real rich, real simple, redux

This is a redux of a 2009 post, but it’s about time that I gave my newer readers a heads-up as to what we’re all about … if I had to point somebody to just one of my posts to get them started this would be the one; putting in all of the links nearly killed me ūüôā

______________________

I get a lot of questions, comments, and e-mails in general from new readers, and this one – from Chad – is reasonably typical of what I might see:

I’m turning 27; just got a job making 50k/yr.; on the market for my 1st condo to live in (and hopefully rent out a room); have 1 student loan at < 3% fixed interest. My goal is $7 million in 13 years.

1. I have very little to no knowledge of finance/investing. Do you recommend any resources to get me up to speed so I can understand what you write about?

2. Where does my situation put me in terms of Making Money 101 and 201, i.e. where do I go from here?

I appreciate ANY direction you can give me as I do not want to be stuck behind a computer in a cube for the next 30-40 years.

While I love reading these sorts of e-mails (AJC: I really do!], I have a hard time responding because I can’t / don’t give direct personal advice … but,

I can suggest that Chad think about:

1. Exactly HOW important that $7 million in 13 years is to him, and

2. Assuming it’s VERY important (critical even), how he is going to get there.

You see, my advice might change according to his Number – more importantly to his Required Annual Compound Growth Rate:

a) If low – say, no more than 10% to 15% – then I would point Chad to the various ‘frugal’ blogs (my personal favorite is Get Rich Slowly) and ‘starter books’ like The Richest Man In Babylon, or the more modern equivalent: Automatic Millionaire by David Bach, or anything by Dave Ramsey or Suze Orman.

Each would probably suggest something along the lines of:

– Keep your job; times are tough!

– Save as much of your salary as you can (max your 401k’s, then your IRA’s)

– Pay down ALL debt, following a Debt Avalanche or Debt Snowball, whichever is your favorite

– Invest any ‘spare change’ (after all debts are paid off and the requisite ’emergency fund’ has been built up) into a low cost Index Fund

… and, wait until your government-directed – or, employer-forced if you are retrenched and become unhireable – ‘retirement’. This is where that fully paid off home and a lot of candles and canned food stockpiled will really pay off … you won’t be able to afford real food ūüėČ

a) If high – say, more than 10% to 15% (and, I would venture that $7 million in just 13 years would well and truly put Chad in the 50+% required annual compound growth rate category!) – then I would instead point Chad to books like Rich Dad, Poor Dad and The E-Myth Revisited and then towards this blog and its 7 Millionaires … In Training! ‘sister blog’ and suggest that he starts working his way through the back issues (well, posts).

After reading/digesting properly, he should be able to come up with his own plan … something along the lines of:

– Keep your job, but get into active stock and/or real-estate investing – better yet, start a side-business; because times are really tough(!):

i) A mildly successful part-time business might provide additional income to help you weather the financial storm and supercharge your savings, investment, and debt repayment plans

ii) A more successful part-time business might provide a built-in ’emergency fund’, tiding you over should you lose your job and/or unexpected expenses crop up

iii) An even more successful part-time business that can be started and/or survive during a recession may prove to become wildly successful once the clouds of the recession begin to lift, maybe even carrying you directly to your Number [AJC: do not pass Go, but do collect $200 million ūüôā ]

Control your spending, and save as much of your salary as you can to build a war chest for starting / running your business

– Pay down ALL expensive debt, following the method laid out in the Cash Cascade, but keep your mortgage (lock in to current low rates) subject to the 20% Rule and the 25% Income Rule and seriously think about keeping your other cheap debt loans.

– Invest any ‘spare change’ from your job and business (after all expensive debts are paid off and the requisite ‘business startup fund’ has been built up) into quality ‘recession-priced’ stocks and/or true cashflow positive real-estate.

… and, wait until you have reached your Number (through sale of business and/or conservative valuation of your equity in your investment assets).

That’s it ūüôā

It’s impossible to pay for good advice …

This is not just a provocation … I think it’s true.

It may not be true in some technical professions: think of a doctor or an accountant … you pay for advice and you expect it to be good (after all, she’s got a PHD right?).

Even then, how do you know it’s good advice?

After all, in most cases, you’re hardly expert enough to judge ūüėČ

Should you be worried?

Not  unduly. After all, those articles about the accountant who diddled his clients books is something that you only ever read about. It never happens to you. Right?

What about the guy in the picture to the left? Would you go to him for advice on a healthy lifestyle?

The picture is of a statue, but it bears an uncanny resemblance to a doctor-friend of mine, whose picture I can’t show for obvious reasons; he’s actually a top vascular physician and surgeon.

So, best case, quality of advice is difficult to determine.

But, it’s downright¬†impossible to pay for good, personalized financial (or business) advice!

A simple example: if you want to grow a successful business, can you pay a consultant to tell you how?

Of course not! If they knew the ‘secret’ to building a truly successful business, they would be busy doing it for themselves.

The best you’ll get is some clown offering cheap advice ūüėČ

Let’s try personal finance: people ask me how to select a good financial advisor:

The first thing that I ask them is how much money they want (and, by when)?

The answer is usually $7m7y (or, some other large Number / soon Date).

The next thing that I ask is how much of their own money their chosen advisor has made following the same recommendations that he is giving to them?!

I made $7million in 7 years, but it’s impossible for you to pay me for advice; I give it away … because I want to.

Still not sure?

OK, let’s say you want to invest in stocks.

Who do you want to pay for advice: (a) somebody who’s read about investing in stocks, or (b) somebody who’s made a lot of money investing in stocks?

If (b), why are they taking paltry fees from you?

Oh I see … they aren’t just taking fees from you, they have a managed fund. They’re not really taking money for advice, rather earning a fee for running the business of managing a huge bucket of money (including your tiny drop).

Even so, let me ask you another question:

Who do¬†you want to pay to manage your money:¬†(a) somebody who’s made a lot of money investing in stocks?, or (b) somebody who’s made the most money investing in stocks?

If (b), then who’s made the most money investing in stocks?

Obviously, it’s Warren Buffett (with George Soros a good second … but, if you said John Bogle you fail because he made money through his business of selling his low cost index funds to the masses, not from investing his own money in them).

So, if you want to invest in stocks, you can’t buy the right advice, because nobody’s selling … and, if you want to invest in some kind of fund you can’t pay for the best advice available …

… but, you can tap into that advice for ‘free’ just by buying Berkshire Hathaway stocks.

If I wasn’t going to manage my own money – listening to plenty of ‘advice’ but, ultimately taking my own counsel – that’s what I would do!

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 ūüėČ

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 ūüėČ

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 twicebefore 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 Рbut less than the 10% / 15% Pay Yourself Second target Рdo 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 …

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 firstdrum 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 ūüôā

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

Anatomy Of A Startup – Part V

I’m not sure if this is a useful series for my audience; on the other hand, I do encourage as many of you to start a part-time business as possible – with the Internet being an ideal platform – so it should be useful.

But, do let me know if you want to see more/less of this business-type of stuff on this personal finance blog …

There’s been a lot of Internet chatter about so-called ‘lean startups’: as far as I can see, it used to be called “bootstrapping” (Guy Kawasaki, the¬†legendary¬†Apple early employee, angel investor, startup junkie, and raconteur famously started Truemors for a little over $12k), but should just be called ‘common sense’.

Having said that, I’ve committed $100k to my latest startup, which is currently being spent on partial salary replacement for one guy (apparently, he doesn’t like eating dog food), a padded cell (one small, windowless room, 4 desks, 3 people …. plenty of stale air), and a little bit of web-type outsourcing:

– We purchased a logo on hatchwise for $250

– We purchased a home page image for $19 and spent another $36 on oDesk for two guys in India to turn it into a real web page with KISSinsights ($29/mth), and MailChimp (one of the guys already has an account) integration. $6 an hour buys an awful lot of basic code-cutting.

– We’ve also spent $1,200 locally getting a real home page built, with plenty of back-end functionality [AJC: we need a few different types of home pages for some of the stuff we’re doing, all at different levels of complexity]; but, we’re doing that with the engineer that we want working with us, and this is a sort of ‘feel each other out first’ kind of project.

The other key part of Lean Startup / Bootstrapping / Common Sense is simply getting something out there real quick to test the market response. This is called a Minimum Viable Product (MVP) …

This should be taken to mean:

Get a landing page up now!

Fortunately, that’s really easy with the abundance of new tools and services that have been coming onto the market recently (including unbounce, mybetali.st and launchrock).

This is an example of one built using launchrock [AJC: no, it’s not mine … just some random one that I found; click on the image to get to the site, anyway]:

It’s probably not the best example of one that I’ve seen (why would you want to put down your name just to jump “square to square”?), and I’m betting that it’s a mobile app (think local) because the URL is usehopscotch.com …. but, that’s only a guess and it’s not really important.

What is important is to go ahead and sign up and see how launchrock gives you a share page, complete with a customized URL so that you can track which user has invited whom … and, you can incent them accordingly!

Fork.ly¬†famously did this¬†with the incentive of getting to the top of their beta-invite list e.g. “after 3 people sign up with your link, you make our ‚Äúpriority access list‚ÄĚ and we let you know via email.”

The reason¬†WE’RE putting up prelaunch home pages (as they are known) is so that we can test keywords to see (a) if we can drive traffic to our site (and our value proposition), if so (b) which keywords work best.

This is how to implement the strategy outlined in¬†this post where I shared some great advice from my good online friend Brandon¬†‚Äď it‚Äôs simplicity in itself ‚Ķ¬†here‚Äôs what Brandon says:

Let me sum this up in one sentence:
As a startup or new business, the amount of time you spend writing up a sexy business plan to pitch investors would be better spent running a $500 PPC campaign testing your idea.

[Note: PPC = Pay Per Click online advertising]

You are lucky enough to live in a world with Google Adwords.  This is a good thing.  The costs of launching a new business online are hastily reducing to zero.  Testing a business idea or even a half-baked, half-assed business-sorta idea, is easy.  So do it.

Stop thinking about writing a business plan (that you mostly copy of some web template ‚Äď be honest), and start here:

1. Register a domain name.  Doesn’t have to be good.  Starting a bird feeder biz?  Get birdfeederdepot1.com.
2. Get hosting, install the CMS [e.g. WordPress or Blogger] of your choice.
3. Make 3-4 landing pages.  Ask questions.  Find out some key answers to the market you are hoping to serve with your genius new idea.  Offer to sell your service right now.
4. Setup [a Google] Adwords campaign and spend $500.
5. Read the answers you get.¬† Scour the analytics, the keywords and clicks.¬† Any sale or response is good.¬† Email your new ‚Äėcustomers‚Äô and find out more about them.

The point is, this is so easy and cheap to do, you should do it.  There’s no risk in doing so, and the upside is possibly priceless.

It could save you from wasting 9 months of your life chasing a bad idea.  It could teach you what people really want, not what you think they want.  It makes you get serious.

We’ve been experimenting right now with a FaceBook advertising (watch out Google!) campaign at $5 – $10 a day (!), and have already learned some interesting things for less than $50 total spend (!):

1. Targeting our competitors’ names in our keywords is a great way to reach our exact target market,

2. Paying CPM is usually better than CPC: worst case, we seem to pay roughly the same CPC that we would have paid had we been bidding CPC (about $1 to $2 per click for our keyword niche) and, occasionally, we even see massive spikes where our CPC mysteriously (and miraculously) drops to $0.01 on (comparatively) huge volume of clicks and signups.

… now, that’s good!

 

PF advice in America is broken …

Thanks for the great – and, well thought out – responses to Bristol’s shout out for help with his debts:

I was stuck in an internal conflict about paying off debt or investing for years until now. I would like to apply your debt cascade to my financial situation and need your help.

You’ll have to take a quick look at my original post for the details, but the¬†jury was pretty much split over whether Bristol could (or should) pay off his debts now or later (for the purposes of investing instead).

Marie summarized the ‘FOR paying off the debt fast’ case quite succinctly:

Seems like he can pay off his loans in 19 months

But, many were on the AGAINST side, including traineeinvestor who offered some great advice:

I would invest it all and not make any early debt repayments. Five percent (the most expensive debt ‚Äď assuming it is not tax deductable) is a pretty low threshold rate of return to beat and mortgages and student loans are unlikely to be called early unless you miss a payment.

Me?

I’m right on the fence with this one … for two reasons:

The first is that, while average returns are much better than the interest rates being earned (actually saved … but a dollar saved is a dollar earned right?), if Bristol also applies his $10k cash stash to the debt, it may take him <2 years to pay off all of the loans … over that short period who knows what investment returns will be?

And, there is something to be said for being debt free … especially when it can happen so quickly!

[AJC: on the proviso that the debt repayments are immediately rolled into an aggressive – and, maintained – investment program]

On the other hand, if Bristol has a plan to make an immediate investment (found a great business to buy or invest in; found a great real-estate investment; has a brilliant idea for anew business; and so on) then why hold off on ‘the big payoff’ to pay down circa 5% debt, instead?

But, Bristol has none of those plans right now, and that brings me to my second – much more important – point, foreshadowed by Luis:

Who cares about your debt at this time! What do you want to do with your life?

Bristol’s current life plan – not what to do with his debt – is the problem … because his current life plan is impossible!

Here’s what Bristol shared:

I do have a stable job where I invest in the 401k up to the match% only. I have $10000 in a savings [account] and $10000 in a few blue chip stocks. I would  be willing to invest the majority of my savings. I am currently 23years old and would like to retire at least by age 55. So that would be 2066 and per cnn retirement calculator i would need 5.9million dollars (2.2million in todays dollars) to spend retirement happily. I think i could reasonably get 8% return. I think I would mostly like to invest in the stock market.

I think the expectation of working hard, living sensibly, saving hard, and starting young to retire on $2.2 million dollars (today’s dollars) in 30+ years would seem reasonable, wouldn’t it? In fact, this seems to be the mantra of much personal finance advice right now …

Yet, this is what happened when I sent Bristol off to play with an online calculator for a while:

I have been plugging my numbers into a similar calculator one that takes into consideration additional monthy contributions and have realized that if I want to reach my goal I will have to be much more aggresive. Although it is possible for me to get there, its just not happening on 8%. So I have alot of thinking to do about how to get there and how much risk Im willing to take. One thing is for sure, time is money and I will not be putting extra money onto the school loans anymore!

Inflation forces very large Numbers for even relatively modest retirements: ¬†<$90k p.a. in today’s dollars (Bristol’s approx. target, based on a 4% ‘safe’ withdrawal rate on his $2.2 mill. pre-inflation target) may be considered luxurious by many, but – be honest – would you be happy working hard and being financially disciplined for 30 years and retiring on less?

So, inflated (at a relatively modest 3% inflation rate) an ‘easy’ target like $90k a year (today’s dollars) requires you to save nearly $6 million over your working life; simple logic tells you that this is impossible for a normal working person … Bristol included.

Bristol’s problem isn’t how to pay his debt; it’s how to amass at least $6 million in 30 years!

And, Bristol’s not the only one …

Personal finance in America is broken; the advice is small picture (pay debt, live frugally).

Who’s there to give the Bristol’s of this world the big picture?

Another case AGAINST dividends …

The graph shows the promise of dividend-investing, but Canadian Couch Potato states the reality – the case AGAINST dividends – far more eloquently than me:

Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called ‚ÄúExplaining Investor Preference for Cash Dividends,‚ÄĚ coauthored by Hersh Sheffrin. He also reviews the idea in his new book,¬†What Investors Really Want, pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a ‚Äúhomemade dividend.‚ÄĚ

Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called¬†mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is ‚Äúdipping into capital,‚ÄĚ which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital.

If you want to understand the arguments – both for and against – investing in so-called ‘dividend stocks’ for the sake of the dividends, you would do well to read Canadian Couch Potato’s whole blog post AND the comments … all for/against arguments are well thought out.

Here is my argument against dividends in a nutshell:

Since you can create a dividend stream yourself (“ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend”), it boils down to what could the¬†company¬†do v what can you do with the ‘spare cash’ that the company plans to issue (or not issue) as a dividend:

1. If the company keeps the dividend:

– They could buy more inventory: if their business is a volume business, more inventory = more profits. Consumer products companies such as Kraft and Unilever are great examples.

– They could do more R&D: investing in R&D is¬†necessary gambling on the future; often it will be money wasted (in¬†which¬†case it’s better off in your pocket as a dividend), but sometimes it will provide a huge payback, such as when a pharmaceutical company develops a breakthrough medication, or a venture capital firm finds the next FaceBook.

– They could invest in marketing: more marketing = more sales; pretty simply, huh? Consumer products and technology companies are classic examples; the more often they put their products in front of the consumer, the more sales they seem to get.

РThey could invest in more infrastructure: more factories, more locations = more revenue and more profits. Manufacturing companies, high tech businesses, and retailers are all tied to physical infrastructure.

– They could invest the cash – Many companies (think Microsoft, Apple, the tobacco companies, and the brewers) are sitting on a ton of cash. Heck, Berkshire Hathaway is sitting on so much of it, even Warren toys from time to time with giving it back to the shareholders (i.e. by issuing a dividend); after all, if they can only get 3% while it’s sitting in the bank and you can get …? Inevitably, though, they use this cash to make a spectacular purchase that transforms the company: think Google’s $6.5 billion offer for Groupon, or Berkshire Hathaway’s $44 billion purchase of BNSF Railway.

2. If you take the dividend:

– You could buy more stock in the same company: this is the basis of the¬†automatic¬†‘dividend reinvestment policy’ that most companies now offer. So, let me see … you invest in company ABC because it issues a dividend, and you use it to, what? Oh, buy more stock in company ABC?!

– You could buy more stock in another company: why invest in another company? Oh, because it provides a better return. So, why not pull ALL of your money from the worse-performing dividend paying stock, and put it all in this company?

– You could buy more stock in a bunch of companies:¬†diversification¬†is often seen as a good thing [AJC: by many reading “how I became rich” blogs; rarely by those writing them]. The more you diversify, the more you tend towards average market returns. Why would you want to take your cash out of a company that produces spectacular returns [AJC: that’s why you invested in the ‘dividend stock’ in the first place, isn’t it?!] in order to put your money into something that produces average returns?

– You could keep your cash in the bank: strangely enough, this one makes sense; if the company can’t do anything better with their ‘spare cash’ than give it to you, wouldn’t you rather have it sitting in your bank account rather than theirs, so that you can at least have the¬†flexibility to make the decision what to do next, eg leave it in the bank, buy some index funds, pay down debt, or even buy back into the company stock when they get out of the ‘sit on a ton of cash with no vision for the future’ doldrums.

… but, if any of these things are better than leaving the money in the company, wouldn’t you be better off taking all of your money out of the company all in one go (i.e. sell the stock) rather than in dribs and drabs (i.e. taking small dividends)?

Let me finish off with a story:

Warren Buffett got started by purchasing a textile company and immediately canceling it’s dividends!

Why?

So that he would have more money to invest in growing the company.

Potential investors who wanted dividends invested elsewhere … those who didn’t invested in Berkshire Hathaway and became multi-millionaires!

Berkshire Hathaway still operates on the same principle: why pull money out of BH when Warren can grow your money faster?!

Make money while you sleep?

Making money while you sleep … isn’t that everybody’s dream?

Erica, my favorite small-biz-whiz, shares her success with a business that makes her money not just when she’s sleeping, but also while she’s away:

You don’t need to stay home to work. Whoosh Traffic had its 1st $1000 day, hit $10K in total revenue, & became profitable while I was gone!

But, there’s a problem, the kind of business that lets you make money while you’re asleep / away is also the type of business that tends to produce small numbers. Take a look at Erica’s results: $1k a day in sales, $10k total revenue.

Now, we know that this isn’t Erica’s only income stream – and, even this one is new and growing – but, I’m sure that Erica will be the first one to tell you that there’s a (low) ceiling to the income that a business can grow that can truly “make money while you sleep”.

In fact, I wager that in aggregate, Erica’s “make money while you sleep” businesses actually keep her pretty busy … and, she has plans to be even busier.

You see, I am willing to bet London to a brick (whatever THAT may mean) that Erica has a Number [i.e. the amount of money that you need in order to begin life after work a.k.a. retirement] that is pretty big, but most “make money while you sleep” businesses won’t be enough to help her get there:

a) The income they produce may not be enough to build up the Number on their own, and

b) They have no – or insufficient – resale value.

Of course, there’s a third alternative: if the business makes money while you sleep, and that income is enough to pay the bills, why do you even need to reach your Number?

Simply because no business lasts for ever … and, do you want to bet your financial future in the face of ever-changing technology and market conditions that you will continue to find replacements?

My businesses made money while I slept or went away – on some days. But, whenever my cell-phone rang – wherever and whenever I was in the world – I HAD to answer it because the buck¬†ultimately¬†stopped with me … banks and ceo’s demanded it!

But, the advantages were:

1. The businesses eventually produced enough cash to fund both my ever-growing lifestyle AND my long-term retirement investment strategy i.e. I could buy enough investments that I reached my Number by my Date, without needing to sell my businesses,

2. Even if I hadn’t already invested externally, I could (and did) sell my businesses for more than enough to reach my Number before technology and/or market conditions could change to my detriment.

Two paths to reach my Number: invest and/or sell [AJC: I did both and advise you to do the same … never rely on being able to sell your business]

Price: restless sleep!

So, is there a place for ‘Erica Style’ businesses?

Absolutely:

– You could build up a portfolio of those businesses; in doing so, you are making building these types of business your business! What?! That’s exactly what Erica is doing: she puts in 110% effort to build these types of businesses and to teach you how to do the same. I bet that she doesn’t have a ‘kick back on the sofa and let the business make money while I sleep’ attitude at all!

– More simply: you can build one or two of these types of businesses while you are sitting around at college, writing your blog, or working your ‘day job’, and use the EXTRA income that this business generates to fuel your investment strategy – or, build up the seed capital for that ‘real business’ …

… the one that WILL keep you up at night, until you sell ūüėČ

The ‚ÄėNo Lease‚Äô car lease ‚Ķ

The wrong way to buy a car is to lease it:

You’re financing a depreciating asset: so, as the car goes DOWN in value over time, your investment in it is¬†going¬†UP, payment by payment.

Dumb, huh?

The frugal way is to buy a used vehicle and run it into the ground.

But, what if you like and can afford to buy a ‘certain quality of car’?

Well, I would never buy a new one, and I would usually buy one of a lesser standard than I can afford, because cars do depreciate and are simply NOT an investment (even when you think they are).

Now, this is a blog for aspiring MULTI-millionaires, so I am going to spare you the usual reasons for buying used rather than new [hint: something to do with depreciation vs future resale value curves], because you can actually afford to buy new!

No, what I have to share works on the assumption that you can afford to buy a new car, but you do have budgetary contraints: i.e. a Number that has to fund your required standard of living for life. You can’t afford (literally) to have your money run out before you do!

If you’re either too rich or too poor for that to apply then this post [AJC: actually, my whole blog] does not apply to you …

But, this post DOES apply if you have a new car budget, be it a new $250,000 Ferrari 458 Italia [yum] or a new $11,000 Chevrolet Aveo [yuk]:

No, the problem is that IF your mindset is to buy a new vehicle, then how do you feed your desires in 3 to 5 years when your ‘new’ car becomes just another ‘used’ car?

However you justified the ‘new car’ purchase – new car smell, new car warranty, new car reliability, new car status – in just 3 to 5 years, the ‘gloss’ will have well and truly worn off, and you will be in exactly the same position as you are in today:

You will want ANOTHER new car!

And, you will want another one – similar to the first one (or better!) every 3 to 5 years thereafter, until you are too old to care about cars anymore … and, take it from me, you will be pretty old when THAT happens ūüôā

That’s why, when I ask people to calculate their Number, I ask them to come up with their required annual spending plan (and,¬†multiply¬†by 20), then add in any one-off costs: usually just houses plus your first post-retirement vehicle purchases (what’s your chances of your spouse settling for less than you?).

But, for non-annual¬†repeat purchases (the annual ones should already be in the budget … get it?), I simply ask them to calculate a lease / finance rate for the occasional purchases they are interested in (e.g. cars, around the world trips) as though they were going to finance those purchases, and build that cost into their required annual spending plan (basically, their expected retirement living budget).

This will include your replacement vehicles … the ones that you will need to buy after the first 3 to 5 years in retirement.

How to calculate the correct amount?

It’s actually quite simple:

1. Choose the car from today’s model lists that seems to be likely to suit your purposes from a new car pricing web-site.

Right now, I drive a BMW M3, my next car is likely to be no less expensive. But, I actually want more, so I will build in the cost of a Ferrari 458 Italia (that should pretty much cover me for any other car I decide to ‘graduate’ to as I get older, e.g. top-of-the-line Mercedes). If I didn’t aspire to more in the future then I would use the current list price of a 2011 BMW M3 as my ‘base’.

2. Find the current price of a 5 year old Ferrari F430¬†(because the 458 Italia wasn’t around 5 years ago) from a used car pricing web-site.

3. Subtract 2. from 1.

4. Find an online auto leasing calculator and use 3. (i.e. the amount over the trade-in of your current auto that you will need to come up with every 3 to 5 years) plus the age of the vehicle that you selected in 2. (i.e. how often you expect to want to changeover cars) plus select an interest rate that is likely to reflect long-term averages for investment returns on your remaining money (6% Р8% is plenty)

5. The calculator should then spit out the monthly amount that you need to add to your required annual spending plan

Now, why should you choose “an interest rate that is likely to reflect long-term averages for investment returns on your remaining money” rather than the expected cost of FINANCING such vehicles?

Didn’t you read the opening paragraph of this post?!

You’re not financing anything, you are SAVING to replace you current auto (or, the one that you first bought when you reached your Number and stopped working), and you are building in the LOST OPPORTUNITY COST of having your cash tied up in your cars rather than sitting in your investment account working for you, and you are accounting for inflation pushing up the price of your future, future, future replacement vehicles.

What if you make a mistake with you future financial position or the price of your next car?

Well, you simply hang on to the cars that you already own for a while longer … or, ‘down-size’, if you have to …. who says that you HAVE to replace your cars every 3 to 5 years?

Now, you can apply this same strategy before you retire: it’s called saving up for your next car (and, the one after that, and the one after …) rather than financing it ūüėČ

AJC.

PS If you run these numbers again, here’s an even better strategy:

Instead of buying a new car, buy a slightly used – but much better – make and/or model of vehicle. Because I’ve found that cars – just like radiation – have a half-life (but, different for each brand of vehicles) and some depreciate 20% as soon as you drive them off the lot, you may find that you can buy a much better car for the same money albeit 1 to 2 years old. If you choose well, you may find that you are (a) driving a better vehicle and (b) can keep this vehicle for another 4 to 6 years before replacing it (because ‘classic cars’ tend to remain classic long after your shiny new American/Japanese/Korean production-line ‘beauty’ has well and truly gone off the boil). Plug a 6 to 8 year replacement cycle into you calculator v the 4 year one that you chose for new and see what that does for your retirement plans!