Category Archives: Saving Money

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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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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Analyzing Personal Finances with Ratios

Financial ratios are a common tool to measure the financial health of a company.  The price-to-earnings (P/E ratio) is a ratio that is commonly referenced by the financial media.  The P/E ratio is a quick measurement for valuing a company that measures the current share price to its per-share earnings.  A company that has a high P/E ratio is normally linked to a stock that investors have high expectations for growth.  The average P/E ratio of the market is in the 25 times earnings range. A value stock will have a low P/E ratio.  Ford (F) comes to mind because it has a P/E ratio of 5.

Another common ratio is EBITDA ratio.  This is giving me a flashback to Accounting 101.  The EBITDA ratio measures revenue with earnings.  EBITDA stands for earnings before interest, taxes, depreciation, and amortization.  It is believed by many financial managers that EBITDA determines the true financial health of a business.

For a business to be successful, its management needs to take stock of its financial health.  For an individual or household to be financially successful, they too should take a deep dive and look at their metrics.  Are there financial ratios that are relevant to personal finance?

There are many different aspects to being successful in personal finance.  There are, however, far fewer variables when it comes to personal finance than the financial management of a corporation.  With that, there are far fewer ratios to measure.

What should an individual investor measure to determine if their personal finances are healthy?  For a business to be successful, it needs revenue.  On the personal finance side, income is needed.  Too much debt is negative for both businesses as well as for an individual.  One sign of a healthy company is that it has many assets on its balance sheet.  That is also true for individuals and the foundation of acquiring many assets starts with having a high savings rate.

Income

Income is what drives your personal finances.  Income is a key factor for those who are working to earn a paycheck.  It is equally important for retirees who require income-producing investments to sustain their standard of living.

To save money, income is needed.  How much should people be saving?  In the 1980’s, Americans were saving 10% on average.  That percentage has decreased over the decades.  American’s are, however, trying to get their savings back on track.  They are currently saving more than 5% on average.

While saving 10% is better than the current rate, it is not as high as it should be.  In the Richest Man in Babylon, a savings rate of 10% was suggested.  I do not know the average lifespan from 5,000 years ago, but I know that it was not as long as people are living today.

To find out if you are saving enough, the saving-to-income ratio is a helpful tool.  To determine the saving-to-income ratio, divide household savings by the average household income.  Savings include everything that is in a 401K, IRA, brokerage account, savings account, and checking.  Real estate holdings such as your house should not be used.  Income includes all earnings from a job, business, and side-gigs.

For example, Sarah is a 25-year-old math teacher.  She has $20,000 in total savings.  Her salary as a school teacher is $40,000 per year.  Sarah would have a saving-to-income ratio of 0.5.  Sarah would have a high savings-to-income ratio for age.

A good savings-to-income ratio for the average 30-year-old person would be 0.1.  The saving-to-income should increase with age.  At mid-career, a person should have a 1.7 savings-to-income ratio by age 40.  At age 50, with retirement in sight, the savings-to-income ratio should be at 4.5.  If a person is still employed at age 60, the savings-to-income rate should be in the 8.8 range.

Debt

The second factor consider is to measure debt.  As a member of the financial independence community, I view all debt as bad.  For a more mainstream approach to measuring debt, the debt-to-income ratio is a good measure.

Start with total debt.  Include both good and bad debts.  Calculate the totals for the monthly student loan, credit card payments, mortgage payments, and any other outstanding debt that you might pay every month.  Next, calculate the total monthly income.  To determine debt-to-income ratio: total monthly debt/income.

For example, Jim has $2,000 in monthly debt payments.  His household income is $10,000.  That would equal a Debt/Income Ratio of 0.2.  That would be considered a reasonable amount of debt.

A household should never exceed a Debt/Income Ratio of 0.36.  Anything above 0.37 is considered the danger zone.  It is considered the danger zone because of that ratio measures if there is enough household income to cover monthly debts and other obligations.  When the ratio of 0.36% is exceeded, there is less money to cover other expenses as well as for savings.

Savings

The last ratio is an important ratio for retirement planning.  Every personal finance blog, forum, and publication states that people need to be saving more for retirement.  How much exactly should people be saving?

The Saving Rate-to-Income Ratio is a helpful tool to determine how much a person should save for retirement.  An employer match on a 401K plan should be counted.  If an employee contributes 8% of their salary to their 401K and the employer provides a 4% match, the Savings Rate-to-income would equal 12%.

A good starting rate for a young employee who wants to retire early (younger than age 65) would want to start at 12% and try to increase their Savings Rate-to-Income Ratio by 1% per year.  If an employee is satisfied with a more traditional age of 65, the 12% rate should be adequate if it is followed for 40 or more years of employment.

That 12% does not include interest, dividends, or capital gains.  It does not include Social Security withholdings.  The 12% Savings Rate-to-Income also does not include any contributions that an employee makes to a defined benefit plan.

Conclusion

Financial ratios are a useful tool to measure and track how healthy a household’s personal finances are.    With financial ratios, they do not tell the whole story.  They should be used as a helpful tool.  They are useful to gain a snapshot to determine if income is sufficient, debt is at a manageable level, and if savings are high enough to cover future living expenses.

When you calculate the income, debt, and savings ratios, the results might be eye-opening.  If these ratios reflect that your personal finances are not as healthy as you thought, the good news is that they can be improved.  As you work to earn more, pay down debt, or save more, your efforts will be reflected in the ratios.  A 45-year-old should have better ratios than a new college graduate.

Calculate these ratios every six months.  A good time to run them is when you review your asset allocation.  These ratios are for tracking the progress you are making.  As you work to make improvements, your efforts will be reflected in these metrics.

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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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Financial Planning for New College Graduates

You did it.  You earned your college degree.  Congratulations on this major life accomplishment. Now it is time to learn about financial planning for new college graduates.

Hopefully, you have a job lined-up in your field of study.  If not, don’t get overwhelmed.  Start applying and interviewing.   Before you know it, you will be working, growing your career, and earning a paycheck.

The good times are not over, but it is time to enter the real world.  By starting this next chapter of your life on the right track, you will be able to better ensure a sound financial future.  Right now, time is on your side.

As a new college graduate, I am sure the last thing on your mind is retirement.  Retirement might be many decades away, but the actions you take in the coming years will shape your financial future.  Below are the key steps that will help you to establish a plan that will guild you on your journey toward financial independence.

Step 1 – Save 15% of your salary.  Start this process of saving with your first paycheck.  It might sound like a high percentage, but this is just the first step.

Step 2 – Sign up for your employer’s retirement savings plan.  If you work in the for-profit universe, it is called know as a 401K.  At a not-for-profit organization, it is called a 403B.  If you work for the Federal Government, it is a Thrift Savings Plan (TSP).  On your first day of work, go to the Human Resources office and sign up to contribute 15% of your salary to their retirement savings plan.  Increase the amount that you contribute to your retirement plan by 1% every year.

Step 3 – If possible, only Invest using low-cost mutual funds and index funds.  Avoid trying to pick individual stocks or trying to time the market.  Identify an asset allocation that best matches your age and risk tolerance.  Historically stocks have produced higher returns than bonds. Stocks, however, are more volatile.  On the other hand, bonds are less volatile but do not keep up well with inflation.  Establish a plan that uses both stocks for growing your wealth and bonds to retain your wealth during bad economic times.

Step 4 – Establish a plan to pay off your student loan debt.  Don’t fall victim to the mindset of the masses when it comes to student loans.  You attended college and earned a degree.  Hopefully, you paid attention in class and are ready to put your degree to work for you as an employee.  You attended class, possibly lived in a dorm, and most likely ate your meals in the cafeteria.  It is time to pay back what you owe.  Avoid self-pity and feelings of entitlement.  Those ill feelings will just hold you back on many levels.

Step 5 – Get a part-time job.  For those who have the entrepreneurial spirit, start a side business.  You are young and full of energy.  Now is the time for you to be working and building a solid financial foundation.  Getting a part-time job will allow you to earn extra money.  Working a couple of evenings during the week and picking up some hours on the weekend will greatly help to increase your earnings. That extra money can be used to pay off your student loans, establish an emergency fund, or open a Roth IRA.

Step 6 – Put off attending graduate school.  Unless you work in an industry that requires a graduate degree to obtain entry-level employment, put off attending for a couple of years.  Find an employer who offers tuition assistance as part of their compensation package.  That will allow you to work in the day and take graduate classes in the evening or on the weekend.

Step 7 – Write a financial plan.  A financial plan is a map.  It allows you to identify where you are at from a financial standpoint.  A financial plan is also a map that can be used as a guide to where you want to be in the future.  It helps to have a guide than to go it alone.  Financial planning is too important of a topic to not have a plan and just fly by the seat of your pants.  A financial plan is a living document that needs to be reviewed annually.  The great feature of a financial plan is that it can be amended as your plans and goals change.

Step 8 – Establish a budget.  Calculate how much you will earn every month from your job.  Write out your budget based on percentages.  Know how much of your salary will go towards housing, food, entertainment, and every other expense.  Be sure to write a budget that is practical in terms of expenses and prudent in terms of savings. In other words, always try to reduce expenses and to increase savings.

Step 9 – Keep your transportation costs low.  Transportation costs are simply an expense in your budget.  Use your budget as a guide to determine how much you can afford to spend on a car.  Keep your transportation costs at 11% of your budget.  Your budget will determine if you can afford a fancy new car or a used economy model.  Try to keep in mind that a car does not determine your identity.  It is just what enables you to travel from Point A to Point B in a timely manner.

Step 10 – Keep your housing costs as low as possible.  If you are renting, try to find a roommate or two.  Having a few roommates greatly reduces the amount you will have to pay for rent every month.  As you advance in your career and if you have a family, you might consider buying a house.  Use your budget as a guide to determine how much house you can afford.

Step 11 – Be sure that you are properly insured.  If you are under the age of 26, you should be able to remain on your parent’s health insurance.  If not, ask your employer about when you are eligible for coverage under their plan.  You are young and most likely healthy, but one trip to the emergency room could ruin you financially if you do not have proper health insurance.  Also, be sure that you have the proper amount of insurance for your car, home or apartment, and life insurance if you have a spouse or children.

Step 12 – Avoid Debt. Keep your debt to a minimum.  Avoid payday loans and credit card debt at all costs.  Having a high credit score is important because it will allow you to get the most favorable interest rates if you do have to borrow money.  To ensure you do not take on too much debt, monitor your debt with the Debt-To-Income Ratio.  Always try to keep your DTI under 16% and never exceed 36%.  In life, sometimes debt is unavoidable.  Most people will have to take out a mortgage to purchase a house.  Some people will have to take out a car loan in order to have a means of transportation.  When doing so, use both your budget and DTI to determine how much you can safely afford.

Conclusion

There you have it.  You are finished with college and ready to take on the world.  Don’t put off applying these steps.  You can start implementing some of these steps on your first day of employment.  If you start out with a well-established plan, you will be well ahead of your peers.  Use these steps as a guide and you will surely become a financial success story.

Do you agree with these suggestions?  Do you think that anything is missing from this plan?  What would you add or do differently?

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