Entrepreneurs: Pack Half the Luggage, Bring Twice The Money

A version of this post ran in the San Antonio Express News.

In late high school and college I travelled to Mexico as often as I could. Some trips I went for ten days, later trips for a semester of school, then a whole summer. Finally, after graduating from college, I lived and studied in Mexico for a year.

I always carried the student travel bible at the time, Let’s Go Mexico, whenever I crossed the border.

I memorized two pieces of advice in the Introduction to my Let’s Go Mexico book.

“First, lay out all of your clothes and other luggage you intend to take in one pile on your bed. Next to that pile, place all of the money you think you will need to spend.

Now, pack half the stuff and take twice the money.”

The second piece of advice from Let’s Go Mexico was of a similar vein, something along the lines of “Take no more luggage than you could – if necessary – carry at a dead run in the middle of the night for a mile.”

I loved that advice and it always – for me at least – put me in the right adventurous frame of mind for border crossing.

Advice for Entrepreneurs

I’ve written before that it helps entrepreneurs to be a bit ignorant and maybe a touch funny in the head in order to launch themselves into a new business venture.

Entrepreneurs are risk takers. They exhibit the kind of crazy that would enjoy situations involving a dead run for a mile at midnight on the streets of Juarez.

Lately I’ve thought about the Let’s Go Mexico advice, and how that’s exactly the advice I would give to first-time entrepreneurs.

Instead of luggage, of course, you have your business start-up costs.

First, in your business plan, lay out all of the costs of things you think you need to get started. Next to that, figure out how much money you already have available for your venture. Here’s the thing: To survive your first year in business, you’ll have to make do with half those things, and you’ll need twice the money.

Also, if luggage in my analogy equals costs, try to start your business with no more costs than you can carry at a dead run for a mile in the middle of the night. Ok, the metaphor doesn’t quite work. But I hope my point is clear(-ish.) Entrepreneurship is incredibly difficult, your business will encounter the unexpected, and you’ve got to be ready to pivot in a totally unanticipated direction.

Writing a Business Plan

I work on educational videos for a regional non-profit microlender LiftFund that offers training for new (and experienced) entrepreneurs. Writing a business plan is one of those things which every business owner does.

A couple of my videos walk folks through the different component parts of a business plan. What I want to say at the end of the videos, however, is that – no matter what your plan says – you’ll need to cut your planned costs in half and figure out a way to put your hands on twice the cash.

Mike_Tyson_Strategy
Business Guru Mike Tyson

Everybody’s Got a Plan

I guess the following is a true story, since I found it on the interwebs.

Boxing great Mike Tyson was peppered, pre-fight, with journalists’ questions, asking how he would respond to his opponent’s plan for delivering a devastating left uppercut.

Mike responded sagely “Everybody has a plan ‘til they get punched in the mouth.”

(In my mind’s ear, I always hear that quote in a high-pitched voice, the final word pronounced ‘mouf.’)

Anyway, the point is, an entrepreneur’s written business plan only gets you so far. Because, at some point, everything goes into complete disarray.

Metaphorically speaking, you’ll be bleeding from the mouth, running your business at top speed for a mile in the middle of the night, just praying you make it to safety.

So remember, you entrepreneurs: carry half the luggage, and bring twice the money.

 

Please see related posts:

Videos Playlist for Entrepreneurs – Learn Excel

Video for Entrepreneurs – Personal Financial Statement

Entrepreneurship Part I – Fixed Income v. Equity

Entrepreneurship Part II – Lessons From Finance

Entrepreneurship Part III – The Air, Taxes, Retirement

Entrepreneurship and Its Discontents

 

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A Confusing Puzzle Made Simple – Retirement Plans

A version of this post ran earlier in the San Antonio Express News

paradox_of_choice

I recently received in the mail retirement plan documents for a local employer’s 403B plan.

I’m going to spend the first part of this column complaining about this 403B plan provider. Later, I am going to offer a better, simpler, version of the plan. And that better, simpler, version of the plan will make 99.5% of all investment advisors throw up in their mouth. But they are wrong and I am right.

But before I complain

Let me start with an important public service announcement first:

403B plans and 401K plans – employee-sponsored, tax-advantaged retirement accounts for non-profit and for-profit employers respectively – are Totally. Freaking. Awesome.

If you have access to one of these through your job, and you are not taking full advantage of these accounts, then drop your newspaper or iPad right now – seriously, right now – and call your HR department and sign up for automatic payroll-deduction investing.

Do it. I’ll still be here when you get back.

What are you waiting for? I said I’ll be right here.

Go!

Ok. Are we good?

Now then, my complaining

I received in the mail this packet entitled “important information about your retirement plan,” consisting of 42 pages, printed on double-sided paper and in small letters. You might be able to guess where this is going.

The problem

I’m bothered not by any deficiencies in the plan, but rather, the opposite. The document provides a gold-plated menu of options.

The problem is that anybody except a sophisticated financial professional would find the choices totally overwhelming.

I did some simple addition and this is what I found:

141 mutual funds of 100% stocks;

38 mutual funds of 100% bonds;

41 mutual funds with a blend of stocks and bonds, in varying proportions;

6 money market mutual funds; (By the way, this is perhaps the most ridiculous part of the whole list.  A money market fund is a money market fund is a money market fund. You don’t need 6 to choose from.)

6 fixed return investments;

1 lifetime annuity investment;

And a partridge in a pear tree.

Hello? Is anybody there? This makes me so mad.

Paradox of Choice

These choices make no sense. You would think the designers of this 403B plan had never heard of the behavioral finance theory known as the ‘paradox of choice’ idea in retirement planning.

too_many_choices

Behavioral economists have shown that the more mutual funds you offer, the less likely people are to actually invest in anything. We tend to choose instead to delay decision-making to some later date. And that delay, in the case retirement planning, is a horrible outcome.

An economist’s study using data from fund company Vanguard showed that for every additional 10 mutual funds offered in a retirement plan, the rate of employee participation in the 401K and 403B programs declined 2%.

If you offer 50 additional funds for example, we would expect 10% fewer employees on average to participate in their retirement account.

The decision – due to confusion – to defer contributing to some far-off future date may cost you millions of dollars in your retirement. I’m sure the friendly folks in charge of designing this 403B plan felt good about offering so many choices because, hey, more choices are better, right?

Unfortunately, not when it comes to encouraging people to invest in their retirement accounts.

My solution, as DRAGO

Sometime in 2035, when I am elevated by President Miley Cyrus to the post of Dictator of Retirement Account Great Options (You can just call me DRAGO, for short) there will be two – and only two! – funds to choose from.

miley_cyrus_patriotic
Miley Cyrus is a Patriot

In this way I will maximize your participation.

Risky and Not Risky

I will call these two funds Not Risky, and Risky.

Not Risky will never lose you money. Not Risky will provide you between 0 and 2% positive annual returns year in and year out. It will also never make you any money on your money, especially after taxes and inflation.

If you have 10 years or more until your retirement (a key ‘if!’) Not Risky is totally forbidden for your retirement account.

Risky, by contrast, is quite volatile. You can lose as much as 30% of your investment in one year. You can also gain as much as 30% in one year. Viewed over long periods of time, Risky has returned about 9% per year in the last century. Risky is also the only way to actually grow long-term wealth with your retirement account.

In the future with Risky, you should reasonably expect no more than 6% annual returns, over the long run, with tremendous volatility in the short and medium run.

But after taxes and inflation, Risky offers you a far better return on your money than Not Risky, many, many times over.

Finally, as your DRAGO, if you have more than 10 years to go until your retirement account (a key ‘if!’), I will force you to only have Risky in your portfolio.

Retirement money for most of us, remember, is long-term money. For most workers in their 20s, 30s, 40s, and 50s, retirement is more than 10 years away.

Only if you plan to retire within the next ten years (a key ‘if!’), will DRAGO allow you to invest in a blend of Risky and Not Risky.

In this way, I will maximize your wealth in retirement.

You can thank your DRAGO, as well as President Cyrus, for this important service and improvement in your quality of life in your retirement years.

 

 

please read related posts:

Stocks v Bonds, the Probabilistic Answer

Book Review of Simple Wealth, Inevitable Wealth by Nick Murray

 

 

 

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Ask an Ex-Banker: Mortgages Part II – Should I Pay My Mortgage Early?

mortgage or invest

Dear Banker,

Most months we manage to cover our costs and have a little extra left over.  Sometimes I send the bank an extra $500 or $1,000 toward paying down our mortgage balance, which has another 21 years to go.  Once I sent close to $5,000.  Does this make sense?  — Manny T., Chicago, IL

Dear Manny,

Congratulations on doing the first-order hardest thing in personal finance – produce a monthly surplus in your household.  Wealth for you – while not inevitable – is made possible by this monthly surplus.

I appreciate your question whether you should – or anyone should — pay off a mortgage early with small interim payments of principal.

This perennial question generates as many strongly held opinions as there are mortgage holders.  There’s a thoughtful discussion to a similar question prompted on this personal finance site.

Like most interesting personal finance questions, the answer depends on a combination of personal psychology and finance math.[1]  Your own personal relative weighting of this combination may lead you to a different ‘correct’ answer than that of someone else.[2]

My own short answer is that while paying off your mortgage principal in small early increments does not make much sense from a pure financial math perspective, it can be the totally correct thing for certain psychological reasons.

Therefore, while I don’t advocate paying off a mortgage this way, I fully acknowledge that for people with a different psychological approach than me, the incremental payments make plenty of sense.

The math side of things – forward rates

First, it’s helpful to understand mechanically what happens when you make an extra, partial, principal payment on your mortgage.

After making your regular monthly payment, let’s say you send an additional $1,000 to the bank for principal.  The bank – actually the mortgage servicing company, but let’s not nitpick – applies that principal to the furthest-away-in-time mortgage payment.  In Manny’s case, his $1,000 payment gets applied toward a payment due 21 years from now.

In other words, Manny’s total mortgage principal gets reduced by $1,000, but not in any way that affects his current monthly mortgage costs.  He’s still obligated to make regular mortgage payments next month.[3]

You may have read, not entirely incorrectly, that when you pay debt principal early you get a guaranteed return on your money equal to your interest rate.  If you have a 6% mortgage, the conventional wisdom goes, you get a 6% “return on investment” when you pay off your mortgage.

But this is not entirely correct either, in purely financial math terms.

I’m going to assume Manny’s mortgage (obtained 9 years ago) has a 6% interest rate.  Since he’s eliminated by early payment the obligation to pay 6% interest on his borrowed money 21 years from now, we could more precisely say he’s invested the equivalent of $1,000 at “6% interest rate, 21 years forward.”

That may seem like an odd turn of phrase, except that the bond markets operate precisely this way – on today’s interest rate (you might call this the ‘spot’ rate) as well as tomorrow’s forward rates (incorporating the idea for example, of 1 year interest rates, one year from now, stated as “1 year rates, 1 year forward.”)

We don’t all have to be bond geeks to make good decisions about early mortgage payments, nor do we need to know exactly what I mean with this clarification, except you should understand the following:  We don’t know with very much precision what prevailing interest rates will be 21 years from now.  As a result, it’s not as obviously a ‘good trade’ to pay off your mortgage at 6%, precisely because it’s not actually true that you’re locking in a “6% return” on your money today.

21 years from now a 6% mortgage interest rate may be extraordinarily high or it may be extraordinarily low (I’m agnostic on the issue) but the imprecision around the question of forward rates makes it less obvious what your effective ‘return on investment’ really is, or what you should reasonably expect to earn on your money 21 years from now.

One major and obvious exception to my clarification on “forward rates” is that if you pay off your full mortgage balance early – entirely eliminating the need to make future monthly payments – then indeed you did lock in a 6% ‘return’ on your money.[4]

Inflation scenario as an illustration of forward rates

To return to the problem of unknown forward rates for a moment, it may be helpful to think of specific, possibly extreme, scenarios.  I’ve written before that the combination of home ownership with a mortgage can be a very powerful inflation hedge.  One way of seeing that is through the concept of forward rates.

A future high inflation rate can illustrate the ‘forward rates’ problem.  If future inflation, say 10 years from now, runs at an annual 15% rate, with prevailing mortgage interest rates around 18%, then it becomes obvious that locking in a 6% return on your money in the final years of your mortgage was not a good idea, from a personal financial math perspective.  In my example you might have earned 18% just leaving your money parked in a money market account.  That kind of future interest rate can show us why we should be less sure of ourselves that earning a 6% return by paying of a mortgage early is the right decision, from a purely mathematical perspective.

More on the math side of things – comparative rates of return

I have not yet addressed the most common financial math reason why people claim you should not pay off your mortgage in small early chunks of principal payment.

Specifically, many argue that you may be able to earn a higher return on your money “in the market” than you can by eliminating personal debt and locking in the rate of return of your mortgage’s interest rate.

This is possibly true, although it depends on specific scenarios, like the following:

·         If you are talking about credit card debt – with interest rates between 9% and 29.99% – it’s clear to me that paying off your debt offers a better return than you could reasonably expect from another investment “in the market.”

·         If instead you are talking about current prevailing mortgage rates – like my newly refinanced 15-year mortgage at 2.75%! – then I heartily agree that a better return is quite likely available “in the market” rather than through paying down personal debt.

·         If you are able to invest in a tax-advantaged 401K or IRA vehicle, and you have a sufficiently long time horizon to invest in risky assets, then you can stack the odds mightily in your favor to earn a better return “in the market” rather than paying down debt.[5] 

The Psychological approach – Arguing against myself

So I’ve made the case that locking in a specific return on your money – by paying down mortgage debt – is not as clear-cut as it first appears, from a purely finance-math perspective.

However, I do think the psychological aspect of making early mortgage payments should not be forgotten.  We are all humans,[6] responding irrationally to myriad inputs.  For many of us, money left on a monthly basis in the checking account gets spent, so the key to not spending is to not leave extra money lying around.

If Manny’s realistic choice every month is between sending $1,000 to the bank to pay his mortgage early or instead – like many of us – to spend $150 more on Amazon Prime downloads, $300 on jewels in Farmville and $273 on One Direction concert tickets, leaving just a $277 surplus at the end of the month, then the choice is clearer. 

All the possible market returns in the world cannot undo the simple fact that paying off debt guarantees an incremental increase in net worth.  If you can’t stop yourself from spending your surplus – and this really comes down to the psychological imperative: “know thyself” – then paying off the mortgage in small extra increments makes total, perfect, unassailable sense.

And then there’s risk tolerance

In addition, there’s the “know thyself” imperative applied to risk tolerance. 

Investing money in the market – instead of paying down debt – makes an increase in net worth possible, even likely, but has no guarantee.  If you hate losing any amount of money ever, then by all means pay down all of your debts before investing in anything risky.

Earning a 6% return by paying off your mortgage[7] early may sound much better than shooting for a possible 10% compound annual return but with a possibility of a 25% sudden loss in any given year.

Few investments in the long run are worth 3AM insomnia.  A fully paid-off mortgage may do more for encouraging restful sleep than all the Posturepedic  mattresses in the world.

Please see related posts:

On Mortgages Part I – I Am a Golden God

Part III – 15 yr vs. 30 yr mortgages

Part IV – What are Mortgage Points?  Are they good, bad or indifferent?

Part V – Is mortgage debt ‘good debt’ A dangerous drug?  Or Both?

Part VI – What happens at the Wall Street level to my mortgage?


[1] My bond sales mentor memorably told me once that bond sales consists of 5% bond math and 95% child psychology.  Personal finance strikes me as a similar deal, although probably even more weighted toward the psychology part of the spectrum.

[2] And since I’m always looking for an excuse to quote Jack Handey, let’s review this gem: “Instead of having ‘answers’ on a math test, they should just call them ‘impressions,’ and it you got a different ‘impression,’ so what, can’t we all be brothers?”

[3] I’m assuming for the purposes of this example that Manny has sent the money to the bank to be applied to principal since that’s how his question is phrased, rather than specifying something like ”I’m paying the next 3 months early.”  Presumably that’s also possible, but non germane to the question.

[4] At this point further math geeks will point out that the tax-deductibility of mortgage interest means that your effective interest rate is probably closer to the 4% than 6% rate, making your effective ‘return on investment’ lower than it seems.

[5] As always, if you can get an employer match for 401K contributions then that use of money trumps everything except paying off high interest-rate credit card debt.

[6] All of us, that is, except for my Rihanna-bot, who takes care of me in my old age, on my hovercraft.  She’s not human, just human-like.

[7] Yes, closer to 4% after taxes, and yes, actually “6% 21 years forward.”

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