Your Brain Makes Building Wealth Hard

One of the first steps to overcoming a challenge is to recognize there is a problem. If you do not know where your stumbling blocks lie it is often impossible to achieve the results you desire. In the wealth building process there are multiple challenges, but one that many people don't recognize is your own brain. Our brains developed to do a great job helping us hunt, gather, and reproduce. Unfortunately our brains are not particularly suited to the challenges of creating wealth.

There is [relatively speaking] a new field of study called Behavioral Finance. The basic idea is that investing decisions are made by people, and people are influenced by psychology in addition to the pure numbers of the markets. In fact, investors (being human) are subject to quarks of neurology, biochemistry, and evolutionary anthropology which in turn influence all of our money decisions.

So, now that we realize that there is more to investing than just the numbers, what does that mean? First off, it means that your brain is not always aligned with your aspiration to build wealth. In many cases your brain can drive you to do the wrong thing with staggering regularity. The best example is the tendency to sell your investments (in panic) during a market downturn.

Everyone knows that to make money a person must "buy low, sell high" but in practice most investors jump on the bandwagon when the market seems to go up, up, up and then sell to stop the pain as the market falls. What is the result? The average investor buys stocks when they have already gone way up and sells after they have dropped. This is a "sell low, buy high" strategy that will loose money every time. Why then do some many people follow this pattern?

The short answer is people "feel" the pain of a loss in the market much more strongly than they "feel" the joy of a gain in the market. Think about this, if you have saved a nest egg of $200,000 which would effect your emotions more, gaining $20,000 or loosing $20,000. The vast majority of people are more emotionally impacted by the loss. In order to stop the pain, they sell the stock. This effect is call Myopic Loss Aversion and has been studied and documented in the majority of people, professionals and amateurs alike.

Behavioral finance relates to several other important ways in which your brain sabotages your finances. It has uncovered important data about why people have such a difficult time saving, budgeting, and investing for the long term. It turns out we are nearly all subject to a Stone Age era inability to evaluate the benefits of long term returns versus instant gratification.

Centuries ago it was much better to have a bird in hand (to eat tonight) than to wait a few weeks or months to be able to eat two birds. If you starved now, doubling your "investment" isn't worth anything (you'd be dead). This is one key reason our instincts fail us when it comes to evaluating market returns. Market bubbles and crashes are another example of psychology creeping into our investing reasoning (and reaping havoc).

In other words, behavioral finance has some impact on nearly all aspects of our financial lives. Now that we know there is a problem, lets do what we can to create wealth for ourselves in spite of our brain.

[ Read More ]

Millionaire Rule #7

Fund 401(k) to Get the Full Match
There is no better way to save for your financial future than to take advantage of a 401(k) which is matched by an employer. It is rare that I will state anything in the personal finance domain with this much certainty. An employer match is free money. No offense intended, but you would have to be an idiot to ignore FREE MONEY!

For those of you who have never heard of a 401(k) or don't really understand them I will give a quick primer. It is named after the section of the tax code which defines the rules of these accounts. A 401(k) is a savings account for the purpose of funding retirement. If you take money out before age 59 1/2 you will owe taxes and a 10% penalty to the IRS (DO NOT DO THIS). Money contributed is completely protected from taxes until you withdraw it. This tax benefit means that you can avoid taxes now. By avoiding taxes you will have more money to save, and each year your savings will continue to grow tax free until retirement.

A 401(k) account is set up by your employer, held at an independent financial services firm, and managed by YOU the investor. You choose how much goes into the account each pay check (call your HR department to set this up) and you pick your investments from a list of choices provided by the servicing firm. Lastly, and most importantly, many employers encourage employees to save by contributing money on the employee's behalf. This is called "matching" because it is normally arranged such that the employer will kick in a certain percentage of what the employee contributes. Common matching arrangements are 50% of every dollar up to a maximum of 3%; in this case an employee would contribute 6% of their gross pay and the employer would add an additional 3% (for a total of 9% of gross pay saved). Some employers are very generous and offer even more free money!

I will give a simple example to show the power of a 401(k). Lets consider Joe, a regular guy making $50,000 a year. Each year he will get a small raise of 3% and his investments return a moderate 8% per year. He is 30 years old and will work until he is 67 year old. The table below shows Joe's results depending on the type of investment account he uses.



I will say again, that not putting in the money necessary to get the full match is leaving free money on the table; don't do it. The best case shown in the table produced a nest egg of over $1.28 million which is roughly double what could have been saved in a taxable retirement account.

Now I realize that not every person has been lucky enough to find a job that offers a 401(k) and that a match is not offered in all 401(k) plans either. Do not loose hope! There are still other retirement saving options that are pretty good. If you want more information on your choices, continue reading the rest of my series Millionaire Rules.

[ Read More ]

Millionaire Rule #5

Save an Emergency Fund
What would you do if you car broke down tomorrow and needed major repairs? How would you pay for it? What if you or a family member got hurt and the insurance company (or worse yet doctor) sent you a bill? Do you have enough to meet your co-pays and deductibles?

Unexpected expenses pop-up every day and it is important to have money set aside to pay for them. Keeping an emergency fund that is large enough to meet these expenses is an absolute necessity. I don't want to sound all gloom and doom, but bad things happen so be prepared.

There is a lot of debate among personal finance writers about how much spare cash should be stored in an emergency fund. There seem to be two primary camps, one advocates a large fund that is equivalent to several months of a families net take home pay. Kathy M. Kristof of the LA Times wrote the article It's Time for an Emergency Fund that says, "Pretend that tomorrow, for whatever reason, you are not going to be able to work for six months and the stock market is down 15%." From here it goes on to suggest keeping at least 3 months worth on income in a savings account.

The other prevailing take on how much to save is to keep a few thousand readily accessible. J.D. at the blog Get Rich Slowly writes in his post How Much in an Emergency Fund?, "there are few catastrophes that would ever require you to come up with more than a couple thousand dollars on short notice. Insurance will mitigate many problems. For everything else, there’s time to obtain capital: to tap into home equity, to sell stocks, etc." Those in this camp would expect to keep $1,000-5,000 in liquid savings and possibly open a home equity line of credit to supplement the savings.

Both approaches seem equally valid, but which you choose should reflect your own situation. I feel very secure in the stability of my employment. I also have insurance that covers short term disability. Because of these two facts, I plan to have a lean emergency fund that is enough to cover my insurance deductibles and little else. My maximum out of pocket expenses for my health insurance is $4,000 per year so I will use that as my benchmark for a major catastrophe. Over the next couple of years, part of my financial goals will be to save a little bit each month until I reach this level.

The next major decision is where the money should be kept. Most importantly, the money must be readily accessible when it is needed. It would be counter productive to tie your emergency fund cash up in a Certificate of Deposit (CD) which keeps it locked up for months at a time. It is also important that the money is able to keep pace with inflation or it will quickly lose buying power. Local banks and credit unions rarely pay a high enough interest rate to keep pace with inflation. Another consideration for emergency funds is that they should not be invested in stocks or other volatile investments. The last thing you want is for the value of your account to have plunged right when you need it the most.

Based on these considerations, it seems that money market funds and high interest online accounts seem to be the best savings options. I selected one of these high interest online banks for my emergency fund because it has the added security of FDIC insurance on the deposit which a money market does not. Rates are currently competitive with short term CD's and the money can be transfered into my checking account in no more than 3 days.

The important thing to take away from Millionaire Rule #5 is that bad things happen when we least expect. An emergency fund is the best way to make sure you are always prepared for whatever may come your way. This post is the fifth installment in my series Ten Simple Rules to Build Wealth. If you Aspire 2 Wealth like me be sure to read the rest of the rules and subscribe to my RSS feed.

[ Read More ]

Millionaire Rule #4

Set Up Automatic Savings
No matter how great your will power, spending money is the easiest thing I know. Saving it is hard. Plain and simple, if a person has money they will spend it. If you make it hard to access your money you will spend less and save more. The solution is to effectively 'hide' money from yourself.

The biggest reason people fail to save money is that they only save what is left at the end of the month. This approach indirectly declares that saving money is your absolute lowest priority. All your savings account gets each month is the crumbs that are left over. Instead you must treat your savings as a top priority so the money is shepherded to safety first before any spending can take place. You must treat saving as an expense, the same as any other bill you receive. In this manner you can ensure that every month you meet your savings goals.

There are four ways to save automatically that I use and highly recommend:

First, if your employer uses automatic deposit to pay you directly into a bank account, use it to make saving automatic. To do this, you can request that a payment is sent to both your savings and checking accounts instead of a single one into your checking. Money arrives on each payday automatically in your savings account without you having to lift a finger.

Second, use your bank's online bill payment feature or the brokerage's automatic debit system to automatically send a check to your brokerage or investment company. This way you can fund your IRA a little bit each payday without any action needed.

Third, start a change (or even better $5 bill) jar or piggy bank. At the end of each day empty your pockets into the jar. If you take the $5 bill route then each evening if you have any bills with Abe Lincoln's face on the front, tuck them into the jar too. You will be amazed how much cash you have at the end of a year or two. Use this money to make a special purchase or for a vacation that you wouldn't otherwise be able to afford.

Finally and most importantly, enroll in your employer's 401(k) plan. There are great tax advantages and many employers offer a matching program for money that is hidden away in a 401(k). Saving is automatic, and the money is also protected (from frivolous spending) by strong incentives that encourage you keep your hands off the cash until retirement.

The final automatic savings method I would like to address is purchasing your home. Many people have built a great deal of wealth through home ownership. Owning a home has features similar to other savings methods. That's right, it is a savings method NOT an investment. It entails mandatory payments (principle paid on a mortgage) and builds up equity that is difficult to spend. This money is hidden from the saver because, in the past at least, selling the house and then relocating to a less costly place to live was necessary to get access to the cash. In other words, owning a home does not inherently make one more wealthy, instead it creates a 'forced savings' where principle payments build up over time.

In recent years this mechanism, that worked so well for our grandparents, has broken down with the ease with which you can obtain a Home Equity Line of Credit (HELCO) or second mortgage. An even worse tactic is to hold a negative amortization (also known as an option , differed interest, or graduated payment mortgage) in which you literally loose wealth every month holding this loan as you pay less than the interest owed. In order to reap the benefits of home ownership a person must recognize that the only true wealth created is the forced savings of paying principle and building equity. Buy a house, utilize forced savings, and create wealth.

If a person takes advantage of these Automatic Savings techniques it is nearly assured that they will become an millionaire even if they have a moderate income. Check out the rest of the Millionaire Rules from my post Ten Simple Rules to Build Wealth.

[ Read More ]

It's The Big Things Stupid!

One of the biggest misconceptions that I read all the time related to personal finance is that the little choices we make about money are the key to fixing our financial ills. Every time I turn around someone tells me the reason I am broke is that I buy my coffee every morning and have a couple cans of soda every day; that the little things sink our financial boat. I don't buy it. I think the reason most people are broke is that they don't do the BIG things right. Think about it, what has more effect on your overall financial health, your car buying habits or your coffee habits?

Buying a car is a Big Thing in our financial lives. When a person finances a $40k car for 60 months at 8% (or even higher) interest the monthly payments are over $800 a month not even including the insurance, maintenance, or taxes. Sadly I have a neighbor that lives up the street who has $200k worth of cars parked in front of his $180k house for himself, his wife, and his 3 driving age children. You could drink 6 designer coffees every day to catch up with what is wasted for each of his 5 cars. You could buy a house 5 miles closer to the city center and install a full roof of solar panels. Or you could continue to throw you money away for the speeding tickets that a V-8 turbo charged engine brings you. The same consequences are true for buying a house or leasing an apartment which exceeds the needs of its occupants. The picture gets even worse when you consider boats, ATVs, jet skis, or other pricey toys bought to keep up with the Joneses.

Another Big Thing that will ultimately sink your financial ship that so few people consider the free money that comes from a 401(k), IRA, or Roth IRA plan. According to this paper by the Social Security Administration the 401(k) participation rate was 67% and the Traditional IRA participation rate was only 8% (Roth IRAs were not included in the analysis). The choice to skip using these vehicles to contribute to your quest for instant gratification is the loosing end of a million dollar choice. That choice has consequences which far outweigh whether or not you uses coupons when buying your OJ at the local grocery store. It has even been shown that the amount contributed and the particular investments selected within these retirement accounts is not nearly as important as simply contributing NOW.

The final Big Thing that I think too many people get wrong is they miss the opportunities that education presents. A good paying middle class job for the high school graduate is a thing of the past. According to this Census Bureau paper investing in a college degree is another million dollar decision that people fail to make. Public and private assistance for college is available for nearly everyone in some form or fashion. Federal Tax incentives such as the Lifetime Learning Credit and Hope Credit apply to everyone who has earned income and wants to attend higher education.

I don't abdicate completely forgetting the little things, but I think if you make good choices about the Big Things you will end up doing better than most. So far I feel like I've gotten most of the big things right, but screwed up plenty of smaller things. Despite these mistakes which might amount to a few hundred dollars here and a couple thousands dollars there, I know that buying a house I can afford, striving to pay cash for my reliable (not luxurious) transportation, investing as much as I can stand (and then a little more till it feels tight), and taking lifetime learning to heart I build my wealth and bring prosperity.

[ 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 ]

Back to the Grind

I am back from my Holiday travels. The entire trip consisted of three things: 1) Driving, 2) Eating, and 3) Football. My wife and I had a good time visiting her family, and I'd say the trip was a success.

During the trip I was asked several times what my plans are for the future. That got me thinking that I don't really have a cohesive plan for the next phase of my life. I've reached a point where most of my short term goals like completing my masters degree and buying a house have been achieved. What do I do next?

I might get a Ph.D. It can almost never hurt to get more education (especially when my work contributes to these endeavors) and it would be really neat to be Dr. Adfecto! I have also thought about becoming a Certified Financial Planner. Why not make my favorite hobby into my day job? I might actually enjoy my work that way. I have also looked into becoming an entrepreneur by starting businesses in a few different fields; 1) real estate investing, 2) real estate property management, 3) franchise (Subway, Papa Johns, etc), 4) home theater/networking/automation/AV installer, and 5) financial services firm. I can already see the glass ceiling above me at my current job (though I have a few years before I hit it) so I want to be prepared to maximize my earning potential.

Another thing I thought about a lot over the last few days is my near term financial goals. I'd like to put them down here to document my thoughts and outline the specifics. First, I want to pay off all of my debt except my mortgage. That is my most immediate goal and I think is a great goal that everyone should achieve. I currently have about a 12k car loan and about 12k in consumer debt that I want to pay off. I also want to reach a savings level that maxes my Roth IRA ($5500/year) and puts me on course to max my 401k (15% of gross pay). Next I want to purchase (preferably with cash) a replacement for my 1999 Chevy sedan that is sadly already struggling. Third, I want to establish an emergency fund with > 3 months of expenses in an online savings account. I have set a very ambitious completion date of July 1, 2010.

This is the basic advice that the columnists like Walter Updegrave (CNNMoney), Michelle Singletary (Washington Post), and Liz Pulliam Weston (MSN Money) or the gurus like Dave Ramsey (The Total Money Makeover), Robert Kiyosake (Rich Dad, Poor Dad), and David Bach (The Automatic Millionaire) or the scores of personal finance bloggers (Money Blog Network) write about every day. I agree with them and will put these goals into practice in my life. Reading these articles and books is a great start however, is not enough to bring out the type of wealth I want in my life. I want to be able to travel to exotic places, to own a beautiful spacious home (or two) with upgrades like a home theater and billiards room, own a pair of late model mid-luxury cars (for example Infinity G35 for me and an FX35 for my wife). I want be able to work with flexibility and generate as much of my money as possible from completely passive sources (bonds, stocks, 3rd party managed real estate or businesses, etc). In other words, I want to be truly wealthy with a net worth of 10-15 million. That my friends is not the 'Millionaire Next Door' or the 'Comfortable Retiree' that will result from the advice of those I mention before. What then should I do to achieve this kind of wealth that such a small percent of Americans achieve? That is a whole different set of ambitious goals I need to figure out.

Aspire 2 Wealth is a center piece of this thinking. It will provide me a place to put my thoughts into concrete form so my ideas don't go to waste. It will also (hopefully, one day soon) give me an audience (or even better, a community) to give me feedback, encouragement, and tough love to push me further toward my goals. I think I need someone to call me on my pie-in-the-sky dreams and make me take action on the dozens of "million dollar ideas" I think I have on a regular basis. Thoughts and suggestions appreciated.

[ Read More ]