A Million Dollars Richer – For Almost Nothing Except Coffee

Editor’s Note: A version of this post appeared in the San Antonio Express News

coffee_money
There’s my million dollars

I’d like to be a million dollars richer.

And I don’t particularly want to work for it.

I feel the way native San Antonian, former San Antonio Express-News writer and Saturday Night Live faux-philosopher Jack Handey did when he wrote:

“It’s easy to sit there and say you’d like to have more money. And I guess that’s what I like about it. It’s easy. Just sitting there, rocking back and forth, wanting that money.”

In the spirit of Jack Handey and his idle wish, I recently downloaded a budgeting app called Zeny.

Then, for one week only, I recorded my daily “indefensibles.”

Indefensibles, since you asked, are my own term for small consumption purchases that I did not have to make.

I don’t mean my kids’ after-school care, or the mortgage, or gas for the car. I don’t mean eating out with the family once in a while. I really mean things that are financially indefensible.

samuel_jackson_motherfucker
Yes, my barista actually made this Samuel Jackson latte and gave it to me. That’s how good a coffee customer I am. Which is scary.

Take my expensive coffee habit, for example. Because in my life, indefensibles come mostly in the form of caffeinated beverages.

I figure the cost of a cup of coffee, ground and brewed at home, averages about 15 cents.

Instead of grinding and brewing at home, however, I choose, day after day, to buy expensive coffee at more than ten times that price per cup. Well, actually, multiple cups. Plus, of course, a snack once in a while to accompany my fancy coffee.

And yes, since you asked, my “indefensibles“ concept is inspired by Warren Buffett’s pet name for his corporate jet. When you have Buffett money, a corporate jet qualifies as an indefensible, rather than the morning latte. Which is just one of the small ways my life’s financial path has diverged from Buffett’s.

Anyway, I downloaded the Zeny app on my phone to track my indefensibles for a week after reading the personal finance classic “The Automatic Millionaire” by David Bach. He famously coined the term “Latte Effect” to remind us that purchasing small daily items — a morning latte, for example — had massive implications for personal wealth creation (and destruction!) over the long run.

After reading his book, I became curious. How big is my Latte Effect?

Here’s my data from Zeny:

Day 1: $11.80

Day 2: $6.45

Day 3: $2.27

Day 4: $0

Day 5: $8.58

Day 6: $11.04

Day 7: $0.

All of these expenses I annotated in the app as either coffee or coffee-and-snack related.

My total indefensibles cost for the seven days: $40.14.

Does that seem like a lot of money? Check your own indefensibles against mine for a week. Gum and Tic-Tacs at the register. iPhone downloads. Hulu membership. That third beer for $3.50 at the bar. Whatever it is.

Over the course of a year, my $40.14 per week of indefensibles adds up to $2,087.28 (calculated as $40.14 multiplied by 52 weeks in the year).

What if I invested $2,087.28 every year for the next 40 years in the S&P 500, until age 82 — at which point it will be 2054 and I will be living on my hovercraft, being served hand and foot by my ageless Rihanna-bot?

rihanna_robot
This is what comes up when you Google ‘Rihanna Robot.’ Also, this is what 2054 will look like.

And what if that investment compounded at 10 percent per year? Then I’d have an investment pool worth $1,016,196.

What a coincidence! Because as I said in the beginning, I actually want to be a million dollars richer.

What? You don’t think 10 percent is a reasonable return assumption? Maybe not. Reasonable people can disagree.

But just so you know, the compound annual return from the S&P 500, assuming reinvestment of dividends, over the last 40 years was actually higher than 10 percent. Including the oil embargo years and stagflation of the late 1970s, the tech bubble bursting in 2000 and the Great Recession of 2008, the compound annual return including dividends from the S&P 500 was 11.7 percent.

If I achieved 11.7 percent compound annual return on investment over the next 40 years, my little pool of weekly indefensibles would grow to over $1.6 million.

Maybe you prefer I assume a more modest 6 percent future compound return? Fine, my indefensibles would only grow to $342,413.45.  Which, while not the same as a million dollars, isn’t nothing, either. $342K would place me squarely above the average American adult’s net worth.

From skipping premium coffee!

Let’s look at the calculation another way, however. What if I hadn’t ever gotten addicted to premium coffee outside the home in the first place? What if, instead, I had begun saving myself from indefensibles at age 22?

Even with a modest 6 percent compound annual return from the market, my indefensibles’ savings would grow to $1.1 million between age 22 and 82.

Deep_Thought_On_Money
A Deep Thought, by Jack Handey

So, I’m just curious — is there anyone else graduating from college this year who would like a million dollars without trying?

Look, every single person outside of the top 0.1 percent of wealth in this country struggles with one of two financial goals. Either you are:

1. Trying to reduce your personal debts, or you are

2. Trying to build up investments.

The same Latte Effect applies powerfully to both situations. Whichever goal you seek, you can decide to be a million dollars richer at the end of your life.

It’s easy. And that’s what I like about it. Just sitting there, rocking back and forth, not buying that latte.

 

Please see related posts:

Book Review of The Automatic Millionaire by David Bach

Wealth And The Power Of Compound Interest

Become a Money-Saving Jedi

 

 

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529 Accounts v. Retirement Accounts

future investingA version of this post appeared today in the San Antonio Express News.

People who give financial advice – like me – can be so annoyingly contradictory sometimes.
Some friends of mine with young kids – like me – asked me recently to look over their investment plans, and to give them my opinion on what they were already doing, as well as what they should do next.

They had already embarked on an automatic-deduction investment plan with their financial planner, and they also had an available $5,000, and they wanted to know where to invest it next.
They were doing something I had been urging my fellow parents to do – funding 529 educational savings accounts for their two girls – so, naturally, I told them it was all wrong.

Let me back up and explain.

I already wrote about the panic attack I experienced when I visited a useful College Board website to calculate the future cost of college. At the present rate of tuition increases, in ten years from now college tuition will cost the equivalent of checking your little darlings into a 5-Star Hotel in the fanciest building in Dubai.

Seven_Star_Hotel_College
Here’s the 7-Star hotel you will send your child to

For. Four. Years.

(*All prices here are my best estimates, using round numbers. Actual results may vary. Always read less than six financial columns in any 24-hour period. If headaches persist, please call your doctor.)
The only way to deal with that impending college tuition catastrophe, of course, is to start eating rice and beans today and send your surplus savings into a college savings account like a State-sponsored 529 Account. 529 Accounts, as you probably already know, typically offer tax-advantages for education savings and investments.

My rice-and-beans-and-529-account advice still holds if you can do it, provided one other condition is already met, which I’ll tell you about in a moment.

So like I said, my friends had set up their 529 account contributions in the name of their 9- and 11-year old girls, complete with automatic deductions.

The problem, however, is that they planned to contribute to these 529 accounts before they maxed out their IRA contributions and 401K contributions.
You see, there’s a clear “order of operations” when it comes to tax-advantaged investment accounts, and it goes like this:

1. Personal IRA – up to $5,500 this year (And more if you’re older than 50)
2. Employee 401K – up to $17,500 this year (and more if your employer matches)
3. 529 Education accounts, or other savings accounts for health or medical expenses

So, I told my friends they have to first contribute $5,500 each to an IRA this year, then make sure they have filled up their 401K bucket to the max. Then – and only then – should they direct any surplus to their girls’ 529 account. Their existing financial advisor had not made this order of operations clear.

Dubai_hotel
If they don’t get into the Seven Star hotel, Try the Six Star hotel in Dubai

Why do I insist they fund IRAs and 401Ks before funding a 529 account?
At least four factors make IRAs and 401Ks a better target for initial investment than 529 accounts.

First, both IRAs and 401Ks offer federal income tax savings on contributions, whereas 529 accounts do not. State-by-state legislation created 529 accounts, and in some states a 529 account offers state income tax relief. Since we all live in Texas, which has no state income tax, their Texas-based 529 account has no income tax advantage. So right off the bat, IRAs and 401Ks beat 529s by somewhere between 20% and 39.5%, depending on your marginal income tax bracket. But even outside of Texas, state income tax relief from 529s pales in comparison to the federal income tax relief of IRAs and 401Ks.

Second, while both a comfortable retirement and a four years college require big chunks of cash, as parents we get the opportunity (misfortune? punishment?) to borrow money for college, but not for retirement.

The student loan industry – all $1 trillion of debt and counting! – stands ready and willing to lend your little darlings what they need to check into Hotel Dubai University (Fight Fiercely Sand Dunes!) at pretty low interest rates too. I know of no similar program to lend to retirees, except halfway-predatory programs like reverse mortgages.

Next, 401K plans often come with an employer match, one of the few real-life examples of free money here on planet Earth.

Finally, compound interest – the secret sauce to the long-term growth of money – works best over the longest time periods. For my friends, they can watch their investments compound for 30 to 40 more years in their retirement accounts, versus merely 10 to 15 years in the 529 accounts for their girls. Always choose the longer time horizon when it comes to investing.

Of course, we know the best option is to fund them all and not have to pick and choose. For my friends, and for most of us, however, we need to choose, and that means picking our investment vehicles in the right order.

In sum: first retirement accounts, then college accounts. Ok? Ok.

By the way, some clever readers will urge maxing-out the 401K first, before the IRA, to take advantage of any employer match. That’s good advice, it just so happens that my friends don’t have 401Ks at their jobs now, so I told them to max out the IRAs first, then pressure the boss to start a 401K plan second, and then fund their 529 accounts third.

Here’s the TL:DR – Place the mask over your own face first, before placing it over your child. Now, just, apply that to investments.

Max out retirement account contributions first, then place the mask over your child
Max out retirement account contributions first, then place the mask over your child

 

Please see related posts:

 

College Savings vs Retirement Savings

College Savings and Compound Interest

Interview with College Advisor Part I – The Rising Cost of College

Interview with College Advisor Part II – Is The College Model Broken?

 

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Book Review: All The Math You Need To Get Rich

I learned from my wife the concept of the “feedback sandwich,” by which she means if you want to give someone an important piece of critical advice, it’s often most strategic to cushion the blow with a compliment to start, and a compliment to finish, with the criticism nestled in between.

Michael Scott in Scranton, PA might have given feedback this way.

“Hey, I love your ability to file those papers alphabetically!”

“Everyone here in the office has just one word for you: halitosis.”

“Also, cool green shirt you have on today!”

In reviewing Robert L. Hershey’s All The Math You Need To Get Rich I have had recourse to the feedback sandwich. First, I will list some examples from the book that I quite liked. In the middle, a couple of important concerns. Finally, some kind words about how I would use this book if I taught math to high school kids

What works

Hershey presents basic, essential, practical, financial math and then follows it up with numerous word problems at the end of each chapter to help lock in the knowledge.

Two examples in particular stood out as excellent, and paraphrasing them from Hershey’s book illustrates the importance of Hershey’s project.

Example 1

Two twin brothers, each of whom wants to get rich in 45 years, pursues two different paths toward their goal.

The first brother (aptly named Lucky), in a hurry for wealth, decides to buy lottery tickets. He makes a plan to buy $10 of lottery tickets every day, six days a week, for the next 45 years.

The second brother (named Tim) decides to invest exactly half of the amount spent by brother Lucky in a balanced portfolio of market securities, such as stocks and mutual funds.

How much does Lucky bet and spend over course of 45 years, and what is the probable outcome? How much does Tim invest over the course of 45 years, and what is the probable outcome?

While results may vary, we can calculate the expected value of each of these brothers’ behaviors.

To calculate Lucky’s results, we need to know that lotteries return an expected value of $-0.50 per $1 bet. The point of a lottery, after all, is to raise money for the lottery organizer, and to return about half the money over time to the players.

Lucky bets $3,120 per year ($10 x 6 x 52)

And a total of $140,400 over the 45 years ($3,120 x 45)

Since he loses an expected amount of $0.50 per $1 bet, we can quickly see that Lucky loses $70,200 over the course of his 45 years of lottery playing. Lucky might win $10 here, $100 there, and occasionally $1,000, but the odds in the long run mean he’ll burn up an estimated $70,200 over the years, nearly guaranteed.

What about Tim’s results?

Tim invests $5/day, 6 days a week, 52 weeks per year. His annual investment is $1,560 ($5 x 6 x 52).

Hershey (the book’s author) assumes a 10% gain on investments[1] to calculate Tim’s results after 45 years. Aggregating the compounded returns of annual $1,560 investments at 10%, we can see Tim’s net worth climbs to $1,121,492 after 45 years.

Tim’s a millionaire using just half of the money Lucky ‘invested’ in lottery tickets, while Lucky has a zero net worth.

Now, that’s what I call a useful mathematical comparison.

all the math you need book

Example number two that I loved from the book

A recent college graduate named Patience is thinking of taking a trip to Europe, which will require her to max out her $5,000 credit card and pay the 18% annual interest charges on the card. Realistically she knows she will stay maxed out for 10 years, so she will have to pay that 18% interest all the while for the next ten years. How much is that?

Alternatively, Patience considers not making the trip to Europe, and instead may invest the amount of the unspent interest in an S&P500 index fund. Hershey assumes a 15% annual return[2] on that investment. How much money would she have then at the end of 10 years?

The annual finance charge, following the trip to Europe, would be $900 ($5,000 x 18%). Over ten years Patience would end up paying $9,000 in interest charges, and still owe $5,000 at the end of ten years.

If, instead, she invested $900 per year in the mutual fund that earns 15% per year, we can calculate – using the magic of compound interest – that she would have $18,274 in her fund.[3] Her positive net worth from investing beats the $5,000 deficit by a long shot. And just as importantly, the interest charge on the credit card ends up costing more than the original trip itself.

My critical thoughts – the bologna in the feedback sandwich

First concern – Who reads this?

One concern I maintain with a book like this – which I fretted about earlier in a review of another math-book-for-non-math-types Innumeracy – is who, honestly, will ever pick up this book? Will people who already feel uncertain about their math skills, however theoretically eager to learn the mysteries of numbers or tempted by the chance to “Get Rich,” actually dig past the first few paragraphs to learn what they do not know?

I don’t know. I doubt it. Math-oriented people enjoy confirming their own math aptitude with a book like this, and they may be able to expand their skills into useful finance applications with this book. I have a harder time picturing non-math folks picking up and actually working their way through the instructions and sample problems, however accessible this book may be. I think Hershey has made this as approachable as possible, but I still question the draw of those who are the intended audience.

Second concern – No way to teach compound interest (my pet peeve)

Every finance-math for non-experts book that I’ve ever read relies on a terrible crutch when it comes to teaching compound interest: The table in the Appendix with compound interest multiplication “factors.” I hate this.

What a proper book on compound interest should teach is the formula FV = PV * (1+Y/p)^N, with definitions of each variable and multiple examples to shows its application. That formula, once understand, can solve any compound interest problem flexibly, and precisely.

This book’s appendix features a y-axis listing the number of compounding terms from 1 to 100, for example (the N in the formula), while the x-axis shows ascending percentages of yield (the Y in the formula). At the end of every example in the book that references these tables, Hershey is forced to say: “That’s not exactly the answer, but it’s close enough.”

I can’t endorse this. I refuse.

All The Math You Need to Get Rich was first published in 1982, the same year in which my fifth grade teacher introduced us to the Timex Sinclair 2000.

[10: Print “Mike” ; 20: Goto 10 ; Run]

At that point in 1982, text appendices of compound interest tables made perfect sense.

Not in 2014, though.

Any reader of a book in 2014 also has use of an Excel spreadsheet program that sits on their desktop or laptop, and can be used to good effect with the formula above.

The text-based, imprecise, crutch of an Appendix table, which no person will carry with them, ever, gets in the way of anyone who ever wanted to actually learn how the compound interest formula really works, in real life.

Phew, got that off my chest.

Back to the complimentary thoughts

If I was assigned a high school math class as a substitute teacher and given 1 month to teach the kids something useful, I would pick a book like All The Math You Need To Get Rich as a textbook. Here are real-life skills for understanding interest rates, percentages, probabilities, and dealing with orders of magnitude – in short most of the things households, investors and citizens need to use on a daily basis to get by. Certainly these help most of us think much more, and much more often, about useful math applications, than the traditional courses – Geometry, Trigonometry, quadratic equations, and Calculus – that make up the majority of traditional high school math curricula.

Not only do these relatively accessible concepts come in handy more often, I would hope – as their substitute teacher – that I could impress upon the unruly high schoolers their own self-interest.

“Learn this about probabilities” I would exhort, “and save yourself thousands over your lifetime by not buying lottery tickets or gambling.”

“Deeply understand interest rates and percentages,” I would urge, “and use your powers for good (getting wealthy) instead of evil (making credit card companies richer).”

This is a fine book and I may use it for teaching my girls what they need to know in the future.


See related book reviews:

Innumeracy by John Allen Paulos

Master Math: Business and Personal Finance Math by Mary Hansen

 

 

 

[1] Astute readers will argue that 10% is too high an assumed return from a portfolio of stocks for 45 years, and I agree. Using a 6% return, Tim’s net worth at the end of 45 years climbs to $331,880. This doesn’t have quite the ring of ‘millionaire’ that the author Hershey probably wanted, but it still isn’t anything to sneeze at, for the cost of a daily Starbucks addiction.

[2] I know I know, too high, but still, work with me here a little bit.

[3] If we assume a more modest 6% return, she would have $11,863.

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Rapunzel and Compound Interest

Rapunzel
Trapped in the tower for the Summer, learning Compound Interest

“Daddy,” began the little princess plaintively, “I’m bored.” The poor thing is trapped in her tower for the Summer months. Wizarding school ended the first week of June, and will not start again until next Fall.

Also, it’s a Sunday and her 4-year old sister, the other little princess trapped in the tower, naps deeply on the couch.

“Oh is that so?” replied the wizard, looking up from his desktop computer, the glass desk table strewn with envelopes with coffee mug circles, and toast crumbs.

“Yeah, there’s nothing to do.”

“Huh. Sounds like we need to do some math magic. Would you like to do that?”

“Ok!” she brightens.

“Can I show you how to spin ordinary straw into gold, so you can be very rich 50 years from now?

“Daddy…” she gives the wizard her stop-pulling-my-leg look.

“What?” the wizard looks back innocently, eyebrows raised.

“Ok fine, show me.”

It turns out the sweet thing will do anything to escape the existential prison-tower called Summer. The wizard cackled silently to himself.

 

Calculating Annual Returns

“Let’s take this magical spell step by step. We have to build up the magic in small pieces to be able to do all of it.

Do you remember last Fall, when you invested $500 in shares of Kellogg?”

“Yes, you took all my savings and risked them in the market,” The princess looked up reprovingly.

“That’s right. Well, I’m sure that must have been magical money – received over eight years from Godparents, Santa Claus, and the Tooth Fairy – because look what’s happened to your $500.”

With that, the wizard took out his magical iPhone and pressed the ‘Stocks’ App, which showed a closing price of 68.91 for ticker symbol K.

“The stock is up 11% since September last year,” pointed out the wizard. And since it’s been less than one year, so far you’ve grown your money at an annual rate of 15%.”

“But that might not last, right? Because you said it could always go down?”

“That’s true. It still might, and it probably will go down at some point. But in the long run, it probably continues to go up. And since you don’t need the money for a long time, you can think about what’s going to happen in the long run.”

“Ok.”

 

Calculating one year’s annual growth

“The magic spell I want to show you – how to spin ordinary straw into pure gold – happens over a long time. In fifty years, when I’m over ninety, and a very old wrinkled wizard, you will be a very rich princess. But first, let’s talk about how to figure out the growth of your money in one year

Do you remember how we talked about percents?

To figure out how your money can grow over one year, you have to multiply your original amount by the percent growth, and then add it to the original amount.

So to do the first part of this spell, you need to calculate 15% of $500, and then add that to $500. Let’s see how much money you could have after one year.”

With that, the princess took her blue-ink wand in hand and scratched out the runes on a paper notepad. After a half-minute of spell-casting, she looked up.

“$75 more. So after one year I would have $575 if it grows by 15%.”

 

Calculating Compound Returns in multiple years

“Very well done. Now I’ve got two more intermediate steps that you will find too hard, but after you try it and can’t do it, I’ll help you through the magic.

Tell me how much you would have after 2 years and 3 years, if you start with $500, and achieve 15% growth each year, for 2 years, and then for 3 years.

The princess began to puzzle over this. Her magic didn’t seem to be working. She wrote some runes, and then some more runes, and then scratched them out. Some heavy sighing followed. She held her golden head in her left hand, while working magic with her right. Finally, with a little prompting, she came up with $150 in extra money, over two years.

“$650 after two years?” she looked up hopefully.

“Close, but not quite,” replied the wizard. “The difference is that when you compound growth at 15% for two years in a row, you have to start the second year’s growth from the previous year’s ending point. With this, the wizard quickly showed how the magic spell gets cast.

“One year’s growth gets you to $575, and then the second year’s growth will be 15% of the $575, or $86.25. When you add that to $575, you end up with $661.25.”

The princess looked up, a little unsure where this was going, or why the difference mattered much.

The wizard plowed ahead anyway.

“Can you show me how you’d get to the third year?” asked the wizard.

This time, the young princess had the right insight.

“Multiply the $661.25 times 15%, and then add that to $661.25?”

“Exactly!” The wizard pulled out his magical iPhone, pressed the calculator App, performing a mystical ritual involving intricate numerical symbols.

“Accio Numericus!” he exclaimed as he pressed the “=” on his calculator with a flourish.

“Daddy.” eye-rolled the princess. The wizard turned the magical iPhone face toward her so she could read it.

“760.44,” she read.

“That’s not the real trick though,” warned the wizard.

 

Do you want to see something really magical?

“Ok,” said the wizard conspiratorily, lowering his voice a little bit. “Do you want to see the whole magic spell? We had to learn the basic magic before you could handle this.”

“What if you could keep compounding your 15% return over the next 50 years? When I’m a wrinkled old wizard, that $500 of straw you invested could become gold. But how much gold? This magical spell tells you.”

Calculating long-term compound growth of an existing investment

The wizard added to the tension in the room by slowly checking over his right shoulder, then over his left. Seeing no prying eyes of elves, orcs, or bad wizards, he returned to the pad of paper in front of them.

There, he wrote a mysterious series of letters:

FV = PV * (1+Y)^N

The wizard looked up, wide-eyed, expectant.

Here, finally, some powerful magic to impart to the young magi princess.

The princess giggled.

The wizard frowned.

“That is totally confusing!” she exclaimed. “Why are there so many letters?”

“No, no, no, you can understand all of this math. Let me just tell you what everything means and you’ll see.

Writing “FV” on the pad, he said “FV just means “Future Value,” which is what our magic is going to calculate. That’s our magical answer – what we’re working towards, how much gold you’ll have in fifty years.”

And now writing “PV” on the paper, the wizard continued, “PV is just Present Value, which is the amount we started with. For you, that’s the $500 you invested in Kellogg.”

“The magic symbol ‘Y’ in this spell,” the wizard went on, is the annual return that we’re working with. Since we’re trying to figure out the answer to a problem with a 15% annual return, we can use 15% for Y in this formula. Since 15% can also be written as a decimal 0.15, we’ll end up turning (1+Y) in the formula into 1.15 for our magical calculation.

“But Daddy you’ve never told me anything about an N. N doesn’t make any sense to me.”

“N is just the number of years. And it has the little carot symbol to show that it means ‘raised to the power of,’ do you remember that?”

“I think so.”

“Right, so when we did 3 raised to the power of 2, we wrote it 3 times 3. And 5 raised to the power of 4 we wrote it 5 times 5 times 5 times 5. In this magical spell, we’re going to have 1.15 times 1.15 times 1.15, but multiplied by itself for a total of 50 times. Which we’re not going to do in our heads, but rather with the magical and mystical iPhone calculator App.”

“Ok,” came the princess’ reply, a little skeptically.

“Are you ready for the magic?” intoned the wizard, upping the drama once again. “First, I want you to guess how big your $500 straw can grow into spun gold in 50 years, when I’m an old wrinkled wizard.”

“I don’t know.”

“Just guess. Something big.”

“I don’t know, maybe $2,700.”

“No, bigger. I said you’d be rich.”

“Ok. How about $9,000.”

“Let’s see what the magical iPhone calculator app tells us. First, we turn it horizontally to be able to see additional calculator functions, in particular the ‘X raised to the power of Y’ button. Now, remember to always say ‘Accio Powerzoom Numericus’ when you input numbers like this.”

Sigh from the Princess. Half an eye-roll.

“No, you have to say it. Say it with me.”

“Accio Powerzoom Numericus!”

The wizard theatrically pressed buttons while describing his process.

“First, enter 1.15, then the ‘X^Y ’ button, and then 50, for the number of years, and then hit the “=” sign.

Now multiply that result by our original PV of $500.

There’s your answer: $541,828.72”

“That’s a lot of money, Daddy.”

“Yes, and do you know what you have to do to make that gold come to you?”

“What?”

“Nothing. Absolutely nothing. Just never sell. The people who work for Kellogg do all the hard work. They sell cereal and whatever else and keep growing their business. You do no more work than you ever did to put that $500 into that stock.”

“Whoa. That’s cool. But what if it only goes up by 10%?”

“It might. So we can use the same magic formula to see what happens then. We can make Y just 10%, so then our “(1+Y)” is 1.1 instead. We raise that to the power of the same N, 50. Then we multiply it by our original present value amount of $500.

And don’t forget:

“Accio Powerzoom Numericus!”

“Boom! At 10% annual return you’d only have $58,695.43.

Which, for not doing any work for the next 50 years, would also be a lot. Most people I know would like to have an extra $58 thousand dollars right now.”

“Yeah, that’s still a lot. Daddy, can my sister and I go outside to play on the porch now?”

“Sure kiddo. Great work there.”

Boom! Mischief managed.

mischief_managed
Mischief Managed!

The front door banged closed, and the wizard cackled quietly to himself.

Once she was out of earshot he rehearsed the following under his breath:

“I don’t mind if you go out to the porch this time, but just promise me one thing, my sweet girl?” in his gentlest wizard tone.

“Sure, anything, what do you need, Daddy?” he answered quietly to himself, in a little princess falsetto.

“NEVER ASK. TO LEAVE THIS TOWER. AGAIN.”

 

Please also see related posts:

Compound Interest and Wealth

Book Review: Make Your Kid a Millionaire

Daddy I need an Allowance – Teaching Compound Interest

The Allowance Experiment gets even better

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College Savings v. Retirement Savings

college_fundAn astute reader pointed out some qualifications to my Friday post on 529 college savings accounts – specifically, reasons not to fund them.  The most compelling reason, coincidentally covered in the next day’s New York Times, is that funding your 529 accounts is not as important as funding your 401K retirement account.

The New York Times article, which is worth reading in full, makes the following correct argument: If you have to choose between fully funding your 401K vs. funding your child’s 529 education account, fund the 401K account first.

The first reason for this is that many people can borrow money to fund a college education, but we will have a harder time borrowing to fund our retirement.  Another reason is that the income tax advantages available by funding a 401K – available to everyone subject to federal income taxes – are far greater than the potential state income tax advantages of a 529 account.  In addition, 529 account generally do not trigger employer matches the way many 401K plans can.

In sum, all my big tough talk about funding one’s 529 account only applies after you’ve fully maximized your 401K plan contributions.

 

 

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College Savings and Compound Interest

My littlest one turned four years-old last weekend1, and my eight year-old is taking a Texas-Public-Schools-3rd-Grade-State-Mandated-High-Stakes-Standardized-Test this week2, so you can probably guess what’s on this ex-banker’s mind:

That’s right! Good guessing!3

Time is quickly running out for me to save money for their college tuition.4

The only thing scarier than those scary scary clown head trash cans at my littlest daughter’s birthday party5 is the prospect of saving enough money for her college tuition.clown trash can

For my eight year-old, I’ve got just 10 years to go before C-Day, so I thought I’d share my current ex-banker thoughts with others, in the hopes that we can experience this horrific fear together.

Also, “saving for college” allows me to discuss my favorite topic (compound interest!) so that’s always a good enough reason by itself for a Bankers Anonymous post.

I see three big questions about college savings, with the most interesting one being #2.

Question #1: What college savings account or investment vehicle, if any, should I use?

  • Question #2: How much do I need to save, per month, to be totally set for college tuition payments when they arrive?  (Compound interest calculations coming up!  Yay!)
  • Question #3: What kind of investments do I need in my college savings account?

I’ll take these in order.

Question #1: What savings account or investment vehicle, if any should I use?

Open up a 529 College Savings account.

Ok, that was easy.

But, why a 529? Also, which one?

The first “why” is because you may get an income tax advantage when you make a 529 account contribution, depending on the state you live in.  When I lived in New York and paid New York state income tax, I enjoyed an income tax break on my contributions.  Now that I live in Texas, I get no state income tax advantage from 529 account contributions.6  So that may, or may not, apply to you.

The second ‘why’ is that any capital gains or investment income – which might be triggered when I sold stocks or earned interest on my investments – remain protected from taxation in that year, assuming I do not make withdrawals from my 529 account.  If I just held my college savings in a regular, taxable, brokerage account, I’d be required to pay taxes on capital gains or other income from my investments.  The result of this 529 account tax protection is that I can grow my money much faster than in a regular, taxable, brokerage account.

Ok, so that sounds good, but which 529 account should you open?  Probably you should start by investigating your own state’s offering7, precisely for that potential income tax break.  But if you live, as I do, in a state without an income tax, then you can consider other advantages, having to do with

a) Contribution limits – Some states allow higher contributions than others

b) Flexibility of investment choices – some states offer restricted types of investments

c) Cost of available investment choices – some states offer higher-cost plans than others

d) Convenience

I opened a New York state account for my oldest daughter because we lived there, then.  My youngest was born in Texas, but I opened a New York state account for her as well, purely for convenience sake. I prefer tracking both girls’ college savings information on a single website.

Question #2 – How much do I need to save, monthly, to have everything covered?

The College Board (The fun group that brought you the SAT, the PSAT the AP tests, and more!) has a couple of incredibly useful online calculators.

First, they can help you figure out how much of college’s cost you, as a parent, will likely have pay.   To try the calculator, go here.

This calculator asks some specific questions about your family situation, plus your income and savings, and then tells you how much the financial aid department of a college will likely expect you to contribute for your child’s annual college expense.

Beware, because [**Spoiler Alert**]

This number will be much higher than you want it to be.

I don’t think of myself as wealthy, and generally we don’t have much left over at the end of the month.  Which is why the expected contribution number from a typical financial aid department left my face feeling a bit tingly.

Is it getting warm in here, or is that just me?8 thinks I’m either suffering from menopause or anaphylaxis based on these symptoms.  We’ll just have to wait and see.]

Next, the College Board has a great college savings calculator to tell you how far your current plan will go toward paying for college.  Before you go there, I’d like to warn you – the result is scarier than scary, scary, clowns.

First, you input the current cost of college, an assumed rate of tuition inflation, how many years your child will attend, and how much you will likely have to pay, which you may have some idea about based on the first online College Board calculator above.  Next, you input how much you’ve already saved, what you expect your annual investment returns will be, how many more years you have before your child goes to college, and how much you plan to contribute monthly, between now and then.

You input all of that, and then you have a heart attack immediately and die, because there’s Just. No. Way.

I personally can’t feel the whole left side of my face right now.

For example, let’s say I’ve managed to put aside $19,000 for my 4 year-old up until now.

Looking good, Billy Ray.

And let’s say I plan to invest $200 per month until she turns 18, and I can earn a 7% return on my investments, via my 529 account.

Feeling good, Lewis.

Looking_good_billy_ray

Also, assume a private 4 year college costs $50,000 per year today, the college cost inflation rate is 5%, and I plan to pay 90% of that from savings.

I have an estimated shortfall of $276,399.

Randolph, this isn’t Monopoly money we’re playing with.

 

Some of you clever readers may just be smirking because your little darling will likely either get a ton of scholarships or else attend a state college, no?

Well, the bad reality is that state college isn’t that affordable these days either.

The average 4-year in-state tuition cost, according to the College Board, will set you back $21,477 this year.

If I have zero savings for my 4 year old, but I manage to invest $200 per month, starting now, and she attends an average cost in-state college, I’m still $107,582 short, 14 years from now.

The answer to the question “how much should I be saving per month to be totally set for tuition” is provided by the College Board calculator, just under the shortfall number.

I’m sorry about this, but as you know: Compound interest is powerful.

After you recover from this shock, you’re ready to move on to question #3.

Question #3 – How should you invest your child’s 529 Account?

This one’s easy, and frequent Bankers Anonymous readers will not learn a single, damned, new thing from me here, because the answer is unchanged from previous, similar questions about how to invest for the long run.

Hopefully you noticed, from playing around with the college board’s calculator, that you need a fairly high rate of return on your investments from now until college to even have a chance of closing the gap between your current savings and how much you’ll owe for your child’s college, every year, for four years.

Now, since returns have to be high, you have precisely one choice for how to invest: 100% equities.

Let me further clarify, in a way that will again make me sound like a broken record for careful readers: You need to invest your long-term savings for college in a highly diversified low-cost (probably indexed) mutual fund, invested in stocks only.

Why 100% equities?

Why not bonds or other safe investments?  Two reasons.

The first reason is low returns.  For the vast majority of us, we can’t afford to invest in bonds over the medium to long run.  An intermediate-term bond fund will return somewhere between 0.5% and 2.5% right now, and that’s just not going to cut it.

The second reason is that – on a probability-adjusted basis – you will get more from investing in equities.

Here are the relevant facts to back up my assertion, as well as a cool graphic of these statements[9 Courtesy of David Hultstrom at Financial Architects LLC.]

probability_stocks_vs_bonds
Stocks vs. Bonds given a time horizon

If you have a 5-year investment horizon, you will be better off entirely in stocks, rather than bonds, 70% of the time.

If you have a 10-year horizon – as I do – you will be better off entirely in stocks rather than bonds, 80% of the time.

If you have a 15-year horizon – as I do with my youngest daughter – a 100% stocks portfolio9 outperforms a 100% bonds portfolio 90+% percent of the time.

Is that guaranteed?  Of course not

Probabilities are not the same as guarantees,10 so of course the bet you make on investing in 100% equities in your child’s 529 account could go wrong.  But making the other choice – including bonds in your portfolio – is a low probability bet.  By investing in bonds you are implicitly saying “Probabilities be damned! I don’t care about history! This time is different!”11

Look, I play poker with the neighborhood dads, so I know that low-probability bets sometimes work out.  But I also know it’s kind of stupid to make low-probability bets.  Trust me, because I’ve been losing $20 a week on a regular basis to these guys, testing this hypothesis, since I’m not a strong poker player.

You can decide to weigh down your kid’s college savings account with bonds, and you may be under the illusion that this is ‘prudent’ because they’re bonds and “bonds = safe.”  But it’s not prudent, any more than it’s prudent to bet with jack seven off-suit.

Low probability bet
Low probability bet

Would I advocate investing in 100% equities if my kid is going to college next year?

Well, this gets trickier. Stocks still beat bonds in most years, so if you want to play the odds – and if you have some kind of cushion – you could reasonably keep the account in stocks. Most of the time – on a probabilistic basis – this would be a winning choice.

But I realize this seems a bit extreme, so with one year to go I’d probably take next years’ tuition (potentially only 1/4th of your position) and plunk it into a risk-free investment, like a money market fund12, and leave the rest exposed to stocks. Remember, 3/4ths of your account has more than one year to remain invested.  Each additional year invested increases the probability that stocks beat bonds.13

Tick Tock Tick Tock

For my wife and me, that loud ticking we hear is not the biological clock anymore, but rather the college financial clock.

For anyone in our demographic14 who checked the College Board calculator,15 I’ll now sum up the only other good pieces of advice I can think of related to saving for college.

  1. Open up a 529 Account for each kid. Like, right now.  Stop reading blogs and do this immediately. Really. Did you do it yet? How about now?
  2. Set up an automatic withdrawal from your bank account, so you don’t have to make a choice about contributing every month.  Because if you have to make the choice every month, the money might not be there.  Even $25 per month in automatic withdrawals is better than nothing.  Increasing that $25 monthly contribution over time, once the account is open, will be much easier than you think.

Best of luck!

Please see related posts on:

Interview with College Advisor Part I – The insanely rising cost of college

Interview with College Advisor Part II – is the 4-year college financial model broken?

New York Times on funding your 401K Account vs. 529 Account

And related post: Stocks over Bonds – The Probabilistic View

And related post: Ask an Ex-Banker: Should I open an IRA?

clown_under_the_bed
You want to see something really scary? Check the College Board Calculators

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  1. Kiddie Park, established in 1925! A Merry-Go-Round from 1925! Scary, scary, clowns!  Oh my!
  2. First, take the Pre-Test! Then the Practice Test! Then the Real Test! Oh my!
  3. As Dora the Explorer would say.
  4. My wife and I like to jokingly append “–should they choose that path,” whenever we discuss our daughters going off to college, but the fact is that’s our chosen path for them and they can deviate from it at their peril. I’d like to see you just try it, kiddo.
  5. Everything you need to know about my view on little kid birthday parties was captured recently by Drew Magary at Deadspin.com.  We have got to do something about the Big Birthday Industrial Complex.
  6. In a news item that may or may not be directly related to this fact, my local urban school district boasts 7% college readiness among its graduates.  I will now light myself on fire.
  7. Here’s a nice website for getting starting comparison shopping for 529 accounts.
  8. My editor-in-chief [aka wife.  Also, she’s an MD
  9. Hopefully the following is obvious, but just in case it’s not: When I say 100% stocks I mean a highly diversified mutual fund, not an individual stock or even a small group of stocks, or a single stock sector.  When I say bonds I really mean a AAA-rated bond fund of, say, intermediate duration.  Not junk bonds or emerging markets or anything else interesting and high-yielding.
  10. As my close, personal friend, Nate Silver would say.  (I wish.)
  11. “This time is different” is one of those investing No-Nos as a justification for making an investment decision. “This time is different” is a fine gambling notion (for investing in individual tech stocks, for example, or buying into a venture capital fund) but is not a fine investing notion.
  12. Why a money market fund and not a bond fund?  Because a bond fund, with only one year to go, could actually lose money as well – in a rising interest rate environment – so only a money market fund guarantees you zero volatility of results.
  13. Incidentally, investing today for your kids’ college next year is NOT the way to do this. Sorry if you are reading this with a 17 year-old breathing down your neck. 529 accounts have little to offer in this case, and compound interest can’t help you much either.
  14. Meaning, you’re going to pay for some kid’s college some day.
  15. And if you haven’t yet used the calculators, have a swig of whisky and then seriously you should go check them, it’s the right thing to do.