brian, Author at Speed To Freedom

Exponential Growth Here We Go!

9 minute read

It’s now a tradition for bloggers to do year end write-ups and forward looks. This post certainly aims to pull together threads of a 2020 review and a 2021 look ahead. I’m also introducing a demonstration of exponential growth and a trade-off between two different modelling approaches. Let’s begin. while my general sentiment is to say, “Good riddance” to 2020, we’re super privileged to have escaped mostly intact (knocks on wood)…

Let’s start with what matters most:

Health

We’re healthy, all of us. We took as many precautions as we could to minimize our Covid19 risk throughout last year. We’re patiently waiting for our turn to get vaccinations and look forward to some semblance of normalcy. Our hearts go out to the millions of families who have lost loved ones and to the millions more whose lives have been upended.

We survived the in-hospital birth of our second child. We now have two healthy girls! After a significant scare with my wife’s health post-delivery, I have a healthy partner again. I am so grateful to have healthy girls in the house.

Next, as this is a website about the journey to financial independence, let’s talk money.

Wealth

I actually wasn’t planning to write a 2020 review/2021 forward look. But, then I stumbled onto a thread at boggleheads about the shape of folk’s net worth curves. I think this is a fascinating topic and worthy of exploration. As we’re still starting out the 2021 calendar year, I was inspired to reflect on several lessons from 2020 and look forward to 2021 and beyond.

Exponential Growth Is Real

The path for financial independence feels like a marathon. But, unlike a marathon, the first miles on your journey to financial independence are the hardest. We scrimped and saved to pack pennies into our accounts only to see minor or maybe modest gains year over year. It felt like financial independence was totally out of reach. But, through the steady inspiration and encouragement of the online personal finance community, we kept at it. We’re not there yet, but that exponential growth curve makes me do a double take every time I see it.

Here’s a plot of our net worth since I started tracking it in 2009.

While it doesn’t feel life altering yet (in part because we cannot touch most of our net worth), it sure looks like we’re on an exponential growth curve, even with our conservative asset allocation. Why do I think this: a little statistical concept called standard error.

Standard Error

I’m not going to delve deeply into stats here, but this concept is useful here and will be again in many of the other topics discussed. Standard Error is a measure of spread. It tells is how much distance is between a group of data and some statistic. In this case, we’re looking at how far the points are from the fitted line. When comparing different models, smaller standard error (less distance) means the fitted line is likely a better fit for this data.

Let’s try it. We see the fit and standard error for the exponential growth model. Here’s the same data with a linear fit. Just eyeballing it, you can see this line doesn’t match the data as well. Standard error calculates the distance from the fit line to each point. Models (lines) with better fit have smaller standard error.

A linear growth model of net worth. Notice how the standard error is worse than an exponential growth model. — Linear regression model fitted to our net worth growth over time. Not such a good model, but in this case, I’m OK with that.

Take a look at the exponential model again, especially at the most recent months. The most recent points are consistently above the fitted line. You could attribute this to our investing genius. Or, maybe irrational exuberance round 2. This model is not perfect either. We need to be very careful not to extrapolate too far into the future lest the difference between the model and reality becomes too big. I don’t think we’ll be 401(k) billionaires in 20 years!

Between the two models, it’s obvious that exponential growth is a better fit, both visually and using math. Now that we can measure our net worth growth and fit a decent model to it, let’s dig into why the shape of the curve looks the way it does. We’ll also discuss what we could be doing differently to change the shape.

Analysis: Why Our Net Worth Is At An All Time High Despite The Pandemic

Despite the worst health crisis in a century, our net worth is at a record high. Why?

We kept our jobs
We benefit from the booming equity market
We benefit from the booming real estate market
Our rental business has lower but still positive cash flow

We Kept Our Jobs

Let’s take each in turn, starting with our jobs. Like it or not, our jobs provide 90+% of the income into our lives. Therefore, as much as I grump about being a W-2 employee, these revenue streams are important! We both work hard to contribute as much value as possible to our employers in the hope that they will continue to provide gross income in exchange.

Call it fate or luck, both of us have continued to be gainfully employed throughout the pandemic (knock on wood!). This means our ability to save/invest/grow net worth continued throughout the pandemic. One of my favorite pod-casters has a whole series on why the number one task of any employee is: “Don’t lose your job.” Obviously, that can be easier said than done depending on the industry and ones’ specific circumstances. Regardless, the number one priority for each of us is to maintain our respective revenue streams.

We Benefit From The Booming Equity Market

While we’re not 401(k) millionaires (nor “Teslanaires”), we have consistently invested in a broad mix of index funds for the past ~20 years. (OK, OK, we do have some “dumpster fire money” in individual stocks). That said, we’ve largely maintained an asset ratio of 60% stocks and 40% bonds over this period. We re-balance when things get too far from that mix. I know: it’s boring. No options trading. No short selling. I couldn’t even tell you what a put or a take is. And, I don’t really care. What I do care about is the overall growth of the equities market, namely the S and P 500 and the total market indices. Their values have exploded relative to the values of our other asset classes (e.g., bonds, cash, and real estate).

If I am honest, over the past several years, stocks have been the main engine of our net worth’s exponential growth. We keep these other asset classes around for when the market inevitably turns. But, just like JL Collins says, “Toughen Up Cupcake.” Embrace the volatility that comes with exponential growth via the stock market.

We Benefit From The Booming Real Estate Market

Speaking of other asset types, real estate remains my favorite. I love the tangibility of it. I love the chance to provide meaningful value directly to other people. I love the way the government treats it when tax time rolls around. Thus far, we only have one rental unit, a nice 2 bed, 2 bath condo. We took this plunge back in 2015. While we’ve had one challenging tenant, for the most part, it’s been an awesome investment. We negotiated with our current tenant at the start of the pandemic: lower rent in exchange for an 18 month lease. It was a relief not worrying about filling an empty unit during the lockdown. Most importantly: we’ve been able to maintain positive cash flow throughout these crazy times.

And, guess what, due to the booming real estate market, the theoretical value of the property rose too. Of course, we’re not interested in selling any time soon. But, we do track the market value of the property as part of our net worth (discounted to an investor friendly price). Lately, our real estate has grown, maybe not with the same exponential growth that equities have, but I believe real estate will be a lot less volatile whenever the next downturn comes.

Our other real estate, our primary residence, also shows a decent lift in the market value. Again, we’re not planning to sell any time soon, but these increases do contribute to net worth growth. They also buffer our net worth during down turns. While real estate may not be negatively correlated with stocks, it tends to be less volatile. Unfortunately, our house (like everyone’s) is not really an asset. It consumes cash rather than contributes it.

Our Rental Business Has Lower But Still Positive Cash Flow

You cannot eat net worth.

This is an interesting realization. So many of us are taught to invest in stocks and bonds so that we can take advantage of their long term appreciation. The plan is to sell some of these appreciated assets during our retirement years. The hope is that we draw down our pile slowly enough to die before we run out of money. As long as you stick to certain assumptions, this works pretty well.

Let’s talk about tax deferred retirement accounts for a minute. If you want to draw from your retirement pile before retirement age, the government charges a fee of 10% Further, because you put tax advantaged dollars in, you will pay income taxes on the dollars you take out. No opportunity to pay the potentially lower taxes on dividends or capital gains.

The cash that a rental property generates (assuming it is not held in a tax advantaged account) is available for use immediately. And you don’t have to sell a bathroom from your rental property to get the income. (This is unlike stocks where, unless you are only spending the dividends, you have to sell part of your base.) That’s what rent is for. I can feed my family today using the positive cash flow from our rental. Or, I can reinvest it for the future. This flexibility is awesome.

When the pandemic hit, our tenant reached out to us looking to renew his lease with us. In exchange for an 18 month agreement, he asked for a 20% discount. He’s a great tenant, and there was a pandemic just starting! We wanted to keep him We did a little math and offered a 15% discount. We agreed and signed the new lease. I’ve never been happier to give a discount! So, while our business income is down, we avoided (for at least a while longer) a dreaded vacancy.

Resiliency

To me, all these things add up to the beginning of a resilient lifestyle. If one part of the system fails, the rest of the system can absorb the shock and we can continue onward. It helps that we have a pretty big gap between our total income and our total expenses, again part of a resilient system is avoiding overloads. For example, if I lose my job, between my wife’s job and our other income sources, we could continue to maintain a substantial portion of our current lifestyle. If we have a vacancy in our rental property, we can afford to cover the expenses using cash reserves and surplus income until we can get a new tenant. We have tried to set up our affairs such that some part (or parts) are always able to perform.

To see a master of multiple income streams and truly resilient financial setup, check out John C over at actionecon.

There will be ups and downs; there will be bumps in the road. The hope is that through good times and bad, we continue to stay the course: keep earning, saving, investing, and growing. When the pandemic hit and now, as things recover, our assets continue to grow… hopefully for decades to come.

Actions to Take in 2021

No one has a functional crystal ball, so I’m always leery of forecasting economic or market movements. Regardless of your circumstances, I think there are some fundamental ways to approach finances in 2021.

Grow your gap either by increasing your income or decreasing your expenses. This is a good action to take in almost any set of economic circumstances, market conditions or time of your life. Today is no different. The job market may be terrible or amazing; reducing expenses gives you more financial runway in case of a change in your employment. The market may be high or low. Having a bigger gap gives you the ability to invest that cash directly or save it for another opportunity.
Adjust your asset allocation. Whether 2020 was financially kind or terrible for you, it’s a good time to review your specific situation and adjust your mix for the coming year(s).
- By some measures, the US stock markets are significantly over-valued. If your asset allocation percentage is out of balance, this might be a good time to rebalance. You can lock in your gains from the past 10 months of ear-popping highs. Be sure to balance prudence with the fear of missing out. No one knows how high (or how low) an asset class will go tomorrow.
- Age adjustments. We turn 40 this year. We have 2 kids. Our risk profile looks way different now than it did 15 years ago. Back them, we could say go all-in on the stock market. Now, our asset base has grown, and our appetite for full risk has perhaps decreased a bit…or not. I’ll save a discussion of how we approach risk/allocation for another time. Regardless of what our asset allocation was for the past 10 years, we may need to have a different ratio for the next 10 years simply because our runway to needing to use our assets is a lot shorter. And, the same may be true for you. Think carefully about how much risk you are really willing to accept. My heart goes out to the family of this young investor who took his own life after (mistakenly) thinking he lost almost $750,000. I know our allocation is pretty conservative, but I sleep well at night. I hope you do too.
Pay down debt. For us, this would most likely be early payments on the note at our rental/primary residences. We’re not rolling the dice with Bitcoin. Instead, every extra dollar we pay towards our mortgages, comes with a guaranteed interest cost that we avoid paying. It’s like our own bond fund.

Keep plugging away; exponential growth is alive and well. With that, we wish you and your loved ones a prosperous 2021 and beyond.

Why Does It Takes So Long to Save $1000?

2 minute readWhy does it take so long to save $1000? Every guru will tell you to start by saving at least $1000. But why does it take so long?

2 minute read

Start by saving $1000

It’s good advice.

Let’s face it: when you are just starting out, it takes a long time to save money. It can feel like it is taking forever to save your first $1000.

But, that first $1000 forms the basis of your emergency fund. It is the thing that will cover life’s unexpected obstacles and keep you from back-sliding into ruinous debt. If you are just starting out, working diligently until your savings account (not the ~~spending~~ checking account!) has at least $1000 in it.

Blown tire? You’re OK
Dental emergency? You’re OK
Flight home for a funeral (outside of COVID-19)? You’re OK
Family member in need? You can help
Home repair? You’re OK

Enough with the lecture; you know you need to save the money for your emergency fund. Let’s explore why it takes so long as this is where the real opportunity exists.

Saving $1000 is not the only place your money goes

Your emergency fund (or whatever other savings goal you are working towards) has a lot of competition:

Taxes
Retirement savings
Required expenses (housing, food, transportation, child care, etc.)
Desired expenses (entertainment, vacation travel, subscriptions, splurges, etc.)

Or, when considering a purchase, a lot of folks will tell you to take the purchase price and divide by your hourly wage. That will tell you how many hours you must work to afford the purchase.

Let’s say your family has single income earner and they earn the median US American household income of about $63,000/yr. At 2000 hours per year, their hourly rate is $31.50. Conventionally, you need to spend 32 hours (1000/31.5) to fully fund the first $1000 of your emergency fund. That’s less than a week of work! Unfortunately, it’s not that easy. If it were, I would say see you next week when you have saved $1000.

You don’t keep every dollar you earn

Let’s think about it a bit differently to understand why. You don’t keep every dollar you earn; you have to pay taxes, housing, transportation, food, entertainment, and everything else you typically spend.

Lets say you earn $63,000 as before, but your saving rate is in line with the US American savings rate of 6%. (Networthify has this awesome calculator showing the relationship between savings rate and career length). This means that 94% of your earnings already pay for taxes, housing, transportation, food, entertainment, etc. Without making any changes, the money to fund your savings needs to come from your unallocated budget, the 6%.

Trouble is: 6% of $63,000 is $3,780 of savings per year. Your hourly savings rate is $1.89/hr That’s what you pay yourself. At 6% of gross earnings, that’s downright miserly. At this rate, you need to work over 1/4 of the year just to save $1000. If you start on Jan 01 with $0, you will save $1000 by April 6.

Something has to change

Lots of people write about how to mind the gap, increase your income, decrease expenses. We’ll cover our own in time, but for now, it is enough to understand why saving $1000 takes so long.

Retire Earlier by Understanding How Expenses Change With Age

3 minute readIf you could afford to retire (or consider yourself Financially Independent) earlier, wouldn’t you want to know? Check out our app and see if you can reduce some of the uncertainty around your future expenses!

3 minute read

TBD min read

If you could afford to retire (or consider yourself Financially Independent) earlier, wouldn’t you want to know?

I’m pretty risk averse. So, I look at the simple rules some people use to evaluate their ability to walk away from work with a bit of skepticism.

The most commonly touted ways to estimate forward looking financial needs are the 4% rule, from the Trinity Study and the 80% of income guideline, from the BLS Consumer Expenditure Survey. Just so you know I’m not making this up, please take a look at Fidelity’s source for their 80% # here.

Example: I’m a 38 yr old software engineer and single. I’ve saved $750,000 through extreme frugality and a high savings rate. Using the 4% rule, I can safely withdraw $30,000/yr, covering my lifestyle. I am FI and planning to walk away from my full time job soon. Should I?

Maybe. First, pat yourself on the back for being FI now. My hesitation stems from the uncertainty around annual expenses of $30,000. What if you:

Find a partner
Have a kid (or more!)
Get really sick (stupid Covid19)
Level up your lifestyle
Simply get old

Any one of these events (and a whole lot more) could result in significant changes to your financial picture. And that’s the point: understanding how your expenses change over our lives can better inform your planning efforts (as a new Dad for the second time, I can say for certain: little girls are expensive).

We set out to build a view of people’s expenses as they move through life. We found the Bureau of Labor Statistics’ Consumer Expenditure Survey and spent some time working to visualize the data to give folks a better idea of the range of expenses that participants in the survey group faced at different times throughout their lives. It is important to note that these are not the same people surveyed at multiple ages; rather, the BLS surveyed lots of people across different ages.

Start by entering an income value and then selecting demographics values. This will filter the dataset to provide the subset of matching folks and automatically update the displays.

Variation matters.

In the output pane, you will first see an income histogram. This shows the shape of the distribution of incomes for the survey participants with the same demographic data. Sometimes people will use an average to represent the center of a distribution. We don’t think this makes sense, especially when we’re trying to understand uncertainty and when the distribution is skewed. We’re displaying where the entered income falls within the distribution of similar folks from the survey. That gives us a percentile, or position in the distribution. (i.e., the 65th percentile is the income where 65% of the other incomes are below it).

Next, we take the distributions of expenses for all the folks with the same demographics and split them up by age group. We visualize all these distributions using boxplots (if we used histograms, it would be tough to see all the data in a small, useful space). So, think of a boxplot as a dense picture of a distribution.

By Jhguch at en.wikipedia, CC BY-SA 2.5, https://commons.wikimedia.org/w/index.php?curid=14524285

In this case, each boxplot represents the expense category for one age group. Notice how the shapes of the boxplots change within an expense category for different age groups. We’ve also overlaid a black line that shows the expense percentile over age group based on the income percentile entered as input. Because, it can be tough to see the actual numbers this way, our tool also provides a table of these values.

Check out our app and see if you can reduce some of the uncertainty around your future expenses!

How to Afford Your Dream House Without Going Broke

3 minute read

We are buying a Big A$$ House and it scares the living daylights out of me. So I’m going to blog about it.

First, let’s define big.

Six bedrooms. Four for immediate family, one for guests, and one to offset the cost (more on this later) of all the rest. Four+ bathrooms. Probably north of 3000 square feet of climate controlled goodness for us humans, one dog, and our Stuff.

Next, let’s talk money. In our neck of the woods, if we buy this kind of turnkey place, it’s probably $800,000. No, that is not a typo… let me write it out to be certain you fully grasp the magnitude: Eight Hundred Thousand Dollars. My heart is racing again just thinking about it.

If we bought a fixer, we might be able to get an old and busted place for $450,000. Then, we need to put in up to $150,000 to fix it for a total of $600,000. These are just estimates of course, but I’m already seeing opportunity!

As I write this in Dec 2019, interest rates are around 4%. Let’s say we’re able to put in $160,000. (We’ve been eating a lot of peanut butter and jelly to save for this). At 4%, our monthly payments are ~$3100 for the put-your-toothbrush-in-the-bathroom-and-it’s-ready purchase and ~$2300 for the fixer, assuming full financing of the renovation. I know there are intangibles: whoever heard of a full gut-job renovation going smoothly? But I do believe the market charges a premium for no-hassle.

Next up: maintenance, taxes, bills. Let’s assume these are equivalent between the two options. A good estimate for maintenance is 1% of the house value every year. That’s $8000 per year.

Taxes in the county we’re considering are $1.014 per $100 of assessed value (1.014%). Again, let’s keep things simple and assume the assessed value is $800,000 for the ready to go. Taxes become $8,112/yr. For the reno option, we’ll assign the assessed value at the purchase price + repair value. I think that will be conservative. Reno taxes are then close to $6100/yr.

Bills (Gas, Electric, water) can be pretty significant when you’re heating/cooling such a big space. An efficient build averages $210/mo for a total of ~$2500/yr. Let’s apply that to both options.

Add that all up and our annual recurring costs for each of the two options look like this:

Turnkey ($800,000 purchase) total: $55,300
- Mortgage Principal & Interest: $36,600
- Maintenance: $8,000
- Taxes: $8,112
- Bills: $2,500
Reno ($450,000 purchase+ $150,000 reno) total: $42,100
- Mortgage Principal & Interest: $27,500
- Maintenance: $8,000
- Taxes: $6,100
- Bills: $2,500

Ouch. we’re basically locked in to this cost of living for the next 30 years.

Now, let’s make this a bit more exciting. We’ve planned to take on a renter in either case. As part of the deal, each property must have a 1 bedroom suite in the basement. The suite must be isolated from the main house (with a locking door), have a kitchenette, separate access, and a full bathroom (at least a shower). Rents for a 1 bedroom/1 bathroom apartment in this area range from $800-$1200 per month in this area. Let’s pick the midpoint of $1000/mo to keep the math easy.

All of a sudden we get an extra $12,000 of rental income to apply to the total recurring costs. And, we can write off a proportion of the recurring costs. For a 3000 sqft house, we would estimate 500 sqft being allocated to the rental. That means we can write off 17% of every expense associated with the property. Here’s the line item reductions:

Turnkey ($800,000 purchase) total offsets: $15,105
- Mortgage Principal & Interest: $12,000
- Maintenance: $1333
- Taxes: $1352
- Bills: $420
Reno($450,000 purchase+ $150,000 reno) total: $14,434
- Mortgage Principal & Interest: $12,000
- Maintenance: $1,000
- Taxes: $1,014
- Bills: $420

Remember these are deductions not credits. To accurately estimate our total expenses, we need to apply our tax bracket first. Let’s say we’re in the 24% tax bracket. Here’s the final costs of these two options once the reductions are included.

Turnkey ($800,000 purchase) total: $40,200/yr
- Mortgage Principal & Interest: $24,700
- Maintenance: $6700
- Taxes: $6760
- Bills: $2,100
Reno($450,000 purchase+ $150,000 reno) total: $27,700
- Mortgage Principal & Interest: $15,500
- Maintenance: $5,000
- Taxes: $5070
- Bills: $2,100

This still is no yurt, but it’s a whole lot better than just paying out of pocket.

If you are in to frugal living, the entire concept of a house like this is probably just silly. But, if you live in a high cost area, are trying to get your kids into good schools, or simply have the ability to hack your residence, it can be a very worthwhile endeavor. Some other house hacks to consider:

Rent part of your house
Buy a small multi-family and rent most of it
Set up a home office
Subdivide your lot
Build a carriage house and rent it out
Buy an RV; live in the RV and rent your entire house

We’re In The House (hacking) Market … And You Should Be Too.

3 minute readWe’re in the market for a new house/rental property. We’re considering house-hacking, a mixed use rental property where we live in one part, and rent out another.

3 minute read

4 min read

We’re in the market for a new house. Because ~~I’m cheap~~ we’re on the path to financial independence, I want to incorporate a rental property. Fusing the two is a form of house hacking, a method of turning your single family home into a small multi-family rental property. Today, I’m going to walk through how we are analyzing the cash flow for a house hack where we combine our primary residence with a rental unit.

A friend of ours passed along a community for us to look into. I figured it’s worth showing our evaluation approach (OK, it’s my evaluation approach. My wife is much more interested in the big picture rather than how the math is done).

The community is in Fulton, MD. (Montgomery county for those of you that read my last post on growing counties in MD). Fulton is a planned community under construction. It has a Town Center with a community area complete with exercise facilities, a pool, and common spaces. There’s a mix of neighborhoods, ranging from apartments, condos, and townhouses to single family “estates”. The community is in the southern part of Howard County MD, so it definitely checks our box for good schools.

Let’s talk more about the math of evaluating a mixed use rental property where we live in one part, and rent out another. While we’re not explicitly looking for a duplex, that’s essentially how I’m approaching this topic. Here’s two of my favorite bloggers weighing in on general rental property evaluation: Afford Anything, and Financial Samurai. Finally, here’s an article specifically about duplex investing on Bigger Pockets, one of the biggest real estate blogs out there.

Analyzing Cash Flow When Hacking Your House

Let’s start with cash flow. For a typical owner “un-occupied” (rental) property, cash flow must be positive to even think about moving forward (rents must be higher than expected costs). In your personal residence, total costs should be less than some % of your gross income. We’re looking to blend the two, For better or worse. See how this seems different: we’re looking to buy a place with a portion of the costs offset by a renter. If it was a classic duplex, we’d likely want to “live for free” such that the renter covers not only their portion of the costs but 100% of ours as well. Somewhere between “live for free” and rents subsidizing our lifestyle is the trade space we’re looking into.

With that said, the math still ends up being pretty straightforward. Here’s a link to the spreadsheet I’ll be using to evaluate potential properties that fit into this kinda-sorta-duplex. (Note: I am tweaking a spreadsheet that I use to evaluate potential rental properties, so don’t worry too much about the Cap Rate, Cash on Cash %, or NPV metrics.)

We can estimate what an individual property will cost us to own and operate/maintain as our primary residence. We can estimate market price point for a rental property that looks like ours. E.g., a 1 BR1BA basement apartment. We can subtract the two to find out what our net cost of living will be.

Financials of house hacking where rental income offsets primary residence expenses.

If you add up the monthly costs above, it would cost over $5,000 a month to live this way! But, by taking on a renter, we can drop our estimated net costs to about $3,500 a month (and that is before any tax benefits).

Next, appreciation. Zero (this one is easy). I never assume we’ll benefit from any appreciation on a rental property. There’s some good reasons for this: real estate tends to appreciate only as fast as inflation. This keeps the math simple when evaluating prospective properties, and keeps my analysis conservative.

Finally, taxes. I figure out what the estimated property taxes will be so I can factor them into cash flow. The source for the tax information is either based on the listing (if available) or the historical tax records…You know those are all public records, right? Here’s the MD website. And, here’s a link to an online public records search site so you could look start your search anywhere in the US. After that, any deductions, expenses, etc are all gravy. I would never advocate buying a rental property just because of the tax benefit. The underlying investment needs to be sound first.

So, how does our primary residence/rental unit stand up?

Now the good news. A 1 br/1ba in this neighborhood is also a pricey affair. I saw $1,900/mo as the nominal rent for such an apartment. So long as we don’t mind neighbors downstairs indefinitely, we could end with a net monthly cost of $3,468.19. That’s still a big number, but it helps to illustrate why I’m so keen on having a rental property baked into whatever becomes our next home. Note that I took a wild guess to arrive at ~20k to convert part of the basement into a rental unit. Here’s hoping that’s in the realm of reasonable! Because these numbers are still pretty big for us, I’m leery of making this kind of commitment without doing some serious homework.

What do you think? Would you ever accept a long-term rental situation in order to afford a big honkin’ house? Is there another way to make this kind of move and keep it affordable?

Did I Just Blow 20K?

4 minute read

…Over a decade and a half. I know: bad trick, using the headline that way.

But seriously, almost everyone in the personal finance space now talks about how using low cost investing options is a good idea. Put your money in index funds rather than actively managed mutual funds or with an adviser.

Why?

One word: fees.

Unfortunately, the investing world does not operate on the, “You get what you pay for” principle.

And, over the long haul, those little fees add up to be a drag on your returns. How big of a difference? Let me tell you a story…

My First Foray Into Investing

When I was 18, my Dad gave me a gift that I will never forget. He started me (now us) on the path to financial independence.

When I was 18, I had my first W-2 job working as a sales associate in the electrical section of the regional hardware store. (I worked for years before that, but I was always a small amount and paid in cash, so it was never eligible for taxation let alone retirement savings.) At the then-minimum wage rate of $5.15/hr, I didn’t make much. But, the little I made was reported to the government as earned income. “Fortunately,” my earned income was so small, I was ineligible to pay taxes.

I was using the money I earned to pay for some of my college expenses. So, my Dad said he would match up to my earned income and put the money into something called a Roth IRA. Of course, this became table stakes to hold a discussion on the general topic of saving for retirement. We talked about the differences between a Roth and a traditional IRA. We talked about contribution limits and the difference in withdrawal rules. Once, we made it through the lecture, we got into the fun stuff: what to do with the money. Pretty quickly, we ruled out a down payment on a car or storing it in my sock drawer. Instead, he suggested investing in a mutual fund, The Growth Fund of America (ticker: AGTHX). AGTHX is, you guessed it, an actively managed fund. Its annual expense ratio (one of several potential charges people pay to invest their money) is 0.62%.

Active Fund Fees Are A Real Drag

So, why is that a problem?

If a typical index fund charges ~0.1% in fees, the observation is that actively managed mutual funds at ~.6% or a human adviser at ~1-2% don’t make you enough extra money in the long run to justify their cost.

Compare AGTHX to Vanguard’s S&P500 index fund (Admiral shares because we’re over $10,000). The Admiral shares have an expense ratio of 0.04%. While the Investor shares (minimum of $3000) have an expense ratio of 0.14%. Last, I checked, 0.6% is more.

Comparing the actively managed fund, AGTHX, with passively managed index fund, VFIAX, fees — Source: www.morningstar.com

But, wait! You say, “don’t the hotshot fund managers get a better return for their customers?” How else can they justify charging more?

Maybe…

Let’s look at the numbers.

I used Morningstar’s portfolio analyzer to get a bit more information. Note that it only looks at changes in share prices (no capital gains/dividend reinvestment included). I simulated buying $100,000 of each fund on Jan 5 of 2001. How have the two funds done over the past ~20 years?

Comparing market returns for $100,000 invested in actively managed fund vs. index fund.

Ouch. Let’s make this even more apparent. If you look at a Google Finance image of the two mutual funds’ values over time, it looks kind of like this:

Comparing % market returns over time for actively managed fund vs. index fund.

So, what gives? At almost no point in the past 20 years was AGTHX returning a higher rate than VTSAX. I think this illustrates something called “reversion to the mean”. That’s fancy talk for an idea that most investments eventually deliver average performance. They may out/under perform for years or a decade and a half, but eventually, they produce average results. This is one of the core reasons for selecting low-cost index funds as your primary investment vehicles. Over the long haul, if most funds perform similarly, then the lowest cost fund wins. You can read a lot more about this from John Bogle, inventor of the index fund, founder of Vanguard, and personal hero. While AGTHX may have outperformed VTSAX before the internet was widespread, in more modern history, VTSAX has outperformed. Yet, AGTHX consistently charges fees that are almost 10x higher. What?

By the way, those fees are pretty insidious. If you look at your statements, you will not see actual dollar values coming out of your account. Instead, the fund management team takes them off the top before they show up in any individual statements (I spent a few hours looking through some pretty arcane sections of both American Funds and Vanguards websites before I convinced myself of this).

Deciding To Make A Change To Indexing…Or Maybe Not

So, now the conundrum. I admit, it’s an emotional one. Math says, roll everything from AGTHX into a lower cost fund (e.g., VTSAX). Our goal is not to tap these funds for at least a few decades. So, shedding the fees should be the right decision. But emotion says maybe those über-smart folks at American will outperform the index once again. And, what about diversification? If hackers get into Vanguard, they may not simultaneously get into American. And besides, my Dad is the one who got this ball rolling, even if I’ve done the vast majority of the contributions. I feel some (totally irrational) guilt at moving away from this fund.

So, what to do? I’d love some other perspectives…drop me a line in the comments.

Living Better, Okinawan Style

< 1 minuteThe simple, frugal, socially connected lifestyle of Okinawans can teach us a lot about how to achieve financial indpendence.

< 1 minuteIt’s only my third time in Okinawa, but every time I visit, I learn a bit more about Okinawan culture. Each time, I marvel at their resourcefulness and the many ways they live fully and healthily yet frugally.

Okinawans laugh … together. Over a cup of tea and a small snack, there are always funny stories of kids, grandkids, and neighbors. At least that’s what they tell me. Not understanding shimakutuba, I have to trust that’s what is actually being said. It’s a fascinating exercise: observing a conversation when you understand almost none of the spoken words.

Okinawans are social. We’ve been staying with family while we’re here, and at least once a day, a random neighbor, friend, or relative stops by to say hi. Inevitably, they have a small omiyage or gifts to share. Okinawan omiyage are often fresh from their own gardens, (and therefore free!).

Speaking of the garden, so many food items grow well in Okinawa. On a small plot of land, our family has 4 kinds of citrus trees (lemon, shiquasa, tankan, and kabochi), bananas trees, and persimmon trees. There are green onions, cabbage, carrots, and a staple: Okinawan purple sweet potatoes. Finally, a number of chickens inhabit the property providing fresh eggs daily. You can literally have half or more of your basic food provided fresh from the garden! Growing up with little money, our family did exactly that.

There is so much goodness that comes from having skills to survive without just pulling out cash (or a credit card). We can all learn to stand on our own two feet a little more.

I shelled out 548 Yen for an Espresso

2 minute read

As my family and I travel across Japan, I’ve been drinking a lot of tea. When in Japan, it’s the thing to do. And I like tea, especially Japanese tea. But, I love coffee. And, after 11 days in country, my perfectly prepared Espresso really hit the spot. So, at current exchange rates, that Espresso cost almost 5 bucks. Frankly, it’s ludicrous for a cheap-skate like me to spend that much on a single coffee. And, that is against the backdrop of our 3 week trip to Japan, itself no exercise in frugality.

How does spending so much money fit into the context of a Financial Independence website? Simple; this is my dream: to spend time with the people I love most. This is why I save money in almost every other facet of my life. This is why I put in over-time at work to boost my income. This is why I invest in as many assets as possible.

My family and I have saved for almost 2 years for this trip. We’ve decided to spend our holiday vacation and significant financial resources to visit extended family in Japan and tour other parts of the country while we are here. Our almost 3 year old will meet her 98 year-old Okinawan great-grandmother, and the memories and pictures will be priceless.

So, for an (almost) inaugural post on a Financial Independence website, starting with my “why” seems like the right place to begin.

In the coming years, Dan and I intend to share lots more about our personal journeys, including our mistakes and successes. We plan to distill the principles that guide our decisions into a sequence of modular courses designed to inform your own actions. Our goal is to pay it forward and help others navigate their personal financial journeys to achieve freedom as quickly as possible.

To that, I say, “Kanpai!”