All About The Personal Financial Statement

All About The Personal Financial Statement

By keeping tabs on your finances, you can create a secure and fulfilling future. That’s where a personal financial statement comes in. At its core, a personal financial statement offers an overview of where you stand financially at any point in time. It can help you succeed in various aspects of your life.

Why You Need a Personal Financial Statement

There are several reasons you may want to create a personal financial statement. It can help you if you’d like to:

  • Take out a loan.
  • Apply for financial aid.
  • Make a guarantee.
  • Design a retirement, estate, college savings, or other financial plans.
  • Lease a commercial office or other types of business space.
  • Develop strategies to reduce your tax burden.
  • Run for public office.
  • Keep track of your credit.

Ideally, your personal financial statement will show that you have a positive net worth and your assets are greater than your liabilities. This can allow you to position yourself as a responsible borrower and someone who knows how to manage their money well. It may also prove that you’re thriving with your finances.

How a Personal Financial Statement Can Change Your Money Habits

A personal financial statement can be instrumental in the way you think about your money and manage it. Here’s why: When you see your net worth, you’ll realize that many of your previous and future behaviors affect that figure. It informs you of whether or not you’re on track to meet your financial goals. A high, positive net worth, for example, may mean that you’re closer to your dream of:

  • Buying a dream home or rental property.
  • Retiring early.
  • Working part-time instead of full-time so you can spend more time with your family.
  • Donating more money to a cause or organization you value.
  • Funding your children’s college.

Low or negative net worth can give you a wake-up call. It may be just what you need to change your behaviors and be more cautious with the way you spend your money. You may be more likely to get out of debt, pick up a side job, and stick to a budget if you’re displeased with this figure.

What’s Included in a Personal Financial Statement

The three major components of your personal financial statement are as follows:

Balance Sheet

Your balance sheet is an overview of your personal net worth and will list all of your assets and liabilities. Assets may include your home, car, savings accounts, and investment accounts. Liabilities, however, might be your mortgage, auto, student loans, and credit card balances. Your balance sheet will state the difference between your assets’ total value and the total amounts you owe on your liabilities. It’s a great representation of your net worth.

Income Statement

Your income statement will consist of your salary, bonuses, and commissions. If you have other income from interest, a side job, or dividends, you’ll include this information as well. Your income statement will also outline your insurance premiums, income taxes, and any other consistent cash outflows you may have. With your income statement, you can determine whether you spend more than you earn and what you can do to improve the way you spend money.

Cash Flow Statement

A cash flow statement shows how you spend your money. It breaks down your cash into three main categories: fixed, non-discretionary expenses, variable, non-discretionary expenses, and discretionary expenses or fun money. It bridges the void of information from the Balance Sheet and Income Statement. You can use a cash flow statement to figure out if you’re on the right path to building wealth and meeting your goals.

What to Exclude From a Personal Financial Statement

Now that you know what’s included in personal financial statements let’s discuss what they should exclude. Your personal financial statements will not contain any business-related assets or liabilities. The only exception is a personal loan for your business or any other tool you’re directly accountable for.

Your personal financial statements mustn’t include anything you rent or personal belongings like household goods or furniture, as their values are rarely high enough to be considered assets.

How Often Should You Update Your Personal Financial Statements?

Once you prepare your personal financial statements for the first time, your work is not done. Since your finances will likely change regularly, your personal financial statements require frequent updates. It’s essential to review and modify your statements every month or every other month. This way, you’ll always be up-to-date on where you stand with your finances and can make adjustments to your spending and saving habits as necessary.

Personal Financial Statement vs. Business Financial Statement

Business financial statements usually consist of a profit and loss statement and balance sheet. As stated, personal financial statements include a balance sheet, income statement, and cash flow statement.

With a business financial statement, you can start or grow your business and obtain small business loans to help you do so. However, personal financial statements focus on your personal life and can help you achieve your personal financial goals like buying a house, retiring, or sending your children to college.

Ways to Increase Your Net Worth

Your net worth is essentially the value of your assets over your liabilities. You can have plenty of assets and have plenty of liabilities, meaning you don’t have a high net worth. On the flip side, you can have minimal assets but no liabilities and solid net worth.

So what is the ideal net worth? It depends on your age, unique lifestyle, and comfort level. There is no hard and fast number that everyone agrees with. However, you can use a formula developed by Thomas Stanley and William Danko, authors of the book “The Millionaire Next Door,” to get an idea of where your net worth stands. The formula is Net Worth=AgeXPretax Income/10. If your pretax income is $60,000 and you’re 35, for example, your ideal net worth would be $210,000, according to this formula. There are 18 financial ratios you should know, including this one.

Of course, this is just one way to look at your net worth and doesn’t necessarily mean that you’re struggling with your finances if you’re below the $210,000 mark. It’s all about what type of net worth you feel comfortable with. Another way to use your personal financial statement is to look at your liquid net worth that provides a more conservative view.

If your personal financial statements prove that your net worth is in the negative or lower than you’d like it to be, don’t worry. There are a variety of ways you can achieve a positive or higher figure. Here are several suggestions.

  • Cut Expenses: The less money you spend, the more you can use towards saving and investing. Take a look at your budget and figure out where you can reduce or eliminate expenses. If you rarely use that gym membership, for example, cancel it. If you tend to overspend on dining out, cook more meals at home. Remember that even a few dollars here and there can add up and increase your net worth in the long run.
  • Look for New Income Sources: If your 8 to 5 job doesn’t pay enough, don’t be afraid to earn money through other outlets. Depending on your schedule, preferences, and interests, you may want to take on a second job or freelance work. Or perhaps you have many items that you no longer need or want and can sell them on Craigslist or Facebook Marketplace.
  • Buy a House: If you’re currently renting, saving for a house may be a good option. Your mortgage payments can allow you to build equity, which can increase your net worth. If you do pursue homeownership, make sure you choose a home at or below your means. Otherwise, it can turn into a liability rather than a wealth-building tool.
  • Build an Emergency Fund: Unfortunately, life happens, and your car may break down, or your roof may need to be replaced when you least expect it. In these situations, it’s helpful to have an emergency fund. With an emergency fund, you can cover these unexpected expenses and avoid debt. Most financial experts recommend three to six months’ worth of savings in an emergency fund.
  • Get Out of Debt: Although it’s easier said than done, do your best to reduce or eliminate your debt. This includes your student loans, mortgage, credit card debt, car debt, and other places you make monthly payments to.
  • Invest: The sooner you begin to invest, the better. Once you have an emergency fund, make your money work for you via investing. You may want to consider some investment vehicles, including a 401(k), Roth IRA, Traditional IRA, and 529.
  • Get Insured: Insurance can protect you financially when and if the going gets tough. Life insurance, car insurance, and health insurance are important investments that can protect your (and your family’s) financial future.

How to Prepare Personal Financial Statements

If you’d like to prepare personal financial statements, you have two options. You can go the DIY route and complete them yourself. Fortunately, there are many free and fee-based templates available to guide you through the process.

Another option is to consult a financial advisor or hire a financial coach to help you. They can provide you with the expert guidance you need to ensure your personal financial statements are thorough and accurate. Even if you create your own statements, a financial advisor may review them and provide you with the peace of mind of knowing it’s in good shape.

A financial advisor can also help you increase your net worth. Once they learn more about your particular situation, they can make appropriate recommendations and steer you toward a healthier, happier financial future.

This article originally appeared on Your Money Geek and has been republished with permission.

Understanding Inflation And How To Protect Yourself From Its Effects

Understanding Inflation And How To Protect Yourself From Its Effects

Have you checked out the latest prices at the grocery store and the pump?

Understanding inflation and its effects on our household and investment portfolio is crucial. We almost always have some inflation, meaning wages and prices increase which helps job creation and economic growth. The absence of inflation is deflation, which means declining prices and could cause or worsen a recession as businesses lay off workers.

We have had low inflation with relatively stable pricing for years, primarily due to the Federal Reserve’s efforts.  However, the low inflation levels could change as our economy rebounds from the pandemic. To find higher rates, you have to go back to 1990, when inflation was 6.1%. Double-digit inflation was more common in the 1970s, with its peak at 13.3% in 1979.

The Federal Reserve’s Actions

The Federal Reserve has dual goals: maintaining relative pricing stability and sustainable economic growth with full employment. In the Great Recession and in March 2020, due to the pandemic-related economic downturn, the Fed steered towards accommodative monetary action to drop their fed funds rates to the lowest levels of zero to 0.025% to stimulate the economy. 

Chair Powell and the Fed intend to keep interest rates low through 2022 and have said they would be more tolerant of inflation rates that exceeded their 2% target. There is a reasonable possibility the Fed will have to act sooner as higher inflation is here.

Will The Fed Stick With Their Accommodative Policy?

Despite their intentions to stay with their current policy, the Fed’s policy mandate is to adjust their stance to changing information. The 10-year Treasury note’s yield has been rising and could signal higher inflation expectations. The Fed has tools to combat high inflation, such as raising interest rates. 

It is not clear if the Fed will change gears, but we can prepare ourselves. Should inflation increase to moderate levels above 2%, there are ways to protect ourselves from the potential erosion of our money. Some higher inflation may provide some benefits. You need some level of inflation to promote more spending.

Understanding Inflation

  • The Fed intends to remain accommodative for a while, with lower rates and liquidity.
  •  Fiscal support helped businesses and households.
  • Higher levels of vaccinations rising are boosting the economy.
  • With the latest US personal saving remaining high at 12.7% in May, we are saving more about twice the rate seen in 2019.
  • Credit card balances at the end of 2020 reflect the largest yearly decline since 1999, reflects consumer spending is down.

These factors, if combined, may unleash consumer spending to kick up our economy and contribute to higher inflation. Offsetting these factors is high unemployment levels staying stubbornly high and may keep inflation low for now.

It has been difficult for anyone to earn any income in a low-yielding environment without taking on more investment risk with low inflation. For investors with 60/40 retirement portfolios investing in stocks and bonds, respectively, some have shifted more significant proportion into stocks.

Investors will need to seek assets that are at least keeping pace with rising inflation. Holding cash in savings and checking accounts are suitable for liquidity purposes.  However, their safety feature will diminish as their values erode with rising inflation.  Later on, we have a list of investments that can protect you during a higher inflationary environment.

What Is Inflation And How Does It Affect Your Buying Power?

The definition of inflation is a steady rise in the general level of prices of goods and services. For example,  a gallon of milk cost $1.57 in 1975, rising to $2.20 in 1985 due to high inflation in the 1970s to early 1980s. It now costs $3.61 in 2021. The changes in prices are due to inflation, not scarcity. 

As a result of inflation, your purchasing power, the number of goods and services that one’s income will buy, go down. When prices rise, purchasing power declines, usually falling by the reciprocal amount of the price increase. Your paycheck may stay flat or go up more slowly, leaving you with less money. Union members may be an exception as they receive a cost of living wages as part of their contract.  

Calculating of Inflation

The US Bureau of Labor Statistics calculates inflation monthly using the consumer price index (CPI). The CPI is the best measurement of prices of all goods and services purchased for consumption in urban households. This index tracks a market basket of food, transportation, housing, health care, and entertainment, broken down into over 400 subcategories bought by end-users.

The CPI is a cost of living index with a starting reference point from 1982-1984 as the base period of 100. The CPI for January 2021 was 261 reported on February 10, 2021, the cost of living would have risen 161% since the base period [(261-100)/100= 1.61 of 161%]. If car prices rose 15% over the past five years, you may be paying $34,500 for a car that had cost $30,000 ($30,000 x 1.15%).

Economists tend to look at sequential (quarter-quarter) or year-to-year changes in the CPI. The most recent sequential rise in January increased by 0.3%, and up 1.4% since a year ago. These price increases confirm the low inflation we have had since the Great Recession began in 2007.

The Purchase Pricing Index, or PPI, is similar to the CPI but measures wholesale prices from raw material through the production stages. When PPI rises, the higher costs often are passed on to consumers.

Low inflation has stymied returns. Finding income in the low-yield environment has been challenging as we discussed here.

What Contributes To Inflation?

Various factors may influence inflation.

Higher Demand

Demand-pull inflation occurs when total demand for goods and services in an economy outpaces supply. In the early 1970s, a strong economy caused oil prices to rise and pushed up inflation to 12% in 1974. Strong consumer demand for goods and services could result in higher spending leading to higher inflation.

Increase In Production Costs

A different way of rising prices than demand-pull can come from increases in production costs without higher demand is known as cost-push inflation. Higher production costs can come through increased wages, raw materials, depletion of natural resources, droughts, or higher taxes. Businesses are not always able to pass these higher costs onto consumers.

There have been conflicting views on whether raising the federal minimum wage to $15 per hour would cause inflation. One side of the argument points to wage hikes which have been slow to come for many employees, and therefore, increases are overdue. Wage growth often leads to a more robust economy.

However, the pandemic-related recession has caused high unemployment that has crippled many small businesses. Many believe that we should have an improved economy and higher employment before raising wages.

Natural Disaster Shortages 

Prices can rise when shortages in goods and services are associated with natural disasters such as severe weather conditions, droughts, floods, fires, or avian flu. These disasters impact manufacturing plants, businesses, and residential areas. These unpredictable events may put temporary or long-term pressures on the production of goods, causing inflation due to scarcity.

In 2010, British Petroleum’s oil spill was the largest marine disaster in the Gulf of Mexico, causing higher gas and seafood prices. This area accounted for one-third of all seafood consumed in the US. About 40% of the Gulf waters needed to be closed to commercial and recreational fishing due to the spill.

Government Overspending

The US budget deficit has been rising from already high levels since the pandemic to counter the economic downturn. A government budget deficit occurs when expenses outpace revenues, not unlike the household budget.

Multiple fiscal stimulus packages related to hardships caused by the pandemic have been essential to provide funds to businesses and unemployed workers. This boost to government spending has required the US Treasury to raise capital and increase money creation by printing money. Both US Treasury and the Federal Reserve have increased money supply to increase liquidity and keep the financial markets calm, but a higher money supply typically leads to higher inflation.

Higher Prices From Higher Demand Post-Pandemic 

Many businesses lost revenues during the pandemic because of social distancing needs. As more people are vaccinated, our economy may rebound from strong demand in travel, entertainment, dining out, and going about life more normally. We may see some prices go up with increased demand and pressure to recoup lost revenues.

Different Kinds of Inflation

The various forms of inflation that are most worrisome are stagflation, deflation, and hyperinflation.

Deflation

Deflation is when there is an overall decrease in the cost of the economy’s goods and services. When price declines are minimal, consumers may spend more. When deflation is more pronounced, we may demand less, expecting more price declines. Businesses anticipating lower spending will cut production to prevent swelling inventories, and layoffs may result.

This deflationary scenario is considered the opposite of inflation and its evil twin. The Federal Reserve uses a 2% inflation target as part of its monetary policy, preferring low inflation to deflation. Deflation can send an economy into a recession or a worse downturn, causing layoffs.

Stagflation

Stagflation refers to a stagnant economy reflected in high unemployment and high inflation simultaneously. This problematic situation, spurred by an oil shock, lasted from the early 1970s into the early 1980s and was challenging to resolve. 

Hyperinflation

Hyperinflation has not been around for a while. The closest the US experienced hyperinflation was during the Civil War, and I think that is where everyone wants to see it, that is, in history. Between 1921 and 1923, the Weimar Republic, Germany’s government, experienced hyperinflation rising over 300%!

Relationship Between Inflation And Interest Rates

Inflation and interest rates are not the same thing, but they relate to each other. There is a tendency for interest rates and inflation to have an inverse relationship. When interest rates are low, it stimulates economic activity, and inflation rises. But, when interest rates are high, consumers slow spending, the economy slows, and inflation declines. It takes time for the economic changes to take place.  

Investing For Protection From Inflation

As an investor, you should have a better understanding of inflation to protect yourself from its effects. Some investments keep better pace with rising inflation than others. Real or physical assets often appreciate at or faster than inflation and provide better returns for investors. It is helpful when investing in understanding the economy, as we discuss here.

Money Market Securities

Cash and cash-equivalent securities make poor investments in a low-yielding environment. However, when inflation rises, the annual percentage yield (APY) will increase. Seniors have been clamoring for 5% CD yields which do not currently exist. Should inflation rise to higher levels, having cash to investing in money market accounts that are FDIC-insured will be a desirable place.

Build CD Ladders

The six-month CD rate hit a high of over 17% in March 1980 when inflation was 14.8%. I don’t think anyone wants to see inflation reach those levels or expects inflation of that magnitude. However, you can build a CD ladder to take advantage of rising APYs offered by the banks and credit unions.

You can start with short-term periods such as three or six-month CDs as inflation rises, lengthening their maturities as high inflation stabilizes, locking in nice returns. CDs are a less risky way to earn higher returns, especially if inflation is over 5%.

TIPS And Other inflation-indexed Bonds

Currently, bonds at fixed rates do not yield meaningful returns. However, bonds with variable rates are worthwhile investments in rising inflationary environments.

Treasury Inflation-Protected Securities, or TIPS, are issued and backed by the full faith of the US Government. They are considered the safest security, most liquid,  and rated AAA for the highest quality. Holders receive interest income twice per year at a fixed rate. These securities are an excellent way to diversify your portfolio for the least risk among other inflation hedges.

As inflation-protected securities, TIPs provide investors with a guaranteed real rate of return. The principal of TIPS increases with inflation and decreases with deflation measured by the CPI. At maturity, you are either paid the adjusted or original principal, whichever is greater. Like all Treasury securities, TIPs are exempt from state and local taxes.

Municipal Inflation-Linked Bonds

 Like TIPS, investors can buy municipal (munis) inflation-linked securities that track CPI and adjust the bond’s principal. These securities can keep pace with inflation better than a municipal bond without this feature.

Compared to TIPS, munis do not have backing from the federal government, are less liquid, and its ratings vary by municipality.  Funding purposes are to build roads, schools, airports, or infrastructure projects. To offset its higher risks, holders of muni bonds are tax-exempt from federal income taxes.

Corporate Inflation-Linked Bonds

Corporate bonds may have inflation-linked features, similar to the other bonds, adjusting to the CPI changes to better pace with higher prices. These securities tend to have higher risks that vary by the quality of the corporation. These bonds are less liquid than Treasury securities (every investment is!) and don’t have any tax-exemption benefits for their holders like Treasuries or municipal securities.

Variable-rate bonds have floating interest rates for coupon payments. Municipal and corporate bonds may have this variable feature that is adjusted to the current money market rate for their interest rate.

Gold

Gold is an inflation hedge and offers diversification for any investment portfolio. As a physical asset, gold is in limited supply. Central banks own gold in their portfolios as part of their foreign exchange reserves.

Gold prices were up 25% in 2020, among the best-performing assets. You can buy gold in its physical form as bars or coins. Typically, gold doesn’t pay dividends. However, some gold mining stocks pay dividends (e.g., Newmont and Barrick) individually,  as gold miner ETFs or SPDR Gold Shares or GLD, the bullion is in a fund.

Silver is an inflation hedge with a lower price point, attractive for retail investors.

Commodities

Commodities are not just pork bellies. As an inflation hedge, it is a broad group with many different products you earn and store. There are three main categories:

  •  Agriculture commodities include food, meat, timber, and cotton.
  • Energy has crude oil and its refined products.
  • Metals categories are largely precious metals and industrial metals.

As the price of the commodity rises, the product that contains the commodity will likely rise. When aluminum or steel prices rise, manufacturers may pass on the higher costs to consumers.

Real Estate Investment Trust or REITs

Real estate property makes excellent investments when inflation rises, but it may require work to maintain. A REIT is a company that owns and operates income-producing real estate. There are many different REITs for equity, retail mortgage, health care or hospitals, and data storage, providing diversification for any portfolio.

They generate stable income from above-average dividend yields. That’s because REITs are required to distribute at least 90% of their taxable income to shareholders annually.

Common Stocks

Stocks, as an asset class, have historically provided returns that beat inflation. They are a sturdy investment for the 60/40 investment portfolio, with inflation-indexed bonds likely to improve when there is higher inflation.

Certain sectors may perform better than others. Energy stocks, much like the commodity itself, are often inflation hedges. Financial stocks earn better income margins on loans in times of inflation, and healthcare insurers have performed better when higher inflation appears.

We already mentioned REITs and gold stocks as a worthy areas to invest in if inflation rises. Let’s add Dividend Aristocrat companies for inflation protection. They are represented by stocks that raise their dividends consistently for at least 25 consecutive years. There are different stocks in various sectors and are available as ETFs.

Another way to invest in stocks is to buy the S&P 500 index as a fund or ETF for inflation protection and diversification. If you choose to purchase stocks individually or as a sector, you may want to avoid utilities, consumer discretionary stocks, or companies with debt-laden balance sheets, like United Rentals.

Final Thoughts

Many suggest that we will have higher inflation over the next few years. Higher inflation, so long as we don’t have stagflation or hyperinflation, is manageable. Several investments are attractive as inflation hedges for protection.

Thank you for reading! Share any comments or feedback, we would love to hear from you. Please share this post with others if you found something of value, and join us at The Cents of Money!

 

 

 

Bitcoin ETF – How To Invest In Bitcoin and Other Cryptocurrencies

Bitcoin ETF – How To Invest In Bitcoin and Other Cryptocurrencies

It’s been a dismal year for the economy. But one bright spot amidst the recession has been the explosion in the value of Bitcoin and other cryptocurrencies.

Since its low in April 2020, Bitcoin is up almost 800% in less than 12 months!

So how can you take advantage of Bitcoin’s rise in the world economy? What is the best and easiest way to get exposure to cryptocurrency in your portfolio? Is there a Bitcoin ETF?

Read on for answers to all those questions and more.

Bitcoin Basics

In 2008, a person or persons using the pseudonym Satoshi Nakamoto released a whitepaper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” that described how Bitcoin would operate. Nakamoto mined the very first Bitcoin on January 3, 2009.

Bitcoin was a novel concept in that it was an entirely digital peer-to-peer currency. That means that it could facilitate payments between two people instantaneously without a third party (such as a bank) in the middle.

The Bitcoin cryptocurrency relies on a system of decentralized nodes that record all transactions on a blockchain.

A blockchain is a digital ledger of sorts that stores every transaction on the Bitcoin network. Each node keeps a copy of the same blockchain, and anyone can access and see the transactions. Because the blockchain gets duplicated thousands of times, it prevents cheating the system because each node contains all of the same information.

Bitcoin was initially conceived to take power away from banks and governments to artificially increase or decrease the supply of money and remove the need for a bank to be involved in transactions between individuals.

Per its design, there are a total of 21 million bitcoin that can be mined. After that, no more can be created. That means that supply is a known quantity, and thus demand will drive the price up or down.

Is Bitcoin a Good Investment?

Imagine you invested $1,000 in Bitcoin at the beginning of 2012. Can you guess what it would be worth today? $10,000? $100,000?Try $8 MILLION.

By comparison, $1,000 in the S&P 500 would be worth around $3,000; in the Dow Jones Industrial Average, up to $2,500.

There is much opportunity in the cryptocurrency market.

A single Bitcoin was trading at around $5 at the beginning of 2012. As of this writing, Bitcoin is hovering around $40,000 – 8000x what it was worth nine years ago. Even if you had invested $10,000 at the beginning of 2020, you’d have averaged making $200 a day since then.

What caused the enormous increase? In a few words, supply and demand. Bitcoin is a unique, innovative product that the world has never seen before. It offers a way to send money globally with virtually no cost and no intermediary, and by its design, there is a limited supply.

The Bull Case

Those who champion Bitcoin (the Bitcoin Bulls) see it as the equivalent of gold for the modern world. While gold itself doesn’t have any inherent value, other than for some industrial uses, there is a limited supply. That, coupled with the fact that most countries have moved to a fiat currency (i.e., one that is not tied to the value of gold or silver), makes gold an excellent hedge against inflation.

In the same way, Bitcoin’s value comes from it’s scarcity and the fact that as the world’s currencies become devalued by inflation and money printing, Bitcoin will hold its value. Even traditional Wall Street bankers and hedge funds are starting to see the potential.

One of the great hedge fund managers, Ray Dalio, sees its potential as a gold-like asset, calling it “one hell of an invention.” While Bitcoin’s future is still very much unclear, Mr. Dalio also admits that “Bitcoin has succeeded in crossing the line from being a highly speculative idea to something that could have value in the future.”

The Bear Case

Of course, on the other side of the coin (pun intended), Bitcoin is still relatively young. Many people have a hard time believing that an invisible asset is worth anything at all.

It is also beginning to be scrutinized by regulators and governments who see it as competition for their currencies. There is certainly the risk that it could be regulated out of existence or at least modified such that it bears no resemblance to the Bitcoin of today.

How to Invest in Bitcoin – Is There a Bitcoin ETF?

All of this leads to the big question: how can you invest in Bitcoin?

Until recently, the only way to buy Bitcoin was through specialized exchanges such as Coinbase or Gemini. You would then either keep it in an account with the exchange, which entails a not-insignificant risk of hacking and losing your Bitcoin, or transfer it into “cold storage” to a Bitcoin wallet. With this wallet, you would need a specific encryption key to access a 64 character long password of sorts.

In short, it is a reasonably clumsy process with a considerable downside risk of either hacking or losing your password and being unable to access your Bitcoin forever.

In contrast, in the traditional world of stocks and bonds, it’s pretty simple to invest in a company or an asset like gold or silver. These days there is a mutual fund or an ETF (exchange-traded fund) for almost anything. Want to add gold to your portfolio? Buy a Gold ETF, such as GLD.

Unfortunately, Bitcoin still has not reached universal acceptance by Wall Street and its regulators. Currently, in the U.S., there is no such thing as a Bitcoin ETF because it is not legally allowed.

However, many experts see it as a question of not if, given its rising popularity, but when regulators would work out the kinks to offer a full-fledged Bitcoin ETF.

A Bitcoin ETF would make it much easier for the average person to invest in cryptocurrency and open the door to broader investors’ adoption.

Benefits of a Bitcoin ETF

If you’re interested in cryptocurrencies and investing in a Bitcoin ETF, make sure you understand both the benefits and the risks of this new digital asset class.

As a relative newcomer to the financial industry, Bitcoin could be an excellent way to make extra money in your investment portfolio if you can withstand the volatility. Here are some of the benefits of a Bitcoin ETF.

1. Increased Investor Adoption

Investing in Bitcoin is not a streamlined process. Many investors may be interested in owning Bitcoin in their portfolio but are unwilling to open yet another account or dive into the specifics of holding Bitcoin in a wallet on their hard drive.

The introduction of a Bitcoin ETF would allow anyone with a brokerage account to invest in Bitcoin, which opens the doors to a much wider audience.

2. Lower Compliance Risk

Bitcoin is still in its infancy, and there is significant risk in the form of government regulations reducing its viability or outlawing it entirely.

The introduction of a Bitcoin ETF would go a long way toward legitimizing it as an asset and would force regulators to work out some of the hurdles to mainstream adoption.

3. Better Storage Solutions

The average investor does not want to mess with encrypted passwords, cold storage wallets, and other difficulties to hold Bitcoin in their portfolio.

Having an institutional investor in the form of a Bitcoin ETF manage all of this would remove the investor’s burden and provide added security and peace of mind.

Lower Transaction and Holding Fees

Currently, Bitcoin is a fragmented industry with new exchanges popping up frequently to compete with existing ones. Since they have to operate outside the efficiencies of Wall Street, fees can be high.

For example, on one of the most popular exchanges, Coinbase, fees for buying or selling Bitcoin range from 0.5% -1.5% or more. While that might not seem like a lot, at a current valuation of $40,000, buying one Bitcoin could cost you $600 in fees alone.

With a Bitcoin ETF, you would not be subject to buying or selling fees. Most ETFs charge a very low (0.1-0.25%) annual fee to manage the assets, which would bring costs down for individual investors.

Risks of a Bitcoin ETF

Investing in Bitcoin, whether as a Bitcoin ETF or owning the asset outright, also comes with significant risks. You need to understand your risk tolerance as an investor to see if Bitcoin should be a part of your portfolio or not. Even then, it would be wise to limit your allocation to a small percentage of your liquid net worth.

As there are many unknowns surrounding Bitcoin and other cryptocurrencies, they tend to exhibit extremely volatile, rising or falling in value by thousands of dollars in a single day.

1. Regulatory Risk

Bitcoin is a competitor of fiat currencies such as the dollar and the euro. There is a genuine risk that governments would want to regulate how Bitcoin is used, which would affect its value or make it outright illegal to own.

Also, the “seedy underbelly” of cryptocurrencies could lead to additional regulation.

In its earlier days, one of the prominent uses of Bitcoin was to facilitate transactions in the underground black market economy. The Silk Road was a dark web marketplace known for its illegal drug trade, among other things, and was only recently shut down.

Since Bitcoin transactions are untraceable and anonymous, it was (and still is) used in illegal trade for anything from drugs to weapons.

2. Security Risk

While Bitcoin has so far stood the test of time without any major hacking or security incidents, it’s still unknown whether the blockchain technology will hold up to future attacks.

Unlike gold, an actual tangible asset, Bitcoin is an ephemeral collection of ones and zeros on the internet. This makes tracing stolen Bitcoin all the more difficult if something were to happen.

3. Perceived Value Risk

There is still a lot of skepticism about a wholly digital, intangible currency that you can’t touch or feel. Bitcoin has value because people believe it does, and there is a demand for it.

If something were to happen that affected the asset’s demand, or people no longer believed it was a safe store of value, the price could plummet rapidly.

Best Bitcoin ETF Alternatives

While there is no true Bitcoin ETF, there continue to be innovations in the marketplace with new and easier ways to invest in Bitcoin and other cryptocurrencies.

Here are some of the best Bitcoin ETF alternatives available right now.

1. Grayscale Bitcoin Trust (GBTC)

Grayscale Bitcoin Trust is about the closest product available to a Bitcoin ETF. It trades on the market under the ticker GBTC and can be bought and sold like an ETF.

The main difference between GBTC and an actual ETF is that it is a closed-end fund. This means that it can trade at a premium or discount to the NAV (net asset value).

Historically, GBTC has traded at a 20-30% premium to NAV. So, in addition to the 2% annual fee, you could be paying $1.20 or $1.30 for each $1.00 worth of Bitcoin.

2. BlockFi

BlockFi bills itself as the “future of finance.” While it is not a bank, it offers many of the functions of a bank. You can buy and sell cryptocurrencies, hold cryptocurrencies on their platform and earn interest, and even take out a loan against the value of your Bitcoin.

You can currently earn 6% interest on your Bitcoin deposits and 8.6% on “stablecoin” deposits such as USDC. They can offer such high-interest rates because of the interest rates they charge when they loan money on the value of their deposits.

In a world of sub-1% interest rates in a “high yield” savings account, this sounds like a slam dunk deal. However, since BlockFi is not a bank, deposits are not FDIC insured. There is the possibility you could lose money if something drastic happened to the company or the price of Bitcoin.

3. Coinbase

Coinbase has been around for a while and is probably the most popular exchange to buy and sell Bitcoin and other cryptocurrencies.

While there are fees that can add up to 1-2% of the price paid, Coinbase provides a user-friendly and convenient way to buy and hold Bitcoin without dealing with encryption keys and cold storage wallets. It also provides a large assortment of other altcoins – non-Bitcoin cryptocurrencies – often hard to find.

4. Blockchain ETF

One alternative to a crypto ETF is to invest in the revolutionary technology that Bitcoin is based on – the blockchain.

Many companies are working on various uses for blockchain, from banking to public record storage.

A blockchain ETF such as BLOK would allow you to invest in the future of the underlying technology.

Bitcoin ETF:  Final Thoughts

Is there a Bitcoin ETF? That is one of the most-searched terms in the world of Bitcoin. While the answer to that is currently “no,” there are encouraging signs that may soon change.

In the meantime, many innovations are making it easier to buy, sell, and hold Bitcoin and other cryptocurrencies as an investment.

As long as you do your due diligence and understand the risks, investing in Bitcoin (even before the advent of a Bitcoin ETF) is not only possible but could be a worthwhile investment for your future.

Thank you for reading! Please visit us The Cents of Money for articles of interest, including A Letter To Young Investors During The Market Frenzy.

This article originally appeared on Your Money Geek and has been republished with permission.

7 Deadly Sins Of Investing And How To Avoid Them

7 Deadly Sins Of Investing And How To Avoid Them

In Seven, the neo-noir thriller, detectives David Mills and William Somerset (played by Brad Pitt and Morgan Freeman) track down a serial killer who uses the seven deadly sins as a motif in his murders. Investing may not be as lethal as a serial murderer. Here, we discuss the seven deadly sins of investing,  how they may impact our stock performance through destructive mistakes, and how we can avoid them.

What Is Investing?

Investing is a way to potentially grow the amount of money you have. The goal of making investments is to buy financial securities and hopefully sell them at a higher price in the future than what you initially paid. A saver can become an investor by giving your money a chance to work for you.

Investing is the best path to achieve wealth but it’s not a straight road. Unlike saving, investing involve some risks that could cause you to lose money.  You need to understand these hazards so you may be able to mitigate them. Investors purchase stocks and bonds with long term goals, unlike traders who have short term plans.

We can lose money when investing leads to emotional behavior or bad habits. Start investing as early as you can so you can earn money on top of the money you already earned, called compounding returns. Stay focused and purposeful so you can avoid behavioral biases which often play a detrimental role. Using financial discipline when investing can help you to achieve success

The seven deadly sins passed down from the Catholic Church of the Middle Ages may cause investors to perform poorly as modern examples for each deadly sin. The seven deadly sins are lust, gluttony, greed, sloth, wrath, envy, and pride.

1. Lust

When thinking of this deadly sin, I can’t help thinking about Jordan Belfort, better known as The Wolf of Wall Street. Belfort, or what we see of him, nearly defines every deadly sin. For that reason, he and the movie based on his memoir is pure entertainment and instructive for those who lust after sex and money.

As the first deadly sin, lust is a strong craving or intense longing such as sexual desire. It can also mean hunger for money. From an investor’s point of view, falling in love with your investments can be hazardous. Heavily favoring one stock may result in too much concentration risk in your portfolio.

Overexposure To One Stock Poses Concentration Risk

Take the example of Gur Huberman’s “Familiarity Breeds Investment” study in 2001, which involves ATT’s (“Ma Bell”)1984 breakup. When ATT split into the 7 Baby Bells, its shareholders received equal amounts in each new company.

Huberman found investors tended to retain a disproportionate amount of shares in their local Bell company. These individual investors held as much as $10K-$20K of a single stock, a higher concentration than the typical stock holding in a US household’s net worth.

Overexposure to one stock poses more significant risks to your portfolio that can sneak on you from slowing fundamentals. Investing in the company you work for is common for many people. However, if you have substantial ownership of shares where you work for and in your investment and retirement accounts, you have too many eggs in one basket. Instead, you need to diversify your portfolio with different stocks, industries, and asset classes.

2. Gluttony

Gluttony is the overconsumption of eating and drinking. We have all been there, gorging ourselves over an excellent meal, and feel our regrets afterward. Dante refers to this sin as “excessive love of pleasure.” We may be engaging in gluttony by overindulging our funds into less liquid investments without leaving a cash balance to buy stocks in a correction or pay off debt.

The recent excessive trading of GameStop shares by retail traders to shake up Wall Street seemed to be foolhardy, if not reckless. Sending that stock into the stratosphere caught everyone’s attention before coming back to earth but may have been costly.

Diversification, Asset Allocation, and Rebalancing

Alternatively, some people hoard their cash in a savings account, which generates little interest income, especially in this low rate environment. Investors need to be careful in allocating money into investments and having funds for emergencies, debt pay-offs, and retirement.

The antidote to gluttony is purposefully investing with strategies that embrace diversification, asset allocation, and periodic rebalancing.

3. Greed

“My name is Jordan Belfort. The year I turned 26, I made 49 million dollars, which really pissed me off because it was three million a week.”

The Wolf of Wall Street

“Greed is good…Greed, in all its forms, greed for life, for money, for love, knowledge, has marked the upward surge in mankind and greed.”

Gordon Gekko, Wall Street, the movie

Greed is not good, but it is very prevalent in the world of investing. The Wall Street (“the Street”) culture is all-consuming. It breeds greed and the need to make more than the person next to you. Not everyone working on the Street is greedy, or a criminal but temptations are there as they are everywhere.

The definition of greed as a sin is an intense and selfish desire for something of value, referring to wealth, material possessions, power, or food. Trendy investments are often collective greed that may become long term losers. Stock manias reflect “irrational exuberance,” a phrase used by then-Federal Reserve Chair Alan Greenspan when he commented on stock’s higher asset values than fundamentals warrant.

Bubble manias of the past–Dutch tulips, South Sea, Japan’s real estate and stocks, dot-coms, housing– should provide historical context to fear and greed in today’s markets. We hear about overbought markets but justify our purchases in SPACs, bitcoin, Tesla, Nio, so we aren’t left out of some of the apparent winners.

Lock-In Some Profits

How can we better deal with our greed, so we don’t become a casualty of fickle markets? No one gets hurt taking some profits off the table. I sell a small percentage of my gains regularly, usually, after a stock rises 20%-25%. This way, I may avoid my winners blowing up, an experience I have in my past.

Recognizing the need to be rational when investing is essential. It means doing your research, or if you feel you don’t have the time, are too emotional, or don’t have the inclination, you may be better off finding a financial professional to advise you in your best interests.

Take heed from another respected investor, Warren Buffett, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” There is a Fear and Greed Index (FGI) that measures investor sentiment for those opposing emotions daily, weekly, monthly, and annually. Too much fear can send stocks down, while greed indication may push stocks up.

4. Sloth

Why do they have to pick on this cute animal known for moving slowly and spending most of its time upside down in trees? As a deadly sin, sloth translates to an absence of interest or not exerting oneself physically or mentally. Said another way, it is the avoidance of hard work and perseverance, or simply laziness.

We can usually spot sloths who are lazy about physical exercise. However, investing requires cognition or understanding of what you are doing with your money. 

Laziness can hurt you when you are jumping into stocks without rhyme or reason. A slothful investor may under-invest or spend too little time reviewing one’s portfolio. Investing is not a “set it and forget it” activity. Investors may mistake the buy and hold strategy as akin to that. The buy and hold strategy means that you have a long-term perspective, but you need to adjust your portfolio for new or changing information.

Be Aware of Biases At Work

Making investments requires research. Even if you are planning to use a financial advisor, research is necessary. You still need to find a person or team that works to understand your financial goals to work with you on your financial plan.

Slothful people may be prone to procrastinate over making decisions. The status quo bias occurs when someone may be resistant to change. The endowment effect is similar, but it occurs when someone places a higher value on what they already have. Shortly after my parents passed away,  I inherited stocks, such as ATT and IBM, conservative names appropriate for their portfolio but not necessarily mine. Yet, I held on to their stock picks as an example of an emotional bond that was irrational.

How To Avoid A Slothful Nature?

If you intend to monitor your portfolio, recognize the need to be proactive in having diversification, taking some profits, and making adjustments as warranted based on changing company fundamentals. There are many different kinds of low-cost index funds that have other purposes of fitting your investment strategies. For example, you may look at target-date index funds that may appropriately adjust holdings based on your age.

Automation

You can automate your paycheck by allocating a certain amount or percentage to go into retirement savings, so you don’t have to remember to contribute to this account regularly. It is essential to use your paycheck to make it easy to make investments, save money, and pay bills.

Consider talking to a financial planner to help you with your financial goals and make investments for you.

5. Wrath

“Heeere’s Johnny!”

Jack Torrance, off-season caretaker in The Shining

There are many images of wrath, but Jack Nicholson’s character comes to mind. Wrath is defined as uncontrolled feelings of anger, rage, vengeful, and even hatred. Jim Cramer’s very rational rant in 2007 (and transcript) as the financial crisis was unfolding, but the Fed Chair was not yet cutting the fed funds rate or adding liquidity to the markets.

When the stock market becomes volatile as it did during 2007-2009 and in March 2020, we have wrathful states that pose dangers for any investor. We become angry at bad decisions for keeping stocks too long or selling them too fast as many jumped to do as the stocks sold off in March in the shortest bear market in memory.

GameStop As An Example of Irrational Buying

Retail traders who may lack experience may seek greater risk than they can handle and make irrational buying decisions.  We saw some recklessness as buyers were bidding GameStop shares up to crazy prices beyond their poor fundamentals.

It seemed as though traders were trying to punish short-sellers such as hedge funds by engaging in combat. Stories of young investors who took out costly loans to buy shares at exorbitant prices are heartbreaking. We wrote a letter to young investors you can read here.

Studies suggest that anger may increase our risk-taking. Don’t be reckless and engage in using leverage like margin trading.

Avoid anger and other emotions when making investments. The market doesn’t hold grudges, know how to be vindictive, or have a memory from day-to-day.  Investors need to make adjustments for changing circumstances.

Learn From Mistakes And Use Discipline

Learn from your mistakes to not sell as the market is plummeting unless you need liquidity. Stay rational by not impulsively trading or investing. Give yourself some discipline by selling a losing stock after it drops 7%-8% to avoid a more significant loss. Consider taking some profits off the table to lock in those gains.

6. Envy

Have you ever felt envious? Of course, you have. Envy is a feeling of resentful longing often brought on by someone else’s possessions, better standing, or luck. Envy often leads to conspicuous consumption to match those around them at work or in the neighborhood. The phrase “keeping up with the Jones” may mean buying a new car or a boat to fit in with other people around you.

Investing circles may envy those who are “killing in the market” when they share their wins in the most trendy stocks or funds. What they may not be telling you is about the mistakes they have made in the past. At one time, people envied Bernie Madoff’s clients for above-average returns, and we know how that movie ended.

Herd Mentality Bias

Merrill Lynch may still refer to its financial advisors as its “thundering herd,” but following or copying the herd is a negative sentiment. In behavioral finance, herd mentality bias refers to the investors’ tendency to follow what other investors are doing in the market.

Think of dot-coms, GameStop, or popular acronyms for groups of stocks such as “FAANG,” standing for Facebook, Amazon, Apple, Netflix, and Google, before it changed its name to Alphabet.

It is not always the wrong move for individual investors to buy rising stocks that reflect heavy trading volume. Sometimes that is a healthy indicator of institutional buying, and it is painful to go against the smart money crowd. However, it will financially hurt when large investors start shedding stocks in their portfolios.

Don’t Chase Hot IPOs

Individual investors, who typically do not have access to new issues, often seek the hot IPOs after pricing in the primary market. The average first-day pop in the post-IPO stock is 20%, but hot names have shot up 80%-100% or more. Six months later, many of these stocks have fallen below their IPO price as the aura on these stocks is gone, a casualty to weaker fundamentals than expected.

Instead of being envious, learn about investing, risks, and develop strategies that work for you. Remember that Madoff’s returns were fictitious. It is in our nature to compare ourselves with others. However, you cannot be sure that you are looking at anyone’s full picture. Don’t waste your energy on envy.

7. Pride

“Details of your incompetence do not interest me.”

Miranda Priestly, The Devil Wears Prada

Pride or extreme pride is hubris, a Greek cousin to pride. Hubris means self-confidence, arrogance, and corrupt selfishness. One who has hubris irrationally believes they are better, superior and has excessive admiration of their self-image. Having this kind of pride is a self-destructive vice, especially harmful when you are an investor.

It is hard to work for someone like Meryl Streep’s Miranda Priestly, who always desires to be right. As an investor, the need to be right can hurt your ability to make money.

You may hold on to a losing stock and an unrealized loss rather than admit you are wrong. The justification for holding on to the stock is that it is only a loss on paper until you sell it. However, a 10% unrealized loss can widen if fundamentals warrant it. Loss aversion bias is the tendency to prefer avoiding losses to acquiring gains.

Overconfidence Bias

Another bias is overconfidence, which means having an egotistical belief in your investing acumen. It is challenging to perform better than the market averages, but those who are overconfident tend to operate with the false comfort they can perform well.

Instead, having a fear of being wrong in many investing situations can help you stay on your toes. The best investors avoid overconfidence and consider worst-case scenarios as medicine to remain aware of downsides in the market. They recognize that there is much that you cannot control about the market.

Avoiding The 7 Deadly Sins With These Investing Rules

To recap some of the ways you can avoid the investing pitfalls associated with the seven deadly sins:

Avoid concentration risk by diversifying your portfolio and do asset rebalancing.

Be aware of the emotions and behavioral biases that impact our decisions.

Don’t dump stocks during times of market turbulence.

Buying hot IPOs post-pricing is not a good idea, as there will be a better time and price to do so. 

No one gets hurt taking profits off the table to lock in gains.

Don’t engage in reckless strategies such as short-selling or using leverage to buy stocks.

Use automation to move money more quickly from your paycheck to contribute to your savings, retirement, and investment.

 

Final Thoughts

When investing, you may have run into the seven deadly sins that can impact your performance. Counter each sin, often wrapped in emotion or biases, with purposeful investing to avoid common mistakes.

Thank you for reading! If you found some value in this article, please share it with others. Consider joining The Cents of Money community by subscribing and getting our weekly newsletter.

 

 

 

How Do You Measure Your Financial Success?

How Do You Measure Your Financial Success?

 

I wanna be a billionaire so f**king bad

Buy all of the things I never had

Uh, I wanna be on the cover of Forbes magazine

Smiling next to Oprah and the Queen.

Billionaire, Lyrics By Travie McCoy

 

You Don’t Have To Be A Billionaire

You do not have to be a billionaire to consider yourself to be financially successful. If you have a roof over your head, food on your plate, loving family and friends, you are already in a good class. To measure financial success, use specific personal financial ratios and qualitative factors to evaluate your financial health. These benchmarks can help you develop better financial habits in savings, spending, retirement, investing, and debt payoffs.

 Limitations of Financial Metrics

Financial metrics have some limitations. For example, debt-to-income will be different for people of different ages. At 30 years old, when you are at the beginning of your working career, you are accumulating more debt and likely have a low savings amount. However, by age 60-65, as you enter retirement years, the balance shifts to high savings and low-to-zero debt levels. For those who have unpredictable income, ratios may be difficult to assess without normalizing for volatility.

We zero in on a few of the most important financial ratios. For our post on 18 personal financial ratios where we look at the array of money topics, please visit here.

We look at qualitative factors, those you can’t calculate, that can help you measure your financial success.

Having money is not the only factor in our attaining success and happiness, is it? Money isn’t everything

Have An Emergency Fund That Can Absorb A Financial Shock

Having liquidity on hand for emergency purposes provides much-needed peace of mind. Liquidity refers to your ability to easily convert assets into cash with little to no loss of principal. When you are liquid, you have the financial ability to pay for unexpected costs such as a loss of job, death in the family, or your roof is leaking.

According to a recent Charles Schwab survey, only 38% of Americans have an emergency fund, with 59% of American adults live paycheck-to-paycheck. It takes time to stash away money for unforeseen events such as a job loss. However, it should be a priority. Without it, you will have to borrow more.

Liquidity Ratio

Monetary assets are liquid investments. The average household can include cash, money markets, savings, and checking accounts. As such, they should be able to provide liquidity to pay your fixed monthly expenses. 

Liquidity Ratio = Monetary Assets/ Monthly Expenses

Fixed monthly expenses are basic living needs like groceries, rent or mortgage, utilities, and car loan for six months. A  ratio of six means that your monetary assets can pay for your basic needs of food, rent, utilities, and a car loan for the next six months, if necessary.

 Emergency Fund Ratio

The liquidity ratio is linked very closely to the emergency fund. This cushion is essentially a cash fund for emergencies in unforeseen events such as job loss, death in the family, unexpected surgery, or immediate house repair.

An emergency fund ratio works ample enough to support you through these unknowns for a targeted timeframe. If you are looking for six months or higher (and this is highly recommended) to set aside in one fund investing in a high yield savings account or a money market account, then:

Emergency Funds Ratio= 6*Monthly Expenses

This ratio will give you a targeted amount of monetary assets needed to be comfortable for the possible emergency. It takes time to accumulate money for these purposes. How long it will take depends on you and your ability to save.

Related Post: Why You Need An Emergency Fund

Net Worth Is A Key Benchmark

Your net worth, also known as net wealth, is a snapshot of your current financial position. How rich are you? You can calculate net worth as total assets, that is, what you own less total liabilities or what you owe. Hopefully, what you own is more than what you owe. I consider knowing what your net worth is to be an essential personal finance benchmark.

Net Worth Ratio

Net worth is your personal balance sheet measuring your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier. Another financial measure is your liquid net worth which strips out non-liquid assets.

Net Worth Ratio= Total Assets Less Total Liabilities

Your total assets are what you own at its current market value. Like art and antiques, some assets are more difficult to calculate and may require a professional appraisal. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan, and any other loans you have. The higher the positive number you have, the better off you are financially.

 

Targeted Net Worth Ratio (The Millionaire Next Door)

One of my favorite personal finance books, The Millionaire Next Door, is an oldie but goodie. I have read it at least twice and refer to it often when teaching my college students about money habits.

The more successful millionaires are the prodigious accumulators of wealth (PAWs). They tend to be less extravagant, as most of us believe of millionaires. Instead, PAWs lived frugally, often buying used cars. As such, they accumulated and retained their wealth.

This ratio uses age as a factor in the calculation, as some other ratios do.

Targeted Net Worth Ratio= Age x (Pretax Income/10)

Your targeted net worth provides you with an indication of what you should be worth after liabilities.  As a 30-year old making $95,000 annually, your net worth should be $285,000. The calculation amount is 30 x (95000/10). It is a guidepost to help you reach your goals.  Although somewhat arbitrary, it gives you some context of what is achievable if your goal is financial flexibility.

These Ratios Consider Our Age

There is a fundamental relationship between our income, debt, and savings. These ratios (savings-to-income, debt-to-income, and savings-rate-to-income) consider our age. We make lower salaries in our early career years when we borrow for a house and a car and make debt payments. Keep your debt burden at manageable levels and save for 401 K retirement and Roth IRA.

Savings-To-Income Ratio

When looking at savings, add your assets, including cash and money markets, the current market value of retirement savings, notably 401K and IRA balances, brokerage investment accounts, real estate investments, and the present value of other business interests.

Don’t include less liquid assets to total savings like art, antiques, your car, or primary home. The monetization of these assets is less predictable in terms of time. It is also harder to peg a reasonable value as they are usually less liquid than securities.

Savings-To-Income Ratio= Market Value of Savings/ Gross Income

Your ratio will be minimal at age 25 or 30, growing to a multiple of 3 or better when you are 45 years, and continue to grow to 10x-15x your pre-retirement income, so you have a comfortable cushion for retirement.

Debt-To-Income Ratio

A better way to look at whether your debt burden is too high is to compare it to your gross income, that is, the amount you make.

Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100

Typically, when you are age 30, when your salaries are at the low end of your career, you may be borrowing for a home or a car while still paying student loans. Your ratio should be no more than 36% of gross income. This ratio should decline as you command higher salaries and save more.

An alternative way to calculate the Debt-To-Income ratio is looking at your total debt balances compared to your income.

For example, you owe $175,000 on your mortgage and $25,000 on your car loan. Your salary is $110,000, or (175,000 +25,000)/ $110,000 = 1.81. This amount is a fairly normal ratio for a 30-year-old. As your salary rises and you pay off part of your loan, you should be at a ratio of 1 in your 40s. Target little to zero debt as you enter your 60s, so you are debt-free in retirement.

Savings Rate-To-Income Ratio

Savings should be one of the essential parts of your household’s financial goals. Adopt a “Pay Yourself First” attitude. Your monthly budget should call for savings to be at least 10% of gross income.

Savings Ratio = Savings/Gross Income

Savings refer to money in the bank, liquid funds, deposits, money markets, and other liquid funds, such as your emergency fund. Gross income is your total source of income on your budget and includes what you earn, side businesses, bonuses, dividends, and interest income.

Your savings rate should be at least 10% of gross income. Saving is difficult to do when you first start to work. As your salary or what you make rises, it should get easier to put money away for savings. A healthy savings ratio of 20% would be a good target and allow you to put some of this money to pay down debt.

 Personal Cost of Debt

Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score.  If you have high monthly credit card balances, then you probably have a high price of debt. Card companies notoriously charge high-interest rates.

Also, your credit score matters. If you have a lower FICO score, that is, below 650, for example, lenders will see you as a risky borrower and charge higher interest rates. Reducing debt will help you to raise your credit score.

Pay Down High-Cost Debt

In debt reduction plans, there are two types: Snowball Method (tackles the smallest debt first) and Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method so that you can get rid of the highest cost of debt first. Try eliminating your credit card balances altogether by paying your bills in full.

Related Post: How To Pay Down Your Debt For Better Financial Health

Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)

Debt           Debt Amount             Interest Rate %            % of Total Debt              Interest Rate x Weighting

Loan 1           $25,000                          7.0%                            42%                                      2.9%

Loan 2           $35,000                          4.5%                            58%                                      2.6%

Total              $60,000                                                             100%                                      5.5%

Your goal would be to reduce your higher-cost debt, that is, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be a more significant amount than your liabilities. Your investments should be ideally earning returns above your cost of interest.

For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% aftertax returns. Therefore, you should look to carry debt at lower costs than stock returns.

This calculation is very similar to how businesses look at borrowing capital for projects. Companies select projects expected to generate returns above their cost of capital. Your household is your business. You want to have higher returns in your investments than your borrowing.

Retirement Savings Ratio

There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.” 

Saving for your retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and begin contributing to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.

Retirement Savings Ratio = 25 x Primary Income

If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.

This ratio complements the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” The 4% withdrawal rule means that you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000.  It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.

Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (his analysis pegged the number closer to 4.15%), your retirement savings could last 35 years. Use this as a guideline rather than something etched in stone. Whether you can withdraw 3% or something closer to  5% depends on what kind of lifestyle you will have in retirement. 

The 80% Rule

Some experts use the 80% rule as a rule of thumb for estimating what your income at retirement would be. If your final income before your retirement is $100,000 x 80% = $80,000.

This rule means that you should be able to live on $80,000 comfortably in retirement. The assumption is you may be able to eliminate some expenses associated with work, such as work attire, transportation and can take public transit.

If you use this $80,000 amount in conjunction with the 4% withdrawal rule, then $80,000/ 4%= $2 million. This lower amount (than the $2.5 million above) reflects the reduced lifestyle needs of a retired person.

Related Post: Saving For Retirement In Your 20s

Qualitative Measures of Being Financially Successful

Sometimes number crunching is just not enough, especially for measuring your financial success. We embrace our lives differently. Making a million dollars a year may be a bad year for someone used to making eight figures in the past. Others may feel retiring by age 40 is their mark of success. Being a barber at the age of 108 years was a supreme achievement for Anthony Mancinelli.

What are the qualitative ways of being financially successful?

Being Financial Independent

You are having a target of being financially independent. As such, you have enough savings and income to pay for your living expenses without being employed in a job you don’t want to have or be dependent on others.

You may support yourself through alternative sources of income like dividends, passive income, part or full-time work you enjoy. It is an excellent mindset for those with many interests and who don’t want to work if you don’t like non-flexible hours.

Debt-Free And Financially Flexible

You have paid off all your debt. The only obligation you carry is monthly credit card payments, but not if you pay them in full. You have a financially flexible life, meaning you can meet your current and financial obligations and have savings. You are not living paycheck to paycheck. You have liquid savings in the event of an emergency.

Don’t Fight About Money With Your Spouse

You and your spouse are on the same page regarding your financial goals and communicate regularly to stay on track. You agree on the game plan for spending, savings, and debt. Being aligned is an ideal scenario but challenging to achieve regularly. It is up to both spouses to meet periodically to review their budget for the short term and assess long-term goals.

Couples often fight about money issues. It will happen for most of us. Being honest and transparent to each other is what counts. If you veer off track from your goals, review your plan together and make changes if needed. I don’t think shielding the other from potentially bad or embarrassing developments is the right thing to do.

Be open and proactive about financial problems that should be dealt with promptly. Avoid financial fidelity.

Passionate About Your Career Job

It is easier to increase your chances for financial success if you enjoy your job and career. Some people have had success in starting up several successful companies or even starting up one great one after several failures. Apoorva Mehta, the founder of Instacart, the online personal shopper, reportedly had 20 failed startups before he successfully built Instacart.

I have had success in very different career paths. When I worked as an equity analyst, I enjoyed the quick pace and satisfaction of meeting with senior company management and communicating my research with institutional investors. I was passionate about my job. It was an exciting time for the telecom industry as digital Internet technologies created new products and services.

As a professor, I love teaching and the “Aha” moment when students make connections in the classroom. When I feel I’ve made a difference, it is priceless.

Don’t Compare Your Financial Situation To Others

We often compare ourselves to others. It may give a point of reference to our peers, which may not be a complete picture. Obsessing over these comparisons is unproductive and may be stressful.

Social comparison bias is a human reaction. We allow ourselves to be influenced by comparing our financial achievements–income, net worth, status, job title—to others. We negate different paths, personality traits, and the possibility that some inflation has been taking place.

A better comparison is to look at you are currently against the person you were in the past. What have you accomplished relative to what you anticipated in your plans? How do your results fit with your long-term goals? That is a more accurate picture and will allow you to move forward with your next moves.

Enjoy Learning And Picking Up New Skills

To be successful, keep learning from your experiences and pick up new skills. Continue to challenge yourself with strengthening a weakness or adding competence. Continue to evolve in your career, expand your skills, manage people or learn a language. Not only will it keep you from being hampered, but you will also be more valuable at this job or elsewhere.

Final Thoughts

Financial ratios are proper as a starting point to understanding your financial health. They do not take the place of a sound financial plan. Although they have limitations, like age specificity, these metrics can move you to the next goal post. Consider qualitative measures of what being financial success is. What we all want is to be able to say that we had a life well spent.

Thank you for reading! Please find other articles of value on The Cents of Money where you can subscribe for freebies. 

How do you measure your financial success? How does it coincide with your financial goals? Look at your financial plan relative to your goals regularly. What works for you? We would like to hear from you!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

I wanna be a billionaire so f**king bad

Buy all of the things I never had

Uh, I wanna be on the cover of Forbes magazine

SmIiling next to Oprah and the Queen.

Billionaire, Lyrics By Travie McCoy

 

You Don’t Have To Be A Billionaire

You do not have to be a billionaire to consider yourself to be financially successful. If you have a roof over your head, food on your plate, loving family and friends you are already in a fortunate class. Certain personal financial ratios may help you to evaluate your financial health. These quantifiable benchmarks can help you to develop better financial habits in savings, spending, retirement, investing and debt payoffs.

Financial metrics have some limitations. For example, debt-to-income  will be different for people of different ages. At 30 years old when you are at the beginning of your working career, you are accumulating more debt and likely have low savings amount. However, by age 60-65, as you enter retirement years, the balance shifts to high savings and low-to-zero debt levels. For those who have unpredictable income, ratios may be difficult to assess without normalizing for volatility.

We zero in on a few of the most important financial ratios. For our post on 18 personal financial  ratios where we look at array of money topics, go here.

There are qualitative factors, those you can’t calculate, that can help you measure your financial success.

Having money is not the only factor in our attaining success and happiness, is it?

Have An Emergency Fund That Can Absorb A Financial Shock

Having liquidity on hand for emergency purposes provides much needed peace of mind. Liquidity refers to your ability to easily convert assets into cash with little to no loss of principal. When you are liquid, you have the financial ability to pay for unexpected costs such as a loss of job, death in the family, or your roof is leaking.

Only 38% of Americans have an emergency fund, with 59% of American adults live paycheck-to-paycheck according to a recent Charles Schwab survey. It takes time to stash away money for unforeseen events such as a job loss. However, it should be a priority. Without it, you will be forced into borrowing.

Liquidity Ratio

Monetary assets are among the most liquid of assets. These assets includes cash, cash-equivalent securities or money markets, savings bonds, savings and checking accounts. Liquid assets can be used to support your fixed monthly expenses for 3-6 months. The larger the amount the more comfortable you will feel.

Liquidity Ratio = Monetary Assets/ Monthly Expenses

Your monetary assets should support your fixed monthly expenses such as groceries, rent or mortgage, utilities and car loan for 6 months. A  ratio of 6 means that your monetary assets can pay for your basic needs of food, rent, utilities and car loan for the next 6 months, if necessary.

 Emergency Fund Ratio

The liquidity ratio is linked very closely to the emergency fund. This is essentially a cash fund for emergencies in unforeseen events such as job loss, death in family, unexpected surgery or immediate house repair.

Emergency fund ratio works by using a targeted number of months that you believe is ample enough to support you through these unknowns. If you are looking for 6 months or higher (and this is highly recommended) to set aside in one fund that can be invested in a high yield savings account or in money markets, then:

Emergency Funds Ratio= 6*Monthly Expenses

This ratio will give you a targeted amount of monetary assets needed to be comfortable for the possible emergency. It takes time to accumulate money for these purposes. How long will it take depends on you and your ability to save.

Related Post: Why You Need An Emergency Fund

Net Worth Is A Key Benchmark

Your net worth, also known as net wealth, is a snapshot of your current financial position. How rich are you? It is calculated using total assets, that is, what you own less total liabilities, or what you owe. Hopefully, what you own is in excess of what you owe. I consider knowing what your net worth is to be an essential personal finance benchmark.

Net Worth Ratio

This is your personal balance sheet measuring your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier. Calculating a net worth statement and updating it is important to do regularly.

Net Worth Ratio= Total Assets Less Total Liabilities

Your total assets are what you own at its current market value. Some assets, like art and antiques, are more difficult to calculate and may require a professional appraisal. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan and any other loans you have. The higher the positive number you have, the better off you are financially.

 

Targeted Net Worth Ratio (The Millionaire Next Door)

One of my favorite personal finance books, The Millionaire Next Door, is an oldie but goodie. I have read it at least twice and refer to it often when teaching my college students about money habits.

The more successful millionaires are profiled as prodigious accumulators of wealth (PAWs). They tended to not be extravagant or status seekers as commonly believed of millionaires. Instead, PAWs lived frugally, often buying used cars. As such, they accumulated and retained their wealth.

This ratio uses age as a factor in the calculation as some other ratios do.

Targeted Net Worth Ratio= Age x (Pretax Income/10)

Your targeted net worth provides you with an indication of what you should be worth after liabilities.  As a 30 year old making $95,000 annually, your net worth should be $285,000. That amount is derived as 30 x (95000/10). It is a guidepost to help you reach your goals.  Although somewhat arbitrary, it gives you some context of what could be achievable if your goal is financial flexibility.

These Ratios Are Linked To Our Age

There is a fundamental relationship between our income, debt and savings. These ratios (savings-to-income, debt-to-income and savings-rate-to-income)  are closely linked to our age. In our early career years, we make lower salaries, borrow for a house and a car and make debt payments. Keep your debt burden at a manageable levels and save for 401 K retirement and Roth IRA.

Savings-To-Income Ratio

When looking at savings, add your assets including cash and cash-equivalents, current market value of retirement savings, notably 401K and IRA balances, brokerage investment accounts, real estate investments, and current value of other business interests.

Your art, antiques, your car or primary home should not be included in the total for savings. Monetization of these assets are less predictable in terms of time. It is also harder to peg a reasonable value as they are usually less liquid than securities.

Savings-To-Income Ratio= Market Value of Savings/ Gross Income

At age 25 or 30, your ratio will be minimal, growing to a multiple of 3 or better when you are 45 years, and continue to grow to 10x-15x your pre-retirement income so you have a comfortable cushion for retirement.

Debt-To-Income Ratio

A better way to look at whether your debt burden is too high is compare it to your gross income, that is, the amount you make.

Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100

Typically, when you are age 30, when your salaries are at the low end of your career, you may be borrowing for a home and/or a car while still paying student loans. Your ratio should be no more than 36% of gross income. This ratio should decline as you command higher salaries and save more.

An alternative way to calculate Debt-To-Income ratio is looking at your total debt balances compared to your income.

For example, you owe $175,000 on your mortgage and $25,000 on your car loan. Your salary is $110,000, or (175,000 +25,000)/ $110,000 = 1.81. This is a fairly normal ratio for a 30 year old. As your salary rises and you pay off part or your loan, you should be at a ratio of 1 in your 40s. Target little to zero debt as you enter your 60s so you are debt free in retirement.

Savings Rate-To-Income Ratio

Savings should be one of the most important parts of your household’s financial goals. Adopt a “Pay Yourself First” attitude. Your monthly budget should call for savings to be at least 10% of gross income.

Savings Ratio = Savings/Gross Income

Savings refer to money in the bank, liquid funds, deposits, money markets and other liquid funds, such as your emergency fund. Gross income is your total source of income on your budget, and includes what you earn, side businesses, bonuses, dividends and interest income.

Your savings rate should be at least 10% of gross income. This is difficult to do when you first start to work. As your salary or what you make rises, it should get easier to put money away for savings. A healthy savings ratio of 20% would be a good target and allow you to put some of this money to pay down debt.

 Personal Cost of Debt

Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score.  If you have high monthly credit card balances, then you probably have high cost of debt. Card companies notoriously charge high interest rates.

Also, your credit score matters. If you have a lower FICO score, that is, below 650 for example, lenders will see you as a risky borrower and charge  higher interest rates. Reducing debt will help you to raise your credit score.

Pay Down High Cost Debt

In debt reduction plans, there are two types: Snowball Method (tackles the smallest debt first) and Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method so that you can get rid of the highest cost of debt first. Try eliminating your credit card balances altogether by paying your bills in full.

Related Post: How To Pay Down Your Debt For Better Financial Health

Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)

Debt           Debt Amount             Interest Rate %            % of Total Debt              Interest Rate x Weighting

Loan 1           $25,000                          7.0%                            42%                                      2.9%

Loan 2           $35,000                          4.5%                            58%                                      2.6%

Total              $60,000                                                             100%                                      5.5%

Your goal would be to reduce your higher cost debt, that is, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be a larger amount than your liabilities. Your investments should be ideally earning returns above your cost of interest.

For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% aftertax returns. You therefore should look to carry debt at lower costs than stock returns.

This is very similar to how businesses look at borrowing capital for projects. They will pick plans that are expected to generate returns above their cost of capital. Your household is your business. You want to have higher returns in your investments than your borrowing.

Retirement Savings Ratio

There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.” 

Saving for your retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and begin contributing to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.

Retirement Savings Ratio = 25 x Primary Income

If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.

This ratio is complementary to the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” This means that you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000.  It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.

Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (his analysis pegged the number closer to 4.15%) your retirement savings could last 35 years. Use this as a guideline rather than something etched in stone. You need to figure out what kind of lifestyle you will have in retirement.

The 80% Rule

Some experts use the 80% rule as a rule of thumb for estimating what your income at retirement would be. If your final income before your retirement is $100,000 x 80% = $80,000.

This means that you should be able to live on $80,000 comfortably in retirement. The assumption is you may be able to eliminate some expenses associated with work such transportation and can take public transit.

If you use this $80,000 amount in conjunction with the 4% withdrawal rule, then $80,000/ 4%= $2 million. This lower amount (than the $2.5 million above) reflects the reduced lifestyle needs of a retired person.

Related Post: Saving For Retirement In Your 20s

Qualitative Measures of Being Financially Successful

Sometimes number crunching is just not enough especially for measuring your financial success. We embrace our lives differently. Making a million dollars a year may be a bad year for someone used to making eight figures in the past. Others may feel retiring by age 40 is their mark of success. Being a barber at the age of 108 years was a supreme achievement for Anthony Mancinelli.

What are the qualitative ways of being financially successful?

Being Financial Independent

Having a target of being financial independent means that you have enough savings and income to pay for your living expenses without being employed in a job you don’t want to have or be dependent on others.

You may support yourself through alternative sources of income like dividends, passive income and part or full time work you enjoy. It is a great mindset for those with many interests and don’t want to be tied down to a job you don’t like or non-flexible hours.

Debt-Free And Financially Flexible

You have paid off all your debt. The only debt you carry are monthly credit card payments and are able pay them in full. You have a financially flexible life, meaning you can meet your current and financial obligations and have savings. You are not living paycheck to paycheck. You have liquid savings in the event of an emergency.

Don’t Fight About Money With Your Spouse

You and your spouse are on the same page regarding your financial goals and communicate regularly to stay on track. You have a game plan for spending, savings and debt and are aligned for the most part. This is an ideal scenario and difficult to achieve regularly. It is up to both spouses to meet regularly to review their budget for the short term and assess long term goals.

Couples often fight about money issues. It will happen for most of us. Being honest and transparent to each other is really what counts. If you veer offtrack from your goals, review your plan together and make changes if needed. Don’t think shielding the other from potentially bad or embarrassing developments is the right thing to do.

Be open and proactive about financial problems that should be dealt with promptly. Avoid financial fidelity.

Passionate About Your Career Job

It is easier to increase your chances for financial success if you enjoy your job and career. Some people have had success in starting up several successful companies, or even starting up one great one after several failures. Apoorva Mehta, the founder of Instacart, the online personal shopper, reportedly  had 20 failed startups before he successful built Instacart.

I have had success in very different career paths. When I was worked as an equity analyst, I enjoyed the quick pace and satisfaction of meeting with senior company management and communicating my research with institutional investors. I was passionate about my job. It was an exciting time for the telecom industry as digital Internet technologies created new products and services.

Now, as a professor, I love teaching and the “Aha” moment when students make connections in the classroom. When I feel I’ve made a difference, it is priceless.

Don’t Compare Your Financial Situation To Others

We often compare ourselves to others. It may give a point of reference to our peers which may not be a very complete picture. Obsessing over these comparisons is unproductive and may be stressful.

Social comparison bias is a human reaction. We allow ourselves to be influenced by comparing our financial achievements–income, net worth, our status, job title—to others. We negate different paths, personality traits and possibility that some inflation has been taking place.

A better comparison is to look at you are currently against the person you were in the past. What have you accomplished relative to what you anticipated in your plans? How do your results fit with your long term goals? That is a truer picture and will allow you to move forward with your next moves.

Enjoy Learning And Picking Up New Skills

To be successful, keep learning from your experiences and pick up new skills. Continue to challenge yourself with strengthening a weakness or adding a competence. Continue to evolve in your career, expand your skills, to manage people or learn a language. Not only will it keep you from being stymied, you will be more valuable at this job or elsewhere.

Final Words

Financial ratios are useful as a starting point to understanding your financial health. They do not take the place of a good financial plan. Although they have limitations, like age specificity, these metrics can move you to the next goal post. Consider qualitative measures of what being financial success is. what we all want is to be able to say that we had a life well spent.

How do you measure your financial success? How does it coincide with your financial goals? Look at your financial plan relative to your goals regularly. What works for you? We would like to hear from you!