Worried About Inflation? Think About Purchasing Power.
A constant risk I see new investors take is their unwitting belief that wealth should be measured in nominal currency, such as United States dollars or British pounds sterling, instead of purchasing power. In the end, purchasing power is the only thing that matters. It is the only thing that counts - how much stuff you can buy or give away to help others.
In To Guard Against Inflation, Focus on Purchasing Power Not Dollars, we look at some of the specifics of why this is so important. By taking a net-of-inflation approach to your portfolio, you can opportunistically look at the returns from investing in bonds or other asset classes and realize that what looks like a good return might actually be a money-losing proposition!
Successful Investing Comes In Bursts and Sputters
Those of you who are new to investing need to know that your journey to wealth is not going to happen as one gradual, gently sloping incline. It's not comparable to getting an education, where you enroll in kindergarten and follow your way through the various grade levels until you are handed a piece of paper and a congratulations. You can toil away for years, spending less than you generate in income, investing the surplus in stocks, bonds, real estate, mutual funds, private businesses, or whichever other asset classes interest you, and suddenly find a big payoff or, alternatively, wake up one day and realize just how much money you've amassed.
The first type of experience happens most often when someone builds a business and sells it. This is called a liquidity event in industry lingo. Although the person isn't technically worth any more money, suddenly they have gone from having all of their resources tied up in property, plant, equipment, payroll, working capital, and investments to seeing a giant pile of cash, which they will most likely park in short-term Treasury bills.
The second experience is often the result of living responsibly for most of your life. Several times a year, I visit an old friend in the Midwest who is enjoying her retirement. She lives in a modest house. No one knows she has money except her banker. Her net worth lies in the 7-figure range. Whenever we go over her holdings, she remarks, "I just don't know how I amassed this much money. I never made more than $50,000 or $70,000 in a year." Today, she routinely writes checks to buy rental properties to add to her portfolio, paying cash to buy a house lock, stock, and barrel.
When you factor in the inflation rate and taxes, you cannot grow your net worth smoothly like a savings account. You can only do intelligent things, manage your risk, invest in what you know, and let time do the rest. Fluctuations - peaks and valleys - are part of the equation. For a disciplined approach that is adhered to and wisely structured, these represent opportunity.
What Is The Buffett Rule President Obama Proposed?
The Buffett Rule, as the media has taken to calling President Obama's tax proposal, is simply a way to say that anyone who earns over $1,000,000 per year must pay a personal income tax rate of at least 30%. It is designed to make sure a hedge fund manager or other financially savvy earner that knows the tax code can't dodge paying the same rate a successful baseball player or television personality would on their paycheck. It should come as no surprise that The Buffett Rule was named after legendary value investor Warren Buffett, who has been a proponent of the concept.
The downside of The Buffett Rule is it is not as simple as it sounds. Frankly, it's not entirely fair when you factor in that many people paying so-called "low" rates have already paid taxes once through their holding entities. It also doesn't solve the fundamental, structural issues in the tax code and could inevitably lead to the same sort of monstrous results and unintended consequences things such as the Alternative Minimum Tax (AMT) did in the end, hitting middle class families over the years instead of solely the high-end, rich tax payers it was designed to ensnare when it was conceived.
How the Average American Family Spends Its Money
The Consumer Expenditure Survey from the U.S Department of Labor and U.S. Bureau of Labor Statistics has released the 2010 report, which pulls from 2009 data, and here are some highlights of how the average American family lives.
- Average age: 49.4 years old
- Number of vehicles owned: 2
- Percentage who own a home: 66%
- Number of persons in unit: 2.5
- Number of earners in unit: 1.3
- Pre-tax income: $62,857
- Expenses per year excluding taxes: $49,067
Leaving aside that "average" is meaningless because a person with $0 and Warren Buffett in a sample would have an "average" net worth of $30 billion (instead, we should be focused on median, the point at which 50% are above and 50% are below), what are some ways that $49,067 gets spent? Here is the breakdown:
- Food: $6,372
- $2,619 is spent on food away from home
- $3,753 is spent on food at home
- Insurance and Pensions: $5,471
- Entertainment: $2,693
- Healthcare: $3,126
- Transportation: $7,658
- Apparel and Services: $1,725
- Housing: $16,895
- Other: $5,127
The sad part about it all is that the average American family is foolishly spending far more on transportation than they do on funding a 401(k) or Roth IRA. To spent $15 to $16 out of every $100 you make after taxes on a car is inexcusable. You cannot become wealthy by throwing away that much precious capital on a regular income.
What, Exactly, Do Economists Mean When They Say There Is No Such Thing As a Free Lunch?
For more than a century, the phrase, "There is no such thing as a free lunch" has been a regular part of the American experience. Popularized more than 40 years ago by famed Nobel-prize-winning economist Milton Friedman, the adage is a way of expressing the ever-present existence of opportunity cost.
You can't get around it, you can't avoid it, and you can't ignore it. Someone, somewhere will pay for your actions. Right now, the very fact you are reading this screen presents an opportunity cost in that you could be outside throwing a frisbee, or on a plane traveling to Bora Bora. Financially, the implications of opportunity cost, which I explained years ago in You're Spending Your Millions $1 at a Time, are staggering.
The biggest thing new investors seem to forget, or not realize, is that doing nothing has its own opportunity costs. To help illustrate why, in cold, hard facts and figures, I wrote There Is No Such Thing as a Free Lunch: A Look at Opportunity Cost. It can open your eyes how waiting, even five or ten years, to start fully funding your retirement accounts can cost you enormous sums of wealth.
A Real Life Example at How I Use Opportunity Cost to Manage My Own Money
Many of you have written to ask me about opportunity cost and, specifically, how I use it to evaluate my own personal financial decisions. Several years ago, I gave you one of the basic time value of money formulas in an article called Know Your Opportunity Cost, but last week, I found myself in a situation that provided a perfect example of how I measure the trade-off between what I want today, and what I'd like to have tomorrow. I chronicled the math and decision process in a new article, Opportunity Cost: How I Spent $2,385,600 to $24,074,400 in Future Wealth.
Walking through life with an opportunity cost approach to making decisions is empowering; freeing. It allows you to decide what you really want, and helps you protect against choosing what you want right now, versus what you want for your life overall. Start your education. It can revolutionize your understanding of how to manage your investment portfolio, pocketbook, and even career.
The 3 Types of Opportunity Cost That Matter To You
Although opportunity cost is a broad topic, there are three, specific types of opportunity cost that matter a great deal to your pocketbook! You should learn about each of them if you want a chance at living off your dividends, interest, and rents each month. In my newest article, 3 Types of Opportunity Cost That Influence Your Investment Portfolio, I walk you through each, explaining why they are so vital.
It may seem like I am hitting this topic hard and, it's true, I am. If I achieve nothing but getting you to go through your life thinking about, evaluating, and considering your opportunity cost, I will consider it an enormous success. I want you to be financially independent. I want you to generate passive income. This approach might help some of you.
What Is Opportunity Cost?
Over the next few days, I am going to publish several new articles about an important economic concept that often gets overlooked by new investors. It is called opportunity cost. The first place to begin is by answering the question, "What is opportunity cost?", and go over both implicit and explicit examples. If you can't define it instantly, and with conviction, I want you to click that article link and take a few minutes to educate yourself.
Why do I care so much about opportunity cost, to the point that it is my sole focus this month? Simple. Mastering it lies at the very heart of becoming financially successful. Each of us is given 525,600 minutes per year. What we do with that determines how we live; our friends, family, career, hobbies, relationships, mistakes, successes, net worth, and lifestyle. It is our opportunity costs that define who we are, how we live, and what we achieve (or don't achieve, in the case of many people.)
I want you to have the very best life you can. Start by reading this ...
Don't Fool Yourself Into Thinking You Are a Long-Term Investor If You Aren't
Just as everyone likes to fancy themselves middle class (the facts: unless you make between $2,894.83 and $4,335.75 per month, the middle quintile for the American population, you are not middle class), everyone likes to talk about how they are long-term investors. Unfortunately, the facts don't show that to be the case. While the average American stays in their home for seven years before selling it, many investors think displaying the same patience and horizon with a partial ownership stake in a company such as Pepsi or Johnson & Johnson is unfathomable. To them, six months is a long-term investment!
This begs the question: How can you be sure you aren't just fooling yourself into thinking you have the right time perspective? To help answer, I wrote a new article called How Do You Know If You Are Making a Long-Term Investment?, which includes a checklist to help you determine if you are in it for the long-haul or trading stocks and fooling yourself.
The article also explains that not every company should be a long-term investment. Typically, you only want to own so-called "excellent businesses" that have very specific financial characteristics. (For more information on that topic, instead, read Getting Rich By Investing in an Excellent Business).
Both should be good places to start for new investors who don't consider a good time to be chugging Pepto-Bismol in front of a trading screen, afraid to go to the bathroom for fear of losing their nest egg due to a change in the Dow Jones Industrial Average.
Investing In Individual Stocks Is Not the Only Game In Town
We need to have a talk. Some of you? Yeah. I hate to break it to you but some of you will never have the emotional temperament to invest in stocks. Many financial planners and professionals seem to refuse to accept or believe this basic fact, hoping that rational arguments will win those of you who make up this minority over to their side by using historical proof, statistical evidence, and logical, well-documented cases. In some instances they are correct. In the end, some of you are a lost cause.
That does not mean you have to give up on your hopes and dreams for financial independence or significant wealth! Far from it! It just leaves you with one less tool in the toolbox of your family's finances and that we need to look further than Wall Street to find intelligent things you can do with your savings.
Specifically, it reduces you to two big asset allocation asset classes unless you want to get into the esoteric like mineral rights, music copyrights, patents, trademarks, etc., which isn't an area most normal investors want to tread in unless they have unique insights in a field or industry due to their career.
How do you know if you are the type of investor that probably shouldn't be holding individual common stocks in your portfolio, much less try to choose new positions to add to your holdings? This checklist might help ...