My circle, my prison.

1998 capped a long period in my life when I was imprisoned by a circle.

I suspect this is the same for most. What separates me from the others – and, I suspect you, too – is that I broke out.

The ‘circle’ was my life and the things that I was trying to deal with:

- Keeping myself sane in an increasingly mad world

- Keeping my family safe, fed, and healthy

- Trying to earn a decent living to pay the bills and keep a roof over our heads.

This type of existence is inherently inwardly focused … we focus on ourselves, our immediate family, our friends, and our work colleagues (probably in that order) and little else.

The reason why it’s a prison – well, a financial reason (there are others beyond this scope of a humble personal finance blog) – is that our ‘investments’ are similarly inwardly focused; aside from what little we manage to save in our bank accounts and 401k’s, our so-called investments center around the things that make our inner-circle lives a little better.

We invest in our health (as much as we can – or feel motivated to do), our education (often because our parents tell us that “it’s an investment in our future”), our home (because that’s what our parents did) and, of course, our cars & possessions (because that’s what our friends and colleagues do), and so on.

Why do we invest?

So that when our income stops we can try and continue living within our circle and simply maintain what we have?

But, when I broke out of that circle my life began to change!

My First Big Realization was that my life wasn’t about my money … so why was I spending so much of my life – that precious, finite resource – attempting to earn money?

When, in 1998, I found my Life’s Purpose, which included what was in the circle (family, health, and so on) but also a lot more than I had ever felt desirable or even possible, I was forced to look outside the circle … way out.

Interestingly, and logically, I also realized that the investments that I had been making for my circle-bound future would no longer be adequate for a far less bounded life.

Not only did my thinking have to move beyond the circle, but so did my finances. And, if my finances wouldn’t be adequate for the life that I really wanted to lead, then neither would my investments!

So, in 1998, my investment strategy also shifted … and, shifted dramatically.

[AJC: if you want to understand a little more about this process, then check out this free site:  http://site.shareyournumber.com/]

No longer would I try and upgrade my home and my car.

No longer would I try and upgrade my lifestyle in an attempt to keep up with the Jones’ (and, I had plenty of those to try and keep up with!) …

… I would simply begin to apply every spare penny to investing outside of the circle: in true investments that I could not eat, live in, drive, or share over a beer.

Now that those investments have born fruit, finally freeing me up to live my Life’s Purpose, I realize that living outside of the circle has actually also helped me live within.

The difference is that my inner circle is no longer my prison but my sanctuary.

The sooner that you identify what is in your circle and what – if anything – outside of the circle truly drives you, the sooner you will be motivated to seriously start making money and investing.

Then this blog will suddenly become very interesting to you

Pay Yourself Twice!

It is commonly taught that in order to build wealth, you first need to save; and, the best way to save – so common financial wisdom says – is to pay yourself first.

Investopedia (the online investment dictionary) explains Pay Yourself First:

This simple system is touted by many personal finance professionals and retirement planners as a very effective way of ensuring that individuals continue to make their chosen savings contributions month after month. It removes the temptation to skip a given month’s contribution and the risk that funds will be spent before the contribution has been made.

Regular, consistent savings contributions go a long way toward building a long-term nest egg, and some financial professionals even go so far as to call “pay yourself first” the golden rule of personal finance.

Whilst certainly better than the other 99% of the population who don’t even bother saving anything, paying yourself first doesn’t go far enough:

Never mind underestimating what it costs to live a reasonable lifestyle, realize that the old “retire a millionaire’ ideal is no longer adequate; this is largely because of inflation i.e. over 40 years, you will suffer roughly two doublings in the cost of living.

Another handy way to think about this is to think of your retirement date & financial target:

Think of a ‘number’ … the amount that you think is reasonable to aim for in retirement, given the financial strategies that you feel that you can employ. Can you save $1,000,000 by your expected retirement date? Less? More?

Don’t guess; there are plenty of retirement saving calculators around to help you with this task …

1. If 20 years out, ask yourself: “would I be happy with living off no more than 2% of that number, each year?”

2. If 40 years out, ask yourself: “would I be happy with living off no more than 1% of that number, each year?”

If your answer is a resounding ‘yes’ then you are done … it looks like your retirement savings strategy will work.

Congratulations!

Now, stop reading this $%@@# blog, it will make your head spin

But, I’m guessing that the answer will be ‘no’ … then what?

Then, you have to face some realities about your current “pay yourself nothing” and “pay yourself first” and “no debt in my life” strategies:

- A million dollars in 20 years (= approx. $500k today) to 40 years (= approx. $250k today), is too low a target,

- 10% isn’t enough to save,

- 20 – 40 years is too long to wait,

- Your 401k – more importantly, the underlying investments – isn’t the right place for your money,

- And, you are probably under-leveraged.

Today, we’ll deal with the first issue:

If you have two reasons to save money (1. to pay down debt, and 2. to build your investment war chest), then it stands to reason that you should pay yourself twice!

But, most people pay themselves second, if at all.

From now on, I want you to concentrate on paying yourself twice … before you spend money on anything else (other than taxes and social security); here’s how:

1. Pay Yourself Once: If you currently participate in an employer-sponsored retirement plan, then you should continue to do so, and

2. Pay Yourself Twice: You should save an additional 10% of your take-home pay – for now, this can be in an ordinary savings account clearly separated from your other funds.

If you do not currently participate in an employer-sponsored retirement plan or if you and/or your employer are currently contributing less than 5% of your gross pay into your retirement account, then you need to increase your pay yourself twice target to 15% of your take-home pay.

Of course, this is easier said than done: if you had 10% of your take home pay just lying around, by definition you would already be saving it …

… in other words, you are already paying yourself twice; if not, all of your take home pay is currently spoken for!

So, let’s start slow:

Step 1 – Could you save just 1%?

Take a close look at where your money is going: do you think you could find any spending areas where you can cut back enough to allow you to save just 1% of your take home pay?

If you are already saving – but less than the 10% / 15% Pay Yourself Second target – do you think you could find any spending areas where you can cut back enough to allow you to save another 1% of your take home pay?

[AJC: No need to start at 1% if you can find ways to save more; start at (or, adding) 2% or even more, but make sure that once you start that you never turn back ... be realistically aggressive in setting your Pay Yourself Second target]

Step 2 – Wait 3 months and double it!

Over the next three months, perhaps by scouring the personal finance blogs on the internet, dedicate yourself to finding ways to double your savings rate i.e. if you started at 1%, after three months you should be saving at least 2% of your take home pay. If you started at 2%, don’t take your foot off the gas … double your savings to 4% of your take home pay.

Step 3 – Repeat

Keep doubling every three months until you reach 8% of your take home pay; three months later, save that 8% plus an additional 2% of your take home pay.

Step 4 – Almost there

What you do next depends on your Pay Yourself Second target:

- if you are already saving at least 5% of your gross pay in an employer-sponsored retirement plan (or similar), then you are done! Keep saving that 10% of your take-home pay.

- if you don’t participate in a retirement plan, or if you contribute less than 5% of your gross pay (including employer contributions), then you should keep saving 8% of your take-home pay plus you should concentrate on doubling the additional 2% every 3 months (i.e. 2% to 4% to another 8%) until you reach your combined target of 15%.

Step 5 – NEVER give up

Start today and never stop!

Unfortunately, as I’ve already pointed out, saving alone won’t get you to Your Number … it won’t even replace your current salary!

So, next time, I’ll help you decide what to do with your Pay Yourself Twice savings …

More on the the myth of paying yourself first …

You can play with numbers until you go blue in the face, but unless you understand the principles you won’t be able to make the right life choices.

So it is with the myth of paying yourself first.

It’s usually pitched as putting aside the first 10% to 15% of your paycheck into your 401k with any excess (when your 401K’s maxed out) I guess being put to work elsewhere. Some offer slight variations on the theme, like David Bach’s one hour of salary a day (or 12.5% of your gross).

Any way the ‘gurus’ put it, the alluring promise is of following this discipline your whole working life to ‘finish rich’. David Bach – author of the book to the left – goes even further calling this a powerful one-step plan to live and finish rich.

We have to examine this promise very carefully, because following this line of reasoning for 40 years to see what happens leaves very little room to maneuver if you come up short.

If the ‘normal’ working life is 40 years – to me this concept is almost incomprehensible – then, picking a mid-point in your career and a mid-salary of $50,000, adjusted for inflation, that you think (another terrible assumption) that you will be happy with for the rest of your life, then in my last post I showed that you would need to save almost half of your pay packet (again, indexed for inflation) until you retire …

… simply to replace your $50k salary (by then, inflated to roughly $100k but so have all of your living expenses).

But, what if you start young – as Bret @ Hope To Prosper suggests – and are happy to work 40 years?

Firstly, I would have to ask why you’re reading a blog titled “How To Make $7 Million In 7 Years”

Putting that aside, you would need to save a tad under a quarter of your paycheck if you want to maintain your $50k per annum lifestyle beyond retirement (inflation would have roughly halved your buying power twice in that period, meaning that you would actually be withdrawing around $200k per annum just to maintain the same lifestyle that $50k buys you today).

Unfortunately, you are unlikely to reach your desired salary so early in your 40 year working career …

So, if you’re a graduate with a starting salary of, say, $30,000 and you somehow ramp that up to $50,000 after 5 years (at which point you start saving for retirement), you would need to save around one third of your paycheck for the remaining 35 years until you retire.

To be clear, following the common wisdom and “paying yourself first” 10% of your $50,000 gross paycheck (then indexed for the next 40 years for inflation) as recommended by many (if not most) personal finance ‘gurus’ is a sure-fire way to make sure that you retire on over $60,000 a year.

However, far from being a pay increase, because of inflation it actually represents less than 50% of your current $50k salary. Work and save diligently for 40 years and cut your paycheck in half …. nice

Any way you look at it, paying yourself first is no Powerful One-Step Plan to Live and Finish Rich as claimed by David Bach and his ilk.

Next time, I’ll share a plan that will work much better …

Anatomy Of A Startup – Part VII

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Please let me know (in the comments) if my slightly off-topic forays into the world of internet-startups are interesting, boring … or, somewhere in between.

If you’re still not sure, read today’s post then answer the poll

I’m sure that many people are put off the idea of starting a business – any business, not just a web-business – by the perceived failure rates: the ‘urban myth’ is that 9 out of 10 businesses fail in their first five years, so I wouldn’t blame you for simply dismissing the idea of becoming an entrepreneur!

For you, though, the chance of failure is 50/50: either you will fail … or you won’t.

Statistics (i.e. what happens to OTHER small business owners) mean nothing to you … but, your personal success or failure means everything.

Even if you subscribe to the statistics more than my philosophical view, we can still agree because the real numbers are much closer to 50/50 than 90/10 [click on the image to enlarge]:

[Source: Amy Knaup, Monthly Labor Review]

The chart shows that the four year survival rate for small businesses across the USA is anywhere from nearly 40% to nearly 60%. While not quite 5 years, and not quite 50/50 (you can reduce these 4 year survival rates by approx. 10% for each succeeding year), it’s certainly not as glum an outlook as the 90% failure rate that the popular press would have you believe.

So, how would you like a surefire way to tell IN ADVANCE if your Internet-business has an 85% chance of surviving, with an additional 9% chance of being sold for millions of dollars, and with a ‘booby prize’ of at least a 75% chance of achieving a huge amount of additional funding (an average of $500k)?

Fortunately, for the Internet entrepreneur there is a super-reliable way of doing this:

Simply apply to join one of the respected Venture Accelerators springing up all over the world!

If you DO manage to make your way through their selection process, here’s what you can expect in terms of survival/success after 4 years:

[Source: Techstars]

Time to dust off that business plan?

The fallacy of multitasking?

Kevin exposes a fallacy:

Concentration…fortunes are built on it—or lost by the lack of it…

Here’s a clue…if you’re a salesman, you have to sell; if you’re a writer, you have to write; if you’re an accountant, you have to be crunching numbers. The more time and energy spent doing something other than your primary activity, the less progress you’ll make in your career and the less income you’ll earn.

.

I used to struggle with this myself …

My natural tendency is to do a LOT of things … at once.

My father (my then business partner) used to tell me to forget the ‘new business’ and just focus on his one.

My wife used to tell me to focus.

Then I did an online ‘psych test’ about ‘money and personality’ (I highly recommend this one: http://www.kolbe.com/assessmentTools/assessment-tools.cfm#rindex you’ll want to do the A-Index AND the Financial MO+) …

I learned two things about myself that changed my mind … then, my life:

The A-Index told me that I was an entrepreneur – this may be “well, duh” to you, given the title of this blog, but – at the time – it was news to me: I was a struggling entrepreneur, but wasn’t feeling very well cut out for the ‘job’.

The Financial MO+ Index told me that I work best by having “several balls in the air at once” – it’s the way my mind works best, the report said, and it was 100% true.

So, these reports – all $150 worth – gave me the confidence to work according to my instincts … and, a 356% compounded return on my investment

Kevin’s ‘fallacy’ may well be true for 99% of people. But, it’s not true for me.

And – just maybe – if you want to achieve results that only 1% of the population ever dare aspire to and achieve, it won’t be true for you, either?

In any event … I learned to follow my instincts and so should you!

Which would make you feel richer?

Last week I asked my readers what would make them feel richer: more income? Or, more net worth?

This was prompted by a Twitter Trail (my term for a thread on Twitter) that started with this:

@NoDebtPlan articulates the classic fallacy: income makes you feel richer because it can be turned into net worth.

But, that is illusory: if your net worth is invested wisely, it’s pretty hard to lose all of it.

On the other hand, ask the millions of people who are ‘down-sized’, get injured, relocated, become under-skilled, out-voted and so on just how easy it is to lose your entire income … and, as soon as your income stops, you begin to feel very poor indeed

Of course, what’s the use of net worth if not to create income?

So, while it is certainly true that income can create net worth … that’s the beginning of the chain, not the end.

The whole point of net worth is to (a) live in / drive in / enjoy and (b) to create an alternate (passive) source of income so that you can eventually stop work, should you so choose (or be forced into).

Now I’m not talking from some book that I read: I created my $7 million in 7 years simply by exchanging income (from my business) into assets (income-producing real-estate and stocks) … and, you should do the same:

Remember that Rule of 75% … without it you, too, will always be a slave to earning an income

The meaning of success …

If you’re a new reader, you’ll pretty quickly find out that I only write when I think that I have something useful to say …

So, the best thing to do is scan this post and if it’s interesting, subscribe by e-mail / RSS and I’ll pop a quick e-mail into your in-box if the urge to write does strike.

Today, I am inspired by a post written by moneycrush about success:

“Big goals take time, which means it can be especially hard to stick to them when they require both time and sacrifice.”

Here, moneycrush equates success with “reaching your goals”. giving an example of getting your house paid off.

So, this got me thinking about the nature of success:

On the surface, I am successful.

Certainly my friends and family talk to me – and, of me – in those terms.

Now, they don’t necessarily know my net worth (after all, that’s why I write here under a nom de plume), but they do know that I sold three businesses in three countries … so, they can connect the dots.

They don’t realize that, by their measure of success = money, I was already ‘successful’ well before  before I sold my businesses, and well before those businesses even made any serious money.

Because I was quietly doing what I advise my readers to do: take your income and use it to buy income-producing assets instead of spending it. What my family and friends don’t realize is that’s how I made I made $7 million in 7 years, starting with $30k in debt.

In any event, I still don’t consider myself successful.

That doesn’t mean that I’m one of those guys who chases ever bigger and bigger financial wins …

It just means that I measure success differently:

To me, success is when I am living my Life’s Purpose. And, money is just one of the enablers.

In 1998, I discovered my Life’s Purpose; it was simply to “always be traveling mentally, physically, and spiritually”.

Now, that means nothing to you … so, let me translate that into some practical incarnations of that Purpose:

- Travel … a lot. This takes time and money.

And, comfortably. For me, this means about $50k a year of business class travel. I’m about to experiment with a roll-up mattress on the business class ‘lie flat’ seats; if that doesn’t work, I’ll need to ‘upgrade’ to first class because lack of sleep on the long-haul flights from/to Australia kills me.

- Personal Finance & Public speaking … twin passions of mine. I hope to be able to combine these, one day. The money I might earn is irrelevant.

I rarely get to indulge in public speaking these days; the hidden cost of no longer being attached to the corporate world. But, I discovered this passion about 30 years ago, yet have spoken publicly less and less as time has gone on. This blog, as well as being a passion in its own right, is one step towards resurrecting myself as a public speaker. My book (out soon!) is the second.

- Venture Capital … this goes with the ‘traveling mentally’ bit.

I must admit I was worried. Stories about VC’s investing in 10 businesses in order to (hope) that one may succeed scared me, with typical (VC-like) bricks and mortar investments requiring upwards of $250k each. Fortunately, the internet came along and I’m happily working on my little angel investing fund, which allocates $25k+ per investment. If 10 fail, well, it shouldn’t hurt much more than my pride. Fortunately, success rates are closer to 30%, so I’m told (hope!). In either case, but don’t tell my partners this, I’m only in it for the stimulation and … fun!

- the touchy/feely spiritual stuff. I’m not exactly the next great guru, but this doesn’t cost any money – or much time – and feels … well … nice.

So, for me success is more about what I do than what I have.

But, I am just starting to live my Life’s Purpose: I’m beginning to travel more; but, I am just starting my venture capital activities and my book isn’t out yet (hence, the speaking offers haven’t exactly flooded in) … so, I am working on my ‘success’ but am clearly not there, yet.

Now, I suggest that you find out what REALLY matters to you and go about becoming ‘successful’ too

Reader Poll: What would make you feel richer?

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Feel free to also leave a comment explaining your answer; the more the merrier

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 …

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?