Bond Investing

Posted on August 23, 2020 by wiseguide

dollar-544956_640 Investing in bonds should be one of the simplest form of investing. I lend a government, corporation, or other entity money and it agrees to pay me that money back at an agreed upon interest rate. So long as they don’t default on the loan, I will get that return on your investment. For individually issued bonds held to their maturity, that’s pretty much the deal. However most people invest in bonds via mutual funds or ETFs and that makes things a little more complicated. If you read any article on bond investing, it will inevitably state that the yield of a bond fund (interest it pays you) moves inversely to its price. That might not make sense, if the bond is now yielding more, shouldn’t it be more valuable? Sort of. I always find it is easiest to explain with an example.

Remember a bond is just a loan. Let’s say you lend $10,000 to Bill, at a 10 year fixed rate of 3%. Bill has a history of paying his debts in the past and therefore you have confidence he will pay you back. Let’s say next year Bill is looking for another 10 year loan, but circumstances have changed. Maybe Bill is starting to struggle with his bills (ha!) or the interest rate environment has changed and now the best rate he can get is 5%. Now, let’s say you don’t really want the original 3% loan you made to Bill and are looking to sell it to someone else. Do you think someone will pay you $10k for it? Why should they? Your loan to Bill only pays 3%, you locked in that rate when you made the original loan, but they can issue a new loan to Bill at 5%! The only way you can sell your loan to another investor is if you drop the price. The amount you drop the price of the bond is to make up for the lost revenue that the person would get between your 3% loan and the 5% loan they could make to Bill. The same happens in reverse if current interest rates drop, your loan to Bill suddenly looks even more valuable and you can raise the price. How much depends on the difference in interest rates and how much longer you have the loan. In other words, if you want someone to be saddled with this 3% loan for 10 years, you’re going to have to drop your price more than if it were only a year. This is why interest rates impact the prices of long term bond funds a bunch, and short term bond funds not as much. You might even need to drop the price so much you lose money on the investment, even though Bill hasn’t defaulted! That is not smart investing.

This is another example of why it pays to be long term on investments. You don’t have to sell the bond. You can keep it, be happy with the 3% you’re getting, and as long as Bill doesn’t default, you’ll get all your money back, with the interest you agreed upon. Buying a little bit over time is a good way to even out the ups and downs of the bond markets just like with stocks. It is important to understand that you aren’t buying bonds for these ups and downs in price. A bond is a loan, you are buying it for its yield, This is critical when evaluating loans as investments. This can be illustrated looking a curve of the 10 year US treasury (10 year loans made to the US Government) and the return of the Vanguard Total Bond Market ETF (BND)

The BND return is generally higher because it has some higher yielding bonds in it, but there is a critical conclusion here. As the 10 year US treasury bond yield, and interest rates in general, have declined over the past 35 years, bond fund returns have fluctuated wildly, but the average return pretty well tracks this yield. It has to, the yield of the bonds is what is making you money! The drop in interest rates has been great for home buyers because of lower mortgage rates, great for businesses borrowing money to expand, but a hit to anyone looking to make money by lending it to others. Looking at the chart above, seems clear that you should not expect average bond returns to be more than a couple percent, maybe even lower for the next few years.

Money for nothing

Posted on July 27, 2020 by wiseguide

Rates have dropped! I mean really dropped. As I write this 30 year mortgages are less than 3%. That is really a staggering number. Keep in mind the the Federal Reserve target for an inflation rate is 2%. So banks, and their investors are basically telling you they are willing to lend you money, for 30 years, at a rate that just barely beats inflation. We all probably don’t fully grasp what an opportunity it is to be a borrower (and, how terrible it is to be a saver) in our time. If you have a mortgage, it really means you should take a look at a brand spankin’ new mortgage (Refinance!) but it doesn’t necessarily mean you should pull the trigger and if you do, what flavor of loan should you get? Like many other aspects of the financial world, this can be (intentionally) confusing. (People make a lot of money on the general public confusion over some rather simple math, and try to keep the confusion as high as possible to maintain their utility).

To add to the confusion, there are experts simultaneously advocating completely opposite points of view when it comes to mortgages. Some will argue paying as many points as you can, some paying none. Some argue paying off the loan as early as possible with the shortest possible terms, some say stretch it out as long as you can. There isn’t a uniform rule on when to refinance. How can all of these points of view be right? Well sometimes it really is because one opinion really isn’t very informed, but usually the answer is that there isn’t a one-size fits all approach and what is right for one person is not right for another. It depends on many personal factors, which means what’s really important is for you to understand the process so you can judge for yourself.

Let’s start with the mortgage itself, which is simply a loan secured with your home (actually, if you are getting a mortgage, it’s probably more accurate to say its more the bank’s home than yours…but it sounds really awkward to say you’re heading over to your mom’s bank’s house). There are really three (good) reasons to take out a loan for something you can’t buy with cash. One, because you believe you can make a higher return with the money than the rate at which you are borrowing (this is the essential business of banks). Two, because buying something you can’t currently afford is necessary for life (meaning, a car required to get you to work, not a car that enhances your perceived awesomeness). Or three, if there is a once in a lifetime opportunity, and the benefit is worth the interest payments (careful with this one, I’m thinking more like seeing one of the 7 wonders of the world, not Justin Bieber, but hey, to each their own) . A home generally appreciates in value and allows you to live a lifestyle much greater than you could if you had to pay for your living arrangements with cash, and you need a place to live, so homes generally meet the loan criteria. But important to remember, any time you are taking on loan of any type you are agreeing to pay extra money for essentially nothing. You get no product or service for the interest you are paying. Therefore it’s important that you are very sure about the investment opportunity if it’s reason number one, or the lifestyle improvement justifies the interest payment if it’s reason number two or three.

Once you decide that living in a home is worthy of a loan, and generally it is, then you have some decisions to make on the length of the loan, comparing fees, or paying points up front. Down the road if rates drop,you may also be faced with the decision of whether or not to refinance again, which is simply getting a new loan to replace the old loan.

When to refinance can be a tricky question, but doesn’t have to be. Note, the reason to refinance should be that rates have dropped sufficiently to allow you to have the exact same thing (live in your home) for less money. It is not because it’s a great opportunity to borrow even more money to buy more stuff. The real estate collapse of 2006-2007 really should have only impacted people who were unlucky enough to buy homes in the few years just prior to that who bought a home at the market peak. Instead it swept up many, many more people because as the housing market exploded in price in the early 2000’s, people refinanced with the purpose of “pulling money out of their home” or put another way “took on much more debt for no real reason other than their home price was artificially inflated”.

The easiest way to compare your current mortgage to refinance offers of all different types and all different durations is to assume all of the expenses associated with getting a new loan are going to be rolled into the new mortgage. In other words, the starting point of your current mortgage is your current balance and the starting point of any refinance mortgage is your current mortgage balance plus fees associated with the refinance (everything except the “escrow pre-paids” which usually includes local property taxes and insurance. These are included in the fees, and you have to pay them, but you’d have to pay these anyway eventually, even without refinancing).

Aside on fees. One expensive one is title insurance. This is insurance you pay in case a prior owner that sold you the house doesn’t have a “clean” title–like maybe someone did work for the person who built the house and never gets paid, they come after the homeowner, which is now you. The bank forces you to buy this insurance for them, but your policy is optional, and the closing companies aren’t always very clear that this is insurance you don’t have to buy for yourself. I personally have never seen a good investigation of the risk of these claims and average liability, so don’t have a good way to judge if this premium is reasonable or not…but my sense is that the risk is low and the premium is very high. I always opt out of this coverage.

Back to my refinance calculation. For each year going forward, calculate the total payments made for the year (the PMT function in excel is best for this) and the mortgage balance at the end of the year (the starting mortgage balance minus all the principal payments for the year, which you can get using the PPMT function in excel). Add these two numbers, total payments for the year + mortgage balance at the end of the year. Do this for any competing refinance offer also, including all variants of points you can pay, which as stated above, we’d be rolling into the starting mortgage balance. Repeat this for year 2, 3, 4 out to as long as you’ll be in the home.

Now look across each column each year. The lowest number is the best deal for that year. What you’ll probably see is that your current mortgage might still be the winner after year one or two, but if the competing refinance rate is at least a percentage point lower, you should start to see some of the refinance offers be a better deal. Also, you should see that paying fewer points are a better deal for those early years, but eventually the loans with more points become the better deal. This is done by design.

Mortgage points simply represent interest that you pay up front. Any time you pay for anything up front vs over time you should always be getting a discount. So if you are comparing mortgages for the total interest paid over the typical 30 years of the loan, the ones with the most points should absolutely be the best deal at 30 years. Aha! Easy answer! Why do they even offer those other loans with less points?

There’s one key variable the above calculation forgets. How many people get a 30 year loan and actually pay it off over the 30 years? Almost none. The average time in a home is 9 years. And note, that is the average time in a home, what you really need to know is how long you’re going to be in the loan. Even if you’re sure you are going to live in the home forever, are you sure interest rates won’t drop so much that you’ll be able to refinance again? If you look at the same mortgage comparisons over 2-3 years instead of 30 years, those with less points start looking a lot better.

So now that you have your table, what you need to decide is the length of time you’ll be in the loan. When deciding if to refinance, and after, what offer to use, it is mostly a personal decision on where you think you’ll be living in the near future and where you think interest rates will go in the future. This is why for some people paying nearly no points is smart and for some people paying maximum points is smart. If you feel like you’re going to be in the home for at least 5 years, and all the refinance offers are a better deal at 2 years…it seems like you should probably pull the trigger, but if you think rates will continue to drop, you might want to wait. In any case, look at all types of loans (10, 15, 30 year) and all types of offers (multiple banks with multiple points and fees) using the approach above to determine the best deal.

Refinancing can be a pain, so it has to be worth your time and trouble, but you should absolutely keep an eye on mortgage rates all the time, and be able to understand how to act as they drop.

Best Laid Plans

Posted on April 2, 2020 by wiseguide

Everyone has a plan until they get punched in the mouth
–Mike Tyson

As I write this the world is in lock-down due to the spread of a global virus. I write mostly about financial issues but try to consistently keep the perspective that your time is really your most valuable resource, and your continued health is what enables you to make the most of that time. So, remember that if you and your loved ones are relatively safe from this, consider yourself among the fortunate. My friends and family who are doctors and nurses see it up close and personal, and I don’t know any of them who have their stock portfolio as one of their top 10 worries. Just keep that perspective.

With that as an important backdrop, looking at this as merely a financial impact can be jarring. I’ve talked about this in prior posts, the occasional, even significant decline in the stock market is completely expected, and is actually a positive. One of the other positive things to result from a downturn is it gets you to measure your real response to a crisis. I can ask myself, what would I do right now if this were happening and I was already retired with my 50/50 stock/bond portfolio? If I’m being honest with myself, I’d be freaking out. This is extremely valuable insight into my psyche, and allows me to avoid those freak-out moments as an old man, at least when it comes to money.

I still think the 50/50 portfolio can work for many people, but recall my analysis for that example showed there was a 10% chance of outliving your money using the 4% rule for withdrawals. As risk-adverse as I am, I realize for me, that’s too big of a chance. I also realized that to mitigate the impact of this kind of downturn in the future, I’d want to have a plan that required no stock sales, so as things dropped it wouldn’t really cause any short term panic selling, which as a stock investor is what you have to avoid.

Here’s the difficulty. At today’s interest rates and stock dividend yields, you can’t count on 4% yields. You can’t really even count on 3%. To get to 4% in today’s environment you have to be reliant on some gains of your investments, or be willing to dip into principal–which can be a vicious cycle of reducing your investment assets, which leads to less yield, which causes you to withdraw more principal. I’ve adjusted my plan to try to address this.

In earlier posts, I talked about two buckets of funds, one to sustain your life from age 59.5 using designated retirement funds, and another to get you from whenever you stop working to age 59.5, your “bridge” to retirement. I’m still a believer in the long term value of stocks, so still recommend my asset allocation for those long term assets. I may rethink the retirement age allocation, but I’m sticking with it for now. For the shorter term assets, part of my solution is an asset I’ve tried to avoid up until now, rental real estate. I’ve avoided this not because I think it’s a bad investment, but because unlike other assets classes, it requires work, so to call it passive income is a stretch. It’s a little bit investment, a little bit part time job. But I’ve come to realize this is my favorite income-producing risk-adjusted asset right now. I’ll have a follow up post on this, but I’ve dipped my toe in, I can’t stay out any longer.

For shorter term, bridge assets, I recommend the following. Instead of my prior approach which was to determine the earliest possible date you can retire, take a little more conservative approach and lay out your intended work plan. How long do you believe you’ll work full time? Part time? With that plan, you can estimate each year’s income and with your forward-looking budget you can estimate expenses. You can do this for each year going out to age 59.5, I even try to estimate when I will make major purchases, like cars.

With your short term assets you can also estimate both yield (income produced) of those assets and growth of those assets. The following is a reasonable example, you may want to adjust these based on interest rates, market conditions, etc. Note the yield and growth values for Real Estate vary considerably depending on how much you initially invest. If you buy the property outright, more yield, less growth. If you finance a great deal of it, less yield, more growth.

Asset	Yield	Growth
Stocks	2%	5%
Bonds	3%	0%
Cash	2%	0%
Real Estate	3%	3%

For each year, assume the yield of your investments can be used to supplement your income and add that to any money you expect to earn working. If your expenses exceeds your income (from investments and salary) draw money only from cash and bonds (the ratio of this draw can be varied but one approach is 50/50). If your income exceeds expenses, put the extra into cash and bonds. A reasonable place to start is equal 25% allocation in each of the asset classes above then project out your balances for each of these assets classes for every year until you are 59.5 or whenever is your long-term retirement age. Do you finish with positive cash and bond balances? If yes, then you have a plan to get to 59.5 without needing to sell any stocks or real estate holdings, so when the market tanks again (remember these downturns are nearly guaranteed, the difficulty is predicting when they will happen, not if they will happen), you are positioned to continue to live your lifestyle pretty much as planned. The idea is trying to set up a condition where a down stock market or down real estate market has no significant bearing on your life.

Why keep any money in stocks at all? Well, you could argue that the risk isn’t worth it, but I still believe that you should have exposure to the growth power of stocks. Over the long term this should still finish as your most productive asset.

What if that plan doesn’t work? What if it shows you run out of cash? Make adjustments. Maybe you have too much money in stocks or real estate. Maybe your date to quit working is too early and needs to be pushed back. Keep adjusting until you have a plan that shows positive numbers for all your assets.

Finally, remember that history says fortunes are made during market downturns. Warren Buffett’s famous financial advice to be “fearful when others are greedy, and be greedy when others are fearful” is difficult to execute. However, hopefully this provides you the confidence that investing in stocks for your long term assets is still a good idea, if buying prior to the crash made sense, certainly buying after the crash makes even more sense. These purchases do not care about the price of stocks tomorrow or next week or next year. These purchases are made looking out 10-20-30 years, where if history is a guide, stocks will be a smart purchase.

Small World Problems

Posted on January 11, 2020 by wiseguide

When I was in graduate school, I was given the book Don’t Sweat the Small Stuff, probably because I had a habit of freaking out over every little thing. I love this book. What it is trying to teach is that maybe the fact that your car needs new brakes is not the human tragedy you perceive. The whole point is to try to gain perspective on the adversity in your life. I like to define “small” as any problem where you can throw a reasonable amount of money at it, and it goes away. One snag with this theory, you have to have that reasonable amount of money at your disposal. This is what I mean by money as a misery-prevention device. I understand the theory that money doesn’t buy happiness, but it can certainly solve small problems, which is a good way to get on the road to joy.

Aside. I never understood the expression Mo Money, Mo Problems. My life has definitely been Mo Money, Less Problems or Less Money, Mo Problems. If too much money is the source of your problems, it’s not being used correctly.

Unfortunately, many people get fooled into buying things as a way to happiness (and usually end up disappointed that the thing did not lead to instant euphoria), instead of building their wealth, and as a result end up doing a lot of sweating (and swearing) over some pretty small stuff. Without that financial protection, the new dishwasher, car repair, or other “small” problem becomes huge. Frequently this simply leads to more credit card debt, which only makes future small problems worse! See the study here. A little dated, but still valid, over half Americans can’t handle a $500 expense without going into debt. Having that boulder hanging over your head places enormous stress on you and is a great way of turning small problems into big problems. And, the unexpected will definitely happen (probably should be called the expected)! It’s not if something will break, it’s when.

Think about happiness, true happiness in your life. Is it buying the latest gadget, or first eliminating this burden? This is the main reason why that emergency fund is so essential to your well-being. Remember, the purpose of money is a time enhancer. It’s fine to buy the occasional toy that catches your eye, but don’t be fooled that this will make you happier than financial security. From my personal experience, I can tell you it is extremely liberating to get up every day knowing that any small problem can be handled. For the big $ “small” problems, there’s insurance and for the other small problems, there’s a sufficient pile of money, sitting around and ready when I need it. I like my mountain bike. I like my kayak. I like my truck. But I love worrying less. That peace of mind in itself is an incredibly valuable purchase.

You get what you pay for—know what you’re paying for

Posted on December 28, 2019 by wiseguide

You can buy a handbag for $500. I’ve been told that people really do pay this for an item that holds your crap. You can buy a watch for $5000. It tells time. You can buy a $90,000 SUV instead of a $40,000 minivan which generally will tow around the same amount of kids and crap. Why would you pay this? What the makers of these products will tell you is it’s quality. If you want a really good bag, or watch or shirt or any other high end item going for many times more than it’s competition, that’s just what it costs, but rest assured you’re getting the best. I’d certainly hope that you are getting high quality items, but FYI it’s not always the case. Look at these dependability ratings from JD Power for cars. Some high end luxury cars score well, but for the money they charge, wouldn’t you expect them to all be very reliable? Why do Hyundai and Kia beat Acura, Audi, Jaguar, Mercedes, Volvo, Cadillac, and Land Rover? I know this is only one measure of the quality of the product, but if I were paying double or triple the price, I’d want some assurance that this thing wasn’t going to be in the shop all the time.

What manufacturers of clothes, bags, jewelry, and tons of other things have figured out is we not only want the functional utility of the item and of course, we’d like it to be nice, but we also need a subtle or not so subtle symbol of our wealth or success we can display to the world. It’s similar as the bird that builds a display to impress a mate (for you super nerds like me, check out the bowerbird). You are buying status. Perversely to the laws of supply and demand, the higher price increases demand. You need the manufacturers to get the word out that their stuff is expensive, and need some label or other marking on the outside so we all recognize that expensive thing.

A classic example of purchasing status over quality is relabeling for clothing at discount stores. There is an accepted practice of designer clothing that is not selling well at high end stores to be shipped off to discount stores to be sold at a much lower price. This famously came to light with Ivanka Trump’s clothing being rebranded to be sold at Stein Mart. Think about this. They are putting MORE labor into the item, and LOWERING the price. For. The. Exact. Same. Item. The reason for this is that if your favorite designer is all of a sudden showing up in Target, that item is no longer a display of wealth and status, it loses value!

Same goes for people living in dumpy apartments driving high end cars. Many more people see you in your car even though you spend more time in your apartment. You are making the conscious decision that is not quality or luxury in your life you value, it’s status, or even just the appearance of status.

This isn’t to say buying status isn’t worthwhile for you. There may be times when the appearance of success is important or you genuinely find the increase in quality reasonable. The main thing to recognize is don’t let someone lie to you—or lie to yourself—that you are buying that $500 handbag solely for its quality. You are mostly buying the status symbol that comes with it. Like everything else, if you are budgeting and choose status as something you’d like to purchase, then go ahead, but do it for you, not for the impression on others.

Saving for College

Posted on November 3, 2019 by wiseguide

One of the great recent tools available for college savings is the 529 plan. This allows you to save money where all gains are tax free, so long as proceeds are used for educational expenses. Additionally, if your state offers a good plan it will frequently make some or all of your contribution a state tax deductible, without any restriction on the school your child wishes to attend. For example, the state of Virginia has given me a tax deduction every year of my kids lives, simply as a thank-you for saving for their education. Over 20 years at a ~5% tax rate, this equates to Virginia providing each of my kids $4000 for their education, and this is in addition to the money I contribute and earn on the investments. Not trivial, and if your state offers a decent plan with tax deductible contributions you should jump on it.

What’s a decent plan? Check if your state offers plans with fees well under 1%, hopefully offering low cost index funds . Even if not, if it’s offering a tax deduction there is still a chance it’s your best option. If not, there are several articles on other state’s plans (which you are able to join even if not in that state), a good reference is here. Many of the plans offer an automatically adjusting asset allocation as your child gets older, which I find convenient and forces discipline for asset allocation.

Alternatively, there are pre-paid plans where you pay today’s tuition prices to an in-state school for attendance later, but these are not my preference. These plans offer less flexibility for your child for school choice and only offer an effective rate of return equal to the rate of annual tuition increases for that school Although this rate of inflation is high compared to normal increases of other things we buy (see below), hopefully it still should be outpaced by the return you should get from a bundle of low-cost mutual funds.

How much to save is a tough question with a lot of variables, and you are unlikely to get help by asking your infant or toddler if they are thinking community college or Ivy League, but I have a suggestion for a reasonable approach:

Start the 529 plan as soon as possible, preferably right after your child is born. Tell all proud grandparents the account is open! Maybe a blatant cash grab, but $50 in their account will be way more valuable to everyone involved than a designer little outfit that the little one will outgrow in a week. After he or she has spit up on it.
As a benchmark, look at your state university tuition, room, and board costs today. Then look at the average inflation rate of these things over the past 20 years. You can find all of this online. This might shock you, I’ve used a number of at least 5% and historical numbers are often even higher, well above normal inflation. Doing this, you can take a good guess at what the expense will be for your child when he or she gets there. For example, if the candidate university for your newborn is currently $30K for tuition, room, and board, the suggested targeted expense is:

Year 1 = (1.05)¹⁸ x $20,000 = $48,000

Year 2 = (1.05)¹⁹ x $20,000 = $51,000

Year 3 = (1.05)²⁰ x $20,000 = $53,000

Year 4 = (1.05)²¹ x $20,000 = $56,000

$208,000

That bottom line number is a big ouch, but remember this ignores things like scholarships and other financial aid, this is just a guide to give you a feel for the costs of college.

The best way to attack a big number is like attacking a whole pizza: small bites. I suggest you make regular monthly savings contributions and assume a reasonable rate of return of 7% and contributions for 22 years. Using the PMT feature in Excel this is=PMT(.07,22,-208000)/12 = $1570 per month. Again, ouch, but this is just your target. Each year you’ll be able to look at your actual balance and the new projected tuition (based on the updated numbers) and recalculate your month goal. And you can make adjustments, like your child has recently developed some massive athletic skills, or suddenly takes a liking to that high priced private school.

Your saving for college doesn’t have to be perfect, and if you fall short there is financial aid of all kinds. But it is important to get an idea of what the college costs could be and to use the power of compounding to start right away.

One last editorial note. College tuition is like any other purchase, and you should approach it based on what you can afford, not just what you want. Just because you want a Mercedes, you might only be able to afford a used Honda (and truthfully, that used Honda will likely serve you just as well). For some reason, we tend to throw that decision making out the window when it comes to college. We pick one, and borrow whatever shortfall is needed. (Side note, this may be partially to blame for why college tuition is escalating far more quickly than other things in the economy, lack of demand by the consumer for prices to be kept to affordability). Student loan debt is a popular issue right now, and the hole that some young people have when they are just getting started is staggering. If you graduate with six figures in student loan debt, likely you picked the wrong school. The community college in my state is less than $6000 per year for tuition, without any financial aid. State universities are about twice that. So 2 years in community college and two years at a state school is less than $40k. Assuming you have saved $0 and get $0 in aid. I know you might not want to go to community college, but there is zero wrong with that education (teaching can actually be superior here) and that might be what you can afford. There is a misconception that if instead you go to a fancier private school, whose tuition is close to $60k per year, clearly you most be getting a massive advantage over everyone else. Well, maybe, but largely college is what you put in to it, and the student from State U at today’s tuition rates has a $200,000+ head start. OK, off my soapbox. If you really want your young one to have maximum college choice, the calculations above can give you a guide–and just so you’re aware, for the priciest private schools, and adding in room and board, that is a projected total of over $700,000. Yeah.

Gain or Pain

Posted on April 20, 2019 by wiseguide

For many people, any time they are deciding on a big ticket item like a vacation or some luxury item, the calculation simply comes down to “Can I afford the monthly payments?” A little better question is “Have we saved up enough money?”, but I’d argue even this is the wrong approach when making a decision.

I don’t want to tell anyone where they should or shouldn’t spend their money. OK, I sometimes do, but really that is an individual decision based on what every person values, and everyone needs to make that decision for themselves. However, I think everyone needs to have the right information when making purchasing decisions, and that comes down to my common theme of using time, not money, as your limited resource.

Instead of asking “Can I afford the payments for that dream vacation?” or even “Do I have the $10,000 in my account for it?” a better question to ask is “How much longer will I need to work to offset this purchase?”. Instead of paying in dollars, you are really paying in “Pain Dollars” or working time. This is key, because the conversion of dollars to Pain Dollars is different for everyone. For example, let’s say that vacation meant you’d have to work 4 more months (more on this calculation in a moment) at your job. Is that worth it? For some, yes, the reward is worth the pain, and for some no. It depends on how painful your job is and how much you value the item you are about to purchase.

To figure out what your Pain Dollars conversion is, I use my early retirement “Crossing the Streams” approach, and compare my original asset curves with one set back by the purchase of the item ($10,000 in the case of this vacation). I suggest you read this blog post to understand this a little better if you haven’t already.

Looking back at that original scenario, we had a 32 year-old doing well, with a projected early retirement in March 2043 (age 56). What if she decides to take that vacation? Her current bucket one assets decrease by $10k and her crossover point shifts by 4 months:

I know what you’re thinking, if I make more than $10K in 4 months, how can the impact be this great? And, the impact above looks like a lot more than $10k! The answer is a) not all of your money you make goes to savings (in fact most doesn’t) and b) we are looking at the impact of a purchase today compounded over time. Is that dream vacation worth it? Some would say yes, some would say no, but I think everyone should be informed of its impact in his or her working time.

This is also part of the power of working in a job you really enjoy. For those lucky enough to love their job, the conversion rate of Dollars to Pain is very advantageous, meaning your able to exchange very little pain for a great deal of dollars. By thinking about “paying in Pain” everything just became cheaper! Four months for you might be pennies—doing your job everyday is a pleasure—four months to someone else might be a fortune.

Punching Out Early Part II: Crossing the Streams

Posted on March 31, 2019 by wiseguide

When I was a kid, I went to see the original GhostBusters in the movie theater. Looking back, it’s a combination utterly ridiculous and great movie. One thing you learned is never cross the streams:

“Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.”
–Dr. Egon Spangler
“That’s bad. Okay. Alright, important safety tip, thanks Egon.”
–Dr. Peter Venkman

Here, we’re going to talk about crossing the streams, and much like the ultimate destruction of Gozer the Destructor (another geeky Ghostbusters reference), it’s good. In the last post we created curves for how much we might need to punch out of our jobs, and have enough to support our chosen lifestyle. Now for the fun part, figuring out when we can get there. We’ll look back at Bucket 1 first, life up to age 59.5.

Bucket 1. Again, this consists of three parts:

Home Equity. This is the current value of your home (you can use zillow if you need an estimate) less your current mortgage. This will go up every year as you pay down the principal on your mortgage. Since we did not adjust our retirement home for inflation, do not adjust your home value either.
College Savings. Hopefully in a 529 savings plan where it earns returns tax-free
Regular Savings. All of your other accounts that are not specific retirement accounts (401k and IRAs are not part of this bucket)

We can project each of these out with time based on the amortization schedule of our mortgage, and an assumed rate of return of the college and other savings accounts. We then add them all together, this might look like the following:

Bucket 2 is addressed in a similar way, and includes 401k, IRA or other retirement only assets, yielding a rate of return appropriate for your asset allocation.

Once we have an idea of our asset growth with time, we can compare that to the needs curves and look at where we cross the streams:

In order to retire, we need to be above both curves. For this example, the most restrictive case is our Bucket 1 money, and indicates an expected early retirement at age 56. This is not guaranteed, in fact there is a LOT that will happen between age 32 and 56 that will change both curves as you get older and life happens. Also, we had to make reasonable guesses for things like rate of return of our investments. But I find this a really useful exercise to compare my current and future lifestyle choices with my current and future savings to see where these choices project. Don’t like the answer? Save more! Or learn to be happy with less in the future! Conversely, maybe the curves are showing a projected retirement well before when you’d like to stop working, possibly indicating that you are not living it up enough in your present. That is sub-optimal use of your assets allocated to your time also–but note, almost no one falls into this group. (Oh no, too much money! Gah!)

Punching Out Early: Part I: What do I need?

Posted on March 17, 2019 by wiseguide

I’ve had some earlier posts on figuring out when you’ll be able to retire, taking the traditional route to 65. However, for many people, myself included, that seems like an awfully long time to spend doing something that isn’t first on your wish list when you get up in the morning. If your job does fit this category, fantastic, and the wish to retire early isn’t nearly as strong. But for most people, they’d really rather do something else, which is the allure of early retirement. People in the FIRE movement endorse the idea of retiring at 30 or even sooner! While I think much of this message gets confused and oversold, early retirement is a laudable and achievable goal. Let’s look at a strategy.

One magic number is 59.5. That’s the earliest you can start drawing on tax-deferred 401k and IRA savings. So, it makes sense to break up your assets into two buckets, 1) Money in taxable accounts for retirement life before 59.5–assuming a goal to retire before this age–and 2) Money for life after 59.5 (in tax advantaged accounts). Think of the first bucket as a bridge account since it bridges your retirement date to 59.5 when your true retirement assets become available. For simplicity, I assume Bucket 1 has to contain everything to get me started in retirement, meaning it covers my retirement (preferably without a mortgage), my kids college, and the money I need to live on until Bucket 2 kicks in at 59.5.

Bucket 1. Similarly to the earlier post on retirement, we first need figure out how much we need. This is a curve that represents our needs starting in the present (Retire Today!) and extends into the future, and is the sum of 3 elements:

Retirement Home Cost. You can use today’s dollars if you are a current home owner since later in the calculation you’ll be offsetting this with your current home equity in today’s dollars. If you don’t currently own a home, you’ll have to calculate this using today’s dollars and inflation, I suggest 2.5%. If you want to rent in retirement, this number is zero, but remember you’ll have to figure the rent into your needed monthly income
College Funds Needed. My earlier post had a rough calculation you can use for each of your kids, assuming you want to pay their way through school.
Living costs, from now until 59.5. If retiring after 59.5, this is zero, but otherwise is a little more tricky than the other two. You’ll want to devise a retirement budget to your desired lifestyle, similar to the approach we took earlier. But remember, early retirement means you’ll be paying your own medical insurance without Medicare, not a low cost item. Also, I suggest tweaking this number up based on inflation to the rough date where you think you’ll actually retire. There are a number of ways to calculate the lump sum you need to support this budget, you can simply multiply your budget by 25 (the 4% rule we used earlier, assuming living off interest only) but that is probably a little too conservative for this bucket, knowing you have another bucket behind it. I use the Present Value equation in Excel, so my needs decrease with each year I get closer to 59.5. In total, your Bucket 1 curve will look something like this:

You can always play with the assumptions, but the curve in general gets lower as you age, simply because the time is decreasing from now until age 59.5, so you need less money to live.

Bucket 2. Bucket 2 is simpler, it only takes into account what you need live on, from age 59.5 until….whenever. Here I’m going back to the conservative rule of 4% withdrawal and assuming I have to live off the interest only. This is conservative, but if I don’t adjust my yearly budget for inflation, it kind of balances out. You can also use the Present Value approach used above in Bucket 1. The question we need to ask is how much do we need as a lump sum for any given year of retirement, such that the money will grow to the minimum amount we need at age 59.5? This is the amount saved at any moment in time that we assume will grow to our need at age 59.5 without the need for further contributions (which we aren’t making when retired!). This will increase each year, since each year there are fewer years to age 59.5 (and thus less time) for our money to grow. The bucket 2 curve will look something like this, this assumed an 8% return on assets:

When can you retire? If your Bucket 1 assets are above the needs line and Bucket 2 assets are above the needs line, you are in-line for retirement. (Ha! See what I did there? Graphing humor. Always kills).

But wait, those are some pretty big numbers, you mean if I want to retire at 40 I need nearly $2M in Bucket 1 and half a mil in Bucket 2? For the scenario above, yes, per our assumptions, at least that much. Are the FIRE people accumulating millions by the time they’re 40? Well, no, probably not. The FIRE people are (hopefully) doing these same kinds of calculations and saying “Whoa, those are some pretty big numbers!” and altering their needs way down to get them more reasonable. Maybe their kiddos will go to community college, maybe they’ll live on $30K a year (though I really don’t know how that would work with health insurance), maybe a $100K condo will do just fine. You can do the same if you like, its all about what kind of lifestyle you value, and what kind of time you’re willing to put in for it. That’s different for everyone, but I do have some future advice on how to strike that balance. (FYI, to give you an idea of this impact, changing to the assumptions I just listed is a need of ~$500K in Bucket 1 and ~$200K in Bucket 2, still a big nugget, but a little more reasonable for age 40).

In my next post, we’ll look at where we stand and projecting out when we’ll meet both criteria.

Freedom, not Retirement

Posted on February 23, 2019 by wiseguide

mountain-984277_640 The Financially Independent, Retire Early (FIRE) movement has gained a decent following recently. Generally, I’m a fan, anything that is encouraging young people to live beneath their means and save as much as possible is right up my alley. Mr Money Mustache is probably the most popular among those promoting this effort, and I encourage you to check out his blog, there is a lot of practical advice to living a life of wealth. But like anything, the approach can be oversold as another magic pill of the easy path to wealth. Back to math for the answers. Love you, math. Love you.

Some within FIRE will shout Retire at 30! Sounds too good to be true, and generally it is if you take it literally. Recall the post on budgeting, the first thing you have to figure out is how much you’ll need to live, and remember if retired you are paying your own medical insurance now. Don’t be shocked but this can be $25-$30K per family (assuming no subsidies from the Government here) and rocketing up every year. And you HAVE to have health insurance. Remember, your time, and indirectly your health is the one thing you absolutely have to protect. You also have food, housing, bills, some minor entertainment. Don’t expect to give up Netflix and be able to live on $10 a day. Assuming all of these things, $60k per year (assuming that health insurance remember) is not an extravagant need. Recall the post on living in retirement, a general rule of thumb is assuming you can withdraw 4% each year for living expenses (conservatively assuming you aren’t drawing down the principal), you need $1.5M, and this is pretty bare bones living. Let’s assume you start working at 22, and you assume a solid return of 11% on your investments which is a pretty aggressive assumption. To retire at 30, you’d need to save roughly $125,000 per year to get to $1.5M. This is savings after tax. You can’t count your 401k or IRAs, those aren’t eligible for withdrawal until you’re 59.5 (question, Congress people. why the 0.5? seems so random). Do you have a job at 22 that allows you to live and save that much? No? Hmm, how about retire at 40? With the same assumptions, it’s still $30k per year. Every year, starting at 22, and assuming you get an 11% return every year. This is at least possible but still really, really tough for most people. Plus, remember that the 4% rule is no guarantee the money will last (see my post on Monte Carlo analysis).

So I’m not anti-FIRE movement, but clearly there is something else to this besides: Step 1, get a job making insane money. Step 2, spend almost none of it. Step 3, invest in a stock market that is consistently going up.

Instead, the movement really should be called “Free to Pursue Work Regardless of Earnings (FTPWROE)” but that doesn’t have quite the same ring to it, and the vowels are in terrible locations. Think about “retirement” at 30 or 40. This is not sitting on a beach with a Mai Tai. Instead, it is saving a decent cushion, so that you can pursue work you find more meaningful and enjoyable, regardless of the income. Recall my post on the 3 elements of a job, here you are ignoring the income element and strictly focusing on the time the job requires and your personal enjoyment, and there is a beauty to this that I respect. Suze Ormann famously criticized the FIRE movement but I’ll bet some of that is she has a certain picture in her head of retirement because she literally retired to a private island in the Bahamas. I understand she and her wife do insane amounts of fishing, and have to admit, sounds fantastic. But FIRE people are still looking to achieve something (besides landing a big snapper). So if you leave your accounting job and decide to be a youth counselor (maybe with an outfit that offers health insurance, score!), maybe you can do it with a big enough supplement nest egg.

So take the good parts of the FIRE philosophy: live frugally, save extensively, invest wisely. Seek joy in the free/inexpensive things instead being sucked into the materialism hole. The power of that pile of cash you build may not be enough to sink your toes permanently in the sand at 30, but may give you the cushion you need to live the life you want.

The Wealthy Wise Guide

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