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Archive for August, 2012

Things You Can Do With Money

August 25th, 2012 at 03:40 pm

It doesn't matter what you do in the world today, you have to deal with money in one form or another. Have you ever thought about what you can actually do with money? I'm not talking about dreaming what you'll do when you win the lottery. I'm talking about actually sitting down and thinking about money and what it entails.

I had a problem when I was younger of not paying attention to money. I've always been employed, and I've always made enough for my needs and wants, but I don't have extravagant needs or wants. Here, I'll outline what you can do with money, and what it entails. It is only a guideline to help you think about what you're doing, rather than just setting a goal and roboticly working your way toward it without any real understanding of what you're doing.

Money use 1: Borrow it
Since you're reading this blog, chances are that you're already well-versed with this use of money. Borrowing entails someone giving you money for your use today, with the promise that you'll pay back even more money in the future.

What do you get for this money? About the only thing is "immediate satisfaction." And debt. You always get the debt part, and you usually get the immediate part - "immediate" being a relative term - but you don't always get the satisfaction part. Have you ever purchased a used car only to wish two months later that you had not? Or maybe you used your credit card for a night out where you had a little too much to drink, and as you were ruining your shoes and your trousers or pantyhose, you regretted the purchase of at least one of the drinks? You didn't necessarily get satisfaction, but you did get the debt.

Now, there are actually two categories for debt, which I call "dumb debt" and "smart debt." How do you tell the difference? Basically, dumb debt - which is the vast majority of debt - is debt that costs you money and doesn't really do anything for you in a positive manner.

"Smart debt" is debt that you use to achieve some other financial goal. About the only thing that falls into this category is real estate loans. Now, it is arguable that stock purchase loans can also fall into this category, but I don't believe that is anything other than gambling, regardless of the odds. Real estate appreciates as long as you purchased it at its real market value rather than at an inflated going rate. See my previous "Dave Ramsey" blog post where I give a bit more information on this topic.

In most cases, borrowing money incurs only debt and hardship, so it is a dumb thing to do with money.

Use 2: Spend Money
This is not quite as bad as borrowing, and as long as you haven't done "use 1" too much, there's nothing really wrong with this use of money. Spending money entails trading a value of cash for some item, service, or other value that is not cash.

In general, spending money does not decrease your net worth, assuming what you get in return for the money has an equal value. Most assets, though, depreciate in value, so in the long run, spending money decreases your net worth over time, or at least prevents it from increasing more quickly.

Use 3: Saving Money
Saving money is what you do with money when you have it, and don't use it for another purpose listed here. Saving money in and of itself is a good thing. It entails putting the money somewhere safe where it cannot lose numerical value - though it can lose spending ability due to inflation being greater than the savings return.

Saving money puts money somewhere that you can get to it more or less "at will." Usually, you pull money out of savings once savings reaches some given point to use it for some other purpose. Often the other purpose is "spending" as above, which will probably cause your absolute value to go down more quickly.

Use 4: Investing Money
The main differences between saving money and investing money are rate of return, risk, and liquidity. Basically, the rate of return is how much you make for your invested value compared to its value; the risk is how likely it is that your rate of return can be negative. Liquidity is a measure of how quickly you can reclaim your money for another use (including re-investing it elsewhere).

Investing money is a personal decision. There is no "right answer" and there is no "right way" to invest your money. You have to balance your needs, your wants, your assets, and your obligations, and your personal ability to remove yourself from the equation. One of the hardest things to do is to watch an investment lose value, yet "stay the course" and not incur even more losses shifting money around to no avail. But that's all a part of investing.

Investing is one of the wisest things you can do with your money, but you cannot invest until you have "extra money" to invest. You should only invest money that you don't need for spending or saving. An emergency fund is not investing. It is savings for unforeseen events that require money. Paying off debt is not investing. It is the penalty you are paying for past immediate return.

The main thing about investing, though, is that it is gambling. You are betting that your investment gains value at a greater rate than inflation or the economy in general takes it away.

Now, the above statement is going to anger just about every investor who reads it. "Index funds have historically returned (blather) amount over any (X) years." Yes, they have. Absolutely every investment vehicle I've ever seen has also said, "Past performance is no guarantee of future results." Why? Because it is a gamble.

The thing about gambling, though, is that you can improve the odds by various means - most of them legal, many of them illegal. For example, you can run a casino and weight dice to insure a certain roll. That's an illegal way, obviously. Legal ways to improve your investment odds is to research your investments. The best advice I can give in this regard is to invest in something you know and understand.

Use 5: Earn Money
Earning money is performing some service, improving some item, or otherwise doing something that someone will give you money in exchange for. Most people have a "job" where they earn money. Earning money always increases your net worth or asset value. This is your best vehicle for increasing your comfort and ability to do all of the things listed above.

Your ability to earn has very little to do with your intelligence, your education, your network of friends. Your ability to earn hinges on three precise qualities that everyone possesses in one degree or another: Integrity, imagination, and dedication.

Integrity is listed first because it is the most important. Integrity is more than honesty and trustworthiness. It is the sum total of your character. "Character" has been described as your penchant for doing the right thing even if no one is watching. This allows people to trust you, work with you, and rely on you.

Imagination cannot be underestimated. This is the quality one has to see a situation, item, or other intangible or tangible object and apply a unique or unthought-of change that others have not foreseen. This is how ebay, Steve Jobs, and about 99% of the other "successful" people and businesses have made their way. Imagination is the ability to see something that hasn't been seen by others. Earning is your ability to exploit this vision to make money from it.

And that takes the last item: Dedication. This is your ability to stick with something because you know it's going to work out for the better. It is your ability to stay with things when they don't look good, but in your heart you know you can make them good. Dedication means staying with something because you believe in it, no matter what anyone else is saying or thinking.

Dedication is a two-edged sword. If you're wrong in your belief, then you are dedicated to a losing proposition. If you're right, though, you can look like a genius and set yourself up for a windfall. Unlike the gamble of investing, though, with dedication, you're believing in yourself and your vision. That's always a better bet than believing in someone else.

Conclusion
In any case, I've listed the things you can do with money from "worst thing you can do" to "best thing you can do." It is up to you what and how you'll follow the list above. It is also true that how often and how badly you've done them in the past will affect how well and how much of each of them you can do in the future.

Remember that you control your own financial destiny. What you've done to this point will only make it easier or harder for you to get to your desired situation. What you do from this point forward, though, is more important to reaching your goals.

The Requisite Dave Ramsey Post

August 24th, 2012 at 04:17 am

Most people who start looking in to personal finances fall into two categories:

1. Someone who realized the need without making mistakes.
2. Someone who realized the need after making mistakes.

Most of us fall into the second category. I know that I am one of the latter group. Someday I may post my personal story, but that's for a later day.

After making financial mistakes, most of us find ourselves deeply in debt. Now, the term "deeply" is a relative term. If you're making minimum wage and find your bills add up to 105% of your income, $1000 can look like an insurmountable debt. If you're making $100K per year but spending $105K per year, then maybe $50K isn't "too uncomfortable."

Regardless of your personal debt depth gauge, if you're looking at this site, at some point you found it necessary to do something about your finances. If you're like most people, you probably googled "get out of debt." Guess what (as of today) the first entry is? Dave Ramsey's site.

Now, I'm not going to try to sell you on Dave's methods. Dave does a good job of selling himself, because that's how he makes his living. And he's doing a fine job of both the selling and the living. I find no fault with that.

This post is written because there are a lot of Anti-Dave snobs out there. For some reason, a lot of people like to tell you everything wrong about Dave's plan. I'm going to tell you the best thing about Dave's plan: It works for everyone who actually uses it.

Dave has a seven-step plan to get out of debt. He calls his steps "baby steps," because each step is a small thing in itself. I think some of the baby steps are fairly large and shouldn't be called baby steps, but that's neither here nor there.

Dave's Plan, Baby Step 1: Emergency fund
His first step is to set up a $1000.00 emergency fund. Now, the wisdom of setting up an emergency fund cannot be argued. Having nothing as a financial shock absorber merely guarantees you're going to have a very uncomfortable time when life's bumps and pitfalls come your way (or you go theirs).

Here's my first problem with Dave's plan. I'm an engineer. Think "Dilbert on brain steroids." Engineers do one thing: Make decisions to solve problems. Maybe that's two things, but you get my point. I approach debt as a problem to be solved.

The first thing you do to solve a problem is to determine what is causing the problem. Dave omits this basic step. Are you in debt because you spend too much on electronics, because your child needed hundreds of thousands of dollars in medical payments, because you were uninsured and had a fire that destroyed your brand new house, car, boat, and ATV?

Each of the above possibilities has a different solution. Yet Dave would tell each of them: "First save $1000 in an emergency fund."

I have a different first step: Figure out why you are in debt. You do this by writing down where and how much money you have coming in, and you write down where and how much money you have going out. You can call this a budget, or you can call it a financial health check, or you can call it a worksheet.

In any case, you need to figure out the problem before you start to solve it, and Dave does have you do this as part of his plan if you purchase his plan, but he doesn't call it a baby step, and I believe he should.

Now, his Emergency Fund (EF) of $1000 is rationalized by him as "enough for emergencies" but small enough to keep you motivated to pay down your other debts more quickly. I would be petrified to have only $1000 as a buffer. I've had car failures of nearly $3000. According to Dave's method, I would then have to either use a credit card, take out a short term loan, or do without my car. None of those are good options, in my opinion. Remember, Dave wants you to put ALL money above the EF into loan/debt payments.

So, for me, I would need at least $5000 for an emergency fund, even at this stage. I don't need any external or false pressure to pay down debt. If I'm motivated to do something, then I'll do it.

My point is that this "one size" fits all doesn't really fit all. Now, the universal truism you get from this first baby step is that you should have some cash-on-hand in case you need it. How much is debatable, but the fact you need something available for outside-the-budget required expenditures is not debatable.

Step 2: Pay off all debt using the Debt Snowball
The debt snowball is not Dave Ramsey's creation. Almost everyone uses some form of it once they realize they are carrying too much debt and need to reduce it quickly. Dave has made it popular, and may even have coined the term "debt snowball," though I doubt he did.

I think this might be better described as a "debt payment snowball." It is a method of using the monies that were used for a retired debt to pay on the next debt-to-be-paid. Therefore, if you're paying $150 per month for a bill, and you pay off that bill, then you have $150 more to pay off the next bill.

Now, Dave suggests you pay off the bill with the smallest balance first, then go on to the next bill in ascending order. This is the first place that many people have a significant problem with Dave Ramsey's plan; mathematically, the debt with the highest interest rate should be paid first.

Now, no one can argue with that last statement, because I specified that it is a mathematical calculation, and it is true. The largest interest rate should be paid first mathematically.

Dave's plan trumps math at this point. In his own defense, Dave states that you need to get some victories early to really adopt the plan. The easiest and fastest way to get a victory is to pay off the smallest loan, regardless of its rate.

Why can I say you should do it? Well, "because it works" is the best argument, and the best basis for that statement is this recent study Kellogg Debt Payoff Study

The study above really isn't the whole story. I will say that once you have made the lifestyle change that this whole project really requires, you can change to the "highest interest rate" first method. Once you actually are dedicated to removing debt, and you have developed the discipline to do it, you should go back to Math and use it to your advantage. The real caveat here is that if you were doing what was mathematically correct, you probably wouldn't be in debt to begin with.

The method I used was "neither of the two above." I have to travel for a living. I have been to 71 different countries as of this writing. There is absolutely no way I could do this without a credit card or charge card. I have brought home expense reports of over $30,000 for one month. Try living in Singapore or Tokyo for a month - as well as pay for the plane ticket - on less than $15,000. Let me know how you fare.

I couldn't do one of Dave's other "truisms:" Cut up your credit cards. That just isn't going to happen. I could easily get 150,000 reward points from Amex every year if I were still on the heavy travel schedule.

Because I could not easily cut up my credit cards when I didn't have the cash to finance my travel, I set up my bills by "loans and lines of credit" followed by "credit cards." Even though most of my debt was business-related, it is just too easy to buy souvenirs and other fluff on credit when you're so used to using the cards. This was a discipline problem, not a financial problem. The financial problem was the symptom. My reasoning was that once the loan was paid off, it was gone. I then snowballed that payment into the next loan.

Of course, I paid the penalty of still spending a bit more on credit than I should have but after a few months, I stopped doing the credit card dance (spend too much, pay some off, leave some debt, cha-cha-cha), and started to put all the excess cash into paying off the loans and LOC's. The point is that I paid off debt in my way, not Dave's but the goal was the same: Pay off all debt.

Step 3: Save up 3 to 6 month's bills in an EF
Once again, I believe this is a good idea, but I question both its timing and its universality. I've already outlined why I believe the fund should be set up as Step 1 (after the budget, but that dead horse has already been beaten).

My second problem with this step is that everyone has unique circumstances. Let's look at my present situation. I work overseas for tax purposes. My job pays for my house, my car, my maintenance, my furnishings... everything except food and entertainment. So, my 1 month expenses that must be paid is about $400, unless I go out more than necessary. The food over here is expensive. According to Dave, I need less than $3000 in the bank for six months.

It will cost me about $4000 to ship my two dogs back to the US when I leave. I need to keep that money in the bank. So, my emergency fund should be at least $15000, for return travel and homestead set up upon my travel back to the US.

So, I modified Dave's plan to be "$5000, plus travel expenses" as my emergency fund. I do agree with his basic premise, once again: Save up enough so that if everything crashes in your life, you can ride through it for at least 6 months without panicking.

Step 4: Invest 15% of your income in your retirement fund
Once again, I don't disagree with the step itself, but I do disagree with the timing and the static amount. If you're 28, then 15% is a great amount to save toward retirement. If you're 58, you probably need to be doing a bit more than that to have any chance of retiring at all.

Secondly, I think the debt snowball should be modified. One warning, though, is that you MUST be committed to reducing your debt to follow my method instead of Dave's method. I will state that mathematically, Dave's method in this case is probably better than mine.

I think you should take at least 20% of your "snowball increase money" after paying off a bill, and put that toward increasing your EF and then toward retirement. In other words, using my $150 example from above, I would suggest you put $30 of that toward your savings or retirement, and the other $120 toward your bills.

My reasoning is that the markets fluctuate. You need to be buying continually to get the smoothest outcome. The old term for this is "dollar cost averaging," and its basic premise is valid: Investing a large amount at one time has the possibility that you have invested at a peak, and you can lose much of your value overnight. If you instead break up the large amount into smaller amounts and invest them over time, then any peaks or valleys are smoothed over. So, the longer you spread out your investments, the greater the likelihood that you won't lose significantly in one crash or downturn. Also, during the downturn, you're buying more shares rather than earning more income.

Again, Dave and I are not in disagreement, but his method does pay off bills more quickly. Also, since many employers offer 401K plans, you lose out on the "free money" of their match if you don't contribute, so using part of your money toward getting the match, which is typically at least 50% of your deposit, is only good financial sense. Dave's plan does not allow even this smart investment strategy until debts are paid off.

Step 5: Save for Children's College
I don't see this as a separate savings at this point. Rather than this title, I would say, "Max out tax-deferred savings, then save the remainder to taxable and therefore more liquid savings." This then allows you to pay for college, cars, or toys, at your discretion.

Why does one earmark his savings for future expenses? I can see the wisdom of making room for this, but by the time you get to this point, you should be able to save at least 30% of your income in some vehicle or another. If you haven't made the lifestyle change, then you're not even going to get to this point. By the time you're to this baby step, you should already have more money than you can spend wisely - and you should have developed the wisdom to know what "wisely" means. If you're still borrowing $50K to buy a $60K BMW, then you never got this far.

Step 6: Pay off your house
This one is a hard one. If you are close to retirement, then I agree with this wholeheartedly. If you are far from retirement, then this may not make financial sense for a different reason.

Once again, I agree with Dave in general. I think everyone should pay off his primary residence in full. I am now going to go into the reasons why you may not want to do so personally.

Right now, you can get a 15-year house loan for right around 3%. Historically, index funds have returned more than 10% over any significant period of time. So, you can reasonably expect to be paying 3% interest while earning 10% interest.

The simplistic reasoning above is correct in itself. Where it fails is that there are a lot more payments you make on your house that are not the loan amount. You pay taxes, insurance, maintenance, and improvements in addition to the payment. Will you still make money buying a house on credit? You most definitely will unless you buy stupidly. Who bought stupidly? About 90% of the people who bought a house from 1998 until 2007. OK... the 90% figure is fictional, but the trend is not.

Real estate was booming in the timeframe I mentioned. This chart shows that from about 1997 until 2007, housing prices were literally skyrocketing. Why was this? Because everyone who played this game was greedy and figured, "I can buy this $100,000 house for $150,000, then sell it a year later for $200,000 and use that $50K for toys." And that's what most people did. People are not underwater on their loans, they are watching their loans on big screen TV's and riding to work in their loans inside Mercedes SL cars.

The money was borrowed and wasted. This is the reap what you sow part of life.

Regardless of the pontificating above, housing prices are now at a decent level, but loan money is cheap. I suggest that if you're young you may want to use a house loan to increase your income. My personal opinion is that you should pay off your principal residence, and use your "extra money" to purchase real estate for rental or investment purposes.

I just don't think I should use a necessity as collateral for investments. I see it as only a small step above using your house title as your bet on one roll of the dice in Vegas. It's still gambling with your house, no matter how you rationalize it. Sure, the odds are better with an index fund than with the roll of the dice, but the payoff with the dice is quicker and more definite - both of these statements are predicated with "if you win." Both of them can be lost.

Step 7: Build Wealth and Give
No argument at all at this point. How you build wealth here is up to you.