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Key Concepts of The Four Percent Withdrawal Rate For Retirement
The Four Percent Rule (a.k.a. 4% withdrawal rate or sustainable retirement withdrawal rate) is a general rule of thumb on annual withdrawals from a retirement portfolio which aids in determining whether you have enough money to retire, regardless of your present age. The sustainable long-term retirement withdrawal rates were originally addressed by Bierwirth (1994), Bengen (1994, 1996, 1997), Ferguson (1996), and Cooley, Hubbard, and Walz (1998). The "Trinity Study" then rehashed the work from Coley et al. (1998) in a 1999 publication stating the following:
This study reports the effects of a range of nominal and inflation-adjusted withdrawal rates applied monthly on the success rates of retirement portfolios of large-cap stocks and corporate bonds for payout periods of 15, 20, 25, and 30 years. A portfolio is deemed a success if it completes the payout period with a terminal value that is greater than zero. Using historical financial market returns, the study suggests that portfolios of at least 75% stock provide 4% to 5% inflation-adjusted withdrawals. Source
Using these findings, many recent analysis have continued to run the numbers to see if the 4% sustainable withdrawal rate is still valid. In most analysis, the 4% rate has held up well for periods up to, and occasionally beyond, 30 years. However, going back to Bengen's original research on the withdrawal rates, there are some serious assumptions that need to be addressed and understood by anyone beginning to consider drawing down on their retirement portfolio, or "nest egg".
How To Apply The 4% Rule
When evaluating your retirement portfolio, according to Bengen, you may make a first-year withdrawal of 4 percent of your portfolio. Each year that follows, you may adjust for inflation to maintain the purchasing power of your dollars. The problem is, Bengen does not seem to suggest how to "adjust for inflation" with these withdrawals. My assumption- to which I may be incorrect- is that you can take your initial 4% withdrawal, and multiply by the anticipated rate of inflation for the year. You may either Google expected inflation rates, or attempt to calculate them on your own which typically requires you to understand changes in the CPI, as well as have a crystal ball since you take the full year's change in CPI.
For example, let’s say your portfolio at retirement totals $1.2 million. According to the 4% rule, you may withdraw $48,000 in Year 1. If inflation expects to be 3% next year, you can give your initial $48,000 a 3% raise of $1,440 to equal $49,440 for Year 2, and so on for the remaining 30 plus years. Most people will stop right there and assume that they can calculate their level of financial independence simply using their net worth. This is not true! Additionally, many people need to understand the premises that exist that make the 4% The Three Major Assumptions That Make "The 4% Rule" Work
Assumption #1 - According to William Bengen, he assumed a balanced portfolio of 50% equities and 50% intermediate term treasuries which are rebalanced. His analysis did prove that up to 75% stocks and as low as 25% bonds would suffice as well.
Most people do not have this type of asset allocation. To reiterate, Bengen suggested keeping a stock allocation of at least 50%, but no more than 75%, of your overall portfolio. The remaining would be invested in intermediate-term treasuries. Consider that most of you, in fact, do not have every last dollar invested in their retirement portfolio the way Bengen's research suggests. Rather, you likely hold some of your money in cash, CD's, money market funds, and checking and savings accounts that are not exposed to the market which is what makes the 4% rule work. The trick is, you need the growth-potential of stocks combined with stability of bonds (especially with dismal interest rates on other savings vehicles) to keep your portfolio alive for a minimum of 30 years. Therefore, every dollar you have outside of this portfolio is best considered emergency or supplementary funds and not used in calculating your financial independence number. Assumption #2 - The funds in which you will be drawing 4% from are in tax-deferred vehicles such as traditional IRA's, 403(b)'s, 401(k)'s, pensions, or 457(b) plans. This is a major misunderstanding in the F.I. community! The reason this is such a big issue is because capital gains and dividends are not taxed as they continue to grow inside a tax-deferred vehicle. You will thus only be taxed on withdrawals from these accounts which will be taxed as ordinary income, not capital gains or dividend rates. This also assumes that you are of proper age- or met one of the IRS exceptions to early withdrawal penalties- to make your withdrawals after the age of 59 1/2. Sure, there are exceptions of withdrawing from retirement funds without penalty for scenarios such as financial hardship, first time home purchase exclusions, and others. However, Bengen did not account for those! Therefore, in order to be valid and effective, the 4% rule was based on your money being entirely in tax-deferred accounts. Bengen actually said the following in his paper:
Further, you may not include home equity or other savings and investments outside of stocks and bonds, in the above proportions, when calculating your financial independence number. The reason for this is because the research did not analyze this, therefore we have no idea how it may hold up over time. Assumption #3 - You never draw above 4% in any given year on your portfolio. This means if there is an emergency expense in a given year, you need to have either income from another source, or outside savings that are not part of your retirement portfolio to cover them. Further, you may not give any of your principle away since your initial 4% calculations were based on you not reducing your principal in any given year by more than 4%. This becomes a problem if you want to give money to heirs while you are still alive since this will likely put you above the 4% annual withdrawal rate. Look Before You Leap!
Keep in mind, this information is not designed to scare you. Rather, use it to help guide you into making an informed decision. The main takeaway is that when considering your safe withdrawal rate, you must use accounts that are accessible and tax-deferred (Assumption #2) and able to be invested in bonds and equities with tax-deferred growth (Assumption #1). Further, giving a large piece of your retirement portfolio away as a gift- or other unexpected expenses- likely means you need to return to the drawing board to determine your new safe withdrawal rate.
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The Harsh Reality For Many Chasing Financial Independence
The pursuit of financial independence, for many, is the holy grail of personal finance. However, a common mistake is often made in pursuing such a financial milestone. Let's take a closer look at where pursuing early retirement and financial independence often goes wrong in the FIRE community.
Allowing Your "F.I. Number" to Rule Your World
Let me first start by saying financial independence is a worthy goal for many. Personally, I am not yet financially independent but am halfway towards our goal. However, use care when first starting out pursing F.I. as you can quickly lead a life of deprivation instead of enjoying the values of frugality.
Financial independence is loosely set at 25x annual expenses (aka your F.I. number). This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. You may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. Take these expenses for an entire year and multiply them by 25. Why 25? This is related to the 4 percent rule of thumb originated from research conducted by William Bengen in 1994. He evaluated 4 percent annual withdrawals from a portfolio with a minimum retirement duration of 30 years. His research concluded the following: Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. Source This research permitted the financial independence community to put an actual number on the pursuit of early or regular retirement. Saving at least 25 times your annual means that your first year withdrawal of 4% is consistent with the total amount of money necessary for the rule to remain in effect. Now, there are a few problems with chasing this number. Problem #1 - Bengen's research assumes you maintain a 50/50 stocks to bonds portfolio, rebalanced annually. For the young folks out there, 50% bonds feels way too conservative! Problem #2 - The rule only applies to money held in tax-deferred accounts. This is because your overall portfolio return would be reduced when factoring in capital gains taxes and dividend taxes therefore reducing the longevity of your money if you continue 4% withdrawals. Bengen actually said the following in his paper: If the assets had been held in a taxable account, the conclusion might have been different, as the certainty of substantial capital-gains taxes would have to be weighed against the probability of a large stock-market decline, and the loss of the benefit of a step-up in basis upon death. Source Problem #3 - Your F.I. number is probably bigger than you think since we are not including home equity and largely ignoring taxation. Having an even larger financial independence number is disheartening since your original assumptions were probably based on net worth as opposed to available balance in tax-deferred accounts. This is a very common mistake in the FIRE community! Problem #4 - Past returns are not indicative of future performance. This data was based on historical observations, not future predictions. Just because these 4% withdrawals survived in a 50/50 stocks to bonds portfolio in the past, does not mean the rule will hold up for the future- although I am still personally betting that it will. This is the point where attainment of your F.I. number can quickly become pathological. Frugality is not about deprivation and therefore neither is financial independence. However, you can quickly become too consumed with your financial independence status and overall net worth and lose site of the joys of valuing a dollar and practicing frugality consciously. I am not implying that we all need to experience a life of sunshine and rainbows with no hardship along the way. Rather, I am cautioning against allowing money and net worth to rule your world over all else. I have personally made this mistake and do not wish to repeat it nor have others emulate it. Ways to Avoid Unhappiness Pursuing Financial Independence
First and foremost- this is one I have resisted the most- automate your savings. Automating your savings removes the necessity to consciously transfer money into your investible accounts and reduces the likelihood of living in the spreadsheet (see Ramit Sethi's book I Will Teach You To Be Rich for more on this).
Second, get clear on what matters most to you on this journey. The number is a secondary outcome and should not be the primary driver of your pursuit. Most of us want more freedom to make conscious decisions with what we do with our time rather than being beholden to a toxic work environment or arbitrary rules set forth by our employers. Third, remember that their are no hard and fast rules for finances. Be flexible and willing to adapt on this journey. For example, the 4% rule is generally a "rule of thumb" and is not meant to be a guarantee. This withdrawal may actually fail in the future depending on market conditions. Further, consider if you even need 25 times annual expenses to make a true career or life change. Suppose you had $250k saved and only spent $50k per year. You still have 5 years worth of expenses saved up! This should be more than enough cushion to make a move on some real life changes if you are not happy in your present situation. If you truly dislike what you are doing please do not feel that you have to get to full financial independence before you make a move. Often times, you can begin making radical changes much sooner. If you love your job, this entire paragraph does not apply and you will likely benefit from staying the course in your pursuit. Lastly, control what you can control. As much as we like control in our lives, admittedly their are things that are beyond your reach. For instance, take the market conditions. Although the 4% rule worked through previously difficult economic times, again there is no guarantee it will work in the future. Can you really control what the market will do in the future? No. Therefore there is no need to worry about it. Use the 4% rule as a general framework, control what you can control, and be willing to abide by the suggestions above as time goes on. Best of luck in your journey and remember to keep things in perspective. Related Content
The Actual Numbers Behind Financial Independence
Financial independence- and thereby early retirement for those who choose- is a worthy goal for those seeking to gain back control of their time. Simply put, financial independence is having enough savings or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance.
Typically, financial independence is thought of as your "retirement age" and not given further investigation by those under the age of 60. Why is this the case? Consider the following societal anchor points for retirement:
The assumption then is that we will need to work until our 60's, at minimum, before we can contemplate early retirement. That is, until we understand that there is actual evidence and analysis that it is possible to retire much sooner than your 60's, although access to the above benefits is likely nil. Remember, financial independence is having enough savings and/or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance. Technically, this can occur at any age. Financial independence, as well as early retirement, can then be simplified into mathematics based on investments and expenses, not age. A commonly held belief is that age is the single most important variable regarding retirement thus neglecting the most significant variable of all, your nest egg of invested savings. Do not allow the limiting beliefs of friends and family to lead you to the idea that you will also have to work for decades, in a job you dislike, just to catch a few golden years of retirement late in life. Financial independence is all about the math. Without further ado, let us dig into the numbers of financial independence and early retirement. To calculate your financial independence number, proceed as follows: [Expected Annual Expenses (in dollars per 12 months) x 25] = Financial independence # (in total dollars) To solve for this individual equation, you will need to estimate your expected expenses per 12 months moving forward. This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. As a frame of reference, you may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. If not, factor in recurring upcoming expenses such as increased health care premiums, increased or decreased housing expenses, etc. Once you have your expected annual expenses, multiply them by 25 as above to determine how much you will need to your investment portfolio for financial independence and early retirement. Why 25 times your expected annual expenses? This is related to the 4 percent rule of thumb originated from research conducted by William Bengen in 1994. He evaluated 4 percent annual withdrawals from a portfolio with a minimum retirement duration of 30 years. His research concluded the following: Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. Source
The overarching theme is that for those who are long-term savers, financial independence and early retirement is not as evasive as we might think. It's merely just one giant math problem.
The Math Shows Us That Early Retirement Is Possible
However, the above is a simple equation and is certainly no guarantee that your money will last forever. That said, consider that most people have no idea that there is actually solid research- as well as a way to calculate- the path to financial independence and early retirement.
Let this math be your framework moving forward. Understand that the above 4% withdrawal rate has some built-in assumptions and problems that need to be addressed and fully understood before you begin withdrawing your money. I will be highlighting those in another post. My guess is that if this is the first time you are hearing about financial independence and the possibility of early retirement, you likely have some more saving and investing to do before you need to worry about the precise mechanics of how you will withdrawal 4% of your money. Why Doesn't Everybody Know About This?
It is not entirely clear to me why this information is not more widely understood. I do, however, have some theories that I can share.
Theory 1. Our financial advisers and gatekeepers are paid to keep us contributing and investing to long-term programs. The problem with financial advisers largely controlling the dissemination of personal finance information to the public is that it is likely their interests will come before yours (unless you have a "fiduciary" adviser). If your adviser's compensation is based on assets under management (AUM) or load-fees, then their livelihood is based on you continuing to contribute and grow your nest egg. Again, this sounds like a good thing and perhaps it is if you detest the idea of managing your own money- or otherwise have a very complex estate to manage. However, paying higher fees and getting encouragement to continue working and investing for many years beyond financial independence will keep you working longer than you otherwise may have needed. Theory 2. Most people are terrible savers. Period. Theory 3. New media anchors us to minimum retirement age in our 60's, for all the reasons mentioned already above. Theory 4. Our parents, grandparents, or guardians worked forever and thus gave us a similar script with which to framework our own lives. Related Content
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Frugality vs. Cheapness
Cheapness... a wolf in sheep's clothing.
Being cheap is very often mistaken for true frugality. Cheapness refers to a state of being consumed entirely by price tags. Cheaper is better and something over a fixed dollar amount, say 100 bucks, is too expensive. Affordability is a less-than-versus-greater-than analysis fixed to a set price amount. On the other hand, frugality hinges on conscious spending. There is no absolute dollar amount for frugality. If you find yourself anchored by such a price ceiling you are more likely leaning towards being cheap instead of being frugal. It's alright, there is hope for you yet. How to Tell If You Are "Cheap"
The above questions are designed to get you thinking about price vs. value. If the first thing you think of is price when assessing the above questions, you likely have a cheap mindset. A cheap mindset is often described as being very fixed, rigid, possessing an enormity of limiting beliefs. Don't get me wrong, the goal is certainly to save and invest as an aggressive pursuit towards financial independence. However, years of deprivation and missed life experiences are not. How to Tell If You Are "Frugal"
Frugality is a central tenet of my writing. Value-driven conscious spending and saving towards a worthy pursuit. Yes, financial independence is important but, it's not more important than your health and happiness in the pursuit thereof.
The first post ever published on this blog was an effort to define frugality. The three main pillars of frugality are value, awareness, and freedom. Ask yourself the following questions:
If the answer is no to any of the above don't panic, it just means you are operating from a poor mindset, regardless of how much money you have in the bank. Things can and will change. So where do you start? How to Change Your "Cheap" Mindset
By reading this post, you have already started. Educate yourself and do not be afraid to question your existing money mantras. Do you believe that attaining a high net worth is only for liars and cheaters? Does the thought of saving and investing evade your thoughts entirely? Is it possible that you have missed out on life experiences because of a deprivation mentality?
If there is a vacation you want to go on, wedding that you'd love to attend, or any other experience that you would cherish and value, start figuring out how to make it attainable. Frugality is not about saving costs at every corner but rather finding value in every dollar you spend. Long-time personal finance author Vicki Robin wrote about life energy in her renowned book Your Money or Your Life. Think of your dollars as life hours. How many "life hours" of your day job will it take in exchange for your purchase. If you decide that two weeks worth of work is a worthy trade for a new dishwasher then by all means, go for it. In contrast, aimlessly spending $200 on shoes or $600 on a television you don't need in exchange for several hours at work hardly seems like a worthy ideal. Most importantly, don't be afraid to assess your spending. So many of us have poor financial outlooks because we don't even take the time to look at it or are otherwise fearful that it might confirm our existing limited beliefs. It's time to buck that trend and get honest with how terrible you are at assessing true value in life. Researchers have continuously found that social interconnectedness and experiences are high-value activities in terms of life enjoyment. With that in mind, it seems ridiculous to miss out on a trip with friends or family just because you can't afford it. Rather than traditional budgeting, instead focus on saving that amount by working more or spending less for a short period until you have saved the necessary funds for the upcoming expense. Remember, personal finance is best handled with an open mindset and ability to adapt and adjust when the situation calls for it. Related ContentTax Planning Can Expedite Your Path To F.I.
Certainly tax planning is a dreaded topic for nearly everyone. Yet taxes are mistakenly overlooked when considering overall annual expenses.
Taxes on income, property, and consumer goods adds up to a significant enough total to likely be the biggest expense category for any given household. After accounting for federal, state, and local taxes, further including FICA taxes, you will take home significantly less than you originally expected to be paid. Consider however, that these taxes can be reduced through some very simple strategies that impact your financially independent future as well. Reducing your taxes now (legally of course) will keep you in control of a greater percentage of your dollars Tips for Cutting Your Tax Bill
Nerdwallet posted a solid article on 12 tips to cut your tax bill.
Some of the most common strategies involve contributing to employer-sponsored retirement plans, qualifying traditional IRA contributions, and contributions to health insurance premiums and HSA's. Charitable donations are also valuable ways to positively impact the community and receive a tax deduction in the process. The Impact of Having a Plan for Reducing Your Present Taxes
Let's imagine a hypothetical example of Mr. and Mrs. Gibson. The Gibson's have an expected total household income of $150,000 for the year 2021. This firmly puts you in the 22% federal tax bracket (again, as of 2021).
In this example, keep in mind that the upper limit for the 12% tax bracket is $81,050. This means that every dollar over that $81,050 (12% tax bracket upper limit) will be taxed at 22% instead of 12%, a 10% difference. This is how a progressive tax system works. So in our hypothetical example, how would the Gibson's save 10% on federal taxes in this year?
Keep in mind that NONE of this is tax advice and you still need to consult with a financial professional if you do not feel comfortable planning on your own. This is for educational purposes only. Tax Efficiency Gets Your Money to Work Quicker, If You Plan
In the above fictional scenario of the Gibson's they would be able to use their federal tax savings to make greater retirement contributions while they are young, thus dramatically improving the power of compound interest over time.
Imagine year after year, as the tax rules change, learning about ways to avoid higher taxation and keep more of your money working for you instead of being handed out in taxes. These are perfectly legal strategies that are published in our tax code, but the rules do change often. For that reason, if you do not have the stomach to keep abreast of U.S. tax code, you must consult with a financial professional such as a certified public accountant (CPA) as well as a tax attorney who specializes in your state. Finding Peace Within Personal Finance
Finding peace is a crucial step in your financial independence journey. Without peace, a plan quickly becomes chaos and years of progress can turn aggressively into regression.
According to Ramsey Solutions, "Almost three out of four Americans (72%) say they are burdened by debt, including mortgages. And two-thirds of Americans (66%) reported consumer debt, with an average of $34,055 debt load per person." Worse yet, this same 2017 study also indicated that the higher the level of household income, the greater the amount of consumer debt. With these levels of debt across the board it is difficult to imagine that many are at peace with their finances. The most difficult aspect of debt is that it reflects decisions made in your past. Having peace with your past is certainly easier said than done, especially when it comes to your finances. However, it is not impossible. It can be done. How To Make Peace With Your Financial Past: 3 Steps
1. Own it.
Whatever your past mistakes may be regarding personal finance, take ownership of them. Take full responsibility and recognize that you cannot change the past, but you can control the present. If you continue to blame the economy, injustices, bosses, organizational structures, and society for your present financial situation, you are putting something at fault that you readily have little to no control over. Even worse, all of the aforementioned take a very, very long time to change. This leaves us with one option, take ownership of our situation which places the power of change firmly back within our grasp. 2. Radical Acceptance. This step goes hand in hand with step number one of ownership. Radical acceptance involves eliminating all toxic and destructive behaviors surrounding your personal outlook on line. Eliminate your bitterness towards the world and resentment that you have for past decisions. Realize that the only path to peace, especially financial peace, is to recognize toxic behaviors as quickly as possible and quit reacting destructively to those feelings. How? Mindfulness is an absolute must here. Meditation is an excellent practice that can show benefits even with just a few minutes per day. The trick is to be consistent with meditation above all else. The minute you lose momentum with meditation the quicker you will return to your old impulsive self. Remember, meditation has nothing to do with actually clearing your mind. Rather, it is the important practice of sitting alone with your thoughts and gradually, over time, becoming friends with your mind. Most people are too afraid to sit alone with their thoughts so they assume they are poor meditators because of this. This is the entire point of meditation. Bring awareness to your thoughts and recognize that immediately after you have them there is a small space where you get to choose how you react to them. 3. Control What You Can Control. To move forward in a positive direction financially, focus on the things that you truly can control. Expending energy on complaining about the government, your bosses, or the weather are not only poisoning your mind but also preventing you from focusing your energy on things that you can control- such as your savings rate, reading, and otherwise sharpening your mind and body through exercise and meditation. Admittedly, their are some things that you cannot readily and easily have control over, despite just how wrong they may be. For example, their are injustices in present society that appear to take entirely too long to be rectified. If you are black or otherwise a person of color, perhaps you do have an entirely different experience growing up than those who are white. You are not alone. Take a listen to Episode 216 of ChooseFI's podcast featuring Chris Browning of Popcorn Finance and be sure to look at the show notes of Episode 216 for some strong community voices to be heard. Show Yourself Some Compassion
All three steps above are most successful when we can show ourselves some compassion. If we made a previous mistake, now is not the time for judgement. Rather, now is a time for action.
Keep learning about personal finance. If investing scares you, take a look at how you can start to learn about investing to make is less terrifying. Perhaps you have no idea where to cut expenses to begin saving. Start reading articles about saving money and listening to podcasts on frugality and personal finance. Comment below if you have some considerations for how to further make peace with your finances and begin living in the present. The Role of Bonds in a Portfolio
We are led to believe there are certain things we need in our financial portfolio. Common wisdom implies that we should seek bonds to level out the volatility of our investments. But, is there any truth to this?
A brief review from our last post: Stocks are traded on an equity exchange where individuals or organizations seek to purchase shares of organizations. Examples of stock exchange markets in the United States are the NYSE and the NASDAQ. Bonds are exchanged either over the counter or as part of a fund (ETF or index). In purchasing a bond, or a similar index or ETF fund, you are lending money to either a corporation or a government entity at a fixed or floating interest rate as determined at purchase. Practically speaking, by purchasing a bond you are lending money to one of these agencies similar to the way the bank lends money to a borrower. Essentially, you are the creditor in this relationship. Investment wisdom suggests that individual investors should have a percentage of their investments in both stocks and bonds. One of the oldest rules of thumb is to have a percentage of your overall portfolio in bonds equal to your present age. Then, over time, adjust your allocation into greater proportions of bonds as you increase in age as a primary means of decreasing your overall volatility and increasing your fixed income. Using this example, if you just turned 30 years old, it is time to rebalance to owning 30% of your total portfolio value in bonds. When you turn 40, adjust to own 40% in bonds. Etc. Personally, I prefer a different approach. I plan to delay my investment into bonds until I am much closer to actually needing the money in my investment accounts. This would typically happen around "retirement age", which is a concept that is increasingly being revised due to the FIRE movement (Financial Independence, Retire Early). So what would make me delay my investment into bonds? Let's take a closer look. The Risks and Rewards of Bonds
The universal argument for owning bonds in your investment portfolio is to decrease overall volatility. As many will learn, equities (stocks or index funds/ETFs consisting of stocks) contain a great deal of volatility.
Vanguard has already done the heavy lifting on this one. Take a look at the results they came up with. 100% Bond Portfolio from 1926–2018*
In the 93 year period between 1926 and 2018, stocks nearly doubled the return of bonds (10.1% vs. 5.3%). However, bonds had a positive return 79 of those years while stocks had a positive return in only 67 of those years. The 12 year difference in positive returns in favor of bonds are why many folks choose to hold them.
Further, the worst year for bonds was an 8.1% loss (1969) whereas the worst year for stocks was a 43.1% loss (1931). Imagine your portfolio showing a -8.1% return in a given year, versus a -43.1% drop in value. If you have trouble imagining such a significant drop and would be likely to sell during such a period, perhaps owning a greater percentage of bonds in your portfolio is an idea worth considering. Keep in mind however, the trade off for stocks is that typically the greater risk is usually for a greater potential reward. Past results are not an indicator of future performance however! Do Bonds Offer Diversification?
When considering bonds for a portfolio, the typical investor seeks diversification into different asset classes. Ideally, these asset classes should have a correlation as close to 0 as possible. For those folks into rebalancing, a negative correlation is even better.
When a correlation of 0 exists, the two items you are comparing are believed to have no relationship with one another. The closer an asset class gets to -1, the more the two asset classes move in opposite directions with one another. It is important to note that we will rarely, if ever, find asset classes that consistently move in the opposite direction of stocks. It has been long said that stocks and bonds have an inverse relationship with one another. Conventional wisdom says that when stock prices are up, bond prices are down. Conversely, when stocks drop, bond prices tend to increase because investors are typically seeking bonds for stability and decreased volatility during market drops. However, this is far from a universal rule. In fact, stocks and bonds have recently been moving together. As of 2020, many investment grade and corporate bonds show a positive correlation with stocks. Further, many sources such as Morningstar have demonstrated a correlation greater than 0.5 (the closer to 1 the more related two asset classes are). The authors over at Seeking Alpha have a great article showing how the diversification into different asset classes has been diluted since many asset classes move together (correlation closer to 1). Check out this article and take a look at the last chart on the page. The darker the shade of gray, the more closely related two asset classes are. "Food" for Thought
Perhaps you read all of this and discover bonds are a safer alternative than stocks and you choose an aggressive bond allocation (somewhat paradoxical). Maybe you review the notes above and decided the complete opposite, bonds are for the faint of heart and stocks are the way to go. Either way, I would consider reviewing this article, and any notes you have taken, annually to see if you still feel the same way.
I will leave you with somewhat of a reaching analogy. Stocks and bonds are somewhat related to Aesop's classic fable of The Tortoise and The Hare. It's not a perfect analogy because stocks (hare) typically do beat bonds (tortoise), but it outlines the importance of where you are presently in the race of life. As mentioned above, the older the investor the greater the number of tortoises in their portfolio. Why? Slow and steady is believed to win the race. However, consider that you may want to be the hare in the beginning of the race, and switch over to the tortoise down the road to get the best of both worlds. Regardless, consult with your financial professional prior to making any lasting decisions. Stocks vs. Bonds
Investor success is typically predicated on understanding some of the basic assets that can be owned as part of a financial portfolio. No discussion of financial investment is complete without understanding the basic differences between a stock and a bond.
Stocks are traded on an equity exchange where individuals or organizations seek to purchase shares of organizations. Examples of equity exchange markets (i.e. stock market) in the United States are the NYSE and the NASDAQ. When purchasing a share of an organization, you essentially obtain a fraction of ownership interest in the organization which typically makes you eligible for voting rights within the company, as well as potential investment returns in the form of dividends and capital gains. Stocks can be purchased as individual shares or ETFs through the stock market. Stock ownership can also be obtained through investment into a mutual fund or an index fund, typically purchased through your investment firm.
Bonds are exchanged either over the counter or as part of a fund (ETF or index). In purchasing a bond, or a similar index or ETF fund, you are lending money to either a corporation or a government entity at a fixed or floating interest rate as determined at purchase. Practically speaking, by purchasing a bond you are lending money to one of these agencies similar to the way the bank lends money to a borrower. Essentially, you are the creditor in this relationship. Similarities
First, let us point out clearly where stocks and bonds are similar:
Differences
Now, where do they differ:
*According to Vanguard's Historical index risk/return (1926–2019) **Note: Vanguard's Historical data for stock returns is primarily using one of the S&P indexes over time whereas fixed income (bonds) is highly varied between periods. See the bottom of their article for precise methodology. Who exactly defines our success?
Let's face it, we live in a get-rich-quick, happiness-chasing time. We often permit those around us to determine how "successful" we are based on what we drive, where we live, and our job title. Yet this is terribly misleading and often the wrong way to look at the situation.
How often we permit others to dictate our level of success has a direct correlation with our sense of joy in life. If we constantly use others as a barometer for our success and performance we will inevitably fail to meet the expectations of the only person who matters, yourself through God. So where do we go wrong and how do we fix it? 
Money as a measure of success
In modern day culture, your net worth or financial earnings are often how others determine your level of success. Perhaps you even have judged your level of success based on your earnings or financial worth only to realize you are further behind than you originally desired. Money is tricky and not off limits for determining your level of success, but only if used wisely.
Money can certainly be an indicator of success if used as a small indicator of how valuable your time is to others. However, what about a hedge fund manager focused on tobacco interests? Sure, you could earn a lot of money but would the world really miss you if you were gone? Likely not. In contrast, take a community leader who earns income coaching individuals to value discipline, consistency, and faith and were paid well to do so. Perhaps you have the same earnings as the tobacco investor, but the service you provided to the community was more than just value from a monetary perspective. Ultimately, using money as an indicator of success works best if you are positively impacting the community with your time and skills. Otherwise, the amount of money you make is irrelevant and will be a misleading measure of success. Happiness as a measure of success
If money is not a perfect measure of success, then how about happiness? Happiness is often the pursuit of "feeling good" which is much more difficult to quantify than your financials. Happiness is often fleeting and requires persistent pursuit to feel. This means the pursuit of happiness can also be synonymous with the race to decay.
So why is happiness another imperfect measure of success? Shouldn't I get to choose if I am successful based on a day-to-day sense of happiness? Not entirely. Again, happiness is a pursuit. Feeling joy however is a choice. Joy for the opportunity to wake up again. Joy for the ability to hug a loved one or call a friend one more time. Joy for the ability to lend a friend a hand or hold a door for a complete stranger. The ability to feel joy is a door that opens outwards, towards others. The pursuit of happiness however, is a door that opens inwards or implies selfish tendencies. Experiencing joy on a day to day basis is a much better measure for determining success for yourself, but again, is hard to quantify. So if not money, and if not happiness, then what should one use a measure of success in life? Your habits as a measure of success
I have heard it said many times, and it bears repeating, "how you do anything is how you will do everything".
In recent times, attainment of success and the pursuit of the American Dream are a centerpiece of Western culture. If the journey continues this way, we fail to recognize what matters most on a day-to-day basis- our habits. Our habits are really what defines us. Your neighbor is not somebody who loves to go to the gym; rather she is an individual who goes to the gym everyday. Your cousin is not somebody who eats healthy; rather he is somebody who fresh prepares vegetables everyday. A close friend is not just financially wealthy; rather she is someone who regularly stays abreast of her personal finances. We are creatures of habit. Our habits define us thereby defining our level of success. If you are someone who does not have any positive habits that contribute to your ability to give to the world, then you must start building them. Look first to build habits that help reconstruct yourself. 50 pounds overweight? Time to start becoming the type of person who puts out running shoes everyday. Up to your eyes in debt? Time to get to work and start tracking your money and maximizing your effort towards debt payoff. Feeling foggy and having difficulty with cognitive performance? Time to up your game on learning and self-improvement. One you begin feeling like you are building momentum and reconstructing your own abilities, now you can look to develop outward habits that impact the community. For example, start a blog and educate others with quick reads on what you have learned. Start a community walking group with your newfound exercise habits. Call a friend, or even a group of friends, and show them how to start making healthy recipes. The sky is the limit. "Success is our ability and efficacy to help others on a consistent basis." Our individual habits permit us to improve our effectiveness in helping make the world around us a better place. Ability and efficacy. It takes both to be truly successful in our endeavors. We need to care for both ourselves and others in a continuous process, similar to the idea of sharpening the saw. Simply put, you are either using the saw (helping others) or sharpening it (helping yourself). Not sure where to start? Perhaps assess what you love to learn about or love to do and see if there is a way to teach it to others. If you do this consistently (i.e. build a positive habit) you will be well on your way to a fulfilling and impactful life. Until next time... Do I Really Need a 20% Down Payment?
My last post discussed the wonders of using the 20% rule as a guiding principal for determining a purchase price of a house. Now it's time to investigate the flipside of this argument.
Practically speaking, the 20% down payment rule on a house is mostly meant to serve as an affordability indicator. There will be many times however when a full 20% down payment is unnecessary and borderline dangerous. As you will see at the end, I still believe in having at least 20% down in cash reserves or paper assets as a starting point. Once you have the 20% saved, only then can you make a decision if any of the exceptions below actually apply. Exceptions to the 20% Rule:
1. If you have significant repairs to make.
If you believe you will have significant costs associated with renovations or refurbishment of existing structures, consider that having additional cash on hand might be better off. When mortgage rates are low, it makes more sense to avoid paying more interest for a construction loan. Keep in mind that construction loans seem to run around 1% higher than the prevailing mortgage rates over a given time. 2. If you anticipate needing cash for a large event. Paying for your own wedding? Perhaps putting 20% down is not such a great idea after all. You will want to have additional cash on hand for flowers, décor, and whatever else comes your way. 3. If you are living a F.I. lifestyle In this case, eliminating a significant amount of your capital might hurt your overall rate of return. If you are expecting an 8% yield from the stock market, then why take this money out of the market and put it into a house that typically only increases by 1% in value per year after inflation? If mortgage rates are high, this might make sense. But if mortgage rates are low (3% as of this writing), then you are likely better off leaving your money invested long-term in index funds. 4. When your mortgage payment is still less than 25% of your take-home pay with less than 20% down If you made a sensible purchase, and after only 5 or 10% down you still have a mortgage payment less than one-quarter of your after-tax household monthly pay, then I admit you have some wiggle room. You should never, and I mean never, use this formula to purchase more house than you can afford. In other words, don't put less than 20% down just to purchase a home that is more expensive. 5. If you value having months or years worth of expenses saved in cash over equity in your home This one is self explanatory. Would you lock all your hard earned savings into a home in the form of a down payment or have several years worth of expenses saved in a cash account. Put differently, would you rather have $60,000 in home equity via a down payment or 2 years worth of living expenses saved up in cash (assuming $3,000 a month in expenses)? The choice is yours. How to decide how much to put down
I still suggest saving at least 20% down of your expected purchase price in cash. After that, you can decide if you want to put more or less down based on the criteria above.
Utilizing the 20% rule allows you to keep your purchase price realistic when shopping for a new place to live. It also demonstrates that you have the ability to save money consistently and diligently. It is a valuable rule to live by, yet can be flexible once you have attained it. Leave a comment below if you believe you have another valid different reason to save less than 20% down. Why a minimum down payment of 20 percent is necessary
Many loan products in today's marketplace offer as low as 0% down when purchasing a home. For conventional loans, typically the buyer is required to put at least 5% down. Regardless, using anything below 20% as a down payment when shopping for homes is a big mistake.
The 20% Rule
Generally speaking, a 20% down payment should be the norm when purchasing your home. Here are some reasons to put as much as possible down on a home:
These are some of the most noteworthy reasons to put 20% down on a home. Mortgage interest write offs are a thing of the past and should not be a reason to borrow more money. Remember, large interest payments are the enemy of debt elimination. Having significant amounts of interest is indicative of high principal balance that is ultimately still owed. This is never a good thing for those on the path to financial independence. However, there is still an even bigger reason to put 20% down on a home. 
The single biggest reason to put 20% down payment
The most significant reason to put 20% down on a home is to keep you honest with your home search. If you stay within a price of homes that still permits a comfortable 20% down payment, it will prevent you from living above your means. Using 20% down is a an excellent way to figure out how much house you can truly afford.
As a general rule of thumb, I still like to have 6 months worth of savings in an emergency fund along with at least $2,500 in my checking account after making a down payment and closing costs. Working backwards to figure out how much you need saved would look something like this:
For example, say you have $3,000 a month in expenses and you are seeking to purchase a home below $275,000. Using the equation above, we can find out the minimum amount necessary to fund the purchase of a $275,000 home.
I would suggest that you never expect to use your emergency fund for anything related to a home purchase and closing costs. Do not earmark this money for anything except a true emergency. The extra $2,500 I recommend is to cover some minor expenses and repairs that you come across when moving into a home for the first time. One look at the necessary minimum for purchasing a $275,000 home may leave you feeling like this is unattainable. If this is the case, you have two options. Option A is to lower your desired purchase price. Option B is to save up for longer because you are not ready to purchase this much home. The safeguards of 20% down
Using the 20% rule as a metric for determining how much house you can afford would prevent the most common financial mistake of homebuyers, purchasing too much home. Further, by saving the necessary minimum amount highlighted in the equation above, you prove to yourself that you are financially prepared to make the largest purchasing decision of your life.
Be careful about listening to the advisement of those urging you to put no money down or using bizarre mortgage products such as interest only loans. Saving and preparing financially for a home purchase can be simple and straightforward, whereas using a more advanced strategy like an interest only loan or a 0% down payment can be costly and complex long-term. Nothing is more devastating in personal finance than debt and a mortgage will likely be the largest loan you will ever incur. Do not be afraid to purchase a home, but first make sure you are truly financially prepared by using the tips found above. Related ContentHow one decision can set off a chain reaction - The Diderot Effect
In modern Western society we are driven heavily by consumption which is largely driven by ideology. The West was purported to be a land of discovery, vastly unexplored. Yet, over time, America became known as the "land of possibility". By the early 1900's, a major shift began to occur when American society became aware of the limitless possibilities of a free-market society. By the 1920's, Ford had introduced the assembly line and by the 40's General Motors began spearheading innovation of big business and production standards.
The argument could be made that automobile production was the spark that ignited our modern consumerist culture. With innovations in production and rapid technological development over the following decades, Americans became increasingly expectant in the ability to participate in the free-market. Fast forward another 80 years and the average American presumes that everything should be instant access. Two day shipping is the new norm and instant downloads have overtaken our previous dial-up connections. Our ability to purchase and consume has reached a point the world has never seen. So where do we go from here? Don't get me wrong, the ability to have access to a free-market is a great gift given to us in the West. Our access to fresh food, clothes, and other necessities is a luxury that many other societies may never know. However, this superpower is to be used with caution. Greed is not a word familiar to the people in resource-constrained societies such as Uganda or Haiti. Same day delivery and online shopping are completely foreign concepts to many in underdeveloped nations. Yet, in America, greed drives every socioeconomic class from the poorest of the poor to the richest of the rich. Greed is defined as an "excessive or rapacious desire, especially for wealth or possessions" (source). We all are subject to feelings of greed throughout our lives by wanting and desiring more than is absolutely necessary and required. Introducing the Diderot Effect
The Diderot effect is named after French philosopher Denis Diderot and highlights a profound pattern of consumption that emerges across individuals related to the purchase of consumer goods. The term Diderot effect was first coined by anthropologist Grant McCracken in 1988 but actually originally referenced by Diderot himself a personal essay titled Regrets on Parting with My Old Dressing Gown.
Diderot was in financial need which became known to the Russian Empress Catherine the Great. Upon learning about Diderot's need for money, she agreed to purchase his library for a large sum of money and appoint him lifetime caretaker. What he did shortly after that windfall is what led to the realization of the "Diderot effect". Diderot highlights how the purchase of a beautiful red dressing gown led to a spiral of consumption that ultimately landed him back in debt. Upon the initial purchase of his new red gown (and hence the parting ways with his old dressing gown), Diderot began to examine all of his other possessions in comparison to his bright new red robe. He quickly realized how lousy they were in comparison. His solution at the time was to begin purchasing new items that were more in line with the luxury of the beautiful red gown, all leading back to the same level of financial constraint that he was originally plagued with. We are no different than Denis Diderot
The purchase of a new phone is accompanied by a fancy new case, a protection plan, insurance, and a higher monthly bill to boot. Refinishing your deck or patio area comes with the purchase of a new gas grill, patio furniture, outdoor plants, and some trendy decorative lighting. A new outfit needs new shoes and jewelry to match. We are eternally damned by these types of purchases.
The goal is not to stop this urge from happening, but rather change the way you respond to it. Replacing a worn out or broken couch does not have to lead to new lamps, end tables, coffee tables, and an impressive new area rug. You can replace or fix the couch but be cautious of the temptation to enter a proceeding spiral of consumption. Consider painting the tables or simply changing the lamp shades as an alternative to complete replacements- a substitution of undesired behavior. Instead of substituting the undesired behavior, you could also aim for complete elimination of Diderot-like behavior. This might involve saving up an exact amount for the purchase of a new item- a couch in our example above. Any purchases made within the next 90 days would then need to be examined against whether the original purchase influenced that behavior. If you can hold off beyond 90 days, then the item you were considering purchasing is likely a desire, not a necessity. What to do about it
I will admit, it is definitely nice to have nice things. Although frugality is an important trait that I hope to share with everyone, frugality does not have to be synonymous with deprivation. By recognizing that we are all subject to the same pressures as Denis Diderot, we can recognize that a spiral of consumption is never more than one purchase away. In particular, if you are already in financial trouble, one single spiral can derail a significant amount of positive progress.
Be mindful of your purchases. Truly consider how much you will value your purchase in the long-term. Certainly do not agonize over every single purchase, but rather try to emphasize mindfulness and frugality more consistently over time. With enough practice, you will easily be able to identify what purchases are in line with your values, and which ones aren't. Overconsumption is not an impressive or attractive quality. Take the time to analyze whether something, or someone, is influencing you to engage in spending behaviors that are not consistent with your ideals. How to start investing in low cost index funds
Previously we outlined how to begin investing with 5 actionable steps. Begin with this article if you do not currently have an investing account. After reading that article and setting up an account, then you may proceed to the information below.
After choosing the type of account that you would like to transfer your savings into, you have some options once the money arrives for what you would like to invest in. You could try to pick individual stocks and become the next Warren Buffet, but I strongly encourage you to avoid this temptation. Rather, I like to keep 90% of my money exposed to a broad array of stocks which typically earn 8-10% per year over the last 200 plus years. How do I do this? Low cost index fund investing. The choice is yours. Consult a financial advisor immediately if you are not willing to embark on this journey alone and accept the full responsibility of managing your own money. For those so inclined, managing your own money has the ability to yield superior results, if you are willing to become an expert in personal finance along the way (yet another reason to start reading). My favorite companies to open investing accounts with are Vanguard and Fidelity. They offer some of the lowest cost index funds that give you the opportunity to participate in years and years of compound interest, without all the added fees that active mutual funds typically carry. Be advised, not all companies will offer top notch low cost index funds. Often times, especially in 401(k) and 403(b) plans, your options will be very limited. I believe that you can still find good low cost options that expose you to a broad array of stock ownership by following some simple tips outlined below. How To Find Good Index Funds Regardless of What Company Your Investment Account Is With
When considering index fund investing, here is primarily what you are looking for.
1. The fund should track a major index
Choosing Fund Types
When index investing, you have as few different options into what types of funds to choose from.
You can invest in exchange traded funds (ETFs) that trade in real-time like other individual stocks. Or you may choose a index mutual fund which typically trades once per day at the closing price. Either one is a great choice as long as you keep the expense ratio under 0.1%. Vanguard and Fidelity have great index mutual fund options and iShares, as well as Fidelity, have some great ETFs. There are additional options for those who wish to further diversify such as small cap and mid cap index funds which place greater emphasis on smaller and medium sized companies. My personal preference is to stay with large cap which is what an S&P 500 index will offer. If you were to choose an ETF or an index mutual fund that tracks the Total Market, you will inherently diversify into small cap and mid cap companies as well since it carries large, medium, and small companies in it's portfolio. Speak with you financial professional regarding the above options when investing. If choosing to DIY, check out my resources page for books on how I learned to start investing without needing to pay a financial advisor. The Average Millennial's Financial Situation
Let's face it, most of the discussion around personal finance and net worth involves the Baby Boomer generation. Perhaps this is due to their overall proximity to the traditional retirement age of 60-65 years old.
Generally speaking, the Boomer's have a sad financial state of affairs given their age (more on that later). This lack of financial net worth is significant because of how many Boomers there are in this country. According to a 2019 survey, there are just over 69 million Boomers in the United States. However, most are unaware that there are actually more Millennials in the US to the tune of 72 million. The fact that Millennials actually outnumber the Baby Boomers is lost on most people. Most of the news and media reports are focused on the Boomers proximity to receiving Medicare and requiring long-term care. It seems unwise to focus so intently on one group, especially if they are not the largest percentage of our overall population. That said, we need to put the present state of financial affairs of the average Millennial into focus. Millennials vs. Boomers
Most Millennials (generally considered those born between 1981-1996) entered the workforce around The Great Recession between 2007-2009. That said, with rising costs of education and living in general combined with decreased earnings, the unfortunate average financial net worth of a Millennial is below $8,000 per household according to a 2019 study by the Deloitte accounting firm.
Typically parents want their children to do better than they did. Consider how low that bar might actually be set given that the average Baby Boomer household retirement savings is $144,000, per a recent Transamerica survey. Boomer's are widely considered those born between 1946-1964. That leaves some Boomers older than 75 years old with the youngest Millennials in their early 20's (as of 2020). Some Millennials may be up to 50 years young than some of the oldest Baby Boomers. According to recent U.S. Census data, 60% of married Millennials and 80% of unmarried Millennials earn less than $40,000 per year. The folks over at SmartAsset report that the average salary of a Millennial today is an estimated 20% lower, in inflation-adjusted dollars, than the average salary that a Baby Boomer had at the same age. Although generally Millennials are off to a rough start, there may just be hope for the future. First, let's assess the biggest areas where Millennials are failing. Then we can take a look at what might give Millennials hope fore the future. The Balance Sheet Of An Everyday Millennial
The vicious cycle of spending and consumption that follows societal expectations is leaving Millennials in a difficult situation financially. It is unattractive to live with your parents, drive an old car, and wear old shoes and clothes, so we don't. Instead Millennials have an ever-present pull towards consumption because most of their friends and family mistakenly judges success by your possessions. According to modern society you must be broke and failing if you do not own nice things. This is one of the most pervasive fallacies of the West in the 21st century.
Displaying a high social status is not a measure of success. I would argue that conforming to societal expectations of increasing possessions by giving into unnecessary spending behavior to impress others is borderline pathological. So how has this absurd idealism and pathological societal expectations impact the average Millennial?
Where Do Millennials Shine?
Perhaps Millennials demonstrate the most resilience out of any prior generation. Recall that nearly every young person in the Millennials generation entered the workforce during The Great Recession, or otherwise one of the greatest economic downturns of any of our lifetime's.
To make matters worse, when Millennials were supposed to be experiencing stability typical of approaching or entering your 30's, a had a pandemic hit. During COVID-19, the unemployment rates have spiked sharply. Another economic downturn was bestowed upon this generation making their increased debt and financial obligations even more difficult to combat. Millennials also tend to attain higher education, specifically college education. The downside to this is the ever-increasing student loan debt but there at least demonstrates the continued resilience to endure a 4 year liberal arts education and at least give themselves a crack at becoming more enlightened (although this doesn't always happen). Another positive attribute is the entrance of women into the workforce. According to the Pew study, In 1966, when Silent Generation (born 1928 to 1945) women were between the ages of 22 and 37, only 40% of the women were employed. Compare that to today where 72% of Millennial women are employed. With increased participation in the workforce, families are at least given the chance to earn more money than prior generations, although this has not yet proven to be true largely due to two significant economic downturns during the earliest earning years of a Millennials life. Despite the woes of the Millennial generation they do demonstrate some additional positive attributes:
In Summary: The Potential For Millennials
I believe overall the potential for Millennials in the future is great despite previous history treating them unkindly. Millennials demonstrate their resilience in the face of increased student loans, higher costs of living, The Great Recession, and now a pandemic. We must encourage the entire Millennial generation to continue to increase their financial wit through reading, researching, and asking prudent questions. They have demonstrated that they are willing to ask for help, but this is when the rubber meets the road.
There is hope in the future yet as long as we continue to grow stronger and wiser with our finances and realize that their still may be many challenges yet to come.
Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.
The ability to resist temptation is the key to financial strength
Today, we outline a common theme in the financial independence community, delayed gratification. In financial terms, saving and investing is the equivalent of delayed gratification.
The ability to save is heavily dependent on spending behavior. But why do we spend so much as a society? What is it about spending that taps into our internal reward system? Enter the concept of self-gratification. self-gratification - the act of pleasing or satisfying oneself, especially the gratifying of one's own impulses, needs, or desires. Source
Delayed gratification is actually a form of self-gratification. It is the ability to restrain oneself from immediate indulgence in exchange for a later reward. Delayed gratification also happens to be a highly useful tool for increasing your net worth.
The concept of delayed gratification is simple: instead of immediately indulging yourself for a reward (instant gratification), the temptation is resisted in an effort to attain a future reward. The negative connotations around immediate reward is ever-present in contemporary society. Instant gratification is centered around consumerism and reward-seeking behavior which happens to be the crux of modern day America. Financially speaking, instant gratification is also known as keeping up with the Joneses. We are driven by a culture of consumerism and spending in the United States. Some estimates indicate that we see up to 10,000 ads per day, and that is only from digital sources. That number doesn't even include how many billboards, newspaper ads, magazine ads, and physical advertisements we are exposed to on a daily basis. Being driven by consumerism is not friendly when it comes to personal finances. Instant gratification- keeping up with the Joneses- is inherently self-defeating when it comes to finances. The downward spiral begins when you realize that the first purchase often does not lead to the amount of reward that you originally anticipated. This can often lead to more purchases on the tail-end of a recent purchase, also known as the Diderot effect. The Diderot effect is named after French philosopher Denis Diderot who sudden came into money after the sale of his library. What he did with his windfall was purchase a beautiful red dressing gown, which is exactly where his troubles began. Suddenly, this red gown was the nicest thing Diderot owned and it made all of his other possessions look lousy. He realized there was only one way to fix this- purchasing new items to "live up" to the beautiful red gown. He began replacing straw chairs and old tables until all of his possessions were suddenly beautiful, all at a great expense to Diderot. We have this happen all the time as well. Buying a new phone comes with purchase of a new case, a protection and insurance plan, premium app purchases, and a higher monthly bill to boot. Redoing your deck leads to new furniture, a brand new gas grill, plants, and the trending decorative lighting. This is the Diderot effect in full force. Your goal is to interject before the spiral of consumption begins. The story of the kids and the marshmallows
In 1972, a study was published from a group of researchers out of Stanford. The design of the study involved giving children the choice of immediate gratification or delayed gratification. The children were placed in a room with an investigator and given a marshmallow. They were told that if they waited and did not eat the first marshmallow, they would be given a second marshmallow. Then the investigators left the room for a short period to let the children decide for themselves- eat the first marshmallow immediately or wait and have two to eat in the future. In other words, instant gratification versus delayed gratification.
Now understand that these children were preschoolers, the most likely crowd to give in to the temptations of instant reward and gratification. The remarkable fact is, some didn't give in. Some waited. So what happened to the children who were able to wait? They followed up years later with the original cohort of preschoolers and cross-referenced the data of those who waited versus those who didn't. You can see the studies for yourself here, here, and here. So what did they find when they followed up with the original students? On average, the students who avoided eating the first marshmallow in exchange for two marshmallows later (i.e. those that demonstrated delayed gratification):
Not bad for the pain of waiting a few extra minutes for two marshmallows. So what does this have to do with finances? How delayed gratification affects finances
The children who chose delayed gratification in the Stanford research experiment overall scored better in nearly every objective measure when assessed years later than the children who chose instant gratification. With better ratings of academic competence, social competence, rationality, attentiveness, planfulness, and improved ability to cope with stress, who better suited to resist keeping up with the Joneses than those who displayed delayed gratification!
Perhaps the traits the preschool children showed early in life can help inform us of how delayed vs. instant gratification can effect our finances. For example- someone who is more inclined to value delayed gratification might avoid the temptations of a quick purchase in exchange for long-term growth of your net worth. If you can resist temptation to purchase new things and you value savings, you are likely in a better situation to invest. By investing over a long period, you are likely to participate in the profound powers of compound interest. All of this begins with the simple ability to resist instant gratification in exchange for the future rewards of compounded growth. A better life is often the fruits of displaying delayed gratification. Working out once is not going to give you the body of your dreams. Skipping a small purchase at a gas station is not instantly going to make you wealthy. Eating one salad will not ameliorate the risks of eating poorly at every other meal. Rather, it is the cumulative effect of these choices to delay your gratification and reward system in exchange for a better future self. Make the difficult sacrifices now to provide better financial means in the future. Purchasing everything now, in the moment, destroys your ability to participate in one of the greatest mathematical phenomena known to man- compound interest. Related ArticlesBeing smart with money is about increasing financial awareness
We are living out the cautionary tale urging us to live below our means. Consider that some estimate that we make roughly 35,000 decisions per day. A survey conducted by Dan Goldstein and Principal Financial Group indicated that although we make thousands of daily decisions those who lack financial confidence are 64% more likely to postpone major financial decisions- such as managing investment or retirement accounts.
We live in a consumerist society filled with things we likely do not need to impress people we probably have no business trying to impress. Consider what might happen if you spend a weekend with friends who own a large home and two new cars. Or maybe a long weekend with parents or relatives who own a beach house with a inground swimming pool. How might you feel coming out of that experience? I assure you that this recent experience will have you more likely to spend. For most, success and failure seems to be judged by material possessions, especially in comparison to others. Worse yet, time spent with friends or family who are spenders subjects us to a psychological theory known as recency bias. This type of bias is an error where we place greater importance on events that occurred more recently compared to events occurring further back in time. That explains why you suddenly want a new car or to upgrade your kitchen after you spent time with anyone who is a big spender concerned with the display of high social status. Financial Awareness is more elusive that you think!
Taking a moment to stop and assess whether your financial decisions are related to competing with others versus your long-term goals is an enormous step worth taking. Taking that step is more difficult than you might initially think. Remember that we make 35,000 decisions per day, many of which I bet are around finances, or making the decision to further procrastinate finances. Amidst all those decisions, you need to discover a way to consciously address those related to financial decision making.
This process of becoming aware of your financial situation will bring about many challenges. Admittedly, I have often experienced the strong urges to display my financial status to others by competing with their purchases. Yet I resist because it is in the best interest of my future self to do so.
Given the context above, imagine the frustration of sitting with friends and family who readily assume that we are not "doing well". Imagine the outrage I might have of knowing what real financial strength means, and listening to a dozen people sit around talking about who "has money" and who doesn't. This is a fruitless conversation often coming from those who have no real financial values of their own. Displaying financial prowess with the purchase of material possessions should not be top priority along your path to financial independence. Very few people around us actually have any idea how much wealth we are actually accumulating. Why? Because we don't buy things that display how much money we have. The reality of the situation is you have to become alright with nobody knowing how much you are worth. You have to realize the only person who needs to know your financial worth is you and a significant other, provided you have one. Living a life of frugality and wealth accumulation is often not very attractive early on in the process. Unless you want to walk around and show people your account balances (I do not recommend this), the only person who really needs to knows how "well" you are doing financially will be you. 4 Questions to develop increased financial awareness
I suggest regularly, perhaps even daily, going through the following reflective steps to incrementally build awareness:
1. What are you thinking about, or regularly, purchasing? Like it or not, purchasing decisions are always near the forefront of our minds. Whenever you see something you like, you immediately picture yourself possessing it, wearing it, driving it. This is just basic human nature and the sooner you realize you are drawn to acquiring more things, the sooner you can begin to break the habit of purchasing needlessly. This is the foundation for developing awareness. You are thinking about either consciously or subconsciously, it's just the nature of our being. 2. Why are you thinking about, or regularly, purchasing?
3. How much are you currently saving and investing?
4. Why are you saving and investing?
Contemplate these four questions everyday and you will be amazed at how quickly you start to build financial prowess and control over your finances. As the old saying goes "you don't know what you don't know". Walking around on autopilot only knowing how much you have in a checking account to make a small purchasing decision is not the path to financial independence and strength. Take control of your financial future and break the habit of letting finances hide themselves inside of the 35,000 decisions you make everyday. Related Articles
What exactly is investing?
The definition of the word invest is:
to commit (money) in order to earn a financial return - Merriam-Webster
Further, an investment is:
the outlay of money usually for income or profit : capital outlay - Merriam-Webster
The purpose of investing is to make an initial purchase of something (the outlay) in hopes of income our profit in the future. The income or profit is typically assessed as a return on investment (ROI) and could come in the following forms:
How can you start investing?
There are actually many ways you can begin investing but perhaps the simplest and most common way is investing in the stock market, online.
Whether you choose to begin with automated savings to a retirement plan with your employer, or elect to manually make deposits into your savings and investing account, you first need to identify if you will "do it yourself" or utilize a professional money manager. Doing it yourself can save a significant amount of money over time, but if you are not willing to learn and study about investing and finances, consider hiring a professional. Here are some types of accounts where you can invest in the stock market:
With all of the accounts listed above, I like to purchase low cost index funds in either a Roth IRA or 401(k)/403(b) plan due to the tax advantages of retirement accounts. Many in the financial independence community also utilize retirement plans to purchase low-cost index funds due to the specialized tax treatment for retirement accounts. Ultimately, the decision is yours. For traditional 401(k) and 403(b) and traditional IRA plans, you may be able to lower your current taxable income, but note that you will still have to pay tax later on withdrawals once you retire (based on age 59 1/2 or older for these types of accounts). This "tax break" occurs by notifying the IRS that you set money aside to these tax-advantaged accounts, thereby lowering the amount the IRS can tax you on. With traditional accounts, there is also required minimum distributions (RMD's) starting at age 70 meaning you have to take out at least some money, even if you do not wan to. Keep in mind that their are income limits for these tax breaks so if you are a high earner, find out what income level phases you out of these tax advantages. For Roth 401(k)/403(b) plans and Roth IRA's, you get to withdrawal the money in retirement tax-free (typically starting at age 59 1/2). The downside is no "tax break" now like the traditional accounts offer outlined above. Be advised that there are limits to the amount of annual contributions you can make to these types of accounts. Visit IRS.gov for present year contribution limits for all types of accounts. In Closing
By no means is this investment advice nor is it designed to be a comprehensive outline of the entire investing world.
The most common problem remains that most people get scared off by the "complexities" of investing. In reality, as highlighted above, getting an account open to start investing is actually quite simple. After your account is open and you put in your first small sum of money, then you can consider yourself a beginner investor. Realize that over time, you will fill in the gaps in knowledge just by having an account and asking questions (and making a few mistakes along the way). Leave a comment below on how you feel or felt about first entering the "investing world".
Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.
Are You Worth What You "Should" Be?Net Worth = Assets - Liabilities
Your net worth is an excellent indicator of how well you accumulate money over your lifetime. Certainly, net worth is inclusive of more than just cash savings, as the equation indicates above.
Consider however, net worth is really an indirect (or arguably a direct) measure of your spending behaviors. If you accumulate "things" instead of "assets" in your lifetime, you likely will likely have a very poor showing when it comes to calculating your net worth. Purchasing depreciating assets such as cars, boats, clothes, shoes, etc. contributes to a low net worth because you are spending what should instead be saved and accumulated. If you were to purchase a house, or securities, or any other appreciating asset, you would otherwise expect your net worth to increase. Here is the catch... having a big house and displaying high social status by mortgaging and borrowing can give the appearance of high net worth, but actually leaves you worth next to nothing. What should my net worth be based on age?
My favorite simple equation for determining how much you "should" be worth is based on annual income and your age. It comes directly from the book The Millionaire Next Door by Thomas Stanley.
Expected Net Worth = (Age x Pre-tax Annual Household Income)/10
I really like how this equation actually provides an excellent reflection of your spending vs. accumulating behavior to date.
Essentially, if you make $600,000 a year and you are 50 years old, with a present net worth of $450,000, you are actually a fairly poor accumulator of wealth. Per Stanley's equation, you should be worth $3 million! Why $3 million? Using Stanley's equation, Expected Net Worth = (Age x Pre-tax Annual Household Income)/10, simply plug in the theoretical numbers listed above.
If you are making this type of income and have only managed to save a small portion of it, you live a high-consumption lifestyle. A high-consumption lifestyle is the plague of the West in the 21st century. Displaying high social status to others instead of attaining a high net worth - which typically nobody sees - is a no contest. We tend to lead a lifestyle geared more towards impressing others as opposed to improving our own character and merit. It is truly a sad state of affairs for the average American household. Is it really any great mystery why rates of divorce, unhappiness, and depression maintain such high rates? I think not. What if I don't make much money?
Let's consider a more realistic scenario with more pedestrian numbers than the ones used above. Take a household earning $70,000 combined pre-tax income presently at age 35. Cut them a break right? After all, they are only 35! They aren't doing too bad.
Not so fast... Using these numbers we figure this 35 year old couple should already be worth $245,000
Consider for a moment that most people in the United States, even one's who are much older than our example couple, barely have enough savings to cover a month's worth of expenses let alone $245,000. There is a solution however... Start living below your means, not above them! Closing thoughts on net worth
Best-selling author James Clear eloquently describes how certain outcomes can be a lagging measure of your habits. Poor financial habits and high spending behavior almost always equals low net worth. Frugality, savings, and investing are typically habits that yield an eventual outcome of extraordinarily high net worth's, even with very modest incomes of $70,000 or less per household!
Stanley's equation above is certainly not a perfect example because maybe you are at the very beginning of your journey. Perhaps you just paid off a significant amount of student loan debt or paid for your own wedding. Of course this equation would not capture this event in such a unique situation. I believe that this equation would be something to turn to after you finish eliminating your debt to help keep you motivated along your path. No matter where you are now remember, net worth is timestamped and very specific to a particular point in your life. This means that you can change it, significantly. All you need are better habits. Not sure where to start or how to improve your habits? I suggest taking a look at Clear's book Atomic Habits. He gives great insight on why goal setting is dead and achievement is largely based on relatively mundane "habit stacking". Let us know in the comments below what you learned when you calculated your "expected" net worth using the above equation. Until next time...
Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.
How to Figure Out Your Net Worth
Pretty straight forward stuff here, right?
Perhaps we should take a deeper look, just to make sure we are all on the same page. The first step I recommend taking is to tabulate what you possess that holds financial value. These are your assets. Calculate your assets by adding up the present value of the following categories to find the present value of your assets.
Next, we need to figure out what you owe. This is also known as your liabilities. Add up the following categories to find your liabilities.
Subtract the total number found for your liabilities from your assets, to get your net worth. In other words... Net Worth = Assets (present value) - Outstanding Liabilities Your net worth with fluctuate over time
In other words, it is snapshot unique to the day and time that you calculated it. It will go up and down with fluctuations in the market and differing seasons of saving and spending throughout the year. This also means that just because you got to a point where your net worth crosses a certain threshold, it may not stay there forever. The present value of your net worth is very transient. It is based on both individual behavior and market behavior.
A word of caution: purchasing a depreciating asset (like a boat) is nearly as bad as any other liabilities.
What should my net worth be?
My favorite simple equation for determining how much you "should" be worth is based on annual income and your age. It comes directly from the book The Millionaire Next Door by Thomas Stanley.
Expected Net Worth = (Age x Pre-tax Annual Household Income)/10
I really like how this equation actually provides an excellent reflection of your spending vs. accumulating behavior to date.
Essentially, if you make $600,000 a year and you are 50 years old, with a present net worth of $450,000, you are actually a fairly poor accumulator of wealth. Per Stanley's equation, you should be worth $3 million! Tell us what you think in the comments below. Are you worth what you should be? Are you now motivated to save and invest even more than you already have?! Related ArticlesThe downside of focusing only on earning more money
Earning more money can either turn your life around or turn it inside out. There is a difference between earning to spend and earning to save. The mindset is completely different between the two.
Poor accumulators of wealth spend more as their income increases. Good accumulators of wealth learn to save some, or all, of their increased earnings. This is the difference between displaying and accumulating wealth. Those who "display" wealth, are interested in spending on things that show to others some resemblance of wealth. Savers are frugal with their habits and are more interested in their net worth increasing over what friends think of what they have. Increasing your net worth is simple and it necessitates that you become a good wealth accumulator. It does not mean that you earn a high income and spend everything you make because despite your façade of high social status, you are essentially poor from a net worth perspective. A word of caution: more income is not always better. You can actually be a good wealth accumulator if you practice mindfulness and frugality with your money. Here are some questions to ask yourself before chasing a higher salary at all costs:
If we are always focused on productivity and output, we may miss the very things that are right in front of us. Further, many activities listed above (exercise, sleep, nutrition, meditation, cognitive challenges) are actually scientifically proven to improve BDNF and neuroplasticity thus making our brains even more productive. Does more income always result in more freedom?
Not always. We highlighted above that earning more money can potentially lead to increased psychological, and occasionally physical, stress.
Another axiom worth mentioning is about "working smarter, not harder". At baseline, most people work relatively "hard", they just tend to be inefficient. Efficiency would be working aggressively for a short period of time and then taking a break. For example, the Pomodoro technique is surrounded around taking 25 minutes for a task and then given yourself a break at the end of 25 minutes. This technique is centered around the concept that we have very limited attention spans. Instead of trying to work for 8 hours straight, try instead to break your work down to short intervals interspersed with stretching, standing, or walking breaks. Doing this throughout the day will likely increase your productivity quite a bit. Our work inefficiency and arbitrary 40-hour work weeks actually reduce our freedom greatly. If you work remote, this might be easier to pull off. If you work at the office, you will look like anybody else who is frequently taking breaks throughout the day, they are just doing it at random. You are going to pre-define your time periods and rest intervals. Set the clock for 25 minutes and do not stop and take a stretch break until you get their. Once you reach the 25 minute mark, try taking a true 5 minute rest by breathing, stretching, walking around, or anything else that can allow you to practice mindfulness. "Money Doesn't Buy Happiness"?
The typical belief is that we need to have "nice things" and buy more stuff to display a high social status to prove to others how wealthy we are. In spending more, you fail to realize that you are inherently saving less and therein drastically slowing down the accumulation of your net worth. In the long term, spending more will effectively create more financial strain and stress, not less. This is not likely to result in long-term happiness.
Efficiency and happiness maximizes your freedom
If your six-figure job requires ruthless hours then you are not in control of your own freedom. There are certainly ways to make more money with less stress, but those opportunities are few and far between. More stress traded for more money is almost always the deal.
Think of the promotion to management. Now you have more employees to manage, scheduling to do, deals to close, handling poor performance and lack of motivation. Management is somewhat akin to "adult babysitting". Consider if this is truly something that you want and go into a promotion like that fully aware of how increasing your earnings might impact your job satisfaction. What about the successful business owner who sits in his backyard while earning $10k a month from his business? Where were you the first 35 years he was rolling around on the floor like one of the employees? All you see now is the snapshot of what he has become due to all his time spent, holidays missed, birthdays not attended. All so that he can enjoy the "twilight years" of his life just to have you assume he always did it that way. My ultimate proposal is that we improve and optimize our efficiency. Researchers indicates that happiness plateaus at an annual income around $70k per year. After that, the return is insignificant. This might mean that if you are already above this income level, earning less by taking a role more aligned with your values is more valuable than the increased earnings. I am not averse to hard work and discipline, far from it. However, you need to enjoy life and enjoy what you do. Be careful about becoming beholden to your job. Buying more than you can afford is the number one way to feel stuck in a job you hate. If you are going to participate in periods of life with higher income and higher stress, please do so wisely by accumulating, saving, and investing your increased earnings, not spending it all away! If you are frugal, disciplined, and value-oriented, focus on the following:
Happiness is more important than income
I encourage you to see if there is more to life than determining success based on earnings. Money can only buy certain things, most of which derive very little happiness.
There are plenty of things that move the needle on happiness that are free:
Perhaps your best life is about separating "what you do" from "who you are". Do not think about work after hours or on days off. Be mindful and figure out "who you are" when you are away from work. Spending too much of your precious time at work and thinking about work will make your job define you. From my experience, MOST people do not want to be defined by their jobs. Let us know your thoughts below in the comments section. Are there any other free activities that you really enjoy to share with the frugal community? Related Articles
Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.
What Is "Investing" and How Can I Participate?
If you want to a crack at the big bucks but aren't 7 feet tall with a smooth jump-shot or a square-jawed Hollywood big shot, you need to invest.
There are many different methods of investing from baseball cards to stocks, comic books to silver. Truth be told, you can invest in anything you anticipate will increase in value over time. I would estimate, however, that a great majority of investors build their life and wealth around the stock market or real estate. Entrepreneurship or small business ownership is a close third option. Technically, you can invest in nearly anything understanding that not all investments are not created equal. All you really need is just one person willing and able to purchase something at a higher price than you originally paid to have a positive investment. If you purchase something that is not reasonably expected to increase in monetary value over time, then you are probably making a poor (or negative) investment. Investing is essential for wealth building
So where do you start? What are the very first steps of investing if you are a beginner?
If you are just starting out, I suggest you begin doing some light reading in the areas of personal finance and investing. Reading this blog is a great start and take a look at some of my all-time favorites on personal money management. ducate yourself. Read, study, and immerse yourself in money management, investing, and personal finance. It is imperative to understand money I am not saying be the next Warren Buffet and read financial statements all day for the next 80 years, but educating yourself would be a good place to start. The two most common investment options, both with fairly small barriers to entry, are investing in the stock market or real estate. How do you invest in the stock market?
You actually have many options. Wall Street and the stock exchange began in 1792 under a buttonwood tree and involved actual in-person trading of securities.
Nowadays, nearly everything is done online. To open any individual retirement accounts or brokerage accounts, I like to use Fidelity or Vanguard for my account. For workplace plans, you may not have the option of either of the aforementioned so work with your HR department and a financial advisor in discovering what approved vendors you have for your 401(k)'s, 403(b)'s, and other deferred compensation or pension plans. The primary types of accounts to invest in stocks are:
Again, for IRA's and brokerage accounts I always have used either Fidelity or Vanguard, but the choice is entirely yours to make. These two vendors give you access to some of the lowest fees and expenses available in the industry. My favorite funds to own for each company are listed below. Disclaimer: This is not investment advice.
If you have any trouble figuring out how to purchase stocks and index funds, or how to transfer money into these accounts, call your investment company or financial advisor and ask how to get started purchasing these securities. Vanguard and Fidelity have some of the best customer service departments I have experienced yet. What's the long-term plan once the first investment is made?
My personal preference is to "set it and forget it". I add money to my account incrementally over time and continue to purchase my favorite stocks and index funds in expectation that they will dramatically increase over time. I typically set my investment horizon for at least 20 years, especially my index funds, where I do not expect to sell or withdrawal any of these securities for 20 years or more.
A common long-term for the financial independence community is to continue the aforementioned, year after year, until you have enough money to cover your expenses My plan is to do this year after year until I am ready to start withdrawing this money which will be when I no longer need to work for money and can live off investment income. Please, do not worry about timing the market. Do not worry about crashes. Do not worry about corrections. Just invest in low cost index funds for life and allow your money to compound over time. Use caution when you have anybody telling you they have access to unique metrics and can protect you from market crashes. Unfortunately, actively managed portfolios rarely ever beat passively managed ones. Guess what, they don't. Their "pick of the week" and "insider information" has never historically proven to be accurate. Consider that almost every single long term investment advisor has failed to even match the returns of the S&P 500. That's why I choose to invest in index funds to allow me to match the S&P 500 thereby beating 95% of all professional investment advisors. What About Real Estate?
I have not personally began investing in real estate as of 2020, but I expect that to change over time.
One of the best real estate investment books I have read is How to Buy and Sell Real Estate for Financial Freedom by James and JW Hicks. The two most common real estate investment strategies are:
These two strategies oppose one another greatly. Long-term rental strategies are geared for those looking for many years of residual rental income and who do not mind either managing the properties themselves or paying somebody else to do it. "Fix and Flip" is exactly what it sounds like. Buy a crappy place for cheap, fix it up either yourself or with low cost contractors, and sell it for a profit after factoring in expenses to fix it up. In Closing
Regardless of how you start investing, whether it be real estate, stocks, or otherwise, you need to get your money working for you as early in life as possible.
The most assured way to generate significant long-term wealth is saving and investing. Boring? Maybe. But you can laugh your way to the bank someday when you are counting all the zeros behind a big number in your investment accounts. Related ArticlesThe purchase of your home or primary residence
Most people forget that a home is a type of purchase. When we hear the word purchase we tend to focus on small-ticket items like clothes, shoes, or groceries. Perhaps it is because we tend to associate loans and mortgages with large-ticket items, while purchases tend to be geared towards small-ticket items.
In reality, a mortgage is really just a loan to purchase your home. When deciding on this purchase and larger purchases should be given greater contemplation. Yet it seems that we spend about as much time evaluating home prices as we do shoe prices. We need to be more disciplined and cognizant when considering a home purchase, especially if this is your first one. Choose wisely when deciding how much you are going to pay for the price of your next home as purchasing too much home can have devastating long-term financial consequences. Without question, a home is certainly an investment.. You borrow money to purchase the asset (a house) that you expect to appreciate in value over time. Truth be told, I do not believe that purchasing a home is a significant wealth generator nor does it appreciate well over time. Residential real estate barely beats inflation to the tune of about 1% per year. I would hardly call that a significant wealth generator. However, a home can be a wealth eliminator, if purchased incorrectly. Purchasing too much home will have long reaching implications that will devastate your finances. If you do not have at least 20 percent to put down on a home, you are looking at too high of a purchase price. The benefits of putting at least 20 percent down on a home are:
Be advised, the purchase of your home- especially your first home- sets off a chain reaction that may last for decades to come. Many of the successes (or failures) of your future financial journey depend on the decisions you make when you are young. If you overextend yourself on the purchase of your home you dramatically reduce the power of your savings. That should be reason enough to purchase a home well within your means. The reality is nobody actually cares what house you are presently living in. Nobody cares how many square feet it is, how many bedrooms it has, or if it has a pool or exposed wood beams. Truth be told, the only person any of these things should ever have any meaning to (aside from yourself) is whoever you try to sell it to down the road. That's it. Technically, you will only ever need two people to "judge" the value of your home, you and whoever buys it from you. With that out of the way, the single most repeated mistake in American society is over-mortgaging themselves on a home. This is commonly referred to as being "house-poor" or being "married to your mortgage". A more expensive home has implications beyond just a larger monthly mortgage payment. Consider that a higher purchase price will also have the following effects:
If there is one thing that I consistently see that dramatically alters the trajectory of a financial journey, it is the purchase of your home, especially when considering a first-time purchase. If nothing else, understand that a home is a place of shelter and comfort. Truly assess whether you require such luxuries that high-priced homes afford or if you can delay those wants until you can truly afford them down the road. Especially when you are young, the goal is to save and invest as aggressively as possible. Far to often, the roles are reversed. Mistakenly, people are doing things backwards by spending when they are young and trying to save when they are older. It should be the other way around. One of the largest impacts you can have on your savings is by diligently assessing the purchase price of your first home. Buying a house for even $5,000 over your true budget can have lasting implications that will be difficult to recover from. Until next time... Related ArticlesStep 3: Focus On Your Savings Rate
Two major steps are out of the way at this point. To review, they are:
Step 1. Calculating Your Net Worth or Lifetime Earnings and Savings Step 2. is broken down into 3 phases.
After eliminating toxic debt and building an emergency fund, you will finally be in a position of relative financial strength. For step 2, focus hard on paying everything off. Some of you may want to keep your mortgage, but please realize that the interest on the loan (even if it is only 3%) can dramatically reduce the amount of money you are putting toward investing over the course of 30 years (average mortgage duration). Remember, over the course of a 30 year mortgage, the average homeowner pays 2.5 times the original purchase price due to interest.
Third Step: Your Savings Rate
The first two steps of this journey were highlighted in Part 1 and Part 2. If necessary, go back and review those. The sole purpose of putting those two steps together is to get to the point of attaining a positive net worth.
After crossing the threshold into a positive net worth, now you can begin to focus on your savings rate. Savings rate is defined here as the percentage of your take-home pay put towards savings. Here is a typical way to begin figuring out your savings rate. It is broken down into 2 phases. A. Find out what your after-tax take-home pay is by assessing:
B. How much you are adding to the following accounts on a weekly, biweekly, or monthly basis?
To calculate your savings rate, what percentage of your after-tax, take-home pay (section A. helps you determine this) goes towards accounts listed in section B. above. Savings rate = (monthly savings amount/monthly take-home pay) x 100 Once You Know How Much Your Saving, Find Out How To Increase It!
Now that you have determined how much you are contributing to saving, look at this figure at least twice per year to see if you can increase it.
Never stop doing this step. Ever. You want to see throughout the "seasons of life" if you can be more and more aggressive with your savings efforts. Only you will be able to determine for how long and how much money needs to be accrued before you relax this plan. Many have used The Shockingly Simple Math Behind Early Retirement article as a means for figuring out their "FI number". Perhaps this will be your next step as well.
To increase your savings rate, you can focus on income and expenses. Ideally, focus on both for the biggest impact.
The goal: Increase income and decrease expenses simultaneously Ways to increase income:
Ways to decrease expenses:
The wider the gap between income and expenses, the greater potential your savings and thereby investments will have. If you only have $100 saved, who the hell cares if you invest in something that generates a 25x return... you'd still only have $2,500 dollars---hardly enough to make you rich. This is a 2,500% return on your initial investment of $100. Guess what, "the market" typically returns 8-10% over time, not 2,500%. Remember, your most powerful weapon at your disposal is compound interest. The way you make compound interest even more powerful is by saving, early and often! Summary
Step 1 - Calculate Your Net Worth or Figure Out Your Lifetime Earnings vs. Savings
Step 2 - Attain a Positive Net Worth (most often by eliminating debt) and create some breathing room with a fund of at least 3 months worth of expenses Step 3 - Determine your savings rate and find ways to increase it
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Step #2: Improving Your Personal Finances
In Part 1 of this series, I discussed the importance of getting a grip on how much money has flowed into and out of your life. You had two choices on getting started:
We start here to paint a very clear picture and teach you just how inaccurate your lifelong story about money truly is. You need to understand what your previous money management routine has yielded because it creates an excellent way to track where all your money has gone over your earnings lifetime. The first step of this program was to find out how much your worth. Now what? Step two has three phases - debt elimination, emergency funds, mortgage payoff. Phase 1 - Debt elimination
If you are in debt, and have a negative net worth, there is no such thing as good debt vs. bad debt.
It's all bad debt if you owe more than you have saved. If you are living beyond paycheck to paycheck, stay away from borrowing any further. Slowly begin to turn the ship around on your debt. Start with all forms of debt except for your mortgage (that comes later). Begin with the debt snowball or debt avalanche methods. They have been hashed out in great detail and people love Dave Ramsey's Total Money Makeover book for strategies on how to kill debt as quickly as possible. To that end, I will not repeat what others have already outlined better than I. Go read Dave's book or Google search "debt snowball" or "debt avalanche" to pay off all forms of debt except for your mortgage. Phase 2 - Build Emergency Fund
Age old wisdom advises 3-6 months worth of expenses in your savings account. That is your emergency fund. If you have had difficulty with savings in the past, especially if you have accumulated a history of significant debt, then aim for 12 months of expenses in an emergency account. History tends to repeat itself and the larger cushion you have the greater space you put between yourself and toxic debt.
Above and beyond your emergency fund, maximize your effort to phase 3 (highlighted below). How much for an emergency fund? Anywhere from 3-12 months worth of expenses. The way to decide where you fall in the 3 to 12 month spectrum is being honest with yourself about your previous spending and saving habits. If you have never owed significant debt and are already a disciplined with your savings, 3 months works out just fine. If you previously owed more than $100,000 (excluding your mortgage), aim for closer to 12 months in an emergency fund. To has this out further, let's use an example. Say you previously had $25,000 in student loan debt and $30,000 in car debt, after you pay off the full $55,000 consider having 6 months worth of expenses in your emergency fund (right in the middle of our 3-12 month range). If your monthly expenses are $2,000, you would want to accumulated $12,000 in savings and/or checking accounts to fully load your emergency fund. This is not money earmarked for spending however. You are not to touch your emergency fund unless there is a major repair, accident, or true emergency that requires immediate cash-flow. After eliminating all forms of debt (excluding your mortgage) and building 3-12 months in an emergency fund, the next step is to finish off your mortgage debt. Phase 3 - Mortgage Payoff
Many self-proclaimed professional money managers disagree with this one. However, consider that the average person who takes the full 30 years to payoff their mortgage pays 2.5 times as much for their home as the original listing price.
Even in a market with all-time low rates under 3%, the effect of interest can be brutal when factoring the full cost of homes. Consider that the average American has $202,284 in outstanding mortgage debt according to Experian. Even at historically low rates of 3%, that can be $6,000 per year in interest alone early in your mortgage due to the typical amortization schedule. By the same schedule, nearly all of your initial payments for the first few years of a mortgage go towards interest payments. This means you will initially live in your home without actually paying down your principal whatsoever! Paying off your mortgage as quickly as possible is like earning a guaranteed rate of return on your money. Early on, you will be getting a rate of return equal to the interest rate on your loan. I do not make this recommendation likely however, have you ever met anybody who has significant financial trouble who has a fully paid off home? Neither have I. Not yet, at least. In Closing
Part 2 of this series has three distinct phases. Phase 1, eliminate debt excluding your mortgage. Phase 2, save 3-12 months in an emergency fund. Phase 3, pay off your mortgage in full.
In part 3 of this series, we will discuss what to do once you have established and completed Steps 1 and 2.
Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.
How to Quit Complaining About Having No Money
Money is something that needs to be managed. Whether you make minimum wage or well over six figures, you must understand how to manage your income if you ever expect any of it to hang around.
The first order of business in managing your finances is to understand when, where, and how much money flows into, and out of, your life. To solve this mystery, first begin with finding out where you spend your money, on average, every month. It is imperative to understand where you money ends up at the end of every month so you can begin to identify how you can keep more of it around! At the end of most months, most Americans have little to no disposable income. In the present situation, most of us are actually able to spend more than we earn thanks to the world of creditors and financing. However, there might just be hope for you yet. Ponder the following: if you are over the age of 30, you likely have already had more money pass through your life than you realize. Don't believe me? Take a look at this example:
Chances are, most of you make more than just $10k per year. Where has it all gone? Consider that he average single individual income is just north of $56,000 (according to 2015 US Census data). So how much money does a person making an average of $56,000 earn in their lifetime? Answer: $2.2 million by the age of 65. Where does all the money go?
"In one hand, out the other" typifies money management in the United States. Worse yet, many are spending well beyond our earnings as evidenced by the $8,398 credit card balance of the average American.
Perhaps you find yourself in the same situation. Somewhere along the ride you decided keeping more of your income was not all that important. You may have decided a new car, new clothes, a brand-new house were all worth having savings in the "slim to none" category. You may have decided that it was more important to own something, rather than own your own life. Your decisions make the indentured servitude of regular "nine to five" employment a guaranteed certainty until you meet an early grave. You are responsible for this. Not your neighbor, Not your brother. Not a divorce. Not the weather. Not your injured knee. Not that tree that fell on your uninsured home. It's your fault. End of story. Why do we need the pressure of it being "our fault"? Because by assuming it is your fault, then you can begin to understand that you are the one responsible for changing it. Life happens to all of us. Unexpected expenses will continue to come. They do not end and they come at the worst time. Even innocent expenses like birthdays, holidays, baptisms, wedding, you name it, will continue to come at the most inopportune time. This is life my friend. I take the extreme "my fault" approach to money management because it carries with it a zero-tolerance policy for excuses. Excuses are wasted energy. They rarely, if ever, do anything to change the actual situation at hand. Excuses are a coping mechanism that are designed to make you feel better about why you are not doing better. They are also used to help explain to other people why you aren't doing better in the hopes they won't judge you (trust me, they still are judging you anyway). In the words of the late Jim Rohn, "Don't wish it were easier, wish you were better". While the lifetime earning numbers that we calculated above might be very impressive (especially if you make more money than the example I provided), you may actually find that you are spending more than your annual after-tax income. To make the examples above more accurate, use your actual tax returns from previous years and add up what you have made in your lifetime (note: if you need these but don't have them, visit the IRS Website's "Get Transcript" page to learn how much earnings have been reported on your behalf to date) . This can be a very enlightening exercise, good or bad. If nothing else, it should merely demonstrate how little awareness you have about how much money you actually have made. The concept of calculating your lifetime earnings is a great place to start to introduce you to your income and create a visual of how well (or poorly) you have managed it throughout your lifetime. It is an important first step to understanding how to manage your money. *If you would like greater depth on the concept of lifetime earnings, take a look at Your Money or Your Life by Viki Robbin. Where To Start If You Want to Improve Your Money Management Skills...
Choose one of the following to get started:
Calculate Your Net Worth (assets minus liabilities)
Calculate Your Lifetime After-Tax Earnings - for increased accuracy, use the IRS Website for attaining prior transcripts of your tax returns You must begin this journey knowing where you are so that you can figure out where you want to go. All directions require a starting point. If you insist that you never have enough money, start by looking at where your money actually goes. I don't mean simply looking at your checking account every other week, I mean look at your longer term trends. If someone is 200 pounds overweight, it would be wrong to assume that only last week was to blame for this situation. We need to look at things longer-term. Pick one of the above, and get started. Increasing your net worth can literally be as simple as gaining a deeper understanding of your personal financial snapshot. Just knowing how much money flows into your life (lifetime earning) or simply understanding how much you have saved in your lifetime (part of net worth), you can begin to identify areas where you require significant input (expenses, savings, tax efficiency, retirement accounts, investing, etc.). In Closing
Part 1 concludes with encouraging you to understand where you are starting from. Two choices:
Regardless, you decide. Personal Finance 101: |
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