# Investment logic gone askew …

Whilst I was traveling, I hope that you had a little time to reflect on some of the advice that I’ve been dishing out over the last few years?

It’s important that you don’t just follow my (or anybody’s) advice blindly, else you may end up making some fatal logic errors like this poor bloke:

Suppose I have 100K in an index fund that has a ten year return of 7.4%, a five year return of 8.2%, a 3 year return of 17.5%, and a 1 year return of 24.76%.  That is a pretty dependable return over the last few years, but it will probably not keep up with the 24.76% return, but will probably maintain at least a 7% return over the next year.  So I assume that 7% return.

I want to buy a car for 100K.  I can take money out of the index fund to buy the car, and give up \$7000 over the next year.  I can borrow money at 2% and pay \$2000 in interest over the next year.  If I choose to pay cash, I lose \$7K, but if I borrow and leave my own \$100K in the mutual fund, I pay \$2K and earn \$7K, for a net gain of \$5K.

So my logic says that paying cash for anything when the investment return is higher than the interest rate is a mistake.  Suze Orman won’t give me advice on this, so if my logic is off, I hope someone will show me better logic.

Have you spotted the flaws?

Well …

The principle of taking a 2% loan on the car so that he can invest at 7% elsewhere is sound, BUT his assumptions are wrong:

1. A low-interest car loan is generally subsidized by price.

Check the true rate, if it’s more than 2% then he is probably better off negotiating the cash price lower THEN doing his cash v finance analysis.

`[Source: http://www.bankrate.com/]`

2. Unless he’s planning on a 7+ year auto loan, the correct comparison is the finance rate on the loan against a CD for the same term.

This is because the stock market is way too volatile and he needs an investing horizon of at least 7 – 10 years before returns even approach ‘normal’.

In fact, even though this chart doesn’t show that time period, he needs at least 30 years (based on nearly 100 years of data) to ‘guarantee’ at least an 8% return (the worst thirty-year period delivered an average annual rate of 8.5% between 1929 and 1958).

3. Your past returns are NO predictor of future performance:

His ~25% of last year could just as easily be a LOSS of 48% next year. Look what happened in 2008:

But, he redeems himself, somewhat:

The same logic applies to my mortgage: I pay 2.62% on my house.  I could pay it off, but taking the money out of an international fund with a one year return of 22.85% would result in a net loss of \$100k over the next year (moving \$500K from an investment at 22.85% to pay off a \$500K balance at 2.62%).

4. On the other hand, his mortgage comparison is ideal:

If you can lock in a 3o year mortgage, fixed at today’s ridiculously low rates, and lock that money into a low-cost index fund for the same period then, yes, you are almost assured of a 3%+ net return, compounded for 30 years (which means that he should almost return 1.5 x his initial investment PLUS whatever profit he makes on your property).

That’s why real-estate is such a great long-term investment, and why the stock market is a terrible short-term gamble.

# The Golden Rule of personal finance …

If you find yourself asking a personal finance question like this one, this post will give you all the tools that you need to answer it for yourself:

I am in my early 20s, earning between \$110-180k/yr depending on my bonus. Would it be inappropriate for me to drive a \$50k Mercedes Benz?

Most people would deal with this by saying things like:

– Can you pay cash for the car?

– If you buy a Merc now, what will you buy next year?

– Save for your own home

– And, so on …

Which are all valid concerns …

… but there is one important question that nobody thinks to ask:

What is your current net financial position (i.e. net worth)?

Yet, this is the most important question to ask!

Why?

Because it’s your Net Worth that sustains you in retirement:

– Before your retire, you earn income

– You save and invest as much of your income as possible to build up your ‘nest egg’ (this is your net Worth on the day that you retire)

– After you retire, you live off the income (e.g. interest, dividends, investment income, etc.) generated by your Net Worth and/or deplete it over time

And, this takes you directly to The Golden Rule of personal finance …

… because, it’s the one financial rule to live by; the one above all others; the one that – if you follow it – will answer all of your financial questions and guarantee your financial future:

Always have 75% of your net worth in investments.

This means: at least until you retire at a time and place of YOUR choosing, that you should always have no more than the remaining 25% of your current net worth (tested yearly) as equity in your own home, car, possessions, etc..

These rules of thumb then follow:

– Have no more than 20% of your current net worth as equity in your own home

– Have no more than the remaining 5% of your current net worth in your other possessions. It is typical to split this 50/50 between your car and your other ‘stuff’.

– This means that you should have no more than 2.5% of your current net worth in your car. I suspect that the reader’s proposed Mercedes would break this rule.

There are a few important things to note, if you’re going to obey The Golden Rule:

1. You can – in fact, should -break the 20% Equity rule for your first house (otherwise, you will never be able to afford to buy one), but don’t upgrade for as long as you will be breaking this rule.

2. You will probably need to borrow money to buy your house (first and/or future home), but don’t spend more than 30% of your take home pay on the mortgage repayments, except – again – for your first house (but, only if you absolutely have to).

3. Never borrow money to buy a depreciating asset (e.g. car) UNLESS it’s required to earn income AND you have no other way of buying one. Even then, obviously buy the cheapest that will do the job, borrow the least, and pay it off early.

4. For a pleasant surprise, test these numbers annually: because your Net Worth will go up each year, yet your car and other ‘stuff’ will depreciate (check eBay). This means, you can actually afford to buy more ‘stuff’ every year or so, if you like, or just save up your ‘spare net worth’ for a couple of years to upgrade your car, etc. when ready.

So, are you following The Golden Rule?

If not, what do you have to change in your life so that you do?

# Why you’re not rich yet …

I’ve been writing this blog for 5 years …

… and, I made \$7m in 7 years.

So, if you’re an early reader, that means that you should have added around \$1m to your net worth since you started reading this blog.

Have you?

If you haven’t, I’m guessing that it’s for this reason:

`[Source: http://www.quora.com/Life-Lessons/What-is-the-most-important-life-lesson-that-you-have-learned-up-to-this-point]`

The things that I discuss in this blog aren’t for reading or intellectualizing [AJC: is that even a word?] …

… they are for doing.

If you don’t get out of your comfort zone and actually change the way that you go about things – and, I’m speaking financially, here, but this is equally valid for any aspect of your life that you wish to improve – then how can you expect your results to change?

As Albert Einstein said:

If what you’ve been doing hasn’t brought about the life-changing financial situation that you’ve been hoping for, then think about what you should be doing …

… and, just starting doing it.

# A dollar saved is a \$100 earned …

If you read this blog often enough, you may be forgiven if you leave with the impression that saving is not important.

Of course, you would be wrong!

It’s just that enough is written elsewhere about saving – too much – that little is left for me to say here.

So much, in fact, is written about saving, that you would also be forgiven for thinking that it’s the Holy Grail of Personal Finance.

It isn’t …

But, if your aim is to begin Life After Work (a.k.a. early full/part-retirement) as soon as possible, then every dollar that you save now has a far greater meaning than you may, at first think.

Firstly, though, you have to eradicate from your mind the idea that each dollar that you save is to be closeted in the warm confines of your bank, perhaps sitting shoulder to shoulder with your other dollars in a 5 year CD, locked up like sardines in a tin can waiting for the day that the lid will slowly curl back, only to be quickly consumed.

Equally, you have to eradicate from your mind that the “invisible dollars” scraped from the top of your paycheck and secreted in the mysterious 401k will somehow pop up just when needed to save your retirement, like an airbag in a crash …

No.

It’s clear – at least to me and my long-time readers – that if you need a Large Number / Soon Date (that means, retiring early with a large enough bankroll to happily sustain you until your family finally decides to park you in some nursing home for the remainder of your drool-filled days), then you need to actively manage your money.

Perhaps you need to start a business? Or, you should start rehabbing some houses to build your rental portfolio? Maybe, it’s time to plunge head-first back into that Blue Chip Lottery called the stock market?

Whatever your ‘investing poison’, it should be clear (perhaps with the aid of a few minutes and a simple online compound growth rate calculator) that you need to actively work to gain Very Large Compound Growth on your Net Worth.

So, the value of each dollar saved now is not the paltry 5% to 8% return that others expect, passively watching their CD’s and Index Funds match-racing with Inflation …

… rather, it’s the value of using those dollars to build a small war-chest (OK, a modest level of seed-capital, may be more apt for most of us) that allows you to get started on your business / real-estate / stock-based plan.

And, it is every dollar that you add, or reinvest instead of spending, that helps to fuel the flames of growth.

Once you start to see the value of saving though the spectacle of building a modest pool of funds-for-investing, you begin to realize that every dollar that you save today is really the same as \$100 in a mere 10 years timeif invested in a business.

If you don’t believe me, here it is in black (well, blue) and white:

So, slash those Coke Zero’s from your diet and start drinking tap water and, before you know it, you (too) will be a semi-retired multimillionaire, sitting on a beach in Maui …

Now, how do you feel about saving?
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# A personal finance hieroglyph …

If you left a review on Amazon for my new book, then your personal, signed copy is on it’s way!

[There’s still time: if you downloaded the Kindle version, please leave an honest review at Amazon and I will send you a personally signed, printed version as my way of saying ‘thanks’]

Inside the front cover, along with my ‘AJC’ signature, you will find a scribbly hieroglyph much like the one above …

… hopefully, it’s not too difficult to translate; it simply means:

Too many of us live our lives as though money was its sole purpose: we work more than 1/3 of our life away; we constantly argue with our spouses about it; and, we spend much of the remaining time simply worrying about it.

I haven’t been immune; this was me until a critical date in 1998, when I discovered my life’s true purpose. Without getting all New Age’y on you, I’ll give you a hint: it had nothing to do with money.

My Life’s Purpose was all about how I really wanted to live.

But, I quickly discovered that money does come into it …

… but, only as a means to an end.

My first book (co-written with Debbie Dragon) shows you how to separate your money from your life; but, it doesn’t shy away from the subject of money. Because, as I discovered, money is the key enabler of a fulfilling life for many of us – not all – but, certainly for me.

Probably, for you, too.

So, the real purpose of my book is to help you find out how much money you need in order to be happy. Simple!

If you want to understand a little more about my journey and how I think about money and its real (subordinate) place in life, check out my video interview; it’s with Jaime Tardy at Eventual Millionaire:

# What if money did not matter?

In my new video interview with Jaime Tardy (EventualMillionaire.com) I talk a lot about finding your Life’s Purpose. Now, here is an even stronger argument for finding your Life’s Purpose before working out your financial plan …

Note how the philosopher, Alan Watts, suggests that if you do what you love, the money will follow!

Failing that, do what you need to, but only for a short period of time, so that you can put aside the money that you need in order to do what you want. That’s why I came up with my original ‘\$5 million in 5 year’ target (that eventually became \$7 million in 7 years, achieved) …

What would you do if money was no object?

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# How much interest can you earn on \$1 million?

Today’s post is a pretty good place to start, if you are interested in finding out a little more about how I like to think about personal finance …

And, for my regular readers, head on over to Budgets Are Sexy’s blog and read my provocatively titled guest post (“Why Most Personal Finance Blogs Are B.S.”). The blog’s editor asked me to write something “feisty” and, judging by the comments, I think I did just that 😉

Don’t be afraid to leave a comment on that site (or here, if you prefer) to let me know what you think?

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“How much interest can I earn on \$1 million?”

This is the question, if I am to believe the google search statistics, that I am being asked more often than any other …

And, the answer is very simple: if you keep \$1 million in the bank, earning about 1% on a CD, you’ll have \$10,000 a year in interest. Given that inflation is running at two or three times that, you are running a (very) losing race.

So, the bigger question that you should be asking is: Why do you even care how much interest you can earn on \$1 million?

\$1 million today, if it’s to last your lifetime, probably only replaces a \$35k income (in today’s dollars). It could produce more, but if you don’t know how to make more money than \$1 million in your lifetime, you’ll never know how to actively invest it for higher returns.

So, I’m guessing that what you really want is to know how much interest you can earn on \$3 mill. – \$10 mill. today, or even more.

What you should be asking is:

1. How much income do I want to generate without working (I’m guessing \$100k – \$350k p.a.)?

2. Multiply 1. by 20 (my rough Rule of Thumb for an active investor) to get your Number (likely to be in the \$2m – \$10m range)

3. When do I need to reach my Number (probably 5 to 10 years. Any less and you’re dreaming; any longer and you don’t really have what it takes)?

4. Then you need to spend some time with an online annual compound growth rate calculator to work out what annual % return you need to be generating to get there, on time (3.) and on budget (2.).

Then, use this handy table to work out what sort of things you should be learning about and investing in to get that sort of return:

Now, these returns aren’t what you get ‘off the shelf’ … rather, they require hard work (plus the kind of education that you get from this blog), but they are achieveable (after all, that’s how I made \$7 million in just 7 years, starting \$30k in debt).

How much do you think you need to earn passively to be happy, and when do you think you need it?

# The problem with income …

I’ve been thinking a lot about income lately, which is ironic as I don’t have any right now (at least, not in the traditional ‘work for a paycheck sense’).

It’s also ironic because, when I did have an income, I didn’t worry about it at all:

Back in 1998, I had two businesses that, between them, managed to earn exactly \$0 …

But, I wasn’t at all worried.

That’s because this break even scenario already took into account the cost of my (then) still-quite-basic basic lifestyle.

For example:

– I could deduct the cost of my cars as a business expense, so my business paid for those

– I could deduct the cost of my travel as a business expense, so my business (or the occasional consulting client) paid for those

– And, I could afford to pay myself a fairly basic (at least, for a guy with a family) \$50k salary a year

So, with my combined businesses breaking even (after these expenses were taken into account), together with the fact that I could control my cost of living by delaying gratification (not to mention, my wife was still working and bringing in a decent income), I simply didn’t worry too much about earning an income.

But, all that changed when I started investing actively, and built up my first \$7 million (in 7 years) fortune …

It changed for the worse!

Firstly, my cost of living increased. A lot.

Then, my wife stopped working. Of course.

And, my actively-generated income stopped. Because I sold my biggest business.

Now, I mostly have to rely on ‘passive income’ which is really just spending the money I have in the bank while I figure out how to make more money from investments than I spend on their expenses + the cost of my lifestyle.

And, that’s now a big number!

So, ironically, just when most people think that I have “f**k you” money, I have started to worry about income …

… simply because I have to create my own.

How about you? Do you worry about income? Why (or, why not)?

# Are wealthy people more unethical?

It’s nice to see science magazines writing about money 🙂

This time , it’s trying to find a link between wealth and (a lack of) ethics.

This is not a new notion, just check out Charles Dickens’ “A Christmas Carol” and it’s offshoot – and my favorite cartoon character – Scrooge McDuck and you need look no further.

But, I think that these scientists – and authors and cartoonists – miss the point:

You do not have to be unethical to make money …

… and, I think that it actually harms your chances as people often can spot unethical tendencies and will take that (correctly) as a sign that they cannot trust you.

However, if the study is correct, I think one explanation may simply be that wealthy people have been exposed to more opportunities to make the “should I be ethical or unethical in this situation?” decision.

More exposure simply means more unethical behavior evidenced.

For example, working on a production line may not produce wealth …

… but, it also may not produce many opportunities to take unethical action during the 8 hours a day that you are at work.

[AJC: although, you may have plenty of opportunity to indulge in unethical behavior after hours if that is your bent]

However, being in business or running around making real-estate investments may give you plenty of extra opportunities to (a) become wealthy and (b) exhibit unethical behavior both during and after hours, thereby giving you twice the exposure to both potential outcomes.

So, I think it is a case of increased exposure rather than cause and effect …

What do you think? Do you need to be unethical to make money? If so, is that a ‘cost’ you are willing to carry?

# Did I fail the Ultimate Money Test?

Financial ‘personality tests’ are fun. I like doing them; you should try this one.

Unfortunately, the results don’t always speak for themselves:

[AJC: the star is my score; very average, as I am in (almost) all things in life. The \$7m7y logo to the top-right is how my financial performance probably compares to 99%+ of the population]

Whilst this is a pretty good test – much better than many others that I have seen – it will only identify average performance and sub-/super-performance perhaps to one standard deviation (for those statisticians amongst you) …

… however, these tests can’t identify the factors that produce the outliers i.e. the ones (like me) who can make \$7 million in 7 years.

If you want to produce (slightly) better than average financial performance over your lifetime, use this test – and others like it – to identify areas of weakness, typically:

– Not saving enough,

– Overspending,

– Credit Card Debt,

… and so on.

All valid reasons why you may be in financial trouble today, but certainly not highly relevant to your chances of retiring rich and retiring soon.

If you do want extraordinary financial performance, keep reading read this blog 😉