Monthly Archives: March 2012

A neglected asset class – stuff that saves you money

A big part of being able to retire or work truly voluntarily is having enough non-work income to cover your living expenses. That requires assets.

We all know about cash, bonds, shares, real estate, precious metals and the like – it’s easy to recognise them as assets. As with a few recent posts, I want to draw attention to the importance of reducing expenses. This time, by looking at spending money to save money AKA investing in the ‘stuff that saves me money I’d otherwise have to spend’ asset class.

Things like replacing your cafe coffees (if you don’t want to forgo coffee altogether) with a decent home machine that will reduce your spending year after year. If a $100 machine can reduce your coffee spending from $1000 a year to $200 a year, that’s an 800% return on investment. Even better, a $20 stovetop espresso machine can do a pretty decent job.

Like buying $200 boots and getting 10 years out of them for an annualised cost of $20 per year rather than getting 12 months out of a $50 pair. After 10 years, you will have $300 more in your bank account by buying quality, and you will have been much more comfortable in the intervening period (paraphrasing a quote I read but can’t relocate…)

Or spending more up-front on CFL light bulbs in order to save on electricity every month – depending on your electricity and CFL costs, you could make 100% per annum or more on the little bit of money you put into CFLs. If only there were lots more ways to spend money with that sort of return!

You can create your own ‘supermarket at home’ by finding a bulk supplier (Costco, Sam’s Club and the like, in the States) and some buckets and buying in bulk those items that you use and that will store well. You might be ‘spending’ a thousand dollars or so, but in reality you’re pre-paying grocery bills you’d otherwise pay, with the sweetener of a discount of maybe 10-30% – and the added convenience of having to go to the store less often.

Tools are an area I’m still learning about. We’ve all heard about quality being remembered long after price is forgotten, and about the hand plane that’s been handed through five generations. However, cheap versions of tools can be dramatically cheaper to buy than good brands, and the quality may not be very different. And sometimes even if the quality is different, the number of times you will need to use an item just doesn’t justify the extra spending. I’ve been caught out several times recently, thinking I have optimised tool purchases and being unpleasantly surprised when a tool failed far quicker than anticipated (e.g. a pad type brush that lasted for about ten square feet of ceiling) OR couldn’t actually do the job it’s intended to (e.g. a roller that didn’t roll properly) OR made it hard to do a good job (e.g.  a circular saw that didn’t cut very straight). That’s not counting lost productivity from purchases I didn’t make, thinking that I could do without or not knowing I would need them – forcing me to wait until I could make another trip to town. Still, I’m learning and it’s likely the lessons will be applicable to other areas of my life in some ways.

This is an area of financial optimisation where the person who already has a decent amount of available cash does have an advantage. Some people are in tight enough spots that they can’t see their way clear to investing $50 in light bulbs, let alone $200 on a pair of boots. All I can suggest is to try to think long-term, and find a way to make a sacrifice that will allow you to invest in these assets – in the end, they will allow you to keep more of your cash in your pocket. Spend now to save later! Sounds scary, but you know what I mean.

Look over all of your spending and try to find areas where you could invest to save money over time. For each line item in your bank statement or budgeting software, think ‘How could I spend less on that?’ Cut it out altogether, downgrade, find a cheaper source, invest more up-front to reduce your overall cost, look for discounts and so on.

Net worth isn’t the point

I don’t like the phrase ‘net worth’ – a person’s worth is very different from the difference between their financial assets and liabilities. As the phrase is in common usage I will have to put up with it!

Many people eager to retire focus far too much on growing the net worth number, thinking that they will be ready to retire when it hits $500,000 or $1 million or $10 million.

Income-generating and money-saving assets are vital for the Voluntary Worker, but as I explained in my earlier post on the Voluntary Worker formula, net worth is only one part of the equation. The rate at which you consume dollars is equally important, and in my opinion it’s the better place to apply your focus. Every time you learn how to spend less you are automatically accelerating the growth of your net worth, and through compounding that growth does some growing of its own.

I”ve used a bucket analogy before. Focusing on the level of water in the bucket (net worth) is OK, but a full bucket with a huge hole won’t stay full for long. If, on the other hand, you first attend to patching the holes, it will soon overflow even with modest income filling it.

Not a perfect analogy, but I think it has some merit!

Focus on the ratios of your work income, non-work income, total income and assets to your annual spending. Those are some of the most important financial ratios in your Voluntary Worker plans, and annual spending is the denominator that slashes them. Reduce the spending, and everything will look rosier in short order.

You may be thinking that this is completely self-evident – and it is. However, the majority of workers never really get this connection and the power it has for freeing them up from Forced Work. In some ways it’s an expanded appreciation for the virtues of frugality.

Try it – it’s quite amazing how circumstances shift when there is an increased focus on apparently petty expenses.

Give yourself a 111% raise

You’ve probably heard of the ‘latte effect’ – the long-term impact on your finances of small expenditures like a daily cup of coffee that doesn’t come from your own kitchen.

I like to use similar mathematics to figure out just how big a raise I can give myself – same job, same boss, no negotiating.

So how does it work?

If I earn $10 after tax in one hour and I have to spend everything I earn in the same month or the same year (definitely NOT a Voluntary Worker yet), that $10 will buy me exactly $10 worth of whatever it is I need to consume – let’s say ten $1 chocolate bars.

If I am already a Voluntary Worker I can give myself a 111% raise.

Because I don’t need to consume that $10 straight away, I can tuck it away somewhere it should outstrip inflation e.g. a high interest bank account. It then sits there growing until I chose to use it. If I leave it for 25 years and it grows at 3% after accounting for tax and inflation, then when I come to use it the fruit of my hour’s labour has swelled to $21.15. That’s 21 chocolate bars, an increase of more than 111 percent!

25 years is a long time, but it’s well within my expected lifespan. I fully expect to set aside many of the dollars I’m earning now for at least that long, so it’s not foolish to be thinking about my earnings in this way. It’s an encouraging thought when work drags!

Another motivating thought is the income stream that can flow from earned dollars that don’t have to be spent. If my money is growing at 3% after tax and inflation, then every ten thousand dollars I earn and don’t have to spend is equivalent to a $300 per year income stream for life.

Although this maths is fun, it does encourage the assumption that savings in the bank or in the stockmarket are free from risk (wrong in both cases) and that inflation always trundles along at 1 or 2 or 3 percent (also wrong). This article is about the benefits of deferred spending, not a treatise on risk and inflation, but do consider yourself nudged to think about these matters!

Feel like an intravenous shot of motivation to work? Have a think about what happens if you put your $10 towards a small business returning 25% per year (good but very possible). That $10 will put another $2.50, before tax, into your pocket every year, and that’s just the cash flow! The underlying business is likely to grow in value, squeezing even more out of your $10. Let’s say you put $100,000 into a business, take out $25,000 per year as profit and sell the business after 10 years for $150,000. Every $10 you put in at the start has returned you $25 before tax and inflation, as well as bringing you $15 when you sell. Obviously there is work and risk involved, but a side business like this is the fastest way I know to become a Voluntary Worker.

Why Early Retirement is the wrong idea

I’ve mentioned before (in my inaugural post) that I started writing articles here partly because so many early retirement enthusiasts, both bloggers and commenters, are focused on permanently ceasing work at the earliest possible moment. (Or at least that’s the impression you’d get if you read early retirement blogs for a few hours – I’m sure there are many exceptions, and I know Mr Money Mustache still values hard work.)

What’s wrong with hanging out to hang up tools?

Well, there are much worse things than wanting to retire early, but I believe that work has value intrinsically – that it’s a good thing for humans to do. A person who loafs through life – and there are plenty of people who do, ‘retired’ and otherwise – is cheating themselves of the enormous satisfaction that comes with productivity. If by mastering the Voluntary Worker’s formula a person manages to free themselves of the burden of having to work, that’s great. But I think that person is probably making a mistake if they immediately and permanently stop working. Confusing? I hope not – read this if it is!

A quick aside: There may well be a scary lesson lurking in conventional retirement, too. How about this for a super-scary paper title? Links Between Early Retirement and Mortality Please note that I have NOT bothered reading the paper, as it does not apply to my life and I am not concerned with creating a scientific argument for Voluntary Work. If you are interested, though, you might like to look at this, this and this, and make up your own mind. For what it’s worth, I don’t find any of the results convincing enough to bother considering in making this kind of decision. However, I believe that some questions just aren’t amenable to empirical study, and I certainly believe that some people retire and go dramatically downhill as a consequence. What we should all be thinking about is how to thrive once we do stop work, of course, whether early or ‘late’. Any study of this sort will include people who stop work early and thrive, and people who thrive working until late old age.

From some perspectives it might sound like I’m splitting hairs, but I think the ‘Early Retirement’ buzz phrase is a little unfortunate. Of course, the idea of retiring gets people excited, and the idea of retiring in one’s thirties sounds like heaven to most – so the buzz phrase gets attention. I’m pleased that there are people writing about early retirement, because it’s getting out the message that it’s not compulsory to take on debt to drive a fancy car, that houses are still houses under 2500 square feet, and that you’re not defined by the brand of toothpaste you buy. But I think the focus on ‘making work voluntary’ is preferable (obviously. I have a blog called The Voluntary Worker. Ahem…)

Readers might have come across the concept of ‘Get out of my face money’ (OK, I’m sanitising this – use your imagination) – the idea that having a stash of cash gives options in the workplace e.g. if the boss is just too unpleasant about your TPS reports, you can quit and live off your $10,000 emergency fund for a couple of months (given the rate at which most people burn through cash, that’s probably not too far off!) It’s a start, but the Voluntary Worker has taken it to the point where it’s really powerful – any time, for any reason they see fit, the Voluntary Worker can cease working. For as long as they like.

I will expand on these points in coming articles, as I don’t think the significance of what I’m saying is easy to get from a single reading. Not that it’s profound, but it’s very different from the default work-til-you-are-at-least-65-because-you-have-to option, and from the buzz about early retirement. And to be a Voluntary Worker without making or inheriting very large amounts of money, you have to pay close attention to the direction you’re headed, so the details and nuances take on some importance.

I’ll finish with an observation about early retirement followers. Authors and commenters are sometimes leaped upon (figuratively, by way of comments only as far as I am aware!) by would-be or already-are early retirees when work is mentioned, with comments along the lines of ‘Aha, you’re not truly retired! What is this, I thought you said this was an early retirement blog!!’ And at one point (before I properly got my head around the beauty of Voluntary Work, of course, and realised work is something to feel great about) I was composing a comment myself and noticed that I felt self-conscious about mentioning that I still work. That got me thinking that there was something not quite right with the picture. ‘What is wrong with voluntary work?’, I thought. And two capital letters later, I dubbed myself a Voluntary Worker.

How to make work VOLUNTARY Part Four – Save and invest

If you’ve followed me through the previous parts on understanding the formula of the Voluntary Worker, living frugally and staying out of debt, you’ll know know that the core of getting to Voluntary Worker status is living on as tiny a part of your income as possible so that you can save lots and lots, until your non-work income exceeds your expenses and voilà – you have become a Voluntary Worker.

To my mind, how you go about storing your surplus is surprisingly unimportant when compared with the enormous importance of having a surplus in the first place. That’s right, I’m saying again just how important it is to live frugally and avoid consumption traps.

Anyway, that’s not to take away from the fun and satisfaction that you can get from squirreling away the results of your hard work and frugality. It’s wonderful to see bank accounts swell from week to week, and to reach targets you have set yourself for savings.

As with the other articles in this series on how to make work voluntary, I’m setting out to give you an overview rather than trying and failing in providing a definitive guide complete in every detail. I can’t know every reader’s circumstances, and in any case a big part of the puzzle is YOU learning how to understand and then address the parts of the puzzle – and thankfully there are only a few of them.

I do think it’s important to mention that in modern times we’ve all come to accept the notion that surplus money must be invested – that is, placed at risk in the market in the hope it will increase in value and will be returned when needed. Somehow the idea of preserving one’s purchasing power in a risk-free way has vanished from our collective financial consciousness, and we’re all addicted to finding the bank account with the highest interest rate (banks are certainly not risk free) or the portfolio with the highest returns (I shouldn’t need to say anything at all about risk in stock markets). Perhaps our aversion to trying to simply save has got to do with the covert taxation of currency savings that occurs through monetary inflation. But that’s a topic for another blog. I do encourage you to think about it, though, and to consider assets that can protect your purchasing power without counterparty or other risks.

What’s my approach? I like to store money in high interest bank accounts if I may need it in the next few months to a year. I am always on the lookout for good small businesses, though these are sadly very rare in my local market. I would like to add productive land to our portfolio in the future, and rental properties.

If you’ve read much about investing in the past, you’re probably wondering why I’m not talking about rates of return, or volatility, or asset allocation theories. Well, my perspective on what constitutes an acceptable return has changed since I’ve become a Voluntary Worker. Previously I might have sneered at the idea of a rental property returning 5% if a bank account could give me 4.5%, but now that I have enough to live off, I am more interested in having a diverse range of investments. I think about these things more as a series of nets through which I hope never to fall into Forced Work. Mr Money Mustache has a pertinent article on safety levels that I recommend reading for more on this topic. I’m no longer much of a fan of Warren Buffet, but he has made famous the idea that return OF capital is much more important than return ON capital – on this point I think he is completely right. I want to store my surplus somewhere I feel sure I can retrieve it, and I want it spread around so that I have (a) an array of income sources that keeps me interested and (b) some protection against calamities.

On the topic of portfolio theory, I will just say that I have not come across anything I’ve liked better than Harry Browne’s Permanent Portfolio, chiefly because it makes explicit the fact that we cannot know the financial future, and it does not aim for crowd-beating returns. I do not use the Permanent Portfolio myself. There’s lots of investing information at the Boglehead’s Forum.

PS I can’t help adding one other point, and that’s to be aware of the importance of fees in determining your final return. Many accounts look good from a distance but are decidedly unpalatable when you calculate the impact of fees of various kinds.

Have fun stashing your surplus!

How to make work VOLUNTARY Part Three – Avoid debt like the plague

In one sense, debt is just another expense. However, as well as nasty interest payments, it brings an even nastier inflation of your consumption beyond your means.

Again, there are many blogs out there that explain the evils of debt. For now, suffice it to say that you should NEVER go into debt for anything except a house (I am reluctant to even include that!) or a business. Certainly NEVER NEVER NEVER for any sort of consumption e.g. car, clothing, travel or whatever other crazy things people pretend they can afford by getting into debt.

It took me years to figure out why I always got confused when business books would talk about optimal levels of debt for maximised profits, and why I got chills when real estate books talked about leveraging A to buy and then leverage B. It’s because it makes no sense in the real world. It’s an example of things in the financial plane getting frothy, artificial and unhealthy. Thank goodness I largely avoided the perils of debt, albeit more by good luck than good management initially.

I did, though, have a line of credit with a bank when I started my business. It was a very big mistake. For years that line of credit trundled along at $25,000 or $30,000 or $27,000 or $40,000 in the red – up and down from month to month. Because that was nowhere near the limit, it never worried me (although it should have!) and because I was free to increase and decrease my level of indebtedness at will, I never focused on paying off the ghastly thing. When I came to my senses at 31 or so, I realised what a drag on my finances it represented, and after several YEARS of unnecessary interest I paid off and closed the facility in a matter of months. I have never put myself through the pain of calculating just how much money I flushed away in interest, but I have a good enough idea of the size of the loss that I won’t ever fall prey to a mushy target like that again. Incidentally, after seeing the idiocy that it reduced me to, I’m convinced that banks just love to persuade people to save pennies on interest by setting up a big debt trap of this sort in conjunction with a business loan or a mortgage on a house – you might save a few dollars in interest by having all income go into a line of credit type account, so that the balance is a little lower when averaged over the month, but you will likely lose thousands and thousands of dollars through the fuzziness of thinking that can result. I’m not a stupid person, and I’ve always taken an interest in finance, and yet I was no match for the line of credit. My new Voluntary Worker self, however, remembers the painful lesson.

We have no debt and I don’t plan to ever go into debt again as long as I live. (Actually, I would be OK with taking on a debt equivalent to maybe 25% of our total assets if it made it possible to secure a great business. But I shudder a little bit at the thought and would take it VERY seriously.) If you wish to become a Voluntary Worker, I believe you will be very well served by joining me in a healthy hatred of debt.

How to make work VOLUNTARY Part Two – Live way below your means

In Part One, we looked at the simple relationship between income-producing investments and annual spending, and my rule of thumb that investments must be 40 times annual spending if work is to remainly truly voluntary for me.

Now we move to a vital part of becoming a Voluntary Worker – frugality, or the art of living on a little.

If you think back to the basic equation, non-work income must exceed annual spending. As I said in the earlier post, I think the most important place to get started is reducing spending. If you’re bleeding money every month, you won’t have anything to invest, or at least nowhere near as much as you should.

Imagine trying to fill a big bucket so that the overflow can fill your cup. You can keep filling the bucket (earning income) as fast as you like to no avail if the holes in the bucket (spending) are too big. You need to focus first on fixing the holes, and THEN your bucket will fill quickly.

There are hundreds of articles out there on frugality, and it’s well worth reading lots of them. I’d recommend starting with Early Retirement Extreme and Mr Money Mustache, and it’s worth looking at the Tightwad Gazette to see what some people do in order to save money. It’s up to you to figure out just how frugal you want to be. The important part for now is to commit to learning how to spend less money, so that you can take it to the extent that fits your income, desired lifestyle and desired date to become a Voluntary Worker. Read, read, read – and put into practice those frugality tips that make sense to you. The big ticket items are usually housing, heating, transportation, groceries and sometimes dining out.

Again, your goal is to learn how to save money and then get stuck into doing it in the ways that are palatable to you. You’ll be amazed at how much your spending can be trimmed without having a significant impact on your quality of life. Just getting conscious about spending reaps big rewards.

Some examples of savings that we make in order to live way below our means:

  • We drive a very economical car and combine trips where we can.
  • We shop at the cheapest supermarket in town, and we stock up when items we use are deeply discounted.
  • We borrow if we can; buy used if we can’t borrow; and buy wholesale if we can’t get it used. New from Ebay is next on the list, and retail is a last resort!
  • We live in a modest but charming home of about 1000 square feet.
  • We use CFL bulbs, no heating (we live in a temperate climate) and we’re pretty good at switching things off at the wall when they’re not in use.
  • We use cloth nappies and wipes (mostly).
  • We very rarely buy clothing new.

There are dozens of other areas in which we save, and maybe later I’ll put more of them into an article. For now, you just need to know that you need to get out there and learn how to get maximum value from every dollar, and to prune, prune, prune your spending.