If you decided to "cash in your chips" by selling everything you own for as much as you can and then paying off all of your debts, the amount of money left over would be your Net Worth. Naturally people don't usually sell everything they own but, that does not mean they don't calculate their Net Worth. What they do is make a Balance Sheet that lists the value of all their assets and subtracts all of their liabilities. The difference is their Net Worth.
So, lets do an example.
For Assets you might have
Cash in Bank Accounts $3,000
RRSP Savings $50,000
Appraised House Value $450,000
Vehicles $10,000
So that would be a total of $513,000. Notice how all the money spent on travel, eating out, cloths, entertainment, bank charges, bank interest, taxes and most other day to day expenses do not appear on the Balance Sheet as Assets.
Now let's say that you have consumer debt of $13,000 and a mortgage of $250,000. So, your liabilities are $263,000.
The difference between your total assets and total liabilities would be your net worth, in this example, $250,000.
Now this is an extremely simple Balance Sheet however, just having it and knowing what your Net Worth is, is huge. You see, to achieve a work optional status, you will typically draw down 4% to 6% of your net worth each year. This is called the sustainable withdrawal rate. With a Net Worth of $250,000, this investor should expect to receive an unending sustainable retirement income of $12,500 per year although, she might have to sell her house and car to achieve that goal. While doing this, the principal of $250,00 should continue to grow just a little bit.
Depending on her age and income, this balance sheet could be very healthy or very discouraging. In either case, it is very lopsided because nearly all of the assets are tied up in Real Estate.
The single most important way to protect your Net Worth is to diversify between Real Estate, Equities, and Fixed Income Investments. Typically, in the distribution years we expect to move our investments more into Fixed Income and during accumulation years we tend to own more Real Estate and Equities. By being diversified, we can draw income, during the distribution years, from whichever of the three sectors is doing the best. Not being forced to sell assets into a depressed market to fund retirement income is a huge advantage. In the same way, during the accumulation years, we should choose to invest in the sector that is most depressed in price in order to improve our upside potential.
Depending on the years this investor has given herself to achieve a work optional status, and given the current low interest rates and the just recovering equity market, a financial planner might consider an emphasis on investing in equities, locking in the house mortgage and not buying any fixed income bonds until interest rates go back up.
Because Real Estate, Equities and Fixed Income are such important investment vehicles, I'll take some time in the next blogs to talk about them individually.
Saturday, December 5, 2009
Wednesday, November 25, 2009
Skip Saving and Start Investing
So the idea is to work hard at a job you love, save some money and start investing so that one day the income from your investments is enough to support your life style. I call this a work optional state, others call it retirement and some call it " freedom 55" as if this is something you should wait until age 55 to achieve.
In a country as rich as Canada with all the safety nets in place, and a relatively high standard of living, you would think that saving 10% to 15% of every dollar would be a fairly easy thing to do. Actually it is easy to do, but interestingly enough, most people don't do it. In fact, many people rather than choosing to live a life style that allows them to save 15%, choose to live a life style that costs more than what they earn. Of course the only way to do that is to borrow money, usually from a credit card company and, once your neck is in that credit card noose, it is a painful extraction process. Many people have to start by simply cutting up all their credit cards.The bottom line is this, if you have a credit card and do not pay off the full amount of the credit card bill every month before the due date, then, you are living beyond your means and need to adjust your life style.
Saving money to invest does not necessarily mean, opening a savings account and depositing 10% of every pay cheque into that account. In reality saving and investing are usually concurrent. The people I know who are good at saving are actually really good at investing.
When you invest, you are directing your money in a way that the principal amount is protected and there is a good chance that it will grow. Paying down the mortgage on your house or, placing money into an RRSP are examples of investing because there is a good chance you'll see all of that money, and more, again some day. Buying a Tim Horton's coffee or any manufactured consumer product from cars to cloths or jewelry would not be considered investing because there is only a minuscule chance of recovering your money and no chance of growth.
Financially successful people tend to be frugal. That does not mean they are cheap scrooges. What it means is that they spend money very deliberately. Whenever they spend money, even for a Tim Horton's coffee, they are conscience that the expenditure is, or is not, an investment. Financially successful people are continuously finding ways to increase their investments because their bias is to increase investments and reduce expenditures.
Putting it another way, financially successful people focus on their net worth and on doing things to increase their net worth. For them, cash flow and affordability are important because of how they might increase funds available for investment. They are much more interested in seeing their net worth go up than they are in buying a new car or taking an ocean cruise.
Net Worth ? I'll talk about that next time.
In a country as rich as Canada with all the safety nets in place, and a relatively high standard of living, you would think that saving 10% to 15% of every dollar would be a fairly easy thing to do. Actually it is easy to do, but interestingly enough, most people don't do it. In fact, many people rather than choosing to live a life style that allows them to save 15%, choose to live a life style that costs more than what they earn. Of course the only way to do that is to borrow money, usually from a credit card company and, once your neck is in that credit card noose, it is a painful extraction process. Many people have to start by simply cutting up all their credit cards.The bottom line is this, if you have a credit card and do not pay off the full amount of the credit card bill every month before the due date, then, you are living beyond your means and need to adjust your life style.
Saving money to invest does not necessarily mean, opening a savings account and depositing 10% of every pay cheque into that account. In reality saving and investing are usually concurrent. The people I know who are good at saving are actually really good at investing.
When you invest, you are directing your money in a way that the principal amount is protected and there is a good chance that it will grow. Paying down the mortgage on your house or, placing money into an RRSP are examples of investing because there is a good chance you'll see all of that money, and more, again some day. Buying a Tim Horton's coffee or any manufactured consumer product from cars to cloths or jewelry would not be considered investing because there is only a minuscule chance of recovering your money and no chance of growth.
Financially successful people tend to be frugal. That does not mean they are cheap scrooges. What it means is that they spend money very deliberately. Whenever they spend money, even for a Tim Horton's coffee, they are conscience that the expenditure is, or is not, an investment. Financially successful people are continuously finding ways to increase their investments because their bias is to increase investments and reduce expenditures.
Putting it another way, financially successful people focus on their net worth and on doing things to increase their net worth. For them, cash flow and affordability are important because of how they might increase funds available for investment. They are much more interested in seeing their net worth go up than they are in buying a new car or taking an ocean cruise.
Net Worth ? I'll talk about that next time.
Saturday, November 21, 2009
The First Principle
Some people say I'm good with money.
I once was asked to teach a money management course. I was provided with all of the course materials and after I read through them realized that I could never teach this course. I didn't agree with fundamental premise that "money is hard to come by, we are all poor and unless we are very careful with the little we have, we will be in big trouble" The themes of poverty, control and fear made no sense to me.
We live in one of the richest countries in the world. The free enterprise system makes it possible for anyone to achieve a work optional status and, the social safety nets are all there in the event of a failure.
Notice I said "free enterprise" not fair enterprise. What I mean is that the system does not always make sense if you think it should be fair and should have a stronger social conscience.
In any event, in a free enterprise system, the basic idea is that we are free to earn money by working hard. The expectation is that we will save and then invest some of our earnings so that eventually we will be able to live off of the money we earn from our investments. That's the enterprise part. The goal is invest wisely so that working for money becomes optional because our money is working for us.
Unfortunately, there are all kinds of reasons why we so often lose sight of this simple principle.
More on that another day.
I once was asked to teach a money management course. I was provided with all of the course materials and after I read through them realized that I could never teach this course. I didn't agree with fundamental premise that "money is hard to come by, we are all poor and unless we are very careful with the little we have, we will be in big trouble" The themes of poverty, control and fear made no sense to me.
We live in one of the richest countries in the world. The free enterprise system makes it possible for anyone to achieve a work optional status and, the social safety nets are all there in the event of a failure.
Notice I said "free enterprise" not fair enterprise. What I mean is that the system does not always make sense if you think it should be fair and should have a stronger social conscience.
In any event, in a free enterprise system, the basic idea is that we are free to earn money by working hard. The expectation is that we will save and then invest some of our earnings so that eventually we will be able to live off of the money we earn from our investments. That's the enterprise part. The goal is invest wisely so that working for money becomes optional because our money is working for us.
Unfortunately, there are all kinds of reasons why we so often lose sight of this simple principle.
More on that another day.
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