Upon reading that title, your first instinct should be to run away as fast as possible. All investments have risk and nothing is guaranteed, especially a return that crushes the stock market. But please bear with me as I do a little explaining.
In my past articles about the state of the U.S. economy, I outlined why I believe that the United States is headed for a deep depression with a potential collapse of the U.S. dollar. The housing collapse, and ensuing recession wiped out the life savings of many people who had enjoyed upper-middle class lifestyles and good jobs before the recession. This 60 Minutes report shows just how fragile the financial situation of many Americans has become.
I believe the financial crisis of 2008 was just the warm-up. The next economic crisis will wipe out millions of Americans who are not prepared, but it will also create incredible investment opportunities for those with a strong financial foundation. But, regardless of whether you agree with my doomsday scenario or just think that the economy is in a “soft patch”, one thing is certain- There has never been a more important time to get your financial house in order than right now!
In past articles, I’ve suggested several investments, such as physical gold and silver, commodities and foreign equities, that Americans can make to diversify their assets and protect and grow their wealth in the coming years. One common response I received was, “Sounds great and all, but I’m having enough trouble making ends meet in this economy, much less have anything left over to buy gold coins.”
That brings up an excellent point- what can the average American- who works for a living, supports a family, pays taxes, has some type of retirement account and some debt- do to invest in her future? While anyone can afford a few silver coins, investing in precious metals, like all assets, involves risk and can lose money, especially in the short run. That’s why it’s important to invest in a strong financial foundation beforeinvesting in risky assets.
The “investments” I’m talking about are not your typical stocks and bonds that most people think about when they imagine investing. In fact, these “investments” can be made with simple behavioral changes, regardless of one’s financial situation; and you’ve probably heard most of them before. What I hope to achieve with this article is to reframe these tried and true concepts so they are viewed as an opportunity, an “investment”, to build wealth and improve one’s life, as opposed to a burden that one must endure.
The Psychology of Personal Finance
The real challenge holding most people back from building wealth has less to do with salary, and more to do with financial education and psychology. Schools don’t teach us about finance or monetary policy, and our society and government encourages the wrong behaviors. How else can you explain that an estimated 60% of NBA players (who average $6mil per year) go broke within five years of leaving the league?
While NBA players may be an extreme case, the fact is, many Americans follow behavioral patterns that prevent them from building wealth and put them at risk of serious financial problems if an unexpected expense occurs, or if the economy turns sour. In today’s America, reckless and irresponsible financial behavior is considered “normal” because everybody else is doing it. It’s time for Americans to rethink what is normal.
A recent poll by Careerbuilder.com found that 77% of Americans described themselves as living paycheck to paycheck. A survey by the National Bureau of Economic Research asked households if they could come up with $2000 in 30 days in the case of an emergency. 28% of respondents said they certainly could not and 22% said they probably could not come up with the money. Even crazier, of households making between $100k and $150k per year, nearly a quarter said they certainly or probably couldn’t come up with the money.
In the 1996 book, The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, the authors compare the habits of “under accumulators of wealth” (UAWs) with “prodigious accumulators of wealth” (PAWs). They found that people who spent less than they earned, avoided “status” objects, spent time thinking about their finances and invested their savings, were able to accumulate wealth regardless of income level. Conversely, UAWs rarely build wealth because as their salaries increase, they simply spend more to make up the difference. Unfortunately, in the past few decades, the vast majority of Americans have become UAWs to the extreme, as evidenced by the historically low savings rates and high personal debts.
While individuals are ultimately responsible for their own behavior, much of this behavior can be attributed to the perverse incentives and rules put in place by our government and Federal Reserve. For example, government subsidized housing loans and low interest rates from the Fed enticed many people to buy houses they could not afford, setting in motion the housing market frenzy. The artificially low interest rates also encouraged people to borrow to finance their consumer spending, often by extracting equity from their homes. The low interest rates simultaneously wiped out the returns savers could earn by investing in savings bonds. The clear message was "borrow and spend," instead of "save and invest."
Why is saving money and building wealth so hard? Below are just a few of the educational, societal and governmental pitfalls that must be overcome to build a strong financial foundation.
-An incomplete understanding of the power of compounding interest. Saving and investing just a small amount early in life in a compounding account can have a huge affect on retirement savings. For young workers, retirement seems far off, something they can prepare for down the road, but investing early in life is the key to a happy retirement.
-Higher than reported inflation which is the equivalent of negative compounding interest and eats away at savings returns. The low interest rates and high inflation we see today makes it difficult for people to accumulate wealth through savings and “safe” investments like bonds.
-It’s fun to spend money and it’s only natural to want to live the same lifestyle as your friends. The immediate gratification of spending is obvious, while the unseen consequences are less obvious. Saving seems like a sacrifice. People, especially with high paying jobs, feel they’ve worked hard so they deserve to spend their money.
-Government social insurance programs like Social Security and Medicare give people a false impression that they will be taken care of, so they don’t need to save as much for their retirement. Welfare, and unemployment benefits discourage people from looking for a new job as quickly or as diligently as they otherwise would.
-Inflation causes people to underestimate the amount of money they will need to have saved for retirement. A million dollars today may seem like a lot, but it may not buy much in 20 or 30 years.
-When people get deep in a debt hole such as with student loan debt or high credit card debt, it’s psychologically debilitating. It can be discouraging to work all week just to pay off your debts and can trap people in jobs they don’t like and reduce their opportunities.
To build a strong financial foundation, one must understand these and other pitfalls and make a conscious decision to overcome them. Foregoing a new pair of shoes or a new set of golf clubs may seem like a sacrifice, but the choice isn’t between new clubs or nothing; rather it’s a choice between new clubs today versus the peace of mind, security and financial freedom to do whatever you want in the future.
Getting your finances in shape is just like getting in shape physically. If you haven’t exercised in a while and have developed poor eating habits, changing your diet and getting into the gym can be psychologically difficult and physically painful. The hardest part is getting started, but the best time to start getting healthy is not after a heart attack, but right now. Most people find that as they get into shape, their workouts get easier and their self esteem gets higher. Soon their body actually craves exercise and healthy food. With the right attitude, exercise can be a fun activity, not a chore to be dreaded.
The same is true with finances. The time to get into financial shape is not after a market crash decimates your 401k or you lose your job, but right now. At first, the steps below might seem like painful sacrifices, but as you begin to change your habits, they become easier and more rewarding in a virtuous cycle. With the right mindset building your financial foundation can be fun. Think of it as the Zumba of financial workout programs.
The good news is the deeper you are in the hole, the greater the return on your investments in your financial foundation will be. Hopefully, the no risk returns described below will inspire you to get off the couch and kick some financial foundation ass.
Five steps for building a strong financial foundation.
The steps below are in the order they should be taken to build your foundation. In general, they also happen to go from highest return on investment to lowest and from zero risk to more risk. As a baseline, compare these “investments” to the stock market which has averaged real returns (that is percentage gain minus inflation) of 7% since 1950 and -3.4% in the last decade.
Step 1. Shore up your unmanageable debts. The collapse of the housing market left many homeowners with underwater mortgages and rising mortgage payments due to adjustable rate loans. The recession has left many college grads with limited employment prospects and huge student loan payments. Some people have simply run up excessive credit card debts that they have no hope of repaying. If you find yourself in an extreme credit situation where you simply have no way to ever repay, you may need to undergo a bankruptcy or debt restructuring. In some cases, a creditor will negotiate a reduction of principal to ensure that they at least get paid something. Some underwater homeowners have simply stopped paying their mortgage because banks have been reluctant to foreclose. This is a serious situation and you will need to do some serious soul searching to find out what is right for you. Talk to a professional to discuss the options for your situation, but watch out for shady companies that require upfront fees and have vague promises. You cannot build a financial foundation without resolving this issue first.
Return: 100% instant return on any savings you can negotiate.
Downside Risk: Your credit rating will be F’d. (But let’s face it, it’s F’d anyway.) Also, depending on the situation and your personal beliefs, there may be moral dilemmas involved.
Step 2. If your company matches 401k contributions, contribute the maximum amount they will match. This is free money. If they match 50% of your contribution that’s like an instant 50% return on your investment. Since the money you contribute is automatically withheld from your paycheck, you’ll never even miss it.
Return: 50%-100% instantly depending on what your company will match.
Downside Risk: None (on the matched funds). However, once the money is in a 401k your account can gain or lose value depending on the stock market and the performance of the 401k plan. Also, keep in mind that this money is for retirement and there is a penalty for early withdrawal.
Step 3. Pay down revolving credit card debt as fast as possible. If you don’t pay off all of your credit cards in full every month you are simply throwing money out the window and into the lap of the banks. As of June 2011, the average credit card rate was 16.76%. (source) Paying down your revolving credit is essentially the same as “investing” in a treasury bond that yields 16.76% a year and with no downside risk. Another way to think of it is that everything you buy is 16.67% more expensive than it could be without credit card debt. Pay off your cards one by one starting with the highest interest rate and then consolidate down to two or three of your best cards. Once your revolving debt is paid off, pay off your cards in full every month.
(Note: If you have other investments such as savings bonds that aren’t yielding 16% risk free, sell them immediately and pay down your revolving credit cards.)
Some “experts” recommend cutting up your credit cards altogether and using a debit card instead. If you have absolutely zero self control and can’t force yourself to pay your bill in full each month this may be an option for you. (The other option may be to grow up and stop acting like a child.) The problem with this strategy is that your credit rating is based on your ability to take on reasonable amounts of debt in relation to your credit limit and establishing a track record of paying off that debt. There may come a time when you need to borrow money for a legitimate purpose, such as a mortgage or starting a business, and a high credit rating will greatly reduce your total payment over time.
Return: 16.76% on average per year with no risk and no capital gains tax.
Downside risk: None.
Step 4. Prepare for an emergency. Accidents, natural disasters, and other unforeseen expenses can pop up at any time. It’s important to have an emergency savings fund for when they do so you’re not stressed for cash in a time of crisis. The fund should be separate from your general bank account and should cover two months of expenses. I would recommend keeping a few weeks of expenses in cash at your house in case you can’t access your money at the bank for any reason.
Stock up on food and supplies you know you will need anyway. This is a tip you probably won’t find in financial advice articles, but in today’s uncertain economy, it is an important piece of the puzzle for protecting yourself. This kills several birds with one stone. First, purchasing non-perishable food items and other goods such as forever stamps, toothpaste, razors, etc., can be a great hedge against inflation. As I stated in my Government Numbers article, I believe real inflation is close to 10% and rising, which far exceeds the yield on U.S. Treasuries. If inflation does cause these items to appreciate in value, unlike other investments, you don’t have to pay capital gains tax when you use them. Second, in case of emergencies, essential items like food, water, water filters, toilet paper, medicine, etc. will fly off the shelves or in some cases may shoot up in price. By buying items before you need them, you can buy them in bulk or when that particular item goes on sale. Finally, by buying essential items ahead of time, you will have less cash to spend on impulse consumer goods.
Make sure you have appropriate insurance in case of a catastrophe. The right insurance is an important tool to protect yourself from unlikely (but costly) events and should be budgeted into your cost of living.
Return: Peace of mind. Inflation hedge. Avoids catastrophe if an accident does occur.
Downside risk: Some opportunity cost of keeping money in cash.
Step 5: With most of your foundation complete, it’s time to invest for the future. I would recommend putting at least 10% and ideally 20% or more or your take home pay towards savings and investments. Anything less than that and you’re living above your means. You should have two types of investment accounts- retirement accounts, such as your 401k or an IRA, and more liquid accounts where you have access to the money whenever you like without penalty.
The advantage of retirement accounts is that you only pay income tax on them and don’t need to keep track of your capital gains and pay the capital gains tax. If you’ve been contributing to your 401k as described in step 2 that’s a good start. If you want to contribute more to your retirement you can start an IRA or add more to your 401k. I personally prefer a Roth IRA because you pay taxes on “the seed corn and not the harvest.” You can invest the money any way you like and after five years you can withdrawal your contributions (but not the gains) without penalty.
A standard (non-retirement) brokerage account will allow you to invest money and still have liquid assets that you can sell to put a down payment on a house, start a business, jump on an investment opportunity or pay your bills if you lose your job. Keep in mind though that investing is risky and you can lose money, so don’t invest money you know you will need in a short time horizon or you may be forced to sell assets at inopportune times.
As far as what to invest in, you will need to do some homework and figure that out for yourself. Don’t rely on a stock broker to dictate your investments. (He’s trying to sell you stuff.) Don’t assume that U.S. treasuries are “safe” simply because they have been in the past. Be sure to diversify, not only with stocks, bonds and commodities, but across nations and currencies.
I personally think that physical gold and silver will continue to be the safest and highest yielding investments in the coming years. In the past ten years, gold has gone up 500% and silver up 700% while the stock market has been flat. In fact, I’m so bullish that the precious metals will explode to the upside soon, that I would begin accumulating silver coins in parallel with Step 4. For more of my opinions about stocks, bonds and commodities and how to protect your wealth, check out my State of the Economy papers.
Return: Depends on your investments.
Downside risk: Stocks, bonds, commodities and real estate could collapse.
Action Plan for Your Financial Foundation
Getting your financial house in order begins with honestly assessing your financial situation and committing to make a change. If you’re married, this needs to be a joint effort with your spouse, as it will only work if you are both on the same page. Ask yourself some tough questions: How far along am I in the financial foundation steps outlined above? In an emergency could I come up with $3000 quickly? If I lost my job, could I get by for six months without dipping into my retirement fund? If interest rates were to rise, would my adjustable rate loan become unmanageable. These are just a few of the questions you should be asking, and you should come up with more based on your situation.
To pay for the “investments” outlined above, you can either increase your income or cut your spending. For most people, increasing their income is harder to control unless you can work more hours or take on a second job. That leaves reducing your spending as the easiest way to build your financial foundation.
A penny saved is a penny earned. Actually, it’s more. Let’s say your annual salary is $50,000. If you increase your salary by $1000, you would pay $250 in income tax, $56 in SS and medicare taxes ($133 if you’re self employed), and state income tax of roughly $50 (it’s $95 in CA). So increasing your income by $1000 yields $644 ($522 if you’re self-employed in CA like me). A penny saved is 1.555 pennies earned.
Bust out your credit card and bank statements from the past year and create a budget that categorizes exactly what you’ve been spending money on. By knowing exactly where your money is going you can better identify areas where you can cut. This is the baseline reference for your new budget that starts with your take home pay (after your 401k contribution in step 2 is deducted) and subtracts a percentage that goes towards investing in your financial foundation. The deeper in the hole you are, the bigger this savings percentage should be. After you’ve put aside your investment money, go through your budget and trim the fat until it’s balanced.
Here are some ideas to keep in mind as you create your new budget:
-Can you sell any of your old stuff to pay down your credit cards?
-Can you trade down on big ticket items? If rent or a mortgage is a big chunk of your budget can you find a cheeper place or take on a roommate? Do you need that fancy car or will a more utilitarian one work just as well?
-Look in your closet. How many of those clothes do you actually wear? Can you buy half as many this year? Can you bargain shop instead of impulse buy?
-Do you have expensive bad habits? How much could you save by quitting smoking? Do you really need those last two drinks at the bar? (That’s probably a question for the author.)
-How much do you spend eating and drinking out? Does that $15 bottle of wine in your fridge really taste that much better than the $5 bottle at Trader Joe’s?
-Can you get as much enjoyment out of a simple vacation as you get from a lavish one? Focus on experiences over material items- you won’t remember the stuff you had but you’ll always cherish your unique experiences.
-Can you reduce or eliminate recurring payments? Do you need the super cable package? Can you drop the gym and exercise outside? Why the heck have I been paying $12 a month for Rhapsody when I haven’t used it in twelve months?
-Can you do some extreme couponing or shop at bargain or savings club stores? Make it a game to see the deals you can get.
Making cuts can be psychologically difficult. If you just can’t find enough savings or can’t agree with your spouse, perhaps in impartial personal finance consultant can help. Find a support group, read an inspiring book, separate your budgeted monthly money into boxes- whatever it takes to motivate yourself.
Don’t think of your budget as cuts, but as a proactive plan to invest in your future. Think of the huge returns you are getting on your investments in steps 1-3. Think of the peace of mind you will have knowing you could survive being laid off or if you have another child or if the market crashes or if inflation wipes out the dollar. Think of the potential explosion in the value of your silver coins. Think of how you’ll feel in twenty years asking your spouse, “Remember when we lived in that tiny apartment eating rice and beans? Now look at us.” Make it a game to find out just how fast you can build your foundation without giving up the things that are truly important to you.
The most important investment of all is to invest in yourself. Learn new skills, improve your health, make yourself invaluable at work, and build your relationships. Life isn’t supposed to be a struggle; with your financial foundation in order it won’t be.
More Zumba pics for your enjoyment: