I'm generally a pretty laid-back guy but, like anyone, I do have pet peeves. Because I write about money, I have lots of trivial personal-finance pet peeves. (It's "saving rate", not "savings rate". Dave Ramsey did not invent the debt snowball, and his version is but one kind of debt snowball. It's not the only debt snowball. See? I told you these pet peeves were trivial!)
It's silly that I'm bugged by this stuff, but I am. I'm sure you have pet peeves too, especially when it comes to your work.
One of my top pet peeves in the world of personal finance is when people who should know better conflate income and wealth. A high income can lead to great wealth -- although it doesn't always -- but they're not the same thing.
I see this error frequently -- even in high-profile articles at major media outlets.
This morning, for example, I read an article at Vox about income inequality in Europe and the United States. The piece opens like this:
Income inequality is a growing problem in the United States. The richest Americans have reaped a disproportional amount of economic growth while worker wages have failed to keep pace.
The author elaborates: "From 1980 to 2016, the poorest half of the US population has seen its share of income steadily decline, and the top 1 percent have grabbed more."
What bugs me here are the logical leaps from "low income" to "poor" and from "high income" to "rich". But I can't blame the author of this article; the source material makes the same mistake.
The Difference Between Income and Wealth
Now, I'm not here to explore income equality -- that's a subject for another day -- but I want to talk about the difference between income and wealth...and why they're not the same thing.
First, let's define our terms.
- Income is earning money. Yes, it's the primary piece of wealth creation, but income itself is not wealth.
- Wealth is having money. If you have a lot of money, you are rich. If you don't have much money, you're poor.
Income and wealth are related, but it's a complicated relationship.
The older I get, the more I'm convinced that time is money (and money is time). We're commonly taught that money is a "store of value". But what does "store of value" actually mean? It's a repository of past effort that can be applied to future purchases. Really, money is a store of time. (Well, a store of productive time, anyhow.)
Now, having made this argument, I'll admit that time and money aren't exactly the same thing. Money is a store of time, sure, but the two concepts have some differences too.
For instance, time is linear. After one minute or one day has passed, it's irretrievable. You cannot reclaim it. If you waste an hour, it's gone forever. If you waste (or lose) a dollar, however, it's always possible to earn another dollar. Time marches forward but money has no "direction".
More importantly, time is finite. Money is not. Theoretically, your income and wealth have no upper bound. On the other hand, each of us has about seventy (maybe eighty) years on this earth. If you're lucky, you'll live for 1000 months. Only a very few of us will live 5000 weeks. Most of us will live between 25,000 and 30,000 days.
I've always loved this representation of a "life in weeks" of a typical American from the blog Wait But Why:
If you allow yourself to conduct a thought experiment in which time and money are interchangeable, you can reach some startling conclusions.
Wealth and Work
When I began to fully grasp the relationship between money and time, my first big insight was that wealth isn't necessarily an abundance of money -- it's an abundance of time. Or potential time. When you accumulate a lot of money, you actually accumulate a large store of time to use however you please.
And, in fact, this seems to be one of the primary reasons the Financial Independence movement is gaining popularity. Financial Independence -- having saved enough that you're no longer required to work for money -- provides the promise that you can use your time in whichever way you choose. When I attend FI gatherings, I ask folks what motivates them. Almost everyone offers some variation on the theme: "I want to be able to do what I want, when I want."
To me, one of the huge ironies of modern society is that so many people spend so much time to accumulate so much Stuff -- yet never manage to set aside anything for the future. Why is this?
In an article on Wealth and Work, Thomas J. Elpel explores the complicated relationship between our ever-increasing standard of living and the effort required to achieve that level of comfort.
Ultimately you are significantly wealthier than before, but you are also working harder too. Nobody said you had to pay for oil lamps and oil or books and freshly laundered clothes, but you would feel deprived if you didn't, so you work a little harder to give your family all the good things that life has to offer.
It's a catch-22. You work more to have more money to buy more Stuff...but because you have so much Stuff, you need more money, which means you have to work more. It's almost as if the more physical things you possess, the less time you have.
How do you escape this vicious cycle? There are two ways, actually.
After twelve years of reading and writing about money, I've come to love financial rules of thumb.
Financial rules of thumb provide helpful shortcuts for making quick calculations and decisions. You don't always have time (or want to take the time) to create elaborate spreadsheets when choosing a course of action. In these cases, it's nice to have some rough guidelines you can rely on.
You've probably heard of the "rule of 72", for example. This shortcut says that if you divide 72 by a particular rate of return, you'll get the number of years it'll take to double your money. If your savings account yields 4%, say, it will take about 18 years for your nest egg to increase by 100%. But if you were able to earn 12% on your investment, that money would double in six years.
Like all rules of thumb, the rule of 72 isn't precise. It doesn't give an exact answer but a ballpark figure. Financial rules of thumb don't always hold true. But they're true enough for us to make loose plans based on them.
I have some engineer friends who'd get tense at this sort of sloppy guesswork, but most of the rest of us are happy to trade a bit of precision for speed. That's what rules of thumb are all about!
The trick, of course, is knowing which rules of thumb to use. Most are handy, but some common guidelines do more harm than good.
Rules Gone Wild
In the past, you've probably seen my rant about some of my most-hated financial rules of thumb. Let's look at three things I think conventional wisdom gets wrong (and what I believe are better alternatives).
How much should you save for retirement?
For instance, I get frustrated when I hear financial advisers push the idea that you should base your retirement savings on 70% of your income. Instead of estimating your retirement needs from your income, it makes far more sense to base them on spending. Your spending reflects your lifestyle; your income doesn't.
I think a better rule of thumb for determining retirement needs is this: When estimating how much you'll need to save for retirement, assume you'll spend as much in the future as you do now. Use 100% of your current expenses to calculate your retirement spending. (And if you want to build in a safety margin, base your future needs on 110% of your current spending.)
How much should you spend on a house?
As I mentioned last week, another rule of thumb that makes me cranky is this common guideline espoused by all sectors of the homebuying industry: "Buy as much home as you can afford." No no no no no! Of all financial rules of thumb, this is probably the worst. It's certainly one of the most prevalent. This is how folks end up house poor, chained to a mortgage they resent.
Lenders quantify this guideline by saying your housing payments should be nor more than 28% or 33% or 41% of your income. But, as David Bach wrote in The Automatic Millionaire Homeowner, "You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow." A better rule of thumb? Spend as little on housing as possible. Spending less than 25% of your net income is best -- less than 20% is even better.
How much life insurance should you carry?
A third rule that bugs me is the one for determining how much life insurance you should buy. Different experts give different answers. Some say your policy should cover five times your annual income. Others say ten times. And Suze Orman recommends 20 times annual income needs.
The truth is that not everyone needs life insurance. Like all insurance, it's designed to prevent financial catastrophes. You only need it if other people -- like a spouse or children -- would face financial hardship when you die. If you don't have kids, if your spouse has a good income, or you have substantial savings, then life insurance isn't a necessity.
Even if you do need life insurance, you probably don't need to carry as much as your insurance agent is willing to sell you. To find out the amount that's right for you, check out the Life Insurance Needs Calculator from the non-profit Life Happens organization. (How much life insurance should I carry? According to this calculator, I shouldn't have any at all. And I don't.)
During the month of May at Get Rich Slowly, we're going to turn our attention to home and garden topics. To start, I want to take a brief look at the history of the U.S. housing market. Some folks might find this dry. I think it's fascinating.
Private land ownership is baked into the U.S. culture and Constitution. It's part of the material plenty we expect from the American Dream. For most Americans, homeownership implies success and freedom and wealth.
But for a long time, homeownership was the exception rather than the rule. Only farmers were likely to own land and a house during the country's early days. With the coming of the Industrial Revolution, homeownership became more common for urban dwellers. Still, less than half of all Americans owned their homes until the late 1940s.
The current U.S. homeownership rate as of January 2018 is 64.2%.
I'm sure you could write a doctoral thesis on the reasons for the growth of homeownership over time. I'm not going to do that. After several hours of research into the history of mortgages and the real-estate industry, I feel like we can summarize everything in a few paragraphs. This article -- which is information-only -- will serve as background for future Get Rich Slowly discussions about homeownership.
In the Beginning
During the 1800s, most folks had no way to own a house. They didn't have the lump sum required to make the purchase, and banks wouldn't lend money for average people to buy homes. Mortgages didn't become common until the U.S. banking system was stabilized following the National Bank Acts of the 1860s.
After this reform, banks began to experiment with lending money for homes, and by the 1890s, mortgages were popular across the U.S — although not precisely as we know them today.
A typical mortgage in the early 1900s might have a term of five years and require a 50% down payment. Plus, they were usually structured with interest-only monthly payments and a balloon payment for the entire principal at the end of the term. Borrowers could (and did) renegotiate their loans every year.
Compare this to modern mortgages, which usually have 30-year terms and require a down payment of only five to twenty percent. (I bought my first home in 1993 with a down payment of less than one percent!)
These early mortgages worked fine until the Great Depression. When that crisis hit, banks had no money to lend -- and the average borrower had no cash either. As a result, potential homeowners couldn't afford to buy, and many existing homeowners defaulted. (At one point during the 1930s, nearly 10% of all homes were in foreclosure!)
Whenever you make a choice, there's a cost.
By choosing to buy one item, you pass on the opportunity to purchase other items. By choosing to do one thing, you pass on the opportunity to spend your time on anything else. Opportunity cost is what we give up in order to have the thing we choose.
Let's look at an example.
Imagine you own a delivery company. You have $10,000 to spend on new equipment. You could buy a new truck to add to the fleet, but then you wouldn't be able to replace the ten-year-old computers in the main office. But if you buy new computers, you won't have as many trucks available to make deliveries. No matter which option you choose, something is lost. That's opportunity cost in action.
While this concept is applied constantly in business, it's often overlooked in personal finance.
When you use money for one thing, that money can't be used for anything else. If you purchase a home with a $1500 monthly mortgage payment, for instance, you can't use that money to travel or to fund your retirement.
Opportunity costs are neither good nor bad. They're simply the price you pay to have what you choose. The problem comes when the choices you make aren't intentional -- when you make them out of reflex or habit.
Every time you spend money, there's an opportunity cost associated with it. But you’re not just sacrificing other choices in the present; you're also sacrificing your future freedom.
In order to survive and thrive, you need to earn a profit.
You already know profit is the lifeblood of every business. It's like food and water for the human body. Although proper nutrition isn't the purpose of life, we couldn't exist without it. Food and water give us strength to do the stuff that matters most. So too, profit isn't necessarily the purpose of business — but a company can't survive without it.
Here's a secret: People need profit too.
In personal finance, "profit" is typically called "savings". That's too bad. When people hear about savings, their eyes glaze over and their brains turn to mush. Bor-ing! But if you talk about profit instead, people get jazzed: "Of course, I want to earn a profit! Who wouldn't?"
Profit is easy to calculate. It's net income, the difference between what you earn and what you spend. You can compute your profit with this simple formula:
PROFIT = INCOME - EXPENSES
If you earned $4000 last month and spent $3000, you had a profit of $1000. If you earned $4000 and spent $4500, you had a loss of $500.
There are only two ways a business can boost profits, and there are only two ways you can boost personal profitability:
- Spend less. A business can increase profits by slashing overhead: finding new suppliers, renting cheaper office space, laying off employees. You can increase your personal profit by spending less on groceries, cutting cable television, or refinancing your mortgage.
- Earn more. To generate increased revenue, a business might develop new products or find new ways to market its services. At home, you could make more by working overtime, taking a second job, or selling your motorcycle.
When you earn a profit, you don't have to worry about how you'll pay your bills. Profit lets you chip away at the chains of debt. Profit removes the wall of worry and grants you control of your life. Profit frees you to do work that you want instead of being trapped by a job you hate. When you make a profit, you truly become the boss of your own life.
With even a small surplus, the balance of power shifts in your favor.
One of the fundamental ideas I try to promote here at Get Rich Slowly is your savings ought to be invested for long-term growth. You ought to use the magic of compounding to create a wealth snowball.
Naturally, you want put your money into an investment that offers a reasonable return and acceptable risk. But which investment is best? I believe -- as do most financial experts -- that you're most likely to achieve high returns by investing in the stock market.
But why do so many people favor the stock market? How much does the stock market actually return? Is it really better than investing in real estate? Or Bitcoin? Let's take a look.
How Much Does the Stock Market Return?
In Stocks for the Long Run, Jeremy Siegel analyzed the historical performance of several types of investments. Siegel’s research showed that for the period between 1926 and 2006 (when he wrote the book):
- Stocks produced an average real return of 6.8%. "Real return" means return after inflation. Before factoring inflation, stocks returned about 10% annually.
- Long-term government bonds yielded an average real return of 2.4%. Before adjusting for inflation, they had a return of about 5%.
- Gold had a real return of 1.2%. "In the long run, gold offers investors protection against inflation," writes Siegel, "but little else."
My own calculations — and those of Consumer Reports magazine — show that real estate does worse than gold over the long term. (I come up with a real return of just under one percent.) Yes, you can make money with real estate investing, but it's far more complicated than just buying a home and expecting its value to soar. (It's important to note that returns on real estate are a contentious subject. This recent academic paper analyzing the rate of return on "almost everything" found that housing actually outperforms the stock market by a slight margin.)
Siegel found that stocks have been returning a long-term average of about seven percent for 200 years. If
you’d purchased one dollar of stocks in 1802, it would have grown to more than $750,000 in 2006. If you’d instead put a dollar into bonds, you’d have just $1,083. And if you’d put that money in gold? Well, it’d be worth almost two bucks — after inflation.
It's time for another episode of Get Rich Slowly Theater, boys and girls! This week, we're going to enjoy a thirty-minute YouTube video exploring how the economy works. Think of it as Economics 101, but instead of a semester spent sitting in a classroom, you get all of the info in the time it would take you to watch an episode of Big Bang Theory.
Here's the video:
This animated presentation, written and narrated by billionaire investor Ray Dalio, breaks down economic concepts like credit, deficits and interest rates, allowing viewers to learn the basic driving forces behind the economy, how economic policies work, and why economic cycles occur.
Basically, Dalio says, economic cycles are a combintation of productivity growth, short-term debt cycles, and the long-term debt cycle. It sounds boring, but it's not.
This is the model Dalio uses to view the world and make big bucks. He thinks it can be helpful to other people.
If, like me, you're not a huge fan of watching videos, I've paraphrased Dalio's presentation below.
I write a lot at Get Rich Slowly about habits that foster wealth and success.
Like it or not, there are very real differences between the behaviors and attitudes of those who have money and those who don't. This isn't me being classist or racist. It's a fact. And I think that if we want ourselves and others to be able to enjoy economic mobility, to escape poverty and dire circumstances, we have to have an understanding of the necessary mental shifts.
The problem, of course, is that it's one thing to understand intellectually that wealthy people and poor people have different mindsets, but it's another thing entirely to be able to adopt more productive attitudes in your own life.
In fact, sometimes it's downright impossible. If you're poor, you're often too busy struggling to survive.
The Plight of the Poor
There's a seductive myth that poor people deserve what they get. If poor people are poor, it's their own fault. If they wanted to be middle class (or wealthy), if they wanted to be successful, then they'd do the things that lead to wealth and success.
Look, let's get real. Nobody wants to be poor. Nobody wants to struggle from day to day wondering where they're going to get money for food, for clothing, for medicine. And studies show that if you give poor people cash, they really do tend to use the money to improve their lives instead of squandering it on alcohol and cigarettes.
Yes, there are absolutely people who do dumb things that keep them mired in debt and despair. No question. Some people are poor because they've made poor choices.
But far more people live in poverty due to systemic issues and/or historical legacy than due to a pattern of financial misbehavior. Most poor people were born into poverty and don't have the knowledge or resources to escape it.
What's more, poverty actually alters the way people think and behave. It's great for us to have discussions about the mindsets of millionaires, but the truth is it can be difficult (if not impossible) for poor people to make sense of some of the things we talk about. Here's a quote from a 2015 article about the psychological effects of poverty (from the magazine for the Association for Psychological Science):
Decades of research have already documented that people who deal with stressors such as low family income, discrimination, limited access to health care, exposure to crime, and other conditions of low [socio-economic status] are highly susceptible to physical and mental disorders, low educational attainment, and low IQ scores...
Studies also show that poverty in the earliest years of childhood may be more harmful than poverty later in childhood.
Poverty breeds poverty. Economic mobility does exist and people do manage to make it to the middle class, but it's not easy. On an individual level, people become trapped by a "poverty mindset". On a societal level, there are systemic and historical issues that exacerbate poverty and make it difficult to escape.
I'm excited! The Winter Olympics begin today. Or they began yesterday. Or maybe they begin tomorrow. I'm really not sure.
I know that to convert from local time in South Korea to local time in Portland, I need to "add seven hours, then subtract a day". So, it if it's 11:03 on Friday in Pyeongchang, then it's 18:03 on Thursday here in Oregon. Google says Olympics competition officially begins at 16:05 (4:05 pm) Pacific today (February 7th), so let's go with that. If this article is visible, the Olympics have begun.
Anyhow, I love the Olympics -- despite NBC's relentless drive to show as little of the competition as possible. I love the obscure sorts. I love the human stories. And, most of all, I love the sheer athleticism. For the next couple of weeks, much of Get Rich Slowly is going to be written while I'm watching speedskating and ski jumping.