Risk and Reward

When most people think of risky things they think of the bad things that can happen. Thinking only in terms of “bad things” is an incorrect application of risk. The technical definition of risk is: the amount of uncertainty in the outcome of an event.

This definition of risk relates to the efficient use of capital through investing, because the amount of uncertainty in the return you are expecting from your investment is directly correlated to the amount of return you will get. I know that sounds confusing, but stick with me this gets good. Think of it this way, if a bank offers you 1% return on your investment you should expect to get exactly 1% return on your investment. If you invest in the stock market you should expect to get around 7% return on your investment.  Unlike the bank, the stock market return is unpredictable.  Your actual return on investment can range from +45% and -35%, but on average you can expect your long term investment return will be 7%.

To demonstrate this concept I’ve drawn the picture below. The far right of the picture shows what the stock market expected returns looks like. People are averaging about 7% a year, but they experience years where the return of +45% and other years where the return of -35%. In the middle I’ve shown what the bond markets expected return looks like. On the left of the image is what a typical government bond would look like. If we took it to the extreme left a bank savings account would have no distribution. It would just be a flat line because you are going to get exactly the return the bank tells you. No more no less.

Risk Return

 

So how can we use this concept to manage our capital more efficiently?

By planning when you will need to use your money you can invest at the appropriate risk level. For example if you don’t need your money for another 35 years you should be willing to take on a large amount of risk, because the investment carries the highest long term average return. Sure you will have bad years where you lose more money than you’d like to admit, but you will also have amazing years to go with it.

If you need your money in a few months to buy a car don’t invest it in the stock market. Yes, you could end up driving a Porsche, but you might also end up having to buy my neighbor’s car.

The Porsche

 

Beater car
My Neighbors Car

 

 

 

 

In a future post I’ll cover negotiation to help you get a really good deal on my neighbor’s car, unless he reads this also. Please subscribe on the right hand side of this post so you get that update.

 

Be Efficient with Capital Through – Your Company 401k Match

The other day at work a group of my coworkers and I were discussing our 401k options.  An informal poll took place. I asked my coworkers if they participated in our company 401k, if they knew what amount the company matched, and if they were getting the full matching amount.  I was surprised to find out that not everyone was taking advantage of the company match on our 401k. I am generally not a very judgmental person and I managed to keep my mouth shut, but I really wanted to scream, “WHAT ARE YOU THINKING!?!?!”

Today I am going to walk you through the math of why If you tell me you aren’t getting your company’s full 401k match I am going to silently judge you. Every company is different so it is important to understand what your company benefits are exactly. Getting the full match from your employer means you are contributing enough to meet their requirements to give you the most they will give you.

Let’s say my coworkers were earning an average mining salary of $88,000.  Let’s compare one coworker who is getting the most they can get in company match to one who isn’t getting any company match because they aren’t participating. In this example we will say the company matches all 401k contributions at 50 cents on the dollar up to 6% of your salary.

First we will start by calculating their taxable income. *Note that company 401k match isn’t subtracted from base pay when calculating taxable income.

Table 1

Next we will look at both of my coworkers take home pay after taxes.

Table 2

At this point you will notice the full match coworker has a $4,000 lead over the no match coworker in Gross after Tax plus 401k.  This isn’t a fair comparison because all the 401k money is before tax.  So now we’ll look at what would happen in a worst case scenario where the full match coworker had to take all their money out of their 401k and pay the full penalty and all their taxes to get use of the money.

Table 3I hope at this point you are convinced that your employer matching is the best return for the risk you’ll get on any investment.

So to close I have an offer for my non-contributing coworkers (you know who you are). If you happen to read this post, I would be willing to give you the money upfront you need to start contributing to your 401k and getting the company match and in return you pay me back in full at the end of the year and we split the efficiency bonus money. I am willing to offer a 50:50 split since I am such a fair guy. This would result in wins all around. You win because you wouldn’t see any difference in cash flow. I win because I get half the newly created bonus money. You win again because you also get half of this newly created bonus money.

Image: iStockphoto

Be Efficient with Capital Through – The Emergency Fund

Personal finance experts throughout the land will tell you that you need to have an emergency fund. Today I am going to discuss the reasons behind having an emergency fund and what we can do to optimize it.

The purpose of an emergency fund is to act as a risk mitigation tool.

An emergency fund is a form of self-insurance. If you need to use it you are sure glad you had it, but if you don’t need to use it you would have been better off doing something else with your money.

There are a huge number of risks people and businesses face each day that warrant keeping an extra bundle of money in a very liquid form (cash). The most commonly cited example I hear from people is that they are keeping 3 to 12 months worth of expenses in cash in case they lose their job. I think this is a great reason to keep some extra cash around to pay for everyday living expenses while you figure out where you are going next.

Too much Emergency Fund

I’ve had a few people ask me what the drawbacks of having a much bigger emergency fund is. The answer is that having extra money sitting around in the form of cash is not productive. There are far more efficient things your capital can do for you (i.e. investments) rather than sitting in a bank account collecting the minuscule interest that a bank will pay for your cash deposit.

Some of the best interest rates for bank cash deposits I have seen are currently around 1%.

Too Little Emergency Fund

Let’s say you have zero emergency fund. What happens when you need to pay an extra car repair bill you didn’t plan on? Since your car mechanic doesn’t accept homemade cookies as payment (I do) you’ll have to pay him with some form of a loan. Let’s say you use your credit card, but you aren’t able to pay the balance at the end of the month because you don’t have any leftover cash. This means you are going to be paying interest on whatever the cost of the repair is.

The average interest rate of credit cards is between 15% and 22%.

The Goldilocks Zone for Emergency Fund

The Goldilocks Zone is the amount of money where you strike a balance between your lost opportunity on the money that only makes 1% in a bank account and the amount of money you have to pay a high interest rate on because you don’t have the liquidity needed to cover expenses in an emergency.

No single answer is correct for everyone. Let’s look at some factors to consider that can help guide you towards the best decision.

  • How secure is your current income? If your current company is posting great profits and you are a valuable part of that team you might consider holding a smaller emergency fund. This isn’t a set it and forget it situation though. If circumstances in your company change, you need to be aware and give yourself additional cushion.
  • How easily could you find new source of income? If you have skills that are needed by many businesses you might consider again reducing your emergency fund.
  • How old is your car? Your house?
  • Do you have any concerns with your health or your family members’ health? How old are you? What are your health risk factors?
  • Look back at your old income statements and see how often you have large  unexpected spikes in expenses.

Do you have a smaller or larger emergency fund? Have you thought about why? Let me know if the comments.

Measuring Efficiency with Money

This week I’m excited to start talking about the efficient use of capital. The efficient use of money is a topic that I think gets far too little lip service in everyday conversation.

How you use your money is a direct reflection of either your mission, vision, or values.

I want to begin by discussing a few tools that can be used to measure the efficient use of money.  On some level everyone has a SMART goal related to using money more efficiently.  The Specifics, Achievability, Relevance and Time bounds of the SMART goals vary slightly for every person, but Measurement is the same.  Therefore, I want to focus on a couple of tools used for money and the “M” of the SMART goal, Measurement.

  1. The first tool is called an income statement.

An income statement is a measure of all the money you earned in a certain amount of time subtracted by all the money you spent over that same time period.

Prepared and reviewing an income statement has two primary effects:

  • Makes you aware of all the places you are earning money as well as spending money.

Being aware of where you are spending money can quickly alert you to spending that is not in alignment with your values.  Being aware can also help you identify opportunities for improvement.

  • Tells you if you are making a profit or going further into debt.

Earning more than you are spending means you are making a profit. Spending more than you are earning means you are digging yourself a hole. I will let you figure out which one is better.

  1. The second tool is called a balance sheet.

A balance sheet is a measure of how much you are worth at a certain point in time. It is calculated by adding up the value of everything you own, these are called your assets, and then subtracting the amount of money you owe, these are called your liabilities. The difference between these two numbers is how much you are worth, called your net worth. In accounting terms, it is also called owner’s equity.

The income statement and balance sheet are two financial documents that help us measure the current state of our finances (money) as well as help measure any future improvement. I have been creating a personal monthly income statement and balance sheet for almost a decade now.  I find them extremely helpful with understanding where my money is and where it is going.

Do you have questions about how to get started with using or creating these tools? Do you use them in your personal or business life? Let me know in the comments and if you haven’t already subscribed please do so over on the right.