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Financial Freedom Is Merely Organized Common Sense
Investing Is Like a Cup of Coffee
If, for the same price, I offer you less coffee in a better cup, or charge more for the same amount of coffee but in the good cup, would you take the good cup or the paper cup? Many would not take the exquisite cup. They understand that the coffee is the important part and the cup is merely a package. Not everyone would assess the situation the same way and that is okay, too.
Life sometimes has components that we choose without challenging the details to understand what we give up to get them. Sometimes we end up paying for something that we do not value.
Investments are like that sometimes. For example, one of the factors that affects the yield on a specific investment is, “How fashionable is it?”
A limited partnership interest in a feature film is quite attractive for its ability to be a topic of discussion at the country club. Tax sensitive and maybe you get to go to the cast party when it is done. Not so attractive in terms of what it could earn. A mutual fund that is environmentally or politically or health sensitive may feel good, but do the feelings replace the cash shortfall that may result.
Social and sensitive decisions are not always in your best financial interest.
All investments pay the same rate of return.
Here’s how.
You bring resources to each investment. Money is obviously one of them but there are many more. Risk tolerance, predictability, time as in the need or non-need of liquidity, access to the investment, ability to manage the investment, special knowledge or skills, and your tax position, are all things you may have and could be paid for if they are present.
If I decide to be a distributor of cocaine, my rate of return on money invested may be quite high, even after deducting reasonable expenses for body guards, bribes and sub-distributors. But I am not only being paid for my cash investment. I have invested more than that. I need contacts, and time, and management ability. More importantly, I am being paid for my investment of the not small probability that I will be executed or imprisoned. That is what the extra cash return is for. People who distribute orange juice seem to have a lower return on investment but if all things are considered, they do not.
Similarly investments can pay you in different ways.
Possibly in money. Interest, dividends or growth. But also possibly in other ways. The investment might reduce an expense you incur. For example, I might buy a hot water tank instead of leasing it. The investment may be fashionable like the movie investment above. The investment may create a tax preference or it may be exchangeable for some other investment or I may need no skill or time to participate. If the investment pays you in other ways, you may reasonably expect the cash return to be lower.
The yield on an investment balances your ability to contribute with the investee’s need to get the capital for the lowest possible cost to themselves. In the long run you can get no more than the capital is worth to the investee and many of them will make pretty packages so that you will overlook the fact that cash on cash may not be that attractive. Pay attention. It is just a package and you may or not value it.
Your optimal investment is one where all of your money and other resources are employed and there are no discounts from cash yield as the result of the investee offering payment in forms other than cash for things you don’t want.
It will pay you to understand what your investment resources, other than money, may be. Once that is clear, you can tell when an investment is outside your comfort zone.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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A View of Financial Plannning
Financial planning does not work the way most people think. At least not in the beginning. Financial planning is not about making you wealthy or even secure. It is about getting the most of what you want by using the least of the resources you have today. Wealth and security may result.
Ideally lifestyle now and in the future will be unaffected by the planning.
Step one is just arithmetic. Find the lifestyle today that allows you to save enough and pay off enough debt so that there will be enough money to live in the way you are accustomed to doing, forever.
That means two things are important.
- You need to know what you want and when you want it, and
- You need to know what you can use to get it
Many if not most people come to a financial adviser without a clear idea of these two concepts. Eventually they find that life would have been easier or worked out better had they known.
Financial planning is about compromise. You cannot save and invest the money you spend. A year gone by is gone forever. You cannot have high yield and risk free at the same time, unless you are bringing special skills to the table.
Financial planning is about understanding straightforward concepts.
- Compound interest is the power source for everything financial. It works for you when you invest over a long time, and it works against you when you borrow.
- You cannot spend a given dollar more than once. If you borrow, you can spend it now, but it you have committed some future dollar to repaying it. Plus interest of course.
- Think of life financial things as a balance beam. Resources on one end and commitments on the other. There is a fulcrum between them and just like in physics, the effect of something depends where you put the item on the beam. On the resource side, things you own now will be far left of the fulcrum and will have a big effect on how it tips. Things you will have later are closer to the fulcrum and don’t affect balance much now.
- Yield is what the economy allows you to earn. There are no magic bullets. Time matters and a fair yield matters. Try not to impose conditions on your investments that are in fact, not necessary. More conditions reduces yield.
- Many of the things that affect your plan are outside your control. (taxes, inflation, regulation, banking risk, government policy, the length of your life, special needs in the family)
Do your advisers and especially do yourself a big favour. Understand the process. Understand resources and time. Understand insurance, understand debt and understand a little about how investments work. Do all that and you will tend to be successful and you will tend to have less fear because you will see how it fits together.
Last. Start soon. Time matters as much as money and more than yield.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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Can You Count A Failure As A Success?
When you plan, notice that choosing one thing has two effects. Always. The first is the thing you are trying to accomplish and its end. The second is all of the other choices that are available and that you deny to be part of your life by choosing the first. They also have information contained in them.
We all have the tendency to pick one thing and then analyze it in terms of what happens. The problem with that is that we only use the variables that were present in the initial decision. If it failed, we frequently do not take away all of the message that we could have learned.
Thomas Edison, in speaking of his work on the incandescent bulb, has said, ” In creating the bulb, I don’t see myself as having failed a thousand times, I see that I have learned a thousand ways that don’t work.”
This is frequently cited as an example of the value of persistence. While it may be that, there is more value than that in examining what he did. Try answering this question.
“In the thousand ways that failed, do you suppose Edison noticed something about each failure that helped him to find a way that worked?”
Certainly Yes. It was not a case of trying random guesses and throwing away the failures until he accidentally and persistently hit upon a solution that worked. In reality, the solution evolved and each failure contributes a small piece to the ultimate success. That is the way it is with financial plans and life in general.
It is useful to think about another facet of Edison’s experience. Do you suppose he learned something from his failures that did not contribute to the eventual light bulb success, but did contribute to the success of some other device? Almost certainly yes.
Most inventive people fail far more often than they succeed, but like the elephant they never forget the lessons.
Successful people learn from what went wrong as much or more than they learn from what went right. There is no useless knowledge, but is easy to learn little from success. Success confirms your biases and they are certainly incomplete.
You might want to remind the young people that the courses that look useless in high school may actually be valuable in another context on another day. Or maybe the thinking or research methodology learned in a useless course may turn out to be a time saver later. You can never know in advance the thing that will be useless.
Steve Jobs took a “useless” course in calligraphy while dodging real college courses. In the early Apple computers, the ability to select beautiful fonts was a clear advantage to owning one of those machines. The Apple became the standard in graphic arts, and for a long time that was its only viable market sector. Apple had a tiny fraction of the overall market but a piece just big enough to let them struggle through. I wonder if Jobs had never taken the calligraphy course if it would have survived at all?
Success is frequently opinion. It made money. It got something done. It created an easier life. Not considering the monetary value, I wonder if Edison would see the thousand failures as more valuable to him than the one instance that worked?
Experience is the best teacher. Useless is seldom useless. Failure is seldom permanent. Mistakes are your friends. Meaning is partly enclosed in what you did and partly included in what you did not do. Try to notice the whole spectrum.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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When To Buy Life Insurance
Many people would like to know, “When is the best time to buy life insurance?”
Best is an interesting idea in this context. I suppose the best time is the day before you die. A challenge to make that work. Underwriters are a bit cautious about the things that might motivate you to buy on that day. When they are okay with it, the probabilities of “success” on your part is near zero.
Okay, so when is the next best time?
For low priced term insurance, now is a good time. $50 a month goes a long way if you are a young non-smoker. Aside from the affordable premium and large coverage, buying now guarantees your future insurability. Not everyone who is a healthy vibrant 25-year-old, will be an insurable 40-year-old.
The trick in determining the best time is to understand the reasons to own the coverage.
- Life insurance replaces the earnings that you would have enjoyed had you lived longer.
- It liquifies assets that are otherwise locked up. It is hard to pay of debt or provide living expenses with money tied up in vacant land or a small business.
- It offsets losses. No one ever dies when everything is complete. We are always in the middle of something and cancelling or failing to complete things has a price.
- Life insurance replaces skills and knowledge. Survivors can buy what they need if they have enough money.
- Life insurance provides a safe, sometimes creditor proof, storage space for long term investable cash. Participating life insurance looked at as an investment, is similar to a high quality bond fund with a very low MER and some bonus yield for improvements in life expectancy. Universal life can be made to look like a mutual fund portfolio with an insurance wrapper.
Life insurance is an efficient way to solve otherwise unsolvable problems.
We can all think of reasons to not own life insurance. No value in the present is the most common excuse. But that is just an excuse. It is like a high school student who can’t see the value of reading a particular book or learning algebra.
Properly designed insurance is not about what it is or does, it is about what it allows you to do because you have it. Things like invest in assets that are valuable because only you know how to use them.
An insurance portfolio is a lifelong project. It can provide value in unforeseeable ways while living and it makes end of life decisions and outcomes profoundly better.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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Money and Teenagers
What does your teenager know about money and what should they know?
Success with money begins early and is a skill that grows with experience. You need to participate to learn. Like golf, you cannot learn it from a book or a DVD. Books and DVDs can help but the important parts are experienced.
There are only a few things that are important.
- Money is value that a person receives in exchange for some other value they gave up. Wages are in exchange for effort and time. Interest is in exchange for waiting to use the money. Profit is the return for investing and providing skill, time and effort.
- Money is the method that allows the time of earning and the time of spending to be different. A $20 bill in a drawer will buy something another day and waiting will not diminish it.
- If someone gives you money, they are essentially giving you some past effort that they have made. There is no free money.
- Governments want to spend money and they have none of their own and no way to earn any. They need to take it from the people. All government money is the people’s money first. A citizen should notice that it would work better if the government spent less or at least spend what they take wisely. Be aware of governments. They will likely be your single larges expense.
- There is a difference between earning money and getting money. People can get money in many ways. Gambling is one, albeit unevenly profitable. Reorganizing the capital in a publicly traded business is another. Packaging and unpackaging assets is another. Remember mortgage backed securities. The most insidious “get money” deal is credit cards. Few ads show the pain of getting out of credit card debt. The pain of payments and the cost of interest lasts much longer than the joy of dinner.
- Money is time and skill and effort. Sometimes spending makes sense if they think about it in terms of hours instead of money. Is a video game worth five hours of working at a menial job with people who don’t treat you very well?
- Don’t spend all your money as you receive it. If you do then you can never save and you cannot repay a debt without reducing your lifestyle. Most people do not like reducing lifestyle. Better to not start by spending all your money.
- You can only spend a given dollar once. You cannot have your cake and eat it too. When you decide to spend a dollar on something, it automatically means that you choose to not spend it on anything else. Pay attention to what you have decided to exclude. It is very easy to miss that the dollar you spend today was actually committed to be spent later for something more important. In simple terms, you cannot buy hockey tickets today with tomorrow’s gas money and still expect to get to work.
Teenagers need money in order to learn what it is for and how it works. Ideally regular income for required work. Be sure they have enough to make some stupid mistakes. Advances are okay but they must be repaid from reduced future income. Do not bail them out when they do make mistakes. They need to learn that once the money is gone, it is gone forever. The only way to pay off a debt or to save capital is to reduce lifestyle. They will learn this lesson eventually, better they learn it when they are 17 than when they are 32.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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Avoid Duplicated Payroll Taxes
If you have a business with several divisions, it can make sense to consolidate your personal salary in just one of them. Pay attention to payroll taxes.
In Canada both employee and employer contribute to the Canada Pension Plan and to Employment Insurance. For CPP, both contribute 4.95% to a maximum near $50,000 of salary and for EI the employee contributes 1.88% and the employer 2.632% also to around $50,000.
If an employee over-contributes, probably because they changed jobs in year, their excess contribution becomes a credit on their tax return when they next file.
In most cases, business owners can get an EI exemption if they control the corporation that pays them or if they are related to the person who pays them. If you or your family pay EI on salary, consider getting a ruling and claiming a refund. The amount in question is not insignificant and is not especially onerous to acquire.
I think that the EI waiver is well enough known that people do not have a problem here. The CPP problem still shows up sometimes.
Consider Ed’s business. It is a specialized construction firm. They do store interiors. The business consists of three parts. A design business, a construction business and a manufacturing business that creates fixtures for the stores. The components have Ed as controlling shareholder, but each has minority shareholders that are not present in the other two.
Ed draws a salary of $165,000 annually and to be fair to the minority shareholders, he takes $55,000 from each of the businesses.
In 2014 that will cost the group $4,851 that it need not pay. The $55,000 salaries attract CPP requirements of $2,425.50 from each of the employee and the employer. When he files his tax return, Ed will get his over-contribution back but the corporate group will get nothing.
It is not difficult to avoid this problem and it is a costly one when missed.
If you, as adviser, see a business owner with CPP refunds on their tax returns you might suggest that they attend on their accountant to work out a method to solve this.
An easy value added service.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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Are There Language Absolutes?
Words don’t always mean the same thing. They are contextual and need to be modified by that context. People can manipulate meaning or at best confuse you, if they use a word in one context that has a different meaning in yours.
Consider “rich.” In a general way it means having enough money to do the things you want. It is the amount that is different from place to place and from time to time. By that definition a rich person in Peterborough would be middle class in Manhattan and probably would need a sponsor to get through the door at the country club at Palm Beach.
Wealthy does not mean the same as rich. Margaret Bonnano has said it best. “Being rich is having money; being wealthy is having time” I suppose the clever rich people use their money to buy time. We can all do that to some extent. The teenager up the street likes the money and you like the time you save if he mows the lawn.
Safe and risky mean different things to different people. Some people are never safe because they carry fear. In the same way, risky is graded. Risky for me is not the same as it is for someone who knows what they are doing and has the capacity to absorb temporary fluctuations. You need to consciously decide what you mean by risky. Learn about tolerance, capacity and exposure and then set your own standard. That decision is fundamental and will make your investing life easier, once known.
I am preparing this early Friday, the 3rd of January. The thermometer says it is -27C. Wind chill around -36C. To me that is cold. When asked about the differences between India and Canada a recent immigrant from India said, “Cold means something different here.” I wonder if that is surprising.
When you are setting goals and discussing methods, be sure that you are using key words, like risk, in the same way as your adviser. It is hard enough to communicate without having confusion on the essentials. It is not enough to find meaning. It is essential that you find “your meaning.”
Need proof. Bi-weekly means either once every two weeks or twice a week. You could look it up. Makes you wonder about those car ads offering bi-weekly payments.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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What About Rate of Return?
Back in the ’80’s there existed a financial advisory firm that could make anyone’s financial plan work. Need more, can only save a little, or have a only a little time to retirement? No problem, we can make it work for you.
A pretty compelling presentation for people who do not pay attention to reality.
Yesterday I talked about the triad of financial planning factors. Capital, yield and time. Before creating a financial plan, you should have a clear idea about all three. What capital can you contribute, what time and what realistic yield is your knowledge, access to investments, management skills, time to do so, and many other variables.
Suppose I know that I need capital available in 30 years. And, further suppose that I know what investments are available to me. I will discover that availability is only part of the question. There are some things I should not buy.
For example, I might notice rental real estate. I have studied carefully and know that I can earn a 10% return, cash on cash, and I can have a tax shield from depreciation in the early years. In 30 years, I can easily have it paid for and could have the net income to live on forever, mostly inflation proof too. Maybe even a capital gain when I sell. So why not buy up as many as I can afford?
Two reasons:
- There are not that many available that have the right price/yield characteristics.
- I have no skill, patience or inclination to be a landlord.
So even though a triplex might be a good investment, it is not a good investment for me.
Knowing what is a good investment, for me, is important pre-knowledge. Think it through before talking to an adviser.
This failure to think through what was possible, was the key to the “We can solve anyone’s financial planning problem.” They just assumed whatever rate of return they needed.
“Given your needs and available capital, we can make it work for you if you get 16.5% on your money over the time to completion. And, fortunately for you, we have available a fund that made more than last year so it would be conservative to assume they can get what you need next year.”
For a naive investor, that might make sense. It will not happen, but that is what the naive requirement is for. Losing time while the fallacy comes clear is very costly.
As a client, before you decide how to proceed, know what you need to get, when you need it, what you have to get it with, and finally, what yield you can expect from the part of the investment universe that matches your skills and inclinations.
Every investment provides the same return on investment if you consider all the factors invested. If you want something with no effort or skill and no risk, you must accept a very low rate of return. Money by itself does not earn much.
A simple example. A five year investment certificate pays more interest than a one year certificate. Reason? You invested the same amount but in the five year certificate, you gave up the right to have the money longer (liquidity) and maybe took a little risk because it is harder for the issuer to survive five years than one. The difference in the rate is the price of liquidity and risk for that particular investment. If you cannot accept the risk and the illiquidity, you cannot have the extra yield.
Investment fit is like buying shoes. There are lots to choose from but you won’t like all of them and some of the ones you like, won’t fit. Yield measures fit. It is about what you get back for what you put in.
Most investors have not thought through yield and where it comes from.
Investment yield depends on many factors. Easily thirty. The best result comes when you can find an investment that matches all your pluses (the things the market will pay you to provide) and none of your minuses (the things the market will make deductions from yield if you want them.)
Do not skip the step that says, “What is a reasonable yield for me?”
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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The Planning Triad
Financial planning is about balance. The attempt is to balance the present with the past and the future. Needs with resources. Growth and security. Risk and reward. Cost and benefit. Existential risk like death and disability.
The first step is to recognize that time matters more than the other things. Time changes the effect of a need and time magnifies resources that move forward. Time gives you another solution option.
Before you can know how to use it, you need to understand compound interest. The important aspect is that compound interest will double the value of an asset within some period. 9% takes about 8 years to double. You can know the time it takes by dividing the growth rate into 72. The law of 72.
If you have 40 years to invest, and anyone under 50 probably does, then you can expect 5 doubles. 32 times your money at the end. Time is very important because only half the money exists after 32 years. One more double by 40, right? You make more in the last 8 years than you made in the first 32.
You control the accumulation problem by managing 3 variables. The capital, the yield and the time. If you have a little more time you can use a little less resource and/or you can accept a lower yield. (Less risk.)
For example if you want a given amount in 32 years instead of 40, and can live with the 9% yield requirement, it is easy to have it happen. Just start with twice as much capital.
If the capital double can’t work, then you can get the same answer by investing at 11.25%.
Future needs (liabilities) work the same way. A dollar you need in 40 years, with a 9% interest world, is worth just $0.03125 today.
Time allows you to solve problems as a series of steps rather than one big one like we have been working with. You could calculate the monthly saving needed to be equivalent to the lump of capital at the beginning. Maybe inflation adjusted savings or with lumps and skips. It is just a big arithmetic question.
There are lessons here.
- Increasing the rate of return creates other issues. Usually risk, as in losing your money risk, but also variability, availability, manageability, and liquidity.
- Taxes reduce yield. Tax management can create a higher effective yield.
- Inflation increases the need to satisfy future obligations. Take it into account, but do it in terms of what is a reasonable yield over the inflation rate. Hint: 4% over is difficult, 7% is not going to happen.
- Real losses are crucial for two reasons. Fewer capital dollars invested and fewer years remaining to the target. You can sometimes find new capital, but once time has been used it is gone forever. Be very careful of things that might cost you time.
- Manage the risk of loss by limiting exposure to high potential but high risk situations. For example, Wayne Gretzky has said he will not invest more than 10% of his family’s capital in a particular situation.
No one I know has smooth cash flows over long times. In the beginning, free capital is at a premium because there are enormous present demands for money. Debt, acquisition of assets you use, children and more. But for young people, time is long, so a little saving will be very valuable eventually. Later on more capital will be needed to get the result but it may be available then. Kids are gone. Maybe an inheritance. It is good practice in the interim.
When planning, recognize the triad of time, yield and capital. You must manage all three together to get optimal effect from your plan. Find an adviser who can help you make your ideas work over long periods and can help with the arithmetic.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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Avoid Licking Frozen Metal Things
The purpose of learning is to make our lives easier. When a mistake has been made, learn from it and avoid it in future. That seems easy enough.
But, how to learn? What to learn? And, when to learn it?
What to learn is fairly obvious. The best choice is to learn the things you need to know to be a productive, prosperous and contented adult. Skills that let you earn a living, for example. Life skills that let you know how to take your children camping or how to hit a golf ball. Important skills like how to recognize poison ivy and how to recognize a guy in the parking lot who is on meth.
What to learn is maybe not so obvious after all. Maybe learn a little about everything that comes your way and focus more intently on the usable aspects of that.
When to learn is a problem. Things learned out of order are not especially useful. In the 1920’s quantum theory was difficult to address because the required math did not develop until well after the original discovery. Helping someone to learn requires providing order to the parts.
How to learn is easy for some people. They absorb everything near them. Like a two-year-old. For most of us though, we have a preference. Some people learn by watching others, some learn by reading or taking courses. Some listen carefully. Some pay attention to their own actions.
Learning from your own mistakes is likely the most valuable because the hard lessons are the best remembered. Unfortunately these lessons are usually the most costly. Experience is the best teacher and for the price it better be.
The key is to not learn exclusively from your own mistakes. Learn from the mistakes of others. The lesson is not quite as effective but the cost is negligible. That is what education is about. Learning from the mistakes and insights of others. We sometimes undervalue education because it is so stylized. If it were taught in the form, Here is a mistake someone made and here is what they could have done instead, it might work better.
As the new year begins and you assess what you should do for personal advancement consider being more curious. That will help you learn from others. Notice what is going on around you and estimate causes and probable outcomes. You will be wrong a lot of the time but you will get better and something you learned in one context will suddenly reappear in another as an important thing.
Avoid the serious mistake of trusting only your own experience. Look for the mistakes of others for guidance.
It is -15 Celsius here this morning. I know, without having tried it that, licking a metal post today will be a bad idea. I learned that from a friend when we were seven. Thanks Mike.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
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