Compounding – The Good, The Bad, and The Ugly

Credit: jscreationzs at FreeDigitalPhotos.net

• If you were to invest $5,000 per year for 30 years in a portfolio that averaged 5% per year, you’d end up with around $332,000.
• If you were to invest $5,000 per year for 30 years in a portfolio that averaged 6% per year, you’d end up with around $395,000. 
• If you were to invest $6,000 per year for 30 years in a portfolio that averaged 5% per year, you’d end up with around $399,000. 
• If you were to invest $6,000 per year for 30 years in a portfolio that averaged 6% per year, you’d end up with around $474,000. 

That’s the “miracle” of compounding. Sure, investment returns matter a lot, but as you can see from the examples above, how much you save can matter even more! The good part about compounding savings and investment returns is that slow and steady really can win the asset accumulation race in a big way. You might not think you could ever save up $474,000, but do you think you could save $6,000 this year?

 

Recently my wife and I have been looking at houses, and nothing gives me more indigestion than looking at how much a house costs. I’m not talking about the sticker price; I’m talking about how much a house costs over the life of a mortgage. For those of you who have bought a house, this is usually the number that shows up in the top, right-hand corner of one of your loan documents indicating the total amount expected to be paid over the life of the loan. Once interest is baked in on a thirty-year loan, it’s horrifying to see the difference between the initial sales price and what you will actually end up paying. Interest payments alone could be in the hundreds of thousands of dollars! The bad part about compounding interest on a home loan, car loan, student loan, and certainly credit cards is that you keep trying to pay off principal, but you keep getting charged interest. It’s like you have a hole in your bucket. I’ve tried Pepcid, Pepto, and Tums, and the only thing that seems to work is paying off more debt at a faster pace.

 

The ugly part of compounding has to do with the relationship between money and purchasing power. If you have $100,000 in cash and you bury it in the backyard, when you dig it back up, what do you have? That’s right, $100,000. The problem is that while your money was safely hiding underground, there’s a pretty good chance that the cost of goods and services went up (inflation). Think groceries, health care, and education expenses. You might still have the same amount of money, but you are actually poorer than you were because you can no longer buy as many goods and services as you used to since they are now at a higher price. Said another way, your purchasing power has gone down. I don’t see a lot of people burying money in their backyards, but I do see people hold on to exorbitant amounts of cash or an alarming amount of low-interest CDs and bonds. I don’t ever want to take away someone’s “cash blanket,” and I firmly believe that bonds have a place in most people’s investment portfolios to help provide for short-term liquidity needs, reduce overall volatility, and act as an income-producing alternative to stocks. However, just like chocolate cake, too much can be a bad thing. If you have too much invested in cash, CDs, or bonds, your minimal investment returns can lag the rate of inflation, and, compounded over time, you can lose purchasing power even if your assets are slightly growing or staying about the same.

 

That’s the good, the bad, and the ugly truths about compounding.

 

-Tom

 

Summer Jobs, Life Lessons

Credit: foto76

Some of you may recall that my very first 2MuchCents blog post had to do with how my high school job as a dry cleaner taught me how to view the world in terms of cheeseburgers. It taught me that it took an hour of folding pants, hanging up shirts, performing maintenance on the machines, and sweeping the floors to earn $5.15, and that could buy around five cheeseburgers. You and I may both laugh at that now, but at fifteen, it’s not that weird for a boy to think of cheeseburgers as a currency or unit of measure. Either way, when I started viewing all of my purchases and expenses in terms of cheeseburgers, and the corresponding pants-folding, shirt-hanging, maintenance, and sweeping required to purchase those cheeseburgers, my outlook on the real world was forever changed. My experience as a dry cleaner really did teach me a real-world appreciation for having to work so that I could earn enough money to cover my expenses and buy what I wanted, but it also taught me so much more.

• I learned that if I worked harder while I was at work, I would get to go home sooner.
• I learned that if I worked a lot, I got a bigger check, but that it wasn’t always worth it.
• I learned that admitting that I was the one who left the blue pen in the suit jacket that was now ruined didn’t help my boss’s short-term opinion of me, but it helped cement my integrity with my boss and my co-workers.
• I learned that not stepping in the same hole twice and leaving more pens in suit jackets was a wise choice.
• I learned that, most of the time, greeting people with a firm handshake and looking them in the eye garnered me a little more respect in their book.
• I learned that a “How are you?” and a “Have a good day!” are worth the effort.
• I learned that putting your buddy in a dryer is a great idea, but letting your buddy put you in a dryer is a terrible idea.
• I learned that following through on what I said I was going to do when I said I was going to do it was the single most important thing I could do.
• I learned that the customer is not always right, but they are always the customer.
• I learned what “sweat equity” was.
• I learned that if I worked hard and well, I would get raises, and I would gain keys to work at other store locations with less and less supervision.
• I learned that getting to know your co-workers and checking on them when they’re down makes your workplace a lot more enjoyable for you and for them.
• I learned the importance of being careful with transactions so that my cash drawer would balance at the end of the day.
• I learned that what types of clothes you wear don’t necessarily mean you are rich or poor or nice or heinous.
• I learned that the world was a pretty small place and that I would cross paths with many of the people I waited on in other facets of life.

If you’re finishing up your summer job, I encourage you to reflect on what you’ve learned. If you didn’t work this summer or haven’t worked (and you’re old enough to sit behind a steering wheel), I can’t tell you how important it is that you get a job for your future and your personal development, whether it’s temporary or long-term and whether you like it or not. As the great Vince Lombardi once said, “The dictionary is the only place that success comes before work. Work is the key to success, and hard work can help you accomplish anything.”

-Tom

Retirement Cash Flow Strategies

Credit: anankkml

For most people, cash flows in retirement look different from cash flows while working. The difference is a transition that I have helped many clients through. Cash flow strategy is one of the most important parts of planning for retirement, but it can be complicated since cash flows frequently come from different sources, start at different ages, and carry varying tax implications. People who develop a good plan and stick to it can often add stability and peace of mind, take advantage of tax saving opportunities, and even generate more income in retirement. Let’s look at a few areas:

• Pension Annuity vs. Lump Sum – For retirees who get to choose a pension payment option, this can be one of the most important decisions they ever make. Actuarially speaking, there’s a good chance that your employer is thinking they are offering you the same amount of money whether you elect an annuity or the lump sum, but there are still things to consider. A lump sum offers a surge of money at retirement that can be more easily passed on to your heirs and better protect your purchasing power against inflation if it is properly invested, but a majority of clients I work with seem to find comfort in choosing the annuity option. In most cases, the monthly annuity amount will remain the same until the day you die. This may not help you against inflation, but if you live long enough, it could eventually mean more total money for you. In the meantime, an annuity feels like a paycheck, which is what retirees are used to, and the mental comfort that brings is the main reason I am usually a supporter of a pension annuity election. I also advise most clients to select a “joint and survivor option” if it is available so that a surviving spouse won’t lose their loved one and the benefits of their loved one’s annuity at the same time. This tactic usually costs the spouse whose pension it is a little bit of cash each check, but it can be a tremendous comfort to the other spouse.
• Required Minimum Distribution Planning – I’ve discussed this before, but age 70 ½ is an important half-birthday! I won’t take you back through all of the details we covered in my post “Required Minimum Distributions,” but I will say that you should factor this into your retirement planning. If things are a little tight on you before you have to start these distributions, or if the distributions are going to put you in a higher tax bracket once they begin, it may make sense to start prudently withdrawing from your retirement accounts before 70 ½. This could save you tax dollars and allow you a steadier lifestyle throughout retirement as opposed to cutting it close in your 60s and rolling in cash in your 70s. It’s just a thought, but one you should consider if you’re over 59 ½ (there could be penalties if you withdraw from retirement accounts before 59 ½).
• Social Security Strategy – Many people, including me, are concerned about the long-term solvency of the program as we know it going forward, but there are some Social Security strategies you should consider if your retirement cash flows are doing just fine when you turn 62. If you decide to claim Social Security retirement benefits at age 62 (the earliest applicable age), you are deemed to be collecting benefits “early,” and will only receive around 75% of the benefit you would receive at your “full retirement age.” (Currently, full retirement age is usually between age 66 and 67 for most people, but take a look at this chart to find your specific full retirement age.) If you wait until your full retirement age, you can receive 100% of your benefit, but if your retirement cash flow is still doing just fine at your full retirement age, it might be worth waiting until age 70, when you could receive around 132% of your benefit! That’s around 8% growth per year from age 66 to age 70, and that’s not a bad investment return if you ask me! Putting off claiming Social Security could provide you with more money in retirement if you live long enough, but at the same time, you could be shooting yourself in the foot if you end up passing away relatively young. I would suggest you consider your health and family history, and then consider how much Social Security income at age 62 would help before you decide to delay filing. If you do decide to delay, you can always start before your full retirement age or age 70 if you need to with a partially higher amount of benefits, but it’s probably not worth having beanie weenies in your 60s so you can have filet mignon in your 70s.

I hope you’re beginning to see that if you consider your spending and saving now versus later, the importance of starting off strong, your humble abode(s), your health insurance, and your retirement cash flow strategies, that there are many things you can do to put yourself in the position of having a chance to retire early. That being said, I’ve met plenty of people who could retire early but don’t and plenty of people who did retire early and wish they hadn’t. Some even went back to work! The How to Retire Early Series will conclude next week with a look at why you might not want to retire early even if you followed the advice of my previous posts and could. I hope you’ll check it out.

-Tom

Lessons from Black Friday

Credit: imagerymajestic

A couple of years ago my wife and I agreed to add two holidays to our calendar: Husband’s Day and Wife’s Day. On Husband’s Day, I can create a day where we do whatever I want (within reason), and on Wife’s Day, the day is hers. In 2013, we decided to celebrate Husband’s Day in June (it’s a floating holiday), and it was truly glorious. The highlights included trips with my wife to the driving range, the bowling alley, the shooting range, and a golf superstore, with guy movies and greasy hamburgers intermixed. Wife’s Day, on the other hand, seems to have become more of a “fixed” holiday, as once again my sly wife somehow settled on Black Friday. Being one that is always happy with bargains and sales, and already in my wife’s debt for her participation in Husband’s Day, I hesitantly agreed to enter the land of competitive shoppers and “door busters.”

This year was my second Black Friday experience, but I still don’t consider myself a veteran - I consider myself a survivor. However, Black Friday isn’t all bad. There are a few things you can do to help make sure your future Black Fridays are successes and not financial burdens you’ll carry into the New Year. 

First, make a list of stores you want to visit. My wife took the time to make a list of stores she wanted to visit in a relative order of importance, while also considering their locations relative to each other and our home. I’m a lucky man for many reasons, but the fact that my wife took the time to have an efficient game plan on Black Friday is certainly another one. It saved us time, it saved us gas, and it kept us from shopping more than we needed to (or I could stand). Sure, we walked in a couple of stores to see something cool we saw from the window, but we primarily stuck to the plan. Sticking to your list of stores is a simple way to prevent overspending.

Second, make a list of the items you’re looking for. We still needed a few Christmas gifts, and my wife and I were both looking for some things for ourselves that we knew could be discounted on Black Friday, so we made a master list of what we were looking for. My wife walked away with a beautiful jacket (that was even more beautiful on sale), but outside of that one, unplanned bargain purchase, we stuck to our list. Limiting your shopping to a single list of items can also be critical in keeping you from overspending.

My third suggestion for you is to have a hard purchase limit. We had a couple of gift cards from birthdays and previous holidays, but we also had a dollar cap in the back of our minds. It doesn’t matter how cute the purse is, how real the leather boots are, or how soft the sweater is, what matters is how far below the “Black Friday cap” you are. My wife and I are careful, thrifty, picky shoppers, and I’m proud to say we got almost everything on our list without coming anywhere close to our self-imposed limit.

Finally, do not open any store-specific credit cards, regardless of how sweet they make the offer. There may be a couple of stores that have decent-enough perks if you are a frequent visitor, but for the most part, just say no. The additional credit inquiries you’ll generate and constant mailings and emails you’ll receive are bad enough, but the main reason for my stance is that I don’t believe people need any more temptation (or capability) to go into short-term debt than absolutely necessary. I’m not one of those screaming debt management gurus who is going to tell you to cut up all of your credit cards, but I am going to tell you to cut up the mostly useless ones, or better yet, don’t even sign up for the mostly useless ones. When my wife and I visited Old Navy on Black Friday, they opened an express checkout line for people willing to apply for an Old Navy credit card, and you should have seen the masses flock. That was dirty, and very well-played by Old Navy, but I waited in the longer line instead of taking the bait. The new card holders may have saved a few minutes, but at least I don't have a new, tempting line of credit!

Black Friday is not all bad, and it does offer a lot of great deals, so fighting the crowds can help you get a bigger bang for your buck. Just remember, 30% off of something you don’t really need is NOT savings – it’s a 70% expenditure you weren’t planning for! If I were a betting man, I bet I’ll get to do Black Friday again on Wife’s Day 2014, but I’ll be ready. Don’t tell my wife or my very manly friends, but I’m beginning to look forward to it.

-Tom

The Risks of a Fixed-Income Portfolio

Credit: Stuart Miles

You know how most beaches have those ocean flag warning systems? Well even if you don’t, let me summarize: a green flag flying usually means calm conditions (go ahead and jump in), a yellow flag usually means moderate waves (be careful), a red flag usually means The Perfect Storm-type waves (don’t even think about it), and a purple flag signifies that there is marine life of some type nearby (you might want to see what it is, but you don’t want to be lunch). Well if I personally were a flag warning system for a fixed-income portfolio, I’d be yellow. Chances are you, or someone you know, currently has an investment strategy in place that is heavy on fixed income, and today I want to tell you to be careful, and that moderate waves are probably coming!

First of all, what do I mean when I say "a fixed-income portfolio?" I mean money that is being invested specifically in money market funds, Certificate of Deposits (CDs), and bonds. I’m not talking about your day-to-day checking account or your emergency fund savings account because those accounts should be viewed separately, and should be part of your financial plan and investment strategy regardless of the current market situation or forecast.

Fixed-income investments can be a sound strategy, and in my opinion, should be a portion of any well-diversified investment portfolio. Fixed-income investments are great because they are much less volatile than stocks, and theoretically, they offer a probable positive return (as long as the bank, company, or municipality in which you are invested doesn’t fail). On the other hand, fixed-income investments are not so hot historically because they do not keep up with inflation, and more importantly, a bond’s value typically goes down when interest rates increase. It’s inflation and interest rates that have my flag yellow.

From 1914-2012, the inflation rate (increase in prices) in the U.S. has averaged just a bit lower than 3.5%. What interest rates are you currently getting on your money market funds and CDs? For many of you, I bet the answer is less than 3.5%. Now the question I raise is this: even if your fixed-income investments are fairly stable and will likely offer a positive investment return, do you really want to invest a lot in something that will not grow as fast as prices have historically increased? Sure, inflation has been lower than average in recent years, and bond returns have been pretty good too, but over the long term, I’m not sure fixed-income investments will allow you to keep up with the Joneses. Fixed-income investments should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in fixed-income investments, be careful; you could be on a path that will slowly erode your purchasing power.

As I alluded to earlier, a bond’s price and interest rates have an inverse relationship. Let’s say you previously bought a 7% bond for $1,000: you would expect to receive a coupon payment of $70 (7% of $1,000). Well what if interest rates go up 1%? Then, people buying a new $1,000 bond would expect to receive a coupon payment of $80 (8% of $1,000). Would someone still be willing to buy your previously purchased 7% bond for the $1,000 you originally paid when they can now get 8%? I don’t think so! In recent years, people holding lots of bonds have typically fared pretty well because the value of their bonds has been steadily increasing as interest rates have continued to decline to almost zero. The immediate problem for bondholders is that interest rates can’t mathematically go down much more. The bigger problem for bondholders is that interest rates will eventually go back up, and that means the value of bonds will have to go down. This concerns me because it really isn’t a matter of if interest rates go back up; it’s a matter of when. Bonds should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in bonds, “waves” of interest rate increases are eventually coming; the bond investment return you have enjoyed in recent years will be hard-pressed to continue.

Fixed-income investments can be very solid investment positions. The problem is that fixed-income investments are like many other things in life - too many of them might not be good for you. My fixed-income flag is yellow, but I should tell you that not everyone shares my opinion. There are a lot of people much smarter than me out there whose fixed-income flags are proudly flying green. Of course, there are also a lot of people much smarter than me out there whose fixed-income flags are proudly flying red...

Great Tom, what should I do? Well, it all depends on your stage in life and your risk tolerance, but (1) make sure you have an adequate emergency fund, (2) make sure you have a prudent amount of diversified fixed-income investments to protect against market volatility and provide a stream of income, and (3) make sure you also have a prudent amount of diversified stock investments to protect your purchasing power against inflation and interest rate changes. Please talk to your financial advisor about your specific situation if you have any questions or concerns.

Well sorry to be a bit of a “Debbie Downer,” but I think it’s always important to tell you my true thoughts and concerns. In happier news, even with a yellow flag, the beach sounds pretty nice right about now!

-Tom