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The Road to Freedom

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When it comes down to it, the math behind saving, investing, and retirement is pretty simple.  Retirement (a.k.a. financial independence) is simply the point where you are making enough money off of your investment assets to cover your expenses.

To get there, follow the below simple steps:

1. Build an “emergency fund” of cash.  The general rule of thumb in the traditional financial planning industry is to have 3-6 months of living expenses in cash.  Shoot for 3 months of expenses.  Cash can be nice to have, but too much can be a drag.  Once you have sizable investment assets, you can keep less cash on hand.

2. Contribute to employer sponsored retirement plans to take advantage of employer match (if your employer is kind enough to match).  This is a 100% return on your money if you stay with the company long enough to get fully vested.

3. Pay off any debt with an interest rate over 6%* ASAP (Credit card debt is absolutely unacceptable).

4. Max out your employer sponsored retirement plans (401(k)/403(b)/SIMPLE IRA/457/etc.)  This also includes HSA’s (Health Savings Accounts), if you have one.

5. Max out your Roth IRA (If possible).  If you are over the contribution limits, then you can do a ‘back-door conversion’ every year (where you contribute to a non-deductible IRA and convert this IRA to a Roth IRA once per year).  The backdoor conversion only works well if you do NOT have a traditional IRA with built-up gains.

6. Invest in taxable brokerage accounts.  When combined, the amount invested here and in your tax-advantaged plans should be at least 20% of your net (after-tax) income.  The higher the savings rate, the less time until you are financially independent.  If you save and invest 50% of your net income and start at $0, you will be financially independent in roughly 15 years.

*6% is my personal rule.  When paying down debt, you should think of the interest rate as a guaranteed rate of return (effective rate of return).  The long term return of stocks averages around 10%.  Stocks are not guaranteed to return this, and are volatile.  I will take a “guaranteed” return of 6% by paying down debt before investing, but I would rather invest than pay a 4% or 5% loan down.  What your number is depends on your risk tolerance and comfort level with debt.

Index Fund Idiots

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The amount of attention “Index Funds” have been getting lately is insane.  It seems that I either read or hear about index funds on a daily basis now; it has really picked up over the last year.  And rightly so, the capital flows into indexed products (whether index mutual funds or index ETF’s) has been astronomical.  In 2016, $285  billion was pulled from actively managed U.S. mutual funds.  During the same time, U.S. index-tracking funds had inflows of $429 billion!!  Vanguard is kicking serious ass in this trend, they had the top FIVE funds in terms of capital inflows in 2016.

Now, this is all fine and good with ol’ Andrew Jackedson.  In fact, much of the money flowing into index funds over the past year has been my own.  For decades, mutual fund companies (in general) have been overcharging their clients for under-performance. Some might even dare to say that mutual funds (in general) have taken advantage of their investors’ ignorance, and  even intentionally made their fee structures too complex for the average investor to understand.  This certainly seems to be the case with many fund families, especially when you start looking at all the share classes and different ways they have charged investors over the years.  A shares, B shares, C shares, F1, R6, Z shares, loads, CDSC’s, 12-b1 fees….this shit is confusing!

So Jack Bogle and Vanguard (many, many others have followed) have come along and turned the industry on its head.  Indexing is simple, cheap, and has a proven track record.  Actively managed funds will now have to compete by becoming simpler and less expensive; the consumer (the investor) wins.  Yay!!

HOWEVER, there seems to be a strange cult-like following of Jack Bogle, Vanguard, and index funds in general.  I have noticed that there are people out there who are forming very strong opinions about investing, yet know very little about it.  Fueled by their excitement about just how awesome index funds are, these individuals have no problem yelling their investment advice from the rooftops!  The following example is a comment I was unfortunate enough to read on a Wall Street Journal article about 401(k) plans:

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NOOOOOOOO!!!

You should NOT follow this advice, as it is terrible advice.  Even though index funds do have low turnover, you still pay capital gains tax on all dividends while you hold the fund, and capital gains taxes on your gains when you sell the fund.  Plus, if you follow his advice, you have already paid income tax and are investing what is left over.  The tax deduction (which defers your income taxes) in a 401(k)  is a huge benefit.  You can go online and find many different calculators that will show you this.  The benefit will look something like this: what is tax deferred growth

Even IF you were in a 401(k) plan that had above average fees and ONLY expensive mutual funds as investment options, it would almost certainly still be more advantageous than investing in ‘low cost index funds’ in a brokerage account.  (BTW, the average 401(k) participant has an all-in cost of  0.64% of assets.)

Additionally, most employers offer a match and/or profit sharing.  If a participant stays with the company long enough to get vested, this is a 100% return!  This is huge!  Can you name any other situation where you get a 100% guaranteed return on your money?  I can’t…

Most importantly, this is not an ‘either/or’ situation.  Many 401(k) plans offer index funds as investment options.  Many 401(k) plans have very low (or no) costs to the participant, and many (most?) offer mutual funds with ‘institutional’ share classes with very low expense ratios.  Furthermore, periodic contributions are a great thing.  They allow 401(k) participants to “dollar cost average” into the market on a ‘set it and forget it’ basis; not try to time the market like the fool that made this comment.

The real problem here is that these index cult followers believe that index funds are some type of magic bullet.  The answer to every investment question or problem is: “Index funds!” But the reality is that ‘index funds’ are just another investment product, and ‘indexing’ is just another investment strategy.  There are hundreds of index funds tracking all sorts of indexes, all with various expense ratios.  Investing is complex.  There are many factors that need to be considered (costs, taxes, time-frame, risk tolerance, etc.), and it takes a broader level of understanding than just “index funds are the best” to be a successful investor.

 

Cash: The good, the bad, the ugly. (How much should you keep?)

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Sexy, sexy cash…

How much cash should you keep on hand?  This is one of the most common questions in the financial planning process.  The traditional answer in the financial planning world is:

“Three to Six months of fixed and variable expenses should be kept in cash (or cash equivalents), depending on an individual’s personal situation.”  (If a family or individual has two sources of income, then three months is appropriate.  If they depend on one income, then six months is appropriate).

It is important to note that this rule has you hold cash in terms of expenses, not income.  Therefore, your ’emergency fund’ or ‘cash reserve’, or whatever you want to call it, does not need to be any bigger for a high income earner than for a low income earner.  

So, why are we putting a limit on the amount of cash we hold in the first place?  Obviously, there are pros and cons to cash, so let’s review them:

Pros:

  • Cash is liquid.  You can get it right away (with some cash equivalents within a year at the most).   
  • Low investment risk.  If you invest the money, and need it at a certain time in the future, you risk those investments losing value during that time period.  When your money is in the bank, you know you will have the same amount tomorrow, next month, next year, etc.
  • Cash makes you feel warm inside.

Cons:

  • Inflation Risk.
  • Opportunity Costs.

The problem with cash is that every year it sits in your bank account it loses purchasing power due to inflation.  The long term average inflation in the USA has been around 3%-4%.  There have been periods of time when interest rates paid on CD’s and maybe even savings accounts kept pace or outpaced inflation.  Currently, with interest rates near record lows, this is not the case.  So your real return on cash is negative!  

Additionally, cash you hold onto cannot be invested into higher returning asset classes.  This is called opportunity cost.  I.E. you cannot get a 10% return by investing in stocks if you money is sitting in your bank account returning 0.02%.  You cannot achieve a relative return of 4.5% by paying the principal down on your mortgage if the money is sitting in your bank account.  

So, money is liquid and you can get it fast.  However, over time, it is expensive to hold cash because it does not appreciate like other assets.  So, how much should you keep??  

The general rule of thumb of three to six months of expenses is on the conservative side.  You certainly should not hold more than that in cash, and you can most likely get away with holding less.  This is especially true if you have more than one source of income or you have significant stock or bond holdings.  Three months is a good starting point, and you can asses your levels from there.  

 

A lesson from “The Millionaire Next Door”…

One of the first financial books I read when I began my journey into the F.I./E.R. realm was Thomas J. Stanley’s “The Millionaire Next Door”.  Stanley and William Danko (who are both Ph.D.’s) spent years in the 1990’s researching and interviewing millionaires, and then compiled their findings into an easy and fascinating read.  This book had a huge impact on me and truly opened my eyes to the wealth paradigm present in our consumer society.  I realized that my whole life I had been judging people’s wealth wrong.  For example, growing up, I would see someone driving a Mercedes or BMW and assume they were wealthy.  However, as Stanley’s book points out, the Mercedes or BMW was actually an indicator that the person was probably NOT wealthy!

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*The car a person drives is NOT an indicator of wealth!

This makes sense, because actual millionaires value financial independence over displaying high social status.  So it would be silly to buy a $70,000 car, when you can get the same job done with a $20,000 car (or a $10,000 or $5,000 car for that matter).  Buying the $20,000 car would leave $50,000 to buy assets, rather than being tied up in a depreciating vehicle!

A main theme of the book is that millionaires build wealth over time through HABITS.  The following is a description of the upbringing of what Stanley describes as a “UAW” (Under Accumulator of Wealth):

His parents had no understanding or appreciation of invested dollars. Nor does he. And his parents passed this lack of wisdom on to him. Mr. Friend argues that his parents were people of modest means, people with no money to invest. Let’s examine this perception. His parents smoked three packs of cigarettes each day. How many packs did they consume during their adult lifetimes? There are 365 days in a year. So they consumed approximately 1,095 packs per year. They smoked for approximately forty-six years. So in forty-six years, they smoked 50,370 packs of cigarettes. How much did the couple pay for these cigarettes? Approximately $33,190-more than the purchase price of their home! They never considered how much it cost to purchase cigarettes. They viewed such purchases as small expenses. But small expenses become big expenses over time. Small amounts invested periodically also become large investments over time. What if the Friends had invested their cigarette money in the stock market (index fund) during their lifetimes? How much would it have been worth? Nearly $100,000. And what if they had used their cigarette money to purchase shares in a tobacco company? What if they had purchased, reinvested all dividends, and never sold shares in Philip Morris instead of smoking Philip Morris products for forty-six years? At the end of forty-six years, the couple would have had a tobacco portfolio worth over $2 million. But the couple, like their son, never imagined that “small change” could be transformed into significant wealth. This change in behavior alone would have placed the Friends in the millionaire category. 

Now look, I don’t want to pick on smokers.  I have been known to burn a couple heaters myself from time to time when drunk enough.  Plus, they are picked on enough, but maybe rightly so….  I was questioning the math in the example ($0.66/pack?), but this book was written in the ’90s, and cigarettes used to be super cheap before the Government starting taxing the hell out of them!  Additionally, the Friend’s in the book smoked A LOT of cigs; three packs per day seems pretty aggressive.  Today, the average pack in the U.S., with taxes, costs $6.05.  Let’s assume a individual smoker averages 1 pack/day.  If the same individual were to instead invest the money in stocks and get a 10% return over the 46 years, they would end up with $2,133,061.  Holy shit!  Stop smoking and start investing!

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$2.1 million ‘up in smoke’??

Factor in additional health care expenses and decrease in quality of life that a lifetime of smoking is likely to bring, and we can see that this one habit is extremely costly.

Now, you may be sitting there thinking “well good thing I don’t smoke then!”  And I say to you: great job!  However, that is really not the point.  Think about what other habits you have that may seem like ‘small expenses’, and apply the same logic.  Coffees, restaurants, expensive cars, cable TV, clothes, etc.  There is probably some fat to be cut somewhere in there.  The pack/day habit at $6.05/pack comes out to $184/month.  Can you find $184/month somewhere to cut?  That one cut alone could mean millions of dollars over your lifetime.