With the fixed income part of your portfolio, you have three options to choose from:  individual bonds, bond funds and ETFs.  Unknown to most people, holding actual bonds is not the same owning bond funds.  Once you understand the differences, you can determine which is best for you.  For the sake of discussion of this article, bond ETFs act similar to owning bond funds.  Let’s discuss the differences between them.

Return of Principal

Yes it’s true, both will give off income, yet if the bond market has a major decrease in price (which means yield rises), bond funds can lose a decent amount of principal. Bonds, if owned directly, you know will end at par value.  So while they may change in value during the holding period, the principal is returned at the maturity date.  The axiom of you only loose money when you sell definitely holds true to bonds.  You know if a bond returns 3.5%, and you hold till term, your return is exactly 3.5% when it matures. Assuming a default has not occurred, you get 100% of your principal.

Maturity Date

Bond funds do not have a fixed rate of maturity.  They are comprised of many bonds that are added or removed during the time you own the fund.  In 2008, during the financial crisis, the bond market took a major nosedive.  Most bond funds took a hit and experienced a substantial decrease in their NAV price.  A Motley Fool article that discusses this.  A TIPS ETF (iShares Barclays TIPS), what many would consider secure when owning the individual bonds, lost 10%.  Fortunately most bonds funds made a quick come back.

Income

With a bond fund income can vary, but typically pays out monthly.  This is because the underlying bond maturity date owned by the fund will vary during ownership.  Owning individual bonds, payouts amounts are known, and the dates the payouts occur.  By buying specific bonds you can determine when payouts will occur.

Diversification

When owning a bond fund, you don’t need a lot invested to be properly diversified.  When owning an individual bond you have default risk.  When you have only have $10,000 to invest, own only two bonds, and one defaults, you stand to lose 50% of your investment. Many individual bonds have a somewhat high dollar amount to invest in one bond. Ginnie Mae bonds, for example are usually sold in lots of $25,000.  To properly diversify with Ginnie Mae’s, this means you should have at least $200,000 – $300,000 to invest.  A beginning investor usually does not have that amount to invest, and a bond fund is usually a better choice.

Bond mutual funds have a SEC legal requirement to be a specific class of fund, they must invest at least 80%.  This leaves open the issue of the remaining 20% can be invested in other types of bonds, or even stocks!  This means while you wanted to invest in only short term (1 – 3 years) US Treasuries, the fund manager could be investing in riskier assets.  All the more reason to read and review the prospectus before investing.

Liquidity

Some bonds are more liquid than others.  Muni bonds are often very illiquid.  They don’t have a big market compared to the very liquid US treasuries. Meaning if you need to sell a bond before maturity, it’s somewhat harder to find a buyer.  The bid-ask price spread could mean you take a decent haircut on any potential profit.  During periods of market or issuer-specific stress, the lack of liquidity may result in price volatility. In some cases liquidity can disappear altogether for indefinite periods. On the other hand, if you own a bond fund you can sell at any time.

Fees

Individual bonds often bought through a broker.  When buying from a broker you not only have transactional costs, but you also run the risk of not getting the best price.  It’s typical of brokers to sell you a bond available in their their local inventory first than finding the best price on the open market.  Though these fees are a one-time deal they can eat into your profit.  With bond funds on the other hand, even if no-load, you have annual fees.  Bond mutual funds are managed by professional investors (either active or indexed based), which can be an advantage if you are a novice in managing individual bonds.  Specific sectors of the bond market it make sense to use an active manager.  Emerging markets bonds is one such example.

Summary

Bond or a bond fund depends upon your specific circumstances.  If you have less than $100,000 to invest, in most cases it’s best to own index based mutual funds or ETFs.  They offer the best way to diversify, get the proper asset allocation, and low in fees.  With some bonds, like US I Savings Bonds, you must purchase individually and cannot purchase through a mutual fund  No secondary market exists for them, and therefore cannot be owned by mutual funds.  With muni bonds, you are best to own bond funds since they are typically illiquid, and have a higher default risk than other government bonds.  Bond funds on the other hand, are subject to interest rate hikes and can be more volatile than owning individual bonds.

Related posts:

1. Why I Like US I Savings Bonds
2. Ginnie Mae Investing
3. Morningstar Review
4. Tax Efficient Investing

Tax Efficient Investing Order

When investing on an annual basis, it’s best to fill up your accounts in the following order:

1. Your employer’s 401k/403b up to matching amount
2. Invest the maximum into a Roth IRA
3. Back fill your 401k/403b to the maximum amount
4. Invest in a 529 Account
5. US I Savings Bonds
6. MLP and Muni Bonds
7. Taxable Investments

If you have a spouse, you would also do the same order to their accounts (if all options are available) as you would do for yourself.  Based upon your needs and goals, this order may slightly vary.  The basic gist from this list is to invest first in items that give you the greatest tax reduction or tax delay. Let’s go over the list one by one.

1. 401k/403b up to employer’s matching amount

With a 401k you usually get two forms of “free” money.  Your AGI (Adjusted Gross Income) is lowered which effectively lowers your income at least for federal taxes.  The other factor is most companies match 3-4% of what you invest.   This is the reason to invest in these first and contribute at least up to what the employer matches.  Granted some employer retirement plans suck.  Some plans do not have cheap and indexed based mutual funds (i.e. Vanguard), or have only a limited selection of funds.

2. Invest the maximum into a Roth IRA

As of 2010 the maximum for a Roth IRA is $5,000 per year.  Invest the maximum amount.  Open up an account with a firm that offers low transaction fees like ShareBuilder.  Roth IRAs have quite a few advantages over a 401k/403b or traditional IRA.  A traditional IRA reduces your AGI, but must pay taxes when you withdraw.   A Roth IRA on the other hand, is invested after tax, but withdrawals are currently tax-free.   The other nice aspect of any IRA is the potential to invest in pretty much any type of investment.  From physical gold, to real estate (not REITs!), to Lending Club, and of course more traditional investments.   A Roth IRA is much more flexible than any 401k or 403b.  It’s wise to use IRA accounts to help create a proper asset allocation.  Meaning if your 401k offers a poor choice in mutual funds or doesn’t offer specific funds (i.e. international stocks), your IRA account should be used to fill in that gap.

3. Back fill your 401k/403b to the maximum amount

After filling up your Roth IRA account for the year, you are usually best to go back and back fill your employer’s retirement account to the maximum.

4. Invest in a 529 account

If you have children or have future higher education needs yourself, it’s best to invest money into a 529 plan. Money invested is after tax, but is tax free when withdrawn for qualified higher education.  In some states (New York in my case) gives a state tax deduction for investing.  If you don’t have any needs in this area, you can skip this step.  Unfortunately many parents save for their children first, instead of taking care of their retirement plan first.  Retirement plans should always be funded first since you cannot take a loan out for retirement.  In addition, there are situations in which IRA accounts can use for higher education without penalty.

5. US I Savings Bonds

As mentioned previously, I am a big fan of US Savings I Bonds. I think they are a great way to invest some money that’s indexed to inflation, and yet be tax differed while holding the bond.  They can serve multi-purposes in your portfolio, and can be used for higher education needs tax-free.  At minimum, invest the maximum electronic amount (currently $5000) into I Bonds annually.

6. MLP and Muni Bonds

This is an optional investment as it depends upon your income level, and how complex you want your tax situation.  Though, MLP are a great way to get a steady return, and yet most of it be tax differed.  The disadvantage to a MLP is they are much more complex to deal with when filling your taxes.  It is usually recommend to hire an accountant to properly file your taxes when owning a MLP.

Investing in muni bonds depends upon your income level and the state you live in.  High income (you know the one’s Obama vilify) are usually the best to purchase these bonds.  If you have enough money ($250k+) you can directly purchase these bonds, if not you are best to stick with an index-based mutual fund or ETF to get proper diversification.

7. Taxable Investments

After every other item has been filled, only then it’s time to invest in taxable accounts.  Of course if you have other goals than retirement, and higher education (i.e. buying a house or rental property) you may want to push this item higher up the list.  When investing in your taxable accounts it’s typically best to make sure they are still tax efficient.  This means investing in mostly stocks, ETFs, index based mutual funds, and tax efficient mutual funds.  If you are using it as part of your retirement planning, it should be considered as part of your asset allocation.  This means for example, putting stocks with no dividend into your taxable accounts.

Summary

Keep in mind like any part of investing, one should not invest solely for tax avoidance. Do not miss investment opportunities just because it’s tax inefficient, though it should always be considered with your planing.  Though as your different types of investment accounts grow, you’ll be able to put the new asset class into the most appropriate account.

Related posts:

1. Why I Sold Stocks In My Taxable Account Today
2. Ginnie Mae Investing
3. The 4% Rule to Investing
4. Leave Investing To The Professionals

I too think it’s important to teach children about money, and not rely on our public education system for any insight.  During the interview on how the financial reform law will help the general public, the topic wandered into the financial education of his children.

President Obama stated, “They’re starting to get old enough where they may be able earn some money baby-sitting. They’ve got their own savings accounts.”  Obama, like president Jimmy Carter when he walked to the White House after inauguration, is trying to appear he still lives like the common man.  To be president of the most powerful nation, you are anything but common.  His life, even if he is speaking from naivety and not to his political base, will never be like pre-president Obama.  If Obama’s children really go out and baby-sit for a family, don’t you think the secret service would chaperone?  All for a $10/hour baby-sitting job so his children get that “teachable moment”.  Lets not forget of course at the taxpayer’s expense no less.  So remind me again what is Obama teaching them?  I assume his children part-time activities will be included the 3.6 million jobs created or “saved”.

He also goes on to say, “That if they got $100.00 in their bank account at 2-3% for six months this is how much money they’ll have at the end of it”.   The Obama children must get a special CD rate directly from the Federal Reserve with that political pull he has.  As I see the highest 6 month CD rate offered nationally is currently only 1.50% APY, and shows how much in touch he’s with the common man.

Obama then goes on to say, “I mean, it was only a few years ago when, you know, we had high credit card balances, we had two little kids that we were trying to figure out how to save enough for college.”   Records show the Obama household was making a decent salary since 2000, even before becoming the rock star book writer. In other words, depending upon their tax-filing year, their household income placed them within the top 1-10% in the nation.  He’s one of those rich people that the administration likes to vilify.  The Obama’s were not struggling by any means, and if planned properly should have a sizable nest egg for their children’s education.

It’s telling that Obama had such high consumer debt (his words not mine), even with such a high salary. Maybe the Obama family fit into “The Millionaire Next Door” profile of high income, but low net worth.  I assume he’s gotten assistance with his debt from one of those debt counselor ads you see on TV. Maybe it’s time he sat down with one of those counselors to help him with our ever-growing national debt and large deficits.  Granted the previous administration was no slouch with Uncle Sam’s credit card either.

Obama also says, “We were still thinking about our own retirement and looking at our retirement accounts and wondering are we going to be able to get enough assets in there to make sure we’re protected.”  Based upon their 2009 income statement alone, most common folk would have enough to a live conformable retirement.

Then again maybe I’m being too harsh on the President.  After all he called the bottom of the stock in March 2009 and stated it was a great time to invest.  I’ll have to take Obama’s business and investing advice from now on since he’s a big proponent of the free market right?

Related posts:

1. Weekend Reading for January 16, 2010

1 : having wealth : very affluent
2 : characterized by abundance : ample

This definition of course is very vague.   What exactly is “very affluent”? Being a numbers guy, I like specifics and like to measure things like wealth.

I personally like to define wealthy as having enough money where you (and your family) would never have to work another day again (if you chose to). You can live off the fat of the land, otherwise known as your savings.  That is what truly makes you affluent.  In other words, your savings will outlive you.  After all, you can’t take it with you to the grave.  For the average American to become wealthy it takes a lot less than what most people think.  Most American families can meet the basic necessities for currently under $60,000 annually. This is where budgeting becomes oh so important.  If you know your annual expenses, you know how much you need.  If you can generate more than your expenses from your savings on a annual basis, you can consider yourself set for life.   Keep in mind, the overall life expectancy for an American is currently around 78 years old.  So to be wealthy the magic number for most people today seems to be around $2 million saved.  This of course depends upon your age and annual expenses.

Of course many people fall into the lifestyle creep problem.  You’ve heard the movie stars such as Nicholas Cage being forced to sell his house and also behind on his taxes.  He had to live the lifestyle of his peers.  He obviously let his lifestyle get more expensive than his savings.  During the accumulation (saving) stage of your life you must keep luxury items at a minimum. Though lifestyle, by it’s very definition infers luxury items, and not the bare necessities.  To meet the $60k annual budget, I’m taking about the basics: shelter, food, and clothing.  Yes a family of four can live in a 10,000 square foot home, but you don’t have to for survival.  You could just as easily live in a modest 1,500 square foot home.

Let’s talk about specifics.  Use this basic formula to determine how wealthy you really are.  Let’s use me as an example:  I am currently 39 years old, and for my family it costs us approximately $60k to run our household.  So in order to consider us to be truly wealthy, we need $2,340,000 (approximately 39 years remaining of my life X $60,000 annual expenses) in savings at my current age.  Obviously, as I get older it will take less money to make me wealthy, because my expected remaining years on Earth will decrease.

The other great question you can ask yourself if you aren’t currently wealthy, how long could you last with your existing savings? If you and your spouse (assuming you are married) were to stop working tomorrow, how long could you last not working?  A few months?  A few years?  Take your annual spending and divide it by your savings.  Imagine if you cashed out of all savings from retirement, a business you may own, a rental property, etc.  Assume current fair market value.  All the assets you own except your primary residence since you need some place to live.  The amount of years you could survive with this savings tells you how much along you are on the way to becoming wealthy. This calculation is obviously very basic, and is only a paper napkin estimate.  It does not take into account inflation, taxes, investment fees and possible interest earned over the years.  It is though a good rough estimate.

The interesting thing is once your reach your wealthy number, this is the time you can start to increase your lifestyle expenses with little fear. Everything after this becomes gravy.  What do I mean by this?  I mean if you gain say an additional $100,000 in savings, yet your expenses are still the same, you can in theory buy a $100k automobile.   After all, you have enough money saved to cover existing expenses.  A one time expense certainly will not affect your bottom line.  OK, I’m being slightly simplistic because other expensive items will come with the car, but you get the idea.  You do have to be cautious of recurring monthly or annual expenses that can make you poor very quickly.  Let’s say you buy a vacation home, unless you rent it out during the time you’re not there, it can be a costly expense that will add to your annual expenses.  If you lose your wealthy status because of some luxury purchase, don’t do it.

Readers: What do you think of my definition of wealthy? How wealthy are you?  How many months (or years) can you last with your existing savings?

Related posts:

1. Will The Wealthy Donate Less Because Of Health Care?
2. “Stop Acting Rich” by Thomas J. Stanley – Book Review
3. Does Net Worth Matter?
4. Fidelity Investment Rewards Visa Card Review

By making smaller calculated bets, that can be somewhat speculative, you might be able to come out ahead.  A proper asset allocation in my opinion is the most important thing to ensure investment success. As I have mentioned in the past, any predictions about the future are like football color commentary.   While the assessments might be correct, it’s sometimes easier to make predictions when you have no skin in the game.

With all of the disclaimers stated, here is my opinion of what I see happening for the remainder of 2010 and 2011.

• US Bond Market – The ultimate be-all bubble.  In the long run, rates can only go higher, but not sure of the time frame.  We will not experience the same low rate for 10-15 years like Japan.  We don’t have savers like Japan does and a big portion of our bond investors come from outside of the USA.  You are best investing in other alternative investments.  Things like Ginnie Mae Bonds, MLPs, dividend stocks, and preferred stocks.  If you do invest in bonds remain on the short end (less than 5 years).
• Unemployment -  It will remain structurally higher for a least the next two years.  This is because of deleveraging of consumers, business and the government.  Tax increases all around and government intrusion into every aspect of business and this is causing uncertainly by small businesses to hire.  States like California cannot keep going at the rate they are going and will need either some sort of Federal bailout or reduce their workforce.  We will not see under 7-8% unemployment during this time.
• GDP – It will remain subdued for the next 2 years at under 3%.
• Inflation – Some sectors are seeing artificial inflation and growth because of government support.  The injected money has to flow somewhere with a 0% FED rate. Hence why you are seeing some disconnect in the stock market with other factors. While it should be higher than the March 2009 lows, it ran up too much, too fast.  The S&P 500 P/E Ratio at the moment is 19.53, while not at the 2000 highs is above the average of 16, so the market overall is not cheap but not outrageously overvalued.  Only a few weeks ago the P/E was over 22.
• Stock Market – The market for the most part will be sideways (moderately slightly higher) until middle of next year.  Volatility will remain increased during this period, so we will have wild swings up and down.  The VIX will remain slightly elevated above historical averages.
• Fed Rate – The Federal Reserve does not raise rates at least until after the election and is expected towards the middle of 2011.
• Double Dip Recession – While not 100% ruled out, it is unlikely based upon the existing growth rate.
• November 2010 Elections – Based upon the tea party movement with the US many people are unhappy with the amount of government intervention.  Expect a big change with incumbents in government.  Expect a pop in the stock market based upon this news either before (because the results will be obvious) or after the election results.

In my overall opinion we’ll see really crappy growth in most of the economy for the next year and half.  My opinions may change over the period of the next year and half, and will revise this page without deleting by striking through the original predictions and listing the revised date.  I will post new tweets on my InvestorJunkie account via Twitter.

Readers: What is your opinion with the economy?  What do you think will happen?

Related posts:

1. Weekend Reading for February 28, 2010
2. 2010 Is Here! Where’s the Monolith?
3. Our 2010 Hyundai Genesis Purchase
4. How Much is 1% Costing You?

I thought it would be a good time to scout for a new credit card and focus on points since we primarily pay off our card monthly.  I noticed that Fidelity offers two credit cards, one American Express based and the other is a Visa Signature Card. While the AMEX card offers 2% for all purchases, we already had a American Express with Costco.  We also wanted a more widely accepted card so most transactions could go on the card.  The Visa card offers:

• 1.5% cash back when spending up to $15,000 annually
• 2.0% cash back on any purchases above $15,000
• No limits on cash rewards
• No annual fee
• Direct deposit into any Fidelity account when the cash balance is greater than $50.00

Sign me up!  We easily charge over $15,000 per year to our primary credit card.  The card has a somewhat high interest rate (13.99%), which is fine for us since we pay it off monthly.  We charge EVERYTHING on the card: daycare, telephone bills, home repairs, grocery shopping, etc..  Heck, I would even put our mortgage payment on it if we could.  I realize that defeats the purpose of paying off the debt.  I’m just saying…

Based upon my estimates, we should get approximately $1,000 annually into our Fidelity account.

We thought it was the best credit card with cash back, especially since we already use Fidelity.  I am aware that Schwab offered a 2% cash rebate credit card.  It looks like unfortunately that offer is no longer available.  Right now, for us, this appears to be the best deal available that will deposit money directly into an investment account.

Related posts:

1. Open a Chase Sapphire Card – Get 10,000 Bonus Points
2. American Express Merchants Win 10k Promotion
3. When Should A Late Customer Get Cut Off?
4. How Much is 1% Costing You?

This interesting guest post is by Mr. Credit Card. While I (Investor Junkie) may not completely agree with his position, it’s a more common notion to let investment professionals perform the stock picking for you via actively managed funds.

I used to work in the financial industry and I can tell you that I know how difficult investing is. However, many folks are passionate about investing and most spend lots of time doing research and analysis. But in my opinion, unless you are a professional and paid to actually manage money, you are better off spending your time with other pursuits. In this post, I am going to list down the reasons why it is so difficult to actually to succeed as an amateur investor.

Analyzing Stocks is extremely difficult – One of the greatest disservice that Peter Lynch has done with his book “One Up on Wall Street” is that he has convinced many of us that investing is easy. Just buy stocks of companies that make products that you know! But if you think about it, understanding a company is much more difficult that that. One has to understand accounting, how revenue is counted, various FASB rules about stock option accounting, pension liabilities and capital structure.

Analyzing stock is simply not about looking and comparing PE Ratios. You have to truly understand a company’s business model, the products they sell, their accounting. Take banks and credit cards for example. Even the professionals who buy bank stocks did not really understand what credit derivatives were! Or how they were accounted for! If you were analyzing JP Morgan Chase, would you understand what was going on in their trading books, their loans books, their off balance sheet items or even how their Chase credit cards were doing? Look at all the research reports on AIG prior to their demise! Even Warren Buffet did not anticipate how much American Express would suffer in the crisis.

Understanding other markets – But analyzing stocks isn’t simply enough. To really get a handle of how a particular stock or company is doing, one has to be aware of what other market participants are thinking, and what they are pricing into the market. Here are some examples of other markets that a stock investor has to look at.

Options Market – One often has to check what is the options of (vol) market expecting and thinking in terms of future volatility of the stock you are researching. That involves understanding options pricing and what it means.

Understanding private equity valuation – One of the keys in understanding the backstop price of the stock. To do that you really need to understand how do private equity investors value companies and how they do their analysis of what asset sales and leverage can have on potential value.

Understanding Capital Structure Arbitrage – Many savvy hedge funds employ a trading strategy called “capital structure arbitrage” in which they either go long the stock and short the debt or vice versa. They create models to find equilibrium values of both debt and equity and do arbitrage trades if they are trading out of whack. Understanding how these folks look at markets is also necessary to understanding what is really going on with the stock you are researching.

Understanding Debt Value – Very often, where a company’s debt is trading is a leading indicator of how the equity is going to trade. Professional investors, hedge funds and proprietary trading desks look at both debt and stock value. It is important to understand the trajectory of a company’s credit rating as well. But while the pros look at these relationships all the time, most investors simply are not aware of these things. The professionals also use credit default swap levels as a guide to how their debt is trading. Most of us do not even have access to these data.

Macro economics take a lot of work and study – Aside from the amount of information that you have to look at for an individual stock, one has to be aware of the macroeconomic environment as well. It is important to understand monetary policy, currencies etc. In fact, even very few professional investors understand macroeconomics, which was why they were so caught up by the oil spike in 2007 and 2008 and the demise of the banks in 2008. Many value investors fell into “value traps” and kept doubling down on the bank stocks that they own.

But really understanding economics is an extremely difficult thing if you have not studied the topic. Simply relying on consensus forecast isn’t going to cut it. After all, no economist forecasted the near collapse of the financial system in 2008. And it is not just forecasting GDP growth that you have to understand but also knowing and understanding global central banks and monetary policies.

Asset allocation is not a set and forget thing – After writing all of the above, many would say “hey, you are right, and that is why we invest in index funds or do some simple basic asset allocation and be hands off most of the time. And that is true, the majority of us should simply invest in index funds. That is the easy part. The hard part is deciding on what your asset allocation should be. How much of your asset allocation should be in stocks vs bonds, international stocks vs domestic stocks, domestic vs international bonds. How much commodities should be in your portfolio? How much cash should you carry? How much alternative assets you should have? How often should you rebalance your portfolio?

Folks like University endowment funds hire huge staffs just to perform this function. And even then, they have their bad years.

Ending Thoughts – Investing is a really tough job. But books like “Beating the Street” from Peter Lynch and tons of others give the impression that it is easy. It is definitely not easy managing money (whether your own or others). Many folks really spend too much time on their investments or portfolio. But the truth is that those time spent is mostly futile. Only folks who are professional investors should spend all their time on the financial markets. And when I say professional investors, I mean folks like money managers, hedge fund managers etc. You may spend as much time as a successful manager on the “markets”, but the hedge fund manager is likely to make many more multiples of what you and I can make! Even then, a successful fund depends on more money being invested in the fund from investors. That is how money managers make their money. They develop a good track record and investors give them more money to manage and they make more money from fees. But the ordinary folks can have a “good year” and nobody is going to give you anything to invest! Hence, what really makes you more wealthy is how much income you make and how much you save and not really the performance of your portfolio! Focus on making more money from your career instead rather than chasing the extra 1% from your portfolio.

Readers what do you think? Do you think investing should be left to the professionals?  Isn’t it true even “professionals” rarely beat passive indexing over the long haul?

Related posts:

1. The 4% Rule to Investing
2. How is Investing and Owning a Small Business Related?
3. Morningstar Review
4. Ginnie Mae Investing

When driving from your home to a location you’ve never been before, how do you get there?  In today’s world, you plug the address in your car’s navigation system, and based upon the parameters you select, it will tell you how to get there.   More fancy GPS systems also have available:

• The estimated time of arrival.  This is based upon the route chosen, speed limits on the roads to travel, and your previous average speed.
• Possible alternative methods to get to your destination (the super fancy ones have real time traffic info)
• The ability to stop at points of interest (i.e. gas station)

Along the way you can make adjustments to your route and the GPS will adjust accordingly.  If you get off track your nagging GPS back seat driver will tell you “Please make the next available U-turn”.  With the magic of computer technology, you eventually arrive at your destination.  All of this would not be possible if it weren’t for the GPS monitoring important metrics: your location on the earth, direction, and speed.  This metaphor should be used for becoming financially independent.

What metrics should you be monitoring to achieve financial independence?  After all if you aren’t monitoring your goals, how do you know you are going to get there?  I recommend setting up an Excel spreadsheet, and enter the information on a yearly basis.  Here is the information I use to monitor our family’s progress:

• Year End – The year the below information is filled out
• Age – Your age
• Net Worth – The total amount of your net worth.  I do my total assets minus my liabilities.  Even though your primary residence is not an asset, I include it in my calculations.
• Net Worth Change – The difference in your net worth from the year prior.
• Net Worth % Change – The percentage your net worth changed from the year prior
• Net Income – The total amount of income earned from active (i.e. employment) and passive (dividend stocks).  I do not use the government’s AGI formula.  I use the raw net income before any tax deductions.
• Net Income Change – The difference in your income from the previous year.
• Net Income % Change – The percentage your income changed from the year prior
• Amount Saved – The total amount saved in that year.  Include tax differed (i.e. 401k) and taxable accounts.
• % Saved – The amount saved in percentage to your net income
• Total Taxes – The amount of federal, state and local taxes you paid.
• Effective Tax Rate – This is your net income divided by your total taxes.

Once you start recording this information on a yearly basis, you can start asking questions like:

• Has my income kept up with the inflation rate? If anything it should surpass inflation by a wide margin
• Am I saving enough? Am I saving too much?
• How is my effective tax rate compared to my peers?  This will become a more important issue in the future as taxes increase.   It’s not how much you make, it’s how much you keep that’s important.
• Most importantly, at what age will I reach financial independence? Am I on the fast track, or did I hit a major roadblock?

Once you start collecting this data over time you’ll have great nuggets of information.  This can help predict future numbers and show progression.

Some other possible metrics to monitor:

• Amount of consumer debt
• Amount of passive income
• Yearly expenses – Which can help track your estimate for if and when you retire.  I would exclude unusual, one time expenses (i.e. home remodeling)

Readers: Do you have any other suggested metrics to monitor?  Would you be interested in a pre-made Excel spreadsheet that had all of the fields and calculations already made for you?

Related posts:

1. Does Net Worth Matter?
2. “Stop Acting Rich” by Thomas J. Stanley – Book Review

With index funds, you are investing a bucket of companies that match specific criteria.  For example, the S&P 500 is a very common index.  To the average observer, the S&P 500 looks like a mystical black box, and in a way it is.  The issue is it’s hard to relate to a specific company within the index.  There is nothing wrong with index investing, and I believe it’s an easy way to invest and beat 80% of the active mutual fund managers in the process. It’s a very passive process and you are betting that the pool will do better over time.  What makes index investing great, can also lead to just average performance. For the purpose of this article I won’t talk about proper asset allocation, but that is one method to help improve passive investing.

The issue with index investing is you are betting that the overall economy (macroeconomics) will do better, and not a specific stock.   As history has shown, the economy generally grows over long periods of time (5-10 years), so it’s a smart bet to take.   This then means most company stocks will increase over time, and in turn will increase the value of the S&P 500.   Just like a life preserver that rises with the tide, stocks collectively rise with the economy.

Now take an index, and compare it to a specific stock.  When you invest in a specific stock, you are dealing with the specifics of that company.  It’s not uncommon for a specific company to grow, while their competitors are contracting, or even the entire economy is in a recession.  Investing in specific stocks is where the experience of entrepreneurship is key.  You can apply your small business skills to investing in stocks. When you own shares of a specific stock, it’s like being a silent partner in that business.   When owning shares in a company you trust that the board of directors and the executives will properly manage the company, and you’ll get a return on your investment.  Your skill sets are even better used when investing in sectors you know (in my case technology).  You know the trends in the industry.  You know the good companies from the bad ones.

Now lets talk about the financial side.  At least with value investing, you analyze the financials of a company and determine their tangible book value.  That then in turn can be derived down to a price per share of their stock.  The question is, does the stock and the valuation you determined match?  Is your valuation higher or lower?  If the valuation is higher than the current stock price, that means the stock is not priced correctly and a possible stock to buy.  If you believe in efficient market hypothesis, this should never happen.  Does the market always price a stock correctly?  From my experience, the answer is definitely no.  For the long term yes, for the short term maybe no.  Fortunately, in the short term (weeks, months and in some cases even years) a stock can be priced lower than it’s real market value.  Benjamin Graham called this Mr. Market.  As we mark the 1-year anniversary low point in the Dow Jones, it is a perfect case in point.  During that time there were many stocks priced as they were going out of business, and the world was going to end. Warren Buffet’s has stated “Be greedy when others are fearful” and this definitely applied last year.  Many stocks last year had red tag sales like “40% off!” and “buy two shares, get one free”.

To give a specific example from my investments, I’ll mention Apple (AAPL).  At their low point they were priced at around $80/share, yet at the time, they had over $30/share of cash on hand.  Meaning $50 of their price was for their future sales, their technology patents, other assets and employees.  Without going into the details of financial analysis, it was a real bargain for sure. People panic when stocks reach new lows, yet flock to stores when things are on sale?  To give a little insight, they are exactly the same! The real skill is being able to spot the real bargains stocks from the artificially marked up and then slightly marked down (net means it’s not a bargain, which is also a tactic stores do).

To help you determine what’s cheap and what’s expensive you should have a good understanding of financial statements.  At least from my experience in owning a business, it’s the most important asset I have.  If you don’t, you might as well pack things up and go home.  With that said, what applies to your small business, works with larger corporations.  I recommend buying some books on the subject.

As a business owner, it’s not uncommon for me to deal with these issues on a daily basis:

• Cash Flow – Do we have enough money to pay bills and salaries?
• Assets and Liabilities -  How much debt we have, and at what interest rate?  Do we have too much debt?
• Business Planning – Is my business plans solid and will they generate income?  How much income should we expect?  Where is the market heading in my industry?  What are the trends?
• Sales and Marketing – How can I attract new customers to our product/service?

All of these are also important factors when doing stock picking.

My suggestion.  Own a business.  Even a part-time business that ultimately results in a failure.  At minimum you’ll get a priceless education about investing and entrepreneurship.  Best case, you’ll have a profit, turn it into a full time career, and become a good investor in the process.

Disclosure: Long shares of AAPL

Related posts:

1. How I Learned Everything About Business By Owning A Lemonade Stand
2. Is Owning a Toyota Risky??
3. 2010 Is Here! Where’s the Monolith?
4. The 4% Rule to Investing

In many ways we fit Thomas Stanley’s “The Millionaire Next Door” profile.  I think it’s great that Thomas details the life of an average millionaire, and differentiates them from the glittering rich.  Last year we saved over 30% of net income (that’s before taxes).  I suspect the audience that reads my blog saves at least 15% of their net income per year.  If you aren’t, you should be doing this a minimum to have a decent retirement.  At least from the research I’ve done, if you save 30% of your net income you’ll be pretty set.  It’s of course relative to your net income.  For most people, it’s easier to save 30% out of 250k net income, then out of 50k a year.

The question I have with saving, is there such a thing as being too frugal? Is it possible to save too much per year?  At what point are you saving too much?  One way I’ve looked at it is saving should have an end goal in mind.  What’s the purpose of saving? After all, it makes no sense to be the richest man in the graveyard.  When you die you can’t take it with you.  I’m not saying you shouldn’t leave money to your children, relatives, and your favorite charity.  Wouldn’t it be better, while you are alive, to give a portion of your money these people?

Unfortunately you never really know when your number is up.  Today you could get hit by the proverbial bus while crossing the street, and your savings will be for naught.  Shouldn’t we plan for tomorrow because in most cases tomorrow will come?  In addition, shouldn’t we also live for today – the here and now?  This is something I’ve wrestled with for many years and come to the conclusion, like most things in life, it’s about balance.  I should save and set specific goals, yet also don’t be afraid when I hit specific targets to buy some material things.

We have setup savings goals for some of the material things we would like to have in our life.  If you work hard, and make sacrifices shouldn’t you be rewarded in the end?  We aren’t doing it to impress our neighbors or friends. We are doing it for ourselves.  For example, I’ve always wanted a nice big screen TV for the media room in our basement.  In 2009, I setup a goal of how much income we needed to make, and how much we needed to save for the year.  We hit both marks and rewarded ourselves by buying the TV.  The TV wasn’t cheap, and came to $5,000.00.  Could I have taken the money and saved it instead?  Could I have invested the money into some stock, bond, or business?  Of course yes, but how much do I want sacrifice in my life?  The classic saying “you can’t take it with you” is something that should always be considered.  We met our yearly goals and rewarded ourselves in the process.  In Thomas Stanley’s latest book “Stop Acting Rich and Start Living Like a Real Millionaire“ (which I just recently reviewed) he states:

I don’t mean to suggest that one live like a miser; the occasional guilty pleasure is perfectly acceptable.  If you work hard and save accordingly, you should enjoy a treat from time to time.  The problem is that people have come to enjoy the guilty pleasure every day to the exclusion of working for a financially independent future.

My recommendation is paradoxical – plan for tomorrow, but live for today.  You never know when your number is up.   This applies not only to money, but any aspect of your life.

Readers, what do you think about being frugal?  Is it possible to save too much?

Related posts:

1. “Stop Acting Rich” by Thomas J. Stanley – Book Review

Three Types of Wealthy

In this book Thomas breaks down people into three classifications:

• Glittering Rich – The ones you see and hear about in the press.  It is what most think is wealthy. They are hyper-consumers, but no matter how much they spend it’s not going to affect overall net worth.
• Income Affluent (IA) – Typically high income, but low net worth. They try to keep up with the Jones (glittering rich) and fail miserably.  They aren’t wealthy as they have very little saved.
• Balance Sheet Affluent (BA) – The more common wealthy that plan to be wealthy by savings and investing.  This type of person has been the focus of most of his work.

From reading his previous work, I just know one of our neighbors fits perfectly into the Income Affluent (IA) category – they lease their BMW, are constantly doing construction on their house, and dress in the best clothes.  I’m not mocking them, but I know that’s not how my wife and I want to live.  After reading his books, it becomes an eye opener of not only what to do with your personal finances, but what NOT to do.

The Best Offense is the Best Defense?

Thomas frames perfectly how to become wealthy either by a great offense (high income), or defense (being frugal and saving a decent amount of income). Most have the chance of becoming wealthy by great defense, and not by a high income. He states:

The only way you will become rich is to play extraordinary defense like those millionaires at the other end of the continuum: by living well below your means, by planning, savings and investing. We need to stop acting rich, and you need to adopt the values and lifestyles of self-made millionaires.

How Wealthy are you?

Comparative to your peers how do you stack up? I’ve always been the type of person who beats his own drum, and doesn’t follow the herd. After all, do what everyone does, and you get what everyone has. With that said, and my computer science background, I love stats.  I always want to know how my current measurements stack up.  Am I on track, or do I need to amp up our savings? Thomas has a great method to help measure becoming BA wealthy.

Use the Wealth Equation to determine how you stack up. Simply stated, your net worth [augmented] should equal 10 percent of your age times your annual realized household income (0.10 x age x income = expected net worth). If your actual net worth is above this expected figure, I consider you’re affluent, given your age and income characteristics.

This was originally in his first book “Marketing to the Affluent“. In his newest book, he adds the wealth index (WX) to differentiate the BA group from the IA group:

The threshold WX for those included in the BA group was 1.84. The median WX for those in this category was 2.49. In other words, the “typical” member of the BA group had an actual net worth that was 2.49 times the expected figure, given this age and income at the time he first reached the seven-figure wealth threshold. The IA, interesting enough, had a much lower net worth respective of their age: The IA millionaires ranked in the bottom quartile along the WX continuum. The highest WX within this group was 0.880; the median WX was only 0.665. This means that the typical IA had an actual net worth that was only 66.5 percent of what was expected, given his age and income at the time of hitting the millionaire threshold.

Tax the Rich

With all of the current rhetoric in government to tax the rich, otherwise known as IA in “Millionaire Mind” speak, they are targeting high-income earners.  Currently and shown throughout history, accumulated wealth isn’t usually taxed -  it’s income.  Thomas confirms that high-income earners are targeted by the government:

The average IA paid more in income tax than the typical BA generated in income during a year: $95,847 versus $89,167. Overall, IAs pay nearly six times more in tax than the BAs. IAs pay the equivalent of about 10 percent of their wealth each year in tax. BAs pay less than 2 percent. The large tax burden associated with being an IA is reflected in their less-than-stellar wealth index.

He then continues:

This situation will worsen given federal and state tax increases that high-income earners now face. The road to becoming rich via the IA method is lined with income tax tolls and consumption-inspired roadblocks and detours.

So going under the radar of what currently is considered rich (the sub $250k threshold) might be a better route to minimize your taxes, and lower consumption. This is something I’ve always suspected and the book’s data shows this.

What Motivates the Wealthy?

For me I’m always interested in the psychology aspect of things in life – why do people want to become wealthy.  What’s the reason?  Thomas states:

Most millionaires are motivated by their need to gain financial independence.  For most, consumption is a nice side benefit to becoming wealthy.  It is not the most compelling reason why these people become financially successful.  When asked, they will tell you that given the choice, they would readily unload their consumer goodies before ever giving up their independence.

I agree, the things don’t matter; it’s having enough money to choose what you want to do in your life.  It’s the ultimate freedom that allows you to live your life to the fullest.  It’s not about purchasing some fancy car.

Where do Hyper-Consumers Live?

This is something of concern for me since I live on Long Island, NY.

The highest concentration of glittering rich people in America lives in the Tri-State metropolitan area of New York.  Understandably, this area also contains the highest concentration of aspirationals.  Not only are we what we eat, we are also the product of where we live.

I live only a 1/2 mile away from one of the most frequented malls in the country.  During the past two years, I’ve been amazed at the number of cars I see going into that mall.  You would never know we are in a severe recession.  It’s also amazing that my wife and I don’t frequent the mall that often.  Typically it’s get in and get out.  Buy what we need, and go home.  I guess we are fortunate enough to have the discipline of not going on weekly buying sprees.  Thomas continues in his book stating:

Trey lives in the South, one of the areas that holds the lowest concentration of glittering rich and aspirationals.

It seems the biggest factor in determining you’re wealth is the choice of where you live.

The bottom line is that your choice of house and neighborhood will have the biggest impact on your balance sheet.  Your choice of home, more than anything else, will have the greatest impact on your spending – either a lot or not so much.

While we don’t live in a very rich neighborhood, we see hyper-consumption all around us and it’s hard not to mimic what others do.  It’s part of human nature.  Maybe I should move my family to the south, to a low or no income tax state.  I love the term Thomas uses in the book he calls many income affluent (IA) are “Big Hats, No Cattle”.  That term could definitely apply to many around the area where I live.

In Summary

This book is more a compilation of the author’s previous works then it is a completely new effort.  Yes, some of the content is repetitive, and it’s possible the book could be summarized into 30 to 40 pages. Even so, it’s a quick read and I enjoyed reading it.  Like his previous books, it is slightly preachy in the conclusions he derives from the data. While I don’t flat out disagree with his conclusions, it is possible alternative conclusions could be drawn.   If you have read any of his previous work, there are some new nuggets that might be worth the price of admission. If you never have read any of his previous works, you should definitely pick up this book.

Rating: 3 1/2 out of 5 stars

Related posts:

1. “How to Make a Fortune from the Biggest Bailout in U.S. History” – Book Review
2. Review of “The Investor’s Manifesto” by William Bernstein
3. Morningstar Review
4. Does Net Worth Matter?

The Details

The book is a quick read, and is slightly under 200 pages.  Ron quickly dives into where we’ve been with a quick history lesson.  He then adds a dash of some rudimentary investor psychology.  Ron then allocates most of the book to discuss what opportunities he thinks exist in the future.  Ron states you should invest in these areas:

Whether you agree or disagree with the areas is a matter of opinion and it is fine to disagree.  Some of his ideas to invest aren’t bad in of themselves.  The concern I have is some of the content might be outdated in the six plus months when the book was finished.  With such timely information, Ron may have been better suited of pushing this out electronically as he was writing it. Another option, there are also many traditional financial magazines this content may have been better suited for.  What may have been a great area to invest in when he wrote the book, say for example financials, could be considered priced high at the moment this blog post is written.

The other concern I have is some of the generalized statements mentioned in the first two chapters.  He mentions:

While I believe it always pays to study the past, a quicker way to profit, in this market, is simply follow the pros . . . in the present.

While there is some truth to that statement, my question is what professionals do you follow? Which ones do you NOT follow?  If you are looking for professionals to aid in your investing, why not invest in them directly, ala a Bill Gross from PIMCO mutual funds?  If you believe in Warren Buffet, and his investing methodology, should you not just buy Berkshire Hathaway (BRK.B)?  Buying direct, so to speak, requires a much less thought process, and easy to implement.  Instead Ron goes the sexier route, and advises to pick stocks and mutual funds that the professionals are picking.  Again not necessarily a bad investment strategy, but doesn’t offer enough details to properly mirror an expert.  Included in the book is some basic market psychology, and does have some correct general assertions like:

Every investment is fraught with risk, although the riskiest time to invest, to be quite honest, is when investors are most complacent about the dangers of investing.

Ron does get into some specifics of sectors, and even specific stocks he’s invested in, in the past year.  He does present some good ideas, and valid arguments why they should be purchased.  He also discusses some advanced investing options that the average investor may not be able to easily take advantage of.

With its timeliness, I’m not sure if this should be in book form, and not in a multi-part Barron’s article.  Having the lag of six to eight months from writing till publication, we have a crystal ball to see how some of Ron’s predictions have worked out so far.  This can be a good or bad thing. Ron mentions in his book about Sam Zell and his Equity Residential REIT (EQR):

According to recent published reports, despite the troubles in real estate, EQR’s properties are 94 percent occupied and rents have been quite stable.  The dividend yield on EQR is above 8.5 percent return on your investment annually[.....]  The company has indicated it has no plans or reason to cut its payout – it has never done so since it came to market.

Whoops! Since this statement has been written EQR’s dividend has been reduced to 4.05 percent.  So far, not a great pick. It’s my opinion that REITs on the whole are not a good investment yet, and Ron may have jumped the gun on this one.  I believe more headwinds exist in the next year or so, and mainly for commercial real estate.  Though he is correct on this statement about REITS:

I say that the yield, or more precisely the dividend yield should not be too generous because, often, an extraordinary dividend yield could be a sign of trouble.

He should have taken his own advice, and applied it to Equity Residential.  His assumption is correct, and it applies today to REITs even in the traditionally “safe” range of 7 – 9 percent.

All is not lost with his book.  He does discuss  home purchases with the quote:

A home is not necessarily an investment, but it is the biggest single purchase you will ever make.  And there is never a good or a bad time to buy.   There are better or worse times to buy, based on market cycles…,this is among the best times in modern history to start building equity that you’ll have for your golden years.

His is clear that the  primary residence is not a piggy bank, and applaud the honesty he treats the subject.  He states it should be looked at as an asset that more than likely will rise in future years.  Obviously purchasing a primary home is very location specific and a personal decision.  What might be a great time to buy in say Dallas, might not make sense yet in New York City.  Bottom line you buy a house to live in with the prospects it should increase in value over time.

In Summary

Ron’s book while not bad, it may have been better suited in some financial magazine or online publication.  Some of his content contained very timely investment ideas.  What may have been a great opportunity eight months ago, may not exist today.  He does have some interesting ideas, and the book can be perused for areas to invest into.

My Rating: 2 1/2 out of 5 stars.

Disclosure: Book courtesy of TLC Book Tours.

Related posts:

1. Morningstar Review
2. Review of “The Investor’s Manifesto” by William Bernstein

It’s amazing how much money you lose if you just make 1% less in returns, over the course of say 30 years.  It’s only 1% we are talking about, and can’t be that big of a difference.. can it?  To simplify things, let’s use a retirement account as an example.  Depending what numbers you look at, returns on the US stock market have been around 8-9%.  Let’s assume all money is invested in the U.S. stock market, and not get into proper asset allocation.  For our hypothetical example, let’s use an 8% return on the money invested.  It’s invested in a 401k/IRA, so you don’t have to worry about taxes.  While investing for 30 years $10,000 is added annually.  Here is the break down every 5 years, and a comparison to a 7% return.

Over the course of 30 years your return would be $1,132,832.11.   OK, let’s assume you didn’t make some wise decisions, and over the course of 30 years your return was only 7% instead.  Your total return has been reduced to only $944,607.86.   A significant difference of $188,224.25 in the net result.  So a 1% return difference in your investing can be dramatic.  Over 30 years you have 16% less in your pocket.  Notice after only 5 years the difference can become dramatic.  Now you know why investors scour constantly for the highest returns possible.  Obviously notice as time marches on the difference increases dramatically.  That’s the “magic” of compound interest.

The Takeaway

I think two things can be said about the relieving results.  For investing and saving -  start early, do it consistently, and do as much as possible without cramping your lifestyle.  Secondly, what most people don’t realize is how much expenses can eat at your returns.  It’s not uncommon for investment fees to be higher than 1%.  Over the long haul, it’s common for active investments to trail an index because of their management fees.  The active investment becomes more or less the index, and mirrors its results.  The net effect is the expenses they charge equal the amount they drag against the index.  This is one of the valid reasons not to use active management in your portfolio.

The sad part is most people don’t consider expenses as part of their return.  For the average index based mutual fund the expense fee is 0.50 -  1.00% annually.  On actively managed funds, the rate is much higher.  Keep this in mind when choosing your investments, and choose your investments wisely.  Otherwise over the course of 30 years the difference in return can be dramatic.

Related posts:

1. The 4% Rule to Investing

Portfolio X-Ray tool

Click for a larger view

As I discussed in my review of “The Investor’s Manifesto” by William Bernstein, I definitely think asset allocation plays an important part of a successful investment strategy.  If you are doing passive investing, too many eggs in one basket can lead to too many broken eggs.  The Portfolio X-Ray tool that Morningstar offers is second to none. It offers the great details that would be very difficult to compile on your own.  It will analyze your holdings and expenses, revealing strengths and weaknesses that affect your financial goals.  While a mutual fund’s prospectus may state its allocation in only US based companies, the statement may not be completely true.  Morningstar takes a mutual fund’s quarterly SEC reporting of their individual stock ownership and uses it to help determine your asset allocation.  So while on a macro level you may have the correct asset allocation, you could be heavily weighted in a particular stock or category unknown to you. This could unknowingly increase your investment risk and decrease returns.

To get started you manually enter your portfolio information.  I wish there was a way to link from Mint, but it does have an option to import from a Quicken .qif file.  If doing it manually it’s a tedious process but well worth it when finished.  Though keep in mind anytime you update your portfolio you must re-import/adjust on Morningstar’s web site.  The first time I plugged in our retirement portfolio, I was amazed with the detail it offered and adjusted our portfolio to the goals we had.  I found out we were too much invested in a specific country.

iPhone App

They recently updated their iPhone/iPod Touch app.  In version 2.0 they added the ability to sync portfolios from the web site to your iPhone.  This feature is a big addition, compared to the previous version. I’ve tested their latest version, and while better than the first, it still lacks the depth of information available via the web site.  It’s free to download, but doesn’t offer that much additional information available from other free apps like Bloomberg’s and Yahoo’s tech ticker.   Personally if I’m on the go, I’m more interested in news and Yahoo’s Tech Ticker app.  It is better suited for my needs.  Though I can see some value for the jittery investor where they can see up to the minute valuations of their portfolio.

In Summary

Morningstar premium membership offers a wealth of information, and is a must have for any investor junkie like myself.  The yearly fee is $179.00 and is well worth the cost.  You’ll quickly recoup the Morningstar yearly fee because you’ll be able empower yourself to make much better investment decisions. You can test drive their service free for 14-days and with no obligation.  Morningstar’s service is like getting an investment adviser, without the costly fees. You can also sign-up for their free service which excludes the premium options.

Related posts:

1. Review of “The Investor’s Manifesto” by William Bernstein
2. What is a Master Limited Partnership (MLP)?
3. Should I Buy Gold?
4. Mint Review: Should I Use Mint.com?

1. As a 13 year-old boy I vividly remember watching that movie thinking my future will be something like this in 2010.  Unfortunately fiction sometimes does not match reality.
2. The movie came out in 1984 (over 25 years ago) and thinking what goals and dreams I’ve had in the past 25 years.  What have I achieved and what things I still want to do.

The year 2010 is now really here and it’s time to do some goal setting.  My local gym was already beginning to crowd up with people to loose weight.  Like every year, come February 1st, the new faces will be gone.  If you are going to create a goal, create one that will be long lasting and with small incremental steps.

I like making 10-year goals and reviewing my previous 10 years. Nothing like the change of a decade, a zero at the end of a year, to review these items. Creating these goals gives me something to shoot for and gives me great direction. You see I’m a dreamer, and I think it’s important as an entrepreneur to constantly dream of how things could be.  Daydreaming might be fine, but no successful businessperson just didn’t wish things into creation. They took action on their dreams to make them into reality.

My Past Ten Years

Obviously we’ve had many political, technical and economic changes in the past ten years. Things that happened in the past ten years: dot com stock market crash, 9/11, two wars, mortgage meltdown, stock market crash part deux, first African American President, and don’t forget Twitter.

I would rather discuss things on a personal level, as those things seem to affect you more.  Since I don’t know what happened to you, I can discuss what happened to me.  For me personally, the past ten years have been a doozie.  In somewhat time order:

• Quit working for a company named Commerce One to start up a business full-time.  At the time Commerce One was a very well known start up.  It’s IPO was one of the biggest gains in price of all time.  I had my boss and people who I worked with say I was crazy to leave.  If you look around now, you can see why they were nicknamed Commerce None.   At the time, it was one of the toughest decisions I made, but in retrospect is easy to the many more difficult decisions I make today.  Anthony Robbins has said making decisions is similar to working out; the more decisions you make the easier it becomes.  What was once hard to bench press, becomes much easier if keep pushing yourself.
• I started this business with partners who had an already existing business.  I thought they would add, and give valuable wisdom to the business. In retrospect, they did neither. Though the experience I gained in other areas was priceless.  For future reference, I need to make a mental note that experience in one field does not translate to another industry.
• Put a down payment on a rental property on the morning of September 11, 2001.  Being this was my first rental property, I was nervous.  Coming out of meeting with my lawyer I initially felt good, until I turned on the radio. Gulp! I thought I just made the biggest mistake in history.  I still own the property today; so far it has had huge gains capital gains (even after the mortgage meltdown) and has been cash flow positive since I purchased the unit.
• After years searching for my soul mate, I found my wife Jeanne.  We met, believe it or not, online via Match.com.  Since the author being uber-geeky thought this was the best way to find women via the virtual-bar scene.
• Got rid of my first round of business partners.  Brought in another business partner who had no experience, but had lots of “gusto”.  I thought it would be a good fit.  Two and half years later he came to my house dumping all of the company assets he had, and told me he quit.  In retrospect, this turned out to be a great thing for the business.  I was able to streamline operations that my business partner did not want to do.
• Jeanne and I married, and we sold her house at the peek of the real estate bubble.  We then proceeded buy a house closer to NYC and her work.  Our new house so far has since decreased 15% in value, but we don’t plan on moving anytime in the near future.
• Bought assets from another company to merge into my existing company.  It was a mini MAA (merger and acquisition) because it was only $60k in assets.  I was partly sold a bad bill of goods. In reality the owner was either; very disorganized in their operations, flat out lied about who were active customers, or a little bit of both.  This business owner later sold their entire business to another company.  Hmm…I wonder how that transaction went.  From my experience, I was not impressed with their business experience they now promote they have.  Either way I have no hard feelings for the person, and wish them the best.  I’ve easily recouped the costs, and then some from the purchase.  Overall it was a great experience in merging assets from another company.
• Jeanne and I had two children.  Opened up 529 investments to ensure we can pay for their college education.  We are now expecting our unexpected third child.

I can say, for the exception the revolving door of business partners, all of these goals were listed in the late 1990′s.  From my direct experience writing your goals down is a very powerful experience.  Did I achieve all of my goals I set out to do? Absolutely not.  I have modified some in the past 10 years, others I no longer want, and others I have yet to achieve.

My Ten Year Goals

As I’ve mentioned before, I have very long term horizons in my investment goals.  I look at investing as at least a 5-10 year process.  Along the way I make small incremental steps.  Here are my financial goals for the next 10 years:

• At least $200,000 yearly passive income via stocks, bonds, real estate and my businesses
• Have at least $75,000 in each child’s 529 education plan (as the oldest will be 14 years old)
• Have enough in our retirement accounts where we “could” retire.

I say “could” retire as I don’t believe in retirement per se, because in many cases retirement equals death.   I believe in enough money invested where you didn’t have to work another day again.  You work at only the things you love to do without worrying about money, and what I define as truly being wealthy.  For most people that magic number is around $2-3 million in net worth.  What matters more though is not net worth, but your cash flow.  Personally, we are very much along that way and should reach that goal long before the ten years are up.  I should also state the passive income is truly passive; no more than 5 hours per week should be needed to ensure these assets are performing.

I will not bore you with the detailed steps on how I plan on achieve these big goals, but I will say you need to detail out each of your grand goals.  There are many great books on the subject of goals setting and suggest you start there.

In Summary

You see, like in my case, a lot can happen in ten years.  If you plan it out, you will be able to anticipate things down the road.  You’ll be able to seize the opportunity when the time comes. The future will most definitely come; it’s your objective to plan for it.

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1. Merry Christmas! We are Canceling Service with your Company

My company is an IT consulting firm, and one of the services we offer is on-site technical support for servers and IT operations.  The client is an 80 million plus year net income business, yet their IT budget was less than 1% annually.  This is a company that has over 300 employees.  To give perspective, in some years our own IT budget for servers was greater.  Even in their case, with manufacturing businesses being on the slightly cheap side, they are typically in the range of  5 – 10%.  We were always the fall guys for their lack of spending in IT.

How does this story relate to risk?  The client once told us, if their servers were down for an 8-hour business day, they loose a mythical $100,000.  You would think that with a potential loss that large, you would invest money and time in the proper infrastructure.  A little $50,000 from petty cash would have put enough in place to prevent any major crisis.  Problem solved, you’re the hero.  You know the things most business should do; proper risk assessment and risk management.  We’ve pitched them five ways to Sunday on why this is a no brainier of an investment.  I’ve unfortunately learned from life, like many Americans engorging too much on debt, most people don’t plan to fail, but fail to plan.  Business, as in life, and investing, is a chess game.  I try to plan five or more moves ahead. With system administration, if people see you running around like a headless chicken doing a lot of work, they assume you must be doing a great job.  The secret is that the exact opposite is true.  The system administrator who monitors their setup very closely, and takes action before items become critical is the one to follow by example.

In the case of this poorly planned customer, wouldn’t you know that one day, their myth turned into reality.  The manager calls me directly, and in a panic, needs to have my tech get to their office immediately.  Of course caring for the customer, we dropped every other customer, and were able to get over there within an hour.  Even then, their one server for the task was down the entire day.  The point of the matter, in business, as in investing, and even life there is risk all around you.

If the customer invested $50,000, it would have prevented them from losing $100,000 in worker productivity.  It’s the classic, penny-wise, but pound-foolish.

I know in the end, loosing this customer, is best for my company.  To put a positive spin on it, I’m glad they are moving on to another vendor.  This also puts the flame under my butt to find other customers that are more aligned with our beliefs.  I’m happy to replace that income with a more positively aligned customer. I’m not so much disgusted with the customer leaving, it more a matter that I have tried to have a somewhat personal relationship with the manager.  Like many previous un-returned phone calls and E-mails, I assume he will not contact me directly to cancel service.  The guy doesn’t have the integrity for that.  I’m sure we’ll get the notice from their billing department.

I left the corporate world to better my community and myself.  I wanted to run a business in the way I would feel proud.  It’s interesting; many people start their own business so they don’t have to work for “the man”.  When in-fact, I’ve got news for you, “the man” works everywhere.  He’s your customer, vendor and employees.  By becoming an entrepreneur and starting a business, you will ALWAYS have to deal with “the man”.  In some cases in even more annoying ways. I’ll give you a little secret to my business success.  Have a solid ground on your beliefs, ideologies on how to run your business, and stick to them no matter what. After all, you have to be happy with yourself in the end.  Life is too short to not ensure you have a meaningful impact with the people around you.  Shed the client, customers and employees that have shown to have a negative influence.  In the past I have “fired” customers because of their rudeness, or if they had unreasonable expectations with our service.  I won’t kid you, we work 110% to try to keep our customers are happy.  Unfortunately the 80/20% rule (otherwise known as the Pareto principle) applies to your customers and this customer was in the lower 20%.  A funny side note – the cheaper customers are usually the most difficult clients.

You’ll have to excuse me now while I go try to get some new customers.  Merry Christmas, Happy Holiday’s and I hope you have a great and prosperous New Year!

Update (December 23rd 2009): The client has finally responded to our Emails, after we approached them about the domain registrar changes.

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As of right now, Fed rates are expected to stay this low for a good portion of 2010.  I’ll even go out on a limb and state these traditionally safe investments, with their current rate of returns, are not safe.  Rates are artificially low, and can only go higher from here.  In the long run, any of these investments run the risk of not keeping up with inflation.  Inflation risk is a real issue, that’s rarely mentioned when investing.  Inflation for the previous 30 years has averaged 3.28%, and it’s a good chance to be higher for the next 30 years.  The Federal Reserve is punishing savers/investors, to help debtors, and that’s a topic for another discussion.

So what’s the 4% rule?

I consider this as part of my security bucket of investments.  These are investments that have a low beta, but yet generate monthly income.  I have this rule because of the tax man, inflation and expenses quickly eat at your return and can make your return effectively zero.  If expected returns are lower than this, in my opinion, you are best not investing in that asset.  If you have a 5+ year investment horizon, you should get much more sizable returns on your investment.  Any investment goal of less than 5 years should be only put into fixed rate investments, even if less than 4%.  The goal is to prevent having to take the money out of the investment at an inopportune time.  Money invested should be used for the ultimate goal to increase cash flow and should not be needed for any short term goal.  My investment horizon is always 10 – 20 years and something I’ll discuss in future blog posts.

One of the basic rules of investing: The higher return, generally higher the risk.  Depending upon the investment, there are things you can do to mitigate risk, but the general rule applies.  For the past 100 years the return of US stocks has averaged 8%.  With your investment, you may do better or worse, but is your top line goal.  Annual investment returns above 8%, while possible, the odds become stacked against you.  Getting somewhat safe returns of above 4% isn’t difficult, and should be the goal you shoot for.

Investments Options

The government is forcing investors, on purpose, to put their money into riskier assets.  The question becomes, what other investment options are available that offer higher returns, yet are not as risky as say stocks?  Since traditional fixed rate investments are earning nothing, what other alternative investments are available?

• Peer-to-Peer loans.  See my Lending Club Review
• Ginnie Mae bonds
• Master Limited Partnerships (MLP)
• High interest savings
• TIPS and I-Bonds
• Corporate and junk bonds
• Muni bonds
• High dividend stocks
• REITs
• Whole life insurance
• Debts owed

Each can and will be a future blog post discussing each in detail.  Like the song, “Which one of these is not like the others?” It’s the last one of course. Any debts you may have are not traditionally thought of as “investments”.  Benjamin Graham mentions in “The Intelligent Investor”, like a scale, investments are always compared to other possible investments.  Although debt owed is not discussed, I believe it should also count.  For example, if you have a credit card rate that is 8% or greater you should pay off that debt first before adding additional investments to your portfolio.  It’s a guaranteed rate of return that’s hard to beat.  It becomes hard to find investments that can consistently beat 6-8% year after year.  If you find something that will, go for it, but the odds are stacked against you.  Home mortgages, because of their tax deduction, can have a higher APY (8-10%) before pre-paying.  Bankrate.com has a great calculator for your mortgage interest rate after taxes and use that as a guide for the number to beat.

The questions you have to ask with any investment:

• Can I get a better return somewhere else?
• Does that investment have a similar or less volatility?

As the Federal rate increases so will the traditional investments in: CDs, government bonds, and money market accounts.  Once their returns go above the 4% annual rate I will consider them attractive investments again.  For now, I am placing money from my security bucket into alternative investments.

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1. Lending Club Review – How to Become a Bank

Photo Source: Phoney Nickle@Flickr

I see all of these financial blogs focusing on their net worth progress.  My question is, do I care?  Not do I care about what is their net worth, but do I care about monitoring my net worth?  It’s kinda neat being a voyeur, watching people discuss their net worth to the world, and maybe that’s the fascination.  It’s what the general public and media focus on. I think they are focusing on the wrong goal.

Let me ask you a hypothetical question.  For simplicity, assume taxes and debt are not part of the equation.  Let’s say you want to get out of the rat race, and you need $60,000 yearly to survive.

Which would you choose? Both options give you a $1 million net worth.  The answer is easy, you would choose option #2, it gives you $60,000 income for the rest of your life. With option #1, you would run out of money in year sixteen.  Not bad, but not good either. If you started collecting at age 50, based upon average lifespan, you would out of money before you die.

Cash flow is a much more important metric to measure; how much is left at the end of the month after subtracting expenses from income. This becomes obviously important when you have low or negative net worth.  If you have no savings (net worth) to fall back upon you’re dead, you need cash flow to keep you going.  This is the same as owning a business; the income/expenses report.  If you have constant negative cash flow, you won’t be in business for too long.  As your net worth grows past a specific point, the interest alone can keep you going without doing anything else.  The interest is otherwise known as cash flow, or at least adds to your monthly cash flow.  While it’s nice to have a high net worth, it’s useless if it doesn’t generate any cash flow.  Why do we hear of lotto winners, rock stars, athletes, who after hitting it big, are broke a few years later?  It’s because bad management of their cash flow, net worth wasn’t an issue.  Constantly increasing your cash flow will automatically increase your net worth.  This is why everyone says live within your means.  If you don’t have the cash flow, don’t purchase it!  That might seem like a no brainier, but remind me how the housing crisis started?

What I care about is how much money my active, and passive investments generate for me monthly.  Are they helping add to my net worth, or are they depleting it?  If you focus on consistent positive cash flow, and ways to increase your cash flow, you most certainly will acquire a high net worth. This blog discusses ways of increasing income, and some smart ways in decreasing expenses.

So what’s more important to you, cash flow or net worth?  While I may devote posts discussing net worth from time to time, it’s not the core reason for this blog, and shouldn’t be in your life.

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