Tag Archives: saving

Personal Finance Foundation – Part 1 – Know Where You’re Starting (Calculating Net Worth)

So you’re on the journey to get your financial house in order.  You first need to know where you’re starting.  You do this by measuring your net worth.  Net worth is calculated by adding up your assets and then subtracting your liabilities.  A very, very simple example: You have a savings account balance of $10,000 and have a credit card balance of $2,000.  You’re net worth would be $8,000 ($10,000 in assets minus $2,000 in liabilities).  It’s certainly possible to have a negative net worth (think of the recent college graduate with student loan debt but no assets to their name), too.

As you can see, one way to increase your net worth is to increase the value of your assets.  Another way to increase your net worth is to decrease the value of your liabilities.  Often, though, and especially in the world of personal finance loud mouths, an extreme emphasis is placed on either increasing assets or decreasing liabilities, as if both can’t be accomplished simultaneously.  Both can be accomplished together and you’ll find positive movement in your net worth by focusing on both initially in your journey to a healthier financial state.

Here is a screen clip of an Excel spreadsheet I use to track my net worth:

Net Worth Spreadsheet
Net Worth Spreadsheet

You can download the spreadsheet here.  As you enter assets and liabilities, the spreadsheet automatically adds up both categories and automatically updates the resulting net worth value.  I update my spreadsheet monthly in order to keep tabs on my financial health and, more importantly, to see if something is out of whack and needs to be addressed.  Frequently updating your net worth will provide you with encouragement when you’re taking the right steps and seeing net worth grow, but it will also alert you if you’re slipping into bad habits.  It’s better to catch a bad habit a month or two in rather than realizing years later that the bad habit has caused you major financial damage.

Here are some challenges I’ve encountered while tracking net worth:

Challenge 1:  Accurately valuing certain assets and liabilities.  The value of a given asset or liability may not be black and white.  For example, when including a home’s value in net worth calculations, you should use the going market price for your home and avoid using values that may inaccurately inflate or undershoot the actual value.  This means that your home’s taxable appraised value may or may not be near the home’s market price (i.e., what you’d get if you sold the home).

Challenge 2:  If you have an asset that you’re financing, like a home or a car, make sure to include both the asset and the accompanying loan on your net worth statement.  Again, make sure you’re valuing the asset accurately (hint:  Kelley Blue Book is a great way to value cars).

Challenge 3:  Even though you’re enthusiastic about a collection you have (American Girl dolls, stamps, coins, etc.), they may not be nearly as liquid (i.e., easy to sell) as you think, and they may not be worth nearly as much as you envision.  I don’t include collectibles or jewelry in my net worth statement because I don’t see them as liquid assets.  This is an arguable point, though.  If you choose to include collectibles or hard-to-value items on your net worth statement, try to be accurate with their valuation.

Challenge 4:  You’ll encounter ups and downs in your net worth if a sizeable portion of your asses are in volatile categories, like stocks.  You’ll notice the ups and downs even more if you track your net worth monthly.  This is OK, as stocks (I’m thinking index funds when I say “stocks”) appreciate over long (10+ years) periods of time.  Just make sure that if you’re net worth is declining in value that you’re not contributing to this with reckless spending, overloading credit cards, or buying that Corvette you probably can’t afford right now.

Now that you know your net worth, you have a baseline from which to measure progress or regression.  If your net worth increases, this shows financial progress.  If your net worth decreases, this shows regression, and you should be especially aware of what’s causing the decline.  Your goal should be to increase your net worth over time.

Personal Finance Foundation – Part 2 – Coming Soon!

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%



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.