If I knew that updating a .plan file was this entertaining, I would have started doing semi-regular updates a long time ago. Oh well. My web space is located at http://nuthouse.org/~hendersa and I can be reached via e-mail at email@example.com. Archived .plan entries can be seen at http://nuthouse.org/~hendersa/finger. ******************************************** * 20 February 2004 - Some financial advice * ******************************************** Here it is. The way to get rich without trying very hard. It takes time, but it works. Interested? You know, ever since I started working on my MBA degree a few years back, I've found that a large number of people have fairly flawed thinking in regards to business. In fact, it goes beyond that. There will always be people that think that business is a horrible game that takes advantage of the little guy for the benefit of the big guy. People often live under the constant fear that they'll lose their job and be flat broke within a month or two, if not immediately. The concepts of pensions and social security are eroding away, and the idea that a company will take of its workers after retirement is antiquated. In short, it's time for all you smart folks out there to take a step back and figure out what is really going on in business. Better yet, you need to figure out how to make these shifts in the business world work for you, rather than against you. I've been an engineer from day one. I graduated from college with a degree in computer science, and I've been flipping the bits for a living ever since then. I rode the dot-com bubble until it burst, and I lived through the mad scramble of finding a tech job when the market went soft. Like it or not, high-tech jobs are not necessarily a commodity. My observations are that high-tech support and maintenance jobs are, in the business world, viewed as overhead. Take the system administrators that keep IT systems chugging along without a hitch. These efforts are noteworthy, and the current salaries of experienced sys-admins reflects this. But, how does this directly relate to the products that the company sells? The salary of the sys-admin is recovered by allocating a tiny percentage of the profit from every good sold by the company. In this regard, the cost of maintaining the IT infrastructure of a company is an overhead expense imposed on all products the company sells. The IT job sector has become the janitorial staff of the 21st century. With big businesses viewing our jobs as overhead expense, it's no wonder that our jobs are being outsourced, down-sized, and "right-sized". You have no more right to a good living than someone who digs ditches for a living, files paperwork in an office, or is CEO of a large corporation. You aren't anything special. With a few rare exceptions, your skills are easily replacable by people living anywhere from across the street to across the world. There are people out there that are willing to do your job for less money. It is for this reason that it becomes important for you to understand how to handle your finances and prepare for the future. IT employment is a volatile state of affairs right now, and you're going to get stung in the future if you don't have a good plan in place. Many egos are undoubtedly hurt by this reasoning. You've all spent all-nighters fixing something and spared your company some incredible expense. You know how indispensible you are to your organization. Your knowledge of your company's infrastructure is reason alone to secure your job. You know that you are unreplaceable, right? Well... maybe. Granted, you're probably unreplaceable right this second. But what about in a year? Two years? Three? How secure are you in your skill set? Will you be able to master all the buzzword technologies popping up? Does upper management even know who you are? Ready to hear a lot of things you aren't going to like? Here is how you break the dependency on the income from your job. First off, take a good look at where your money goes each month. You're probably going to go through the process that most people with a decent income go through when they decide if they can afford something. You'll take the amount of your paycheck, subtract the cost of your utility bills and such, subtract your fixed payments (car, rent, etc.), and subtract your more flexible expenses (credit card, food, entertainment). Knowing the general geek penchant for toys, DVDs, equipment, and entertainment, I'll bet the amount of money left at the end of the month is probably rather small. Sometimes, it'll even be negative (around, say, the Christmas season or other periods of heavy spending). Pretty depressing, right? It doesn't take too long to get wiped out when you are in this situation. All it takes is an unexpected layoff or sudden expense to really upset the apple cart. Suddenly, those fixed expenses are tearing you apart each month. And you don't need me to tell you that "that ain't good". When coupled with the realization that people are standing in line to take your position for less money, this upgrades to "that really, really ain't good". So what to do? Let's lump the two ends of that balancing act into the categories of "assets" and "liabilities". If it puts money in your pocket, it's an asset. If it takes money out, it's a liability. Well, there is a line of reasoning in the book "Rich Dad, Poor Dad" by Robert Kiyosaki that sums up this situation rather well. The idea is that the "poor" struggle just to purchase the most basic of liabilities (such as paying utility bills). The "rich" purchase assets (such as stocks, bonds, or property... things that generate income). The "middle class" purchase liabilities that they think are assets (such as a car or a house). I can't say that I agree with Kiyosaki 100% on his reasoning. He believes in a pure dollars and cents approach to everything, which isn't, in my opinion, a healthy approach to every problem. He also advocates paying "yourself first", which equates to paying your bills late in an effort to purchase more assets. The book also suffers from the general problem of most pop finance books: a good idea is presented and then repeated over and over in enough different ways as to fill 200 pages. While I would suggest the book as interesting reading, I'd also advise you to take it with a grain of salt. I think that a standard finance textbook that gives a good description of the capital asset pricing model and weighted average cost of capital would explain the concept in a far more meaningful way. But hey... what can I say? We engineers like formulas and graphs. Unlike Kiyosaki, I believe that you receive utility from some liabilities. Obviously, if you are paying rent or a mortgage payment each month, there are benefits that you derive from these expenses that aren't monetary in nature. You have a place to live and the peace of mind that comes from having space that is yours. But, setting aside the idea of usage utility, these liabilities do take money out of your pocket each month. Have you ever known someone, even yourself, to have an income far greater than their expenses for a long period of time? It does happen, but it goes a bit against human nature. Most people will increase their standard of living as their paycheck increases. Perhaps you'll move into a nicer apartment or buy a house. Maybe you'll trade in your current car for a nicer one with higher payments. It's possible that you'll buy one of those televisions that can be seen from space. If you've been working for a while, can you honestly look back at when you just got out of college and say that you still have the same amount of liabilities each month as you did back then? So, you have two approaches to combating the drain that liabilities have on your assets. You can either reduce your liabilities or increase your assets. Pretty simple, right? Either reduce the negative cash flow or increase the positive cash flow. Note that I'm refering to cash flows when speaking about assets. True, you can buy a DVD and claim it is a personal asset. After all, it's something you receive utility from, and it isn't costing you anything beyond the initial purchase price. But I'd like to open up an account with your bank if that bank will let you deposit DVDs! Therefore, buying toys isn't going to effect the asset-liability balancing other than decreasing the cash you have on-hand. Undoubtedly, there are people sneering at this and saying that they contribute to an IRA or 401k account and are just fine. I see no problems with this aside from the fact that you can't touch the money until you are 59.5 years old without incurring a nice little zing from the IRS to the tune of 10%. If that is what makes you comfortable, then consider the advice I am about to give you to apply to you when you are 60 years old. But, I think you'd be better served by applying this advice as soon as you can. First, figure out the nature of the negative cash flows you have. Can the minimum payments for your negative cash flows be reduced, or are they fixed payments over a period of time? An example of a reducable negative cash flow would be a credit card payment. A non-reducable negative cash flow would be rent or a car payment. Make a note of which expenses are flexible, and which are fixed. Second, figure out the interest accruing on your negative cash flows. Is interest accruing on these cash flows (i.e. interest of a car or mortgage loan)? What are the rates? 8%? 9%? Even worse? High interest rates can easily inflate your liabilities by hundreds of dollars each year. By identifying where you are paying money for the privlidge of borrowing money, you can kill two birds with one stone. Third, figure out the amount and interest rate on all cash inflows. How much is your net paycheck? Is it based upon a salary, hourly rate, commission, or a combination of these? If you have investments, how much of a return are you getting on them? Are any of your cash inflows taking advantage of compounded interest? Now that we've gathered the data we need, we can start making our plan. The idea is pretty simple, really. We're going to reduce cash outflows from liabilities and increase cash inflows from assets. Take your total cash inflows and divide it by the total cash outflows. If you get a result less than 1.0, you are in immediate danger with no breathing room at all. You can start feeling more relaxed when the ratio passes 1.5, and at 2.0 you are in very good shape with a decent amount of discretionary income. One of the best things you can do to encourage improvement is to measure it. Constantly. People tend to act more responsibly and set aside short-term gain for long-term gain if they think their choices are being monitored. The only one seeing this will probably be you, but there is a chance you'll want to provide this information to an accountant or broker later. But, it's mostly a psychological push to do the "right thing". So, you now have two new goals based upon the ratio above. One goal is long-term, and the other is short-term. Your short-term goal is to make the above ratio exceed 2.0 when you include your paycheck as an asset in the ratio. By having your cash inflows that are twice your cash outflows, you can pay your bills, invest some money, and still have a little left over for enjoyment. If you are close to the 1.0 mark on the ratio, you need to either reconsider your line of work or visit a credit counselling agency for help on reducing your liabilities. Refinancing loans and fully utilizing promotional APRs on credit cards really helps lower the amount of money you lose to interest. Cutting down the phone bill can really help, but I would advise against cutting your grocery budget. Cutting your budget for dining out, however, is a good move. Simply cut spending where you can. Your long-term goal is to make the above ratio exceed 1.0 when you completely remove any paycheck from the picture. Impossible you say? Hardly. Returns on a stable, small-cap mutual fund over the last 5 years run about 10%-15%. Take a look at performance of the Armada, Baron, Bjurman Barry, BlackRock, BNY Hamilton funds if you don't believe me (and that's just a few of the hundreds out there... I just picked a few from the front of the list). These funds often did far better than 10%-15%; 30% returns were actually fairly common. Real estate and rental property not only generate cash flow, but they appreciate and hedge against inflation as well. In fact, real estate can be sold, the proceeds applied to new property purchases, and you don't have to pay taxes on the profit thanks to section 1031 of the tax code. In short, once you purchase assets that are capable of making money, they will continue to make money even when you are not. Plus, reinvestment of the cash flows will continue to increase the ratio (unless you increase your liabilities, that is). Remember the old adage of "work smarter, not harder"? The money works hard. You work smart. These goals are all well and good, but how do you "buy assets"? After all, buying real estate can be tricky business, it's awfully hard to invest in a mutual fund when you have no clue what you are doing, and it seems a lot smarter to put extra money into the principle of your mortgage rather than invest it in something risky. I'll admit, those are pretty good points. So, you need to sit down and consider whether reducing liabilities is a better strategy than increasing assets. If the interest rate on your mortgage is 8% or so, and you can make 15% in a mutual fund, why not put the money towards mutual funds? 8% of the 15% return covers the interest you would pay on the mortgage, so you certainly come out ahead. But, some people are very risk-adverse and would want to pay off the mortgage rather than invest money when they still have debt. It's all up to you, really. Just keep in mind that there are limits as to how far you can reduce liabilities, there are no limits to how much you can increase assets, and the risk premium between your mortgage and a good mutual fund is far higher than the actual risk. The interest rates of your liabilities and your potential sensible assets should dictate your actions. When you decide that you should be buying assets, you're on the right track. If the cash flow from assets pays for your car or home, the cash flow will most likely still be there after the car or house is paid off. Asset cash flows can offset on-going liabilities such as property tax or insurance. Cash flow is really the only thing that separates the haves from the have-nots, if you think about it. Now we can get back to buying assets. First off, max out your Roth IRA ($3000) each year. Period. The savings on taxes alone make it an extremely wise investment, and you can contribute in small amounts to it as you go without any outlandish fees. Get some cash in the IRA and buy some reputable mutual funds with it. Then let it sit and auto-reinvest in itself with the dividends. For the truly cheap folks out there, go to your local bank and ask about opening a Roth IRA with them. They'll be tripping over themselves to offer you all sorts of information. Once you learn what you want to know, go open a Roth IRA with someone like E-Trade or Charles Schwabb so that you can buy stocks online with the IRA funds without having to go through a broker. You can't pull the money out until you are 59.5 years old, but it'll be tax free. All of it. All the original money, all the capital gains, the dividends... everything. Pretty neat, eh? There are worse fates than having all your retirement income tax-free. After you max out the Roth IRA, you have some decisions to make. There are a lot of places to stash money if you know where to look. Paying off current debt is always a popular choice. This works out well when you are at the beginning of a car loan or mortgage. It's the "sure thing" because you know exactly how much of a return you are getting on your investment. If you have a mortgage at 8% and you pay off $1000 of it, you'll "make" a touch more than $80 within the next 12 months. You could buy some rental property, but this could be prohibitively expensive depending on where you are located. Southern California isn't the best place for this sort of thing if you are a starting investor, for example. A chat with some of the local real estate agents will get you a considerable amount of information on current offerings and the general climate of the local market. Just remember who the info is coming from and take it with a grain of salt. Remember to start small and step up to larger properties via the 1031 tax loophole. When you turn your $20,000 investment in a trailer you rent (actually, more like a $2,000 investment, since you only are putting in a down payment and the rent pays the rest) into a $150,000 house that you own in the clear in 10 years, you'll be amazed. If this sounds good to you, check out property management companies in your area and look for proposed sites for new shopping centers and schools. If you can guess where property values will jump, you can make an excellent return when you trade-up. Continuing to invest in the stock market via mutual funds is a good choice. I'd steer clear of investing in single stocks unless you have a widely diversified portfolio of such stocks. Stocks and mutual funds can be both short and long term investements, and it is this flexibility that draw a lot of people to them. Avoid hunches and do some solid research on what stocks and funds you want to buy. Bonds are an interesting investment for those that like to know exactly what they are getting. Bond funds also have the added advantage of arbitrage as interest rates fluctuate. Triple tax-free municipal bonds are a very wise investment once your tax rate breaks 30%. Not only are the monies received from the TTF munis completely tax free (federal, state, and local taxes), but the funds are used to improve your municipality. Bonds work best when interest rates are high, so stay away from them for another two or three years. To sum this up: - Avoid gaining new liabilities until you have the non-paycheck asset cashflow to cover them. - Your short-term goal is to live well within your means and avoid incurring new liabilities (ratio of 2.0 or greater with your paycheck). - Your long-term goal is to offset the liabilities you'll encounter when you retire with cash inflows generated by your assets (ratio of 1.0 or greater without your paycheck). - Stick with mutual funds until you know what you are doing. One last thing that I'll probably hear about from you folks is the idea of saving a chunk of money and then spending it little by little during retirement. I assert that this will require you to do some calcuations based upon when you think you're going to die, which isn't a very cheery proposition. Plus, you end your life with nothing in the bank. Nothing is left as a legacy for your children, spouse, community, or favorite charity. Granted, you can't take it with you, but it can be used to give people chances that they wouldn't have otherwise had. Think about it.