Personal Finance

There are two sources of personal financial wealth.

1)      Existing wealth is either transferred to us, or

2)      We create and accumulate new wealth that never existed before.

Existing wealth is transferred to us by gifts, inheritance, government programs, marriage, etc.  We create or produce new wealth with our bodies (physical labor) and/or our minds (ideas, innovation, etc.).

Human capital is a measure of an individual’s potential for creating new wealth by calculating the net present value of their lifetime earnings.  Assuming your current earnings of $22,000 and a working life of 40 years, the value of your human capital can be estimated as $509,000.

You may have heard that the United States is leaving the Industrial Age and entering the Information Age.  As we transition from a manufacturing to a knowledge economy, those who create more wealth with their mind (knowledge) will have a significant advantage over those who create wealth with their body (physical labor), unless they have a specialty such as professional athlete or washing the windows of skyscrapers.  By investing in your health to prolong your working life, and investing in your mind to increase your earning power, you increase your individual human capital.

Gross Domestic Product (GDP) is a measure of a nation’s produced or created wealth.  In 2008 the US economy produced $14.4 trillion dollars of wealth or Gross Domestic Product (GDP).  Our GDP per person or per capita was $47,440.  Our GDP per household was $129,540.  In other words, even after the market crash in 2008, the average US household created $129,540 in new wealth.

After 40 years of working (age 25 to 65), the average US household will create $5,181,600 in new wealth.  We are the largest economy in the world and the US worker is the sixth most productive in the world.  Yet, in an aging America 80% of all households have a net worth LESS than $250,000!  How can so many produce so much and have so little to show for it?

We propose two simple answers:

1)      BEHAVIOR – Individually, we are CONSUMING more wealth than we CREATE.

2)      BELIEFS – Most likely we have beliefs which

1. trigger consumption instead of investing
2. block the unlimited human capital in our minds

A Financial Plan addresses both issues and accelerates the journey to Financial Independence. 

Off course you can!  Most people underestimate their ability to grow both their income and their wealth.  Most people do not create a written plan to increase their income and wealth.  Do you believe you can double your net worth in five years?

The four primary areas of increase where average people build their net worth are:

1. Savings
2. Portfolio return
3. Real estate (home) appreciation
4. Debt reduction/amortization

There are five major inputs or “levers” by which you can control the four sources of increase.  These include:

1. The growth rate of your income
2. Your savings rate
3. The rate of return on your investment portfolio
4. The rate of appreciation on your home
5. The rate at which you pay off debt

You have the most control over your income, your savings rate and your debt reduction rate.  You influence your portfolio rate of return with your asset allocation.  You have the least influence over the rate of your real estate appreciation.  However you influence the return on your investment or equity in real estate through leverage or the size of your mortgage debt and the rate at which you pay it off.

Start now!  For the next 30 days, when you get up in the morning and before going to bed at night, ask yourself the question: “How can we increase our income?”

It is extremely important that you believe your plan is achievable.  90% of achieving financial goals is mental, not financial.  “Whether you think you can or can’t, you’re right.”(Henry Ford).  Belief determines behavior.

For example, you can reject your Financial Plan because it does not fit your belief systems.  Or you can change the Financial Plan until it fits your belief systems.  Or you can work on changing your belief systems.  Helping people change their belief systems is the work of therapists, psychologists, ministers, educators and financial planners.  The purpose of all human communication is to change belief systems.

There are many ways to change your belief systems which are beyond the scope of the work of a Financial Advisor.  I believe the primary way to influence your belief system is through education.

From 1988 thru December 2007, investors underperformed the stock and bond markets by -7% and -6% respectively.  It is an empirical fact that individual investors sabotage their own portfolios because they have no strategy.  If you think you are an exception, you should have what professionals call an Investment Policy Statement that describes your strategy by answering questions like the the following:

What is the target return for your investment portfolio?   4-6%?   7-9%?   10-12%?   

How much risk are you willing to take in order to get that return?   Are you willing to lose 40% of your portfolio one out of every five years in order to have a 65% chance of averaging 12% over 20 years?   How much risk is acceptable as defined by the “volatility” or “variablity” in your annual returns?

What is the time horizon for your portfolio?   When do estimated withdrawals from your portfolio exceed the contributions and earnings?  Ten years from now?  Twenty years?  Fifty years?

How many asset classes do you use?   Three?  Five?  Seven?  What is your target allocation for each asset class?  What are the band limits?  When do you rebalance?

Have you chosen an active or passive management philosophy for security selection?    

If you have chosen active management for the equity (stocks) asset class, what strategy have you selected?   Do you buy growing companies or beaten down value companies?  Do you use a buy and hold, momentum or market timing strategy?

Achieving investment goals requires a plan and a strategy.  One of the most frequent mistakes investors make is they have no written plan or strategy to address some of these most important questions.

There is a difference between investor and investment performance.  In 2008 the US stock market, as measured by the S&P 500, lost 37.7%.   But investors did even worse by losing 41.6%.    The US bond market, as measured by the Lehman Aggregate Bond Index gained 5.2%, but bond investors actually lost 11.7%.   In other words, the stock market as an investment outperformed investors by 3.9% and the bond market beat investors by 16.09%.  

This is not just a one year phenomenon.   Every year the Dalbar company measures how investors performed compared to the capital markets themselves.   For the 20-year period from 1988-2007, the US stock market, as measured by the S&P 500 returned 11.81%, but equity investors only earned 4.48%.  For the same period, the US bond market, as measured by the Lehman Aggregate Bond Index, gained 7.56%, but fixed income investors earned only 1.55%.   In other words, over the past 20 years the stock market outperfomed investors  by 7.33% and the bond market beat investors by 6.01%.   If we’re not shocked, we should be.

What are investors doing wrong?  How do they unintentionally sabotage themselves?

These are ten broad categories of mistakes that we have seen investors make:

1. They have no strategy
2. Their strategy is to beat the market  (Market Failure Theory)
3. They don’t hold themselves accountable (No Benchmarks)
4. They listen to the media more than the math (The Loser’s Game)
5. They don’t count the impact of costs (SEC Cost Calculator)
6. They let emotions overrule numbers (Behavioral Economics)
7. They don’t understand or set a portfolio time horizon
8. They don’t define long term (Speculators vs Investors)
9. They don’t understand all the risks
10. They measure risk tolerance instead of risk capacity

Most investors believe they are the exception, but it’s pretty easy to prove they are not.   People’s Financial Advisor offers a Financial Checkup that will estimate the cost in your personal portfolio from just one common mistake.  In future postings we will explore each of these mistakes in greater detail.