Series: Essentially Essential – Compounding with Time


Time. You cannot hold it. You cannot see it. You cannot stop it.
But… you do have a choice. Utilize it or don’t.
When it comes to planning and building wealth (or for anything) – time matters. And, compounding most certainly does too.

1

Time Value of Money

2

Compound Interest

These two concepts are both fundamental, foundational and most certainly essential. The sooner you learn them and the sooner you apply them – the better off financially YOU WILL BE!

Whether you realize it or not, time and compound interest are powerful. Time allows for potential. Compounding allows for growth. Both concepts are simple, so let’s analyze why time and compound interest matter.

What is Time Value of Money?

Time Value of Money. You may have never drawn the comparison that time and money have a mutualistic relationship - it does. Money not only has a monetary value; it has a time value too. Let’s look at a quick example:
You completed a service for a client, and you are owed $10,000 dollars. The client calls you to let you know that he is ready to give you a check for the bill. He gives you a choice to swing by his house to collect the $10,000 before he goes out of town for a month. You have a choice. Do you wait for a month or do you go by his house to collect what he owes you?

Some may say it doesn’t matter as long as they get paid, but time value of money says it does matter. Why? Because receiving money today is worth more than receiving that same $10,000 dollars at any given point in the future. Yes, even if you had the option to receive it tomorrow. Your money has potential earning capacity. This means that the $10,000 you received today; you have the potential to earn money on that $10,000 today. So, if you took the $10,000 a month from now instead of today, you would miss out on all the potential earning capacity of each day you did not have the funds.

Simply put:
• If you receive the money today – you can make money on your money today.
• If you receive the money tomorrow or at any given point in the future but had the option to receive the money today – you lose out on the potential earnings of today and every day in the future that you delay receiving the money.

What is Compound Interest?

Formula: FV = PV (1 + r)^n
(FV): Future Value
(PV): Present Value
(r): Interest rate earned per year (%)
(^): Exponent – the number of times a number is multiplied by itself
(n): Number of periods



Said to have been described as “the eighth wonder of the world” by Albert Einstein, compound interest can be simplified from the formula above. Yes – FV, PV, R, and N are each important in making your money grow, but where you capture the most growth is often the most overlooked piece of the formula. The “upside-down v” or exponent allows for compounding. It allows you to exponentially grow the present value (PV) to a greater future value (FV). To get from PV to FV the compound interest accrues - this means that not only will you earn interest on the principle (initial amount), but also you will earn interest on your interest.

Yes, you read that right. You can earn money on the money you’ve earned.

Let’s take the previous example above and say you decided to swing by your client’s home to receive the payment of the $10,000. Let’s also say you immediately took those funds to the bank and put it in a savings account. It also turns out that the savings account at your local bank is yielding 10% (for simple math – FYI, most savings accounts yield less than 1% unless it’s an online bank). Here’s what that would look like if you deposited the $10,000 and did not touch the funds for the following years:

Year One: $10,000 x (1+0.1) = $11,000
Year Two: $1,100 x (1+0.1) = $12,100
Year Three: $1,210 x (1+0.1) = $13,310
Year Four: $1,331 x (1+0.1) = $14,641
Year Five: $1,464.1 x (1+0.1) = $16,105.10
Year Ten: $1,610.51 x (1+0.1) ^5 = $25,937.40
Year Twenty: $2,593.74 x (1+0.1) ^10 = $67,275

After year one, you would have made $1,000, because you earned 10% on your principal ($10,000). In year two you would have earned $1,100, because you earned 10% on your principal ($10,000) and the interest you earned from year one ($1,000). This is what compounding looks like.

How does time value of money and compound interest work together?

In the compounding example above, let’s assume you put the $10,000 under your mattress for ten years, then decided to put it in that same savings account that was offering a 10% yield. Instead of turning your $10,000 into $67,275, your $10,000 would only be worth $25,937.40. This is due to the fact that you decided not to make the choice to utilize time, you would have lost out on $41,337.60. That’s why time matters and coupling it with compound interest amplifies its importance.

Key takeaways:

• Money grows, but you must have it to receive the potential of growth. If given the option, ALWAYS take the money NOW.
• Compound interest is perhaps the 8th wonder of the world. You can earn money on the money you’ve earned.
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Are you Psychologically Fit?

It’s the day you’ve dreamt of. The day that has caused your imagination to run like a stallion. You’ve watched others experience it many times over only wishing it was you in their place. This day, the day you’ve been working for is here.

Retirement!


via GIPHY

So, you’re good financially? Great! But, what about psychologically? Asking the question, “Do I have enough?” is not the only question that you should be asking. Although it is important and can be liberating, having enough is just one of many steps along the path of a having a successful retirement.

Think back to the very first day you began your career. The excitement, the newness, the possibilities. Retirement is like that! Now think back to the day you began your seventh year. The normalcy, yet you're filled with questions and new roles. Retirement is also like that.

Change occurs early and often. Unfortunately, many retirees do not think practically past the first day of retirement or even the first year. The questions of worth, purpose and identity may creep in. What you must realize is that you are a creature of habit and when change occurs, you deal with it differently than someone else. Below are some questions/strategies to spur thought as you begin that transition into retirement and if you're already to that point - start where you are now.

  • Do I have enough?
  • Am I ready to retire or am I just retiring because that is the natural progression?
  • Will I miss the relevancy that my job provided? If so, what can I get involved in to fill the void I may experience?
  • What will I be leaving behind?
  • What is my purpose in life? In what ways can I go about accomplishing that?
  • Realistically, what will my lifestyle look like? Have I put off activities or interests that I want to pursue?
  • Who has transitioned into retirement that I know? Call them and talk about the transition they had.
  • What tasks will I implement to stay active, healthy and keep my mind sharp?
  • Just like your career goals, formulate retirement goals. Set short-term, intermediate and long-term goals.
  • After the bucket list items are checked off and the grandkids have been visited, what will my day-to-day look like?
  • If I am social, what organizations or clubs are available for me to join?
  • What type of legacy do I want to leave?


Final Thought: There is no one-size-fits-all solution to retirement. Everyone has different desires and different circumstances. What everyone can do is take those desires and circumstances into consideration before and during retirement and apply serious thought to them. Each decision creates complexities. Keep in mind that life happens, so remain adaptable just like you are in your career. Keep an open mind and surround yourself with people you trust and can have tough ongoing conversations with. This is where we want to end up:

 

via GIPHY

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SECURE ACT Update - Rights Can't Offset Wrongs

This is why Washington is broke but politicians aren't

Background

On the surface, changing IRS rules to delay required minimum distributions from 70 1/2 to 72 years old looks like a major win for older taxpayers. In fact, the SECURE Bill making it's way through Congress with bipartisan sponsorship would do this along with a few other attractive changes:
  • Repeals the maximum age of worker contributions to company sponsored retirement plans
  • Make it easier for small business owners to cooperatively offer retirement plan benefits to their workers
  • Require companies to open eligibility to non-seasonal, part time workers

These features of the bill are net savings for workers, so what's there to not like?

Lobbyist Step In

Currently, workers can comfortably contribute to their company retirement plans with the knowledge that their money is going into an account that is well-protected from financial thievery. IRS "safe harbor" rules require company plan sponsors to meet stringent rules that help keep costs in line and junk out of these retirement accounts. This is why you don't see annuity products in 401k plans. Insurance company products are notoriously expensive for consumers which, conversely, makes them very lucrative for insurance companies. Insurance companies know how to use their profits to buy influence in Washington. Purists call it lobbying, I call it what it is - bribery. 

Congressman Richard Neal (D-Mass), who co-sponsored the SECURE act, receives thousands of dollars from the insurance industry. In this bill those corporate donors are getting what they paid for from Neal. The SECURE ACT grants IRS safe harbor status to annuity products so they can be used to pilfer your retirement accounts through unnecessarily high fees and commissions. 

To make matters worse, an appealing amendment from Rep. Kevin Brady would have allowed home school families to tap into 529 education accounts to pay for education related expenses. This measure made it out of committee but was stripped out of the final bill before a vote. Who would be against this? 

The Bull Elephant in the Room

Here's where things get ironically interesting. Rep. Neal (who obviously feels zero compunction from taking money from insurance companies in exchange for favorable language in legislation that he drafted and co-sponsored) smugly invoked an arcane IRS regulation, to demand 6 years of Donald Trumps tax returns. Neal sent this letter on April 3rd the DAY AFTER his SECURE ACT passed in the house with bipartisan support. That tells us everything we need to know. 



This bill has merit for many taxpayers. Sadly, the eventual costs to worker's retirement plans from allowing annuity salesmen in don't offset these benefits. Another bill is working it's way through the US Senate. Let's hope it's better than this. 

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Lessons Learned from Warren Buffett's $377 Million Ponzi Scheme Loss

Imagine coming home from work and telling your spouse that you lost $377 million dollars in a Ponzi Scheme. Now imagine that you are legendary investment guru Warren Buffett and admitting this to shareholders in his company, Berkshire Hathaway. #BadDayAtWork.

Mr. Buffett has more investment wins than losses. That's why he's known as the Sage of Omaha and Berkshire's annual shareholder meeting looks like a cult meeting. Buffett and his 95 year old Vice Chairman, Charlie Munger have decades of wisdom, experience and a vast team of corporate talent that provides research. This gives Berkshire a massive advantage in weeding out good opportunities from bad ones.

None of that mattered in this loss. He got swindled out of $377 million dollars!

Here's the scene when it all fell apart:





We need to learn from his loss to hopefully avoid some of our own. Let's look at his potential mistakes.

Mistake #1- The investment was in a new company with little financial history. As I write this, Uber just priced their initial public offering. Customers know the company and enjoy the transportation benefits. Uber has a limited financial history which consists of losing money not earning profits. This type of "investment" is for speculators only. Stick to investments that have been making money for a decade or more. This alone will dramatically reduce the potential for fraudulent outcomes.  

Mistake #2- His solar investment thesis apparently focused on tax-related benefits more than investment activity returns. We invest our money to earn a return from the investment activity of the business. If the company's business turns a profit, you have a strong chance of earning a positive return. Real estate limited partnerships in the 70's and 80's relied on complicated tax benefits to entice wealthy investors into parting with their cash. With a simple IRS tax law change, these benefits were wiped away over night and so were most LP's. Nowadays, insurance products are often marketed as tax savvy "investments" but at the end of the day, it's an indemnity policy that should insure you against some sort of specific loss (life, income, health etc.) period.    

Mistake #3 - He didn't recognize the problem soon enough. Berkshire made investment in DC Solar from 2015 all the way through 2018. At LeConte, we tend to be deep value investors which means we like to buy cheap investments. The trick is to differentiate when something is cheap (for a reason) and when it is worthless. After 3 years, Berkshire should have realized their solar play had issues. 

Mistake #4 - Buffett was a victim of his own hubris. Over time investors can fall victim to attribute their success to skill rather than good fortune. The Good Book reminds us that Pride comes before a fall. Stay humble or markets will make you humble. 

We are never too old (or too smart) to learn and improve. I suspect that Buffett will make adjustments after this loss. Don't feel sorry for him though. $377 million is a chunky loss but Berkshire has more than 100 Billion sitting in cash. Warren and Charlie will be fine. 

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Series: Essentially Essential – The Pay Stub: Why Understand It

It was all jacked up

Yes, my pay stub was all sorts of messed up and if I didn’t understand it, then the issue would have persisted.

True story. For months I had collected a paycheck only caring about the bottom-line number (Net Pay). Of course, I didn’t have any real reason to look at the pay stub because it would have only told me what I already knew – that I got paid! Also, I assumed payroll processors could never mess up an employee’s pay…

It was Friday afternoon (I had been working for the company for a little over a year), I received my pay stub and as I began to fold the pay stub to put it in my desk drawer as I did many times before - curiosity struck,

  • How do I even know if the amount I am taking home is correct?
  • Are my deductions correct - 401k, charitable contributions, withholdings?
  • Do I need to make any adjustments?

As I was prompted by these thoughts, I noticed something was off. The deductions – this was the part that was all jacked up…

Most likely, you don’t review your pay stub for two reasons:

  1. You know you got paid.

    You got paid, cool! But what if you could have taken home more or saved an issue from getting even larger? Your payroll processor is human just like you, which makes them susceptible to the same mistakes you make. Even the most well-intentioned person messes up.

  2. Education. You do not know all the terms or how it flows.

    Our educational system does not teach people to read a pay stub in school, so how do people learn? If you don’t understand what you are looking at, ask someone to walk you through it or keep reading. Remember, there is no shame in making sure you’re being compensated for the work you’ve performed. I guarantee you that you are not alone in not understanding a pay stub.

Below, I have covered the minimum of what every pay stub should include. Keep in mind that pay stubs vary in look and the type of deductions based on your situation.

The Basics:


  • What is a Pay stub?
    • The document that outlines detail about your compensation.
    • The first piece of information to take into consideration when forming a budget. Every number in a budget flows from the information contained on a pay stub. 
  • Employee Name
    •  This is YOU!  (Just wanted to make sure you’re still reading)
  • Current and YTD
    • Current is what you were paid for in the most recent pay period.
    • YTD (Year-To-Date) is the sum of how much you have earned in the current calendar year, thus far.
*You should see Current and YTD in each category on your pay stub.

Earnings

*This section may look different depending on the way an employee earns wages. If you are paid hourly, you will see the hours worked and the rate (how much earned per hour). If you are a salaried employee, you may only see a current and YTD number. You may also see other forms of compensation within this section.

  • Gross Pay
    • The amount before any taxes or deductions have been subtracted.
  • Net Pay
    • The amount after subtracting taxes and deductions from gross pay. Net pay is commonly referred to as “take home” pay.

Deductions

  • Taxes
    • Federal Income Tax
      • Depends on the number of exemptions you claimed when filling out the W-4 Form when you were first hired (it informs your employer on how much federal tax should be withheld).
    • FICA (Federal Insurance Contributions Act)
      •  Social Security Tax
        • For 2019, the tax rate is 6.2% (the employee and employer both pay this tax for a total for 12.4%). Any dollar earned over $132,900 is NOT subject to this tax.
      • Medicare Tax
        • For 2019, the tax rate is 1.45% (the employee and employer both pay this tax for a total for 2.9%). Every dollar earned is subject to this tax - Any wages earned over $200,000 have an additional 0.9% tax for the employee.
    • State Tax
      • Each state has different laws regarding state tax. For more information, consult your Human Resource Department.
        • For an example, see the sample paystub above under the taxes section – there is a withholding for the state of North Carolina.
*Employers have additional taxes they must pay because they have employees. These additional taxes do not impact your earnings in any way.
  • Pre-Tax (Before)
    • Deductions taken from your gross pay before taxes are withheld. Pre-tax deductions reduce your taxable income, which will more than likely result in paying less Federal Income and FICA tax.
    • Below are examples of Pre-Tax Deductions:
      • Certain Retirement Plans
      • Life Insurance
      • Health Insurance
      • Health Savings Accounts or Flexible Spending Accounts
*Though you save on taxes when this deduction occurs, you may owe taxes on the withheld money in the future.
  • Post-Tax (After)
    • Deductions taken from your gross pay after taxes are withheld. Post-tax deductions do not reduce your taxable income, but could be beneficial depending on how these deductions are used.
    • Below are examples of Post-Tax Deductions:
      • Certain Retirement Plans
      • Disability Insurance
      • Life Insurance
      • Garnishments
      • Charitable Contributions

…To conclude my story, the payroll department had mistakenly deducted the 401k match (Employer contribution to my 401k) from my earnings for more than a quarter of the year. Thus, resulting in my net pay being less than it should have been. So, if you don’t want your paycheck to be jacked up, get educated on how to read your pay stub and scan over it each pay period.
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The Value of Nothing

In The Picture of Dorian Gray, novelist, Oscar Wilde wrote “Nowadays people know the price of everything and the value of nothing.” I am mindful of how applicable this quote is to investor behavior over the past few years. We have the price of everything available instantly on our mobile devices, but we’ve lost our curiosity about the true value of things. When this bull market ends, investors who have grown complacent in this area will pay a hefty financial price.

This is the lesson of market volatility. We have experienced nine years of consistent, increases in the broad stock market averages with little in the way of normal corrective price action along the way. There are sound arguments about the suspect nature of this low volatility bull market. Most of these observations cast a critical eye toward the powerful yet secretive Federal Reserve Bank system. The Federal Reserve’s unprecedented use of “creative” techniques after the housing bubble contributed to the bull market in ways that will take decades to understand. The deluge of stock buybacks which were often funded by corporations' ability to borrow money at near zero interest rates are one example of suspect behavior that the Fed's policies promoted.  

Long bull markets also tempt investors to consider two familiar forks in the behavioral road. Without the occasional price correction to jolt slumbering investors, they can drift into lazy thinking and numbly follow herd behavior. They forego the hard work of calculating the true value of their financial assets and simply trust in the masses. Other investors take the fork to blind hubris. They misinterpret market action as an affirmation of their intellect and ability to discern future price action. These investors adopt the mindset of short-term traders, churning through tweets, blog posts and charting software. They begin to trade higher risk instruments that they have little experience or understanding of but, as the bull rages, their risks pay off frequently enough to amplify their behavioral miscalculations.

We highlighted Tesla and Netflix in January as prime examples of the price/value conundrum. Netflix generates revenue but returns no money to shareholders. In fact, the company is burning through billions of dollars creating original shows with little expectation for how profitable the shows will be. The price of Netflix stock increased from $190 in January to $423 per share in June. Now (October 2018) it is on the verge of breaking $300.


This 122% jump followed by a 29% decline demonstrates the gap between the price of the company and the value of it’s shares. Placing a tangible value on Netflix requires making many unknowable assumptions about the future. Investors are left following a price trend that could reverse violently at any time.

I have a name for opportunities like Netflix and Tesla – uninvestable. There are other examples of companies whose stock price bears little resemblance to the intrinsic value of their products, services and financial assets. The Federal Reserve started reversing the housing crisis recovery experiments a couple of years ago. Stock investors were slow to understand the Fed’s persistence. Price volatility this year is an indication that investors are beginning to examine the price they have paid versus the value they bought. We have further to go before this price/value gap returns to historical norms.

Once they acknowledge the disconnect between prices and values in domestic stocks, investors can look at foreign markets where the price/value ratio is more favorable to long term appreciation. Pursuing value is our preferred path to build long term wealth.

via GIPHY

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