Category Archives: Financial Independence

Opportunity Costs

When it comes to getting the most value for your money, it makes sense to measure the opportunity costs linked to where your money is being dispensed.  Opportunity costs are based on a theory from microeconomics.  It is based on making decisions that provide the best value for your money.

Many economic theories are just theories to the average person.  They are discussed in the classroom or in the financial media, but the average individual investor does not receive too much practical application from most of these theories.  They can be discussed, but not really applied to everyday life.  The theory of opportunity costs does not fall into the category of academic mumbo-jumbo.   It can easily be applied to the management of your personal finances.  Paying attention to opportunity costs can totally change how you think about money.

Total Cost

What do you think about before you buy something?  Most people only look at the direct cost.  When most people decide to buy something, they just look in their wallet to see if they have enough money to pay for it.  Some people don’t think at all and make the purchase with credit and just take on more debt to make the purchase. 

The only time people tend to give any serious thought to what they are buying is when they are making major purchases.  A good example of this is when someone decides to purchase a house.  The potential home buyer will have their credit score checked, shop for the best interest rate, analyze how much they can afford in monthly payments, as well as many other considerations. 

This type of thinking is not the most prudent form of financial management.  Managing the finances around major purchases is important.  Getting the big purchases right can make or break your financial situation. 

Death from 1,000 cuts

The lesser financial decisions are also important.  Not thinking about day-to-day spending can equally jeopardize a financial plan.  The little costs add up quickly if a person is not mindful about their spending.  They are like death from 1,000 cuts.

It is easy for small amounts of spending to get out of control.  A couple of lunches out per week can add up to $100.  Watching a movie at the cinema with snacks can cost $25 per person.  Taking your kids to an indoor water park on the weekends can add up to hundreds of dollars.  Without being mindful, the wasted spend can add up quickly and so do the wasted opportunities for that money to be put to use in a more prudent way.

When money is spent without thought, that is a sure way to not get the most value for the energy that you are exerting to earn it.  To be successful with your personal finances, a consumer needs to be intentional.  Otherwise, they are missing out on maximizing the opportunities that are available.   

Always run the numbers

When making a financial decision, opportunity costs are based on weighing the pros and cons of how money is utilized.  An example would be when you decide to buy a new car.  When you establish the budget do you decide on buying a $30,000 car or a $20,000 car?  If you decide on the $20,000 car, the additional $10,000 that you decided not to spend can be used to pay off debt or to be added to savings?  Buying the $30,000 car would have $10,000 in wasted opportunity costs.

Being mindful of opportunity costs is a great way to maximize the value of your money.  If you are trying to reach financial independence, getting the most bang for your buck needs to be front and center whenever you must spend money.  By always evaluating the opportunity cost of a purchase helps to develop a savers mindset.

Investing

Tracking opportunity costs also have a role when it comes to managing investments.  There is an opportunity cost involved with being too conservative with your selection of investments.  If an investor kept all their savings in a money market account from 2007 until 2017, they would have earned less than 1%.  If that investor put their money in an S&P 500 index fund, they would have earned almost 10% during that same time period.  If an investor was not comfortable investing 100% in equities and wanted to invest in a more moderate allocation, they would have still earned 7.3% in the Vanguard Star Fund (VGSTX) that has an allocation of 60% in stocks and 40% in bonds.

Conclusion

If reaching financial independence is your goal, measuring the opportunity costs of all your purchases will help you get there.  After you start to practice measuring the opportunity cost of every financial transaction for some time, it becomes like second nature.  It is useful no matter where you are in the journey toward financial independence.  If you are new to this way of life and working on paying off debt, it will help to curb your spending.  If you are in the saving and investing phase, being mindful of opportunity costs will help you to free up more money to be used to build wealth.  If you are entering retirement, keeping track of opportunity costs will help you to spend less and preserve your wealth.

Whenever I must spend money, I think about the opportunity cost tied to that purchase.  I credit that thought process as helping to establish a high savings rate.  It is a fun mental game to play.  By being aware of how I am spending my money, it helps me to not miss out on all the better opportunities that are available for my money.

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Don’t Focus on The Middle Class

When it comes to where people rank on an economic level, the vast majority of people think that they are middle class, but they are not.  The single mother with two children and an income of $25,000 thinks that she is middle class.  The CEO of a small business who earns over $400,000 thinks that he is middle class.  While most people are working hard, everybody cannot be middle class.

I think that everybody thinks they are middle-class because they want to fit in.  They do not want to accept that they are less than or feel superior to their peers.  They also do not know the exact income parameters.  According to The Pew Research Center, to be considered middle class, you have to have to have an annual household income between $35,000 and $106,000.  According to the 2010 census, that is about half of the population in the United States.  The Census Bureau also reported that the median household income was $59,000.

After looking at those numbers, the two examples that I gave are not members of the middle-class.  The single mother does not meet this threshold.  The CEO is actually closer to being a one-percenter than a member of the middle-class.

Location

Location is also a key factor.  Where you live also makes a difference.  In South Carolina, the median income is $47,000.  In New Jersey, the median income is $70,000.  Even though the median salary in New Jersey is higher than in South Carolina, so is the cost of living.  Taxes, real-estate, and insurance are much more expensive in the Northeast compared to the South.

Home Ownership

Many people associate being a member of the middle class with home ownership.  Homeownership has long been associated with being middle-class.  The location has to be considered when evaluating homeownership being a strong characteristic of the middle-class.  In South Carolina, it is easy to find a new three-bedroom house under the $200,000 price tag that Zillow classifies as the median price.  Prices are much higher in San Francisco, New York City, and Boston.  In those markets, a two-bedroom flat can easily cost more than $1,000,000.  Based on the difference in cost, homeownership is even a challenge for high-earners in those major markets.

Education

What about a college degree?  Having a bachelor’s degree once allowed for easy entry into a middle-class existence.  Today, it depends more on what the degree is in and how much debt you had to take on to earn the degree.  While people with a bachelor’s degree still earn much more than those who do not have one, there are more variables to consider.

Behavior

Some people judge their class status by how they act.  They do not focus on income, homeownership, or education.  They judge it on their lifestyle.  While this might be the worst possible way to measure what class you are a member of, some simply think they fit into a particular class if the just act the part.  Pretending to be in an economic class that you do not belong to will just lead to economic woes in the form of debt.  It is better if you are honest with your lot in life.  If you want to improve your situation, it will take sacrifice and hard work.

Making personal progress

I do enjoy reading about the different classes.  Sociology is an interesting subject.  It is fascinating to study how people act and try to fit in with different groups.

When it comes to financial independence, knowing about what class you fit into does not make much difference.  It is not something that you should stress over.

What matters is that you are earning a living and always trying to improve your skills to earn more money.  Instead of focusing on how the middle-class spends their money, focus on how you can save more of your own money.  Once you get your savings in order, invest your money wisely.

I have never put too much thought into if I belonged to the middle-class or not.  I break it down to a much simpler classification.  I do not focus on earnings, but rather assets.

Financial Independence

There are those who are working class and those who are financially independent.  If you have to work for a living, you are working class.  If you have more than enough money to cover twenty-five years of expenses or beyond without having to earn a paycheck, you are financially independent.

When you have enough money to pay your bills for twenty-five years, it is up to you if you want to work or not.  If you do not have that kind of financial cushion, you have to work for a living.  After your savings have reached that level, you can keep your current job or find something that might be more meaningful.  It is up to you to decide.  That is the type of freedom that being financially independent provides.

If you are new to this blog or to the financial independence community, you might think that saving that much is an impossibility.  It is not impossible.  It is hard though.  It takes many years of living below your means, saving a large part of your salary, and investing it wisely.

Do not compare

Instead of trying to figure out if you can move to a nicer neighborhood or if you are in the same class with your neighbors, change how you think about the classes.  Boil it down to being financially independent or working class.  Focus on your own financial situation and do not try to compare where you fit in with anyone else.

By focusing on where you stack up to the middle, your measuring stick will never exceed mediocracy.  The middle is being squeezed from so many different directions.  Rise above that situation and mindset.

Play by your own rules and set your own financial goals.  Why do you have to be placed into some outdated economic pigeonhole?  The Industrial Revolution is dead.  Break free from the way society has taught you to think about how your earnings define you.  Don’t compare yourself to your peers unless you want to give away your joy.

Conclusion

No, I am not trying to become the Gore Vidal of the financial independence movement.  All I am stating is to use your money to build a life of freedom.  Don’t pay attention to class warfare.  That is a losing battle.  Make the most of what you have and always try to improve your situation.  Focus on what you truly want and go get it.

Be grateful for what you have instead of envious or others.  Help someone every day who is less fortunate than you instead of feeling self-pity.  Work smarter not harder, spend less, save until it hurts, and invest wisely.  Follow those principles and you will not have to worry about what class you are part of because you will be too busy working for your freedom.

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Was it Luck or Good Habits?

Has anyone ever told you that you are lucky?  I don’t share my financial situation with many people.  I do on this blog, but I do so anonymously.  There have been a few times in my life when I broke my code of secrecy.  I share about my financial situation when someone asks me for financial advice.

I am not a financial advisor, so I cannot give advice on a professional level.  I can, however, share my experience with others.  People seem to get more out of a story than from a list of steps to follow.  This is where I started, this is what I did, this is where I am.

When I have shared my relative level of success, it was never to sound braggadocios.  It was always in the spirit of trying to help that person improve their financial situation.  Most of these conversations where started by them asking if I think they should take out a car loan or if they should start buying stocks.

I never share closed-ended answers.  I just share about how I navigated similar situations.  My approach is to let my results be their guide.

Most of these conversations were enlightening discussions for them.  The other person walked away surprised by what was financially possible if they applied some discipline in their life.  They thanked me for sharing my experience with them.  Some said that I was lucky to be in the financial shape that I was in.

That comment made me think.  Was I lucky?  I never thought of myself as unlucky, but I never thought about if luck contributed to my financial situation.

On some levels, I was lucky.  I was born into a stable and loving family who always supported me and would correct me when I needed it.  There have never been any major health issues in my life.  I also have been blessed with the most selfless person who I have ever met for a wife.  Yes, I do count my lucky stars every day for those blessings.

Debt

Debt causes me fear.  At a young age, I took out a small car loan.  The car ended up being a junk and I had a few grand in debt and nothing to show for it.  I swore off debt from then on.  Fortunately, debt spooked me at a young age.

Being afraid to go into debt forced me to work my way through college.  That allowed me to pay cash for my first two years of community college.  The only debt that I had to take was to pay for my second two years.  I came out owing only $18,000 and my student loans were only $156 per month.  Many of my coworkers had student loan payments of over $700 per month.  They lived in dorms, partied, took out the meal plan, and did not hold a job during college.

The same fear carried over when it was time to buy a house.  My wife had bought our house before we were married.  She was able to make payments on her salary alone.  Instead of moving to a bigger house in a new development, we just decided to stay in that house and pay it down quicker.

Savings

Saving money just came naturally for me.  I did not have debt, so I had money in my pocket.  The work that I performed for my first few years of full-time employment was hard manual labor.  It just felt like the right thing to do was to save the money.  It would have depressed me to blow it on what I felt was stupid crap.

My saving rate was always at least 30%.  Saving money was fun.  It was like a game.  How could I find ways to save more?

That mindset became ingrained in me.  As I earned more, I saved more.  Saving money gave me pleasure, so I kept doing it.

Saving is like exercise.  It is hard but addicting.  A hard workout is painful, but also provides pleasure.  There is a sacrifice with saving money, but the sense of accomplishment is more pleasurable to me than the feeling I get when money is wasted.

Investing

I did not want the money that I was working hard to save just sit in an FDIC checking account.  It would not grow fast enough there.  I wanted my money to grow and work for me.

After reading about compound interest, I decided to invest in mutual funds.  They felt like the right fit for me.  Individual stocks seemed to take up too much time with having to research companies.  With mutual funds, an investor can buy a basket of stocks in a single fund.

My approach to investing was based on life-cycle investing.  When I started investing, I did not have much money, so I wanted to maximize returns.  In my 20’s, I was invested 100% in stocks for about ten years.

After I had a nice little nest egg, I took some risk off the table.  I added some bonds to my asset allocation.  They helped reduce the volatility when the economy tanked in 2007-2009.

Ten years later, I reached financial independence and decided to add even more bonds to reduce risk.  The game is not over, but I have a big lead.  It is now time to run the ball and play stingy defense.  For the next ten years, I just need to earn about 6% based on my savings rate to reach my goal of early retirement.

Conclusion

I was lucky to be born with an able mind and body.  Yes, I have caught a few lucky breaks in my life.  However, I feel that I had taken the required actions and developed the right habits to put myself into the position to be successful.

Lottery winners are lucky.  I worked my butt off for everything I have.  I did not go into debt because I did not want to be backed into a corner by creditors.  Saving money seemed logical to me because I did not want to waste all that energy to just blow it.  As an investor, I took a risk and accepted market returns during booms as well as recessions.

Even though I do not believe that luck has had much to do with what I have achieved, I count my blessing every day.  Life has taught me that it is much better to be practice humility and to always help others.  As the result of all of that, I truly have a thankful and grateful heart.

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Successful Personal Finance Traits

I have always felt that how a person manages their finances is a good reflection of their overall life.  People who are successful with their money always seem to look for ways to improve everything they do.  People who are good at managing their personal finances share a few common traits.  Those traits are not the ability to demand an above average market salary, have an above average IQ, or have graduated from a top-20 university.  The traits that are required to be wildly successful with your personal finances can easily be looked over.

Tuning Out The Noise

There are ads everywhere.  Marketers use TV, radio, print, and digital to push their products and services to the world.  People who are in good financial shape are masters of tuning all of that noise out.  They can delay gratification.  They are conditioned to identify all ads as spam.  People who are struggling with their finances always seem to fall into the must-have-it trap. Most people who are doing well financially do not even notice the noise.

Happiness

They know that spending money on things that are marketed to provide happiness is a lie.  The short-term high of buying new stuff wears off quickly.  They see the live life for today crowd as being short-sighted.  Tomorrow might never come, but if it does, it is better to have the resources to support oneself.

Organized

People who are good at managing their personal finances are organized.  Obviously, they are good at managing their bank account, paying bills on time, and keeping up with their investments.  They are neat, structured, punctual, and live a more orderly life.  If someone looks like a wreck, odds are, so do their finances.  Sure, there is always the eccentric millionaire, but they tend to exist more in fiction than in reality.  People who are organized financially tend to carry that virtue into all of their affairs.

Value

The people who are good at managing their personal finances have diverse interests.  They do not waste their time shopping and buying stuff they do not need.  When they do spend money, it is about buying quality products or meaningful experiences.  They understand the concept of spending a little more for a quality product than spending less on an inferior product that will wear out and have to be replaced.  They have developed the knack for when it is the time to be cheap and when it is the time to be frugal.

Intentional

Sure, people who are getting ahead in this world know how to read financial statements, but they are analytical in everything they do.  People who are good at managing their personal finances are intentional.  They do not rush to decisions or fly by the seat of their pants.  They think before they act.  Being analytical does not require the use of advanced statics.  Don’t fall victim to analysis paralysis.  A simple practice that anyone can apply is to make a pro and con list when it comes to making a financial decision.  If the pros outweigh the cons, move forward.  If the cons outweigh the pros, hold tight.

Balance

There will be many ups and downs in life that can lead people to make poor financial decisions.  The focus always needs to be on the big picture.  While money is extremely important because it is our life’s energy, it truly is just currency.  Most people have many responsibilities in their lives.  Health, family, community, and other areas of life are equally important.  Yes, we hear about the workaholic who has poor health and family issues.  Most of the people who I have met in the financial independence community are masters at living a balanced life.  By having a balance in their life they are in harmony with the universe.

Freedom

I have had sit-down discussions with many people who are in the financial independence community.  Some have their own blog and others just participate by being active on different financial forums.  While they all come from different backgrounds, they all seem to generally get it.  They better understand life, know that money cannot buy happiness, yet understand that many wonderful things come to pass for those who reach financial independence.  Their general understanding is that money equals freedom and freedom equals happiness.

This group has broken the chains that bind most people to their poor habits and financial woes.  They do not use leverage as a get rich quick scheme nor are they fearful of debt.  Their debt ratios are healthy.  They also know how to use debt in ways that can be extremely lucrative like credit card churning.

Be Present 

Everyone is on his or her own journey toward financial independence.  A person might be fresh out of college and ready to start a rewarding career where they have to manage their own personal finances for the first time.  Someone might be at mid-career where they are entering their high earning years and are trying to ramp up savings.  Another person might be near retirement or already retired and has to manage their personal finances during the drawdown period.

Conclusion

No matter where you are in life or what your financial situation looks like, always strive to get better.  Read blogs, listen to podcasts, or participate in constructive forum topics.  Learn from what others have to offer.  Create a blog and share how your own struggles were turned into victories.  By being active, I learn new ways to increase savings, pay down debt, and to improve earnings almost every day.

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Measuring Wealth: UAW, PAW, & AAW

How do you measure wealth?  There are many different approaches to measuring wealth.  Do you have $1,000,000 in the bank?  Some would say that makes you wealthy.  It might unless you have excessive spending habits and spend $1,000,000 or more per year.

Another way to measure wealth is based on years of annual living expenses that you have in savings.  I once read that if you have 10 years of living expenses in the bank, you can consider yourself rich.  If you have 25 years of living expenses in the bank, you are financially independent.  Any dollar amount beyond 25 years of living expenses would make you wealthy.  That scale is logical to me.

One of my favorite ways to measure wealth was created by the late Dr. Thomas J. Stanley.  In his book The Millionaire Next Door, he introduced three categories for people to measure how they stack up as creators of wealth.  Dr. Thomas J. Stanley refers to these three different groups as UAWs, PAWs, and AAWs.

Under Accumulator of Wealth (UAW)

An Under Accumulator of Wealth or UAW is a person who has a low net worth in relation to their income.  A person who is 45 years old, earns $200,000, and does not have a net worth of $900,000 would be considered a UAW.  That formula is based on (Age * Income * 10%).

Most Americans fall into this category based on their low savings rate.  Contrary to popular belief, however, many high-earners tend to fall into this category.  Based on Dr. Stanley’s research, many Physicians are not good at building wealth and are classified as Under Accumulators of Wealth.

You might be thinking, that is nonsense, Medical Doctors are rolling in dough.  How could they not be wealthy?  Yes, doctors earn a high salary.  General Practice Physicians earn around $200,000 per year and specialists earn over $400,000 per year.  How could they not be wealthy?

Doctors come out of school with large student loans.  On average, new Doctors come out of medical school with $167,000 in student loans.  I know of one who owes over $300,000 in student loans.  Doctors are faced with social pressures that members of other professions do not face.  They are pressured to look the part.  That requires living in a fancy housing development, driving luxury automobiles, sending their children to private schools, and joining exclusive country clubs.

I am not picking on this noble profession.  Not all Doctors fall victim to those social pressures.  There are many in the financial community who buck those trends including DocG who blogs at diversefi.com.

Average Accumulator of Wealth (AAW)

An Average Accumulator of wealth would be someone who has a net worth equal to the sum described above.  A person who is 55, has a salary of $150,000 plus $50,000 in investment income, would have to have a net worth of $1,100,000 to be considered an Average Accumulator of Wealth (AAW).  If they have a net worth less than that amount, they would fall into the UAW category.

Prodigious Accumulator of Wealth (PAW)

To be considered a Prodigious Accumulator of Wealth (PAW), you would follow the same formula, but multiply it by two.  From the example above, the formula would be (Age 55 * Total Income of $200,000 * 10% * 2).  In order to be considered a PAW, this person would have to have a net worth of $2,200,000.

Age is a Factor

This formula is better suited for people who are more mature in age.  I read The Millionaire Next door when I was age 26.  At that time, I was a student but had a full-time job.  My net worth at that time was $60,000.  Based on this formula, I was an Under Accumulator of Wealth.  In order to be classified as an Average Accumulator of Wealth, I would have had to have a net worth of $78,000.

This aspect of the formula has led it to be criticized.  In its defense, not many people who are in their 20s are focused on building wealth.  Most are in college racking up debt or trying to pay off debt after they enter the workforce.

In my opinion, a person should not focus on these calculations until they are at least 15 years into their career.  It takes time to build wealth as an investor or entrepreneur.  This calculation is more about where you finish the race as opposed to where you start out.

How to Become a (PAW)

There are plenty of steps that you can take to become a Prodigious Accumulator of Wealth (PAW).  Dr. Stanley has provided a complete outline in The Millionaire Next Door.  Below are some suggestions that will help you to reach these financial heights:

–        Spend less than you earn

–        Save 15-20% of your earnings

–        Invest in equities, bonds, real estate, private businesses

–        Don’t speculate on getting rich quick schemes

–        Invest in yourself by getting a good education and keeping your skills current

–        Avoid luxury items

–        Focus on building wealth for your children

Conclusion

I am a fan of the late Dr. Thomas J. Stanley.  I remember reading about him passing away as the result of an unfortunate car accident the day after it occurred.  His research has helped to spread a message that just about anybody can build wealth if they follow some basic principles and practices.

The UAW, PAW, and AAW classifications do receive some criticism.  It takes hard work to become an AAW and very hard work to become a PAW.  As many of my readers know, I am transparent about my income, net worth, and approach to investing.  With that, we are firmly planted in the Average Accumulators of Wealth (AAW) category.  We will not be in the (PAW) category for some time.  Being an Average Accumulator of Wealth (AAW) at this point in our life has allowed us to reach financial independence and one day retire early.

Are you a UAW, PAW, or AAW?  Use this calculator to find out.

What is your opinion of the formula that determines these classifications of wealth?

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