An Engineering Approach to Money

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.

This post describes how I set up my personal short term accounts. I’ll talk about my long term stuff at a later date, that’s much more complicated, but this is just the basics that show how I set up the accounts how the money flows and how it allows me to get maximum interest, with the least pain.
I use a 3 tiered approach to my short term accounts.

1. Credit Union Checking
2. Credit Union Savings
3. Vanguard Short-Term Investment Grade Corporate Bond Fund

My paycheck gets direct deposited into my checking account twice a month. I then pay the bills for that half of the month and move the extra funds to savings as quickly as possible. This savings account doesn’t pay much interest, 2% or something, but it is convient and I can move money back and forth between there and Checking via the web, a phone call, or a visit to my local bank. There is also overdraft protection on my checking account so that they will pull money from my Savings account to cover me should it be needed. This happens every other year or so because of some screw up or other, and $1 for overdraft protection is much better than $30 for a bounced check. I tend to keep about $400 in my checking account, and let funds build up into my savings until I have $1000 or so to move over to my vanguard account.

The Vanguard Short-Term Investment Grade Corporate Bond Fund account is where I keep my cash cushion. It is also where I keep money that is waiting to invest long term. The balance in that account tends to fluctuate between $30K and $60K depending on how agressive I’m feeling about the market. If I want to be fully invested I’ll drain this down to my 6 month spending minimum, if not I’ll let it build up until the next time I’m ready to push some cash to long term savings. If I have big expenses comming up I’ll also let this grow. For example this is the account I used to purchase my last car. Generally when I need to spend some of this money I write a check and take it to the credit union and put it back into my checking or savings account, from there I can get a cashiers check for a large purchase if need be.

I chose this particular account for several reasons.

1. Vanguard is the low cost leader in this space.
2. My income is not high enough to put me in a tax bracket to want a tax free fund.
3. There is low risk to principle as the fund invests in short maturity bonds.
4. Investment Grade means that it invests in only stable solid companies.
5. The yield is much better than a money market, current yield is about 5% which is great for short term money.
6. The account has free check writing for checks over $500.
7. This is a joint account my wife and I share so we both have to sign all checks which forces us to touch base when drawing money out of this account to make sure we are on the same page.

Because this is not a money market account, the value of the money you put in will fluctuate, but because the maturity on the bonds is so short it will not fluctuate very much, I’ve held the account for several years and shares have varied from $10.34 to $11 or about 6.5% at the extremes, since I move money in and out fairly frequently it all balances out and the higher yield is worth it to me.

As the money comes in it normally flows into accounts with higher and higher yield (interest) until it is ready to be put to use in one of my long term accounts. I keep no more than a couple of thousand in my local Credit Union accounts which means that should someone ever clean out my checking account it would hurt, but not be devastating to me. Because this is short term money it is easy to access with a check and spend in an emergency.

Looks like gas prices are headed down again.  National average price is down to $2.38 a gallon and headed lower.  Sounds like odds are good we’ll get below 2.00 a gallon by the end of the year.  Other than this being a nice bonus in general, is there a way to take advantage of the falling prices?

The first is make sure that you buy your gas from somewhere that moves a lot of volume.  I’m a big fan of Costco for gas.  They generally have very good prices, and are very quick to drop or raise prices as the spot price changes.  This is great when prices are falling.  What you don’t want to do is to buy your gas from a mom and pop place that may only reset their price when the truck comes in, and in any case they are not going to be nearly as interested in lowering prices to match their dropping costs as they are to raise prices to match their increasing costs.  Most people don’t really pay enough attention to what is happening and may not notice.

The other day I paid $2.98 at the local place (for 5 gallons only, I was desperate) and the next day filled up at costco for $2.57.  $0.40 per gallon is enough to get my attention.  That’s like $5 on a single tank of gas.  In an evironment of quickly falling prices you’ll see a big difference between the cheapest and most expensive stations so pay attention, you could save $5 a tank if you keep your eyes open.

I read an interesting book yesterday titled The 5 Lessons a Millionaire Taught Me About Life and Wealth, one of the things that had not occured to me is that if you want to change the way you live the first step is to make a consious decision to be wealthy.  It is not going to happen by itself.  Unless you change the way you approach your finances things are not going to change.

The author also quoted some interesting statistics, one was that “Nearly one-third of lottery winners become bankrupt”.  I’ve stated before that being wealthy seems to have little to do with income, this sure brings that home.  The problem is that winning the lottery does not increase the winners income, but because lottery winners have so much money all of a sudden they increase their spending. Evidently what happens is that folks who have lots of money all of a sudden, feel rich and begin spending money on expensive stuff; fancy vacations, gifts to friends and family, etc.  And then in a couple of years they look up and their big chunk of cash is mostly gone, but they have this large set of expenses they didn’t have before and their income has changed to much.  As a result they are not even close to spending less than the earn, and end up blowing everything in a few years.

Another point the author makes is that you need to spend the time to become the expert on your personal finances.  There are always going to be others smarter on the subject of money in general, but you need to be the expert on your money.  You need to know where every dollar comes from and where every dollar goes.  I’ve talked before about the importance of using a tool like Quicken, but this just brings that point home even more.  You need to know where all your income comes from and what all your expenditures are.  You need to be able to sort this info by category so you can see how much you spend on your cars, including all expenses like tax, insurance, etc.  The same for housing, food, entertainment, etc.  By knowing how much things really cost you can make intellegent decisions about where to cut back and what does not matter.  Yes, it takes time to do this, but without being an expert on your personal finances you allow others to determine where your money goes, if for no other reason than you don’t have enough information to really know if you can afford a purchase.

All in all a good book, lots of interesting ideas and some good little stories about how and why the ideas work. And the sooner you wake up and realize that more money is not going to solve your long term financial problems the sooner you can take the first step and decide to be wealthy by becoming the expert in your money.

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.

Insurance is a requirement for a sound financial plan. To pay a bit every month to help you recover from a catastrophe is money well spent. But most people have so little capability to recover from any setback that they are buying the wrong kind of insurance. The biggest place I see this is Health Care, we don’t have Health Insurance in this country anymore, we only seem to have prepaid Health Care. When you have to provide insurance information for a routine $200 doctor visit then it’s not really insurance which is meant to cover a catastrophe, but getting reimbursed for your pre paid health care.

This is a silly way to operate. If you’re going to pay hundreds of dollars every month for something whether you use it or not, you can be sure that people will use it at every reasonable, and many unreasonable, opportunities. This is not what Insurance should be. Another example is people who have a $200 deductible on their auto insurance. I mean $200? please. It’s hardly worth filling out all the paperwork and going through the insurance hoops unless you get $500 or more for your trouble. And if you make the claim they’ll probably raise your rates anyway.

Remember that by its nature on average insurance must be a losing game. That is the average premium must be enough to not only cover the average loss, but also the overhead of fraud, taxes, and running the insurance company. Likely your premiums are on average twice as expensive as the amount you will ever claim. But, you might be that unlucky sod who’s house burns down, or gets an expensive disease, or has his car totaled. In this case you’ll be very happy that you bought into this losing game. So what should you do when confronted with a losing game that you have to play? My idea is to make the game as cheap as possible, and opt not to play if at all possible. Buy the least coverage I can to do the job.

Use insurance to only cover the big high risk things. The best way to do this is to raise your deductible as high as you can reasonably cover. I have $1000 deductible on my car insurance as well as on my home owners policy. This means that for any minor issue less that $1000 I don’t even have to deal with my insurance company, but if my car is totaled I’m covered. I’m covered by health insurance at work, but if I wasn’t then I’d buy a policy to cover only catestrophic issues, and pay for all my doctor visits out of pocket. The cost for that kind of health insurance is a fraction of a “full coverage” policy.

I figure raising my deductible from $200 to $1000 saves me about $300/year in premiums on my auto and home owners policies. In 10 years I’ve never had a claim on either one so I’m currently $3000 ahead on that deal, plus the return on that money over the past years. So get your cash cushion in place and raise your insurance deductibles, there is money to be saved there.

We all make mistakes, generally due to not paying enough attention to something. And we all should strive to learn from our mistakes, but don’t let making a mistake consume you, and don’t try to be perfect, it’s way too much work.

My wife and I have a philosophy that $50 mistakes are okay, the things we try very hard to avoid are the mistakes that cost hundreds or thousands of dollars. If your spouse makes a few of those annoying $50 mistakes it’s best to just let them go, even at one of those a month it’s only $600 for the year, just let it go.

This is not to say you shouldn’t make an effort to avoid doing stupid things, the less wasted dollars, time and effort due to mistakes the better, but mistakes are going to happen, it’s part of life, just try to keep them to a minimum and don’t beat yourself up when they happen. Unless the number of them get out of control, it’s probably not even worth worrying too much about how to avoid them in the future, just chalk it up to “cosmic rays” or “shit happens”. But those $3,000 mistakes, those you really want to try to avoid, those can add up fast.

Don’t worry about popping a bicycle tire. Do worry about driving the car into the garage with bicycles still on the roof rack, repairing both the bikes and the garage door can get expensive.

Don’t worry about breaking your wrist watch. Do worry about breaking your car.

Don’t worry about Staining the new blouse. Do worry about staining that new Couch.

The small stuff will add up, but one time small stuff is just not worth beating yourself up about, save your energy and effort for those things that will make a difference.

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.

Continuing monthly expenses are the bills I hate the most to pay. I’d much rather pay $200 once than pay $10 a month. Part of this is my tendency to make things last, I tend to keep things well beyond their expected lifetime. Over the years this have saved me stacks of money, but if I was paying for those things with a monthly fee, well then I would not have saved much, would I? I think the classic example for me was my new Tivo, back in the summer of 2000, I bought a brand new Series one Tivo, and plunked down the $200 for the lifetime service. So far I have used that Tivo for 6 years, my lifetime service cost $200, if I’d paid monthly it would have been $10-$12 a month for 72 months or well over $700.

In essence paying monthly for something is like renting it, or financing it, and you all know how much a fan of those I am. It’s also much harder to figure the true cost of something when you pay for it in dribs and drabs over many months. Consider how much money you’d have to save to cover that monthly cost before you take it on. For example $10 a month is $120 a year, if you can get 8% return on your money ($5% after taxes) it’s going to take $2,400 in capital to throw off that $10 in earnings that you are about to spend every month.

The same goes for trimming expenses, every $10 in expenses you trim out of your monthly budget is like an additional $2,400 in savings. So watch the small dollars that occur every month, there’s gold there if you can save and ruin if you let those expenses get out of hand. So don’t sweat the small onetime things, but taking on any additional recurring expense is worth serious thought, even the $10 items can add up quickly.

Yes Virginia, housing prices are officially insanely high right now. The amount of price increase we have seen is recent years in clearly unsustainable, and many people are overpaying at the moment. The recent surge in prices is, however, part of a natural cycle of relatively flat housing prices followed by a sudden jump. This has happened before, and it will happen again. The price surge in the late 70’s and early 80’s was the previous run. Unfortunately, people who do not know what is going on can get themselves in big trouble by assuming current conditions will last forever.

The big problem is that a house costs so much that people stop thinking about it as a $500,000 house, and just look at the monthly payments. This is a huge mistake. When the house loses 5% of it’s value, you still will be on the hook for that $25,000. It’s not about the monthly payments, A clever loan officer can make the monthly payments, at least for the first year of a 30 year mortgage, any number they want, but that doesn’t mean you can afford that house.

There was very scary cover story in Business Week about toxic mortgages recently. With brokers getting less concerned about defaults, and more creative in their lending practices, people are taking on much more house than they can afford. Since this is a home, people are likely to figure out how to keep the payments up for a while, but with interest rates rising, yes these are variable rate loans, defaults are going to start increasing.

So how can you figure out how much house you can really afford? The best idea is to figure out what it would cost to buy the house with a traditional 30 year fixed loan, if you can’t afford that monthly payment, then you can’t afford that house. If you can’t put at least 10% down, then you can’t afford that house. This isn’t to say you should take a 30 year fixed mortgage. I have a 5/1 ARM, but I could afford to pay for the 30 year fixed, I just decided it was better to take the lower interest rate for now. I can always refi later.

My gut says that housing prices are likely near a peak, and at the very least price appreciation will slow way down. Never chase a market that had a good run recently, things get priced assuming the current huge price increase will continue forever, and it won’t. Be patient, wait for the market to turn. In three or four years people will be expecting housing prices to stay flat or decline forever, such is the herd mentality of a market.