Category Archives: Saving

What Can You Learn from the Subprime Mortgage Crisis?

It’s hard to believe time has passed so quickly.  Ten years ago the subprime mortgage crisis led the U.S. economy into a severe recession and carnage ensued.   Many people lost their homes along with huge portions of their retirement savings.  Credit markets froze and taxpayer money was used to purchase toxic assets from the very banks that facilitated the crisis.

A decade removed from the great recession, what takeaways can help you succeed financially and prepare you for the next economic downturn or recession?

  • Only you have your best financial interests in mind.  Banks were more than willing to lend money to under-qualified borrowers, and this resulted in skyrocketing foreclosures when interest rates increased on adjustable rate mortgages (ARMs).  Some argue that banks were negligent in persuading under-qualified buyers into taking on supersized mortgages.  This certainly could be the case, but it hammers home an important lesson:  Understand your financial choices and don’t rely solely on someone else’s opinion to guide you, especially if they are in a position to make money off of you.  Educate yourself before you pay someone for their financial guidance, as this will better allow you to see if your adviser is pursuing your best interests or his.
  • Diversify your investments.  Plenty of folks who planned to retire in 2008-2010 had to delay retirement due to seeing their 401(k) plans shrink drastically as the equity markets plunged.  This meant several more years of work for this group.  What if, though, this group had rental property as an additional source of income for their retirements?  The recession economy saw an increase in renters, resulting in increased income for rental property investors.  These rental property investors could choose to withdraw a smaller amount from their 401(k) plans while relying more on the increased cash flow from rental property investments.  While I’m not advocating only for rental property investments as a source of retirement income (it certainly is a great option), I am advocating for a multiple-legged stool for your retirement portfolio that does not leave you in an anxious place should an investment class take a plunge.
  • Invest more than you need.  I’ve never heard anyone complain that they invested too much.  In the case of workers who had to postpone retirement due to the Great Recession, many of them could have continued with their retirement plans had their nest eggs been larger.  While this may go into the “thanks for the insight, buddy” category, your savings and investment rate is a better determinant for your success than rate of return:  http://www.thesimpledollar.com/five-most-important-factors-for-investment-success/
  • Follow your plan, not your emotions.  The S&P 500 lost about 57% of its value from October 9, 2007 to March 9, 2009, the day the index bottomed out during the Great Recession.  Thankfully, I didn’t check my retirement account balances much during this time, mainly because I had barely entered the workforce after graduating from college.  My plan, though, was to continue working for at least three, if not four, decades more until I retired, and equities with all of their volatility were the foundation for growing a large enough nest egg.  The S&P 500 took four years to reach its value on October 9, 2007 and has grown much more in the current bull market.  Investors who made an emotional decision to sell during the recession likely missed much of the growth during the subsequent recovery and likely missed the opportunity to purchase shares of the S&P 500 while they were on sale.  Recessions and downturns in the economy can be very anxiety inducing if you don’t remember that these are terrific opportunities to buy shares on the cheap and that the market provides substantial returns in the long run.  The past 30 years saw the S&P 500 return 11.66% (10.19% geometric return) with dividends reinvested.
The S&P 500 has returned 11.66% (arithmetic) and 10.19% (geometric) the past 30 years.  Courtesy of http://www.moneychimp.com/features/market_cagr.htm

For a terrific read about the subprime mortgage crisis and its causes, read The Big Short by Michael Lewis.  The book will hammer home my first point regarding educating yourself on financial decisions, especially major ones like taking out a mortgage.  While I think the majority of people in finance are well-intentioned, great people, The Big Short shows that there are individuals who will seek to take advantage of you (as there are in any industry).  While the financial industry may or may not be in a better position to avoid a similar crisis, you can certainly prepare yourself to not only avoid making bad decisions during a recession, but to take advantage of the opportunities presented by an economic downturn.

Three Lessons from The Millionaire Next Door

The Millionaire Next Door is my favorite personal finance book because of three life-changing lessons it imparts, all supported by mountains of research data gathered and analyzed by two professors, Thomas Stanley and William Danko.  These lessons provided me with a financial enlightenment when I was first learning the basics of personal finance, and I suspect many of you will find at least one of them encouraging, challenging, or both.  These lessons taught me to have a new attitude regarding personal finance, and I hope they do the same for you or your loved ones.

Lesson 1:  The majority of millionaires differ radically from what the media and marketers have you believe.

I grew up on a steady diet of TV and, as you know, advertisers and marketers feed you a stream of images and depicting what the rich are supposed to look like.  Of course, their message equates buying their products and increasing consumption with living like a millionaire.  The Millionaire Next Door shatters the notion that the average millionaire consumes the latest and greatest.

In reality, the average millionaire lives a nondescript life and lives in an average neighborhood. This is logical, as over-consuming would lead one to have less money to save an invest.  Stanley and Danko acknowledge that deca-millionaires, the extremely rich, can afford to consume and live up to the images portrayed by advertisers, but this segment of the population is extremely small.  You are more likely to find the ex-millionaire who has spent their fortune away than you are to find a deca-millionaire who can afford to live an extravagant lifestyle.

Lesson 2:  You will not acquire financial independence as long as your sole source of income involves trading time for money.

Many Americans grow up with the idea that working an 8-to-5 is the only way to pay for life. This mentality is one I grew up with and fails to consider what happens if injury, chronic illness, or another circumstance interrupts your employment.  More importantly, this mentality forgoes any consideration of financial independence, as it assumes one must be an employee their entire life in order to sustain a lifestyle.

You will never acquire financial independence without acquiring assets that appreciate without realized income.

-The Millionaire Next Door

Having assets (savings, investments, businesses, etc.) work for you allows you to achieve financial independence as these assets working for you reduce or remove your dependence on realized income (income you earn via employment).  The more assets you have working for you, the more likely you are to achieve financial independence more quickly.  Think of Dave Ramsey’s debt snowball here, but instead of debt, consider an “asset snowball.”

Lesson 3:  The American dream is alive and well.

We’ve all heard in the media many times that it’s impossible for the little man to get ahead, with stagnant wages, a tepid economy, and any number of other reasons.  The Millionaire Next Door provides all Americans with hope:  The vast majority of millionaires are first generation millionaires, having built their fortunes without the benefit of an inheritance.  That’s right, most people who become millionaires are not trust fund babies and do not have a leg up on the rest of us.  The majority of them live below their means, save, and then invest their way to wealth. The American dream is indeed alive!

Psychology and Fear in Personal Finance

Be fearful when others are greedy.  Be greedy when others are fearful.

-Warren Buffet

Warren Buffet is one of the most successful investors of recent times and provided this great quote in 2008 during the height of the subprime mortgage crisis.  During the 2007-2009 bear market, the S&P 500 lost over 50% of its value and many people close to retirement had to delay their exit from the 9 to 5.  In hindsight, as we sit in the middle of a bull market in 2016, Buffet’s quote is great advice, but how are you supposed to separate yourself from emotion when your nest egg loses over 50% of its value?

S&P 500 2007 - 2009 Bear Market
S&P 500 2007 – 2009 Bear Market (courtesy of Yahoo Finance)

There is no easy answer here, as personal finance is indeed personal, but you can certainly make good, informed decisions in the middle of emotionally charged circumstances.  Buffet was right about the subprime mortgage crisis and the need to buy while prices were low (i.e., while the market had lost lots of its value).  He likely looked at the history of the market and understood that it would bounce back.  As of September 16, 2016, the S&P 500 sat at 2,139.16 versus its lowest value during the subprime mortgage crisis of 676.53 on March 9, 2009.  As you can see, the market has more than returned.

S&P 500 - 2007-September 16, 2016
S&P 500 – 2007-September 16, 2016 (courtesy of Yahoo Finance)

How do you disarm fear and anxiety in personal finance?  Educate yourself.

Peace I leave with you; my peace I give to you. Not as the world gives do I give it to you. Do not let your hearts be troubled or afraid.

John 14:27

How should you manage fear and anxiety when making financial decisions?  Start with education, then don’t stop educating yourself.  Read personal finance books (I highly recommend The Millionaire Next Door), visit personal finance blogs (Afford Anything is my current favorite), and listen to personal finance podcasts (Marketplace is great for keeping up with current financial events; Afford Anything has a great podcast, too).  I’ve found that I pull pieces of information from each of these sources and, as a result, have molded a personal philosophy.

The key lesson here is that education will help you see that American equity markets have more than recovered from the multitude of previous crashes and bear markets.  Buffet understood this and saw that equities were simply on sale.

How else do you disarm fear and anxiety?  Understand risk and reward.

I recently listened to a personal finance podcast where I heard an interesting anecdote involving fear.  A caller indicated they hadn’t invested in the stock market for retirement due to their fear of losing money.  While the caller certainly is correct that avoiding the stock market and investing in something safer, like CDs or cash, will help you avoid risk and the large losses that can accompany risk, he is also missing the other half of the equation:  In finance risk is necessary for growth.

While the caller will seemingly preserve capital by avoiding the volatility of the stock market, their capital will erode over time due to the effects of inflation.  The eroding power of inflation will decrease buying power if not offset by gains.  One option for generating more gains than cash but experiencing less volatility than the stock market is the bond market.  The bond market, though, experiences a good amount of volatility, too.

While someone can certainly go to sleep peacefully knowing they will avoid the volatility of the stock market and keep their money safe (at least until inflation eats away at it), it would be rash to do so without being aware of the rewards that accompany carrying risk.  Over the past 30 years (specifically from January 1, 1985 through December 31, 2015), the compound annual growth rate of the S&P 500 was 8.2% with dividends reinvested and adjusted for inflation.

S&P 500 - CAGR for past 30 Years
S&P 500 – CAGR for past 30 Years (courtesy of MoneyChimp.com)

As you can see, $1 invested in an S&P 500 index fund on January 1, 1985 would have returned over 1,100% in 30 years.  While I can see how avoiding significant losses would allow someone to sleep peacefully, avoiding a significant amount of the S&P’s gains during this time period would cause me to lose sleep at night.  My advice to the caller:  Educate yourself about risk and reward, then understand how accepting additional risk could result in your nest egg multiplying in size.

Investment+Savings Challenge

One of my personal financial goals is to become financially independent.  For those unfamiliar with the term, I define financial independence as follows:  A state in which financial assets generate sufficient income to pay for a chosen lifestyle.  In layman’s terms:  More assets = good, combined with fewer expenses = better.

Financial Independence = Passive Income Generated by Assets > Expenses

I am seeking financial independence so that I will have the freedom to walk away from my current or future job should I need or want to in the future.  One example of when I would potentially want to walk away from my job:  My spouse and I have a baby and we decide that my staying home with the child is our preferred option for care taking.  While I absolutely love my job and my career, financial independence allows for many options in the future that being tied to a 9 to 5 does not.

One key step in achieving financial independence is increasing investment and savings rates. Not only does this increase the amount of assets you have working for you by generating passive income, but you decrease your expenses, thereby accelerating the journey to financial independence.

I’m going to start tracking my investment and savings rate on this site, starting with August 2016.  My investment+savings rate is based on my *gross* income.  Also, I’m including in gross income my employer’s 401(k) contribution, as they give me a portion of my salary each month.  This isn’t a match, but a contribution to my 401(k), so I view it as income and include it in my gross income so that my savings+investment rate isn’t disproportionately inflated by this contribution.

August 2016:  40.29%

 

 

Great Personal Finance Podcasts

One of my favorite things to do on long drives is listen to personal finance podcasts.  There are a handful that I have found (so far) to be better than the rest:

My favorite podcast is Afford Anything with host Paula Pant, as she combines an entertaining delivery with great guest speakers.  Paula encourages listeners to both increase their incomes while decreasing their expenses (increasing the “gap”).  Her focus on increasing income differentiates her from many, many other personal finance bloggers who put a great focus on limiting expenses and frugality.  I certainly think both are important, but Paula’s focus on making the gap bigger blows past the flawed binary view on many blogs that we should focus on either increasing income or reducing expenses, but not both.  Paula provides a ton of insight, too, into real estate investing.  I definitely, definitely recommend the Afford Anything podcast.

The Mad Fientist podcast focuses on reaching financial independence.  The Mad Fientist provides some original (to me) ideas:  How to use a health savings account (HSA) as a “super IRA” account; how to minimize taxes when investing in retirement accounts.

The Dave Ramsey Show podcast is targeted more toward people trying to get their financial house in order, but it is still very motivational.  Dave Ramsey releases three hours of the show every weekday, so there’s plenty to listen to.  My favorite segments are Dave’s millionaire theme hours, where millionaires are interviewed and insights are provided into their spending, saving, and investing habits.

Measuring Progress – Tracking Net Worth

As we budget, save, grow our income, and practice self-control in spending, it’s important to have a method for tracking progress.  After all, if we are indeed working to improve our financial lives, shouldn’t we have a way to measure our improvement (or regression)?

I have a coworker who has turned into a terrific friend and we’ll often talk personal finance in our downtime.  He shared with me his primary method for tracking progress in his financial life:  Tracking net worth.  This was definitely a “light bulb” moment and something I started doing (in November 2012) after we had the discussion.

In summary, you list your assets, list your liabilities, and take the difference, which gives you your net worth.  I calculate (actually Microsoft Excel calculates) my net worth every month and this lets me see how I’m doing financially.  Increasing the value of my assets or decreasing debts will send my net worth in the right direction.  Alternatively, keeping monthly tabs on my net worth lets me see where I might be slipping and hurting my net worth, giving me the chance to correct bad habits.

The following is the Excel spreadsheet I use to track my net worth:

Net Worth Spreadsheet
Net Worth Spreadsheet

If you would like to download this spreadsheet, click here.  The spreadsheet includes some simple formulas, including what percentage each asset comprises of each asset category.  Columns F, G, and H detail my net worth history and columns J through P detail what comprises the net worth value.

Categorizing your assets and liabilities can turn into an exercise, as you’ll need to consider whether certain items are assets, liabilities, or both.  For example, you could list your home’s equity as an asset, but you’ll also want to list your mortgage as a liability due to it being a debt owed to the bank.

As you keep track of your net worth, I think you’ll find a sense of accomplishment if you’re growing your net worth.  This will provide added motivation to steer your financial ship properly.  If you’re going in the wrong direction, use this as a tool to help identify what’s driving your loss and what you can do to fix it.  Good luck!

Compounding Interest – Why You Should REALLY Start Saving Now

In my previous post, I illustrated the power of time and compounding interest.  In my example, I showed what periodically putting money into a savings account bearing .8% interest can do over time.  This .8% figure is what a popular, large online bank is currently yielding in its savings accounts. As I illustrated, here is how your money could grow in a savings account:

Amount Saved Monthly 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$50 $3,601.81 $6,248.53 $13,017.30 $20,349.62
$100 $6,123.62 $12,497.05 $26,034.59 $40,699.24
$200 $12,247.23 $24,994.11 $52,069.18 $81,398.48

It stands to reason that if .8% interest can provide you with significant growth over time, higher interest rates can accelerate that growth.  So, where can you find higher interest rates?

Your Money Working Harder

The stock market is a market in which shares of company stock are traded.  The stock market allows organizations to raise capital by selling shares and allows individuals to acquire a piece of ownership in a company.  Individuals who invest their money in an organization can gain money if the organization performs well.  The following are the average returns of large stocks for given periods of time as of October 11, 2011 according to usatoday.com (http://www.usatoday.com/money/perfi/columnist/krantz/story/2011-10-17/rate-of-return-for-stocks/50807868/1):

  •  5 years:  1.3%
  • 10 years:  2.0%
  • 20 years:  7.9%
  • 30 years:  10.5%

Investing in a single company does carry significant risk, though, as the invested dollars increase and decrease based solely on one company’s performance.  If the company performs well like Apple Computer, Inc. has in recent history, its stock could increase over 100% in a matter of months.  On the other hand, if a company performs poorly or engages in fraudulent practices (think Enron Corporation), your shares could become worthless and your dollars evaporate.

Mutual funds offer a way to purchase shares of stock while hedging against this type of risk.  Mutual funds are a collection of stocks, bonds, or other securities and can contain a single security type, or can contain a mixture of different securities (i.e., a mutual fund could contain 85% stocks and 15% bonds).  If the figures above caught your eye and you wanted to invest in a mutual fund that contained stock belonging to large companies, there are numerous large cap (short for capitalization; think “capitalization = size”) mutual fund offerings to choose from.  Two popular options are the  Spartan 500 Index Fund offered by Fidelity Investments and the Vanguard 500 Index Fund offered by Vanguard Investments.  Both of these funds track the Standard and Poor’s 500, a list of the largest publicly-traded U.S. companies.  Using the rates of return listed above, here is how different amounts invested monthly would grow over time:

Amount Invested Monthly 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$50  $3,079.02 $6,569.83  $27,154.92  $108,528.90
$100  $6,158.04 $13,139.67  $54,309.85  $217,057.79
$200  $12,316.08 $26,279.33  $108,619.69  $434,115.59

As you can see, small amounts of discipline exercised on a regular basis can be hugely rewarding in the long run.  Compare the first table above to this table and see the incredible difference interest rates can have on your savings and investments.  If you are already saving and investing on a regular basis, see if you can put a little more away each month.  If you are not already saving or investing, now is a great time to start.

Compounding Interest – Why You Should Start Saving Now

My friend Lisa called me on tax day this year for savings advice and wanted answers regarding whether to open an IRA, how much to put in savings, and several other questions aimed at “let’s put together my financial portfolio on this phone call.”  I gave her my best shot with the caveat that financial decisions are more than a financial bottom line.  “Will you sleep well at night” is a question I posed frequently on the phone call and is a question I use to gauge my own decisions.

One piece of advice I did give Lisa is this:  Start saving now.  She retorted that she is not making very much money currently.  I suggested putting away at least a modest amount ($50 or $100) monthly to start.  Here’s why.

Money Down the Drain, Money at Rest, and Money at Work

Food, clothing, a roof over our heads.  We all have needs that we must provide for.  Day to day life, though, often causes our “wants” to creep into what seem like needs.  The morning latte, after work happy hour, and premium cable TV subscription go unquestioned and two hundred dollars are gone from the monthly paycheck.  This is money that goes to line somebody else’s pocket.  Sure, these expenses can bring us pleasure, but they are also dollars that are no longer in your wallet and can’t be used for important purchases (buying a house, car, engagement ring, etc.) or for major life events (college, retirement, etc.).  A timeline for these dollars and their value to you in the future can be summarized as follows:

Expense Amount 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $0 $0 $0 $0 $0

An alternative is to pay yourself these $200 every month:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $2,400 $12,000 $24,000 $48,000 $72,00

As you can see, a little discipline now can produce large rewards later.  What was a daily latte, a few drinks, or cable TV can turn into a significant charitable gift, a tuition payment, or a car.

Although these numbers are large, these same dollars can grow even larger.  Putting money to work for you via the power of time and compounding interest allows you to significantly increase your savings.  The following are examples of what a few amounts saved monthly can turn into when deposited in a savings account that yields .8% APY, a standard going rate as of 6/10/2012:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$50  $602.61  $3,601.81  $6,248.53  $13,017.30  $20,349.62
$100  $1,205.21  $6,123.62  $12,497.05  $26,034.59  $40,699.24
$200  $2,410.43  $12,247.23  $24,994.11  $52,069.18  $81,398.48

The Math Behind the Scenes

Note how putting away $200 a month for 30 years will allow you to save $72,000.  Introduce a relatively low interest rate like .8% and you accumulate $81,398.48 over 30 years, with $11,398.48 of that amount generated passively (i.e., without you lifting a finger).  Here’s how the $11,398.48 is generated.

A year after you decide to put away $200 a month into your savings account, you’ll have an extra $10.43 in your account, for a total of $2410.43.  So you made an extra $10.43- big deal, right?  At the end of year two, not only will you earn the .8% interest on $4,800 ($200 x 24 months) principal you saved, but you will also earn interest on the previous year’s interest.  At the end of year two, you will have a total of $4,840.21, with $40.21 of that being earned interest.  Should you continue to put away the $200 each month for 30 years, assuming a static interest rate of .8%, you will reach the $81,398.48 figure, with $11,398.48 in earned interest.

Note that my calculations are based on interest compounded monthly with additions made at the start of each compounding period.  Different banks will have different frequencies of compounding and different frequencies of posting, so keep this in mind when you start plugging away at online compounding interest calculators, as these variables will affect your overall savings.

Interest Rates and Time

Interest rates and time are key in passively growing your hard-earned cash.  The tables above also illustrate the power of time.  In a future post, I’ll explore other methods of saving that can allow you to grow your savings even faster over the same periods of time.