people can but few people will get rich. I’ve long believed that it’s certainly possible for the working class/middle class person to save enough and invest enough wisely enough spending very little time and energy to do well, if not “get rich” (I guess it depends on the true definition of “rich” today).

I’ve Paid For This Twice Already again discusses the art of snowflaking, which I’ve discussed here and many other personal finance bloggers have discussed over and over again. Snowflaking pays off, trust me!

Making Money Journal has a similar interest to me: photography. This week they look at making a zero cost macro lightbox. I’m going to work on making one myself when I get a few minutes!

Finally, Mrs. Micah asks a question that many may be afraid to ask: who do your financial decisions reflect on?

While the vast majority of my money that’s invested are in a few different mutual funds, I do have a smaller portion of my portfolio in individual stocks where I try to beat the market. Note that I really don’t believe that it’s possible to beat the market in the long term, but that doesn’t keep me from trying with a small portion of my portfolio, and when I small, I do mean small–all of these stocks combined total less than 10% of my total portfolio and a lot less of my net worth.

So here’s how the stocks I owned did in 2007, sorted by performance:

                 Adjusted
Ticker	   Price (1/1/07)    Price (12/31/07)	Gain/Loss
IAR                $27.33	       $17.56	  -35.75%
ACAS               $42.31              $32.96	  -22.10%
TM                $134.31             $106.17	  -20.95%
WFC	           $34.37              $30.19	  -12.16%
PFE	           $24.74              $22.73	   -8.12%
T	           $34.46              $41.56	   20.60%
MO                 $61.84              $75.51	   22.11%
VZ	           $35.75              $43.69	   22.21%
MRK	           $42.31              $58.11	   37.34%
AAPL	           $84.84             $198.08	  133.47%

About half of my holdings not just lagged the index, but lost money in 2007. IAR, also known as Idearc, Inc., was a one time dividend from my Verizon holdings. I don’t think I would have bought it outright. ACAS, American Capital Strategies, is a private equity firm that pays a substantial dividend. TM, which is Toyota, has baffled me. It’s a dividend paying company that is either the number one or two auto maker in the world and has been nicely profitable for a long time. It has, however, really underperformed this year. I am not planning on selling my shares, however. WFC, Wells Fargo, is a bank that we don’t have in HI (aside from its mortgage services); my friends who have banked with them have been less than thrilled with their customer service, but it pays a healthy dividend. Like many financial stocks, it has suffered this year, but not as badly as many others. Pharmaceutical giant Pfiezer (PFE) has not really done well in the two years I’ve owned them.

For the ones that have done well this year, the two telecom companies (T, aka AT&T, and VZ, aka Verizon) have done quite nicely for some time; I’m not sure I’m sold on these companies long term, and I really have a philosophical dislike of telephone and cable companies, so I’m not sure how long I’ll hold onto them. Altria (MO), the former Philip Morris, is a long term holding of mine that spun off Kraft this year (which I sold); its opening price is adjusted for the spinoff. Merck (MRK) is the other pharmaceutical company I own, and it did considerably better than Pfiezer did–I’ve owned this about the same amount of time as I’ve owned Pfiezer and I think it has become a long term holding. And finally, Apple (AAPL), which gets its own paragraph.

I originally thought about buying into AAPL (well, recently; I thought about it back in the 1980s when I was in college and had less than no money) in the summer of 2006, when I was on my way home from KansasFest. I took a look at a share price in the high 50s and believed that it was very undervalued.

Of course, I didn’t buy any, although I did talk to several of my friends who also have an interest in investing and tell them I thought it was a buy.

In early 2006, when I had a few bucks to put into my Roth IRA, I decided not to make the same mistake again, and AAPL rewarded me with the biggest gain in my portfolio, more than doubling. I have to think about whether or not I believe they’ll be a good long term holding–I think they will be a holding for at least a few more years–but they were, by far, the best performer in my portfolio.

I have yet to calculate how this portfolio did overall; it will take me awhile to do so. However, it does show some of the issues with buying individual stocks; some don’t do all that well and some do fantastic and it’s difficult to tell which will do what. There’s no reliable magic formula to say, “This stock will double this year, and this one will fall.” So while you can minimize your risks by researching the stocks and the markets they’re in, there’s no guarantees.

I like to pick individual stocks and I like to try to beat the index, but I know that I am very unlikely to do so. I do so mostly for fun, although there is obviously the possibility of profit–and loss–involved. I keep my investments in individual small relative to my total portfolio to minimize exposing a lot of my total net worth to the volatility inherent with an individual stock–this is asset concentration, the opposite of diversification, which increases risk. When people ask me about investing, I do tell them that if I put the vast majority of my money into highly diversified passively managed index funds but I will put a very small amount of my money into individual stocks at my own risk.

How’d your stocks do this year?

Frugality is one of the common threads of the self-made financially independent. In his book The Millionaire Next Door, Thomas J. Stanley makes the point that it’s critically important to spend less than you earn or you will never increase your net worth, and that of self-made American millionaires (rather than those who came into money due to their family’s wealth), frugality was a common theme.

Frugality isn’t always fun, although it -can- be fun to hunt for great prices on things you need and to try to see how long you can make that $20 you got out of the ATM last. Sometimes it’s not fun when all of your buddies get new iPhones and you don’t, or they all go out to an expensive restaurant for dinner and you decide you can’t afford it.
Frugality, however, is the primary principle of sacrifice and delayed gratification that is needed to practice the kind of financial discipline that leads to financial independence. The exercise of determining your expenses and income helps to determine if you actually are practicing frugality or not and points you in the direction of areas that might need addressing to become more frugal.

When looking at your month to month income and expenses, there are really only two things that can be done to improve your financial situation:

1) Increase your income;

2) Decrease your expenses.

Yes, it’s also possible to do both, but there really aren’t a lot of other options. Of the two, it’s more likely that you can do the latter quickly. Additionally, if you can decrease your expenses, you can also put the money that you no longer spend into some kind of savings plan, whether it’s to increase your retirement savings or build (or start!) an emergency fund or targeted savings for a particular goal.

Now that you have your budget in front of you, can you identify areas where you’re spending more than you think you need to? Where in your budget can you cut? Are you spending more than you want on your electric or gas bill? How about your cellular phone or cable bill? Can you reduce or eliminate some of your expense in these areas? Do you really need both your cellular phone and your landline? Would it be a hardship to use the public library for your music, video, and book supply?

Where do you think you can reduce your expenses to become more frugal?

Liars, damned liars, and statistics; it’s hard to come up with an out and out number that just says, “If you have this much money, put it in this kind of portfolio, and withdraw this percent per year, you can live on it forever and not worry much about draining your principle,” but I’ll try anyway.

Advice and historical numbers that are given out and often pass for facts are really not; as any investor has heard over and over, past results are not an indicator of future success. Still, history seems to be a great teacher in many ways, so some of these could be useful; in some cases, I’ll round off the numbers to make the math easier.

Average yearly stock market return: 10%

Average yearly bond market return: 5%

Average yearly core inflation rate: 2.5%

Percentage of a balanced (50% broad stock market, 50% quality bond) portfolio that can be withdrawn yearly without affecting the principle of the portfolio: 4%

Percent of income while working required to maintain a similar lifestyle after retirement: 85%

Let’s say I’m making $50,000 a year (which is a very decent salary for a social worker, but it’s not my salary); using the 85% guideline, that would make my retirement income need $42,500.

That’s a very simple look at things and it could be glaringly incorrect. For instance, let’s say that yes, my income is $50,000 a year, but I put 10% of that into a 401(k) or 403(b), so it’s pretax dollars that are gone before I can spend it. I certainly wouldn’t be putting that money away for retirement if I was already retired, so instead of my gross being $50,000 a year, it’s really $45,000 a year for purposes of this exercise; that would make my retirement income need actually be $38,250 a year.

So if that’s how much I need to gross a year, I’d like it to be equal to no more than 4% of my total portfolio; that $38,250 would be 4% of a portfolio worth $956,250.
$956,250 is, of course, nothing to sneeze at; it’s also a figure that’s in today’s dollars. Inflation makes calculating this a bit of an issue. Inflation of 2.5% a year doesn’t seem like much, but over time, it can add up. In 20 years, that $956,250 needs to be $1,606,100.15!

So let’s say that I currently have total investments in the stock market and the bond market totaling $75,000–3/4 of that ($56,250) in stocks and 1/4 of that ($18,750) in bonds. Let’s also say that every year I put away another $5,000–3/4 of that ($3,750) in stocks and 1/4 ($1,250) in bonds. Using those figures along with an Excel spreadsheet and the 10% stock market and 5% bond market returns listed above, in twenty years, when I’d like to have $1,606,100.15 socked away, my little portfolio has less than 1/2 of that–$779,392.69–at my disposal. The news gets better with more time, however; in another 12 years–32 years total from the time I started–I finally get to my inflation adjusted goal. That $956,250 number has become $2,107,342.57, but my total portfolio has become $2,205,515.60.

While it’s amazing to see how money grows over time with average returns, it’s also disappointing to see just how long it took my savings to get where we wanted it to be. However, playing with the numbers can help us in a lot of ways. This is something we’ll look at in a coming entry, as well as a discussion on the importance of being frugal.

Once you have a grasp on your total net worth, congratulate yourself, if not on the total, the accomplishment of doing it. It’s a huge step in the direction of financial independence.

That said, it’s one step. Even though it’s a major one, there’s need for a second step to get further along this journey, and the second step would be determining your cash flow.

This basically means determining what your income is and what your expenses are. This can be calculated using figures for a day or a week or a month or a year; in practical terms, figuring out your monthly cash flow is probably the most useful.

There are some simple steps in determining your cash flow, but several significant barriers to determining it properly. We’ll look at both.

Determining your income ought to be easy, or at least easier than determining your expenses. Your income is simply the money you get from work, investments, Social Security, or any other forms of cash coming in. Simply checking your pay stubs for the last few weeks is likely to give working people a very accurate picture of their income. For a more accurate picture, looking at your previous year’s tax returns or W2s can be a huge help–to calculate monthly income, divide your net income by 12.

Determining your expenses is a bit more difficult. For one thing, while sources of income tend to be limited to a handful–even if you have two jobs and two income generating investment accounts, that’s just four sources of income–expenses tend to be far more varied. Right off the top of my head, there’s your housing payment, your electricity bill, your water bill, your telephone bill, your gasoline bill–all stuff that gets paid regularly.

Some of those expenses are very easy to figure–namely the fixed monthly ones. Quick, what’s your rent payment? Is it the same as last month, and the month before, and next month? If you can say yes, you probably know what it is without a lot of head scratching. Some of these, however, are much more difficult to figure out, because they’re not quite monthly and they’re not the same all the time. Think gasoline–the price of gas fluctuates pretty often. Since my fill ups tend to be close to weekly–sometimes six days apart, sometimes eight days apart, sometimes an actual seven days apart–and vary from about 11 gallons to 13 gallons with gas prices fluctuating all the time, it’s very hard to give an accurate figure for how much I spend on gas a month.

In addition to that, there’s expenses that come up far less frequently than monthly–things like auto insurance, which I have the option of paying monthly, quarterly, or semi-annually. These are a little easier to determine amounts to budget for monthly–a $450 GEICO bill every six months is $90 a month.

Finally, some expenses are just difficult to estimate. Ever wonder how much you spend eating out every month? It may not be all that tough to guess how much it is typically, but what about that once a year you take your buddy out for his birthday? How about that baby shower you went to at the local Olive Garden?

In trying to determine your monthly cash flow, it’s likely inevitable that you’ll have to make some estimates. If you really want to accurately track your expenses, consider a spending diary–write down every cent you spend. For it to be a really accurate diary, it must be kept for a year. I do this personally and have for several years with a composition book. There’s also a certain psychological benefit given to those who keep spending diaries–you have to be able to live with yourself when you write those expenses down, making someone like me think, “Am I really needing that new pair of shoes?”

Once you’ve determined (or estimated as best you can) your monthly income and monthly expenses, it’s time to subtract your expenses from your income and see what your net cash flow comes out to be. If your cash flow is negative, it’s time to really figure out how to get it positive (we’ll cover some of this in coming entries). If your cash flow is zero, then at least you’re breaking even. If your cash flow is positive, that’s great, but there’s always room for improvement.

Knowing your cash flow–not just that you’re in the positive or negative and by how much, but where you’re spending your money and where your money is coming from. Like knowing your net worth, knowing your cash flow will help you to make a plan for the future.

The place to start with personal finance is where you are; the problem with that is most people don’t really know where they are. It’s very typical for those of us in America to go from paycheck to paycheck and say things like, “If there are checks, there must be money.” The unfortunate part about this is not that we joke; the unfortunate part is that we go around, many for an entire lifetime, not knowing where they stand.

So we start at the beginning.

Before we go anywhere else, we need to figure out where we are. If you go to unfamiliar shopping malls often, think of this as looking for the “You Are Here” point on the map.

Collect all of your current balances from your checking, savings, certificates of deposit, brokerage, 401(k) or equivalent, individual retirement account, and any other places you have money stored away, regardless of whether or not you can easily access the cash or not. Add all of these together and you get your current monetary assets. Add to this the value of things like your vehicle and house and you get your total assets.

After all of that (which in and of itself can be exhausting), it’s time to consider your debt. Add up all of those accounts you owe money on–your mortgage, your car loan, your credit cards, your store credit accounts, and anything else you have–and you have your total debt.

Subtract your total debt from your total assets for your total net worth.

Hope really hard it’s a positive number.

If you’re just out of college, you’re more likely to have negative net worth; after all, you haven’t earned very much yet and are likely to have gone into some debt (or, if you went through extensive schooling like medical school, substantial debt) while finishing your education. However, you’re much better off having negative net worth at this time in your life than you will be if you’re still at the total net worth ten years later, since you have more time to pay the debt off.

One way or another, whether your like the number or not, it’s critical to working on your personal finances to have some idea where you are when you start.