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Bay Area Parent


Hey Big Spender

How to Teach Teens About Financial Responsibility

By Corrie Pelc, Bay Area Parent

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Teens love to spend money. A recent report by Teenage Research Unlimited notes that teens spent $159 billion in 2005; nearly half of those interviewed predict that they will spend more in 2006.

However, teens don’t love to save money. A study commissioned by the National Consumers League found that 55% of teens surveyed said they work mainly for spending money, while only 35% mainly save. While nine out of ten teens say they save money, 36% admit that they are saving for specific items they want to purchase, 22% are saving for college and 27% are saving for no particular reason.

Teens may still be financially dependent on their parents, but it’s important for them to learn about financial responsibility and how to manage their money intelligently. “When we think about how our world is changing and how teens have more access to money than probably you or I did, it’s important for them to understand how to properly manage it,” says Sanyika Calloway Boyce, author of Teen Money Tips: Somple Steps for Banking, Saving, and Making Money. “It’s critical to their success at being an adult,” adds Kish Dill, board member and volunteer for Junior Achievement of Silicon Valley and Monterey Bay, which teaches financial education classes in public schools throughout Silicon Valley. “[Also] important is their success in getting through those difficult years after high school, through college, and into their early 20s.”

In most cases, it’s going to be up to parents to do the teaching. Most schools do not offer personal finance classes. According to Bryan Medlin, founder of Alameda-based Money 101, which offers financial life skills workshops for young adults, only seven states nationwide require students to receive instruction in personal finance before graduating high school. California is not one of them.

So, how can parents ensure that they are teaching their teens what they need to know about money management? To begin, help a teens set up a savings and/or checking accounts. Dill says these accounts are a step to financial independence and responsibility. “Often, when I go into a classroom, the kids’ only understanding of a financial system is: I get an allowance every week, and I can spend it on what I want,” he shares. “They never get the chance to practice and understand the whole concept. It also adds some pride to their life because, hey, this is my own; I am learning how to be independent.”

With a savings account, parents can begin to teach the concept of saving for the future, perhaps for “big-ticket” items such as junior prom, their first car or a school trip. Parents can even go further into the future by teaching their teen about the concept behind a 401K plan. For example, parents can say that for every $10 a teen saves from their allowance, they will match that amount. “It helps them see, ‘Wait a second, if I’m willing to put the money away and save it instead of spending it immediately, I’m actually going to get even more back,’ so the reward is huge,” Calloway Boyce explains.

Parents can also help their teen understand the difference between “needs” and “wants” and how to assess them. That is one of the topics covered in the “Money Matters: Make it Count” program offered by the Boys & Girls Clubs of Silicon Valley Levin Clubhouse in San Jose. “We talk about how parents usually provide all the things [teens] need and how they shouldn’t really depend on parents to give them things they want. Young adults should learn as teenagers how to start saving for the things they want,” says Erica Muniz, health and life skills director for the Boys & Girls Club of Silicon Valley. After parents set up a savings or checking account, they shouldn’t just walk away, Dill says. “This should be an ongoing discussion of, ‘Hey, my statement came in today. Let’s look at this and learn how to reconcile the balance with my checkbook,” he explains. “That is a perfect opportunity to promote dialogue without it being a lecture. It can be much more of a learning experience that way, instead of, ‘Here’s your allowance, Don’t spend it all in one place.” Parents should also be aware that many banks and credit unions offer special accounts with teens in mind. There’s Bank of America’s CampusEdge checking account for young adults 18 and up. According to Diane Wagner, a spokesperson for Bank of America, teens can receive a Stuff Happens card. “It’s good for a one-time service fee refund. So, if you did an overdraft with insufficient funds or you needed cash and went to a non-Bank of America ATM and had a fee assessed, you can use your Stuff Happens card so it will eliminate the service fee.”

Should parents let their teens have access to their money through a debit-card? Dill says it depends on the individual parent and teen. “A debit card is a fairly common way of getting cash and getting access to their savings account. So long as it’s understood that this is the same thing as having all your money tucked away in a mattress in your bedroom, I think it’s fine.” He concludes. However, parents need to emphasize the importance of keeping track of expenses. Says Calloway Boyce, “I had a kid say to me once, ‘Well, I don’t have to balance a checkbook because I never wrote a check.’ So the concept of balancing a checkbook needs to still be communicated although we are going to a paperless society.”

What about credit cards? “Teenagers and college students are inundated with card offers in the mail and this leads to trouble,” Medlin says. “Credit cards are power tools and, like a power tool, you can do something good with it or you can really hurt yourself. It really depends on how you use it. And as with a power tool, you need to have a certain level of awareness of the features and how to use it effectively. Credit cards are really no different.”

Calloway Boyce recommends that parents have a conversation with their teens about how credit is not evil, but rather, necessary. “Often, I hear parents say, “Oh, stay away from credit, it’s bad. It’s evil, you don’t need a credit card,” she explains. If you can create for your children a healthy respect for and a constructive relationship with credit while they’re still under your supervision, that’s going to make for a far more responsible and better credit consumer.”

Although special bank accounts for teens and financial workshops can help parents in their quest to teach financial responsibility, some experts also advise parents to use their daily financial transactions as teaching tools. “Include your kids when you’re balancing your checkbook,” Dill says. “I wouldn’t keep it a secret how much money you have in the bank account. Make it an activity that you go over with them; ask them what decisions you should make.” Dill also suggests including teens in financial decisions. “When you’re buying a car, sit down and ask, ‘How much money do we have in the bank? What type of car should we get? And, of course, the kid’s going to say, ‘I want the Escalade’ and you can say, ‘We don’t have that much money, we have this much money, what should we do?’ Any type of transaction when you’re doing normal day-to-day activities is an opportunity to engage your kid in learning.”

Other experts explain that a teen learns from observing his or her parents. “The savings and spending habits of the adults in the home certainly lay the groundwork for the culture of what the young adults will be doing in the future,” Wagner says. Learning to save and budget now will help teens when they go off to college, so they don’t end up misspending money set aside for food and school expenses. Says Muniz: “Even though parents help with college education or any kind of higher education, we want the kids to be able to learn why it’s important to go to college and how they should budget their money if they’re receiving financial aid or if their parents are paying for school.”

Plus, learning how to budget and manage money now will pay off in adulthood when dealing with shrinking pensions, rising healthcare and housing costs, and uncertainties surrounding Medicare and Social Security, Medlin says. “It’s not about how much money teens save—that’s irrelevant,” he explains. “What matters is putting in place the discipline and the awareness required to make progress. Every adult, myself included, can look back on their own lives and identify financial decisions that they made when they were younger that, gosh, if they had been a little bit smarter, how different their lives would be today.”


Corrie Pelc is special sections editor for Bar Area Parent

Oakland Tribune Article

Financial knowledge key to future

By Barbara Grady, Oakland Tribune

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Today’s teenagers have more money at their disposal than did prior generations of teenagers. A survey by financial firms reveals that spending by this age demographic averages $58 a week. According to a study by JumpStart Coalition, by the time they are seniors in high school, nearly a third of teenagers use a credit card. By college, that percentage jumps to 83% of students and their average outstanding credit card balance is $2,327.

Besieged by advertisements and active users of the Internet—where the only way to buy things is with a credit card—today’s teenagers are vulnerable to financial missteps. Think it may be a good idea to make sure today’s teenagers know something about money—about budgeting, the cost of credit, interest rates and saving? Alan Greenspan, former Chairman of the Federal Reserve, does; he says that gaining “financial literacy” in elementary and high school can “help prevent young people from making poor decisions that may take years to overcome.”

Indeed, the fastest growing demographic group declaring personal bankruptcy is people aged 20 to 24, according to Coinstar Inc. Yet research groups also say that most teenagers admit they don’t know much about finance and their parents haven’t taught them about managing money. A large survey of teens and their parents by Capital One, a major credit card issuer, and Consumer Action found that only 44% of teens said their parents taught them about money management while 70% of parents believed they had done so.

And rarely is financial education incorporated into scholastic curricula. Thirteen year old Natalie Boskin, who lives in Albany, may be one of the lucky ones. Her parents opened a savings account for her and she has come to understand the concept of saving money for future reward. Boskin saves the majority of her allowance, taking out only a certain percentage each week for spending. When asked what she is saving for, she says college. But her inclination to save is rare among her peer group. Boskin said, “I found I’m a much better saver than my friends. If they get $20 it is gone by the end of the week. My friends—the ones that spend a lot—have more money in the bank than I do. I think their parents put it there for them. But that is not teaching their child how to save.”

Several national and local organizations have sprung up to help teach adolescents about finances—about balancing checking accounts, about how compound interest rates help grow both debt and savings, and how debt obligations can affect credit scores.

The JumpStart Coalition, in Washington D.C., is the largest organization advocating for youth financial literacy. It has developed a curriculum for use by schools or nonprofit organizations such as scout troops. It’s Web site states that “Many young people fail in the management of their first consumer credit experience, establish bad financial habits and stumble through their lives learning by trial and error.” A survey of high school seniors found that, the 32% who use credit cards are slightly less likely than non-credit card users to understand how interest rates work and the mechanics of compound debt.

Locally, Alameda resident Bryan Medlin is one who took up the charge of teaching youth about personal finance. A California Maritime Academy college graduate, Medlin was appalled at the financial troubles his classmates accumulated. Medlin, who decided to build a business around teaching young people about money management, established a Web site, www.money-101.com, for this purpose. Recently, he has become a guest lecturer at Bay Area high schools, middle schools, and nonprofit organizations.

“It’s preemptive education. Certainly, without the benefit of personal finance training, a lot of young adults will make costly economic mistakes. Their parents don’t always teach them,” Medlin explained. He said that some amount of teaching about money is appropriate at each age, “To parents, I would recommend integrating practical financial education into conversation as early as 6 or 7 years old, the difference between coins and paper money and their respective equivalences should be taught. By the time parents are ready to give their kids an allowance, it makes sense to talk to their kids about budgeting. Many young adults spend money frivolously and, after a week, usually have no idea where their cash went. By tracking personal spending—which can be easily done using a computer and personal finance software—and planning expenditures within a semi-rigid framework instills financial discipline that will benefit them for years to come. By the time they reach high school and college age, young people should understand the time value of money, such as how stocks and bonds work and how to evaluate and select investments that will help them accumulate wealth in tax advantaged retirement accounts. Given average stock market returns over a multi-decade period, young people need only save a small amount of money to become millionaires at age 65. That’s a powerful message.”

Business writer Barbara Grady can be reached at (510) 208-6427 or bgrady@angnewspapers.com

A Budget: The Key to Your Financial Success—Part 1

Financial concepts are slippery things. After all, they can’t be touched or visually examined. To be fully appreciated, they must be imagined. Although this small but necessary feat of mental dexterity can make the economic logic of budgeting seem fuzzy, it’s important to map out an economic game plan that, on a month-to-month basis, clearly identifies how much money you intend to spend and save. This is a useful ongoing exercise because great wealth seldom materializes by itself and accidental millionaires are extremely rare. But take heart, you can amass a sizable fortune over the course of your life with even a modest income. Only, chances are, if you eventually succeed in doing so, your striking it rich later on will be a direct result of careful financial planning, continued personal sacrifice and tireless persistence. You see, when it comes to saving money and inflating a personal balance sheet, doggedness pays off. Believe-it-or-not, if you establish good money habits now and aggressively save and invest throughout your teens and twenties and beyond, you’re likely to attain an enviably high future net-worth. All it takes is a bit of determination and a willingness to make sound financial decisions in your day-to-day life. A budget makes economic miracles possible because it provides a largely self-imposed framework that, in turn, will enable you to relentlessly focus on and ultimately achieve major financial goals. Moreover, a budget will keep you on track and prevent you from blowing great gobs of money on stuff you don’t really want. To understand why a budget is crucial to your economic progress, it might help to compare a budget to something else entirely; something tangible that’s easier to relate to and identify with. What sort of everyday item embodies the potential and promise of a budget? Strangely enough, it’s a car… Though, at first glance, a budget and an automobile might seem to have nothing whatsoever in common, there are striking similarities between them.

Essentially, budgets and cars are vehicles. What differentiates them, however, is the type of transportation they provide. Whereas an automobile is a complex marvel of engineering that converts gasoline into transportation, a budget is an equally intricate and useful device that harnesses the power of an income and channels it toward any number of short-term, intermediate and long-term economic goals. Now, as you speed down life’s highways and biways, the destination is often a place; with a budget, however, it’s a financial goal. Granted, the anatomy of a budget and a car look nothing alike; but if you overlook this superficial dissimilarity and view them instead as elaborate mechanisms whose productive output requires the successful and well-timed coordination of many different and loosely interrelated parts, their similarity is immediately apparent. Just as a glimpse under the hood of an automobile’s idling engine compartment will reveal a puzzling tangle of wires, hoses and oddly shaped mechanical parts, an X-ray view of a working budget’s moving internals reveals an equally active dynamic, one that consists of carefully controlled, frequently monitored and constantly shifting cash flows which, in turn, support your goals and priorities. If you design and stick to a budget–which, make no mistake, isn’t easy–your day-to-day economic choices will gradually foster a deeper and more meaningful sense of personal satisfaction and fulfillment.

Of course, to operate at peak efficiency, cars and budgets require periodic tweaking and maintenance. With automobiles, the oil has to be changed and routine maintenance must be performed. Similarly, for a budget to operate at peak efficiency and produce optimal results, it too must be periodically monitored and adjusted. Sudden or dramatic changes in personal economic circumstances–which can include anything from violent fluctuations in spending to hiccups in income will, for better-or-worse, affect your progress toward financial goals. So, from time to time, you’ve got to pop your budget’s metaphorical hood, reach for the appropriate tools, and tinker with it until it’s once again producing desired results. On the road of life, cars and budgets are essential tools; if they’re properly cared for, they’ll take you wherever you want to go.

Alas, scarcity is one of money’s many qualities. Disappointingly, dollar bills don’t sprout like leaves from trees or erupt from cracks in the sidewalk like weeds. In theory, managing money sounds deceptively simple; in actual practice, it’s anything but—and there are many reasons why. As people distractedly going about the hectic hustle and bustle of everyday life, it’s often easy to forget that we’re continually bombarded by all manner of commercial stimulus. Meanwhile, each of us is inwardly nudged and outwardly cajoled by a shrieking cacophony of wants and needs. With enough money or even the right kind of plastic in one’s wallet, the urge to splurge is understandably difficult to resist. Which brings us to the crux of the problem: it’s extremely difficult–no, impossible–to satisfy an infinite number of wants and needs with limited financial resources. Establishing priorities is what budgeting is all about.

For many, when it comes to making financial decisions, there’s a natural tendency to fixate on satisfying immediate desires at the expense of longer-term goals. Admittedly, the thought of blowing money willy-nilly with no regard whatsoever to future consequence is, at times, powerfully seductive. Like a strictly regimented diet of ice-cream sundaes, the idea is appealing. Problem is, there’s a significant and widely overlooked downside to reckless binge spending. Such behavior seems satisfying but it has unsavory long-term consequences, namely: AFD (Acute Financial Discomfort); the telltale symptoms of this debilitating condition include an inability to save and a tendency to spend more money than one has.

Peeling back the layers of the decision making onion, consumers’ financial choices are guided by numerous factors, and few of them are positive. Social circumstances play a significant but hard-to-quanitify role in establishing the overall tone and tenor of consumers’ relationship with money. Conspicuous consumption is a term sociologists coined long ago to describe a curious but widely observed phenomenon: people spend lavishly on goods and services in an (often futile) attempt to elevate their standing among piers, acquaintances, and, in some cases, complete strangers. For America’s consumer class, maintaining appearances and keeping up with the Joneses is an exhausting full-time effort. It’s worth emphasizing, however, that numerous studies suggest that the link between consumption and happiness is, at best, tenuous. An informative article in The Economist (12/23/06), which examined the murky interrelationship between wealth and happiness, ultimately concluded, “…People quickly grow accustomed to whatever they have—however much of it there is. Moreover, having lots of things isn’t necessarily enough if other people have more. A rising tide lifts all boats but not all spirits, giving rise to a kind of status-anxiety.”

Interestingly, the unlikely field of neuroscience also has something to say about the addictive nature of spending; MRI studies of the brain show that spending money triggers the release of intoxicating pleasure chemicals to the brain. So, because of our fixed neurological hard wiring, there’s a biological explanation for consumers’ economic spendthrift ways. And if all this wasn’t enough to entice shoppers to empty their wallets and stimulate the national economy, there’s another game-changing factor in the mix as well. There’s this industry called advertising. It’s a thriving multi-billion dollar business and it’s how companies large and small compete for consumers’ dollars. Make no mistake, in the no-holds-barred arena of free-market Beyond Thunderdome capitalism, a war is indiscreetly being waged for your dollars. Ever set foot outside of your home, turned on your computer, listened to the radio, answered your telephone or watched TV and been overcome by the feeling that someone somewhere is desperately trying to sell you something? In an economy that’s addicted to profits—which, in turn, requires a steadily escalating level of sales activity—advertising is virtually inescapable. It’s slyly affixed to coffee-cup sleeves; the once blank side of that scrap of paper that’s stuffed into fortune cookies; the rooftops of taxi-cabs; the sides of buses; the periphery of sports stadiums; magazines, and even restroom stalls. As Kalle Lasn, co-founder of Ad Buster’s magazine, rightly points out: “From the moment you awake in the morning you’re assaulted by commercial stimulus. In fact, on average, about 3,000 marketing messages seep into the average North American brain every day.” Susan Douglas, University of Michigan’s Communications Professor, is credited with this clever quote: “Advertising–which is the bread, butter, jam, and mother’s milk of media–has afflicted Americans with a perpetual unease that can be momentarily appeased but never quite satisfied with future purchases. Advertising is designed to sell us envy, and the person we envy is the future self we become if we purchase goods and services.”

So, with a brain that’s hard-wired to spend and so many disparate factions noisily clamoring for your cash, the simple act of hanging onto it occasionally requires a heroic act of self-restraint. Sure, it’s important to smell the flowers and enjoy life now (which means engaging in a bit of retail therapy every now and then), but it’s equally important to develop and strengthen the fiscal resolve necessary to deny these irksome impulses and build personal savings. This is essential if, over the long windy course of your economic life, you want to build the sort of rock solid balance sheet that will enable you to comfortably weather unforeseen monetary setbacks and achieve lasting financial peace of mind. But here’s the kicker: reconciling the need to live large now with the seemingly less urgent need to scrimp and save for the future isn’t easy. It requires striking a sensible balance between hedonistic abandon and Spartan frugality. Unfortunately, this is all but impossible to do if you’re not carefully monitoring daily expenditures. So, the next time you’re next-in-line at the convenience store checkout counter, take a few deep tantric breaths and get a death grip on your economic chakras. Start by creating a shopping list that includes all of the items you’re going to buy well before setting foot outside of your home to run errands. And don’t deviate from the master plan. When creating a shopping list, it’s important to differentiate between a “want” and a “need.” Don’t confuse the two… Although the difference might seem hazy, needs include things like food and shelter. They’re biological necessities and are essential for survival. Wants, on the other hand, fall into that vast category of prospective purchases that can be safely put-off for another time. Bertrand Russell said it best: “To be without some of the things you want is an indispensable part of happiness.”

In short, the simple act of spending money is a frustrating one-step-forward-one-step-backward proposition. Although a purchase may fulfill a desire in one area, it simultaneously lessens your ability to satisfy other (and perhaps even more worthwhile) wants and needs. Obviously, the dollars you spend won’t miraculously regenerate in your wallet’s bill fold once they’re gone. Replacing the money you’ve spent means having to earn it all over again. Think about all the stuff you bought last month. Now, if you had it all to do over again, would you still want the stuff you bought or would you rather have your money back? Keep the answer to this question firmly in mind next time you’re considering a purchase. You see, money is very much like life itself; it’s the lifeblood of your time and labor–both of which are scarce and, no-doubt, valuable. The upshot? While budgeting may seem to be about dollars-and-cents, don’t be fooled, a budget is really about a lot more than that. It’s about your life—and getting more out of it. It’s about dreams and priorities; having them, holding yourself relentlessly accountable to them, and never shrinking from the trivial sacrifices you must make to achieve them.

Now, if you’re eager to whip your financial house into shape but haven’t made much progress because you lack an actionable game plan, take heart, the whole process begins and ends with you. Sadly, no external power is going to formulate a winning economic strategy that’s tailored to your individual preferences and miraculously beam it into your consciousness. Creating a functional budget, one that delivers results over time, is a highly iterative, sadly imperfect and profoundly introspective process. Make no mistake: self-assembly is required. So, be prepared to hunker down and roll up your sleeves. If you need a starter dose of economic reality, start by tallying your financial assets. Next, total your liabilities. Now, put both on opposite ends of a cantilever scale; wait patiently, and see what happens. If your assets outweigh your liabilities, congratulations, you’re among a proud minority of frugal-minded folks with a positive net-worth. Conversely, if the opposite is true, and your liabilities exceed your assets, don’t worry, you’re in good company. Many Americans, not to mention Uncle Sam and a good many U.S. cities and states—are right there with you.

The next step in the economic self-appraisal process is crucial. No matter how dreamy or dire your financial situation might appear, don’t dwell on it. From here on out, the future is your focus. Though the particulars of your economic present may seem paramount, trust me, the financial direction you’re headed is, over time, far more important. Creating and sticking to the parameters of a sensible budget is the single most important step you can take to seize the reins of your economic destiny. If you devise a budget and allow ample time for it to produce results, you’ll eventually look back in awe at your economic progress. But, before reaching for a calculator or applying pencil to paper to create a winning financial strategy, you should know up-front that budget minded living isn’t easy—especially at first. It’s a trying and sometimes heartbreaking challenge. It will test the limits of your resolve. On a cheerier note, if you stick with it, you’ll discover that the benefits of earning, spending and saving according to a specified plan are well-worth the effort and sacrifice. Just don’t expect instant gratification or flashy overnight results. A budget is a process. It’s effective, but it works slowly and it requires considerable patience and persistence to produce meaningful results…

Putting your financial life on stable footing requires following a simple multi-step process. First, figure out how much money you earn. Next, determine how much money you spend. If you blow cash with the reckless abandon of a drunken sailor on shore-leave, that’s a behavioral problem you’ll have to acknowledge and work on. Once you’ve quantified your income and expenditures, don your heartless CFO hat and trim unnecessary expenses. Once you’ve developed the discipline to live within self imposed spending constraints and know your income, do whatever it takes to ensure that they’re harmoniously balanced. Once you’ve accustomed to living within your means, take a deep breath and steady yourself for the next crucial step in the wealth building process. Tighten your financial belt a notch or two and strive to save at least one out of every ten dollars you make. Don’t blow this money; save it (preferably, in a high interest bearing FDIC insured money market account. For ideas, check out bankrate.com)–religiously. If socking away 10% of your income isn’t doable then, by all means, adjust your savings goal to suit your personal circumstances. Once your financial metabolism has reached a productive equilibrium and you’re comfortable spending less and saving more, you’re economic progress will gradually snowball. Before long, it’ll take on a virtuous and largely self-sustaining momentum of its own. And here’s the good news: saving money isn’t only financially rewarding, it’s emotionally habit forming. Even modest financial progress emboldens a sense of confidence that will pay monstrous dividends over time. In the not-too-distant future, the once unthinkable chore of scrimping and saving becomes oddly addictive as you begin to achieve goals and watch your net-worth rise.

No matter how difficult living within the cramped confines of a budget becomes, however, stick it out for three weeks. Behavioral experts say that it takes most people about this long to jettison old habits and reinforce new ones. Ironically, when adjusting to the realities of a budget-minded living, the only thing worse than saving too little is saving too much. Though this might seem wildly counter-intuitive, it’s not. Remember, for a budget to evolve into a lifestyle, it has to be livable. Much like a diet, binge saving leads to binge spending—a common and counter-productive form of self-sabotage. So, when whittling away at expenses, don’t go overboard. Give yourself plenty of wiggle-room. Accept small-scale cheating every now and then as a natural and perfectly healthy byproduct of an otherwise functional process. From time-to-time, you may fall off the budget wagon. Fine… Don’t beat yourself up or waste energy agonizing about it. Simply recognize the error of your ways, dust yourself off, and jump right back on. After all, in the grand scheme of life, it makes little sense to grimly scrimp and save for the future only to party like a rock-star at the ripe old age of 80. Conversely, it’s equally senseless to squander every penny living for the now only to discover—moments after blowing out the candles on your 80th birthday cake–that you haven’t a pot to piss in. Ironically, everybody wants to live a long life but few people save enough to age gracefully in retirement. Just hope that 80 (if that’s the lifespan you’re budgeting for) doesn’t become a momentary rest stop on the bullet-train expressway to age 100. When you take inflation’s long-term wealth withering affects into account, a desirable quality of life three to five decades from now will easily cost a million bucks. Which is why you should aggressively and proactively plan and save for your golden years; and you should do so now–don’t procrastinate. If you’re female, it’s especially important for you to prudently manage your finances because (according to actuarial data painstakingly compiled and analyzed by life insurance companies, which are in the business of knowing such things) women often outlive men—and by a significant number of years. Though on one hand this is certainly news worth cheering, longer life-expectancies imply a much greater lifetime savings burden. Essentially, the longer you intend to live the more money you’ll need to live well. Don’t believe me? A study by AARP makes a compelling argument: though only 12% of our nation’s elderly live in poverty, 74% of them are women. Want to know how lengthy a lifespan you should budget for? Gather up your medical history and check out www.livingto100.com…

In short, it doesn’t matter if you’re male or female, young or old; everyone needs a budget. Fortunately, they’re a cinch to create because they involve only two key variables. And luckily, you control both: financial inputs (whatever money you make) and financial outputs (whatever money you spend). Let’s start by examining the financial output side of the budgetary equation. In life, there are expenses. Though some are overwhelmingly huge, most are small. By and large, Americans’ biggest expenditures are those associated with keeping an automobile on the road, food on the table and a roof overhead. Of course, smaller expenses have a not so funny way of adding up. Personal perks and creature comforts—money spent on things like gourmet coffee, an evening at the movies, electronic gadgets, fashionable threads, trendy hand-bags, chichi shoes, savory restaurant meals, and countless other things—can sabotage a budget. For many, it’s the steady accumulation of many small and seemingly trivial expenses that prevents them from making long-term economic progress.

A Budget: The Key to Your Financial Success—Part 2

Preventing personal spending from spiraling out of control is the main reason why budgeting is necessary to begin with. If you’ve never created a formal written plan for earning, spending, saving and investing, the best way to begin is by tracking daily expenditures. Woody Allen once remarked that 80% of success is showing up. Well, if that’s true, then 80% of financial success is keeping track. No expenditure is too small to be accounted for. Once, a friend of mine flipped a quarter into a cascading fountain and noted the miniscule expenditure in her spending diary under the heading of “wishes.” Though many people assume that a huge paycheck or a staggering windfall of cash would bring a swift and permanent end to their financial woes, nothing could be further from the truth. And the facts bear this out. Often times, lottery winners blow their newly acquired fortunes (perhaps because they don’t feel worthy of them) only to end up flat broke. Sly Stone’s life story is a stirring testament to life’s shifting fortunes. Once a wealthy and famous singer, she’s now living in a camper van in Los Angeles recording music on a laptop. It’s mildly comforting to know that fiscal recklessness isn’t exclusively a U.S. phenomenon. It’s a quirk of the human condition that transcends cultural and national boundaries. Consider the story of Michael Carroll, a British sanitation worker who, after winning the lottery in 2002, blew $15.2 million on drugs, prostitutes, parties and extravagant gifts for friends and family. Of course, these and many other unreported stories play out across many peoples’ lives. Such outcomes are surprisingly common among the lucky few who, out of the blue, strike it rich. According to the National Endowment for Financial Education, 70% of those who come into a windfall squander it in just a few short years. Although six and seven figure incomes are hugely popular and aggressively pursued, stratospheric compensation levels offer an equally illusory sense of economic invincibility. Celebrities (Michael Jackson, Robin Leach and Ed McMahon are notable examples) and professional athletes (Mike Tyson) have achieved tremendous earning power throughout their storied careers only to outspend their lofty incomes and end up flat broke.

The bottom line: it doesn’t matter how much wealth you have or how much money you earn, how you manage money is what matters most in the long-run. If there’s a secret to nurturing a personal balance sheet and achieving economic security, it lies in focusing on your attitude toward and relationship with money. This is well worth dwelling on because it’s going to help or hurt you for the rest of your life. If you’re serious about money, and intend to have a lot more of it in the not-too-distant future, you’ve got to worship at the church of spending less and saving more. You see, nothing screams wealth like a well pinched penny. It helps to think of an income as a modest trickle of water dribbling from the nozzle of a financial garden hose, one that’s been mischievously pin-pricked with lots of tiny holes. Now, the many arcing rivulets of water that are spouting-off along the length of your garden hose represents non-discretionary spending. This is whatever money is left after essential living expenses like food and shelter are deducted and state and federal income taxes are paid. What’s left over is yours to do with as you please. Let’s call this notably diminished remainder your disposable income. Now, if you look around, you’ll notice that there’s a wealth bucket lying on the ground beside your bare wet grass speckled feet. You do want to fill your wealth bucket, don’t you? Certainly, good things come from doing so. Needless to say, most people want their wealth buckets to fill as quickly and efficiently as possible. Should you share this particular aspiration, you’ll need to inspect the condition of your wealth bucket very carefully. Is it too riddled with holes? If so, are they gapingly large? This is a million dollar question because, if the cash flow trickling out of your financial garden hose sloshes into your wealth bucket only to swish through a bunch of holes and hydrate the lawn then it may never fill. The holes in your wealth bucket represent discretionary spending: money spent on wants–not needs… Luckily, it doesn’t take an MBA or an overpriced Ivy League education to know that your wealth bucket won’t fill quickly unless you locate and patch those holes. Interestingly, although everyone has the metaphorical equivalent of a wealth bucket, few of them hold water. The systematic process of locating and patching the holes in your wealth bucket is what we’ll focus on next.

Isn’t it wonderful how technology has, for the most part, made our lives easier? Compared to the prohibitively time intensive and painstaking chore of tracking one’s income and expenditures the old-fashioned way (with pencil and paper), the advent of personal finance software represents revolutionary progress. Thanks to the awesome number crunching power of personal computers, the growing popularity of online banking, and the ease with which financial statements can be quickly and securely download, the hi-tech tools needed to systematically track and manage the smallest details of one’s financial life have never been more broadly accessible. No matter how complicated or fragmented your financial situation might be–and it really doesn’t matter if you’ve got one or multiple credit cards, different saving and checking accounts, and a smattering of brokerage and/or retirement accounts–you can easily consolidate information from all of these disparate sources onto one easy-to-reference place. Because, in theory, there’s a very rich and fulfilling life to be lived outside of tracking the tedious ebb-and-flow of your money in your life, it’s a good idea to make personal finance software the central hub through which the varied spokes of your financial life pass. Personally, I find Quicken’s Premier to be quite useful. Of course, it takes time and effort to install and familiarize yourself with the software and its handy features; but, once you have, with the push of a button and click of a mouse, you’ll be able to generate a comprehensive record of all financial activity on all of your accounts. A credit card charge from Chevron, for instance, will automatically appear in a spending report under “fuel costs,” an automobile expense subcategory. Similarly, restaurant charges can be easily found under “dining out” expenses. With this detailed information at your fingertips, you’ll know exactly (down to the penny) how much you’ve spent on everything from coffee and gasoline to electricity and groceries—and everything in between. What’s more, should your expenditures exceed preset limits, the software can alert you. With such a system, you’ll always be in the know about your money and can adjust your spending by the right amount to get back on track. To make the fire-hose torrent of data that personal finance software collects and dispenses easier to interpret and analyze, customizable reports can be exported to excel for further study. Haven’t got room in your wallet for high-end personal finance software? No problem; Yodlee Money Center and Mint are free (albeit less robust) alternatives. Bundle.com (a venture jointly sponsored by Microsoft, Morningstar and Citigroup) offer valuable perspective on other peoples’ spending patterns. For instance, it can show how your spending in a given area of your budget compares to averages in your neighborhood–by zip code. Click on “Everybody’s Money” and you’ll see how your expenditures on restaurants, groceries, transportation and clothing compare to others’ in your community.

Though personal finance software conveniently eliminates much of the mind numbing hassle of tracking and managing the intricate details of your financial life, its most glaring defect is that it can’t account for cash spending. Until the talented software engineers who create personal finance software products design an omniscient version, it can’t determine where your cash disappears to once it’s been withdrawn from a bank or ATM and spent. Lest you think otherwise, this functionality glitch is shared by all personal finance software products that are currently available for purchase. But don’t despair. If you suffer from obsessive compulsive disorder and simply won’t be able to sleep at night unless you know where every nickel goes, there’s a clever low-tech solution. When withdrawing cash from a bank or ATM, keep the receipt. This scrap of paper, which is often tossed in the trash, has the date and amount of each withdrawal printed on it. Stash this valuable piece of paper somewhere in your wallet’s bill fold and keep a pen handy at all times. This way, as you spend cash, you can note on the back of your ATM receipt how much you spent and what you bought. If you stay on top of this manual accounting system, you won’t have to wonder where your dollars went. You’ll have a complete record of all your cash spending. When you’re wallet eventually empties, you’ll have a detailed summary in the form of hand written notes. Keep your used ATM receipts in one place so that, at the end of each statement cycle, you can manually key in your cash spending along with downloaded transactions.

Do you find that money is frustratingly hard to come by? Luckily, there are many ways to make due with less. Keep a watchful eye out for that blue packet of coupons that’s delivered to most household mailboxes once a month. If you accidentally discarded it along with a fistful of junk mail, don’t worry, they can be viewed online at www.valpak.com. Simply enter your zip code, and, from the comfort and convenience of your own home, you can browse and print money saving coupons on everything from oil changes and dental cleanings to restaurants and lawn care. Still not satisfied? Other penny pinching sites (FatWallet.com, Active-Freebies.com, SlickDeals.net, CouponMom.com, MyGroceryDeals.com and CouponMountain.com) are a bargain hunter’s delight. When was the last time you shopped for a better deal on your automobile insurance? Even if you can’t negotiate a better price on your auto premium, you can save money by raising your deductible. This is the amount you must pay up-front before your insurer will cut a claim check. Are you tooling around in a beat up old clunker that looks like something tnhat belongs on the set of Sanford and Son? If your car’s replacement value is somewhere between nada and zilch, eliminate the portion of your auto policy that compensates you for damage to your vehicle if it’s damaged in an accident. This too will reduce your auto premium. Still wasting almost fifty cents in postage on every bill you pop in the mail? Sign up for online bill pay services. Over time, you’ll save a bundle on unnecessary postage, envelopes and check printing costs. Is the entertainment portion of your budget constantly kicked in the shins by video rental charges? Nowadays, public libraries carry more than books, newspapers and magazines. Many carry an assortment of movies on DVD that can be checked-out for free. Looking for cheap thrills in the big city? San Francisco’s Museum of Modern Art and the Academy of Science offer free admission to the public the first Tuesday of every month. Living richly doesn’t necessarily require great wealth you know; parks are lovely and wonderfully inexpensive places to spend time in the great outdoors with friends. The bay area has an abundance of scenic trails that quietly beckon and invite hours of leisurely exploration. Are you a college student? Do textbook prices send you into a state of catatonic shock? If so, you can save a bundle by not purchasing your textbooks at the campus bookstore. I won’t reveal the extremes I went to as a frugally minded college student to avoid being swindled by unreasonably high textbook prices, but you should look into sites like chegg.com, bookfinder.com and campusbookswap.com. These outfits specialize in textbook renting, selling and buying. The bottom line: if you want limited financial resources to stretch further, you’ve got to find creative ways to spend less.

Now that we’ve covered the financial output side of the budgetary equation, let’s direct our attention to the financial input side. Just as there are many ways to whittle away at expenses, there are just as many ways to boost an income. If you’re an entrepreneur at heart, now might be the perfect time to jumpstart that business venture that’s been collecting dust on your mental workbench. When it comes to transforming a viable business concept into a profitable money-making venture, the Small Business Administration (which offers one-on-one mentoring, financing and all manner of start-up support) can help. Entrepreneurship isn’t your bag? Fine, as Warren Buffet’s shrewd investing exploits have clearly demonstrated over a multi-decade span, you can build an enviable fortune over time simply by kicking your moolah off the couch and making it work as hard as you do. Investing a portion of your savings (money you won’t need in five-to-ten years) in appreciating and cash generating assets like stocks, bonds and real estate–or a sensibly diversified mix of all three–is an effective long-term wealth building strategy. Don’t scoff at the idea of owning real estate. Just because the median price of a goat-shack on the outskirts of the Bay Area is painfully out of reach doesn’t mean you can’t own income producing commercial property. Real Estate Investment Trusts, or REITs, are a perfectly respectable but not widely recognized asset class. Happily, the cost of REIT shares won’t land you in the poor house. Much like a stock, REITs offer investors partial ownership of commercial properties in a wide variety of industries. If none of this sounds appealing, consider going back to school to invest in your professional skills. Of course, these are all tried and true methods of boosting an income. But they often require patience and a considerable amount of time to pay off. If you’re looking for instant income gratification, paid surveys are a good option. Believe-it-or-not, corporations will pay large sums of money to gather thoughtful input from prospective consumers concerning the efficacy and/or desirability of their products and services. Luckily, your two-cents can fetch a lot more than one-fiftieth of a buck. Some companies will pay upwards of $50 for as little as an hour of your time. Google it.

Here’s another nugget of financial wisdom: when it comes to the ongoing struggle to gain financial yardage, it pays to multi-task. In other words, to build lasting wealth, you’ve got to think offensively and defensively at the same time. Can worthwhile money management insights be gleaned from the rough-and-tumble world of professional sports? Can fiscal wisdom be gained from the competitive athletic arenas of baseball, basketball and football? Yes, it can. The basic underlying principles that make for a successful sports franchise can, if rigorously applied to the your pocketbook, make you rich. After all, a football team with a stellar offensive and an inept defensive is sure to lose more games than it wins. High-caliber scoring power is certainly flashy and impressive. But, without an equally competent defense, the game winning potential of a stellar offense won’t be realized. In sports, winning requires a sensibly balanced approach to managing the offensive and defensive side of the ball. The same basic logic applies to creating and protecting wealth. Financial offense (managing what you make) and financial defense (reducing what you spend) are opposite but equally necessary sides of the same wealth building coin.

If income and expenses are the basic building blocks of the budgetary process, personal goals are the real driving force behind it. Unless you’ve got a fire-in the-belly passion for something you truly desire and are willing to sacrifice for, it will be difficult to muster the willpower and resolve to resist giving into countless spending temptations and other distractions that will prevent the budgetary process from bearing fruit. Of course, personal goals vary widely. This is understandable. After all, each of us is driven by a unique and complex combination of desires and circumstances. Moreover, your goals (whatever they may be) are likely to change over time, and they’re likely to do so in ways that will surprise you. That said, not all goals are financial in nature and, opinions to the contrary notwithstanding, money isn’t the measure of all worth. Nonetheless, I’m sure you’ll agree that achieving your life’s ambitions requires accumulating and maintaining a certain threshold of wealth.

To nudge your thinking in the right direction when it comes to assigning money its rightful place in the grand hierarchy of your life, you should know up-front that there’s another (though, to be sure, unfashionable) term for money: fiat currency. In other words (and you might want to sit down before reading further) those ornate pieces of government issued paper that people tirelessly obsess about and fuss over have little-to-no intrinsic value. Fact is, money’s value stems from everyone’s faith in it as a reliable store of value and a universally accepted medium of exchange. Now, if a dollar’s worth is defined strictly by the quantity of goods and services it can buy, its purchasing power is perhaps a good deal less stable than many people suspect. If this sounds absurd, and you’re convinced that the value of a nation’s currency can’t suddenly and violently fluctuate, you should crack a history book and read about how well Germany’s economy performed in the cold winter of 1923. The one-two whammy of a war torn economy and the need to pay hefty war-time reparations dealt a severe and destabilizing blow to Germany’s currency, the Deutsche Mark. A revealing story from this dark chapter of economic history illustrates fiat currency’s true value. Rumor has it that, during the height of Germany’s economic funk, an old woman trudged through the snow carrying a giant burlap sack full of rapidly depreciating Deutsche Marks. She was looking to swap her money for a day-old loaf of bread. On her way to the town bakery, she dropped the heavy sack on the ground to catch her breath. When she’d recovered and was ready to continue on her journey, she saw a pile of loose bills heaped before her. Somehow, a thief had slyly made-off with her burlap sack, leaving her money untouched and piled high on the snow. This story is a stirring testament to the instability of paper—I mean fiat—currency. But I digress; the takeaway point is that the value of the almighty buck (and other forms of government issued money) is supported by two things: 1) peoples’ faith in its dual function as a semi-stable store of wealth and an easy to use medium of exchange, and; 2) our government’s willingness to, if necessary, print oodles more. To be clear, I don’t mean to undermine fiat currency’s perceived value, but rather, to argue that the dogged pursuit of money for its own sake is a hollow endeavor. Which is why it pays to think first and foremost of your life and to make the betterment of that the focus of your lifelong fiscal efforts.

Start by creating three separate lists; each consisting of short-term, intermediate and long-term goals. Remember, when brain storming and cataloging your life’s changing ambitions, it pays to be as specific as possible. Remember, realistic expectations foster achievable results. Examples of short-term goals might include things that, with a modest amount of saving and sacrifice, can be obtained in a relatively short period of time; say, one-to-three months. Achieving intermediate term goals, however, requires a lot more patience and resolve. This list should include items that can be had in six to eighteen months. Realizing longer-term goals is a loftier challenge, but achieving them is also infinitely more rewarding. Examples of long-term goals might include saving for college, funding a ritzy retirement, buying a home or bankrolling the vacation of a lifetime. Once you’ve created a list of attainable goals that you feel passionately about, design a budget and assign it a realistic timeline for success. It’s helpful to write down and post your goals in a place where you’ll see them everyday. This is a subtle yet effective form of reinforcement and a reminder of your true priorities. Budgeting is an imperfect ongoing process, don’t be afraid to make mistakes along the way. The bottom line: it’s your life, it’s your list, and it’s your budget; perhaps it’s time you gave serious consideration to all three.

REITs & Investment Property

Having examined the pros-and-cons of buying a home as an investment, let’s take a closer look at the ins-and-outs of buying income producing real estate directly (with the aid of a lender, title company, escrow service and real estate agent) versus acquiring it passively through Real Estate Investment Trusts, or REITs.

Chances are, you live near one or more of the following: a hospital, apartment building, industrial site, high rise office complex, assisted living facility, mobile home park, shopping center, hotel or bank. Unless these places are deliberately sough out for the purpose of running errands, such properties are seldom given much conscious thought. For many, these varying generic properties are just sort of there and are often ignored. When you think about it, this is downright peculiar given that, nationwide, there’s a staggering abundance of commercial real estate. It’s literally everywhere. What’s more, its dense global footprint is even visible from space at night. Whether you’re surrounded by skyscrapers in a bustling metropolis, strolling the cozy temperature controlled confines of a shopping mall, heading into town to grab a quick cup-o-joe or are running to the nearest bank, much of the property surrounding you is zoned for commercial use. Nonetheless, it seems that many Americans are only peripherally aware of how this vast segment of the real estate industry works. Of course, this raises an obvious but generally unasked question: who owns commercial real estate? Well, it’s generally owned and managed by private and publicly traded companies that, in turn, lease it to businesses operating in every sector of our economy.

Mention the word tenant, and most people think of a person. It so happens that tenants aren’t always people; often times, they’re businesses. Although residential and commercial real estate are identical in the broad sense that both relate to land and whatever buildings or improvements stand on it, there are important distinctions between these two dissimilar categories of property. Luckily, it’s easy to tell them apart. Basically, residential real estate satisfies the property needs of citizens whereas commercial real estate accommodates the property needs of businesses. Believe-it-or-not, knowing a thing or two about commercial property can be quite lucrative—particularly if you know how to put this knowledge to work. In the 1960s, sweeping changes were made to real estate laws that opened up whole new vistas of economic opportunity for small investors looking to add commercial real estate to their investment portfolios. Before legislation allowed for the creation of real estate investment trusts, ownership of commercial properties was off limits to all but the wealthiest and most sophisticated industry elites. Nowadays, anyone with a few measly bucks and a brokerage account can amass an impressive and broadly diversified portfolio of income producing commercial real estate. How is this possible? Interested in the answer? Read on.

Many people are understandably perplexed by commercial real estate’s dual status as both an indispensable factor of production in the business world and an illiquid (that is, hard to monetize) form of financial capital in the real world. Commercial real estate has enormous and mostly impenetrable barriers to entry. If the idea of scraping together enough money for a 10% down payment on a single family home sounds intimidating, imagine having to accumulate enough cash to come up with a 10% down payment on something as pricey as a mid-size shopping mall or office building that’s attractively priced at, say, $75 – 100 million. Alas, money isn’t the only barrier preventing a casual individual investor from pulling off such a lofty acquisition. Engaging in multiple rounds of intense buyer-seller negotiation and eventually consummating such a mammoth purchase requires a rare blend of industry expertise and costly legal representation. Pulling off such a high-level purchase requires a rare blend of resources and talent. Needless to say, one can’t easily become a serious player in the well-heeled world commercial real estate. And yet, strangely, based on your day-to-day experience as a consumer, you’ve probably seen commercial venues in your neighborhood swap business tenants with the speed and ease of runway models wiggling into and out of glamorous outfits. Case in point: if you’ve seen a Sears or K-Mart permanently close its doors and reopen months later as a Home Depot or Best Buy, then you’ve witnessed this extraordinary phenomena first hand. Interestingly, despite the many legal and financial barriers that tend to prevent commercial properties from quickly or easily changing ownership, such spaces frequently change business tenants. Conveniently, this seemingly irreconcilable dilemma is neatly resolved by the property management business model. Simply put, were it not for the existence of property management companies and the essential role they play in the marketplace matching business tenants with needed commercial spaces, our economy would lack the resilience and flexibility it needs to quickly adapt to changing market conditions. You see, our economy is like a beating heart. As it rhythmically expands and contracts, businesses open or close and national employment levels alternately rise and fall. What’s more, regardless of the overall economic climate, this frantic activity occurs simultaneously and is broadly influenced by what phase the economic cycle is in. While it’s certainly true that some businesses own the properties they occupy to serve their customers, given commercial real estate’s hefty price tag and the fact that a company’s Chief Financial Officer can usually deploy its capital more productively elsewhere by re-investing it or plowing it back into the business that generated it in the first place, it’s often in a company’s best financial interest to sign a lease and pay property management companies rent instead of purchasing real estate outright. Of course, this allows companies to devote more of their precious time and energy to improving their own operation. Similar considerations apply to individuals who must decide whether to buy or rent their primary residence.

Curiously, although home values attract nationwide attention and are breathlessly discussed, people seldom regard their homes as a steady and reliable source of cash; and rightly so. For starters, a house isn’t easily bought or sold. Real estate agents, closing costs and the nettlesome prospect of having to deal with bankers and wade through reams of complex legal documents tends to discourage people from trying to squeeze money out of their homes. Fortunately, such procedural obstacles are mere speed-bumps when applied to the well-heeled world of commercial real estate. From an investment standpoint, is commercial real estate as desirable as residential real estate? You bet, perhaps even more so. For aspiring capitalists, the idea of owning a geographically diversified portfolio of income producing commercial properties in a variety of industries would be a dream-come true… Think back to your favorite real estate board game; you know, the one you played as a kid. To help jog your memory, it’s got a colorful foldout board, lots of pretend money and an assortment of die-cast player icons in the shape of a destroyer, thimble, wheelbarrow, a beat-up old shoe and a banker’s top hat. No-doubt, owning a vast portfolio of income producing commercial real estate would be like owning the most desirable properties on the Monopoly board. Imagine how it’d feel to rattle off a long list of prestigious Fortune 500 companies as personal tenants. No-doubt, if you found yourself in such an enviable position, you’d be primed to collect obscenely large rent checks on a regular basis. Better yet, were you to find yourself in such a lucrative circumstance, you’d probably also have oodles of spare cash to hire a team of industry professionals to help you manage and maintain your properties. As the “silent partner” in this happy little arrangement, your most pressing obligation would be to saunter on over to the mailbox every now and then to collect and deposit your portion of the rental income. Suppose there were a way for you to make this dream scenario a reality? Would the prospect of doing so interest you?

Before we get too far ahead of ourselves, however, I should emphasize that there are many subtle differences between how the economics of real estate operate in the game of Monopoly versus the real world. For starters, the financial benefits of owning investment property aren’t limited to the collection of rental income. As Monopoly fans will readily acknowledge, the amount of money that changes hands when someone lands on someone else’s property is fixed. To ease flow of play and keep the rules of the game simple, rental rates never change. For a board-game, that’s convenient. In the real world, landlords generally raise rents over time at a rate of anywhere from three-to-five percent a year. The idea is that property managers want to compensate for inflation and maintain the purchasing power of the money they collect from tenants. Meanwhile, by financing the bulk of a property’s purchase price with a fixed interest rate loan, inflation will slowly reduce the “real-dollar” cost associated with carrying an astronomical amount of debt in the form of a mortgage. After all, it’s a very safe bet that borrowed money will, 20 or 30 years hence, be repaid with depreciated dollars. Also, whoever succeeds in obtaining the deed to Park Place in the real world will surely enjoy years of future appreciation as the value of the underlying commercial property appreciates. To further encourage entrepreneurial risk-taking and stimulate investment, commercial property owners enjoy an expansive range of tax breaks, courtesy of Uncle Sam. Tax breaks on real-estate? You betcha, and for investment property owners there are oodles of them. Though homeowners occasionally crow about the mortgage interest and property tax deductions they receive, investment property owners are treated to a far more expansive range of taxpayer subsidized goodies. In addition to the tax perks that a residential homeowner gets, property owners get to deduct the full value of the building or structure that’s erected on their property. This nice little value-add is parceled-out in equal installments over twenty seven and a half years. Moreover, property maintenance expenses–which includes outlays for a new roof, upgraded fixtures and necessary improvements–also lower an investment property owner’s tax liability. But wait, there’s more. That growing cushion of equity that investment property owners gradually accumulate is heavily subsidized by business tenants that dutifully pay rent. In theory (and often in practice) it’s a handsomely profitable arrangement for commercial real estate owners.

If you’re looking for the biggest bang on your investment buck, you could do a lot worse than own commercial real estate. Problem is, this type of property is difficult to acquire. Such real estate is out of reach for most hobbyist investors. Even if the price tag weren’t an impediment to breaking into this industry, there’s the tedious prospect of dealing with tenants, collecting rents, accounting for expenses, maintaining facilities, and, from time-to-time, renovating properties. Individuals are understandably reluctant to tend to these burdensome and ongoing operational responsibilities. To be sure, nobody could do this on a part time basis. But does this mean you should abandon all hope of owning commercial property? Absolutely not. Fortunately, such properties are lumped into large pools that are divvied up into millions of tiny pieces so that ordinary individuals, university endowments, pension funds, foreign central banks and institutional money managers can acquire them.

Thanks to the growing popularity of the REIT (Real Estate Investment Trust) ownership structure, commercial real estate has morphed into just another liquid and easily tradable form of capital. Every day, billions of dollars worth of commercial properties are passed between buyers and sellers on the floors of the world’s stock exchanges—just like stocks. REITs shrink vast acreages of commercial real estate into something that can be quickly and easily bought and sold. The main difference between REITs and stocks, however, lies in the nature of the underlying asset. In the case of a stock, an investor buys a business entity, which, in turn, exposes that investor to the risks and rewards of owning a company. When an investor buys a REIT, however, instead of owning a fractional interest in a company’s current and future profits, an income producing roster of commercial properties is purchased instead. When you buy one share of a REIT, you get your fair share of the rents that business tenants pay to occupy it and, of course, a team of qualified professionals who’re responsible for managing the whole kit-n-caboodle. All of this is readily available to any investor with a few bucks and a brokerage account. Not only do REIT shareholders receive ongoing cash distributions from operational activities and rent paying tenants, it so happens that capital gains are occasionally reaped from the strategic sale of commercial properties that are held in a REIT portfolio.

Encouragingly, the REIT ownership structure is spreading to other parts of the world. China has been in the news lately because of its growing economic clout. To put China’s largeness and future economic growth potential in proper perspective, Ted Fishman, author of China, Inc., estimates that it has anywhere from 100 to 160 cities with a population of at least one million people; the U.S., meanwhile, has only 9 while Eastern and Western Europe combined have 36. Does the prospect of owning commercial real estate in China’s most vibrant metropolitan markets sound like a feasible long-term wealth building strategy? Since China recently joined the World Trade Organization and its economy is rapidly modernizing and opening to the West, owning commercial real estate in this and other up-and-coming developing countries through international REITs may be a smart way to capitalize on this and other emerging market’s luminous future growth prospects.

Last time I checked, the Standard & Poor’s 500 Index (a well-known index dominated by large U.S. companies) sported a skimpy dividend yield of 1.6%. In other words, for every hundred dollars an investor plows into the S&P 500, they’d get $1.60 a year in income. REITs, however, offer a heftier annual payout–typically on the order of 4% to 7% of a REIT’s share price. Higher REIT yields stem from the fact that commercial properties regularly generate huge cash-flows from business tenants who pay big money for the facilities they occupy to manufacture goods and serve their customers. To qualify as a REIT, which exempts management from having to pay corporate taxes, REITs must, by law, derive at least 75% of its revenues from rents and distribute at least 90% of its operating profits (also known as its funds from operations) directly to its shareholders. Unlike qualified dividends (which are subject to a skimpy 15% tax rate), REIT shareholders must pay regular income tax on whatever “income” they receive from commercial real estate holdings. And, much like stocks, REIT financials are carefully scrutinized and audited by large and respected accounting firms. The 10% of REIT income that shareholders don’t receive goes to management to support ongoing business operations, pay administrative overhead and cover essential maintenance expenses. It’s worth noting, however, that REITs offer an additional benefit as well: “pass-through” depreciation. In other words, the tax breaks that REIT properties generate is automatically factored into the payouts that REIT shareholders receive. Another worthwhile advantage of REIT income is that it’s widely considered to be a safer form of investment income. And this is because REIT cash flows are advantageously placed on the economic totem pole since, by law, corporations must pay operating expenses like rent before they can dig into their pockets to pay interest to bond holders or dividends to stockholders. Consequently, should business tenants abruptly fall on hard economic times, REIT shareholders are first-in-line to be paid.

Considering the diversification benefits that REITs offer; the fact that qualified professionals are tasked with managing the properties in question; the considerable tax benefits that commercial properties generate; the likelihood of future appreciation in the underlying value of REIT shares; and the fact that all of these benefits can be enjoyed passively—and at a much lower incremental cost than buying real estate directly—I’d say that REITs are a better way to cash in on real estate. By all means, those who insist on singing the praises of real-estate should continue humming along; only, they’d do well to include the word “REIT” in the lyrical high-notes.

What’s in a REIT?

Years ago, during real-estate’s glorious heyday, I was drawn into a spirited debate about the economic logic of “investing” in a home versus stocks. To put this conversation in its proper historical context, it occurred at a time of stubbornly buoyant real estate prices. An overly frothy housing market that, for ten years, bubbled nowhere but up had produced speculative frenzy and a bumper-crop of ardent real-estate fans. With financing readily available to all, it seemed like everyone was eager to buy a first, second or third home. So, it may come as something of a surprise that I spent the better part of an hour trying to explain why (if past is prologue) a home isn’t the best place to look for outsized investment returns.

Don’t get me wrong, a house can be a great investment. Particularly if it has vaulted ceilings, a modern state-of-the-art kitchen, and is situated in an upscale neighborhood that oozes suburban charm. A home’s prospects for outsized future appreciation is further enhanced if it’s close to a diverse and economically vibrant metropolitan area that’s supported by a highly educated workforce and a diverse employment base. It’s equally helpful if the zip code you’re home-shopping in boasts higher than average median incomes and has plenty of distinguished schools. Lest we forget, the appeal of home ownership is further enhanced by cozy intangibles: the comforting home and hearth amenities that a home affords. Ultimately, though these and other selection criterion may significantly boost one’s odds of turning a prospective home purchase into a lucrative real-estate investment, just because a home can be a great wealth-building tool doesn’t mean that it always is.

Why the ambiguity? To answer this question, let’s look at the financial advantages of home ownership. For starters, homeowners can deduct their property taxes and the interest (up to a million dollar mortgage limit) paid on money that’s borrowed to buy a home. This results in a sizable tax break every April 15th. But wait, there’s more… Homeowners are the economic beneficiaries of a strong historical precedent of rising home values. Thanks to this trend, people who’ve owned their homes for 20 to 30 years can usually sell them for far more than they paid for them. Additionally, a mortgage is like a forced savings account in that, over time, as monthly payments are made and the balance owed is gradually paid off, homeowners accumulate growing wealth in the form of an ever-thickening cushion of equity. This is the difference in value between what a home is worth minus whatever debt is owed against it. Should unforeseen events force a homeowner to vacate a property for an extended period, it can be converted into an income producing rental. Finally, there’s the copious availability of taxpayer subsidized mortgage debt. Thanks to this and other powerful economic incentives, real estate can be purchased and/or encumbered for mere pennies on the dollar. In light of this exhaustive list of potential financial and psychic benefits, why did I not join my friends in toasting real estate as the king of all investments? There are many reasons.

For starters, home equity has a fuzzy money quality to it. Though it’s easy to confuse a dollar of equity for a hundred pennies in the bank, this can be a costly miscalculation. To understand why, let’s explore a bit of real estate history. Before the Internet era, back when rotary dial telephones were commonplace, just about the only way that a homeowner could turn their home equity into cash was to put their house on the market, wait for it to sell, and use the proceeds to pay off their mortgage balance. After deducting real estate agent commissions, capital gains taxes and other miscellaneous expenses incurred in a property’s sale, whatever cash is left can be pocketed or spent. Collectively, these expenditures aren’t chump change; they can easily amount to thousands of dollars and consume anywhere from five-to-ten percent of a home’s sale price. So, that hypothetical dollar of home equity isn’t really worth 100 pennies, but rather, something like 92.5 cents. Fact is, this reduced figure is somewhat understated because it doesn’t reflect the transactional expenses that are incurred in the purchase of a home. Nowadays, ingenious financial innovations like HELOCs (Home Equity Lines of Credit) enable people to treat their homes as gargantuan ATM machines. Although these complex instruments do indeed liberate homeowners from the traditional hassle of having to sell their homes in order to access the equity they contain, their use is neither hassle nor cost-free. Homeowners looking to avail themselves of such options must complete reams of paperwork, deal with stuffy bankers and sign lots of intimidating legal documents that aren’t easily read or understood. Any way you slice or dice it, whether you sell a home yourself or rely on other less conventional methods, extracting money from a home is a costly and time intensive endeavor. The bottom line: unlike pure-play financial assets like stocks, bonds and REITs (which can be quickly and inexpensively sold), the added difficulty and expense of extracting equity from a home makes real-estate a comparatively less desirable investment.

Is a home a financial asset? To answer this question, and build a framework for discussion, let’s define two relevant economic concepts. What is a financial asset and how does it differ from a liability? To keep things simple, let’s agree that an asset is something that puts cash in your pocket whereas a liability does just the opposite, it takes money away. Sounds simple, right?

The most perplexing thing about real estate is that, as investments go, its status as an asset or liability is somewhat elusive and hard to pin down. Fact is, a home isn’t permanently categorizeable as an asset or a liability; many factors go into making this determination. No matter how the economics of home ownership are analyzed, buying a property initially qualifies as a liability because it means parting company with a huge pile of cash in the form of a down payment. This sizable outlay, which amounts to anywhere from 5% to 20% of a home’s asking price, will be followed by a very long series of follow-up payments as the principal and interest components of a mortgage are paid off in monthly installments over twenty to thirty years. And while it’s certainly true that a home’s potential for long-term price appreciation is indeed substantial, this shimmering pot of gold at the end of the debt service rainbow often takes decades to materialize. Meanwhile, the outflows associated with a monthly mortgage payment will suck plenty of cash from a homeowner’s wallet. But that’s not all, there are other costs for a would-be homeowner to consider. Property ownership is an arrangement that, once entered into, carries with it additional financial obligations that must be satisfied. And the failure to do so sets in motion a strange circuitous legal process that eventually results in a homeowner being forcibly relieved of his or her property. Essentially, there are two ways for a homeowner to go seriously wrong. Failure to pay a mortgage is one because it prompts foreclosure by a lender. Refusing to pay one’s property taxes is another because it causes a home to be relinquished to its default owner: Uncle Sam. Our government is in the business of renting land to its citizenry; short of a successful foreign invasion, no other entity will threaten to and eventually reclaim your property in event that these taxes aren’t paid. A close reading of the tax code relating to a homeowner’s patriotic responsibilities in this regard should dispel any confusion on this topic. Sadly, the economic burdens of home ownership don’t end there. In addition to these expenses, there’s also the cost of property insurance and ongoing maintenance expenses to consider. After totaling all of these costs, and taking a thoughtful moment to contemplate the lifestyle implications of having to satisfy them for several decades, it should be readily apparent that a home purchase is a tremendous financial liability. Basically, a newly acquired home with little-to-no equity is just a rental garnished with a heap of debt and a few other financial obligations.

But here’s the part where real estate fans will reach for their sparklers and break out their party hats, if a home is held long enough, it morphs into an asset. But how can this be? How can a home start out as an economic liability, and then, poof, become an asset? At some point in the long tedious process of paying off a mortgage, the amount of equity that’s accumulated in a property will equal the amount of debt that’s owed against it. Let’s call this eagerly anticipated and widely celebrated moment in a homeowner’s life the economic tipping point. At this stage of the game, monthly mortgage payments enrich the homeowner’s bottom line more than the mortgage originator’s. Once this delicate economic point is reached, assuming the value of the home in question doesn’t decline, then and only then can a home become a financial asset. It‘s worth noting, however, that it usually takes decades of faithful debt-service for real estate to shift from the liability column of a homeowner’s balance sheet to the asset column.

Now that we’ve explored the asset-liability duality of home ownership, let’s examine the opportunity cost of buying a home. When we crunch these numbers, you’ll see that it’s enormous. What is opportunity cost? Economists define it as the highest foregone alternative. In other words, whenever you spend money you forfeit the right to invest that money elsewhere. By making an economic decision you’re passing up alternative choices for how you might have spent your money. Makes sense, right? Now, when weighing the pros and cons of buying a home, it’s worth noting that any economic decision carries with it a series of potential costs and benefits. Though marrying a mortgage might seem like a can’t-miss wealth building strategy, there’s a minor (and frequently overlooked) fine point to consider first. If the primary purpose of buying a home is to transform a hefty down payment and a staggering amount of debt into an even greater sum of money somewhere down the calendar, it’s worth considering the time value of money and thinking about how rapidly the cash that’s invested in a home might appreciate if it were allocated elsewhere instead. Suppose the financial capital that’s put into a home were to instead appreciate at a rate equal to the S&P 500’s long-term historical returns? When we run these numbers, and compare the side-by-side returns of investing in a home vs. stocks, the economic logic of buying a home is downright questionable.

To illustrate this point, we’ll pit $500,000 invested in a home against $500,00 allocated to the S&P 500 stock market index (with dividends reinvested) and examine the comparative returns of both investments over three different holding periods: five, ten, and twenty years starting from July 2006. According to research conducted by Edward Jones, half a million bucks invested in a home over a five year period would’ve amounted to $730K, easily trouncing the S&P 500’s returns by $155,000. Over a ten year period, however, real estate’s luster dims noticeably; $500K invested in the S&P 500 appreciates to $1.2 million whereas $500K invested in a home is worth $937K, a $263K difference in the stock market’s favor. When we compare the price performance of real estate vs. stocks over a twenty year period, the disparity in returns widens even more aggressively; $500K invested in the stock market amounts to $4.83 million whereas $500K invested in a home becomes $1.5 million—a staggering $3.33 million difference in the stock market’s favor. Clearly, though real estate has proven it can outperform stocks over a five year period, it hasn’t demonstrated an ability to do so over the long-haul.

Another frequently overlooked risk of home ownership is that it concentrates a high percentage of one’s net-worth in a single investment. The fact that our government chooses to subsidize interest on real estate debt distorts incentives and encourages people to take on bigger mortgages than they might otherwise afford. The tax code is one reason why consumers over-concentrate their wealth in housing. From a risk management standpoint, this can be costly. Disruptive events of natural and economic origins have, throughout history, adversely affected real estate values. The San Francisco Bay Area’s 1987 earthquake gave property values a nasty shake. Home values in New Orleans were similarly devastated by levee failures caused by hurricane Katrina. These and other disruptive events show how violently real estate values respond to natural disasters. Major economic events, which tend to have a less visible and dramatic impact on housing values, can be equally traumatic and damaging. Consider the market-wide adjustment in property values owing to deteriorating economic condition in hard-pressed areas like Detroit, a once vibrant and thriving metropolitan hub that was once home to a dominant and seemingly unstoppable U.S. automotive industry. More recently, during the 1990s, the loss of defense contracting jobs in southern California had a chilling effect on real estate values in that part of the country for years. The economic aftermath of the 1980s Savings and Loan fiasco exerted downward pressure on numerous hard-hit real estate markets. Clearly, economic and natural disasters both pose significant (but frequently overlooked) risks to housing wealth. Those who’ve been adversely affected by these and other calamitous events realize—perhaps more keenly than most—the folly of concentrating so much of their personal net-worth in their homes.

Having examined the pros-and-cons of home ownership, I think it’s fair to say that a home (though it doesn’t offer the best long-term returns—those bragging rights go to stocks) can be a powerful wealth-building tool. When it comes to cashing in on real estate, however, it turns out that there’s an easier way to go about it than to shackle oneself to a mortgage. As investments go, real estate is dandy. Luckily, for people who don’t have oodles of spare cash lying around or are unwilling to assume an astronomical amount of debt, there’s a much easier way to cash-in on real estate. Which brings us to Real Estate Investment Trusts (REITs). These financial instruments put the American dream of real-estate ownership within easy reach for ordinary folks by enabling people of modest means to acquire professionally managed income producing commercial properties. Moreover, with REITs, the underlying asset is owned free and clear. Moreover, it generates income from the get-go without the subsequent hassle of having to pay a mortgage or fork over additional money for taxes, maintenance expenses and property insurance. Insofar as real estate investing is concerned, REITs are terrific and will be discussed in greater detail next.

Taking Stock of Your Financial Future, Part 1

Though it takes time to become a seasoned veteran investor, it’s never been easier to become a successful investor. Thanks to plummeting transaction costs and an explosion in the number of web sites and online resources that are devoted to helping novice investors make smart and better informed choices, the playing field between do-it-yourself bark-a-lounger capitalists and Wall Street’s  Big-Whigs has never been more level. Technological advancement and financial innovation have opened up whole new vistas of economic opportunity for the masses of ordinary investors who don’t commute to work on Gulfstream jets, sit on corporate boards, own starter McMansions or roam the corridors of power. Nowadays, computers with blinking lights, once the stuff of campy futuristic science-fiction movies, rank right up there alongside the telephone and the microwave as indispensable and commonly owned household appliances. In this bold new financial era–where knowledge is arguably the highest form of capital–the widespread availability of financial data (on demand and at little-to-no cost) is a real game-changer; particularly for young people just starting out.

Contrast current economic reality with the financial dark ages of the early 1990s–or, worse yet, late 1980s. In those bygone days, obtaining actionable investment information was neither simple nor easy. Moreover, putting it to work in the capital markets required knowing the right people, paying hefty up-front fees and waiting hours (sometimes even days) for requested financial transactions to be executed. Not so long ago, the spring-loaded gears and cogs that kept the stock market’s machinery churning were manually cranked by a patchwork of brokers, floor traders and other specialists. Nowadays, stocks and the future earning power they represent can be bought and sold on-the-fly in a matter of seconds with the aid of an Internet enabled smart phone. Though the old financial guard certainly had a good run, its convoluted architecture served only the super wealthy. Back then, ordinary Americans were unable to tap into and participate in the world’s stock markets.

Clearly, times have changed–and mostly for the better. The old financial guard has been snappily replaced with a new financial order, one that’s decidedly less stodgy and far more responsive to the needs of a larger and more demanding constituency: The general public.

Nowadays, when it comes to the once difficult task of investing smartly over the long tenure of one’s career, the hi-caliber tools and analytical resources that were once available only to the one percenters are now readily accessible to anyone with a personal computer, a bit of investment know-how, a brokerage account and an Internet connection. But how did this unlikely turn of events come to pass? Why did the old financial guard–which profited handsomely for decades from its indispensable role inter-mediating stock market transactions–surrender its considerable market power to upstart industry competitors? No-doubt, this involuntary loss of influence didn’t occur overnight. Steadily intensifying competition in the financial sector has, slowly but surely, shifted the underlying dynamics of the marketplace, forcing inflexible and inefficient firms to close their doors. These consumer friendly forces have rewritten the rules of the economic game and revolutionized how capital markets work. Consequently, ordinary people from all walks of life are newly empowered to research and select their own investments. Suddenly, consumers are less reliant on the advice and solicitous hand holding of licensed industry professionals and self-proclaimed “experts” when it comes to managing their brokerage and retirement account assets. The Internet, which makes accurate and timely investment information available to all, has been a powerful driving force behind this remarkable new trend. Tom Friedman, New York Times columnist and Pulitzer Prize winning author of The Lexus and the Olive Tree, calls dubs this phenomenon “The democratization of finance.”

The growing popularity of sites like Yahoo! Finance, MSN Money and Morningstar, which generate tremendous visitor traffic, reflect the investor-friendly times we now live in. The ease with which company information can be found online speaks to the public’s large and growing appetite for all manner of financially oriented content. Want to know how a particular stock is doing? Simply key in its corresponding ticker symbol, and, viola, you can view late-breaking business headlines, see what financial experts are saying about it, scrutinize every aspect of its past financial performance and view its stock price over any specified interval of time. No-doubt, having all of this information at your fingertips is tremendously enabling. Through the medium of technology and the hi-tech zoom lens of financial supermarkets, consumers can put their money to work for them in new and unprecedented ways. The interest and enthusiasm that some Americans once reserved for the sports section of their local newspaper has begun to spill over to the business section. Because millions of people are directly or indirectly participating in the stock market through participation in employer sponsored pensions, 401Ks, personal brokerage accounts, IRAs, 529 college savings plans and medical expense savings accounts, they’re as likely to cheer the performance of their investments as they are to root for their favorite sports home team(s). As financial assets like stocks, bonds, commodities and real estate (Yes, even real-estate. To understand why real-estate can be as easily purchased with a brokerage account as it can with the costly aid of an appraiser, real-estate agent and a lender, read What’s in a REIT? & REITs and Investment Property. Both articles are posted to this site.) become easier to acquire, people from all walks of life can afford to accumulate them.

To help novice investors successfully navigate this new and mostly foreign investment landscape, firms like Vanguard, Fidelity, Morningstar and others offer a wealth of educational self-help content, a host of robust and interactive tools, and a dizzying menu of low-cost investment products for investors to choose from. Mutual funds, exchange traded funds and life-cycle funds are fantastic options for those interested in participating in the stock market but sidestep the hassle and tedium of researching, selecting and managing their own portfolio and investment holdings. Nowadays, novice investors armed with only a basic understanding of stocks and a rudimentary grasp of investment theory can easily and inexpensively create a broadly diversified age-appropriate portfolio; something which, back in the day, couldn’t be done cheaply or easily. Through the purchase of mutual funds, investors can hitch the future financial performance of their investment wagons to the best and brightest minds on Wall Street. Throw in the long-term gale-force economic tailwind of tax-deferred and even tax-free growth (which can be enjoyed by opening and funding a 401K or Roth IRA) and the allure of investing becomes even harder to resist.

Capitalizing on the economic opportunities that these favorable circumstances present, however, is doable as it”s never been before. Cashing in on capitalism requires owning stocks (an asset class whose multi-decade returns easily outperform bonds, real estate, cash and commodities), as well as a basic understanding of what they are and how they work. Stocks are closely followed and tirelessly discussed because they offer a mechanism allowing investors to own a dazzling array of proven, and, in some cases, obscenely profitable companies. You see, stockholders are legally entitled to an interest in a company’s current and future profits; something which, in turn, is generally well supported by an organization’s abundance of human talent, operational cash flows, and mote of competitive advantages. Think about it. This is a powerful concept. If you buy a few shares of, say, Starbucks, you’ll reap a small fraction of the profits that result from the sale of each and every beverage or scone that it sells across the registers of its thousands of stores. In theory, whenever a new store opens, this corporate investment may benefit your bottom line. Of course, as an investor in this business, you share in all of the organization’s operating costs as well. Stocks’ long-term record of out-performance is further supported by the execution and creative talent of its management and the many contributions of its employees. Clearly, you’ve got a lot going for you as a shareholder and stock market participant. Moreover, through the exercise of voting rights, stockholders exert influence on how the businesses they own are managed.

The likelihood of future appreciation in the value of one’s stock holdings is bolstered by several factors. Ben Graham, Warren Buffet’s mentor and an iconic investor in his own right, once remarked that “In the short-term, stocks are a voting machine but in the long-term they’re a weighing machine.” Translation: one’s perspective of stocks and their performance is heavily skewed by the interval of time one examines to evaluate their performance. On a daily, weekly or monthly basis, stock prices are volatile and prone to wild fluctuations due to unstable market conditions and shifty investor sentiment. Over longer periods of time (think decades) companies and their stock prices tend to reflect a smoother and less erratic upward bias as the consistency of its earnings and bottom-line profits become more apparent. And, so it is that, with continued patience and a longer term perspective, the stock market’s nerve-racking day-to-day gyrations, which Mr. Graham likens to a voting machine, becomes a weighing machine that tends to reward patient long-term investors.

Luckily, investors don’t have to agonize about cherry picking good investments and shunning bad ones. With blunt force instruments like mutual and exchange traded funds, hundreds or even thousands of individual stocks can be acquired in a single transaction. To be sure, the old adage about not putting too many of one’s investment eggs in a single basket is well worth heeding. Sprinkling one’s long-term savings over a variety of asset classes (commodities, real estate, stocks, cash and bonds) is, in the long run, an effective way to reduce risk and optimize returns. Imagine how foolish you’d have felt if, back in the day, you’d incautiously invested the entirety of your life savings on a single holding like, say, AIG, Enron, GM or WorldCom. No-load and low-cost mutual funds, though certainly nice, aren’t necessarily your best investment choice either. Nobel laureate William Sharpe calls indexing (buying low cost exchange traded funds, or ETFs) “a dull, boring way to become a better investor than many of your friends.” Index investing offers instant diversification and cost-efficient exposure to almost any sector and theme. What’s more, ETFs can zero in with laser-like precision on companies of a certain size or even those that operate in specific sectors of our economy like health-care (Johnson & Johnson and Pfizer are household names that dominate this space), technology (Microsoft, Intel and IBM are sector standouts), the energy complex (Chevron and Exxon are names you may have heard of), consumer staples (Procter & Gamble, the maker of Crest toothpaste is an industry giant), or banking (Bank of a America has branches and ATMs everywhere). More importantly, since money and the desire to make it is an increasingly global phenomenon, investors can lace up their walking shoes and dispatch their hard-earned capital to the furthest regions of the earth in search of high-octane returns. Exciting stuff—no? Triumph of the Optimists, written by three British researchers, validates the wisdom of investing in stocks. After calculating the comparative returns of stocks, bonds and government securities in 16 countries over the past century, they unambiguously concluded, “Stock returns beat bonds in every country by a wide margin.”

This is all well and good, of course, but the likelihood of future appreciation in the value of one’s stock holdings is only one reason why stocks are worth owning for the long term. Dividends, which are periodic cash disbursements companies pay their shareholders, are another way to cash in on stocks. Though, at first glance, dividends might seem downright puny, over time they can add up to lots of money. According to Standard and Poor’s Howard Silverblatt, from 1926 through March 2009, reinvested dividends accounted for a whopping 44% of the S&P 500’s 9.5% annualized gains. Of course, not all stocks pay a dividend, but many do. And once a company establishes a consistent track record of paying them, management is understandably loath to cut or eliminate dividend payouts to shareholders for fear of the negative signal it sends about its financial health and the likelihood that such a move would alienate current and prospective investors. Moreover, as a company’s financial outlook brightens, its dividend payout is likely to increase at a rate that handily outpaces inflation. Dividend are paid in regular annual installments and the amount of a company’s annual disbursement typically ranges from one-to-five percent of a stock’s purchase price. This largely reliable rate of return compares favorably to the anemic returns you’ll get from a money market savings accounts. Dividends are dandy for another reason as well. Thanks to the passage of investor friendly tax legislation by plutocrats in Congress, qualified dividends are subject to an ultra skimpy tax rate of just 15%. Is this good? Well, to put this tax rate in perspective, consider this: a dollar of earned income (that is, wages) will, after taxes (assuming you’re in the 33% State-Federal tax bracket), put 67 cents in your pocket. If that same dollar were received as dividend income, you’d enjoy the equivalent of a 27% pay increase. Now, a few measly pennies one way or another may not thrill you, but, to reframe the original question, which would you rather have, 85% or 67% of your income?

Remarkably, though stocks have proven themselves to be fantastic wealth-building tools over very long periods of time, many people are skittish and downright reluctant to own them. Some are understandably put-off by stocks’ inherent volatility while others are drawn to them by the tantalizing prospect of higher returns. To the uninitiated, the stock market is an understandably confusing place. For starters, there’s all that pretentious jargon to think about. Profit margins, price-to-earning ratios, market capitalizations and debt-to-equity ratios are, for many, a sure-fire cure for insomnia. And it doesn’t help matters that these closely followed metrics aren’t fixed, they’re driven by numbers that change every day. Considering all of the nuanced and highly dynamic variables that are associated with stocks and their constantly shifting values, there’s justifiable cause for apprehension on the part of any non-investor.

Nevertheless, although putting money to work in the stock market might seem scary; investing successfully over time isn’t. In fact, given the vast arsenal of tools that are now readily accessible, investing—and doing it right—isn’t that hard. Once you’re familiar with the stock market’s long-term upward bias and are comfortable with its erratic short-term performance, you’ll someday look back and wonder what all the initial fuss and consternation about investing was all about. Done right, investing occurs automatically, as if on autopilot. Opinions to the contrary notwithstanding, investing isn’t particularly sexy or exciting. In fact, it’s a little boring; sort of like watching paint dry or bread toast. Over one or more decades, however, investing perks up and becomes a lot more exciting. Fortunately, cashing-in on capitalism doesn’t require much in the way of shrewd analytical genius. What you do need, however, is faith, unwavering perseverance, and a cast-iron stomach for volatility. Basically, investing well over time requires: 1) a basic understanding of how stocks, bonds, real estate and commodities work, and 2) the intestinal fortitude to establish and consistently fund a diversified investment strategy—in good times and bad.

Now, despite what the revolving parade of talking heads on CNBC would have you believe—what with their intimidating power ties, quasi authoritative news anchor demeanors and meticulously quaffed hair—you needn’t be Gordon Gecko (that swaggering cocksure money manager artfully portrayed by Michael Douglas in the movie Wall Street) to do well in the stock market. Resist the urge to swing for the fences. Don’t be that swashbuckling yahoo who incautiously puts everything on a single or even a handful of promising stocks because they’re the toast of tinsel town and the business media is fawning over them. Beware silver tongued pitchmen who tout “can’t-miss” investment advice. Want a stock tip? Don’t listen to stock tips… First off, the well-paid hucksters out there who hawk investment advice don’t know you. Secondly, they aren’t paid to champion your interests. More often than not, they’re secretly promoting a different agenda and are hoping to cash-in on the market activity that their overtly public comments will generate. The takeaway point? Trust no one—except maybe yourself; and even then, only after you’ve done your homework, have squirreled away emergency savings equal to anywhere from three-to-six months worth of current living expenses, and are absolutely clear on that fact that, come hell or high water, the money you’re investing in the stock market today won’t be needed for ten plus years.

As an investor, why would you own individual stocks when you can so easily and inexpensively create a sensibly diversified portfolio? Content yourself with getting on first base. Be patient, sit back and let time do its thing. Of course, when you invest, the money you’re risking is yours. Needless to say, you’re the one who’s going to suffer the greatest losses if you fail and reap the greatest rewards if you succeed. Because nobody else will take your financial interests to heart as nearly and dearly as you, why would you check your brain at the door and entrust this important job to someone else? Once you get a handle on the basics of investing (the library’s a good place to jump-start this process–Ron Muhlenkamp’s Harvesting Profits is a recommended read) you’ll be equipped to safely follow your own instincts. Trust me, this is a far better strategy than relying on the received kindness and wisdom of complete strangers.

The stock market is an oft used term that, I fear, isn’t particularly well understood by would-be investors. To dispel any confusion, this issue deserves closer examination. What, exactly, is the stock market? In short, it’s an elaborate living-breathing mechanism whose day-to-day gyrations are driven by a bewildering assortment of mostly unrelated and largely unpredictable factors. Of these, two of the most prominent are investors’ collective perceptions of stocks’ future value, and, from a broader 30,000 foot perspective, the overall health of the national economies in which they operate. Basically, it comes down to this: for every seller of a stock there must be a buyer—and vice versa. When you multiply this straightforward concept by the trillions of dollars that are sloshing around on the world’s courses, it’s easier to understand why the phrase “stock market” refers to somethings that’s gosh darned complex. But, for convenience sake, suppose we swept all of this mind boggling complexity aside and reached for a simpler explanation for the stock market’s manic day-to-day performance. Generally, if the total volume of all selling activity exceeds that of buyers, market indexes (the S&P 500 and Dow Jones Industrial Average are well-known examples) and the share prices of many companies in them will rise. Conversely, if net trading activity favors sellers over buyers, this process works in reverse and valuations fall. It’s both that simple and that complex. And here’s another thing: when you consider each market participants’ individual agenda and motive, and the varied circumstances that ultimately prompt the buying or selling a stock, and you add to this the dynamic X-factor of automated trading programs which collectively move massive amounts of stock on market exchanges, it’s easy to understand why the sum total of all this frantic and sometimes random activity cannot be neatly or even accurately explained by a succinct summary of any given day’s business headline news. Though, to be sure, this is precisely what pundits on CNBC and elsewhere would have you believe with their allegedly insightful market commentary. Ultimately, it boils down to this: the stock market is like a referee. It doesn’t offer an explanation for its decisions and its verdict is all that counts. Barron’s columnist Michael Santoli likens the stock market to “an ongoing argument over the future, staged over six-and-a-half hour sessions each weekday, among people who can’t even agree on what’s most important to be arguing about.”

Usually, when people think about investing, it’s within the context of achieving faraway financial goals; the kind that seem so vanishingly remote that viewing them up-close would require the aid of sophisticated equipment; perhaps something along the lines of a tricked-out Hubble telescope. Rightly or wrongly, for most Americans, the economic burdens of retirement seem light-years away. Unfortunately, young-adults and newly minted professionals are especially vulnerable to this virulent strain of fiscal myopia. And there’s no shortage of supporting evidence. According to a study by Vanguard, less than half (42%) of employees between the ages of 25 and 34 participate in 401(k) plans. It’s reasonable to conclude that many young people aren’t terribly preoccupied with how they’ll make ends meet in retirement. Chances are, this will be a costly oversight because, though bankrolling their golden years may not rank highly on their list of day-to-day priorities, there are many reasons why it should.

For starters, unlike life’s other big-ticket expenditures–like, say, for a house or a car–banks don’t offer retirement financing. And this inconvenient fact is unlikely to change anytime soon. Of course, young adults will (assuming all goes well) gradually age. Inevitably, at some point in their lives, they’ll want to bid adieu to the grueling monotony of the work-a-day-world. Although the vast majority of teens and twentysomethings may not yet realize it, accumulating enough moolah to make retirement a viable option is a monstrous challenge. Incubating and later hatching the sort of super-sized nest-egg that will be needed to support a dignified standard of living will require thrift, financial literacy, and conscientious economic planning. For reasons that’ll be glaringly apparent to young people half a century or so from now, they can’t afford to wait till they’re middle aged to discover that they should’ve been aggressively saving and investing for their economic futures during their formative teens and twenties. The takeaway point? If youngsters don’t get around to mastering the ABCs of personal finance till they’re old enough to collect social security (whatever meager sum that may then be) they’ll be greatly aggrieved to discover that they’ve squandered what is arguably their greatest asset: the wealth compounding power of time. You see, with one-third to one-half of their economically productive years in the rear-view mirror, they’ll be in a tough economic bind. As any money manager worth his or her salt will tell you, at a certain point in the wealth building process, it’s impossible to quickly or safely compensate for having not established sensible money habits earlier in one’s life. The gravity of this point is perhaps best illustrated with numbers. Over the last 100 years or so, money in the stock market has grown at a rate of about 10% per year. Assuming this rate of return can be banked in future years, how much money must a 20 year-old save every month to accumulate $100,000 by age 65? Answer: less than ten bucks. A 50 year-old, however, must set aside $239 each month to hit the same saving target by age 65. To be sure, the prospect of grinding poverty in old age doesn’t elicit much cheer or enthusiasm. Nonetheless, given our society’s newly pervasive ownership bias, this could be the default life path for those who don’t aggressively plan against it. Because saving enough for retirement–even for those blessed with gainful and mostly uninterrupted employment, a multi-decade investment time horizon and generally favorable market conditions–is a feisty challenge, this process is best begun as young as possible.

For students and nascent professionals who dream of a ritzy retirement, an inability to simply borrow the cash necessary to support the preferred lifestyle in future years is a source of concern. Yet, as worrisome as this may be, there are many other equally troubling factors in play. As many workers who’re nearing retirement today will no-doubt loudly attest, simply having enough money to cover life’s basic necessities (keeping food on the table, a car on the road and a roof overhead) doesn’t necessarily rank among their most pressing economic concerns. Inflation, which slowly erodes the purchasing power of a buck (and, by extension, the value of one’s life savings) is another unwelcome wild-card in the awkward financial calculus of everyday life. Another no less significant economic variable is the future trajectory of taxes in an era of skyrocketing entitlement obligations. Collectively, these factors raise the bar a good fifteen feet when it comes to what young people must know about managing their money if they’re to successfully pole-vault their way over the retirement hurdle a half century from now.

Ironically, though teens and twentysomethings may not recognize the looming enormity of the financial adversity they face, a good many will be around to blow out the candles on their 100th birthday cakes. Thanks to steadily rising life expectancies, future generations of retirees are likely to spend as much as a third of their lives in retirement. From a social and economic standpoint, this is unprecedented. In the 1800s, people didn’t worry about having enough cash to see them through their golden years because, by and large, life-spans and work-spans were one and the same. Nowadays, it seems that people have rosier expectations for their sunset years. But, just as the question of retirement, and, perhaps more importantly, how to pay for it looms more menacingly in the minds of a graying U.S. population, the government and private sectors have discreetly begun tip-toeing away from their grandiose and once affordable socio-economic commitments. According to the Center of Retirement Research, among workers with retirement plans, the percentage covered by pensions has fallen from 83% to 30% from 1980 to 2006. Increasingly, workers are having to fund their own retirements. SmartMoney, April 2012, reports that Americans have $4.3 trillion parked in 401(k)s and similar defined contribution plans; a colossal jump from roughly zero four decades ago. The elimination of employer-sponsored pensions coincides rather suspiciously with workers’ growing dependence on tax advantaged and mostly self-funded retirement, education and healthcare savings accounts. Despite a growing chorus of concern about the post-boomer solvency of pay-as-you go entitlement schemes like Social Security, Medicare and Medicaid, many of those who’re nearing retirement today are likely to receive much of the economic support that politicians have promised them over the years. Subsequent generations of aspiring retirees, however, may need to rethink how they’ll bankroll their golden years. To which, outraged tax-payers might angrily respond “How could this possibly be?” Well, ironically enough, the answer has everything to do with people—lots of them.

In 1930, when the average life expectancy in the U.S. was 60, the number of Americans age 65 and older comprised a mere 5.4% of our nation’s population. Nowadays, that figure is 13%–and rising. Demographers refer to baby-boomers (the children of World War II veterans born between 1946 and 1964) as the “pig-in-a-python” because their numbers, when plotted alongside those of neighboring generations, produce a conspicuous bulge in an otherwise flat population distribution. In 1935, when Social Security became law, its future solvency seemed ironclad because the ratio of workers who were then paying into the system vs. those who drew against it was a lofty 40 to 1. In 2030, this ratio is expected to plummet to just 2 to 1. Although some might cavalierly dismiss the severity of this economic problem, in one respect, they’re absolutely right to do so because Social Security is the least of our country’s fiscal woes. A former high-ranking government economist agrees; in a March 2007 appearance on CBS’s 60 Minutes, David Walker, the United States’ ex-Comptroller General—Uncle Sam’s chief accountant—warned that the fiscal problems facing Medicare and Medicaid are roughly five times greater than those facing Social Security. Esteemed number crunchers at the Congressional Budget Office predict that, by 2026, Social Security and Medicare obligations will add another $6.6 trillion to our already sizable multi-trillion dollar budget deficit. Though politicians and economists often quibble about the magnitude of future outflows associated with entitlement spending, it’s clear that the cost of maintaining and extending present benefits to future generations of retirees will force our government’s already leveraged financial house into an ever-worsening state of fiscal hock. If the New Deal era envisioned and championed by FDR in the wake of the Great Depression elevated living standards for all U.S. citizens through a widespread sharing of social costs, then it appears that the New-New Deal era that’s replaced it—which, in turn, is characterized a growing reliance on tax-advantaged and mostly self funded savings accounts—signifies a dramatic retooling of a longstanding socio-economic contract.

To which, social safety-netters might rightly ask, “But, aren’t U.S. government finances prudently managed?” Swelling budget, current account and trade deficits argue otherwise. In answer to the question, “Is the U.S. bankrupt?” Lawrence Kotlikoff, an economics professor at Boston University, dutifully crunched the numbers and answers in the affirmative; he concludes, “The way to judge a nation’s solvency isn’t to measure its’ fiscal inflows and outflows from one year to the next—as our government is fond of doing it—but rather, to examine the lifetime fiscal burdens of current and future generations. Based on this broadened criterion, the current U.S. fiscal gap is roughly $65.9 trillion—more than five times U.S. GDP and almost twice our national wealth.” Somewhat helpfully, Kotlikoff goes on to suggest that “eliminating the current federal budget and trade deficits would require a doubling of personal and corporate income taxes, or a 66% reduction in Social Security and Medicare benefits.” According to a report by the Congressional Budget Office (CBO), the national debt–which is roughly 62% of GDP–will rise to 87% of GDP in less than ten years. It’s expected to reach 109% of GDP (its previous peak during World War II) by 2025 and hit 185% by 2035. After that, the economic outlook gets notably dimmer.

The writing, as they say, is on the wall; and the message is as deafening as a liberty bell smacked with a twenty pound sledge hammer. What are the economic tea-leaves whispering to generations X, Y, and Z? Welcome to the ownership society. Of course, this isn’t a well kept secret. Uncle Sam, who long ago anticipated the possibility of financial hardship for millions of working class Americans, took decisive action long ago by aggressively rewiring the tax code and making tax-deferred (and yes, even tax-free) retirement savings accounts available to taxpayers whose incomes don’t exceed arbitrary limits. The good news is that these powerful wealth building tools do indeed offer conscientious savers a significant economic advantage. The bad news, however, is that they only benefit those who use them.

Taking Stock of Your Financial Future, Part 2

Because planning and saving for distant financial goals isn’t easy, it’s best to break this process down into a series of smaller and more manageable steps. Take retirement for instance, many people want to know if they’re on track, and yet, very few can confidently assess their overall level of preparedness. There’s a perfectly sensible explanation for this: it’s practically impossible for anyone to determine how much money it’ll take to support a given standard of living indefinitely. But take heart, the good news is that there’s a clever way of estimating how much money the retirement lifestyle you’ve had your eye on will cost. Now, the problem with putting a price tag on something as overwhelming as retirement is that there are many changing variables to consider and countless ways for the messy economic calculus to go horribly awry. Unless you’ve got a properly calibrated crystal ball that can peer deep into the foggy faraway future and accurately discern dynamic variables like inflation, future investment returns, personal longevity, the precise trajectory of health care costs and tax rates, there’s just no telling how much money you’ll need to live well in retirement. Throw in wildly variable living standards and the long-term cost of supporting them, and it’s jarringly apparent that retirement numbers resemble snowflakes; no two are exactly alike.

Fortunately, when it comes to eliminating a lot of the uncertainty in guesstimating how much a dignified retirement will cost, there’s a simple back-of-the-envelope approach to crunching the numbers that dispels much of the economic confusion. In fact, if you follow the simple multi-step procedure I’m about to outline, you’ll have a very accurate and reliable estimate of your retirement number. This time and labor intensive process–which I call the price tag estimator–will produce a lifetime savings target that’s likely to meet your unique personal requirements. That’s the good news. The bad news is that it takes considerable effort on your part to produce worthwhile results. Start by gathering and organizing a bunch of old receipts. Haven’t got any old receipts to work with? Fine, stockpile them until you’ve got one or two years worth of living expenses to analyze. The idea is that you want to create a thorough and excruciatingly detailed record of your day-to-day, week-to-week, and month-to-month spending behavior. Naturally, this means carefully tracking and tabulating expenditures on everything from housing and transportation to phone and cable bills, groceries, entertainment and, of course, restaurants. Once you’ve correctly quantified and categorized your personal spending and have an all-in-one figure representing much it costs to support your standard of living for a year, multiply the grand total by a factor of, say, twenty-five. By all means, if you want to live dangerously (and aren’t terribly concerned about the possibility of running out of money before running out of time) then, by all means, feel free to experiment with a smaller number–though I’d caution against using a multiplier of less than 20.

So long as your inflows and outflows don’t dramatically change in future years, this monstrous sum is what you’ll need to squirrel away over the course of your working life to achieve a lofty and largely self-sustaining financial orbit without ever again having to rely on the economic support of a paycheck. Rest assured, when your net-worth approaches this impressive magnitude, you’ll have your proverbial cake and be able to eat it too. Once you’ve allowed ample time for the enormity of your thoughtfully calculated retirement savings target to sink in, take stock of your emotional pulse. Is your retirement number a scary number? It should be… The Number, by Lee Eisenberg, offers a detailed yet refreshingly down-to-earth step-by-step overview (this is essential reading for anyone who’s interested in more closely exploring this worthwhile topic) of how to size-up the nest-egg you’ll need to drop out of the rat race and figure out how strong a balance sheet it’ll take to indefinitely support a given lifestyle. Believe-it-or-not, establishing good savings habits and a constructive wealth ethic early on in life is essential to the success of this process. Sacrifice and shrewd economic planning throughout one’s 30s and 40s can, through the magic of compounding returns, make all the difference between merely getting by or living it up many decades from now. The takeaway point? Retirement is expensive. So, when it comes to feathering your nest and saving for the eventuality of your golden years, brace yourself for a sobering dose of high-voltage sticker shock. Even if the prospect of retirement seems absurdly remote and the idea of saving for it now seems ridiculously premature, make no mistake, old age looms menacingly somewhere down the calendar like the financial equivalent of Mt. Everest. For reasons that’ll be painfully apparent a half century or so from now, the ongoing work of planning and saving for it shouldn’t be delayed another day.

Well, I’ve got good news and bad news. What’ll it be first? Okay, we’ll start with the bad news… Although saving aggressively, early and often is absolutely necessary to the lifelong struggle to reach retirement, the unsettling reality is that regularly saving may not, by itself, be enough for you to accumulate enough wealth to retire comfortably. But don’t despair; before resigning yourself to a bleak and incredibly remote future wherein you’re old and gray, shivering for warmth beneath a pile of blankets and lounging before the drafty chill of an empty fireplace while clutching a bowl of cold oatmeal—here’s the good news. Are you ready? Thanks to capitalism’s buoyant long-term record (as shown by 80+ years of stock market history) it’s possible for individuals with modest means, a decent savings ethic, and a multi-decade investment time horizon to bridge the yawning divide between what they can comfortably afford to save on a paycheck-to-paycheck basis and what they’ll one day need to retire in style.

To prove that the good news scenario just alluded to isn’t a cruel hoax, we’ll analyze and trace the economic choices of three made-to-order retirement crash test dummies. Consider this unorthodox narrative a fun thought experiment. Using fancy mannequins to illustrate important financial concepts and compare side-by-side the long-term results of three different and distinct saving and retirement funding approaches will, in theory, bring a welcome touch of levity to an otherwise dreary and emotionally charged topic. Because of the whimsical (and hopefully, entertaining) nature of the three-way retirement race that’s about to get underway, and since the long-term welfare of our experimental subjects and whether or not they reach their retirement savings goals is unlikely to elicit much concern (after all, they’re inanimate objects and, as such, are ideally suited to weather even the harshest of future economic conditions) we can, with near clinical detachment, dispassionately focus on the outcome of this fascinating fiscal experiment. The economic results, which will slowly and progressively manifest over 40 long years so as to simulate a real person’s professional tenure, will enable us to more clearly see how each crash test dummy’s financial strategy pays off. Sit tight; this will be an informative lesson in fiscal physics you won’t want to miss.

To lay the groundwork for this three-way retirement race, let’s begin by clearly establishing the respective similarities and differences between each of the crash test dummies in how they manage their money and what they do with their long-term savings. Luckily, they’re all equally diligent savers, have identical incomes and, in lockstep, set aside equal amounts of money for their golden years. At the risk of prematurely giving away the moral of this riveting story, we’ll soon see that how much money each crash test dummy sets aside each paycheck will, at the far end of 40 years, have surprisingly little influence in determining the magnitude of their end of career nest-egg. Remarkably, it’s what they do with their hard-earned money that’s the single biggest factor in their future wealth. So that we won’t have to impatiently wait around four decades for the results of this fiscal experiment to materialize, we’ll take the easy way out. We’ll accomplish this by strapping each of our intrepid prosthetic contestants into a fancy electronic chair. Shortly thereafter, we’ll flip a switch in the time control room and, presto, dispatch each economic crash test dummy to the distant past. Borrowing from the storyline to James Cameron’s hit film The Terminator, in a spectacular haze of special effects, our experimental subjects will miraculously emerge from out of thin air 40 years ago and will be indentured to a world of gainful and blissfully uninterrupted employment.

Of course, each crash test dummy works tirelessly and with grim machine-like determination toward the realization of a shared goal: a million bucks in retirement capital. Now, to achieve this lofty financial goal, each saves $145 from each and every paycheck they’ll earn over the course of their 40 year-long careers. Because dummy # 1 is preoccupied with the safety of his money, he dutifully stuffs every saved dollar into his mattress at home. Dummy # 2, who isn’t quite so risk averse, puts his retirement money into certificates of deposit that yield rock-steady 4% annualized returns. Unlike dummies # 1 and # 2, however, dummy # 3 is something of a financial dare devil; he consistently plows his retirement cash into a broadly diversified mix of stocks. Although the value of dummy #3’s savings seems to violently fluctuate over any one-to-five year period, this volatility eventually disappears and produces a notably higher annual return of 11.15%. Interestingly, this number wasn’t blindly plucked from out of thin air. According to Ibbotson Associates Inc., a research firm, this rate of return corresponds to the stock market’s average annual return from 1926 to 2002.

Now that the ground rules for this far-fetched fiscal experiment have been clearly defined, let’s sit back in the time-control room, kick up our feet and enjoy a refreshing beverage or two. We’ll allow the pages of the calendar to fly by. Time will accelerate on its not-so-merry way, but we’ll be sure to stop the clock exactly 40 years from the day that our crash test dummies first begin to earn a paycheck. Of course, calculating the results will require crunching the numbers. Since each is paid twice a month, or 24 times a year, a 40 year career produces a whopping lifetime total of 960 paychecks, which, when multiplied by $145 (remember, this is the dollar amount each saves per paycheck), yields a baseline nest-egg of $139,200.00 for each retirement contestant. Dummy # 1, who misused his savings as glorified mattress stuffing, clearly misses his million dollar savings target. Inching to retirement at this sloth-like pace, I estimate that he’d need to work a not-so-grand total of 247 years before he’d have enough moolah to stuff his mattress with a million bucks—and this hypothetical doesn’t even take into account inflation’s sinister wealth withering effects. It’s a good thing that a crash test dummy’s plastic parts are sturdily constructed and don’t easily break down. Were this not the case, dummy # 1 wouldn’t reach his retirement savings goal at all. Recent advances in healthcare and rising life expectancies notwithstanding, however, an actual flesh-and-blood person may be unable to withstand such a lengthy career. What about dummy # 2? Because his money grows at a considerably faster non-zero clip, he ends up with a lot more money after 40 years: $343,340.00. Regrettably, dummy # 2 still falls well short of his million dollar savings target. Although dummy # 2 easily beats dummy # 1 to the retirement finish line, it still takes him 63 years to do so. Moreover, if inflation were factored into dummy # 2’s long-term economic results, the purchasing power of his nest-egg would dwindle to just $163,330. Ouch! How about dummy # 3, that swashbuckling financial yahoo? Certainly, he endured greater volatility in the short-term value of his savings to achieve significantly higher long-term returns. But, the million dollar question is: are the stock market’s returns great enough to propel him to his savings goal within a biologically normal 40 year career span? Amazingly, because dummy # 3’s savings compound at a far more impressive 11.15% annualized clip, his bank account not only reaches the million dollar threshold, it surpasses it; amazingly, with $2.64 million to spare.

At first glance, dummy # 3’s outsized fortune seems suspiciously large. One might rightly argue that these numbers don’t make sense. After all, how can dummy # 3’s 11.15% annual rate of return, which is roughly three times greater than dummy # 2’s 4% rate of return, produce nearly 7.7 times more wealth over four decades? Admittedly, the asymmetry of their economic results may, to the uninformed observer, look suspicious. Nevertheless, the figures have been triple-checked and they’re all correct. The moral of this story is that the wealth-building power of higher compounding returns acting over a multi-decade period are extraordinary! In fact, the mechanics of compound interest are so remarkable that Albert Einstein dubbed this mathematical phenomenon the “most powerful force in the universe.” Even with inflation’s wealth withering affects taken into account (estimated at 3.22% per year), dummy # 3 still retires in style with the purchasing power equivalent of a million bucks.

So, as you can clearly see, when it comes to planning and saving for distant financial goals like retirement, the simple act of saving (though still vitally necessary) isn’t necessarily enough. Although dummy # 1’s mattress-minded ways certainly protected his fortune from loss, he paid dearly for the illusory peace of mind it provided. Ironically, dummy # 1’s pathological aversion to financial loss is largely responsible for his disastrous long-term economic results. Similarly, though dummy # 2’s retirement savings earn a significantly higher rate of return, it’s not nearly high enough for him to amass a million bucks in 40 years. Unlike dummies one and two, however, dummy # 3’s results are positively astounding. In his case, it’s as though a financial magician reached into a cavernous top hat, and, with considerable effort, extracted a wheel-borrow brimming with crisp and tightly bundled hundred dollar bills. What’s not readily apparent in dummy # 3’s case–because 40 years worth of stock market history was conveniently glossed over in the blink-of-an-eye–is that the gut-wrenching volatility he endured in the stock market was anything but pleasant. To be sure, if dummy # 3 had a real stomach and actual nerves to match, he surely would’ve lost his cookies—and on many occasions. At times, the stock market treated Dummy # 3 so harshly that, were he an actual person subject to emotional whims and reflexive knee-jerk reactions of a sane person, he would’ve been sorely tempted to pull the proverbial rip cord and bail out of the stock market altogether. Needless to say, in those dark and difficult times, nobody would have questioned his judgement for doing just that. Fortunately, we see that dummy # 3’s patience and indifference to volatility are generously rewarded.

Now, a few words of caution are in order. Just because a statistical accounting of the stock market’s performance from 1926 to 2002 yields an average annualized return of 11.15% doesn’t mean that equities can be safely trusted to produce similar returns over any future span of time. Nor, for that matter, does it mean that the stock market actually delivered a return of 11.15% during any 12 month period during that lengthy 77 year interval. Bear in mind, 11.15% is just an average. In other words, for half of those 77 years the stock market produced returns that were better than the 11.15% average. For the other half, it posted annual returns that were worse–in some cases much worse. Over one or more decades, however, the stock market tends to respond favorably to capitalism’s buoyant influence and humanity’s boundless ingenuity when faced with a profit motive. So, despite its erratic short-term volatility and violent mood swings, over any multi-decade period, the price chart of any well-known and closely followed index (the Dow Jones Industrial Average, Wilshire 5000 and S&P 500 are notable examples) tends to trace a nice smooth upward sloping line. It’s worth emphasizing, though, that during its long and rocky history the stock market has witnessed many a calamity, including: the threat of nuclear holocaust; two world wars; a presidential assassination; the great depression and just about any other disaster that a thinking species can throw at it. And yet, despite these horrific events and recurring systemic shocks, the stock market has risen seven out of every ten years going all the way back to 1928. Interestingly, in this time, the stock market has experienced 57 up and 24 down years. To be sure, you won’t find these odds, or the prospect of recurring dividends, in Vegas. The upshot is that the longer one remains invested in the stock market, the less risky investing in it becomes.

Paradoxically, although stocks have generated outstanding long-term returns, it’s unwise to own just stocks. Why mimic the overly rigid financial mindsets of dummies 1, 2, or 3 when you can combine the best elements of all three? Though dummy # 1’s overly cautious and conservative approach to managing his savings ultimately lands him in the poor house in retirement, don’t be mislead by his disastrous results. There’s a place for cash in any long-term savings portfolio. It’s a good idea to keep some handy at all times so that, should the stock market tank, you can take advantage of the opportunity to snap up high-quality cash generating businesses at irrationally depressed prices. Similarly, although the slow plodding performance of investments like bonds aren’t exactly thrilling, their steady performance brings a worthwhile measure of stability to partly counteract the gut-churning volatility of an all-stock portfolio.

In short, it’s best to have a little cash here, a few safe and stodgy investments there, and the bulk of one’s retirement savings in stocks. The bottom line: when it comes to planning for distant financial goals (like retirement), it pays to make informed choices and have a plan. Luckily, with enough time on your side, you needn’t save a lot of money on a regular basis to wake up a millionaire one day. The important thing to remember is that it’s never too early to start saving and you can’t afford to manage your wealth too conservatively. Don’t learn what dummies one or two learned the hard way. When it comes to achieving faraway financial goals, it pays to think beyond the mattress.