Monday, March 08, 2010

Saving and Investing

This is a continuation of our finance series. Here are the other's so far:

Saving and investing is a very important piece of our financial plans. Here's a classic exert from the Bible that speaks to the importance of saving and investing:

The servant to whom he had entrusted the five bags of gold said, "Sir, you gave me five bags of gold to invest, and I have doubled the amount." The master was full of praise. "Well done, my good and faithful servant. You have been faithful in handling this small amount, so now I will give you many more responsibilities. Let's celebrate together!" - Matthew 25:20-21 (NLT)

How we manage our money is practice for later. It's like when we practice our "times tables" in grade school - we did it so we could do more complicated math easier. As the passage indicates, managing our money, and investing it wisely, is very important. Before we can dive into the wonderful world of investing, we first need to talk about saving.


Part of being a good steward of your finances is saving. Believe me, this is tough to do because it requires patience and a very long term view. In our world where instant gratification is highly rewarded and encouraged, it's hard to go against the flow. For me, I have to remember the numbers are in my favor if I wait. Here's a simple example showing a $1,000 purchase. One is by saving for the purchase at 1% APR (currently ING is offering 1.1%) where you make the purchase when you have enough money (in month 11). The other is using a credit card at a rate of 10% to purchase the item right away (month 0). Both assume you are able to contribute $100 each month toward the purchase.
Saving vs. Credit
Making this purchase using a credit card will cost you $53 more - that's like an additional 5% tax on your purchase! Now imagine if the purchase was $30,000 and lasted about 5 years - the difference would be substantial! Of course, if you need the item right away, it might be worth going into debt. Deciding whether you need it, or want it, is very important. Jessi and I want another computer, and so we're going to wait and save for it (believe me, it's tough waiting, but it's worth it). Another huge difference, which you can't really quantify is that by saving you have options. For example, Jessi needed to pay to get official credit for a class she's taking to keep her teaching licence updated. We were able to take part of our computer fund money and use that to pay for her credit. That's peace of mind that is worth many percentage points!

We open saving accounts for everything simply because of this principle. We save for travel, car maintenance, Christmas and birthday gifts, impulse shopping (I know... ironic), etc. Basically, we save regularly for expenses that tend to happen in big chunks and are sporadic. This helps us avoid using our credit cards, earn a little interest in between, and thus actually save money. To be clear, it's hard, if not impossible to save for huge purchases. For example, we took out a loan for our duplex because otherwise we would have never saved enough, and the alternative, renting, wasn't really saving us money anyways. A car might be another example, but you really need to evaluate whether you want or need it to be new. OK, let's get more tactical.

The recommendation we were given for saving were these steps:

Step 0: Spend less than you earn - if you don't do this, nothing else matters.

Step 1: Pay off your consumer debt - specifically, pay off your credit card debt and personal loans. At this time I wouldn't worry about paying your car or home loan faster.

Step 2: Set money aside for an emergency - the amount you want to save will depend on your tolerance. Jessi and I are aiming for 3 month's worth of expenses, plus 3 months worth of rental income. What counts as an emergency? There's no strict definition, but you really want to only use it for things you need and don't currently have saved for.

Step 3: Save for major purchases - set up a separate savings account and add to them. It's so much fun to see the balance tick up! Great examples are computers, cars, furniture, appliances, TV's. For some of ours, we automatically deduct somewhere between $10-$100 monthly and then add on top of that as we're able.

Step 4: Diversify your investments to meet your long-term needs - start saving for retirement. By the way, when have you saved enough for retirement? When the principle and interest can pay all of your expenses from when you stop working to when you pass away. Do you know who much that is? Are you saving at a rate that will meet that goal? Obviously, the huge unknown is when you're going to pass away, but don't let that stop you (pick 120 years old if you want to be safe). I HIGHLY recommend getting together with an expert and figure out those numbers. The sooner the better too because you'll get to take advantage of compounding interest over time (more later).

Now it's time to switch gears to investing.


The very first thing we learned about investing this week was that there's no such thing as a perfect investment. In business school, they always said the perfect business was a mailbox where people show up and drop off their money on a regular basis. No work required, no risk, and a practical infinite return. Clearly this doesn't exist, but I think it can lay the framework for how you evaluate the types of investments you want to make.

When looking at investments, I typically think of two components, and two multipliers: (Money & Time) X (Leverage & Market). The choice of your investment will most likely be determined by what you have available.

If you have money to spare because you spend less than you earn. Awesome! You can choose investments that require money. Classic choice = mutual funds.

Maybe you don't have money, but you have time to spare and work on a side project. Sweet! Pick an investment that doesn't require much, if any, money. Instead trade your time. Classic choice = a job.

This is the degree to which you can use other people's time and/or money. The more you can leverage those, the more powerful your investment will be.

This is the risk side of the equation. Part of your investment's success is determined by the market in which your investment is in. Some markets are growing, some are shrinking, some have too many competitors, some are brand new. By doing your research, you can reduce much of this risk.

This is why starting a business can be so powerful. If you identify a need within a market and create something to fill that need, you can get a business loan from a bank and then with that money you can hire others to help you. That's doubly powerful! Of course, it requires a lot of your time and your money, so it isn't perfect either.

One of the reasons I decided to start up my shirt printing business was because I didn't have much money, but I had the time (sounds crazy for grad school... I know). Unfortunately, this business had zero leverage: it was only me and I used money I already had. When I started working full time, it didn't make sense to continue to invest in this business: I had less time and more money. So I changed my focus to investments that could leverage my money and my time. Now we own a duplex which is leveraging our money. We also have Univera which allows us to leverage our time as we build a team around us.

By the way, Jessi and I don't have any kids, and don't live near our family. So these investments make sense for us because we have a lot of time. Perhaps you work full-time and want to spend time with your kids. Investing in your company's 401K might be perfect for you. Later down the line, we'll probably change our focus as our situation changes (but that's not any time soon... for family who's reading).

Speaking of investing in your 401K, I can't talk about investing without bring up the power of compound interest. Compound interest is when you gain interest off of your interest - another example of leverage. Here's a table from The Automatic Millionaire which shows how profoundly different investments can be when you combine compound interest with time:

I realize that a huge drop in the stock market can negate most of these gains (that's part of the risk of that market), but assuming everything is the same, you're much better off investing a little bit up front instead of trying to play catch-up later in life. Much like giving, you should start investing now, even if it's only a very small amount.

There's so much to talk about when it comes to investing, and a simple blog post is just the tip of the ice burg. Hopefully, you've been intrigued enough to do your own research on saving and investing.

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