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April 2012: Thoughts on Saving, Then Investing

4/2/2012

 
Dear Clients and Friends,

Spring is finally here! Hopefully that means the rain will end in the San Francisco area. At least the stock market performance has been sunny!

Over the past few years, I've written a lot about investment strategy. I've talked about bonds: Bonds are the New Black (Oct 2010), inflation: Inflation Expectations and Portfolio Construction (July 2010), risk: Thoughts on Risk (July 2011) and bear markets: Investing in a Bear Market (January 2012). These are important topics and I want to be sure that clients understand the Why's of how their portfolios are constructed. But over the next several quarters, I'll be turning my attention to the financial planning side of the relationship. At Bootstrap Capital I offer two basic services: financial planning and investment management. Client interactions often focus on one or the other, but I strongly believe to address your total financial life, you need to focus on both. And whenever I start to talk about financial planning, I like to start with one of my favorite topics: saving money.
Thoughts on Saving, Then Investing
(or: Tough Love on your Spending Plan)


I can just hear the groans now... Everyone is thinking I'm going to lecture them on budgets. But the truth is I hate budgets as much as you do. I prefer to think of it in terms of a Spending Plan. That's right, not how much do you have to save, but how much do you get to spend! It doesn't sound revolutionary, but I feel that changing your mental positioning can help enormously in how you view your money flow.

First, let's talk about why this is so important. Then I'll move on to the tough love. Short of a big inheritance, or winning the lottery, the way most of us are going to build wealth is to save it. That's right, you've got to sock it away to make it work. The arithmetic is compelling and brutal (OK, maybe I'm moving on to tough love already). Think about this example: a family earns $150,000 per year. Every year they save 10% of their salary or $15,000 per year ( for the sake of argument, we'll assume they deposit it at year end). For illustration purposes, let's assume they earn an annual term return of 7%, how many years does it take before their investments are generating an amount of money equal to the $15,000 they save every year? The chart below illustrates the answer:
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It's not until after the 10th year that investment returns start to equal the amount they are saving in this example. You know that saying, "It takes money to make money." That's what this chart illustrates. But look, once you get to year 15, the investment return is significantly more than the $15,000 annual savings and at year 20, its almost three times as great. You can change the assumptions, but you really can't argue with the outcome: for the first 10 years of your investing program, your savings is doing all the heavy lifting.

Tough Love Lesson #1: Prioritize, Prioritize, Prioritize

When you make a spending plan, it is imperative to prioritize your goals. I truly believe you can do anything you want in life. We live in an amazing country full of outstanding opportunity. Unfortunately this does not necessarily mean that you can do everything you want in life. When you prioritize, be honest and realistic with yourself and try to withhold judgment. For example, if you like nice cars, then put it in your spending plan. You shouldn't feel guilty about what you spend your money on. You earned it! Enjoy it however you want, whether that is cars, travel, or sixteenth century poetry. Spend on what you deem the highest priority.

Tough Love Lesson #2: Be Ruthless on Low Priority Items

Once you've identified your priorities, you need to be ruthless about cutting spending on things that are not a priority. For example, if you decide that over the next five years, you want to spend major money renovating your house, maybe you decide to take less expensive vacations until the work is done. If you like going out to dinner and a movie, maybe you slash your cable service. When you make conscious decisions on what you want to spend your money on, it becomes much easier to economize in other areas of your life.

Tough Love Lesson #3: Make it Automatic

Here's the reality, if your saving and investing plan relies on you logging into your accounts and transferring money to your savings every month, it's probably not going to get done. You need to put it on autopilot. Once you decide what you want to spend your money on, create a savings account, set up automatic transfers around when you get paid and make sure to fund your goals in advance. Too many times, we buy what we want and worry about how we are going to pay for it later.

With good priorities and a well thought out spending plan, you should be able to devote resources to long term saving goals. Next quarter, I'll talk about some additional mental tricks that you can use to really ramp up your savings potential. In the meantime, if you have any questions about spending plans or any of the ideas discussed in this letter, please don't hesitate to contact me. Also, if your friends or family have questions about any financial issue, please feel free to make an introduction or forward this letter. I provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances. I will treat your friends and family with the same care and diligence that I treat you.

Thanks,

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Brian McCann, CFP®

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