An Engineering Approach to Money

I know you’re going to be shocked, but just like the fact than All Assets are Not Equal, the same holds true for liabilities. A liability is something that you owe. Most liabilities are loans of one form or another. I’m sure you’ve all heard how bad credit card debt is, this is a clear example of a bad liability. Any time you are borrowing money to purchase anything other than an good asset you are incurring a bad liability, I’ve talked about this before. The worst of the worst is to use debt to purchase a service. While reading blogs the other day I stumbled across a guy who was going to finance his Honeymoon with credit card debt. This is a huge mistake, and is incurring the worst kind of debt. If you are putting “fun” stuff on your credit card because you have not saved the cash for them, then you are simply living beyond your means. In this case Matt simply can’t afford this Honeymoon and would be much better spending less, perhaps much less. How about a nice camping trip at a National Park Matt?

Good liabilities are those where you are borrowing money to purchase an asset that will return you more than the liability will cost. An example of this was that I took about $20,000 out of my home equity when I refinanced by house back in 2001 and put that money into the stock market. In my case it was in the Mathews Pacific Tiger Fund. I purchased 2,809.2 shares @7.15 on Oct 16th, 2001. I ended up paying about 4.75-6% for that money (I refinanced again in 2003), but those shares are worth $25.12 today (4/20/07). To borrow that money for 5 1/2 years cost me approximately $6,000, but returned about $50,000. I could sell my shares to cover the original $26,000 loan + interest and still have $44,000 left over. In this case I got very lucky and hit a jackpot investment. But even if it grew much less I have an asset in my hands to pay off the loan with. Compare this to Matt who will have to use future earnings to pay off the credit card debt he is going to take on.

Some rules of thumb

• Never take on debt to purchase something “fun”. If you will have fun spending the money don’t do it with borrowed funds. Save first, then have fun spending the money.
• Never borrow money to buy anything that is not a good asset.
• Borrowing money, even for good assets increases your risk. What would you do if the value of the asset you purchased with your borrowed money lost half its value? Beginning investors should try to never borrow money.

But Kit, what about borrowing money to buy a House or a Car, is that bad? As with most things, it depends. I’m not a fan of car loans at all. The only time you should be borrowing money to purchase a car is if you absolutely need that car for basic transportation. In this case borrowing the money will allow you to increase your income, because you can now get to work, over what it would be without the car. But there is no real excuse for buying anything more that basic transportation this way. If you are spending more that $10,000 or so on your car, you should not be borrowing the money, just buy a cheaper car.

The argument that you need a car to hold down a job, and thus borrowing the money to buy the car is a good financial move can hold water. But only if you are buying the most inexpensive car that will meet that basic need. If you are borrowing money for a BMW then you are incurring bad debt. If you want an expensive car then you need to save the money first and then buy that trophy car. Hey it’s your money, spend it any way you want. But don’t try to convince me that you job requires you to have a certain image and thus a certain car. I’m not buying any of that.

Home Loans are even more complicated. Because your home is both an investment, and consumption. In addition, it’s not realistic to save $200,000 or more for a home before you make the purchase. So a decision to borrow money to purchase a home can be a good thing. But you should be very careful about the kind of loan that you take. Any time you take any loan you are increasing risk. Even if the asset drops in value you still have to make payments on the loan, and if you sell the asset you must pay off the full value of that loan, even if the value of the asset does not cover that loan.

Consider a house purchased with only 3% down. You are immediately in the hole because to sell a house you have fees to Realtors and other costs that can run between 5 and 8% of the value of the house. You may also have to drop the price below market value if you are in a hurry to sell. All this means that unless you are putting at least 10% down on a house you are counting on the value of the house to go up to get you out of the situation. For the past 4 years prices have been rising so fast that it has covered everyone taking this risk. But there is no guarantee this will continue. In fact, prices have risen so far so fast it is likely that prices may stay flat or even slowly decrease over the next few years.

I believe this is the reason why traditionally a 20% down payment was required to purchase a house. With 20% down the odds of your ending up in a bad situation is significantly reduced. Therefore, I believe that unless you can afford to put down 20% to purchase a home you can’t afford it. Either save more money, or buy a cheaper house. According to this about 80% of the people are purchasing more house they cannot afford. From what I’ve seen that’s probably not that far wrong.

The biggest mistake that most people make is spending more money than they have. Easy credit and taking out bad loans is what allows people to make this mistake. It also can hide the effects for years. But eventually it will catch up with you. By paying with cash or doing without you will already be in an elite class of people who take responsibility for their own actions, are willing to live within their means, and are on the road to financial success.

Full Disclosure: I don’t have any car loans, but I do have a Mortgage on my house. I put 20% down, and the loan to value ratio on the property is now about 50%.

Earlier we talked about totaling up your assets and your liablities on a regular basis to know your net worth. At the time I kind of skipped over exactly what is an Asset and what is a Liability.

What is An Asset

So let’s start with assets. An asset is anything that you can turn into cash. It does not need to be cash, it can simply be something you can sell for cash. It should be valued at its fair market value. But please don’t be overly aggressive, some things can fetch a big premium if you take the time to find exactly the right buyer and get full value. This is not a realistic valuation though. What I try to do is value all my assets at whatever I could get if I needed cash in a hurry. A stock can be sold in a hurry for the market value and the cash will be there in 2 or 3 days. A car is trickier. If you needed to sell it in a hurry you might have to sell it for 10 or 20% below market value to get the cash in a hurry. Houses are the same. Furniture and hosehold items are worse, you might only get 50% if their value if you had to sell them in a hurry.

I think it is important to take this kind of worst case approach to valuing assets for many reasons. Things like household items are crummy assets. This is because they are almost certain to be worth less next year than they are this year. Ideally your assets should all be growing over time.

This is one of the big differences between the wealthy and the middle class. The middle class take their money and buys services or poor assets like cars, boats, furniture and big houses. The wealthy take their money and buy good assets like stocks, bonds, and rental properties. This brings up the important point that…

All Assets are Not Equal

If you truly want to be wealthy you need to buy good assets. Those items that put money in your pocket over time. A good asset will be worth much more over time than you originally spent on it, as well as any costs you spend to maintain it. Most good assets aren’t much fun while you own them. You can’t water ski behind them, you can’t show them off to the neighbors. They don’t make your life much easier today. But the income or capital gains that they generate over time will grow your net worth making life much easier down the road.
In general buying good assets means putting off your gratification until another day. Instead of buying that PS3 you buy 3 shares of Goldman Sachs. Instead of buying that new living room sofa you purchase 100 shares of Cisco Systems. It won’t be very comfortable to sit on while watching TV, but it will grow your net worth over time instead of just filling up your house.

If you want to be wealthy spend your money on good assets, not on simply acquiring more stuff.

It is a good idea for everyone to know their Net Worth. It’s easy to calculate, just total up all your assets and all your liabilities. If you are using a tool like Quicken it will do all the work for you.

After I had been out of College for 3 or 4 years and before I started using Quicken full time, my then Girl Friend (now Wife) and I would total up our Assets and Liabilities every year, print it out and save it. This allowed us to track the progress we were making every year. Being a pack rat I still have this stuff. I can see that the money saved in my investment accounts went from $24,114 to $47,112 from April 15 to Dec 31 1991. I think I was making about $60K/year at the time working as a computer programmer. Dana, my girl friend, was a grad student, and we were living like grad students saving about 40% of my paychecks. By writing down exactly what was in our investment accounts at the time we could track how we were doing and what progress we were making toward our long term goals.

This is not to say we didn’t spend money on things just because it was fun. Shortly after this statement we dropped $20,000 on an Airplane that we owned for about 4 years. As any private pilot knows an airplane is a huge money pit, worse than a boat. But by tracking our expense we knew we could afford it, and what the effect of that purchase and it’s running costs would be on our savings.

We each had about $15,000 in student loan debt at the time. so our total net worth was just barely positive. But we were making good progress and could see our assets growing every year. To know where you stand and from that project how quickly you will meet your goals allows you to make decisions about how much to spend and how much to save.

I believe the old saw that people don’t plan to fail, but simply fail to plan is not far wrong. It is important to know where you stand on a regular basis so that you can now how you are doing and if your current choices will get you where you want to be.  You will also know if you need to change something up. Take the time at least once a year to track down all your assets and all your liabilities and calculate your net worth. Pull it out a couple of times a year and see if you are still making good progress.

A tool like Quicken makes that much easier since it allows you to graph your net worth over time, look at the current values at any time, and watch it on a much more regular basis.

Saving money is not about giving up everything that is fun in your life, but it is extremely important to know where you are, where you want to go, and if you are making progress toward your goals. This allows you to know if spending that money is okay, or is going to put you in a pickle.

So take the time to calculate your net worth every year and use that info to track your progress toward your goals. If you don’t know where you are or where you are going, how will you know how long it will take until you get there?

For a new investor the task of deciding when to invest can be daunting, but I have a secret for you, you can’t time the market wrong when you are starting out, no matter which direction the market is moving you’ll win because of the broad trend upward that the markets always maintain.

But if the market is going down, or going to go down in the short term shouldn’t I wait? If you are certain the markets will be down in the short term then, yes, you should wait. But how can you be certain? I have been at this for 20 years and I’m still constantly surprised by the short term moves of the market.

The trick here is to use dollar cost averaging so that no matter which way the market moves you’ll be a winner. By putting a fixed number of dollars in no matter which way the market is moving you have the advantage of winning if the market is up and winning if the market is down. You can look at movements in both directions as positive for you.

Here is how it works, say you can buy into an total market index fund that invests in all companies and is currently trading at $20 per share and you have $200 a month to invest, the first month you get 10 shares. Now lets look at the two possiblities:

1) Stock goes up $1

In this case during the 2nd month the price is $21 per share (and your original shares are now worth $210). Your $200 now buys only 9.52 shares so you own 19.52 shares worth $410.

2) Stock goes down $1

In this case the price is now $19/share (your original shares are worth $190). BUT your $200 now buys 10.52 shares so you now own 20.52 shares worth $390. So while your investment is, in fact, worth less, you own more shares, so that each upward move over the next 20 years will be with more to you. In 20 years when each share is worth $200 instead of $20 that extra share you got this month is worth another $200.
If the market went up your investments value went up, but if the market falls your value went down, but each new investment buys more shares and so your total number of shares is greater.

Since the total market has a broad upward bias, that is the market always goes up over a long enough time period, if you are planning to be invested for the long haul (the next 20 years or more). Then a short term correction means the broad market just went on sale and by purchasing now you get a bargain price.

By spending the same amount every month you win if the market goes up in the short term, and you win more if the market goes down in the short term. The only way to lose is to not invest your money at all and piss it away on consumer goods which we know will be less tomorrow than they are today.

Compound interest is the best friend of a young investor, and by young I mean anyone who will be saving for more than about 20 years.  Which is probably everyone under the age of 50.  The ability to earn interest on your interest can over time turn a small amount of money into a large amount of money, if there is one thing you need to know as an individual investor it is the advantage of putting your money away and letting your interest earn interest.

Fundamentally the concept is so simple, but the effects are so powerful.  Take $1000 invested at 10% with earnings reinvested and see how much you earn every year.

• Year 1: $100
• Year 2: $110
• Year 10: $236
• Year 20: $613
• Year 30: $1586
• Year 40: $4114

Without putting another dollar away after 26 years you are getting a return equal your original investment.
As you can see there is huge money to be made by putting cash aside and not touching it for a number of years.  The advantage of compounding is lost if you spend the investment returns, or dig into the principle.  The advantages are also lost if you wait to long to start.  This is why waiting until you are in your 40’s to begin saving for retirement makes thing much more difficult than if you start in your 20’s.  That extra 20 years of compounding can make a huge difference in the size of your retirement savings and the earnings those savings can throw off during your retirement.

It is the magic of compounding that allows people in their 20’s to become wealthy with a small amount of savings every month.  The compound interest on those small amounts can add up to a very big pile of cash over a number of years.

So don’t delay, begin saving today, even small amount now will pay off big later due to the magic of compounding.

It’s very important to have something to strive for, saving money is hard work. It’s just so much easier to spend that $20 than it is to put it away. Delayed gratification is not exactly a strong suit of most people. So rather than going out and just putting that thing you want on your credit card, use it to motivate yourself to save.

Examples:

1. When we pay off all our credit card debt, my wife and I will have a weekend away without the kids.
2. When our cash cushion is 6 months spending we’ll plan a family trip to Disneyland.
3. We’re saving $40,000 for a down payment on our first house.
4. When our net worth is 1,000,000 we’re going on a 2 week Cruise.

Whatever works for you as a goal will give you something to shoot for other than the abstraction of the dollars in your bank account. Don’t bust the bank, putting a vacation on your credit card to celebrate paying off all your credit card debt is not a good plan. But try to make it something big enough to motivate you through the tough times it will take to reach these goals, but not enough so that the cost of the motivation sets you back on your real goal which is to become financially independant.

A free market is a funny beast. Prices tend to go through cycles. On average, prices are accurate, but at certain points things get priced either way too high, or way too low. I think the reason for this is people tend to have a very short view when estimating where things will go from here. And knowing how much something will be worth in the future is important when you are figuring out how much to pay for something.

Consider a stock that will grow 20% a year for the next 5 years. You are going to pay much more for that stock than one that will increase 5% a year. The same thing with a house. A house that is rapidly increasing in value is worth more than one that is not. Unfortunately, one can never really figure out what is going to happen in the future. So what people do is look to the past for a prediction. The problem comes in that we tend to only look at the last year or so, sometimes at the last 2 or 3 years. When you have an item that runs in cycles this short term view can give you a very bad picture.

Let’s assume that the price of a stock is a wave as shown above. If you use a straight line price assumption based on recent information you’ll get very different results based on where you are on this curve, as show by lines A, B, and C. The most accurate number is Point C which is a close approximation of the actual average price increase over time. But if you purchase at point C, you’re going to have to hold for a long time until the next peak to get that return. If you end up having to sell at the low point between A and C you could lose a lost of money.

The best returns will be between the valley and the next peak where the rate of return could be two or three times as much as the average. The trick, of course, is that you never really know where you are on this curve, and the time between peaks can be 10, 20, or even 30 years. For most of us taking the long view can be difficult. There is also no guarentee that for any individual stock that the average slope is actually positive, nor that the curve will be this smooth, look at the price graph for any stock and you will see lots of bumps in it.

But you can see that purchasing right at the peak can be hazardous to your financial health, as it might be a long time before the price actually goes up again. Before you get into a market where prices have been rising for some time, think about where you might be on the long term price cycle. You don’t want to buy at point C.

It’s now clear that all those people who got into the stock market in 2000 got in at the local maxium. It sure seems to me that we are getting very close to the local maximum for most housing markets in this country. I’m betting that the stock market which is still pretty much out of favor is getting closer to a local minimum and that soon we’ll see the outsized returns there as people reaslize what is happening in Real Estate and start looking for better returns elsewhere.

When I talk about money, and my goals, becoming wealthy is right up there. But what is wealthy? Is it having a million dollars? It it having a billion dollars? How will we know when we have acheived it? Let’s think about this some.

It certainly used to be that you had arrived when you could lay claim to the title millionaire, that was enough money so that you could live the rest of your life in style and not worry about running out. When a nice house cost $20,000, a million was a lot of money. But with more and more homes selling for a million dollars, I don’t think having a million dollars in the bank automatically puts you in the wealthy club anymore.

A billion dollars certainly puts you in an elite class. I can’t imagine how I’d ever go through a billion dollars. Heck at a 4% rate of return that billion dollars throws off 40 million dollars a year. Even in Uncle Sam takes half I couldn’t spend money that fast. On the other hand, I can’t see how I’ll ever be worth a billion dollars unless I live to be about 500 years old, which seems unlikely somehow. So while a billion dollars is certainly wealthy, I don’t think you have to get close to that to be wealthy.

I don’t think that being wealthy is a specific number. Robert Kiyosaki had one of the best definitions for wealth that I have seen, he says that you are wealthy when your passive income covers your expenses. For those of you unfamiliar with these terms your expenses are all your money out, everything you currently spend money on. Your passive income is the income your assets produce for you. Of course, most assets do not produce a steady revenue stream, but will vary depending on market conditions. When you can reliably count on the passive income from your assets to produce enough money each month to cover all your expenses you no longer need to work to support yourself. When you have acheived such a state at a level of spending that you are comfortable with, then in my book, you are wealthy.

To me this is the reason to manage your money well, because being wealthy depends not only on your income, but also on your spending. My goal is to become wealthy enough to do what I want with my time, and let my assets produce enough income to support me and my family. I’m getting closer every day, in good years my passive income now exceeds my spending, but in bad years it’s not even close. After 19 years of work I’m on the right side of the power curve headed down hill and hope to acheive that goal in the next 5-10 years. My hope is that by reading this blog you too will become inspired to start yourself on the road to joining the ranks of the wealthy.

Most people don’t have any idea that their life could be so much easier, they have found a way to survive with their current level of spending and earnings and that’s good enough. They don’t know how money works, so they simply have money in from their job and money out from their spending and hope like heck that the money in will continue to flow and support the money out. These people have no idea that it could be any other way. Let me give you a mental picture of what I call the power curve.

Think of the power curve like a hill, most people live on the upslope, some live on the crest, and a few have made the journey all the way to the downslope on the other side. Of course you don’t just stand on this hill, you are pushing a big rock. It’s much harder work to do that on the uphill slope, than on the crest or the downhill side.

• The upslope represents debtors. Those people with little or no savings but with credit card, auto, and mortgage debt. Trying to save is hard because a chunk of their earnings go to pay the interest on stuff they bought last year or earlier. The bigger their debt the steeper the hill. If the debt gets too big the rock is going to crush them no matter what they do.
• The crest is those people who have paid off their debt. They no longer have to pay interest on past debts, they can live slightly below their means and still save money. It’s much easier for them to save as they have little or no interest payments.
• The downhill slope is those people who not only have little or no debt, but also have an investment portfolio or other passive income generated by their assets. Eventually their passive income will grow to the point where the rock will roll itself downhill and they can stop working and still maintain their standard of living.

Where are you on the power curve? If you are not somewhere on the downhill slope then you have work to do, the work will not be easy, you have to move your rock uphill. But trust me this first step in the hardest and once you reach the crest and dig yourself out of debt things get much easier because now you are on the good side of the power curve and don’t have to push your rock up hill.

I started pushing my rock about 18 years ago, and within a decade I was rolling down the good side of the hill, it takes a while to dig out of college debt. My passive income is growing every year and I continue to move down the good side of the power curve. Don’t wait for someday, get your financial house in order and start moving toward the crest of that hill, you will be glad you did.

The other day I’m driving home in the car and an ad comes on the radio telling me how easy it would be for me to get a home equity loan. The ad further went on to tell me how I could use this extra cash for those needed home improvements, paying down credit card debt, or that great vacation I’ve been longing for. I was dumbstruck, yea it’s an ad and the entire point is to get you to purchase the loan, but still, taking out a home equity loan for a vacation! That’s just several flavors of stupid.

It occurs to me that people may not know when taking out a loan is a good idea, and when it a bad plan. The short answer is that loans in general are almost always bad, if you are not a business, or you are not purchasing an asset that will throw off more cash than the cost of the loan then don’t take out the loan.

Don’t take out a loan and then spend the money on services or something that you won’t be able to sell for more than you paid for it. So vacations are right out, cars and most consumer goods are out as well. A home loan is okay, but you want to put at least 10% down and 20% is better. Student loans for college are okay as they will allow you to increase your earnings over your lifetime much more than the cost of borrowing the money. But be smart don’t use a college loan to get a degree in underwater basket weaving, as that’s probably not going to add to your future earning potential.

The only loan I’ve had in the last 10 years is my home mortgage, but I did refinance and take cash out a few years ago to put that 4.8% money back to work in the stock market. This is an example of taking a loan to buy an asset that will earn more than the carrying cost of the loan. That’s leverage, and a little bit of leverage is a good thing, though too much can hurt much more than it will help.

Good rule of thumb from old Mr Franklin, “Neither a lender nor a borrower be”.