When it comes to improving our quality of life, getting the most happiness out of every day,  and reaching our goals, it helps to have some type of plan in mind. Giving some thought to what you want, and how to get there, is generally more effective the operating randomly without a plan.

To me, when it comes to those aforementioned aspirations, my framework is to focus on relationships, health, and wealth. As I wrote in one of this blog’s foundational articles, the role of money in our lives is of course personal, but for me it does encompass those 3 aspects I just mentioned.  Relationships, health, and wealth can all influence one another.  To the extent that we are strong in one area, we can potentially help ourselves in the others – with the opposite holding true as well.

So clearly, while money isn’t the most important thing by a long shot, it’s realistic to say that it can help improve the quality of our lives. To that end, tying back to the opening paragraph, it behooves us to have a plan for how to manage our money and grow our net worth.

With that in mind, I’ve come up with these 15 ways to protect and grow net worth:

1. Get a good formal education.  I’m starting with this one since there has been much chatter in the blogosphere in the last few years about the value of a college degree, and whether or not it’s really worth it. This topic was addressed here in a discussion on the choice between college or entrepreneurship. Well, I do think that where one goes to school and how much it costs can greatly impact the ultimate value proposition of a particular investment. However, that doesn’t change the reality that a college education is important and does matter. Plenty of data out there indicates that those who avoid higher education will face a lifetime of lower earnings. Again, just be extremely careful when making your decision on where to spend tuition dollars. Also remember, you can always be an entrepreneur and a college graduate!
2. Embrace continual learning.  Keeping up on the education theme, it’s important to keep in mind that what we learn in our formal education gives us a good foundation and an essential piece of paper, but the learning doesn’t stop there. I think that the ability to continually grow through experience, along with the trait of intellectual curiosity, are important factors in determining personal and career advancement. We can always learn something new everyday, and add this experience to our toolbox.
3. Focus on your career.  Your experience, and the value you can add to someone who will pay you for your services, is what will make you a big share of your money.  Unless you’ve inherited big money, where else – realistically – are you going to be able to generate the income for your food, shelter, transportation, etc? Basically, my idea is this, as I’ve expressed before: you have to make money before having anything to save.
4. Generate multiple sources of income.  While your career will likely be your biggest source of income for a good part of your life, you don’t want to put all your eggs into one basket. Jobs can be lost, career tracks can be altered, and a whole host of so-called unexpected events can happen. For safety, it’s a good idea to work on alternate sources of income that can be done on the side. Plus, aside from safety, these efforts can provide additional income and maybe an opportunity to do something entirely different someday!
5. Discern wants from needs. What do we need? I had put together a personal finance hierarchy of needs that I think provides a framework for thinking about certain priorities. Along those lines, it’s essential to be able to decide upon what we presently need, and what we simply want. For example, if given an option of a older, dated 3 bedroom house or a brand new, sparkling 4 bedroom McMansion, choosing the older home over the newer home is looking at needs vs wants. Nobody needs a brand new house.
6. Maximize the income minus expense gap. Once we earn money, as noted above in #3 and #4 – and figure out needs vs. wants, as noted in #5 - we can work on saving. This is the bottom line, where income and expenses intersect to result in savings. It’s kind of like a company that reports profits -  income minus expenses equal how well they did. I mean, unless we focus on this gap and actually save, our net worth will have difficulty growing.
7. Practice effective asset allocation.  Put your savings to work for you. If you have an immediate need for funds, you may want them in safer investments (like cash). If your investment timeline is longer, you may want to increase the percentage of funds in stocks. There are many approaches people take to asset allocation, and it’s vital to utilize one that matches your situation.
8. Put money in your employer 401(k) plan.  The employer match is a great deal for employees. The rate of return that you can earn on such allocations can be significant. For example, if you drop in $3,000 – and your employer matches it dollar for dollar with another $3,000 – that’s pretty good!
9. Manage Risks.  Not all risks are bad. It’s good to keep in mind that risk and potential reward often go hand in hand, which is factored into our decisions in #7 above. Additionally though, there are risks in which we need to protect the downside.  When it comes to assets, the the Buffet’s Rule #1 on losing money is one to keep in mind when it comes to making up losses. In a different context, avoid big losses, and get proper insurance for your home, health, and vehicle. Additionally, proper estate planning falls into this category as well.
10. Eliminate Debt.  If you owe someone money, you’re essentially a servant to them. If you needed to take out a mortgage loan to buy your home, then you’re effectively a servant to your lender. If you don’t pay your lender, you’ll be out of your home. That puts things in perspective, right? Plus, by paying high interest, you can really dig yourself in deep. Best to avoid debt if you can, and pay off what you do have as soon as possible
11. Think long-term. While living in the moment is important and a source of joy, we also have to spend some time also thinking of the future too. Taking a long-term time horizon, and remembering that we ultimately need to retire, is fundamental to growing and protecting net worth.  Personally, I like to think that I’m working for the me of today, as well as the me of 35 years from now, who might not be able to work. That’s my biggest financial motivator right now – making sure I’m not old and broke. The opposite would be old and financially prosperous, which is preferred!
12. Be relentless and persistent.  My own observations are that the times where I’ve truly wanted something badly enough, and really, really worked hard for it – are the times when I’ve achieved the most success.  I’ve observed this in others too, where some people who are determined and tenacious may achieve things that others who are seemingly brighter and more talented – yet less persistent – may not.  The more I’m around, the more it seems like once you pass that threshold of being “smart enough” to do something, the next real differentiator between success and lack of it is hard work.
13. Be resilient.  For most people, life is not a straight, linear path to some type of nirvana. While we hope that the majority of days are spectacular, there will be a few speed bumps along the way. More than that, there might be times where truly “unexpected” setbacks occur. Job loss, health issues, divorce, accidents, and the like come to mind. It may not be easy, but try to be mentally tough and prepared, as the odds are that at least one of those less than exciting events will happen to most of us.
14. Nourish positive relationships.  So, we’re back to what I said up front – how wealth is tied in some way to relationships and health. In terms of relationships, this can take on many forms. First of all, people that are married tend to have a higher net worth than those who are single, on average. At the same time, divorce can damage finances severely.  So, that’s one way relationships matter! However, this applies to many other relationships. If you get along with your boss, for example, you’ll be better off than if you were at odds. If you network well, you’ll learn more from others and might have more professional and business opportunities than if you were more isolated. To the extent that you enjoy people, are interested in others, and are able to get along with others effectively (and smartly), it seems like you’ll be in a better position to succeed.
15. Stay healthy. Most importantly, of course, being healthy means that you can enjoy life and be there for family and friends. However, it also matters for your net worth. First of all, if you’re not healthy and incur significant medical bills, that be money out the door that you could have saved. Second, and actually this might be more important, if you’re not healthy, you’ll have trouble working. Which means, you’ll have trouble earning an income.  That’s yet another motivator to eat well, get plenty of exercise, and manage stress. Even sleep can impact wealth, so it’s important to get enough!

My Questions for You

What are your thoughts on this list? Are there any here you especially agree with?

Which of these approaches do you feel like you do best and worst?

Do you have any more suggestions on general tips to grow and protect net worth.

It’s said that there are two things that are certain: death and taxes. With respect to the former, it’s important to plan for what will happen to your money when you pass on. That day might be a long time from now, and you might not have any kids at this time. Regardless, it’s a topic that at some time or another will find its way on the minds of many people. With kids later in life, it might even generate conflicting emotions for people in terms of how to divide up assets.

OK, it may seem cold and unemotional to think of ourselves as economic assets that will eventually be cashed in and allocated to different people. However, the reality is that we won’t live forever. And when we do leave, and emotions are running high with family, it’s possible that amidst the sadness there could be worries over who gets what. I certainly think that’s unfortunate, but it happens.

My question is this: from the perspective of someone drawing up a will, would you ever leave more for one kid versus another?

I know people who have had these issues, as I discussed in a prior post on siblings dividing an inheritance. They were very civilized, and looking back, I’m impressed at how my friend in particular (the one I keep in touch with) ultimately moved on from the whole ordeal.  Now, with question I’m asking here, I’m looking at dividing assets for children from the perspective of a parent.

What got me thinking about this from this different vantage point was an article in the WSJ on how to give less to one kid in a will. Admittedly, it’s a concept that in principle went against the grain for me at first. I believe in fairness between kids, and looking out for their best interests equally. After all, each child is important and should be treasured. Kids that feel less loved than a sibling- even if adult kids – can be hurt deeply, whether or not they admit it. Clearly, it can be a hot button issue.

So, my original thought was that things should be divided equally. Simple as that, right? No need to complicate things or be subjective about it. Fairness is in equality.

Well, thinking about it some more, I think it’s not really that simple.  Kids can grow up and end up having very different situations on a variety of dimensions. Examples include:

• Profession – one could be in a lucrative field, another in a modest-paying one, despite both working hard
• Spouse – one could be married to a high earner, another to a low earner
• Marriage – one could be happily married, and the other could be perpetually single or have been through a tough divorce
• Ability – one could simply be more talented than another
• Health – one could be in much better health than another
• Kids – one of your own kids could have 3 kids of his/her own and the other just 1 kid, for example
• Luck – one could have been lucky in life, while the other has simply has some unlucky situation happen

These are all examples of how kids, as they grow up into adult kids, can take divergent paths from their siblings. Note that I’m not talking about differences in basic work ethic, financial responsibility, or integrity.

It’s clear that among siblings, some can end up with much better financial lives than others. Think about your own situation compared to any siblings you might have, or what you see in other families.

Considering all these factors, I now think of equality in a more holistic way.

Meaning, I would consider leaving assets for kids in a way that’s not an exactly equal distribution of what I’d ultimately have. It would be influenced to some degree by true need. Again, hopefully this won’t come into play for a long, long time. When it does, I’d try to pay close attention to the kids’ individual situations and plan accordingly.

The key thing is to be honest, and to make sure that kids don’t get lazy in any way and fall back on any potential for an inheritance. Easier said than done, perhaps. We’ll see, many years from now:)

Not everyone would agree with my philosophy. Many would advocate exactly equal division regardless of need, or some other philosophy.

My Questions for You:

What do you think of the idea of dividing up assets based on a holistic view of equality, rather than based on a clear division?

Or, do you simply not care about equality and feel that money would be left based on some other decision process?

Or, do you feel very differently than I do, and you don’t believe in leaving money for anybody?

Have you ever heard of the Rule of 72?

It’s one of those personal finance calculators that’s been around for a while, and it’s about as basic as it gets. Yet, it’s been used by some people to quickly project results for a given investment over time.

The rule is essentially a quick way to determine how long it will take you to double your money at a current rate of return. It works as follows: start with the number 72, and divide it by the rate of return of an investment over time. The result will be the number of years it will take to double your money.

For example:

Let’s say you have an investment that will earn you a total annual return of 3%.  It would then take you 24 years to double your money (72/3 = 24).  Too long? Well, jack that rate of return up to 6%, and it will then take you just 12 years to double your money.

While I consider myself to be analytical, and comfortable with complex calculations, I do like such tricks such as the rule of 72.  They allow us to quickly, on the fly, do some basic calculations. In this case, we all could have quickly divided 72 by 3 (or 6) in our minds to get the answer in just a matter of seconds.

For whatever reason, this one in particluar has struck me as being nice for those of us who gravitate toward investment growth thoughts.  It”s a quick way to think about what money could become in the future.

As with any shortcut, however, there are pitfalls.  There are three that I see with the Rule of 72:

1. Taxes.   If you’re paying taxes on earnings, this needs to be considered in any calculation. So, if you’re earning 6%, but will pay some tax on that, your after tax rate may actually be somewhere in the neighborhood of 4% or so.  This needs to be factored in, or the Rule of 72 will give you erroneous results.
2. Inflation.  Let’s say you’re earning 3% after taxes for example. If inflation is 3%, you’re not really getting ahead. The $1,000 you have invested will turn into $1030 a year later, but will still buy the same amount of goods as $1000 did the year before. So, inflation needs to be taken into account.
3. Accuracy. This rule is meant to be a shortcut, so it’s not 100% accurate down to the decimal point. For example, if you wanted to see how long it would take to grow a $1000 investment into $2000, with a 3% rate of return, the Rule of 72 would tell you 24 years. If you calculate it manually, it actually comes out to almost 23 1/2 years. Close enough for an quick estimate, but important to note that it is in fact an estimate.

Personally, I find that many quick financial projections, particularly those that are intended to show the power of compounding over time, tend to ignore both taxes and inflation.  To the latter point, always keep in mind the time value of money.

In any event, as long as we’re aware of it’s limitations, the Rule of 72 can be a useful tool for quick projections of how long it will take us to double our money.

My Questions For You:

Have you ever used the Rule of 72?

Do you ever stop to question assumptions in such financial projections, such as I did with taxes and interest?

Have you ever considered why currency prices move up and down?  If you have been trading for any length of time, you understand that currency values move according to all sorts of factors.  They move due to scheduled news releases, they can definitely move quite strongly due to unexpected news events, they can move based on technical levels and they can move on a daily basis due to a host of other reasons.  When an international firm engages in the acquisition of a foreign company, it will have to buy and sell potentially hundreds of billions of currency, and this will cause the market to move to some degree.  However, these things only move currencies in the short-term.  Over the long-term currencies are driven by interest rates.

The Importance of Yield

The primary duty of every fund manager in the world is to make money for clients.  Therefore, fund managers must produce positive yield each year.  Each currency has an interest rate that is attached to it, which is set by its Central Bank.  Therefore, the Federal Reserve, which is the Central Bank in the United States, sets interest rates for the U.S. dollar every month.  Fund managers, banks, and very wealthy investors pay close attention to the changes in this interest rate because it determines how much yield they can get for their investment in that currency.

If a fund manager is given the choice of two different investment opportunities, with both having relatively the same amount of risk, which one will the fund manager choose?  Of course, he is going to choose the investment opportunity with the highest yield potential, and this is exactly why interest rates drive currency value over the long-term.

Follow the Capital Flows

Investment capital tends to flow into a currency with a high interest rate because investors are in search of higher yield; conversely, capital tends to flow out of a currency with a low interest rate because there is little incentive for investors to hold the currency at a forex broker if they are not earning any yield.

This Weekly Chart of the AUD USD shows price action from March 2001 through December 2007.  You can see that the Aussie made a massive move against the dollar over the course of these 6 years.  In 2001, the AUD/USD was trading at 0.4850 and by the end of 2007, it was trading at 0.9400.  That means that during this 6 year period the AUD/USD moved up over 4,500 pips!

During this time period, the Federal Reserve, headed by Mr. Alan Greenspan, pursued very loose monetary policy and kept interest rates at very low levels.  During the same 6 years period, Australia’s economy was growing very aggressively, and the Reserve Bank of Australia had to keep interest rates very high in order to stem inflation.  This very wide interest rate yield spread led to a massive appreciation of the Aussie dollar versus the U.S. dollar.

Pairing Individual Currencies By Interest Rates

One way to strategically play interest rates in the forex market is to purposefully pair a very low-yielding currency pair and a very high-yielding currency pair.  By buying the high-yielding currency pair and simultaneously selling the low-yielding currency pair, a trader can take advantage of the yield spread between the two currencies and possibly catch an appreciation in the high-yielding currency.  This trading strategy is known as the carry trade—which is traditionally defined as borrowing money in a low-yielding currency and then buying a high-yielding currency.  This strategy tends to do quite well during times of high risk appetite, but when risk aversion hits the market, investors liquidate risky positions and the carry trade falls apart

It’s cool when readers make comments that prompt you to create a post on a certain point, no matter how brief. Recently, on my post 5 Rules for Achieving Debt-Free Living, a simple yet valuable point was made in one of the comments:

“Look at what you want and figure out how many hours (post-tax!) you will have to work to earn it. Do you want it badly enough to buy it?”

It’s something I have thought about before. These days, I think in terms of maximizing the income minus expense gap, investing intelligently, and the concept of time is money.  This approach is one I actively thought about as a teenager, when I realized that for me to spend $9 to see a 2.5 hour movie and enjoy popcorn and a soda, it would take me that long at work just to do that. It got me thinking about how maybe I didn’t need to get the popcorn and soda, and maybe should just get one or the other:)

But as adults, it helps to remember that calculation from back in the day. I had a few friends who, upon getting their first jobs out of undergrad studies, purchased new cars. Not just new cars, but nice new cars. This was a while ago, and these people were buying $25,000 cars. Keep in mind, their salaries were in the range of $25,000 as well. Pre-tax.

These guys spent a lot of time working just for a car.

So, let’s do the math.

1. $25,000 salary, divided by 250 working days, = $100 per day.
2. $100 per day, divided by 8 hours, = $12.50 per hour.
3. $12.50 per hour, multiplied by 75% - to account for tax – = $9.38 per hour post-tax
4. $25,000 car, divided by $9.38 hourly rate, = 2,665 hours.

They worked 2,665 hours for those cars. When you consider that the calculation above assumes 2,000 working hours per year (when you consider #1 and #2 above), this comes out to 1.33 years of their life that they worked just to pay off a car.

If they just would have purchased a decent used car for much less, it would have made a lot more sense, though it wouldn’t have been “cool”.

The good news is that many years later, both guys are now savers who try to put a way a solid percentage of their income. I have only talked to one about the cars he bought when younger, and he acknowledges that it was totally nuts for him to do that.

Maybe he started to do this type of math exercise and figured it out later!

Question for You: Do you ever think of things in this way, figuring out how much you would have to work in order to pay for something you wish to purchase? This can apply to any big purchases, not just cars.

I have had a few conversations over this past year regarding extreme frugality, with a few people I know as well as a few in the media. Some examples that I see are inspiring, many are entertaining, and some just way out there and over the top. Some, as I have alluded to, cross the line by taking advantage of others or causing one to lose self-respect. So, there is a spectrum when it comes to extreme frugality, ranging from very good to very bad.

That said, stripping away the inspiration, entertainment, and morality issues related to some of these tactics, a key question remains: Is it worth the time? Is it worth going to extreme measures to save money – even pennies – when it costs time to do so?

This is where it appears many people are not fully thinking through the value of their time. I have certainly fallen into that at times, and I’m guessing we all have at one time or another. Its important to keep in mind the value of our efforts in terms of the precious time we spend on such time saving efforts.

To illustrate, lets take the example of a person with the following hypothetical employment situation:

Wages: $50,000 annual salary

Work Day: Standard 8-hour day.

Days Worked: 250 days per year (factoring in 5-day workweek, plus holidays/vacations)

For this person, his total imputed hourly rate is $25 ($50,000 / (8*250)). Thus, before taxes and other deductions, this person sells time to an employer at a rate of $25 for every hour on the job.

Lets say that this person’s employer came back to him and said that they wanted him to work overtime on a special project. This project would not lead to a better performance review, nor would it provide a leg up for promotion. Additionally, it wouldn’t provide experience that could benefit your career, nor would it impact his job security. All this said, the employer would pay him $5 if he spent an extra hour working on this project each week.

Would this employee, who normally gets paid $25 per hour, jump for joy at the possibility of making $5 more if he works that additional hour on this non-value added special project? I suspect that this employee might evaluate this, and think: “Why should I get paid $20 less – or 20% of my regular pay – to do this? It’s not worth my time!“

Its something to think about as we spend time devising ways to save money.

Is it worth $5 to spend an hour round trip, to shop at a cheaper grocery store?

Is it worth $5 to spend an hour driving to buy that printer that’s cheaper at the store which is a 20 mile drive from here?

Is it worth $5 to use that coupon to buy a new pillow at the store in the next town over, when I could spend just buy it at the store right around the corner?

Is it worth $5 to hunt for bargains online for an hour, when I could just go to the site I know and buy my product in a matter of minutes at the price offered?

When you frame these “savings” in terms of opportunity cost such as in these examples, it provides another perspective on frugality: Sometimes its just not worth our time to focus excessively on extreme frugality. Perhaps it’s often better to spend that extra time on improving one’s capacity to earn?

Back to the topic. Of course, I’m presenting this as a purely dollars and cents argument here. Sometimes people feel great pride in finding a bargain, and take on frugality as hobby – the thrill of the chase. In that way, if it works for someone, so be it:) Its also understandable that if frugality becomes a habit – a way of life – then this mindset can provide benefits in other decision scenarios.

I’m all for sensible frugality. It’s a great practice! That said, on an individual case-by-case basis, its worth thinking about the value of time when trying to save money. Every little bit helps, but if it costs us all of our time, it makes sense to re-evaluate that investment of time. Because while money can always be made, new time can’t be made!

Note: I originally posted this piece very soon after Squirrelers was launched. Given the blog’s increased readership, I wanted to revise the post a bit and revist this topic to get everyone’s thoughts

Those of us who are personal finance bloggers or blog readers know that it doesn’t necessarily take remarkable luck and good fortune for someone to eventually become a millionaire. Sure, those things are a tremendous help, there is no question about that. However, an individual or family with a more modest level of income and not coming from wealth still has a chance to get there, provided they start saving early enough.

Yahoo! Finance had an article on 7 common millionaire myths that are commonly held. Below are those myths, with my comments:

1) Millionaires Don’t Pay Their Taxes.

As the article states, they already do, and this is not likely to change in the near term. While we all want to be millionaires, there’s no need to hate on those who are, just because they’re millionaires!

2) Millionaires Just Inherited Their Money

Some sure have, but the viewpoint that all have inherited big money is simply not true. Many of them have worked hard for their money. I think that this myth is one that’s perpetuated in order to make people feel better about their own situations. Believe me, I’m no millionaire but I’m not going to stick my head in the sand and think that all millionaires just had the money handed to them. Some did, but not all. Sometimes that’s evident.

3) Millionaires Feel Rich

I’m not a millionaire, so I can’t tell you exactly how they feel. It would be nice to find out from personal experience someday! That said, from what I have seen, I suspect it’s the drive to cover life’s necessary expenses, and a bit of ”paranoia” about being broke, that has driven people to get to the point of being wealthy.  

4) Millionaires All Have High-Paying Jobs

No, they don’t. Some people are able to live within their means, maximize the savings minus expense gap,invest properly, and avoid big financial and life mistakes. With a mixture of discipline (and in some cases a little luck), there have been innumerable middle-class people who have accumulated wealth.

5) Millionaires All Drive Fancy Cars

Many people became millionaires by living within their means, and being able to discern wants and needs. If I had a million dollars handed to me today, I still wouldn’t buy a new, upscale branded car. Rather, I would buy a reliable used car.

6) Millionaires Hang Around the Golf Course All Day

If they did this, they had better be worth well more than a million dollars! Otherwise, their millionaire status would be gone in a hurry. This myth is a bit strange.

7) Millionaires are Elitists

Some may be, and I’m sure many are out there. I have also seen a few that are outwardly just like the average person, but behind the scenes when you get to know them their hidden snobbery comes out. Also, I have seen a few that are not elitists and frankly, don’t want to spend any money at all if they could help it. I think it’s tough to generalize about the attitudes of millionaires.

What do you think of this list?

I think there is much wisdom to be gained from those that are. Having a mentor, role model, or millionaire teacher are ways to get help and wisdom. In order to absorb that wisdom, I believe one must cut out biases, perceptions, and jealousies, and focus instead on embracing reality.

I also think that some people who want to be wealthy try to act like they’re already there. You know, driving a car that’s really a step or two above what they should be driving, buying a home that’ s not a good fit based on their income and savings, or purchasing designer clothes despite not saving much money.

A buddy of mine who is in his mid-30′s and dating shared with me a story about a woman he went out with who told him about her vacation preferences. She said that when traveling, she preferred to stay in 5-star resorts and get pampered as that was her standard. She just wouldn’t stay in someplace lesser. His take was that this was a huge red flag, and the relationship never got started. Clearly, to him, she was someone with very high tastes that was living well beyond her means. He’s not stingy at all, by the way. He’s a good guy that would be generous to anyone he is with (in case you’re reading, my friend!).

Anyway, I think that outside of those who inherited or got extremely lucky in some way, many people who are millionaires got there because of hard work. In addition, they got there by living within their means, saving a significant percentage of their income, making smart health choices (such as deciding to stop smoking), and being responsible overall in their lives. For example, making smart decisions such as saving enough money in tax-deferred accounts, and only making an IRA withdrawal when the rules are clear. Furthermore, these aren’t necessarily extraordinary income earners, either.

What do you think? Do you agree that these are generally myths? Do you have any examples from your own life to prove or disprove these assertions?

This article was included in the Carnival of Personal Finance at Budgeting in the Fun Stuff

There are many ways that we measure wealth, and many ways that we can fund our retirement through our wealth.

One way to measure to determine where we are in terms of our savings is to look at months of covered expenses. For example, if a couple had $600,000 in net worth (assets minus liabilities), and $4,000 in monthly expenses, then they are 150 months wealthy in terms of savings.

Covered expenses is a simple, practical way for many of us to assess where we are financially. I’m a big fan of this personal finance diagnostic tool. It tells us how long we can live on what we have saved. Most of us are not multi-millionaires who can live off interest income and not touch our principal. Some folks reading this might be in that position, but if the rest of us stopped working, we would have to use our savings. This approach tells us how long our savings will last.

Stretching our minds and looking at things differently, perhaps we can save money with the intent of accumulating year in, year out, and never spending your savings. Keep on saving it, even when your months of covered expenses exceed your estimated remaining lifespan.

Why? Well, not touching savings is not just letting money sit there. Rather, it’s repurposing the money to be used as a source of more money.

This is where portfolio income comes into play. Instead of consuming your savings, you preserve your savings and let your money work for you. It becomes your faithful source of your own personal social security check.

Lets say the couple with $600,000 wants to live off an income stream without touching the principal. One could look at the required rate of return to see how how hard this money needs to work in order to satisfy their expense needs.

Taking a conservative view of returns, however, one could try to backsolve for the required nest egg size they would need to accumulate in order to live on their income stream.

For example, if the couple wanted to live on $4,000 monthly – $48,000 annually – they would have to amass quite a nest egg. If you took $48,000 and assumed a 3% rate of return to match inflation, it would take a next egg of $1.6 million for them to live on that $4,000. If they reduced their expense needs to $3,000 per month, it would take a nest egg of $1.2 million for them to accomplish the same goal.

This specific example doesn’t factor in the idea that your principal will reduce in purchasing power every year due to inflation. Remember that a dollar today is worth more than a dollar tomorrow. That said, portfolio income is cash flow that you can rely on without directly touching the principal. The good thing is, if you need that, you can eventually tap that as well. It’s another layer of conservatism is making sure you have enough to live on.

Ultimately, my take is that by working toward portfolio income, while trying to leave the principal intact as much as possible, you’re taking a big step toward financial freedom.

You will have worked hard to save and grow your money. Allow it to reciprocate and work hard for you in return!

Any thoughts? Do you look at retirement savings in terms of income streams, or in terms of a lump sum to tap into?

One note: I am personally a long, long way from retirement. Not going to stop me from dreaming big though:)

This article was included in Carnival of Personal Finance #264 at My Journey to Millions

Have you saved enough for retirement, and your future financial needs?

As much as I would like to say that I have done so, I’m a long way from that point. In fact, I’m not even remotely close. I’m actively working on it though, day by day, focusing on growing the income minus expense gap. I’m guessing that if you’re reading this, then you’re probably somewhere on that same journey as well. 

Since we know that we aren’t there yet, just how close are we to actually being able to retire? What is health of our portfolio, and how do we measure that? 

One could take the traditional approach, and focus on net worth, calculated as assets minus liabilities. I have advocated taking this a step further by calculating months of covered expenses, to determine just how long you can survive based on your current net worth and expense needs. 

I often look for different ways to answer such questions, with the hopes that some additional insights could be gained by viewing a situation through a different lens. In this case, determining where we are with respect to being able to retire, I suggest that we also consider our current required rate of return.

So, what is the current required rate of return? 

In essence, it is the rate of return that we will need to earn, in order to survive with our current nest egg. 

Let’s assume a couple with the following financial profile: 

Assets: $800,000

Liabilities: $200,000

Monthly Expenses: $4,000 

Further, let’s assume the following additional information:

Tax Rate: 25%

Rate of inflation: 3% 

To calculate their required rate of return, let’s first subtract liabilities from assets to obtain net worth: 

Net Worth = $800,000 – $200,000 = $600,000 

Then, let’s annualize their expenses: 

Annualized Expenses = $4,000 x 12 = $48,000 

Next, calculate percentage return on net worth:

$48,000 / $600,000 = 8.0% 

So, this means that the couple needs to earn 8.0% on their nest egg to meet their expenses. Or so it seems. 

The 8.0% figure is an interim step. There are two more factors that need to incorporated:

1)      Inflation

2)      Taxes

 To account for these factors, let’s take these steps: 

1)      Rate of return adjusted for inflation = 8.0% + 3.0% = 11.0%

2)      Adjusted rate of return, pre-tax = 11.0% / (1-.25) = 14.67%. 

Thus, on a pre-tax basis, the couple’s portfolio must return 14.67% annually in order to meet their annual expenses. 

Here’s the formula:

1)      Return on net worth = annual expenses / net worth

2)      Required return = (return on net worth + inflation) / (1 – Tax Rate)

What insights can we get from this calculation? 

1)      The ability of the nest egg to meet income needs. In this case, when you see a required rate of return at 14.67%, it tells you that you likely don’t have enough saved!

2)      Direction on reallocating our investment mix. In this case, with this type of required return, one might want to consider a mix of assets that is more likely to obtain a higher return. With higher potential return comes higher risk. And closer to retirement age, that might not be such a good thing. But it’s something to consider.

3)      Information on how we can improve our balance sheet and cash flows. Taking this formula, we can make changes to net worth and expenses to see how increasing/decreasing these measures can help us meet our goals. For example, in this case, reducing expenses to $3,000 per month and boosting assets by $200,000 changes the required rate of return to 10.00%.

It’s interesting to view the health of our portfolio using different calculations. What I like about this one is that it incorporates taxes and inflation, which many more basic views don’t.

Any thoughts? Do you have any other measures for assessing the ability of a portfolio to meet future cash flow needs?

This article was included in Carnival of Personal Finance #260 at Rainy Day Saver.

How do you measure wealth, in strictly financial terms?

Some people measure wealth by the amount of money that they make, in terms of salary, revenue of a business, etc. This basically amounts to a cash inflow measure of wealth: the more you make, the higher your wealth. More, people, however, take the approach of measuring wealth by how much money they have saved. Typically, one takes assets and subtracts liabilities, with the result being net worth.

Let us take two people, A and B, with these respective financial situations: 

Person A:

Monthly Salary: $5,000

Assets: $350,000

Liabilities: $150,000 

Person B:

Monthly Salary: $6,000

Assets: $350,000

Liabilities: $125,000

According to salary, Person B makes more and would be considered wealthier. According to net worth, Person B’s total of $225,000 (assets minus liabilities) exceeds Person A’s total of $200,000. Thus, using either measure, Person B comes out ahead as the wealthier individual.

I propose taking another look at wealth, and looking at it in terms of months of covered expenses.

By covered expenses, I’m talking about expenses for which you have the savings available to be used, if necessary. For example, if you have $4,000 of household expenses per month, and have $4,000 saved, then you have one month of covered expenses. If you have $4,000 of household expenses per month, and have $100,000 saved, then you have 25 months of covered expenses.

Taking this concept and applying it to Person A and Person B, let’s now include the additional information on monthly expenses to the data provided above: 

Person A:

Monthly Salary: $5,000

Assets: $350,000

Liabilities: $150,000

Monthly Expenses: $3,000

Person B:

Monthly Salary: $6,000

Assets: $350,000

Liabilities: $125,000

Monthly Expenses: $4,000

As you can see, I kept the salaries, assets, and liabilities the same; only monthly expenses have been added. One might be tempted to first look at monthly net cash flow, to see how that looks; both parties have equal net cash flow.

But when you look at months of covered expenses, the picture looks different:

Person A:

Net Worth: $200,000

Monthly Expenses: $3,000

Months of Covered Expenses: 66.7

Person B:

Net Worth: $225,000

Monthly Expenses: $4,000

Months of Covered Expenses: 56.25

Thus, despite Person B having a higher net worth and higher salary (as shown before), it is Person A that can survive the longest on his savings.

That’s the point – given our sustainable level of expenses, how long could we survive if our income stream completely dried up?

One could always take this further, and add in any number of caveats, such as unemployment income, interest income on savings, etc. Additionally, I do find validity in the other measures, as keeping ones earning power healthy is important, and net savings is a standard way to view wealth that most of us probably use at one time or another.

That said, I think this provides an alternative, yet easy way to look at how “wealthy” one really is. Different individuals and families have different money needs, so the value to salaries and accumulated net savings is different for everyone. By leveling the playing field, basing it on how long you could survive on what you have, it’s another way to look at where you are in terms of your finances.

What do you think of this concept? Do you have any other approaches to measuring wealth in financial terms?