## Learn To Be A Discounting Cashflow Wizard Part 3 – With Book Excerpt

Editor’s Note: This post first appeared in Make Change magazine, an online personal finance site with a social conscience.

I don’t believe it’s an actual conspiracy of silence to keep us in the dark about our finances, but sometimes it feels that way to me. That’s partly why I wrote The Financial Rules For New College Graduates, because I’m convinced that learning how to do some not-too-sophisticated math in a spreadsheet could go a long way toward demystifying finance for the non-finance professional.

The skill of discounting cashflows is the fundamental tool of all investing. It answers important questions like:

You may not want to always do the math on these questions, but if you learn how it works you have a much better shot at pulling back the curtain on supposedly complex financial mysteries.

Watch this first video, for example, to see how we would build a discounting cashflow calculator in a spreadsheet.

Learning the math

It’s not hard, and if you’ve learned compound interest, then it’s kind of a snap. See for example earlier posts on Be a Compound Interest Wizard Part I, and Be a Compound Interest Wizard Part 2.

But it does involve math and poking around with a spreadsheet.

[Begin Book Excerpt]

So what is it?

Discounting cash flows – in the simplest mathematical sense – is just the opposite action to compound interest.

Specifically, the discounting cash flows formula tells us how a certain known amount of money in the future (FV) can be ‘discounted’ back to a certain known amount in the present (FV) through the intervention of an interest rate (Y) and multiple compounding periods (N).

Notice that we use the exact same variables in both formulas. Notice, also, that the only difference mathematically is that we’re solving for a different number.

The discounted cashflow formula simply reverses the algebra of the compound interest formula.

The discounted cashflow formula solves for Present Value, so that:

PV = FV / (1+Y)^N

So why do we care about discounting cashflow?

A simplified example should help to get us started.

A builder’s insurance company offers you a \$25,000 lump sum payment to compensate you for the pain and hardship of an injured pet hit by an errant beam that fell from his construction site.

Picture a big piece of wood, it hurt the dog’s paw, the dog will likely make a full recovery, but the developer/builder offered you this settlement to avoid a costly lawsuit with bad public-relations potential.

Importantly, however, the settlement will be paid out 10 years from now. Note, by the way, that this is common practice in injury-settlement cases. Lump sums get offered far into the future. This is partly because such agreements incentivize the victim/beneficiary to comply with the terms of the settlement for the longest period of time. But also importantly, as we will see, it’s much cheaper for the insurance company to make payments deep into the future.

Now, back to the math.

Let’s assume the insurance company is a very safe, stable, company, and we expect moderate inflation, so the proper Y, or discount rate for the next 10 years, is around 3%.

How much is that settlement worth to us today?

We set up our formula in a spreadsheet that the value today, or Present Value (PV) is equal to FV/ (1+Y)^N.

We know the future payout, FV, is \$25,000.

We know how many years we have to wait, so N is 10.

We’ve assumed a Y of 3%.

The present value will be equal to \$25,000/ (1+3%)^10.

This is easy-peasy math for your spreadsheet, which tells us the present value is \$18,602.

What does this mean in practice? We’re not going to ‘invest’ \$18,602 in this future \$25,000 insurance payout, but it can be very helpful for us to understand that the future \$25,000 payment really only costs the insurance company about 75% of what it first appears to cost

By the way, how did I come up with 3%?

Frankly and honestly, I made up the 3% for the example.

I don’t just say ‘I made it up’ to be flippant. I mean to emphasize that ‘I made it up’ because ‘making up’ Y, or the proper yield or discount rate (remember, those mean the same thing!) is a key to effectively using the discounted cash flows formula.

In fact, any time you discount cash flows, you have to “make up,” or assume, a certain Y or discount rate, and the Y assumption you use is as much art as science.

Is that 3% Y I assumed “correct?”

I don’t know, but it’s reasonable, and that’s usually the most we can say about any assumed Y. How do we come up with a reasonable Y number?

Y as an interest rate or discount rate (remember: same thing!) reflects a combination of

1. a) the market cost of money, which is often called an ‘interest rate,’
2. b) the expectation of inflation in the future, and
3. c) the risk of the payment actually being made in the future.

Only some of these things can be known at any time, so only some of our Y is scientifically knowable. The rest has to be assumed according to best estimates. That’s why we can reasonably say that sometimes this Y assumption is as much art as science.

[End book excerpt]

If you want to take it to the next level of how discounting cashflows is used in practice among investment professionals, you could set up your spreadsheet to discount a series of cashflows. Setting up formulas to discount a whole series of cashflows is how we build a model for valuing bonds, for example, or fundamental pricing of stocks.

This video explains the basics for setting up a series of discounting cashflows.

If you decide later become a complete discounting cashflows ninja, you’d then want to layer in one more additional level of complexity, by discounting cashflows that happen more than once a year. A simple video introducing how to deal with that is here:

The last thing I would say about this is that while you don’t have to learn this math in order to manage your money right, I think its useful to know what the Wizards of Wall Street are up to. If you understand their tools, you’re more likely to ask a financial guru a hard question, like:

“Um, why do charge so much, when this doesn’t seem that complex?”

1.  Important personal finance PSA: Never Play The Lottery!

## PODCAST “Charged Up” about The Financial Rules book

Editor’s note: This podcast recorded last month features an interview between “Charged Up” host Jenny Hoff and me, regarding my book The Financial Rules For New College Graduates: Invest Before Paying Off Debt And Other Tips Your Professors Didn’t Teach You.

You can listen to the audio post here:

You’ve graduated college and you’re ready to start your first job, but are your financial skills sharpened enough to make the right choices early on? Former Goldman Sachs trader1 and current university lecturer and columnist, Michael Taylor, takes you through the most important mathematical concepts you need to know to avoid massive debt and cash in on the amount of time you have to build millions in wealth for retirement.

Let’s get Charged Up! on learning the financial lessons you need to know!

Transcript:

Jenny Hoff:  Michael, thank you so much for joining me today.

Michael Taylor:  Thank you for inviting me. I’m excited.

Hoff:  So first tell us a little bit about your background and what motivated you to write this book.

Taylor:  Sure. Well, I start with my mission which is financial education – only a few people feel like they know enough. So that’s what I’m doing. The way I’m doing it is I have a weekly column, weekly finance column in two Texas papers, Houston Chronicle and San Antonio Express-News. I teach a course at Trinity University in San Antonio.

But how did I come by my mission and my expertise? I worked on Wall Street for six and half years for Goldman Sachs. I sold emerging market bonds and mortgage bonds, in that sense I like to say I sold the products that nearly blew up the world in 2008, but forgive me for that. I’m now doing penance. And then I ran a fund so I have sort of high finance experience and in a sense low finance experience.

And the mission is really from 2008 which was, “Wow, nobody seems to understand finance, not the political leaders, not the bankers, not the ordinary homeowners, and if nobody knows, we got a real problem.” So that’s what I’m working on trying to get the word out in many different formats.

This book is targeted toward 20-somethings, recent graduates who have a unique opportunity to sort of change their life with high leverage decisions that are going to be made in the first couple years after graduating from college.

Hoff:  Absolutely, and I really like in your book that you give mathematical concepts and you explain what those concepts are but you put the math in there as well, why is it important for somebody to understand the math and not just kind of the concept?

Taylor:  I am so glad you went straight to my pet peeve, which is I have been a reader of finance books for a long time in order to write my column and to teach. And what typically happens is the author of every other finance book that I’ve read has said, “Hey, reader. There’s some important reasons why when you compound grow your money over long periods of time, hopefully decades, amazing mathematical things happen.” And then what they do is they include a table that shows you how \$5,000 over 40 years running 6 percent earns X.

The problem with that is that the reader never gets the sense that there’s anything more than just magic happening. And my super fun pet peeve and the one thing I really wanted out of this book was to be the person who attempted to teach the math so that the smart college graduates can go, “Oh, you mean, wait, I could do this? This isn’t wizardry that my financial guru or my financial adviser or some person on TV is able to grow my money, it’s actually you start with certain basic here’s the amount, here’s how much it grows by, and here’s how much time passes, I can calculate it myself of absolutely how much it’s worth.”

So it’s sort of demystifying, it’s taking away the guru and having a person who can apply I would say junior high level math and go, “Oh, you mean my wealth creation over a decade was really an ordinary result of very ordinary things not wizardry, not guru talk, nothing mysterious. I can actually understand this myself.” There’s a lot that I think flows from that. You hopefully make different decisions. It also might occur to you like, “Hmm, if it’s not wizardry maybe I don’t need to pay as much to Wall Street in all its forms to do a magical mystical thing, maybe I could figure this out myself and pay the right amount.” You got to pay something, but the right amount, hopefully fractions of what people normally think, if you kind of go at it yourself. That would be one good reason to understand the math I’d say.

Hoff:  Yeah, because I think that’s a really good point, I think a lot of people hear of these great ideas, “OK, put your money in the stock market, put it in an index fund, leave it there for 30 years, it’s going to grow by 8 percent or so a year over the next 30 years.” And it’s a great idea, but most people don’t do it because it’s not empowering to them at all, right? It’s OK; that sounds like a good idea but if you don’t really understand it and you don’t feel like, “I could sit down and do these numbers and I made that number come across and now I want that number and I have ownership over it,” that is a much better chance you will actually follow that step because you will feel like, “I know what I’m doing.” I think most people feel scared of still to do it because it’s like, “OK, you told me I should do this, but I don’t really still know why I’m doing that.”

Taylor:  Absolutely. It’s very abstract to say, “Start with a thousand dollars, start with \$5,000 and amazing things are going to happen. Trust me. It has to happen over decades, so you’re not going to notice it for the first amount of time.” On the other hand if you were able to, and here’s the thing I keep saying in my book – open up a spreadsheet alongside this book and use this basically as a recipe for learning the math. And I think if you worked with a spreadsheet and learned the math you would go, “Oh, this is not that abstract, this is just a function of time and return and I can understand how it works.”

There are tools now that are able to do that. I’m a big fan of Acors, I don’t know if that’s something you’ve looked at in your life, but they do visualizations of start with a small amount, look at the extraordinary amount it becomes. And something about the visualization I think is very powerful, much more powerful than the abstraction of hand over your thousand dollars and I’ll weave this into gold over a long period of time through wizardry. But the best thing is to figure out that you can actually do the math through a spreadsheet and play with the numbers and go, “Oh, I get how this work. This is not an abstraction. This is something I could do.”

And I think as you were kind of implying it’s hard to just trust in the 30-year process. I guess one of the hard things about investing for the long run is we have monkey minds, which is we focus on the minute to minute and day to day fight or flight responses to financial market moves, and we have to train ourselves to go, “No, no, no, in a sense put on the blinders for 30 years.” So we need tools to do that. One of those I think is learning the math because it helps us do that.

Hoff:  Sure, absolutely and your first question that you post in the book is what’s stopping you from achieving wealth? What do you think is stopping most people from achieving wealth?

Taylor:  Well, I guess that first thing is that we are trained to think in hour to hour, day to day sorts of risks and rewards. And probably the best way to achieve wealth is to somehow train ourselves to think in terms of decades. I mean, there are a small fraction of people who get rich quickly, that’s usually not a sustainable process. Anybody who is getting rich quickly is usually doing a thing that wouldn’t work for the next 20 people who come along and do the same thing.

But getting rich slowly is essentially available to everybody who can generate a small surplus. But it’s a long, slow, decadelong process. So the first thing would be training ourselves away from the monkey mind and into a kind of a decade long thing. It’s super hard to do, it’s probably a lifetime of trying to do that. The next would be we generally don’t get good guidance from professors and parents. A few people, I don’t know, I’ll make up a number, 1 percent to 5 percent of people have parents who are sophisticated about this and they can absorb the lessons. But 95 percent of us don’t have that.

And then third, and this is chapter two of my book, I think as usual media plays a real problematic role. In today’s language I wouldn’t say it’s fake news, but I would say it’s distracting from what we should be doing, because most media is not in the business of calming us down and saying, “Hey, wait 30 years, it’s all going to work out.” Most media is actually in the business of emotions and eyeballs. And we know this but we live in it so it’s hard to separate ourselves from the emotional response to, “Hey, the stock just went up or the stock went down or interest rates are rising or we’re having a trade war with China.” There’s a lot of hourly, daily anxiousness creating things. So I actually hold financial media to blame for a lot of it.

Hoff:  It’s always their fault, huh?

Taylor:  Yeah, it’s all the media’s fault. No, I mean, we ultimately all have personal responsibilities.

Hoff:  No, but I know what you mean. It’s a lot of excitement and it’s not a lot of just be patient, this is the ups and downs. They’ve always happened, they’ve always happened and this will be your average return. Let’s talk about some of the mathematical concepts that you think are the most important for us to understand. You’ve got a bunch in your book, but you definitely talk about compound interest. Let’s start with that, why is compound interest important to understand?

Taylor:  Well, the first concept is really interest rates, and I find even my college students don’t really understand how how interest rates work. Do you multiply the annual percent thing times the amount of money you started with and after a year either you earn more money with your savings and investing, or you owe more money if you’re borrowing? And that interest rate is sort of the building block. But that’s not an obvious thing, and I think financial illiteracy around interest rates is the start. We have to overcome that.

But once you got that down then I think the world opens up and compound interest then becomes a way for people to practically understand how ordinary small amounts of money cannot through magic but just kind of the application of math grow to extraordinary levels. So, a friend of my mom’s is in her seventies sad she had \$250 and she bought a stock many years ago. If it grows for 40 years, which it did, over her lifetime, you now have something worth \$300,000.

And you go, “That’s impossible.” And then actually if you work backwards with the math you go, “No, she earned a little over 12 percent on those initial stock investments, about \$250, and now it’s worth \$300,000.” And it’s not magic; it’s just time and an application of a compound return.

You can sort of show that magic trick and you go, “OK, now but can you understand that magic trick?” And it’s really just math, so I think that’s very powerful to say, “You can start in early in your life, in your 20s or maybe your teens if you have a great newspaper delivery job.” But if you put that away and you most importantly probably never sell and you apply a high but realistic interest rate to that you’re going to end up with some extraordinary wealth later in life. Compound interest is the thing that explains the magic trick essentially, which I think is very powerful.

Hoff:  Yeah, absolutely. And talk a little bit more about interest rates, because I think we’re with CreditCards.com obviously that’s a huge topic when you deal with credit cards especially high reward credit cards usually come with high interest rates, what do most people really not understand? They might see a figure 16 percent, 20 percent, but not really think much about it. What do they need to understand really about those interest rates?

Taylor:  Oh, there’s so much. That’s such a good question. There’s an amazing example by this author, Andrew Tobias, and I don’t know if you ever spoke to him. But he’s got a way of demonstrating the difference between 10 percent interest and 20 percent interest, and he starts with a dollar and you sort of add each day 10 percent on the initial thing, and after a month you get to about \$29 worth with 10 percent interest. At 20 percent interest if you do that same thing it goes to about \$520.

Hoff:  Oh, wow.

Taylor:  Our normal way of applying math instincts would say, “Oh, the difference being 10 percent and 20 percent interest is not that big. It’s only double.” But the result is applying compounding over in the example that Tobias gives, it’s in my book also, and it’s just 30 days but we could extend the same example to say 30 years of compounding.

It’s not twice as much money that you owe if it’s 20 percent versus 10 percent, as we might sort of think. But it’s in fact usually 20 times, it’s not twice, it’s not two times, it’s 20 times or 30 times depending on what the interest rate difference is and how long you go. So it becomes again at the risk of referencing math pictures that people might be aversive to, it’s one of those lines sort of like when you track population growth or you track the spread of viruses, the line goes sort of gradually goes upward and then suddenly it’s shooting straight up in the air. The math term would be asymptotic. But it turns and it curves, and all of a sudden it goes bonkers, it sort of reaches a critical level where it sort of leaves the atmosphere. It’s a rocket analogy.

So when you’re paying 20 percent interest on your credit card there’s a difference between that and 10 percent. The compounding effects of paying that. So that’s the upsetting part, if you need to pay high interest debt. The more positive side is if you are able to earn 10 percent rather than 5 percent, the difference is not two times of the amount over a long period of time, that’s 20 times or 30 times the amount. But just that would be the optimistic side of it.

Hoff:  That’s why at very high levels of wealth when they’re investing you’ll choose between a firm that can deliver even a 0.1 percent increase over another firm you’ll probably go with them, because at very high levels of wealth that makes a huge difference.

Taylor:  Oh, yeah, the move from 4 percent to 5 percent, if you have a hundred million dollars there’s some very big compounding effects of that kind of thing. It’s definitely worth it. But at the ordinary wealth level or the ordinary dealing with debts level, it is sort of I would say a basic financial field to figure out, “OK, do I have to pay 22 percent on my credit cards,” which is not that uncommon. “Can I get that down to 12 percent? Could I in fact figure out a way through a home loan to reduce my debts to 4 percent?” And if you can do that the wealth effects are very substantial. But we have to know to ask the questions – how do I get my interest rates down?

Hoff:  Absolutely. Let’s go on to cash flow. Explain it, how do we apply it in our own lives and why it needs to be front of mind when making financial decisions?

Taylor:  A really good question. I was going two different directions in cash flow, the first would be when I think of investments that are appropriate especially for a young person who is trying to grow wealth. I think you need to focus on things that do produce cash, that means instead of that you’re hoping just the price of the thing goes up, so I’ll just need some quick examples of what I mean. Bonds and stocks produce cash, bonds through interests and stocks through dividends. And they generate cash, and I like to think in compound interest terms that when you generate cash you then get to compound your returns by having the cash that was generated from your investments becomes like little baby cash, and you grow money on your money and that is sort of the process of what compound interest describes.

So you earn 10 percent on your thousand dollars, you have a hundred dollars extra. That hundred dollars is quite, to use a word from biology, second or it produces little baby monies. And that’s a good thing over a long period of time.

In contrast there are things that look like investments or that some people consider investments like gold, or I shudder to say the word bitcoin or other cryptocurrencies, they never generate cash. You are hoping that the price goes up, but in itself gold is essentially a lump of shiny metal and a bitcoin is a fiction of our financial imaginations, but in either case does it ever produce money.

So one of the things I think about cash flow is find investments that produce money. Interestingly enough real estate, there’s two types of real estate – there’s your home which is a form of an investment but does not generate cash, it actually costs a lot of money to live in a home. So I would say your home properly understood does not generate cash, and is not therefore a thing for which compound interest will ignite baby monies that you can grow that turn into big monies.

Commercial real estate or things that are investment real estate, if you can generate cash from that that is a plausible investment that if you have positive cash flow on real estate, which is hard to achieve by the way. It’s easier to have negative cash flow on real estate. It’s hard to get positive cash flow. But if you can that kind of cash then becomes something that can ignite the power of compound interest and make you wealthy over the long run.

I’ll pause there because you might have meant something different about cash flow or maybe that is what you want.

Hoff:  No, that’s great. It’s great. But some people say, OK, they own a house but it’s going to gain in value. You don’t know how much it’s going to gain in value, right? So you’re saying kind of the only thing that you know is if it’s producing money. So the same thing with gold, gold holds its value basically. So gold is kind of a security that you have there in case all else fails and then money tanks then gold is something that can maybe buy you something. But as far as generating new money that is how you have to think of cash flow. So, I’m going to invest in something that will produce more money to either go in my bank account or to reinvest into that property.

Taylor:  Yes, and I feel strongly about that. I think it’s disqualifies gold for most people who need to generate wealth, from my perspective it disqualifies gold as a way to do that. As you said it has a different function which seems to be the thing you hold as last resort, but that’s more of an insurance policy kind of a hedge against everything else in the world going to a bad place, but it’s not a wealth generator, I don’t believe. I don’t think it’s a legitimate wealth generator. I think it is a different function.

And we sometimes confuse that because it fluctuates and you think, “Oh, it just went up, maybe I made money.” Similar to your house often goes up in value or down in value but mostly up over the long run, but it doesn’t generate cash. So it’s a lovely thing to own a house for some reasons and many of the most middle-class people who are homeowners do in the long run make money off their house, but it’s not quite the same category as a cash flow generating thing.

Hoff:  And actually when I spoke to Robert Kiyosaki on this show he kind of said the same thing, he likes to look at things with cash flow. Is more money coming to me every single month? I don’t have to wait for it to gain in value, I don’t have to keep my fingers crossed that it won’t gain in value. I know I’m getting something from it because I’m seeing it come into my bank account every single month.

Taylor:  Yeah.

Hoff:  So also I want to talk about, because I have a lot of things I want to get through, and we don’t have tons more time, so let’s talk about debt. And I think a lot of students get out of college and they say, “OK, my first goal is I want to pay down this student debt. I don’t want debt hanging over me.” Now we know that most people if you get federal loans you’re probably getting a pretty decent interest rate, 4 percent, 5 percent, which is less than obviously credit cards which is 16 or 20 percent. So should they concentrate on taking their first big flow of cash and sticking it to that debt to get rid of it as quickly as possible? Or should they just take their time to pay off that student loan debt as slow as they want to as long as they make those minimum payments and put their money into an index fund or something like that instead?

Taylor:  It’s such a good question and it is a perennial subject for debate. I will say that my answer is somewhat in the subtitle to my book, the main title is “The Financial Rules for New College Graduates” and the subtitle is “Invest before paying off debt and other tips your professors didn’t teach you.”  So embedded in there is I’m saying it is OK, and in fact it’s preferable to start the investment process even before all of your say student loans have gone away.

Also embedded in your question is should you always tackle debt before tackling investments? And the main differentiation there from my perspective is do you have high interest debt, which would be at the worst end payday loans? Or at the more common end many people have credit card balances and those tend to be very high interest debt. Or do you have low interest debt, the main categories there being student loans, usually home mortgage, and often a prime automobile loan?

And if you have low interest debt and in particular to your question the student loan debt coming out, I believe it’s something that doesn’t get in the way of building wealth of 3 to 4 to 5 percent subsidized interest rate loans compared to the opportunity of putting money into say tax advantage retirement accounts like an [individual retirement account] IRA or 401(k) or 403(b), or even a taxable account. There’s a lot of mathematical as well as psychological reasons why you could plausibly and responsibly invest before fully extinguishing your student loan debts.

I’ll give one example of where I’m very certain about the math, and that would be if you have a very good job which offers a 401(k) or 403(b) style employer sponsored matching funds, I think there’s a strong consensus around the idea that if you are able to get matching funds from your employer that’s a 100 percent return on investment immediately. Let’s just to give an example they say your first \$3,000 you put into this will match it. There is no other free lunch in the known universe, so do that. Put in the \$3,000 before almost doing anything including credit card debt.

Hoff:  Right.

Taylor:  Monies above that that are put into your retirement account you are going to save on taxes immediately, so let’s say you have a reasonably good paying job between \$35,000 and \$90,000 and you’re in the 25 percent tax bracket. We could say that you will get on a tax adjustment basis a 25 percent return for all monies you put into that retirement account. So again, there’s very few debts that are going to be above that, so that’s a pretty plausible mathematical case for investing before fully paying off even your high interest debt.

So there’s math answers we can give, and I would say against low interest rates, student loans, or home loan or a prime auto loan, yeah, definitely. Start to build some investment nest egg first.

The main response to that just to argue with myself a little bit would be – people have different psychological approaches to the debt. There’s some portion of people who are addicted to debt, and I would never advocate feeding your addiction. And there’s some portion people who can’t have alcohol and some portion of people who can’t have debt, so if you’re in that abuse category I think you got to go cold turkey and that’s a psychological very personal thing and you got to pay down your debt or you have to work on that before anything else.

Then there would be another category of people who don’t have a problem with debt but they do have a psychological aversion to any kind of risk, and those people will tend to pay down their debt quickly anyway but that’s a fine choice. They’ll pay down debt more aggressively, and it’s never bad to pay down debt essentially.

Hoff:  OK, but in general you’re saying it always pays to at least put it in your 401(k) if you have a matching kind of program, and then if you have the only low interest debt even an investment into the stock market or something is probably going to pay you more than kind of what you’re paying in that debt. Just as long as you make your minimum payments on time because then your credit score tanks if you don’t and it becomes another nightmare and another mess. But just as long as you can handle it and you have a plan of action.

Taylor:  Yeah, if you’re not paying your debts very bad things happen. So I would never say invest and not pay your debt, definitely. But if you can carry your debt and you can make the monthly payment, and especially if it’s low interest it is compatible with building wealth in an investment terms I think and therefore I would say you should probably get started early. The advantages to starting early in your retirement are so strong as well as the tax advantage as well as the matching advantages that it becomes a pretty strong case to do it.

Hoff:  Yeah, I mean, I kick myself all the time that at 22 I was the typical 22-year old who thought, “Well, gosh, 50, 60, that’s so old. I’m not going to put my money away for that right now.” And just that money, how would have grown over these years? And it doesn’t even take a significant amount, it won’t change your life at all just to put it in there, you won’t miss that money and yet at the end of the day when you are 50 or 60 which comes a lot sooner than you think suddenly having that win full of money helps out a lot.

Let’s talk now quickly about savings, you kind of have some savings advice in the book. What do you think is the ultimate savings plan that we should be looking at?

Taylor:  Yeah, savings is one of those things that sound simple. It’s sort of like, “I would like to lose 5 or 10 pounds,” and yet the reality of not eating that extra dessert is so difficult that we have a hard time losing 5 to 10 pounds. And savings is in that category of – it doesn’t make sense how hard it is, but it’s so hard. And I just want to say to everyone who’s managed to do it, congratulations. To everybody who’s struggling to do it, of course, I mean, we’re all there. It’s really, really hard to save money.

And I even think that is true if you’re making \$30,000 to oddly enough that you’re making \$300,000. I worked on Wall Street at Goldman, there are people making more than a million dollars. It’s very hard to save money as strange as it sounds if you make a million dollars because you have friends who have jet ownerships and you need a vacation on St. Barth’s, and it’s very expensive this vacation is a St. Barth’s, so people who make a lot of money also have a hard time saving, so I’m like sympathetic to all levels of it.

I find the most powerful way or at least the advice I’m most confident with when it comes to how do I save money is you basically have to trick yourself. And by that I mean you have to automate the savings some way. There’s a neat app that’s called Qapital with Q, Q-A-P-I-T-A-L, that does this kind of thing where it automatically moves money according to some set triggers. But you could do this with any bank who will set up automated things.

The point is you have to have a way to take money out of your spending account and essentially hide it from yourself, I think, into a hard to spend savings account at a different bank or in the form of Qapital like the app sort of takes the money and puts it in a Wells Fargo account somewhere else where it’s hard to access, because essentially no matter what your income we will expand our lifestyle to fit the income.

Hoff:  That’s true, yeah.

Taylor:  And if the money is there we’ll spend it. So my greatest advice is automating a process to take the money out, probably matching your pay day. So like if you’re paid once a month, on that day move the most amount of money you can plausibly forego and or twice a month, if that’s how you get paid, and move it before you even have it so that you don’t see it and you don’t spend it. I think most of us are not strong enough to see the money in the account and not spend it, and if you’re in that category of most of us you got to trick yourself. That’s the biggest thing.

Hoff:  What’s the number one trick you have for taxes or tip that you have for taxes? Because taxes is one of your chapters in the book, what do you think is the most important thing for people to understand besides paying them?

Taylor:  Oh, yeah, definitely pay them. And I don’t prepare them myself, but that’s sort of a No. 4 tricky. The number one trick from a lifetime perspective of approaching taxes, and this is a thing that is not available to most college graduates at first, but maybe is a thing for which they could shape their financial or working life toward, and I haven’t seen this written or talked about pretty much anywhere, is that the tax system is written for capitalists, which really means labor. If you work for a living as a worker that’s much less tax advantageous than it is if you make money on your money.

So I’m sure a version of this is what Robert Kiyosaki would say which is when you own a business there’s a tremendous amount of tax advantages. So being an entrepreneur or owning your own business, which is really only appropriate for a certain slice of personality type I would say, but if you can do that you will find that the tax code is written for you. And if you work for a living for somebody else as a worker, as an employee the tax code is really not written for you and it is I would say tentative. The rates are higher, you get fewer tax breaks. But if you are an entrepreneur for you there are many more deductions and you have a lower tax burden.

But having said all that entrepreneurship is probably not appropriate for a huge portion of the population, they’re not wired that way. So the next best thing you can do to orient yourself, again, this is over a lifetime, this is not something a college graduate can do. But then you have to think, “Well, the tax efficient way to earn a living or to have money coming to me on a regular basis is to try to make money on my money.” And by that I simply mean the more again over decades, over a lifetime build up a pile of investments those investments will be taxed at a lower tax rate, dividends and interest and capital gains are all tax advantaged when compared to working for a living.

So again, it’s kind of an example of the rich get richer where the tax system is written for capitalists, when you make money on your pile of money it’s much more tax efficient than working for living. For many years many or most people who do this even successfully we’re talking about really in your retirement, you’re making money on your money, you’re not making money on your labor. But if you can shift that forward, if you can get there by the time you’re in your 50s or get there by the time you’re in your 40s, or at least start to replace your labor with your capital from a tax perspective you’ll find yourself taxed less and less. Again, this is not something a 22-year old can see right away.

Hoff:  Sure, but it’s something to consider when they’re making their life plan.

Taylor:  Unless you happen to inherit, try to be taxed as a capitalist not as a laborer is sort of the biggest strategy I would say.

Hoff:  Fantastic. And Michael, of all the things we’ve talked about here, and there’s so much more in your book, what are the three most important things a new graduate could do right now to get on the path to wealth accumulation?

Taylor:  Such a good question. The first one is move, and this is difficult, I’m going to admit right up front this is difficult, but try to move as quickly as humanly possible, maybe it’s going to take you months, it might take you years but try to do it months to move from indebtedness, carrying a balance, or having student loans to a monthly surplus. A monthly surplus is kind of the first goal for somebody who’s graduating. Just whether you’re making 10 bucks more than your spending per month eventually try to make it 100, then make it a thousand.

That move from being in a monthly deficit to a monthly surplus is the thing you have to move to as quickly as possible. And part of the reason it’s hard is because every city where you move, everywhere you move after you graduate from college the costs of living are not built for college graduates, they’re built for 30-year olds and 40-year olds and 50-year old and 60-year olds who have had decades of bonuses and pay raises.

Hoff:  Right.

Taylor:  So every college graduate I would say is expected to be completely underpaid for where you live. It probably doesn’t really work the math of where you can go in your first job. They pay you too little so you have to probably choose a very rice and beans lifestyle unfortunately. So that’s number one is just try to survive a rice and beans lifestyle as quickly as possible to get out of the deficit and into the surplus.

The second related thing is if you can do that start early and start small with investing. I guess, small steps taken early are way more powerful than heroic steps taken a day when it comes to investing, and the math line of that is compound interest, but that’s a thing you should try to do.

And then that the third one is if you really want to get good at this you probably need to read books rather than watch the internet and TV, because I think that somehow properly filtering media is a skill that we have to get better at. So if you want to be a student of investing or a student of personal finance I would say books. Now that happens to be a self-interested statement because I’m selling a book, but that’s the way I learned about it best. Of course I read The Wall Street Journal every day and I read online about finance but that’s never been as useful to me as reading books if you want to be like a student of everything like that.

Hoff:  Yeah, absolutely.

Taylor:  But anyway, move to a surplus, start early and start small, and then read books.

Hoff:  Perfect, and finally our show is called Charged Up, what gets you charged up about breaking down the numbers to make the concept of wealth more accessible?

Taylor:  That’s a good question, and I’m so glad that you’re doing this, and charge up is great. I mean, what is the theme? It is my life’s mission. I mean, I wake up in the morning I go, “How can I be useful?” And the way I can be useful is trying to make the seemingly complex, which is finance, simple to understand. None of the good things we do in finance are necessarily easy to do, but they should be simple to understand. I get charged up about my life’s mission which is to make this stuff understandable.

Hoff:  Fantastic, and you really have, and I mean even though you have a lot of math concepts in the book I hope nobody gets scared off from that because you really break it down, you give examples, you give metaphors, you really try to make it so that even if you don’t have a financial background or a mathematical background it’s not that daunting to figure it out. And I think it’s very empowering once you do grasp a concept much better than just hearing it to put it into practice and to feel like, “OK, I’ve got this. I can build my life. I can build wealth in my life.” Thank you so much, Michael, great talking to you, great book and great advice.

Taylor:  Jenny, thanks so much for the conversation. I really appreciate it.

1. Actually, bond salesperson, but ok

## Discounting Cashflows – A Deeper Dive

Welcome! This post is meant to accompany Chapter 5 and Appendix to Chapter 5 “On Discounting Cashflows” in my book “The Financial Rules For New College Graduates – Invest Before Paying Off Debt And Other Tips Your Professors Did Not Teach You.” (Praeger, April 2018.)

I’m convinced the only way to really learn discounting cashflows math is to practice with a spreadsheet. The only way to gain intuition about how this math is used in the real world – how it can help you build wealth – is through a bit of spreadsheet practice.

In this first video I show how to build a simple calculator for determining the present value of future cashflows. This is the fundamental math used in investing in assets such as stocks and bonds. It’s also how we would value everything from annuity payments to pension payments to public liabilities.

In this second video, I show how to discount more than one cashflow. The key point is that each separate future cashflow needs it own discounting formula.

The next video shows how to discount cashflows using other-than-annual discounting rates. This is relevant because in the real world cashflows don’t just come once a year. They could be semi-annual (like a bond) or quarterly (like a stock) or monthly (like debt payments). We need to adjust our calculation by adding one extra variable – the number of compounding periods per year – as I show in this third video.

Learning how to discount cashflows can get more complex from here, especially for finance professionals, but the basic math shown here is both within the grasp of non-finance professionals as well as applicable to many important personal finance situations.

On Compound Interest – A Deeper Dive

Book Review: The Intelligent Investor by Benjamin Graham

## Compound Interest – A Deeper Dive

Welcome! This post is meant to accompany Chapter 4 “On Compound Interest” and the Appendix to Chapter 4, in my book The Financial Rules For New College Graduates: Invest Before Paying Off Debt and Other Tips Your Professors Didn’t Teach You (ABC-CLIO Praeger, 2018.)1

I highly recommend you open up a spreadsheet alongside this material.

For starters, we want to know how to set up a spreadsheet to calculate Future Value, if we already know Present Value, Yield, and Time.

This first video below can get you started on that journey.

COMPOUNDING MULTIPLE AMOUNTS OR WITH MULTIPLE YIELD ASSUMPTIONS

The next video adds a level of complexity. Let’s say we want to see multiple years’ worth of compounding returns. For example, we might want to contribute to a retirement account multiple years in a row, and see the results of that activity over time. Spreadsheets are ideally suited for this type of setup, as the next video shows:

NON-ANNUAL COMPOUNDING

The third compound interest video introduces the idea that in the real world, money can compound more frequently than annually. Bonds often compound semi-annually. Stock returns often compound quarterly (because dividends are paid quarterly.) Monthly-pay debts we owe to our mortgage company, credit card company, or auto-loan company compound 12 times a year. We need to add an additional step for compounding more frequently than once a year.

Please see related posts on Discounting Cashflows and Compound Interest:

Discounting Cashflows – A Deeper Dive With Video

And please see my earlier writing about compound interest and discounting cashflows.

Compound Interest – The Most Powerful Math in the Universe

If You Like Feral Cats, You’ll Love Compound Interest

College Savings And Compound Interest

Rapunzel and Compound Interest

Compound Interest and Vampires

How To Win With Powerball – Learn The Discounting Cashflows Math

Discounting Cashflows – Annuities

Discounting Cashflows – Pensions