If you are not a natural number cruncher, you may be like one of my clients who says, “When I see big numbers in an article, my brain just skips over them.” Unfortunately, skipping over numbers can lead to serious misunderstandings. Here are three questions to ask that can help you clarify those big numbers.
1. What’s the time period? The reported cost or savings of something is completely irrelevant unless you know the length of time over which it is calculated.
Would you like to build up a million-dollar nest egg by the time you retire? For middle-class earners, that goal is challenging but possible if you start at age 25 and save $1750 a month. Many married couples could do this by maxing out their 401(k) contributions. Or you could take the route that many people follow and build a small business into a million-dollar asset.
What if you want to accumulate a billion-dollar nest egg instead? Starting at the same age of 25, you would need to save $21 million a year. Good luck with getting any employer match on that.
There’s a vast difference between a million and a billion. Continue reading
I recently had a conversation with a teenager who was annoyed at Disney’s ongoing promotion of the movie “Frozen.” The young woman’s point was that Disney is a creative company and, by pouring so much time and resources into promoting “Frozen,” it was robbing its loyal customers of new material.
My response, that perhaps the reason Disney is promoting the heck out of this movie is because a lot of consumers must want more and are willing to pay more, wasn’t well received. “Disney has all the money it needs. They don’t need to continue promoting old material.” I suggested that Disney won’t always have all the money it needs if it doesn’t profit from its popular hits. That didn’t go over well either.
The concept of profit seems to be increasingly maligned and misunderstood. Every organization, whether it is “for profit” or “not for profit,” needs to make money in order to continue to exist. There is nothing wrong with making money and a lot of things right with it. An organization can’t pay its workers or purchase goods and services from other businesses if it doesn’t make money. And, unless it has a monopoly, a business can’t make money unless it’s providing a service that consumers want.
I would guess most people would agree up to this point. The friction seems to come when we try to parse profit into “fair” and “unfair,” “enough” and “too much,” or “reasonable” and “greedy.” These are all subjective terms. My definition of profit can be significantly different if I am a shareholder of Disney with my future retirement depending on the company’s success than if I am a consumer forking over $400 so my family of four can make memories at Disney World for a day.
As a consumer, though, it’s your responsibility to be aware of the way the seller is making money and to make informed decisions about whether a product is worth what you are being asked to pay for it.
When you purchase furniture or cars from a company, most likely a salesperson receives a commission. When you buy anything, whether it’s from a tiny part-time business or a huge international corporation, the owners of the company certainly hope to make some profit.
Is the amount of the company’s profit or the salesperson’s commission critical to your need, use, or potential enjoyment of the product? Not necessarily.
For example, if you’re just out of college, living in a cheap apartment, working at an entry-level job that you aren’t sure you want to keep, then a thousand-dollar sofa probably isn’t worth its asking price to you. Its level of quality or how much or little the salesperson or the company might make on the sale is irrelevant. For your needs and your budget, value is probably going to be found at a rummage sale or a second-hand store. And of course, even a second-hand store operated by a charity needs to make a profit in order to raise funds to support the organization’s mission.
The bottom line is whether a particular couch, car, or “Frozen” toilet seat is worth its asking price—to you. If you determine the price is too high or the quality insufficient for your needs, you can choose to “let it go” and look elsewhere. If you do, there is no sale and no profit for the company.
Profits are the lifeblood of business. Without them a business is not sustainable. As a consumer, you vote with your pocketbook every time you spend a dollar. And even to a company as big as Disney, your vote counts.
Annuities are popular investments; almost every new client I see has one. Part of any investment adviser’s due diligence is to understand the history and intentions of the investments in a portfolio. When I ask why someone purchased an annuity, the most common responses are: “We didn’t have to pay any fees or commissions.” “There are no ongoing expenses.” “All my money is working for me.” “The principal is guaranteed.”
Any time you read or hear “no fees,” “no commissions,” “no expenses,” “free,” or “guaranteed” used in conjunction with an investment, it’s a red flag. All investments, including annuities, have costs associated with them. You need to ask some probing questions about those costs before proceeding.
Let’s look at the costs for one popular type of annuity, the fixed annuity. This simply gives you a stated rate of return that often can change annually, similar to a bank certificate of deposit.
Suppose Investor A is sold a fixed annuity with a guaranteed return of 3.5%. Investor B invests her money in a plain vanilla portfolio of mutual funds holding 60% stocks and 40% bonds, which has a long-term projected return of 6%.
The insurance company selling the annuity must earn enough of a return on Investor A’s money to cover their expenses, pay commissions, and return something to Investor A. There is no magic formula on how that’s done. The insurance company invests the money in the same asset classes available to anyone. For the sake of this example, it’s reasonable to assume the insurance company would hold the same 60/40 portfolio as Investor B.
The annuity incurs internal costs for administration, managing the money, insuring the return of principal, and commissions paid to salespeople. While these vary somewhat from company to company, a cost of 2.5% isn’t unreasonable.
If the company earns 6% and deducts 1% to recoup the upfront commission paid to the salesperson, 1.0% for management costs, and 0.5% for administrative fees, they pay out the remainder as a “fixed” return of 3.5%. Investor A only sees that 3.5% fixed return. If Investor A wants out of the policy before the cost of the up-front commission is fully recovered (usually 4 to 15 years), he will also incur a “surrender penalty” that is approximately equal to the remaining amount of commission paid to the broker selling the policy.
Investor B’s 60/40 portfolio will have the same 6% gross return as the insurance company’s portfolio. If Investor B purchases index funds from a company like Vanguard, her costs could be as low as 0.10%, leaving her a return of 5.9%.
Suppose Investors A and B each accumulate $1 million in retirement funds. The difference between Investor A’s guaranteed 3.5% return and Investor B’s average and unguaranteed 5.9% return is potentially an extra $2,000 a month in retirement income. Guarantees come with a cost.
Given these numbers, you may wonder why anyone would purchase a fixed annuity. One reason is that many buyers don’t have the confidence that they can invest the money wisely or the stomach to watch the portfolio’s inevitable peaks and valleys. Another reason is that most buyers don’t fully understand the costs.
Unlike stocks, bonds, and mutual funds, most annuities are sold, not bought. I have never had a new client who independently purchased a no-load annuity. The annuities I typically see were sold by someone who received a commission. Commissions are not inherently bad, but in most cases they do inherently create a conflict of interest.
There are always fees associated with any investment. In my experience, the less transparent those fees are, the higher they are.
A basic strategy for asset protection is to hold various assets in different entities. Putting real estate, small businesses, and other assets into trusts, corporations, or limited liability companies (LLCs) is effective protection that is relatively easy to put into practice.
Not only do I recommend this strategy to clients, I use it myself. Recently, however, I discovered a potential downside.
About 25 years ago, I invested in some rare coins in a corporation I owned and put them into a safe deposit box owned by the corporation. When my business relocated 12 years ago, the safe deposit box billing was not forwarded to the new address and was never paid again. Last year I went to retrieve the coins from the safe deposit box, which I had not visited in 25 years. I discovered the box had been drilled open three years earlier and my collection turned over to the unclaimed property division of the State Treasurer’s office.
I was told getting the coins back would be simple enough. I just needed to verify that I owned the company which owned them by providing the corporation’s tax ID number. However, the corporation no longer existed. I didn’t have a record of its tax ID number. The IRS wouldn’t verify the number without my giving them the address the company had used. That address was a post office box number that I no longer used and couldn’t remember. The state’s position was “no tax ID, no coins.”
The only verification of my identity as owner of the corporation was my signature on the bank’s safe deposit box application. Eventually, with the support of bank officers who were willing to swear that I was who I claimed to be, I got my coin collection back.
The hassle involved in this process was a reminder of an important component of asset protection. Maintain accurate records so you don’t end up hiding assets from yourself.
A good start is to create a master file of all the entities that hold your assets. This can be any system that’s easy for you to use: a computer spreadsheet, a set of file folders, or a single paper list. Share it as appropriate with your CPA, attorney, or financial planner.
The master list should include the name of each company, its date of incorporation, tax ID number, address, and other relevant information like phone or bank account numbers. Also keep an inventory of the assets each company owns.
Once you’ve created a master list, it’s essential to keep it up to date as you buy or sell assets, close companies, or transfer ownership. Set up a system, as well, to remind yourself of tasks like filing tax returns, completing minutes of annual meetings, and paying the annual safe deposit box rent.
Make your record-keeping easier by eliminating unnecessary complications. For example, you probably don’t need a separate address for each trust, corporation, or LLC. Instead of creating a separate company for each asset, you might consider grouping smaller assets within one entity. I’d suggest first discussing the pros and cons with an attorney or financial planner. For larger assets like real estate, I do recommend holding each one separately.
When I talk to clients about asset protection, I mention that part of the price we pay for it is an increase in paperwork. It’s easy to accept that idea with casual good intentions. The case of my reclaimed coin investment is a good reminder of the importance of keeping up with that paperwork.
If we don’t, we might protect ourselves right out of access to our own assets.
It may be entertaining to watch Donald Trump point his finger and curtly say, “You’re fired!” When a client says the same thing to me, it isn’t so funny.
I’m especially not amused if a client fires me because their diversified portfolio is underperforming the US stock market and they abandon the strategy. The result is often a financial travesty.
The February issue of “Inside Information,” Bob Veres’ financial newsletter, puts a name to this phenomenon: “frame-of-reference risk.” The term is used by Roger Gibson, Chief Investment Officer, and Christopher Sidoni, Director of Investment Research, of Gibson Capital in Wexford, PA. Veres reported on a presentation they gave at the American Institute of CPAs (AICPA) Personal Financial Planning conference in Las Vegas in January.
Gibson describes “frame-of-reference risk” as clients’ tendency to compare the performance of their diversified portfolios with current returns in the US stock market. He points out, “If the discrepancy gets too painful, they will fire you and abandon a diversified approach at the wrong time.”
Based on the emphasis the media gives the US stock market, one could easily conclude US stocks must be the largest, most important asset class in the world. Not at all. US stocks represent less than 10% of the world’s wealth and make up 10% to 20% of most diversified portfolios.
Neither do US stocks consistently produce the best returns. In the 1970’s, commodities dwarfed US stock returns. In the 1980’s, international stocks led the way. In the 1990’s, US stocks were the stars. In the 2000’s, the leader was real estate.
Yet most investors judge the performance of their portfolios by US stocks. They may compare the returns of a diversified portfolio with news reports about the S&P 500 and the Dow, which together include only 530 companies.
Between 1994 and 1999, Gibson’s multi-asset class strategy delivered a 13.05% return, which paled in comparison to the US market’s 23.55% return. He lost one-third of the assets he managed in 1999, as clients fired him. They abandoned their diversified investment strategy at just the wrong time to save themselves from the 2000-2002 US stock market downturn, when real estate and commodities soared. Gibson’s multi-asset class portfolios did 9.96% from 2000 to 2005, when US stocks rang up losses.
This pattern, familiar to many financial planners, is the sad consequence of frame-of-reference risk.
Another aspect of that risk is our human tendency to stay in a comfort zone where most of our neighbors are doing pretty much what we’re doing. One client even told Gibson, “I would rather follow an inferior strategy that wins when my friends are winning and loses when my friends are losing, than follow a superior strategy that at times causes me to lose when they’re winning.”
Unfortunately, this tendency can lead us into disasters. Diversified portfolios are once again underperforming the US stock market. Predictably, an increasing number of investors are abandoning diversification, right in time to get nailed.
Gibson and Sidoni’s conclusion seems to be that educating clients to stay the course is a no-win game. In their view, advisors need to craft a less efficient, lower-return long-term strategy that clients will consistently follow rather than a more efficient strategy that clients may abandon in mid-stream.
While that view seems pragmatic, it really misses the mark. Instead of dumbing down portfolios to match client’s dysfunctional money scripts, it would be a better outcome if advisors concentrated on helping their clients uncover and modify the money scripts that are driving their self-sabotaging behaviors. This approach can help keep clients from saying “You’re fired!” at the wrong time for the wrong reasons.
Giving away money makes people happy. Spending money on others makes people happier than spending money on themselves. Spending money on experiences makes people happier than spending money on things.
Does that mean it’s okay to max out your credit card to take all 37 members of your extended family on a cruise for Christmas?
Not exactly.
Yes, research shows that some kinds of spending are linked to happiness. Andrew Blackman cites some of that research in an excellent article, “Can Money Buy Happiness?“, published online November 10 in The Wall Street Journal.
Before you pull out the plastic and start shopping, though, there’s one important point to keep in mind: Any spending to create happiness must come from your discretionary money. This is money we have available to spend for our lifestyle, after we’ve paid all our fixed expenses like rent, loan payments, utilities, retirement contributions, building emergency reserves, insurance premiums, etc.
Discretionary spending can include luxuries or extras like eating out, vacations, gifts, entertainment, and gadgets of all types. But it also can include items that may be necessities or fixed expenses like housing, vehicles, clothing, and food. For example, owning a car is a necessity for most South Dakotans. However, a 10-year-old Toyota Avalon with 90,000 miles on the odometer, well maintained, can transport you just as effectively as a new model. The older model costs around $10,000; the new one costs around $35,000. The $25,000 difference is discretionary spending.
If you want more discretionary money for happiness spending, like giving or experiences, you might choose to spend more frugally on necessities. The other option, borrowing for happiness spending, generally doesn’t work. Research finds that borrowing and debt creates unhappiness that pretty much cancels out the happiness created by the spending.
Elizabeth Dunn, associate professor of psychology at the University of British Columbia and co-author of the book Happy Money, puts it this way in The Wall Street Journal article: “Savings are good for happiness; debt is bad for happiness. But debt is more potently bad than savings are good.”
In a series of studies, Prof. Dunn found that the spending producing the highest amount of happiness was spending on others. She found it wasn’t the dollar amount given but the perceived impact of the gift that mattered. Seeing your money make an impact in someone’s life will produce happiness, even though the gift is very small.
The impact experiences have on our lives may be the reason we gain more happiness from experiences than from material things. Even though we tend to see tangible things as offering more value, the memories and learning we gain from experiences actually provide more happiness.
Creating experiences can involve the purchase of some stuff. Buying baseball equipment with the intention of playing with your children is one example. Buying a camper or a boat for shared family experiences is another. Of course, buying stuff to be used in creating experiences only creates happiness if you use it. We don’t gain much happiness from sports equipment gathering dust in the basement or a camper abandoned in the back yard.
After reading this research on the value of spending on giving and experiences, I came up with what might be the ultimate happiness spending scenario: Giving the gift of an experience that includes both the recipient and the giver. While I haven’t found any research validating that hypothesis, I am guessing this may be the perfect happiness two-for-one.
Maybe, if you can afford it out of discretionary money, taking the family on that cruise isn’t such a bad idea after all.
It turns out money can buy happiness, after all—sometimes.
Having a good income and the security of money invested for the future don’t insure happiness, of course. They do, however, give us a foundation that can make it easier to find happiness. Part of the secret to using money to foster happiness is knowing what to spend it on.
First, spending money to lift your mood—the whole “retail therapy” idea—does not lead to happiness. It provides only a momentary sense of pleasure, which often in the long run fosters unhappiness.
There are ways to spend money that do create happiness. Here, based in part on several posts about money and happiness by Dr. Jeremy Dean on his site Psyblog, are a few of them:
1. Experiences. Research says you will find greater happiness spending your money on experiences rather than on stuff. Experiences live in our memories much longer and give us more emotional enjoyment than things, which can quickly lose their importance. In fact, just the anticipation of planning an experience often creates happiness. And if you want to take the happiness level up a notch, take a friend along with you.
2. Exercise. The number-one strategy people can use to feel better, increase energy levels, and reduce tension is exercise. Exercising can mean spending money on a gym membership, a personal trainer, and equipment. However, exercising can also be inexpensive. Walking, for example, requires little more than a pair of good walking shoes and—at least here in South Dakota—a warm winter coat.
3. Stuff that will provide you experiences. Buying things that create or are necessary for experiences count as happiness spending. Music is an experience that research says is a mood enhancer; even sad music can bring pleasure. Spending money on music might mean buying concert tickets, but it could also mean buying recordings, an iPod, smartphone, speakers, and similar equipment.
4. Stuff that supports doing what you’re good at. What are you good at and really enjoy? PsyBlog says spending money for things you excel at typically creates happiness. A set of golf clubs and a budget for green fees could be a great purchase if you’re good at golf—or even if you aren’t so good at the game but you enjoy it for the exercise and time with friends. The same goes for buying things to support hobbies, such as art supplies, garden plants, or quilting fabrics. Maybe you enjoy helping others, so charitable giving or spending money on volunteer opportunities would increase your happiness. I love researching almost anything, so spending money on research data can be a mood lifter for me.
5. Coaching/Therapy. Few things are more valuable for long-term happiness than hiring a good coach or therapist. Research shows talk therapy to be as effective as or better than antidepressants. In my co-authored book, Conscious Finance, I describe how spending $80,000 on therapy was the best investment I ever made in my own happiness and well-being.
6. Meditation. The biggest happiness bang for your buck might come from meditation. It isn’t free, but it’s very inexpensive. You will need to attend a class or buy an instructional video or book. I recommend Open Heart, Open Mind by Thomas Keating, but there are many others.
While we know that money by itself isn’t a source of happiness, we also know that having enough money to comfortably meet our basic needs does make us happier. In addition, we can consciously choose to spend in ways that buy happiness. Such investments may not provide financial returns, but they can provide significant happiness returns.
Over the years, I’ve noticed a commonality among people with money problems. Many of them are also overweight. Is there a relationship between overspending and overeating?
Until now, I couldn’t be sure my experience was anything more than circumstantial. But I recently read about a 2009 study done by Dr. Eva Munster at the University of Mainz in Germany. It found that people who were in deep consumer debt were 2.5 times more likely to be overweight than those who were debt free. This confirms what I’ve observed over the past 15 years.
It isn’t possible to pinpoint one simple reason for this link. Among the causes I’ve seen suggested are overeating because of the stress of being in debt, difficulty buying healthful food with limited income, or an inability to delay gratification in both spending and eating.
Based on my work with people in financial trouble, however, I suspect a deeper root cause. Just as chronic money problems aren’t about the money, chronic weight problems probably aren’t about the food.
For supporting evidence, I went to an expert: my daughter. London recently took a graduate level course in previewing medicine. I asked her what the medical link between overspending and overeating might be. She explained that sugar is addictive and lights up the same part of the brain that narcotics do. It produces a euphoric response within the brain that calls for more of the substance when the euphoria subsides.
She wondered whether people addicted to sugar might overspend on junk food to feed their addiction. They might also spend money they really don’t have on diets, fitness centers, and the higher medical costs associated with being overweight.
I pointed out that I spend a lot on healthy food that costs more than junk food. I also spend money on a fitness center and medical costs to pay for the damage I do to my body compulsively working out. “Well, I guess my argument doesn’t hold much weight,” she quipped.
She pondered for a moment. “Oh, I think I got it. I’ll bet for some people spending money lights up the same part of the brain as sugar and narcotics?”
Bingo.
That is why the key to changing any addictive behavior—eating, drinking, using drugs, or overspending—is not simply about eliminating the substance or the activity. Something else just pops up to take its place. That’s why many people who successfully stop drinking gain weight or get into serious money problems. The brain just substitutes one dopamine producer for another.
The ultimate answer is a sort of “rewiring” of the brain to create new neuropathways that do not require the harmful substance or activity to produce the same euphoric event. The latest research on the brain tells us this rewiring is completely doable.
I’ve seen that permanently changing the most entrenched damaging money behaviors takes more than knowledge about money or budgeting. Experts on obesity tell us the solution to permanently losing weight rarely lies with learning more about nutrition or finding the right diet. Making deep life changes such as these requires looking into the past. This recovery process takes time, effort, and money. It’s a path that many people are just not willing to follow.
But there may be some good news. If the underlying causes for overeating and overspending are the same, then doing the work to recover from one is likely to help someone recover from the other, as well. It’s a sort of “two for the price of one” sale. In terms of long-term financial, physical, and emotional well-being, it seems like a bargain.
“Buy low and sell high.” That was my simple approach when I was a smart young investment advisor. I poured over a company’s balance sheet, earnings statements, and forecasted returns. Then I bought those companies that were bargains and waited for my gains to roll in. More times than not, they did—eventually.
The problem came with the “not” and “eventually.” A majority of my picks did go up in value, but the minority that were “nots” still lost enough to have a negative impact on my bottom line. Even more frustrating, some of my “nots” turned into gains “eventually” after I sold them.
My investment returns were similar to findings from Dalbar, Inc., a financial services research firm. Dalbar’s studies have shown that average active investors barely beat inflation over the long term. They significantly underperform investors who put their money in an index fund of stocks and leave it alone.
So much for my early investment brilliance. Continue reading
Conscious Finance 