Friday, June 17, 2011

first, we avoid debt and develop the habit of saving

Defined benefit (pension) plans are being replaced with defined contribution (401k and IRA) plans throughout America as we transition from a guaranteed monthly benefit upon retirement to a self managed account with no guaranteed benefit. To repeat, the pension benefit is fixed whereas in a self managed account the benefit received depends upon how well our personal investment account performs over the years.

Although in the future we'll discuss in greater detail the implications of this transition from a sum certain pension benefit to an "uncertain" benefit amount, suffice it to say for now that knowledge about these matters will be important.

In a defined contribution plan, how early in our work career we begin saving, how much we save and how often we add to those savings, along with the investment results achieved thereon over time, when combined with any matching contributions from an employer, are all factors that will determine our final benefit. In this largely new world of saving and investing, it's now largely up to us, in other words.

For too long we've tended to ignore this area of personal responsibility, perhaps thinking that social security and our private employer will take care of the details for us. That's no longer the case, if it ever was. Accordingly, it is now essential that we "educate" ourselves as to how this really works. We'll then be better able to fulfill our responsibilities with respect to the future financial security and well-being of ourselves and our families.

In order to be in a position to save and invest, we must first avoid or at least minimize taking on debt. That's because if we accumulate substantial debt early in our adulthood, the resultant interest and principal payment requirements will delay our ability to save. To state the obvious, unless we first generate savings (income less spending = savings), we will have nothing to invest. So it makes little sense to enter into a discussion of investing until we have addressed, at least in general, the perils and pitfalls of taking on debt early in our adult lives.

The three biggest individual debt obligations are related to (1) credit cards, (2) student loans and (3) home mortgages.

Debt is a huge problem. To seriously address this issue, especially in our younger years, we must be ready to think for ourselves and be prepared to go against the "conventional wisdom" of the crowd.


The worst of the three biggest personal debt issues concerns credit cards. Bank issued credit cards are easy to get and are frequently used by the holder for major discretionary purchases with annual interest rates of ~15% being common. In comparison, banks currently pay us virtually nothing on savings deposits. As a result, the bank borrows our money (deposits) from us at a cost of less than 1% and then loans us back our same money at an annual cost of 15%.

Obviously, that's a great deal for the credit card issuing bank, but it's a really terrible deal for the credit card holder. Accordingly, we must make every effort to establish the habit of avoiding interest charges by paying in full any card balances at the end of each month. In fact, we should carefully consider avoiding the use of credit cards at all.


{NOTE: Human capital is our most valuable asset. We need to develop it each day and at every opportunity. I sincerely recommend that everyone work hard and continuously to develop the habit of acquiring knowledge. I also encourage people to get as much education as possible and attempt to graduate from college and graduate school as well, if that's the chosen route. That said, let's be careful about how much, if any, debt we accumulate along the way. My view is that it's best to avoid borrowing, but in the end that's your decision, of course. Let's just try to make it, along with all other decisions, an informed one.}

Now on to student loans .......

Although not as bad as credit cards, student loans are something to avoid. So work hard to get the degree(s), but don't borrow a bunch of money to get it/them. But we need to go to a good school, you say. You will. There are lots of very good colleges that aren't all that expensive to attend. Besides, it's the work of the student that truly makes the difference and not the name or location of the school. In other words, you'll do well wherever you go, and lifetime earnings, and happiness, won't be adversely affected at all, if you wisely choose a good but inexpensive college to attend. So try hard to stay away from the debt accumulation game. OK?

Here are a few additional facts to consider. The average student loan balance upon attaining an undergraduate degree exceeds $24,000. Thereafter, of course, the principal amount of the debt, together with interest charges thereon, must be repaid. Considering the cumulative interest charges and the debt principal as a single whole, a reasonable assumption would be that total payments of ~$32,000 would be required to retire the loan in full.

Now let's look at what could we do with that amount of money if we saved it as opposed to borrowing and repaying it. A whole lot, as a matter of fact. Here it really gets interesting.

The effect of compounding relates to (1) the length of time money is invested (time) and (2) the rate of return (rate) earned on that money. Money invested at an early age is often worth multiples of that same amount of money if not invested until a later point in time.

Here's the appropriate comparison. The earlier mentioned ~$32,000 invested at age 25 would reasonably be expected to grow to more than $1 million by age 65 (compounded annually for forty years at an assumed average rate of return of 9%). On the other hand, if our young graduate instead opts for the "Debt Assumption Plan" while in college and has to wait until age 33 to begin investing (the same ~$32,000 dollars at the same 9% average annual yield), he will accumulate a total amount of $500, 000, or about 50% less than what he would have acquired had he begun investing eight years earlier at age 25.

The point is simply this; the effect of compounding is real, whether it's working for us as an investor or against us as a debtor. So it pays to start saving and investing as early as possible.

(The "rule of 72" as applied to the example herein holds that for each eight year period, at an average annual rate of return of 9%, the result will be a doubling of the initial amount invested (8x9=72). Hence, our bright young graduate's decision to avoid debt and start the investment process at age 25, or eight years earlier than age 33, is a smart one indeed. To illustrate the rule of 72 with a few more examples, if the assumed rate of return is 10%, the money would double in about seven years, at 12% in six years, at 6% in twelve years and so on.)

Accordingly, starting early in life with no debt and some savings gets us to a completely different end result than borrowing to go to college, incurring debt and then taking several years to pay off that debt. Of course, actual results in each case would be different than the above assumed results, but the compounding rules always apply.


This is perhaps the most difficult of the three debt problems facing millions of Americans today. My view is that we must persuade young people not to rush into debt. Although home ownership is a big part of selling the much publicized "American Dream", my view is that taking on too much debt, too soon, is a bad thing.

We should avoid home related debt (when looked at as an investment, a home represents a highly leveraged, undiversified and illiquid investment) at least until we've saved some money for a reasonable period of time and are well on our way to stability and success in our chosen career. Until then, flexibility and mobility are essential. In these younger years, we can rent an equivalent place (rent almost always is cheaper on a monthly basis, contrary to popular belief) and avoid the heavy long term oriented financial burden of a a mortgage loan.

To make the point even more strongly, if we've bought a home and then need or want to sell, we must not only find a willing buyer, but we'll also have to pay a ~7% real estate commission, among the other costs of moving. Thus, if we don't sell for significantly more than 107% of what we paid, we'll lose money. In the early years especially, that's money we can't afford to lose.

Houses are usually hard to sell at an appreciated price in a short period of time (maybe even a long period if there's a "soft" market like we've experienced these past few years) unless we're what the realtors label a "motivated seller", which simply means that we'd be willing and able to accept substantially less than what we paid initially. Again, we'd lose.

Warren Buffett advises us to aspire not to buy the house of our dreams but to aspire to buy a house that we can afford. So let's not hurry into buying, since if for no other reason, the longer we wait to buy, the better the home we'll be able to afford. And with peace of mind, too.

That's my view of credit cards, student loans and early adulthood home mortgages. Avoid them if you can. But if you decide to go ahead anyway, do so with your eyes wide open.

Thanks. Bob.

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