Personal Finance

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.

Tip #1:  The best way to save for college is to put money in the most effective place to build wealth the fastest.  That often means maximizing our contributions to our 401(k) or IRA.  Money saved in a 401(k) or IRA can be used to pay for college and under current law does not reduce eligibility for financial aid.

Tip #2:  The best way to pay for college is to take the money from the most effective source with the least impact on your wealth.  That may mean using government subsidized loans and tax credits, paying out of current income or pulling equity out of your home.

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Can information be bad for investors? Prof. Paul B. Andreassen from Harvard University, compared the investment performance of four groups of investors. Two groups managed a volatile growth stock like Google. The other two groups managed a stable value stock like Sears. In each pair of groups, one group was fed a steady stream of news reports about their stock, while the other group received no information. In both pairs, the group that received no news performed better than the group that was given a steady stream of information. In fact, the investors who received no news and traded the volatile growth stock performed twice as well as the investors who received regular updates on the company’s performance!

How can this be? How does easy access to financial news and the ability to track portfolio values harm investors? Researchers in behavioral finance observe that when investors receive new information there is a natural tendency to “do something” in reaction to that information. It turns out the human brain is programmed to act on new information.

In most cases, acting on new information is good. But when it comes to implementing a long term investment strategy, it’s usually disastrous. Information stimulates emotions which in turn increase the urge to act. So a steady stream of information about losses, moves investors to sell. Later, a steady stream of news about market gains, induces investors to buy. Without realizing it, most investors have abandoned their strategy, if they had one in the first place (See previously posted Mistake #1). Driven by natural urges to act on information, investors unintentionally implement a strategy of selling low and buying high.

Watching daily movements in your investment portfolio is like watching paint dry. Imagine a paint job with a one-hour drying time and checking it every minute by touch to see if it’s dry. Sixty fingerprints can ruin a great paint job.

Assume your portfolio has at least a ten (10) year time horizon. Checking the value every day is like touching the paint 3600 times an hour to see if it is dry. One of the worst things we can do after creating and implementing our investment strategy is to touch the paint. Treat all the daily headlines like static on the radio. Ignore them. Because information can be harmful to investors, we recommend the discipline of an annual investment review.

One key to building wealth is “Don’t turn down free money!”  When you maximize contributions to your qualified retirement plans you accept free money from three sources:

1)      The taxes you normally owe the government,

2)      The interest earned on the government’s tax dollars which are now inside your retirement plan and

3)      The interest earned on the interest.

By maximizing your pre-tax contributions you accept the government’s “free” money, build wealth faster and are able to retire sooner.

Let’s assume you are married with a household income of $48,000/year, and you are my neighbor in Colorado.  Let’s also assume you are contributing 6.25% of your salary or $3,000 annually to your 401(k) plan.  Should you increase your contribution by $1,800/year to get to the lifelong minimum savings rate of 10%?

If you are in the 15% federal tax bracket, you are paying an unnecessary $350 in federal and state taxes, by not contributing the additional $1,800.  In other words, Uncle Sam and the State of Colorado will reduce your taxes by $350 if you will put an additional $1,800 into your retirement plan.  That’s an instant 19.4% return on your savings.

In reality you are only putting $1,450 of your own money into your retirement plan because the additional $350 is the taxes you would have to pay Uncle Sam and the state if you did not defer your income.  Sometimes, I call this $350 in deferred taxes the “government match”.  It’s as if our government is paying you $350 to motivate you to save $1,450 of your own money.  Isn’t this a great country?

In the table below we have calculated the value of this “free money” ($350/year tax savings) invested in a conservative portfolio of stocks and bonds* over 1-, 10- and 20- year time periods.  The table assumes you remain in the same tax bracket every year.

(*) Annual return 8%, average fund operating expenses 0.3%.

There’s an additional bonus.  Money in qualified retirement plans is protected from creditors by federal law (ERISA).  Even though OJ Simpson was convicted of murder in civil court, the judge could not use OJ’s NFL pension money to pay the monetary damages he awarded to the victims’ families.  Is it any wonder that many experts call Qualified Retirement Plans the “World’s Best Tax Shelter”?  Maximizing contributions to your qualified retirement plans is the fastest way to build wealth that can’t be taken from you by creditors.

Check your own “free money” numbers at:  http://www.peoplesfinancialadvisor.com/financial_checkup.php