The myth of paying yourself first …

One of the first books that I ever read on the subject of personal finance was The Richest Man In Babylon … if you haven’t read it, get it and read it.

It is a wonderful primer on the basics of personal finance.

The part that stood out for me – since repopularized by David Bach in his hugely popular Automatic Millionaire series – is the notion of paying yourself first.

The story goes: if you would only pay yourself first [insert popular pay yourself first amount here: 10% of your gross; 15% of your net; up to the employer match; one hour of salary a day; etc.] you will be well on your way to financial success.

Except that it’s a crock …

If you pay yourself first, you’ll be slightly better off than the Jones’, but that’s about it.

Does that mean that you shouldn’t bother to pay yourself first i.e. save a portion of your income?

Of course you should, but not:

(a) where the popular financial press tells you to,

(b) in the amount that the popular financial press tells you to, and

(b) for the purposes that the popular financial press tells you to!

Before we examine how they got it so wrong, let’s take a look at why it doesn’t work; we’ll start with the typical ‘pay yourself first’ amount of 10% of your gross salary:

Let’s say that you start with a $50,000 annual household income, and you want to maintain your current standard of living in retirement … which is in approx. 20 years.

[AJC: why anybody would want to work for 20 years just to maintain their current standard of living is beyond me?! But, let's go with it, just for the sake of proving a point ]

Firstly, you can assume CPI salary increases between now and your retirement date, so in 20 years your salary will approximately double to $100,000. Of course, since they’re only CPI increases, you haven’t really earned a pay rise as all as your gas, bread, milk and so on have also doubled in that time.

At a 4% so-called ‘safe’ withdrawal rate (to allow for average investment returns less the effects of taxes and ongoing inflation, etc.), you will need an approx. $2.5 million after tax lump sum in 20 years to generate $100k for life [AJC: assumption, assumption assumption ... but, we'll go with this, too].

Note: you can get by with less, if you trust that Social Security will be around in 20 years, but I wouldn’t bet on it … and, neither should you.

In order to generate $2.5 million in 20 years you will need to pay yourself first … drum roll please …. 75% of your gross income, starting now and continuing for the next 20 years.

This assumes a 9% after tax return on your investments; 8% undershoots by a couple of hundred grand and 10% overshoots by about the same.

So, what does David Bach’s 1 hour of salary a day (or 12.5% of your gross) actually do for you?

It gives you about $15,000 a year to live off (a little less than $8k a year in today’s dollars) making you a real Automatic Thousandaire

Next time, I’ll answer the where in for questions …

Follow the fundamentals …

The relatively recent gyrations of the stock market from all-time highs to many year lows and back again, and so on, have scared many into pulling their money out of the market … and, keeping it out.

This is a mistake …

Unless you have solid plans (and, expertise) in investing elsewhere, the stock market is a pretty good place to try and build up your warchest.

I would like to see you make major forays into businesses and/or real-estate, as these offer the best opportunity to make money that can be counted in the millions, but the stock market is a pretty good alternative.

And, certainly better than sticking your money in the bank!

The problem is that most people panic during a crash …

What they don’t realize is that crashes will occur around every 10 to 20 years, and recessionary downturns occur every 10 years – more or less – as well.

The question is: which one leads to the other? The answer is not always clear-cut. But, it doesn’t really matter.

You see the market always recovers.

Unless there’s a ‘fundamental change to life as we know it’ (such as the fall of the Roman Empire) the market comes back to life.

Here’s why:

The stock market wasn’t developed as a means to speculate on some random ticker prices, as it has become to many professional traders and certainly to most lay-investors (that’s you and me, bud).

It was developed as a means to share partial ownership (i.e. to raise capital for expansion, etc.) of real, live companies.

Real, live businesses make stuff, sell stuff, and (usually) make a profit in doing so. Their ability to make a profit is more closely related to market forces (i.e. customers, competition, etc.) than it is to economics.

And, their ability to make a profit has virtually zero correlation to stock market sentiment.

Yet here’s what occurs [hypothetical chart]:

The yellow line represents some hypothetical economic indicator (e.g. growth in GDP), and does its thing.

The blue line represents the stock price of a company we are tracking and it rises and falls as prices (both the prices its customers are willing to pay and prices its suppliers feel that they are able to charge) and labor costs and so on rise and fall.

Interestingly, company profits (hence earnings per share) are somewhat related to the economy, but not always obviously: in a down economy, a huge new contract with upfront payments could help to improve company profits; so could a new plant being completed (it was probably commissioned when the economy was looking good!).

However, the red line – which represents the share price of our company – reflects market sentiment: there’s a rumor going around that the ceo is about to be indicted on a racketeering charge, so it goes south very sharply. The ceo, of course, steps aside pending the investigation and in a week or two, there will be an announcement that no charges were made.

Notice that the company still commissions its plant and production goes up; some customers hold off on new purchases because of the rumors (catching up after the ceo steps aside amidst the rumors, and certainly after the charges are eventually dropped) but most contracts were signed weeks/months ago and business generally improves.

The share price, of course, will rebound making some traders very rich.

So, here’s the crux: if you’re a stock trader, you will live by these market sentiment issues; they will misprice the market and/or individual stock prices over and over again and you will make or lose a fortune depending on how well you read things.

But, if you are a stock market investor, you will look to buy future company profits, not future market sentiment.

Investing in market sentiment is gambling, and you can see where that might lead.

But, investing in future company profits is a pretty good game, if you choose good, solid companies and simply close your eyes when the market plays its little games.

Just ask Warren Buffett

The entrepreneurial investor …

There’s a misconception amongst my friends – which I don’t bother correcting – and, amongst some of my newer readers – which I will correct in this post – that I made my first $7 million through selling my businesses.

Since the sale was to a public company, the details of the sales (there was more than one) are equally public …

… which is one reason why I choose to remain ‘semi-anonymous’ here.

What my friends don’t realize is that well before selling my businesses even became an option, I had been quietly building up a real-estate and stock investment portfolio instead of paying myself a decent salary.

In fact, my self-paid salary never exceeded $50k a year (plus cars) until I moved to the USA, at a time when my professional friends were all earning at least double or triple my salary.

At one stage, I owned 5 condos and a commercial office building (now, I still own the five condos, but sold the building, adding an extra house, a small, downtown retail shopfront, plus two high-rise condo development sites in its place, not to mention various business and venture investments).

I did this because I didn’t know that I ever would be able to sell my business …

In fact, I wouldn’t be writing this blog if my first $7 million (that I made in just 7 years) relied on either selling my business, or drawing a huge salary as that wouldn’t be repeatable for most of you.

You see, only a minority of people (a) are really driven (as opposed to simply want) to be entrepreneurs, and (b) only a minority of those ever succeed, and (c) only a minority of those ever succeed in spectacular fashion.

So, for me to write a personal finance blog about my (later) business success would be about as useful as a lottery winner writing about their lottery success: interesting, but hardly a key learning experience

So, you do NOT need to be an entrepreneur to make your own $7 million in 7 years …

… but, you do need to be entrepreneurial.

You don’t need to start a business, but you have to make investing your business.

And, that takes a particular mindset; I’m not sure if it can be learned, either. That’s because I believe that entrepreneurialism is an instinct.

How can you tell if you have the entrepreneurial instinct?

Well, I can think of at least three ways:

1. There’s an old joke that asks: “how you can tell who the psychologists are at the movies?”

Answer: instead of watching the movie, they’re the ones in the audience watching everybody else!

Well, my twist is to ask: “how can you tell who are the entrepreneurs at the movies?”

Answer: they are the ones counting the number of seats that are occupied v unoccupied and mentally calculating the ticket price of each to try an work out how much money the theater is making!

Are you that guy? If so, you probably have the entrepreneurial instinct to try and find the ‘deal’ in eveything that you do.

2. Do you play poker? If so, what kind of player are you?

Are you a ‘rock’ or ‘grinder’ who plays tight and patiently waits for the ‘nuts’ (think a pair of Aces or Kings, if you don’t play poker and you’ll get the idea)? Then you’re probably more suited to frugal ‘save and wait’ personal finance philosophy … forget making $7 million in 7 years: it’ll never happen.

Are you a ‘fish’ who just plays the two cards in your own hand without considering what the other guy may have, do, or represent? If so, you should probably quit poker now; equally, you probably don’t have the creativity and imagination to succeed in ‘serious investing’ either.

Or, are you a creative player who knows when to flat call (with the occasional raise, just to be cagey) with a speculative hand (such as a pair of 3′s, or a small suited connector like a 7 or hearts together with a 6 of hearts) knowing that you will either throw the hand away pretty quickly or you will take a lot of money from the ‘rocks’, if you hit your third 3 or make two pair, a straight, or a flush with your 6 and 7 of hearts.

This is the kind of thinking that will help you test an investment, then follow through if it proves to be working for you.

3. You can try a psychological test.

I distinctly remember making the mental ‘click’ from thinking like an employee who wanted to rise up the corporate ladder to an entrepreneur who wanted to be in his own business …

… but, even though I ended up in my own business/es, I didn’t realize that I had true entrepreurial instincts until I signed up to do a Kolbe A-Test.

Not surprisingly – in hindsight (!) – I came up as an entrepreneur … by instinct!

That gave me even more confidence to proceed at ‘full steam’ with my investing (and, business) plans; maybe one (or more) of these methods might do the same for you?

The Fisherman Fallacy

Ashton Fourie  proposes a fallacy:

I think it really doesn’t matter how you define retirement. What matters is what you are doing, and whether it is what you love doing.

Am I retired? Well, I don’t really care. I can’t see that I would want to be doing any less of what I’m doing now when I’m 70, or 80, or 120 (which is how old I want to become to finish all the work I still want to do)

It doesn’t feel like a fallacy: the idea to make money doing what you love doing has to be ‘right’, right?

To find out, let’s revisit the famous parable of the Fisherman and The Investment Banker:

In case you don’t remember the story [full parable + commentary here], it’s about a fisherman who meets a big time Wall Street investment banking-type who asks what he does.

The fisherman says that he fishes for just a few hours each day then spends the rest of his time with his family and playing cards with his friends.

The Investment Banker then goes into an analysis of how the fisherman could work hard for a few years to build up a big fish-wholesaling business so that he can finally retire and … do what?

Spend the rest of his time with his family and playing cards with his friends!

What this story proposes is that you simply enjoy your life now, and don’t worry about the money.

Well, that’s all well and good until you find that you can no longer fish …

Living from the fruits (actually, fish) of your own labor – or, selling your labor and/or time as Ashton does – are very dangerous ways to live. You may love what you do for now, but one day you may (a) no longer love what you do and/or (b) be ABLE to do what you love to do.

What does a concert pianist with arthritis do?

I enjoyed working for a Fortune 100 company, but after 6 years I’d had enough.

I enjoyed starting my business from scratch, but after a few years I couldn’t wait to sell out.

I’m sure that I’d love fishing, consulting, public speaking, venture capitalizing, whatever …

…. but, after a few years, I’d want to do something else instead.

Unfortunately, my Life’s Purpose is all about traveling physically, mentally, spiritually. It’s ‘unfortunate’ because the life that I have chosen for myself takes a lot of time and money

But, reaching my Number has made living it possible

Applying the Formula for Wealth – Part II

The first part of the $7million7year Formula For Wealth is pretty simple, therefore so is its application:

Where (W)ealth is a function of (C)apital and (T)ime

It’s pretty useful for teaching your children to save part of their allowance; other than that, you need more help than I can give you if you still don’t know that you should be investing at least some of your money (i.e. capital)

But, what about a more difficult questions? Like deciding whether or not you should pay off your mortgage early?

Dave Ramsey would suggest that you pay off your mortgage NOW and INVEST (presumably, once those funds are no longer required in order to pay off your mortgage) LATER.

According to the base formula, you are still putting your money into an asset (hence, creating Capital), and allowing that to sit for a long time, which has to be a good thing, right?

Of course it’s better than spending the money – perhaps literally eating your capital (fine dining, anyone?) …

… but, is it optimal from a wealth-building perspective? For that, you need to turn to the third part of the formula – the X-Factor:

The two sub-sections of this part of the equation simply suggest that (Re)ward is offset by (Ri)sk; you have to rely on other studies (or common sense) to realize that Risk and Reward are related: as you increase Reward, so – to a greater/lesser degree, depending where you are on the Risk/Reward curve – so do you increase Risk.

In other words, Risk is a dampener for Reward – otherwise, we’d be traveling to work by jumping out of planes and playing the options market, as a matter of course!

But, the same cannot be said for (L)everage and (D)rag …

Leverage is the ‘big secret’ of building wealth: increase leverage and you MULTIPLY your wealth.

Using other people’s money is one way to increase leverage … but, by paying off your home mortgage, you are DECREASING leverage!

According to the formula, that’s bad

Interestingly, Peer to Peer lending also fails the leverage test.

You see, peer to peer lending, mortgage ‘wraps’, and other products where you are financing other people, reduces your Capital and increases their Leverage … the polar opposite of what you should be doing!

So, why do banks lend money, potentially reducing their leverage?

Simple!

They’re not lending their money; they are borrowing money as well. They are leveraged to the full extent allowed by their law and their board of directors.

Which brings us back to risk:

As the banks proved before the financial crisis, applying too much leverage can be bad for your financial health.

What about risk and your home mortgage?

The argument often cited for paying down your home mortgage is one of decreasing risk. Yet, if you intend to live in the house for some extended period of time how is your risk increased / decreased by paying down debt?

How have you applied leverage to improve your wealth?

Reader Question: How can I start a small business with no capital?

I guess some of my readers appreciate small / online business advice as well as personal finance advice, so I’ll keep the mix going for a little while longer.

On that note, let’s take a look at Jeff’s question; it’s a very common one, indeed:

I have always wanted to run my own business, and I know what business it is. I have planned out all the details, even got as far as making the business plan for startup, short term and long term. But i keep becoming discouraged at the idea when I hit the same wall every time. Which is startup capitol. Do you have any suggestions as to where or how someone who is smart and determined, but has virtually no personal capitol, can get the means to start a small business?

I don’t have enough (any) information on Jeff’s personal financial situation to make any specific recommendations. However, since this is such a common reader question, let me try and answer it for everybody in this situation.

Startup capital almost always comes from the Four F’s:

- Founders – What does your personal ‘balance sheet’ look like? Do you own a house, car, etc. Many a business has been started by refinancing existing assets, borrowing money on credit-cards, and so on. Desperate times call for desperate measures.

- Friends/Family – These two groups will invest small amounts – from $100 to $10,000 each. Pull a few together and you may get enough. Usually, they are investing in YOU, so financial results are less important to them. But, if you have a business plan that reads well, and you have a wide circle, you’re ready to start asking!

- Fools – These are seed-stage investors who MAY invest in an idea, but they are VERY hard to come by. You probably need more than one cofounder (one-man businesses are usually seen as too one-sided), and you will need to demonstrate a business with good upside.

Putting together business plans is one giant step forward for Jeff.

But, now he finally needs to decide if he’s going to drop it, or go for it. Only Jeff can make that decision

Anatomy Of A Startup – Part VI

If you’re a Dave Ramsey Fan, welcome!

But, you probably won’t stick around … no Baby Steps here, just Giant Leaps in (mainly) personal finance and (sometimes) business from a genuine mult-millionaire (that would be me!) who went from $30,000 in debt to $7 million in the bank, in just 7 years … no BS

We don’t pay off our mortgages early, here. We don’t debt snowball. And, we don’t save until we bleed (but, we do practice delayed gratification).

We DO find our Life’s Purpose, use that find our Number, and do any one of a hundred things to get there, If you do choose to stick around (unlikely, I know) … enjoy! And, feel free to drop me a line to tell me what you think [ajc AT 7million7years DOT com] …

_____________

We’ve done a little bit of FaceBook advertising while we are waiting for the ‘better’ landing page to appear, with mixed results.

What is clear, is that advertising is a great way to test your New Product Idea, but a very expensive way to acquire customers; which is OK, as right now, we are testing various strategies.

One of the things that we learned is that keywording on your more established competitors names is A GOOD THING … for us

One of the other things that we have learned is that the key technical feature of our site may be a lower takeup than we expected, which is why the ‘pivot’ was invented:

Basically, a pivot is a fancy New Age Term for “doing less of what doesn’t seem to work, and doing more of what does”. Also known as: common-sense.

So, right now, we have a nice, new design idea that could be disruptive in its own right.

We will launch with this …

But, that means that I have to change the Executive Summary:

Click to download the  Executive Overview <<<<==== CLICK HERE

The Executive Overview is the two or three page document that outlines what your business is all about:

- What problem you are solving,

- How you are solving it,

- What your ‘secret sauce’ is,

- Who your competitors are,

- Your business plan (how you intend to make money),

- Your marketing plan (how you intend to acquire customers)

- Your implementation plan.

This document – with various sections added or removed can be given to partners, key staff, investors, and bankers.

Oh, and don’t forget that it begins with your USP.

PS Obviously, the documents that I am sharing are NOT for my current venture. Sorry.

Brick Wall Retirement

[pro-player width='530' height='253' type='video']http://www.youtube.com/watch?v=MdmbkeJe6zo[/pro-player]

Late last year we had some discussion about so-called “safe withdrawal rates” i.e. what is the ‘magic percentage’ that you can withdraw from your bank account (or other investments) each year, once you are retired, so that you don’t risk running out of money?

Jacob from Early Retirement Extreme said:

It’s fairly well-established (by the original Monte Carlo paper) that the 4% rule is only good for 30 years. Also it only pertains to a broad market total return portfolio. For shorter periods I’ve seen people quoting up to 7%. For longer periods, 3% or less seems to be in order.

He also suggested for a “more extensive discussions see Bob Clyatt’s book”, which we started discussing last week.

Bob undertakes a reasonably good strawman-analysis of some of the existing thinking on Safe Withdrawal Rates then uses some of his own analysis to come up with three rules:

1. It’s OK to withdraw between 4% and 4.5% of your portfolio each year, but

2. You only need reduce the $ figure of the previous year by 5% to cushion the effects of a down-market, as long as you

3. Follow his recommendations for a highly diversified portfolio of stocks, bonds, bicycles, and sausages.

[AJC: OK, I made up the bicycles and sausages bit ]

If you follow these rules, here’s your chances of NOT running out of money, depending on your time horizon:

Now, a few things bother me about this, indeed most discussions on this and other so-called Safe Withdrawal Strategies:

1. Here’s a bunch of people who generally advocate NOT to try and time the stock market, yet, in most cases (including Bob’s strategy, if you take the 5% option) you are trying to TIME the worst possible market of all: how long you expect to live!

2. There’s always a chance that your money will run out before you do – including  in 7 of Bob’s 8 (recommended as ‘safe’ and ‘sustainable’) categories; and, in the one ‘safe’category, you still have to run the gauntlet of a nearly 20% chance of perhaps losing your money for 2 whole decades.

3. Even if you wind down your % to Jacob’s suggested 3% withdrawal strategy, Bob’s numbers [AJC: you'll have to see the book for this one] still show an almost 15% chance of losing your money in the first decade.

Now, there are other Monte Carlo studies that show that withdrawal rates on 3% to 3.5% are pretty damn ‘safe’ … BUT:

a) Personally, I expect to live forever and expect my money to do the same, and

b) How close to ZERO (but never quite reaching it, according to the statistical analysis of 3% – 3.5% withdrawal rates) do I allow myself to get before I panic?

I can’t help thinking that you need to substitute the words “safe withdrawal %” for “the right length and strength of vines” in the video, above, to really understand what it would mean to suffer a prolonged market downturn in retirement

I’ve said it before, and I’ll say it again: unless you have a perpetual money machine set up, there ain’t no safety in withdrawal rates!

The problem with P2P lending …

I am not a fan of peer to peer lending, so please forgive me, when Glen Millar of Prosper – one of the leading P2P lending sites – sent me the following e-mail, if I didn’t fall all over myself with excitement:

As a personal finance blogger we thought you might have interest in Prosper (www.prosper.com) and peer-to-peer lending.  You may know that Prosper was the first peer-to-peer lending marketplace in the US.  In 5 years, we have originated over $215 million in loans on our site.

In fact, here’s what I said in my reply:

Oops!
http://7million7years.com/2010/01/13/peer-to-peer-lending-a-7m7y-tool/

My argument in that post was about risk; Glen responded with a link to the following:

The basic argument being that Prosper manages loss/risk better than competing P2P sites through their proprietary rating system which “allows [Prosper] to maintain consistency when giving each listing a score. Prosper Ratings allow you to easily analyze a listing’s level of risk because the rating represents an estimated average annualized loss rate range.”

Which is all well and good until it is YOU that suffers the statistical loss/es (you can get unlucky and lose on a number of your loans); I don’t know about you, but I don’t like any system where I play statistical roulette without at least some measure (OK, illusion) of control.

The only control that you can really apply here is diversification: take out lots of small loans in your risk/reward categories:

In fact, if this risk-rating-system is so good, why doesn’t Prosper simply knock out the competition by adjusting the interest rate earned by the rating-weighted loss-rate and carry the risk themselves?!

But, what’s your for/against reasons?

I would like to hear both from readers who swear by P2P, and those who wouldn’t touch it with a 10 foot pole …

Applying the Formula for Wealth – Part I

There’s no point in having a formula – no matter how simple it may seem – if you don’t know how to APPLY it.

So it is with the $7million7year Formula For Wealth:

The beautiful thing about a formula like this – and, why I am so excited every time I get to share it with you – is that you don’t need to know anything about personal finance in order to answer the typical personal finance questions that arise … the formula makes the answers obvious.

Let’s take a really simple example, you earn money … so, you’re entitled to spend it right?

Well, what you do with your money is your own concern. But, if part of your plans include building wealth, what should you do?

Maslow’s Hierarchy puts physiological needs (food, water, warmth, etc.) right at the bottom, so you had better take care of all of the basic household expenses first. Then comes safety and security so you also had better take care of those brakes!

But, then come the ‘soft’ areas that cover the gamut of love and self-esteem, all the way to self-actualization and self-sufficiency. Which means that you have to take care of your future physiological needs etc. – but, that probably accounts for your basic spending and your 401k contributions.

Then you have to decide the tough issues: do you have more fun now (spend more now) or hold some back – better yet, invest – so that you can also have some fun later?

That’s a personal choice, but one that finding your Life’s Purpose will make much easier.

Which brings us back to the point where you’ve made the decision to build some wealth (e.g. your Number). And, that’s were the Formula For Wealth comes in really handy:

The formula for wealth merely says that (W)ealth is a function of (C)apital and (T)ime.

So, you need to start building capital – the earlier the better to also increase time – which means you shouldn’t spend that excess cash on going out and having (too much) fun, nor should you buy depreciating assets such as cars, furniture, and accessories (other than to satisfy the Maslow-needs for basic transport, protection and comfort).

And, the formula makes it pretty clear that the more your capital increases over time, the better. So, simply sticking your cash under the mattress probably won’t cut the mustard … you’ll need to start thinking about investments that grow your capital over (sufficient) time e.g. CD’s, bonds, stocks, or real-estate.

Nothing earth-shattering, so far. So, next time, let’s use the second part of the formula to answer one of the most commonly-debated questions in personal finance: should you pay off the mortgage on your home loan early, or just let it ride?