Tag Archives: budgets

Small World Problems

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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.

Gain or Pain

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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.

Retirement: When will I get there?

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flag-36198_640My previous post discussed determining needs for retirement life, and for our example calculated we’d need $2.1M.  Ouch.  But here’s the thing, remember that’s with dollars way into the future (inflation adjusted), and if you have some discipline you can get there.  Here’s our approach.   For our financial  projections, we’ll look at each group of assets as we did with with our retirement needs, and try to figure out how they will grow with time.

 

  1. Home.  Your home is one of your larger assets, and should grow in price like other assets and as you pay down your mortgage.  We should be ale to get a reasonable current value of our home using sites such as zillow.  Though not exact, it’s reasonable to assume an increase in value of 2.5% per year.  Each year we also subtract off the principal portion of our mortgage, available from your amortization schedule (Microsoft Excel has a template for this if you need it).  The equity in your home equates to

Home equity = (Current home value) x 1.025years  -Principal Owed

For example, a person retiring in 35 years with a $300K home today, starting with a $240K mortgage at 4%, the home equity looks like this

2. Retirement savings.  Though historical data for stocks is higher, I like to assume an average combined return of 6%, assuming you’ll be allocating assets to a mix of stocks and bonds.  Hopefully your return will be higher, but this is reasonably conservative assumption.  You’ll probably be able to increase the amount you invest each year, but we’ll assume this is fixed.  The easiest way to calculate this is using the Excel formula for future value,

FV = (Current Value, interest rate, years, yearly deposit)

Also, remember money in a 401k or IRA is not available until age 59.5.  So, for example, a 30 year old saving $7200 per year with a current account of $50K:

3. Regular Savings.  Similar to the above savings, however now we don’t have the benefit of tax deferred savings like the 401k, and also part of this savings is in your emergency fund, which will necessarily have a lower return.  I think a reasonable assumed return on investment is 4%, again hopefully you’ll do better.  For example, a 30 year old saving $2000 per year with a current account of $10K:

4. College Savings. Assuming you have kids (congrats!) college savings is another bucket for accumulation of assets.  Assuming you are using a 529 plan, these earnings are tax free, but also should get more conservative (=lower rate of return) as your child gets closer to college age.  Here I recommend assuming a rate of return of 5%.  For example, let’s assume you’re putting away $100 per month for your child.  This probably won’t be enough to cover the whole bill, but will take out a good chunk:

Finally, we sum up all all the curves and compare it to your needs from our earlier post.  For our example:

Whoa.  Made it!  We didn’t have to assume ridiculous returns and we didn’t have to save $50k a year!  Hopefully, this shows you this is achievable.  We made some pretty conservative assumptions, but we show making it to your comfortable retirement while not eating Ramen Noodles and sacrificing Netflix during your working years.  Notice what it takes is discipline to save every month, and starting early.

One other big caveat.  All my calculations and assumptions above show nice smooth curves as your assets grow.  This is far from reality, but a reasonable estimate for projections.  No one can tell you if you will definitely make your financial goal.  In a future post, we’ll get into how this is really just a best guess, and calculate the probabilities of getting there.

When Do I Have Enough?

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money-2724235_640“Enough” is a tough concept to answer for each person, but extremely important to define for an person’s financial goals.  Remember the role of money is only to give you a happy, satisfying life.  For some people “enough” means a yacht with two helicopter pads (because with just one they’d be unhappy), though I’d suggest they may have lost their perspective on what it takes to make them happy.  This concept is so critical that John Bogle, the founder of Vanguard and the father of index investing, used it as the name of his book.

There is a classic bit of financial wisdom, that totally misses this point.  It states you figure out your needed retirement income as a percentage of your current income, typically about 75%.  This is overly simplified, foolish, and sends the wrong message.  Think if you get a big raise late in your career, would you think, “Oh no, my retirement account is suddenly way underfunded!”  Of course not.  Further, your expenses in retirement are completely different from those pre-retirement.  Instead, you want to calculate what you need for enough.  This is obviously different for each person, but I suggest determining your happiness needs in three categories.

1. Lifetime income.  Hopefully you’ve gone through the budgeting exercise for your current expenses.  For your retirement income needs, you should go through this again, except for retirement life.  Your categories will undoubtedly change quite a bit.  If you’re retiring before Medicare age (65), or if you think the Government will screw this up before you get there, your medical insurance will be a significant expense.  This is going up considerably every year, I’d budget at least $2000 per month for medical insurance and expenses.  Also, perhaps you’re looking to travel more, golf more, eat out more, whatever, but you should have less expenses for that house mortgage (paid off!) and for kids.  Again, you’re trying to define “enough” for you.  Lets assume your monthly budget adds up to $5000 in today’s dollars.  If you’re 30 and retiring at 65, with a 2.5% rate of inflation, this is

$5000 x 1.02535 = ~$12,000 per month

Once you’ve built this retirement monthly budget subtract your expected social security payment (also adjusted for inflation and if you are retiring after social security age AND you think it will actually still exist when you retire!) as well as any expected retirement pensions you might have.  Multiply that number by 12 to get your yearly income need, it will look something like this:

12 x (Monthly budget -Social Security-Pensions) =Income need

e.g.  12 x ($12,000-$6000-$2000)= $48,000

Multiply this number by 25 and that is the rough amount you need to save to support the budget you developed, in this case $1,200,000, or roughly a little more than a million bucks.  Multiplying by 25 follows the “4%” rule meaning you should be able to invest your money reasonably conservatively and withdraw 4% per year.  This isn’t magic, and has a ton of assumptions, but is a decent best guess.

2. Home.  I’m a believer that your retirement home should be mortgage free.  If you are carrying a mortgage, that needs to go into the budget above, but let’s assume you are not continuing to carry debt in retirement.  If you’re a homeowner now, generally your retirement home will be no more expensive, and possibly much less if you downsize.  What I suggest is start dreaming about where you want to live, and what kind of house will make you happy.  Use sites like Zillow to see what that house costs.  Once again, adjust for inflation as we did for the budget above, and there is your number.  If you really, really want another big purchase (like that second helicopter) include this cost also.  But please, try not to believe you need a helicopter.  Or two.

3. College.  If you have kids not yet in college, and you believe it is your obligation to pay for it, this is the third big expense.  I’ll have a separate post on saving for college, but in summary a good place to start is the current in-state tuition, room, and board where you live and multiply this by 1.5 for a teenager, 2.0 for a grade-schooler, and 3.0 for a baby.  College inflation is pretty ridiculous.  Thank your parents if they paid your way.  Then multiply this by 4, for 4 years of college, and encourage your young one to finish in 4 years.  Again, this could change a bunch if he/she really wants to go to that expensive private school, or grows into a world class volleyball player, but again, it’s a good guess. For example, where I live in Virginia, current tuition, room and board at UVa is $28,000. For a grade schooler, I’d plan on

$28,000 x 2.0 x 4.0 = $224,000

So now, just add them all up.  For example, let’s say you figured out the $1.2 Million you need to generate the income you want, and figure you would like a $300k house, adjusted for inflation is ~$700k, and figure it will take a little over $200k to send your kid to college.  The total then is ~$2.1 Million.  This is your targeted net worth.  That’s the minimum you will need, assuming all the assumptions above, and is a reasonable target for what you’ve determined as “enough”.  Scary?  It doesn’t have to be, and I’ll show you how to get there.  If that’s too big a goal, you can make some adjustments to your future lifestyle, or decide to work a little in retirement or junior’s college choice.  Also, if your goal is to retire prior to social security age, I’ll have a separate post on retiring early and how to define this need.  The point is to have a definitive goal to shoot for that has some relationship back to what you feel you need.

Getting (and Sticking to) a Budget

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savings-2789112_640Developing a budget is a crucial first step on your road to financial wealth.  The goal is not only to figure out where you’re money is going, but maybe even more importantly what you can afford to save.  If I ask you today, without a budget, can you put away $1000 a month? More?  Less?  You really don’t have a good idea.  At the same time, a budget enforces that your money should be allocated in a way you consciously decide, not just spent until the wallet is empty.  There are a number of personal finance software packages out there to get you started, but I’ve generally found them more of an obstacle than a help.  Personally, a spreadsheet has always done the trick for me.

The first thing you need to do is come up with your spending categories.  Many of these are easy: food, housing, etc but some may be particular for you.  There’s a funny Office episode where Michael is questioned for his money spent on magic sets.  Hey, no judgement.  If it’s important to you and within your budget, go for it.  Magic aside, here an example monthly budget for a person with a yearly salary of $72,000

 

Let’s look at a few of these. Some expenses can be tricky.  I know you probably aren’t going on $300 vacations every month, the idea is to set aside money in your budget so when you want to take that vacation, the money has been saved.  Other expenses like things for your home might have occasional big purchases and some months where you need to spend nothing.   Again, this is just an average so you are ready to replace that washing machine when it craps out.  For the car, I know loans are common, but I really can’t stand borrowing money for a depreciating asset.   It’s a double whammy. I understand you usually need a car to work and sometimes a car loan is unavoidable, but try to avoid it if you can.  Instead, think of some of this money as saving for the car you pay for with cash.  I also have a category here called mad money and I that needs some explaining.  My wife and I set up three bank accounts. One joint, one that’s hers, one that’s mine.  Most bills are paid from the joint account and each month our “mad money” is transferred from the joint account into our personal accounts. Our rule is we aren’t allowed to question each other on what we spend from our personal accounts.  It has really protected me from being ridiculous and headed off at least 1000 potential disagreements.

Estimating your after tax income is not very difficult especially if you are using the standard deduction.  See here for an example.

Once you have your food, car, magic, and whatever other categories for your situation you need to estimate your monthly expenses in each category.  You can do this by tracking your actual expenses for a while, bu don’t be afraid to challenge yourself.  If your spend $500 at the bar every month you’re reaction shouldn’t be “well I guess that’s my bar budget”.  It should be…”holy crap, I’m literally drinking away my future!” The example budget I show above leaves room for fun, in addition to saving almost 15% of the pretax income.

Hopefully when you figure out your budget the monthly income exceeds the total monthly expenses and you can plug in a significant amount for savings.  If not, you have to make some cuts. I know it’s painful, but saving for your future is just as important as food and shelter.  It’s literally your future food, shelter, and medical care. If that means a few less nights out, that seems like a small thing to ask.  Future You says thanks, by the way.

Let’s Get Started

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rocket-launch-67723_1280I starting writing this blog mostly as an advice column for my kids.  I’ve taken what opportunities I’ve had with them to sit down and explain the importance of budgeting, investing for the long run, and making smart decisions, but those conversations are not as thrilling as they sound.  It’s really, really tough for a teenager to look away from a YouTube compilation of people doing crazy things to hurt themselves so you can explain the beauty of index funds.  And I get it–I don’t think my YouTube channel called “Successes” would get nearly the number of hits.  They indulge me and they are great listeners, but this blog will always be sitting patiently, here when they need it.

Always a lover of math puzzles, I’ve made personal finance a bit of an obsession.   As I’ve gotten older I’m constantly amazed at the amount of bad advice out there, and how financial salespeople feed people’s fear of math and investing know-how into making decisions that really only makes the sales person rich.  I’d like to try to fix that.  The math isn’t scary–I’ve worked through all of what you’ll need that I’ll readily share–and the knowledge required is amazingly simple.

Often what people are looking for is what are those “magic” investments that pay insanely high returns with almost no risk. Somehow there is a belief that there are people out there in the know, working their way through the system, hopefully legally, to get richer.  I still hear infomercials on the radio using lots of words like ‘smarter strategy’ basically implying they have found that low risk/high return investment to get you rich with almost no capital.  I’ll write a separate blog post on the ridiculousness of this argument, if there are loopholes of return without risk, they are quickly closed.  But people hear this and think, man, I need to be part of that action if I ever want to be financially secure. Thankfully, cheaters and scammers aside, there really isn’t a shortcut, and furthermore, you can get there without a shortcut.

So what to do? First of all, the mega return on investment is not that necessary, boring and average is just fine.  What is really important is DISCIPLINE. The discipline to automatically and consistently save money, month after month, year after year.  The discipline to not keep up with the Jones’ and not satisfy every wish and desire at the expense of your financial freedom. You need to save as much as your budget can stomach. Very few young people (or old people) get this. If you get it, you will grow your nest egg. Yes, hopefully you are investing smartly, and I do have some advice for this, but the most important thing is to invest consistently.  Don’t sweat too much trying to find that ultimate return year after year.  Even professionals can’t do it, though many claim they can.

The next question is, how much do I save every month?  That is where a good budget comes in.  You need ruthlessly adhere to a budget, and coming up with a budget is not difficult, I’ll show that in my next post.  You can’t really know what you can afford to save unless you know what you really need to spend.  Hopefully the money budgeted on expenses is less than the money coming in.  If not, you need to make some cuts.  Painful if need be, but you cannot support a lifestyle by going further into debt or stealing from savings.  Lots of young people fight this because they figure they are young, shouldn’t this be the time they are living it up?   Well, yes, but that can’t be at the expense of your future, which will only lead to greater stress in your life.  So allow some money in your budget for fun, but if you really want to set yourself up for your future, you need to save early and as much as you can.

All of this is really about freedom (this is another rant coming, prepare yourself).  As long as we NEED to work, all of us are servants to some degree, we are never truly free.  Hopefully you like your job, but few of us would continue coming in if the little pieces of paper that come every two weeks stopped.  Having complete financial freedom is about having options, where money does not have to be part of the equation in your decisions.  So you can keep doing that job you love if you’d like until you’re 90 and that is your choice.  Or, with a big enough pile of cash, you can do what you want, when you want, as much as you want.  That is freedom.

I’ll touch on a these topics in more detail in later posts, but this hopefully gets you fired up to save some cash!  Well maybe not fired up, that’s just me.  Slightly motivated?  I’ll take it.