Financial Happiness

My last article Taking stock of Apple was about Apple as an investment– but it made some assumptions that people know how to invest, or what that is about. This breaks the first rule of teaching, “do not assume, explain”. So this article explains the basics of financial security or why’s and how’s of investing in the first place. I can’t guarantee you’ll become a millionaire by heeding my advice, but I think I can dramatically increase the odds of that happening.

Financial Security

The Sword of Damocles is a fable about a fool that mentioned to the king how much better his life would be if he was the ruler. So the King traded places with him — but the cost of being the leader was that he had a large sword hanging over his head, hung by a thread (horse-hair). Of course the thread could break at any time and take away everything, thus Damocles quickly learned that the responsibilities and costs that came with the job were very high, and decided he preferred his old life without the feeling of impending doom.

I’m one of those people that always related not having some financial security, and living paycheck to paycheck with that sense of pending doom. “What would happen if” and pessimistic visions of the future, trying to erode my security and happiness in the present. But for me to be at peace in the present, I had to have some security in the future. I learned to save, invest, constantly train/educate myself, and have given myself (and my family) some financial security. Yeah, I know, live in the moment and all that; this isn’t an article on the flaws in philosophy or character that make us insecure – that psychoanalysis will be saved for another article. This is just a primer on how to be financially secure, or at least more secure, based on what I’ve learned – and wished I’d learned earlier in life.

The key to financial happiness

It really is really quite easy. Stunning easy. Four words. “Live beneath your means”.

If you can learn to spend less than you bring in, you’re saving and getting ahead. Money becomes far less of an issue. If you’re spending more than you make, and becoming more and more indebted, you are racing towards the slavery of the credit-card and ruin, and giving up your control and freedom to the loan sharks of the world. While you might be pretending to deny it, in the back of your mind, you know that the debt is going to come due, and it ain’t gonna be pretty – and most people I know in this situation are not happy and secure people. How can denial lead to happiness?

There are hundreds of books and articles telling you the same thing; “cut up those credit cards”, “pay off that debt” and so on. I’m not going to rehash all the ways that you can do it; if people learn the basics of what using those things cost, and what the rewards of the alternative are, they will find their own paths to success. All the information says the same basic things in different ways, lower your expenses and/or raise your income, and don’t let your expenses grow just because you make more.

Everyone whines and has excuses, “it isn’t that easy”, “I have bills to pay”, or “you make more than me, it is easier for you”, “but but but”. Bullocks. As my Mom always told me, “Excuses are made for failures”. Find me almost anyone in this country, making any income, and there is someone out there who earns less, but is happier and more financially secure. And the opposite is true too, there are people making dozens of millions of dollars per year, and going broke in the process because they are spending more. Donald Trump basically had to declare bankruptcy a couple times. So it isn’t about the money, it is about your attitudes and how you spend it. So don’t give this message that you’re less intelligent, disciplined or able than other people – just fix it. Those arguments/excuses are fallacy and rationalizations for not learning the basics of self-responsibility or at least financial responsibility. The truth is many people want more than they can afford, and they are not willing to delay gratification. If you’re in this place, it is time to grow up. You know if you had more money than you needed, that you’d be more secure – so stop spending more than you have and create your own peace and security.

Opportunity costs of capital

The first thing any businessperson should know is about the opportunity costs of capital. In investing, this is about weighting the potential risks and returns of investments, and deciding which you prefer. If one investment is 10% return and low risk, and another is 15% and lower risk, well guess which you should choose? Of course it is a bit more complex than that, you need to know net present value and be able to accurately forecast, and there are many more variables like ethics, expertise, and so on. But the basics are all business decisions should be made on business cases; what are the costs, returns, and risks.

In life, all buying decisions should have the same criteria factored in. If you put $1,000 in the bank or in the stock market today, what will it be worth in 10, 20 or 30 years? The numbers are pretty easy to work out. Assuming 3% interest in the bank (fairly high return), you get $1,300 at 10 years, $1,800 in 20 years and $2,400 in 30 years. No wonder few people save, I’d rather have $1,000 to play with now, than have to wait 30 years to get $2,400. But they’re not looking at the big picture. The bank has a lousy rate of return. You should keep some money in there for short term emergencies and because of the liquidity (easy access) – but real savings should be out of the way, harder to get to, and looking much longer term.

Assuming you put the same money ($1,000) in the stock market using the best trading app today (fully diversified, indexed against the entire stock market, thus pretty low risk), and averaged over the last 70 years, you’d get conservatively a 10% return. (Actually 14% is closer to real, so I’m playing it safe). This is low-risk mindless mutual fund or index fund type investing. If you spent a weekend learning more, you could probably do much better.

NOTE: The difference between what the bank pays you, a guaranteed low rate of return, and what the market pays you, with a non-guaranteed but much higher rate is called the risk-return (or risk premium). You’re taking a risk in the market, so you get a higher rate of return for it. And the riskier the investment, the more they must pay you (return) to reward you to take that risk. The inverse is true; if you put your money in bonds, you generally get a slightly lower rate of return than the stock market, yet you have lower risk as well. Either stocks or bonds are better returns than banks, but are higher risk.

Assuming you put that $1,000 in the stock market with a 10% ROI (Return on Investment), how much would you get in dollars? $2,593.74 in 10 years, $6,727.50 in 20, and $17,449.40 in 30. Suddenly, it becomes much easier to save. Should you spend that $1,000 on a bobble or toy now, or would you rather have $17,500 at retirement (assuming you’re already in your 30’s). If you’re 25 or younger, you have 40 years of compounding returns and that $1,000 investment results in $45,259.26 at age 65. If you bump that one time $1,000 investment, into a yearly investment of $1,000, the numbers become significant; $18,531.17 in 10 years, $64,002.50 in 20, $181,943.42 in 30, and $487,851.81 in 40 years. Now is buying a pair of Prada shoes and a Gucci Purse, or that new Electronic gadget really worth $500,000 or even $200,000?

Don’t forget the other side – if you bought it on credit, and the credit card is charging you 10% interest (most are more, and have fees), then that $1,000 purchase is really costing you $18,000 in 30 years in interest (assuming you never paid off the principle) – not counting the lost opportunity of investing it. That’s the opportunity costs of capital – learning to weight the instant gratification versus the returns on delayed gratification. Doesn’t that make you want to invest more and pay down those credit cards?

Notice I’ve always said delayed gratification, not eliminated gratification. No one is suggestion you give up all fun and toys for the sake of becoming a rich miser in your old age. And we all have expenses. But we can all learn to get by on less and be happier with what we have. Learn to balance the costs, and delay the gratification. If you can put off buying that boat or taking that trip for a couple years, and put that money to work bank – half towards saving for the trip, and half towards your future, you will learn financial peace and freedom. You will have more money for the trip, thus be able to enjoy it more, and you will have more saved in case of a rainy day, the kids college fund, or for your retirement.

Do you really need the new car now? Sometimes the answer is yes – often it is no. We’re all trying to keep up with the Joneses, and we see what our neighbors have as far as things – but we don’t see what the neighbors have as far as accumulating debt and insecurity, doubt and fear. Remember the opportunity costs. $300/month for four years on that new car payment, is that really worth $60K in 30 years? If you could hold off buying that new car for four years, and put the equivalent payment to work for you (invest it), that’s how much you’d have. That’s compared to an expense of that amount counting the interest on the loan you took, increased insurance cost, taxes, registration, and so on. My wife and I bought ourselves nicer cars, but instead of turning over cars every 4 years, we’ve had ours for nearly 10 years. We paid off our cars in 3 years, and kept making the same payment to our investments for the next 7 years. The reward for our patience and not having the newest cars on the block is that we can afford nicer cars next time, not to mention travel, savings and money for other things.

Debt

There are no magic bullets. Start paying down the debt you have. If you have a lot of credit card debt and own a house with some equity, take out some equity (lower interest loan) and pay down the high interest debt, or get a lower interest consolidation loan. Do things to reduce the interest, and get the payments down – and start saving. Many people advise you to pay off all debts first, or they tell you to overpay your mortgage; they are wrong. Do not throw all your money into digging out of debt. Balance savings with debt. Learn to do both – save, and pay down debt.

If you have a lot of debt, don’t panic. Debt isn’t all bad. If you had a choice between owning your own home outright (say $200K), or having $150K mortgage ($50K in equity) and $150K in investments – the latter is far, far better. Why? From a business point of view, your house is usually appreciating – say at 10% (national average), on a $200K home, that’s $20K/year. What is better, earning $20K/year return on a $50K investment or on a $200K investment? I prefer the greater returns on the lower amount invested. Plus the interest on the home loan is a write-off (tax benefit) against your income tax (Uncle Sam is giving you a 20-30% kickback on that, depending on your tax bracket). And what happens if you lose your job tomorrow? $150K in liquid investments gives you a lot of time to make payments while you find a new job. Trying to get an equity loan without a job is time consuming, scary, and you will get lousy interest rates. Add in that the extra $150K in liquid cash should be earning you 10% returns, and that’s $15K/year you should be making. (Either towards more investment, towards the house, or towards living).

So debt isn’t bad, as long as you are on-top of it, and getting a better rate of return off your investments than your debt is costing you. Look at it this way, if I can borrow $100K at 5%, and get a return of 10% on that money by investing it, I’m making $5,000 per year (and getting a tax write-off) for taking on that risk. And it compounds (the rate/principal increases over time). Of course that play is way usually too ballsy for me – and I wouldn’t recommend it. But you get the idea. The reason some tell you to overpay your mortgage and get out from under it sooner is because it is forced savings. But the truth is you have to weigh the costs (low interest loan) versus other returns of having that debt (tax benefits, investments, padding, etc.), and then decide which is better for you. If you can learn discipline and savings, then overpaying your house is the wrong move. If you have none, then it is the right move. Either way it isn’t about the extreme of “getting rid of debt at any cost”, it is about the balance of saving and investing while you’re paying down those debts. Don’t let a myopic debt focus consume you.

Investing

So enough of the “why” invest, let’s get into the “how”. Investing is easy. Just start paying yourself first.

Start with a small amount per month or per paycheck that will always go into your investment account (3-5% of your net) – pay that first. Your future is your most important bill. Then pay the other bills, and then enjoy the rest. Over time increase that investment or savings until it is 10-15%. Learn to not let your debts outpace your income. You don’t have to cut up your credit cards – just learn to not rely on them. We rarely carry over a balance month to month, and when we do, we start cutting back on fun or toys until we get them back down. But we’re always making our savings payment first.

The easiest thing to do is grow out of it. You’re going to get raises or promotions over time. The first thing most people do is buy toys or reward themselves. Just see your savings/security as part of that reward. Don’t let your cost of living adjust to your new means (or beyond it), keep your expenses where they are (or slight increase), and increase your savings instead. When my wife went back to work, we just agreed to save most of what she made. We were living without that income, so we knew we could afford to. So we maxed out her 401K and retirement (companies match some funds), we maxed out her employee stock purchase (you can often buy at a discount), we increased our savings, and then we can spend the rest. Again, it isn’t about not having fun, it is about balance the future against the present.

Diversification

So I told you how to save; the Nike, “Just do it”, plan. But the next issue is how to invest. And the thing you’ll hear most often is “Diversify”. Careful there – like all things, it comes down to balance. Diversification is not a panacea.

The idea is that if you have 1 stock, when it is up, you’re up – but when it goes down, you’re hurting. But if you’re diversified, and have 4 stocks, then when one is down, some of the others will be up, and it will smooth out the ride. Don’t be lulled by that – there are many gotchas with diversification.

Diversification isn’t about how many stocks you have, but how correlated they are (or what their covariance is). Whether you owned 50 stocks that did American Steel, or only 1, it made little difference when most of those companies tanked. Sure, some companies did worse than others, so having 50 stocks in the same industry averaged out the losses over the entire segment – but you were still loaded in only one segment, thus not diversified. All the stocks were correlated (highly interrelated). For diversification you want a low covariance or low correlation coefficient – meaning they respond in opposing ways to similar trends. For example, the stock market and gold or oil (energy) tend to be inversely effected by the same event. War breaks out, and uncertainty drives up the cost of oil and gold, and often the stock market goes down or under-performs. The cost of oil goes down, and many companies are going to have lower costs of energy, thus better returns, so their stock goes up. So the number of stocks for diversification isn’t nearly as important as correlation coefficient.

A “fund” is just a group of stocks, managed by someone. Instead of buying an individual company like Apple, you’re buying a fund like, “Computer Stock Fund” which has a percentage ownership in many companies, including Apple. A mutual fund is “managed” more – meaning there are managers that are constantly adding, removing and shifting percent of holdings in various companies, to try to “beat the street”, or outperform the market or segment as a whole. Index Funds (also called Spiders), are just buying an equal amount of shares of all companies in that segment, and they aren’t as “managed” – you are sitting and holding, thus paying less in management fees, and happy earning whatever that market is doing.

Ironically, many people buy a fund (either a mutual fund or an index fund), expecting that they are diversified. But many funds cluster their holdings in a single segment. So if I buy an index fund that is holding many companies in biotech, that’s great – I’m diversified in regards to all the biotech companies (one biotech company going out of business won’t hurt me much), but not in regards to the entire market or in general. If the biotech market is down, then I’m down. All or most of the companies were too highly correlated. If I bought a single biotech company (or a biotech fund), and a single tech company (or fund), then I’m far more diversified, because those things are less correlated.

So the upside to diversification is that it lowers risk. But there are no free meals; there’s a cost to that lower risk. Can you guess what it is? The answer is lower returns. Let’s face it, if I have 10% of my stock portfolio in a company that goes up 100%, and I increased my portfolio value by 10%. If 50% of my holdings were in that stock, and I made a 50% return. Which is better? So diversifying is a form of hedging, but it comes with a price. The question is what is your confidence and risk tolerance – if it is high, you need less diversification, and more risky stocks. If it is low, like most people starting out, then you want more diversification, and lower risk stocks.

Investing

So now that you know the basics, let’s put some money away.

You can certainly pick full service brokers and have them help you manage trades. They have experience and charge a fee for that service and advice. But be careful, their interests are not your interests. Each trade they make costs you more money than if you went with a discount broker (where you’re on your own). Some have maintenance fees, and other things whittling away at your principle or earnings. And assuming they know a lot more than you may be dangerous; some do, many don’t — there are many people that threw away a lot of money trusting their brokers too much. This is why the discount brokers have been exploding; control and responsibility.

The other reason is funds. People can pick good performing funds, stuff money in, and they aren’t trying to trade their way to success, they just let the fund grow on it’s own. Usually, they just agree to put a certain amount out of each paycheck into a fund or funds. Buying (or selling) over time is called dollar cost averaging, since one buy the stock might be a little high, but the next it might be low, so you’re averaging out the total purchase over many smaller purchases. This isn’t a bad strategy at all, and far better than nothing or putting it in a bank (as far as returns). Again, remembering to diversify across funds, and keeping the funds or stocks you are acquiring as uncorrelated as possible. This is a low(er) risk way to slowly become a millionaire.

NOTE: Excel, and many investment tools have ways to help you figure out the correlation coefficient. There was a nice tutorial on the subject here: http://www.macworld.com/2001/05/bc/howtoexcel/

If you’re a savvy investor, have a lot of confidence, or are not risk averse – then you probably want to pick individual stocks and not funds. And you want less diversification; more focus on the better performing securities.

People are scared of risk and self-confidence or the market in general. They think, “Gosh, do I want to gamble $10,000 in Apple stock, that may go up or down, or dissolve and take my money to zero? What if I lose?” True, you can and will lose some money, but you’ll probably make more than you lose.

I’ve learned some lessons the hard way; both making and losing $100,000 in a single year. Since I made it first, and wasn’t playing on margin, it wasn’t that bad – and I’ve recovered and gotten a little wiser. One of the keys to not losing big money in stocks, is called “sell discipline”. Say you are willing to risk losing $3,000 dollars, and think that Apple is fairly volatile. You could put $15,000 in Apple stock, and put a stop-loss (a request to sell the stock *IF* it drops below a certain price) at 20% below the buying price. That gives Apple some room to fluctuate up and down, and you will only sell if it drops below your “floor” (tolerance level). If it triggers, you’ll sell, take your lumps and walk away, $3,000 poorer — but you’ll still have enough money to try again (on something else). Thus the most money you’re likely to lose is where you put your floor – and the most you can make is infinite (the stock can keep growing forever).

Now, there’s some more sophistication and risk than that. Stocks can drop fast, fall through the floor, and by the time your shares get sold, you can get less than your floor price. But you’re likely to be close. And the amount of tolerance for risk, or confidence in the security should dictate how far down you put your floor. Longer term investments where you trust the company long term, but they are going through short term “issues”, you probably want a higher threshold (percentage). Shorter term, higher risk companies, with less tolerance, and I wouldn’t go above 8-10% below current value.

One trick is to keep raising the floor as the stock price appreciates. My floor on Apple used to be $20 (back when they were at $25), now it is at $55 (Apple’s stock price is in the 70’s). As long as Apple keeps going up, or staying fairly flat, I’m in. If they drop too hard or too far, I take the profits I’ve made, and walk away well ahead. And either wait for the next big run up, or more likely move to something that I have more confidence in. If I had less confidence in Apple, I’d move my floor up much closer to the selling price, and either the company would grow, or I’d let the “market” take me out of that company.

Another trick in this game; you don’t have to go “all in”. Put in half of what you want to invest, and see where it goes. If it goes up, you’ve already made some money, and you can put in some more. You’re dollar cost averaging on the way up – but you’re reducing your risk, because you’ve already made some money, and thus it has earned your confidence.

Some people live and die by their “rules” of investing, I tend to be a little more fluid. For example, around Christmas, Apple was dropping down near my floor – but I still had a high degree of confidence because of new machines and expected earnings, and I didn’t want to pay taxes on earnings this last year, so I lowered it a bit. Apple dropped through the old floor, but quickly rebounded, then announced Mac mini, iPod shuffle, earnings and shot up. So that was a gutsy move on my part – but I was looking long term, and think they are going to have a stellar year, so increased my risk tolerance. Unless you’re intimately aware of what is going on with your investment, and have “Grande Cajone’s”, it is better to just walk away.

The other side is I decided some other companies might perform better than some of my holdings. While I liked the companies I held – I just figured there was a better return on these others for now, so sold my holdings took my profits and lumps, and got into my other choices. It’ll either work, or it won’t. Remember, you don’t have to be right all the time, just often enough to make up for the losses.

Conclusion

Stocks are not gambling. Gambling is betting that you can beat the odds that are stacked against you. In the stock market, most companies are actually fairly well run (despite our complaints and whines to the contrary). American companies are some of the best run in the world. Thus the odds are stacked in your favor. It’s more like gambling, if you’re the house (casino). There are certainly bad companies out there; ask the Enron or WorldCom investors – but they are the exceptions; for each of them, there are 1,000 other companies creating good things, employing people, investing in themselves (growth) and/or paying returns to their investors (dividends). And if they aren’t performing at least as well as the market or their segment, they know you’ll put your money somewhere else. So they work hard to be efficient and return at least 10%. Would you rather that, or earning less than half that in a bank?

With a little homework, patience (the opposite of greed), diligence and discipline, you can easily be a millionaire. Assuming future returns will be as good as past returns (low risk, diversified fund based investments), it will cost you about $2,000 a year for 40 years, $6,000 a year to make it in 30 years, or $15,000 a year for 20 years, to put away that first million. And it will double an average of every 7 years after that. (Again, assuming past averages). So no more excuses – make sure you’re spending less than you’re earning, and start investing the rest in companies or funds you believe in, and start building your financial security.