More Ways Your Brain Tricks You

Today I came across a great article about more ways your brain tricks you into making bad financial decisions.  The article, Why You're a Big Sucker, explains how a few blind spots in cause us to make bad consumer decisions and cost us money.

Two examples resonated with me personally.  The first is how the word FREE tricks us into doing some very stupid things.  In short, when a marketer or sales person is giving you something for free there is always a catch.  In my case, I called a toll free number advertised on the radio to collect my "free" trip to Las Vegas.  Of course, I found out when the marketing materials arrived there was indeed a free trip, except for the $29.99 handling fee, the $79.99 conditional cancellation fee, and the mandatory 2 hour time share presentation.  Oh, I also forgot that my wife and I could only collect our plane tickets if we were flying from a designated airport (all on the West coast) or were willing to pay a $200 travel destination upgrade to allow us to fly out of Atlanta (still a 3.5 hour drive from our house).  I also learned that by giving out my person information I landed myself on direct mailing list for every scam under the sun; I was a big sucker.

The next example that hit home is the idea that prices are relative to your surroundings.  When I am in Best Buy looking at televisions, the $1,500 42" LCD TV seems like an absolute bargain when it is put up next to the $2,700 50" LCD and the $3,300 55" Plasma.  A sneaky merchant will add a moderately priced set into a lineup of pricey sets and then tack on a "free bonus."  Of course, $1,500 for a TV is a lot more expensive when considered in a vacuum, but when it is sitting next to a whole row of more expensive options it can seem like a great deal.  Amusement park food also comes to mind when I think about the relative cost of available options.  When it costs $8 for a hamburger and $4 for a 20oz Coke a frugal person will pick the $4 hot dog and a $2 bottled water.  The situation has induced you to spend way too much money, but still get the illusion of being responsible with your money.  In other words, be sure to keep costs in their true perspective and keep the situational bias at bay.

I am regularly fascinated with the ideas behind Behavioral Finance.  A few days ago I wrote another article on the topic that you should check out as well titled, Your Brain Makes Building Wealth Hard.  Thanks for reading.

[ Read More ]

How High is Inflation Really?

If we stop at the gas station to fill up the tank it is obvious that prices have done nothing but go up, up, up these days.  What is even more worrying is that it isn't only fuel costs that have skyrocketed.  Two years ago it would cost about $100 for a trip to the grocery store.  This would provide all of the staples for two weeks.  In a month, the total bill would be about $250.  Lately I am budgeting $300 a month and finding that I consistently go over budget.   It isn't a scientific measure by any means but it feels to me like my buying power has dropped by as much as 25% in two years.  How is that possible?

The official figures for the Producer Price Index, which measures the cost of goods at the wholesale level, rose 0.3% in February and 1.0% in January as reported by Forbes.  Year over year inflation clocked in at a 6.4% rate.  This trend seems to be accelerating to an annual rate in the neighborhood of 7.8% for 2008 based on the most recent readings.  Of course, the policy makers and talking heads bring up that "core" inflation increased at a 2.4% rate year over year.  Core inflation my @$$.  The core inflation rate excludes the cost of food and energy, and be honest, that is completely idiotic.  Exactly what matters to the average person is the cost of FOOD and ENERGY.

Now, what do these inflation numbers mean to you?  It means that if you haven't gotten a 6.4% raise in the last 12 months that you are loosing ground, going backwards, in the earnings game.  Are you in line for a 7.8% raise in 2008?  If not you should start planning now for how you will cut your spending and reduce fixed expenses.  The money won't go as far as it once did and something has got to go.  I feel fortunate, in that it is very likely I will get a raise during 2008 that will be somewhere around 4-5%, but my plan to increase my Roth IRA savings by half that amount (2.5%) may be sidelined in the effort to keep up with rapidly rising prices.   If that is happening to me, I know it is happening to many people all around the country.  We will be the lucky ones; I don't even want to think about how tough it would be to face this inflation on a fixed income.

Another important note is that I have heard a great deal of chatter and online commentary that inflation numbers (which already appear elevated) from the Labor Department are still understating inflation.   I am not prepared or qualified to debate the issue of exactly what the rate may be, but obviously it could be a scary time we do indeed return to double digit inflation as some have suggested.  The bottom line is that inflation has reared its ugly head and if it is 5%, 10%, or 15% it will play a big part in the economic story of the next several years.

Now I want to point out that the media and the government are often wrong about these things as much as they are right.  There is also a component of self fulfilling prophesy whereby the more we talk about high inflation the more it happens.  I don't want to be a Chicken Little and add more fuel to the fire so here is my advice, "prepare for the worst but hope for the best." 

[ Read More ]

Overcoming the Fear of Failure

I want to start my own business. In order to diversify my income streams and increase my income I feel that entrepreneurship is by far the best route. The problem I now face is that I am hesitant to risk my savings on an unproven venture. I am afraid to fail. I think that recognizing both my desire to enter the business world and my reservations is a good start, but as someone wise once said, "You can't win if you never play the game."

I spent some time this evening scouring the net looking for advice. Here is some of what I've found:

• Biz Thoughts: Don't Be Afraid to Fail
• National Federation of Small Business
• Practical Commerce: Four Things You Should Know

Because I went out looking for motivational and inspirational resources that is mostly what I've found. One common theme I have found is to start small. By moving slowly and making a limited investment you can gauge the market without large risks. Next, many people advise that what I consider failure, a business that does not proser and make money, is not actually failure. That seems silly, but learning from mistakes is a common theme too.

"No man ever achieved worthwhile success who did not, at one time or other, find himself with at least one foot hanging well over the brink of failure."

It was also pointed out that bankruptcy isn't that bad. I've traditionally been brought up to completely disagree with this statement. My parents have may encouraged me to learn chess or ride a bike through trial and error, but failing to pay back debt was certainly not something that was acceptable; thus, business by trial and error would have been out of the question. A willingness to follow my entrepreneurial spirit because of, rather than in spite of, bankruptcy is a totally new concept for me, but it is endorsed by the entrepreneurship articles I read.

In the end I have been encouraged to push forward with my plans to enter the business world. I will take the advice of other bloggers and business people and start small in an industry where I already have some experience. I'll put off my grand plans for real estate development and focus more on free lance coding and web based business. I'll try to grow Aspire 2 Wealth and keep the readers informed as I test out my business chops and grow my wealth.

Comments and suggestions are welcomed. Please subscribe to my RSS feed if you like what you've read. Till next time, thanks for reading.

[ Read More ]

Break the Spending Cycle

Just like being on a diet, being frugal seems to go in cycles.  One month we may get our ship going in the right direction, and BAM, the next month we totally drift off course.  In the months leading up to buying our house we saved hard, almost 50% of our income.  For three weeks after we closed, we went into a buying spree that left us with $4,000 of debt.  Some of these purchases were legitimate needs, but much of it was not.  We spent money to celebrate our milestone ($400 for a self thrown house warming party anyone?) and rebel against our months of restricted spending (how about a flat screen TV?).  We went from spending 50% of our income to spending 200% of our income in an instant.

By starting this blog I took the first steps in reigning back in the excess that accompanied home ownership.  Today I am taking another step to try and address some of the recurring expenses that sneaked their way into the budget.  By addressing regular monthly bills I will make a lasting impression on my budget.  Rather than require my will power to hold up next month as if this were a spending diet, I've trimmed my lifestyle instead.  To continue the weight loss analogy, what I did today is like starting an exercise routine rather than some fad two-week juice diet.

The first bill I trimmed is the $41 a month land-line telephone bill.  The most basic telephone hook up from AT&T is $16 and change per month.  Next we add another $9 to add the 2-Option package for Call Waiting and Caller ID.  My wife deems it absolutely necessary to have the ability to screen calls and insists we have Caller ID.  Call Waiting is almost useless but it comes as a package deal.  We also have $2.99 for long distance service which to my knowledge has never been used.  Finally there is an assortment of taxes and fees that bring the total up to $41.

To go about reducing this bill I had very few options.  One would be to convince my wife that we don't need Caller ID.  I was unsuccessful in this task so I moved on.  I did some research and learned that AT&T is currently offering an online-only long distance package that is FREE.  That's right, no charge at all, and a fairly reasonable $0.12 per minute.  Since we never use this except for maybe in the event of an emergency this is great.  It will knock $4.52 including taxes off of our bill.  Next month we should be charged only $36 for telephone service.

The next bill to go about reducing is the satellite TV.   At present it runs $81 a month for the top tier service with two premium channels, High Def programming, and a DVR.  We currently get a $27 credit each month that covers the HD service and the DVR, but that credit will go away in August so the the bill will jump to $108 a month.  That is just too much to pay for TV.  We hardly watch the premium channels so that is the first place to start.  Dropping those will reduce the bill $15 + tax or down to about $65.  For a while I was watching Showtime frequently for several of their series, but lately these shows have been out of the lineup.  Dexter, Weeds, and Californication are great, but I'm not sure if they are worth $16 a month.  All of them will eventually be available from Netflix so today I am going to call and get rid of the premiums.

It may not be a lot but with a couple of phone calls I have trimmed a bit more than $20 a month from my budget.  I can now allocate the extra money to paying down my debt just a little bit faster.  If you factor in the interest savings it will cut a full month off of my repayment plan.  It will be a great day when I am finally free of my consumer debt, and this little action will bring me that much closer.

[ Read More ]

What is an Emergency?

Save an emergency fund!  This is one of the most important first steps to getting control of your finances and stopping the cycle of reaching for the credit card when things get tough.  I even made saving an emergency fund Millionaire Rule #5.  I've scraped together almost $2 grand for my emergency fund over the last year, and that is great progress. Right?  

My problem today is that my car needs work, but I don't want to raid my emergency fund.  The $400 repair bill seems small enough for me to pay out of my regular living money, but history has shown that I won't tighten the belt enough.  I know that if I pay this bill out of normal income I will run out of money by the end of the month.  When the money runs out the immediate response will be to reach for the credit card for groceries and gasoline that I've got to have.  Spending more on credit is exactly what I shouldn't do.

However, I would almost rather seem my credit card balance go up than see my emergency fund balance go down...   I know it is crazy talk, but it took so much to build it up I don't want to use it!  I like knowing if a real emergency happens I have the money to cover it.  I also like looking at the nice balance and watch it continue to grow each month.

So here is the real question, how do you decide what constitutes an "emergency" and justifies raiding savings?  For example, I needed to buy two pairs of shoes (one for the gym and one for work) for which I hadn't planned.  Is that $100 expense for shoes enough to raid the emergency fund?  What about redoing the brakes on the car? What about text books for my wife?  It seems there is a possible emergency that doesn't fit into the budget every month.  Ugh.

In the last two months I've spent significant sums on these unplanned expenses.  Fortunately I've also had a significant inflow of cash from selling unused items on eBay that has covered these expenses.  That extra money was originally earmarked for paying off debt.  Instead of paying down my debt I chose to pay the bills and let my balances tread water.  This seems like a decent trade off, but in reality is is the same as if I had paid down the debt and later (when money got tight again) run the credit card right back up.  That scenario may have actually saved me some interest now that I think about it.

I'm a little confused about how I should be using my emergency fund, and a little frustrated with all of the unbudgeted expenses that have popped up.  Please leave some comments to let me know what you think.  Thanks for reading.

[ Read More ]

Class In America

I stumbled onto a special feature from the New York Times about Class in America. It seemed like a good follow up to my post last week about Wealth Porn. I learned some interesting things by reading the articles and running some numbers in their tools. First, based on the How Class Works calculator I rank in the 74th percentile of Americans. My education and salary both push me high up the scale while my net worth brings me down a good bit. If I put my parents on the same scale, they both have masters degrees and make upper middle class salaries; they are at the 90th percentile. I think with enough time I will catch up to them, but I think it is unlikely for me to surpass the level of my parents. I started near the top and I have followed in my parents foot steps.

Another graphic shows income mobility in America from 1988 to 1998. It clearly demonstrates that a number of people from the very bottom are able to rise to the very top of the scale. It also shows that those in the middle and lower middle ranges have an equal probability to end up in any of the income categories with about half improving their standing. However, this does not mean that everyone has an equal likelihood to end up at the top. Only about half of those in the lowest group are able to move up the scale. Those who had the early advantage of starting in the top bracket continue to populate about half of the of the top bracket 10 years later. Thus, it is equally likely for someone at the top to fall as it it for someone at the bottom to move up. That seems to me like the American Dream is alive and well.

Some of what I read was encouraging. Some of it made me think. I recommend everyone take a minute to read some of the content and explore the tools. Comments about class in America and class mobility are welcomed.

I have been featured in the following carnivals lately that I would like to share with you:

• Carnival of Personal Finance hosted by The Financial Blogger
• Carnival of Homeowners hosted by Homeowners Insurance Lowdown
• Festival of Frugality hosted by Mighty Bargain Hunter

[ Read More ]

Income for Life - Part 1 - Bonds

I talk a lot on this site about the process of accumulating wealth, but today I will expand that focus to include a realistic picture of how much wealth is actually needed to create a steady income for life. There are a few commonly accepted ways to draw income from one's wealth and over the next few posts I will try to I will explain the most common methods. I will also try to address the most important risk factors to your nest egg. These risks turn a seemingly simple process into a mine field of problems that can snag even a well prepared retiree.

Bonds:
It is simple to look up the historical rate of return for bonds and say, "I will put all of money into bonds that pay X% interest and spend the interest each year." Based on data from the Federal Reserve from 1955 to 2007 government bonds averaged 5.735% return. Bonds are suppose to be a safe and stable source of income right? In fact if you look at the data the returns of bonds are actually are fairly choppy. The standard deviation (measure of volatility or predictability of returns) for the government bond data is 3.214. What this means is that in most years the returns from bonds will end up between 5.735% minus 3.214% (or 2.521%) and 5.735% plus 3.214% (or 8.949%). Around 1/3 of the time the returns will even fall outside this broad range (2.521-8.949%) to be very large (like 16.39% in 1981) or very small (like 1.13% in 2003). In other words, from year to year the returns of bonds can still be unpredictable, so you can not count on drawing the same amount year after year without significant risk of dipping into the balance and potentially running out of money.

Another important risk factor for drawing income from your wealth is inflation. Each year prices for all types of goods and services increase, which will cause income needs to increase over time to maintain the same purchasing power ($1.00 in 1987 would require $1.83 in 2007). That means in order to keep up with inflation, the size of your nest egg still must grow in retirement to keep up. Using the same time period as above from 1955 to 2007, inflation took away 1.8% per year of the average 5.725% return. That leaves us with at the most a 3.935% withdraw rate to generate income to account for inflation. There can be some years where the inflation rate even exceeds the return of government bonds. This would also require dipping into the balance to maintain a stable income.

To provide a truly guaranteed income from bonds that is protected from inflation there is a special product called a Treasury Inflation Protected Security (TIPS) that are issued by the Federal Government and pay interest at a rate that varies based on an index which tracks inflation called the Consumer Price Index. The bonds pay a fixed percentage of income historically from 2-3% above the CPI stated inflation rate. This approach will guarantee an income that keeps up with inflation and is fairly stable, but at a price of creating an income stream that is fairly small. A TIPS portfolio that pays a 2.5% premium over CPI the initial principle required for an annual income of $50,000 would be $2,000,000.

If you a person is able to accumulate $2,000,000 today and will need $50,000 income for life then they are all set. However, if you are like me and have decades until retirement (for me 38 years to be exact) then you have to also factor in the effect of inflation from now until then. I feel that the 1.8% average inflation presented before may be a little conservative, and I want a little wiggle room in my calculations, so instead I will use an inflation estimate of 3% for my calculations. This gives me an inflation factor of 3.07 (or a 307% increase in my income needs) at retirement as compared to now. Using these assumptions I calculate the following: ($50,000 * 3.07) / (2.5% TIPS premium) = $6.14 Million. That is a LOT of money to accumulate in my lifetime, but absolutely achievable! At an 8% annual return I would need to save about $1975 per month for 38 years which is roughly equal to taking maximum advantage of my 401(k) ($15,500 plus match) and Roth IRA ($5000).

[ Read More ]

Failed Business #1: MLM

Back in October of 2006 my wife-to-be and I got invited by her aunt to come have dinner. This aunt is fairly young at heart and we enjoy spending time with her. We were more than happy to drive 90 miles to meet up with her. My wife has another aunt who lives half way across the country from us and she was also in town to have dinner. As it turned out the reason for the invitation was that the two aunts were hosting a recruiting event for a multi-level marketing company (MLM).

I won't name the company for a couple reasons. First, these companies tend to have a fairly pro-active legal department, and the last thing I want to do is deal with that problem. Second, based on my experience it is certainly no worse than any other company in the MLM game so there is no reason to use the name. Finally, we do have family members that are involved and I no way want to hurt them or their business.

The way MLM companies work is that they sell their products through a network of independent consultants. These consultants market the brand and make sales which are either shipped directly to the customer or to the consultant (who then delivers the goods). Examples of MLM include Mary Kay, Amway, and Tupperware. Most people have come into contact with these brands either as a consultant or potential client.

One of the key concepts of MLM is that the company stresses that they can afford to compensate the consultants generously because they do not pay for advertising, retail space, or shipping. Compensation from these companies often hinges largely on a consultant's ability to recruit more consultants. This is reinforced by paying bonuses for recruitment and paying a recruiter a percentage of the sales from those they have recruited. In other words, when a person you recruited makes a sale (or sometimes another recruit) you get paid too. This sets up a 'network' where the work of those below you generates the vast majority of the money for a person at the top of the payment pyramid. While not a pyramid scheme per se it does resemble one. The FTC ruled this organization structure is not illegal however it can be ripe for problems.

Now back to my personal story. Dinner with our aunts was a recruitment dinner where we all listened to speakers while we ate our food. The aunt that drove hundreds of miles to "eat dinner" was the featured speaker. Long story short, her husband was involved in a series of businesses and for a time was fairly wealthy. His business interests soured, their family was forced to sell their house, and they lost nearly everything. The former stay at home wife then took up the MLM company in order to save her family. She worked hard and became fabulously successful with MLM. She just bought the house of a famous football coach (costing north of $600,000) and both her and her husband drive German luxury cars. She lives the high life and her husband has retired all because of this MLM company. Now she is here to offer the same opportunity to us (and the room full of 20 others).

I took the bait. I knew that I had the business acumen, and I had a grand plan to follow in my wife's aunt's footsteps. That night on the drive home we listened to the motivational CD presentation we were given, and that night I stayed up very late writing a full business plan. I determined that I had access to an untapped market for the products, I would approach dorms and residence halls on local college campuses and hold 'educational' programs which feature the products. I had been an Residence Assistant during college and I knew that RA's love to have outside speakers talk to their residents (which satisfies an RAs requirement to hold community activities for their students). I had figured out how to pass off my programs as educational and make a low-pressure sales pitch that would not get me booted off campus.

Fast forward 18 months. I have a closet full of unsold inventory and no residual cash rolling in. I collected a total of about $1,200 in revenue and invested about $3,500 in the business. I have over $2,000 in credit card debt left from having a go at MLM.

First of all, I'm a pretty decent sales man. My conversion rate for sales prospects was over 50% which I've been told is pretty good. I also had a business plan and attacked it with at least 20 hours of effort a week. I set up sales sessions and worked the phones. I was able to get my program approved by the local college. It would seem that all would be going fine. Why did I fail?

I did not recruit. I failed to recognize that the real money maker is to recruit new prospects, get them to buy their first shipment of product ($700-1400), and then move on. I also needed to find a few like minded people to work under me and do the same. I recruited a grand total of three people to the organization. I lost a bundle. Both aunts talked big about the potential profits, but when I shared my business plan neither let me know that I was barking up the wrong tree. It is too time intensive and difficult to spend your days selling widgets one at a time for $50 with a 15% margin when you can talk to a room full of 20 people who will buy $700 worth of product. Even a sales presentation to a dozen house wives that may spend $20 each doesn't work out to more than minimum wage. A couple of them may join and build your network but they must be willing to recruit like a fiend too.

I could switch to pumping the recruitment aspect of the business and do what has made my aunts so much money. I can't bring myself to try and bilk other people out of their hard earned money. I know that the success rate is terrible and that only a tiny minority that spend their $700 to get started will ever see more than a fraction of their money back. I am not willing to take advantage of people's natural enthusiasm and hope in order to lead them into an almost certain money loosing venture. Less than 10 percent of those that sign up will break even with the business.

That is my MLM story and an explanation for a portion of my evil credit card debt. Those of you with experience (either good or bad) with MLM I'd like to hear your stories. Please feel free to leave a comment.

P.S. My wife and I still get along just fine with the two aunts who introduced us to MLM. I know that it isn't their fault that I entered into a failed business model. Family is much more important than that amount of money, which is of course another reason the business isn't for me.

[ Read More ]

Acquiring Wealth - An Introduction

How does a person become wealthy? The goal of this blog is to help me and those around me achieve this goal, so this post will start a multi-part discussion to address acquiring wealth. First, what is wealth? For now I am only going to consider economic wealth, which is something which has monetary value. To be wealthy a person simply must accumulate things which have value and get rid of those things which take away value. Examples of things which have value, called an asset, would be stock, bonds, real estate, or business venture. Examples of things which take away value, called liabilities, would be debt, spending, and gambling. Once you recognize the difference between an asset and a liability you can begin to acquire assets and eliminate liabilities to create wealth.

In order to establish a common set of terms that are used to describe the process of acquiring wealth we must define some of the most common financial concepts. First, the outflow of money (spending) is called a debit and the inflow of money (income) is called a credit. Over a specified period of time (a month for example), the credits during that period minus the debits during that period is called the cash flow. When income is greater than spending it is called having positive cash flow and when the opposite is true it is called having negative cash flow. When positive cash flow is carried over to be spent in the future it is called saving. In the most basic sense, it is impossible to accumulate wealth over any period of time if there is no savings.

The model presented in the previous paragraph neglects additional concept that is essential. Appreciation is the increase in value of an asset, and depreciation is the decrease in value of an asset. Appreciation and depreciation can be clearly seen in the fluctuating value of a share of stock. Stock is bought and sold at a price which changes over time based on the perceived value of the stock. When the stock is purchased and the selling price for the stock goes up it has appreciated and wealth has been created. The same process can occur in reverse whereby the selling price for the stock goes down and wealth has been lost. Appreciation and depreciation of assets are the most important process for acquiring wealth because it allows an individual to create wealth many times greater than the positive cash flow that was used to buy the asset.

The final basic concept which must be defined is compound interest. It is the simple concept that the appreciation of an asset is subject to further appreciation. In other words, with compound interest if the value of an asset goes up 25% and then later goes up 25% again the effective appreciation is actually 56.25% rather than the 50% appreciation which would result from simple interest. Over long time periods during which regular savings are invested, the assets which accumulate due to compound interest can greatly outweigh those which result from savings.

An example of all of these terms should help clarify how the wealth acquiring process of assets functions. At age 25, Joe Worker starts saving some of his income each month. At the end of each month his income exceeds his spending by $200. He puts half of his savings into a tax free retirement account at his local bank which pays him interest at 4.75% compounded yearly. He puts the other half into a retirement savings plan which invests commission and tax free in the S&P 500 stock index (historical annualized return 11.9%). Joe continues making both of his contributions each month until he retires at age 65 and is surprised to find that his bank savings account has a balance of $143,011.35 and his S&P 500 account has a balance of $1,139,903.70. The in each account Joe saved $48,000 and compound interest accounts for the remainder of the balance.

This example includes a number of simplifications and assumptions which may not hold true in the real world. It is also important to note that past performance of investments in not a predictor of future success; however, Joe’s example does illustrate the power of building wealth by investing in appreciating assets. Investing only $100 per month can create over one million dollars of wealth if invested.

[ Read More ]