Margin

"An amount of something included so as to be sure of success of safety"

The concept of margin has been on my mind a lot recently.

It started when I heard an excellent speaker talk about the importance of having financial margin in one's life. As he described the concept to the group, he was trying to describe the importance of having enough financial buffer in one's life that they could handle the natural ebbs and flows of life. More specifically, he was trying to describe having enough margin of error that when the unexpected ultimately happened, a person or family would have enough financial to be able to weather the unexpected storm.

In the financial world, we would describe this as an Emergency Fund. Dave Ramsey devotes two of his "7 Baby Steps" to creating an emergency fund that would allow someone to weather the unexpected financial hiccups that inevitably happen to all of us. (No one, no matter how good at budgeting they might become, can expect every blown engine, air conditioning failure, or unexpected expense pop up.) The wise create safety nets.

I've also seen that the concept of margin can and should be pressed into other areas of our life. Certainly if we can create financial margin, the weight of the unexpected begins to lighten.

One of the biggest areas that I have seen failure in my own life in the past is creating margin in my time. Like most in America, it has become exceedingly easy to get fully booked, even double and triple booked, without even batting an eye. I've found that this puts ourselves and our families under incredible strain and stress.

Most of the time, the things that consume our time are good things. They may even be great things. We rarely choose to spend our time on things that we don't believe to be good and fruitful for our lives or the lives of loved ones. However, this pursuit of lots of good things ultimately burns us out. We simply are unable as human beings to run 24/7/365. Our pastor at church often says, "if you're burning your candle at both ends, you're not shining as brightly as you think you are." We just aren't able to give fully of ourselves to our family, work and friends if our schedules are packed.

I believe letting some things go to be a good and wise thing to do.

I think this becomes daunting for most. I know it did for me. What among all of these great things am I supposed to cut. How can I cut out my friends or cut back at work? It just doesn't seem possible.

I've found that the better way to approach this is choosing what to put in. Simply put, I set everything up with priorities, place them in my schedule and when it is full, it is full.

For instance, this is how I might prioritize my 24 day.

1. 8 hours of sleep
2. 4 hours of family time
3. 2 hours of personal time (gym, reading, etc.)
4. 10 hours of work/travel time

Simply put, if something doesn't fit in this schedule then I probably need to consider cutting back from my lowest priority, work and travel. For others it may be personal time. I don't know what it is for each person. However, I do know that for me, this is the order of my priorities.

If I don't get 8 hours of sleep, everything below it: family time, personal time, work, it will all suffer because I didn't take care of myself first. It's similar to the airplane oxygen masks. Every time, without fail, the flight attendants tell the entire cabin, secure your oxygen mask before helping anyone around you. Simply, there's no way you can be your best self, without taking care of yourself first.

After that, it's about building in a little free time, time that you don't know how it's going to shake out, but you do know that it's available for emergency. In fact, my 24-day may look slightly more like this:

1. 8 hours of sleep
2. 4 hours of family time
3. 1.5 hours of MARGIN TIME
4. 1.5 hours of personal time
5. 8.5 hours of work/travel time.

I hope this is an encouragement to you.

Dividends: A Great Source of Tax-Free Income For Most Americans

Around the months of March, April and May, most of the United States turn their attention in one way or another to taxes. Many folks find themselves completing their tax returns, only to find out they owe the federal, state or local government an additional amount of money that hadn't been previously withheld in their W-2 or quarterly payment checks.

Naturally, when tax season comes around, many folks look to find ways to avoid paying taxes. The most common tax deductions are usually seen by increasing charitable giving or paying interest on mortgages, both Holy Grails and therefore unlikely to be radically changed in their tax status.

One area that gets less attention is from dividend income.

Tax rates on dividends is a progressive tax, like the majority of our federal income tax rate structure. For those filers in the 0 or 15% tax bracket, dividend income is tax-free. While those in the 25%, 28%, 33% or 35% will notice that their dividend income is taxed at a 15% rate. Only those filers that are in the 39.6% marginal tax rate (meaning individuals over $415,000 or married couples over $466,000) would see their tax rate on dividend income at 20%.

Any way you slice it, dividend income (or income on your money) is taxed at a very reduced rate to ordinary income.

The majority of American families actually find themselves in the 0% or 15% income tax rate since the median income for the an American family is roughly $55,000, which is well below the $75,000 threshold for married couples, and even likely below the rate for individuals once you enter in your standard deductions, etc.

For most Americans, dividends represent a small, or even non-existent, part of their taxes. Most Americans would do well by themselves to invest in stocks that pay a dividend, as it is a way to increase passive income, without substantially (or at all) increasing their taxes.

Additional Reading:
"Fewer Shareholders Pay U.S. Taxes on Dividends" by Richard Rubin

Do the Heavy Lifting Now, While It Isn't So Heavy

One of the most common reasons people often give for not saving and investing at a young age is "I just don't have enough money now to save."

It's a valid concern.

Life is expensive. It just is. It's also likely to get more expensive for most people. Whether it's getting married, having children, paying for school, rising inflation or the expectation for retirement, as time goes on, more and more of your income will be going out the door in expenses. Rarely does someone's life get less expensive as time goes on.

However, while not having enough money to invest at an early age is certainly a valid concern, I believe that most focus on the negatives, while really missing the biggest advantage there is in finances: the power of compounding interest.

Albert Einstein even called compounding interest "the greatest mathematical discovery of all time."

The earlier you start investing and saving, the better. However, even better than that is the realization that you don't need to save as much money at an early age to propel you on a trajectory to reach your financial goals.

Let me illustrate:

Assume there are two brothers that are ten years apart. Alex is 26, just starting his career, not making a ton of money, maybe $50,000 dollars. His brother, Brandon, is 36, more established in his career, making $120K/year, with a family and two kids. Both have the goal of reaching $1,000,000 for their retirement nest egg at age 60, but neither have done saved and invested anything towards that nest egg yet. The also know that historically the S&P 500 has returned approximately 10% annually and are planning on buying a low-cost S&P 500 index fund to house their saved dollars.

Who's in the better position?

Now while the title of my post might indicate who I think is in the better position, let me show you why I believe Alex is in the better position. Obviously, Alex has less income, and therefore its certainly harder to save large sums of money. However, to reach his goal of $1,000,000 at age 60, he only needs to save $3689 every year from 26 to 60. This works out to 7.4% of his $50,000 annual income.

Brandon on the other hand needs to save $10,168 every year from now until he's 60 to reach the same $1,000,000 goal. This works out to 8.5% of his annual income.

Now you may say that given Brandon's increased income, that additional 1% isn't a big deal. However, by the time Alex gets to age 36 (same as Brandon is today), he still would only need to save $3689 a year. If Alex followed a similar career path as Brandon, and at age 36, he was making $120,000/year, that savings rate would only be 3% of his annual income. This would be a huge advantage to Alex, as it makes saving easier as time goes on (especially considering the increased expenses as time goes on), but it also allows Alex to more easily adjust his goals upwards.

Below is a chart of the annual savings amounts it would take someone to save a constant rate between their current age and 60 years old.

A common rebuttal to this argument is that most people's peak earnings years happen in their 40s and 50s. This is certainly true. Many Americans rapidly increase their savings in these peak earning years to play catch-up, but it is certainly not easy. Most adults in their 40s and 50s are considering the costs of private education, college, weddings, travel to see kids and grandkids, and many other expensive considerations. While they certainly have more money, their are also great demands on their income that life throws their way.

My encouragement to you is why not do the heavy lifting now, while it isn't quite so heavy!

Blessings

I'm 25, How Long Until I Can Be Retire?

It all depends...

That was probably the most truthful answer that I could've given you right off the top, so I figured I'd start there.

There are a number of factors that go into the time it takes to retire. However, if you are reading this, and are in fact 25 (or somewhat close), the odds are very much in your favor that it could be much sooner than you think and take a lot less sacrifice (although greater sacrifice comes greater speed to retirement).

Given our current Social Security infrastructure in the United States, most people equate their retirement age somewhere around age 65. So for the 25 year old, that leaves the worker 40 years to accumulate enough investments through stocks, bonds and real estate to have enough annual income to live on until they pass away.

However, I tend to look at "retirement" in a different way. I think of "retirement" more as financial freedom, or basically the time at which I no longer need a job to support my lifestyle. For example, if my family's current annual living expenses is $75,000, I would reach financial freedom, regardless of age or year, at the point in which my investments are paying me an annual income of $75,000 + enough to cover the distribution taxes (i.e. dividend or fixed income tax rates).

One of the biggest drivers of years to financial freedom actually comes from how much of your annual income can you save. The chart below shows how many years it would take to reach your financial freedom threshold. In this particular chart, the average investment return is 10% or roughly the average annual return of the S&P 500 since the early 1900s.

Most people today recommend saving between 10-15% of your income annually towards retirement and this chart shows why. Saving 15% of your income, no matter how big or small your annual income is puts your years to financial freedom under 30 (meaning 55, for you recent college graduates).

The reason why increasing your savings rate becomes such a huge component of your time to financial freedom is that it is doing two things at the same time. Assume for instance, you take home $50,000 after taxes. You are putting away $7500/year, or $625/mo. This money is able to compound and grow over time. Assuming you're 25 today, that $7500 investment is likely to grow to approximately $130K by the time you reach 55, and nearly $340K if you don't need it until 65. 

However, that's only half the good news. You also are allowing yourself to live comfortably on the remaining $42,500. The ability to keep your lifestyle costs down also allows you to need less money to live on once you reach that financial independence time and maybe choose to not work.

This double lever attack on your long-term saving and investment is one of the very best things you can do for your financial well-being.

Additional Reading:

"The Richest Man in Babylon" by George Clason

Can You Pick the Bottom: Dollar Cost Averaging vs. Perfect Picking

I've spent a good bit of time over the last 7 years learning as much as I could in the areas of personal finance and investing. Over that time, I've learned many of the basics:

• spend less than you make
• stay out of debt
• save up for big purchases (i.e. car, house, engagement ring)
• invest regularly 

While I often have no problem reciting and acting on the first three above, the fourth one seems so counterintuitive. 

Surely it can't be that easy.

So, I wanted to figure out when's the best time to invest my money.

For the purpose of this case study, I wanted to see what strategy would work best, in terms of final total value, over a 23 year period (why 23 years, well since you asked, because the SPDR S&P 500 has been around since January, 1993, and 23 years gives us a pretty good idea of a long-term track record).

Obviously there are limitations to any study like this, especially one that is back-tested, but I wanted to see if there was a difference between dollar-cost averaging and perfectly picking the bottom of the market. I should define these terms in that case of the study:

Dollar-cost averaging: investing a set dollar amount ($500 for this test) on a regular schedule (I picked end of each month)

Perfect Picking: picked the bottom of the market after it set a high (meaning, cash piled up until the very bottom tick, at which time all the money piled up was invested into the index)

For the sake of this test, I assumed that in both strategies, the investor had $500 at the end of the month to invest. In the dollar-cost averaging strategy, the investor put in the $500, regardless of the value of the stock (which is the SPDR S&P 500 ETF - SPY). In strategy two, the investor put $500 in January 1993, the waited for the next lowest point (with perfect intuition to pick the absolute bottom - impressive, huh?!) to then deploy all the cash that he had saved up.

Here's how the two studies compared over a 23 year period:

As you can see from the total portfolio value graph above, the dollar-cost averaging component seems to move in tandem with the perfect timing, although slightly above during most of the 90s and 2000s which saw long bull runs, with sudden and dramatic pullbacks.

Ultimately, this study brought to mind a couple of questions that I have to answer for myself:

1. How good will I be at timing the market to pick the bottom?
2. Is all that hassle even worth it?

For me personally, I believe that this points to steady and constant investment in the market over time will ultimately produce solid returns.

SDG

Here's What I'm Reading This Weekend

(Photo from CNBC.com - in honor of tomorrow's appearance on Squawk Box)

After esterday's Berkshire Hathaway Annual Meeting, I wanted to post a few of the articles and blog posts that I have found particularly useful this weekend.

Warren Buffett vs. Hedge Funds (Fortune)

Review the WSJ live blog from this year's annual meeting

Charlie Munger takes a few shots at Valiant Pharmaceuticals

Sure Dividend's 15 Business Principles Learned from Berkshire Hathaway

Joshua Kennon breaks down BRK's Intrinsic Value

Warren Buffett and Dividend Growth Stocks

Math, Reading and Debt

I was working on a short keynote speech on the importance of education, especially among the poorer communities in the town I live, and I came across an interesting article in the Wall Street Journal titled "Just 37% of U.S. High School Seniors Prepared for College Math and Reading."

The article goes into the usual concerns that most of these articles have about our education system falling behind, especially in the areas of math and science. These concerns are really and we can definitely see them all around us.

However, my attention locked on to a sentence that seemed almost like a throw away to the larger context of the article:

Those who go to college often burn through financial aid or build debt while taking remedial classes that don't earn credits toward a degree.

Before reading this article, I've long been concerned about the rising college costs that I believe are spurred on by both government-issued and privately-issued consumer debt. It's simple supply and demand economics. As more people are able to "afford" college (I use the word "afford" so loosely because often folks are going into mountains of debt to "afford" college) the colleges themselves are able to raise the price of college well in excess of the our going rate of inflation (most estimates have college eduction growing at about 7% a year, whereas our historical inflation rate is approximately 3-4% in the post-WWII era). These rising prices spur on rising amounts of debt as more people try to "afford" going to college and this nasty, endless cycle keeps going.

Be that as it may, the thought that I had come into my head was that overwhelmingly, the communities that are showing the lowest reading and math skills are likely to be areas with low incomes. These kids, pursuing a continuing education in college (great for them) are often times being saddled with debt (because their families don't have the money to send them) to take classes that aren't even getting them closer to their college degrees.

Those that do work their way through a 2-, 4-, or 5-year program are then crushed with mountains of debt that even reasonably well paying jobs can't afford to pay off often times for 20 to 25 years. Even worse, the kids that don't graduate are left with mountains of debt without the economic benefit that a college degree would bring. This leads to an even more destructive cycle of poverty and education.

It hurts my heart to see this as a current state in America. I know many have gotten behind Bernie Sanders largely because of just this issue (specifically the financial component), although his solutions would largely extend the problem, not reduce it. Ultimately, I believe this comes back to spending time in schools teaching basic math and reading skills and the families at home making a concerted effort to get their children reading. I'll be fascinated to see how we progress in the next 5-10 years.

Could Warren Buffett Fund Your Kid's College?

As I found myself watching the Berkshire Hathaway annual meeting on Yahoo! Finance today with my son by my side, I was struck with an idea that I'm sure others have had (and utilized quite well), but had never considered myself: would Berkshire Hathaway stock be a better college savings plan then a traditional 529 Plan.

If you have children, or are expecting one in the near future, you undoubtedly are familiar with 529 plans and their ability to help fund your child's college education in a manner that's tax efficient (although in my state, some of those tax efficiencies have been slowly taken away). The short story is you can invest money in your state's 529 plan and it can grow tax free (meaning there's no dividend or capital gains taxes) and it can be pulled out tax free if it's used on education (including some reasonable expenses for housing, books and the like).

However, many investors find themselves frustrated by the lack of options in their state's 529 plan, while others are frustrated by the seemingly lower returns offered by the "aggressive" plans. (Obviously many that are investing in 529 plans for their children's education treat it similarly to their own 401(k) or IRAs where they will move more to bonds and other less volatile investment vehicles as the time gets near).

So, I was left wondering, what if you invested in something different, that generated a higher rate of return, left you to pay any dividend or capital gains tax, but ultimately gave you as much, if not more income for college. That's where Berkshire Hathaway comes in.

Chairman and CEO Warren Buffett is a world-renown investor and who's holding company Berkshire Hathaway has returned a compounded average rate of return of approximately 20% over the last 50 years. A truly remarkable accomplishment. The company is also well known for its lack of a dividend. (Berkshire did pay a $.10 dividend one time in 1966, which Buffett later joked must have been declared when he was in the bathroom) So I wanted to see what would happen if Berkshire Hathaway (BRK-A, BRK-B) was the investment vehicle used for college education instead of a 529 plan.

For my testing, I assumed college education would continue to inflate at a rate of about 7%/year (similar to what it's done for the past 20). I also assumed that someone was going to make a one-time investment in their children's college education, at birth, to grow to 18, then be deployed over 4 years time. Here's what I found:

In this chart, I assumed BRK would compound at 10% a year (well below the historical rate of return, which Buffett has openly acknowledged he is not capable of reproducing), while the 529 plan would move at a 7% clip (which also equals the rate of education inflation). At the end of 4 years of college, the 529 plan would have done exactly what it was required to do, pay for a 4 year education, with nothing left over. However, BRK would have also provided an additional $200,000 in stock value, after paying for the same education (and the capital gains tax required to sell it). Not too bad, considering the additional flexibility that the BRK stock would provide in the case that your child didn't need to use the money for education.

Obviously, one of the advantages that BRK provides is Buffett's superior capital allocation skills that allow for compounding returns to the shareholder without the need for issuing dividends. This is a unique skill. That coupled with the low rate of capital gains tax, makes this an attractive alternative.

I ran many simulations, many of which with I won't bother you. However, I did look at what would happen if that capital gains rate was increased to 40%. The results for an identical simulation appear below:

In this simulation, the BRK plan survives the 4 year college experience with approximate $20,000 stock left over. Obviously it has done its job, with some (albeit significantly less) left over for secondary education, a down payment on a home, whatever you (or your child) choose to spend it on.

In the end, I'm not sure what the best plan for each individual family is, as it pertains to funding a college education. However, I have found, as I hope you have, that there are definitely some creative ways to pay for college (or other big expenses still to come in life) without simply falling in line with the crowd. 

What I like most about this type of a plan is the flexibility it provides. Imagine, in either one of the scenarios above, you would have been able to spend the same amount of money, not pay tax for 18 years and fully fund a college education. However, with the Berkshire plan, you would additionally have had money left over (in case one, over 2x as much as you started with) and had complete flexibility in how you would've wanted to spend that money in the case that you child didn't go to college (maybe the next Bill Gates or something).

Perhaps something to think about for the future.

Blessings

The #1 Pick Could Sign a $250 Million Dollar Contract: A case study on compounding interest

Tomorrow the National Football League will hold its 81st NFL Draft. The top 253 college players from across the country will be selected (sorry New England fans) over 3 days. However, the bulk of the media attention will be focused on the first round, Thursday night.

The very elite college players will be drafted to their newest, respective teams and be shipped off to cities around the country to begin their NFL journey. It is likely that we will see many of these players playing in Pro Bowls, winning Super Bowls, and earning lucrative contracts in the next 4-5 years. Malik Jackson, now of the Jacksonville Jaguars, just did two of the three back in February and March.

With all the excitement in the air, I felt like this was a perfect opportunity for a short case study on the time-value of money (not to mention how large sums of money can compound into enormous sums of money).

Tomorrow, it is likely either QB Jared Goff or QB Carson Went will be selected first by the now-Los Angeles Rams. Whichever quarterback is selected tomorrow will immediately be slotted into a guaranteed contract worth a total of $27.8 million dollars for 4 years (not bad, but certainly not as good as Sam Bradford has it the last time the Rams had the number 1 pick). Included in that is a signing bonus of $18.4 million dollars, which are dollars paid for just signing the contract.

Now, assume that the player selected simply said to himself (and wife), "we are never going to spend any more money than whatever our annual salary allows us (not as hard to do with salaries in the 7 figures), but we are going to do all of our lifetime investing at 22 and be done," what would his numbers look like.

Once the player pays his federal and state taxes (lucky him, California has the highest state taxes in the country) let's assume after everything he has 50% of his original signing bonus left over. He would have a little over $9 million dollars left. He chooses to put the money in a low-cost S&P 500 index fund (i.e. VFIAX-O, better known as the index fund Warren Buffett bet $1 million dollars to outperform hedge funds over a 10 year period and is winning) and simply reinvests all his dividends from 22 to his ultimate retirement age of 65.

Now, historically, the S&P 500 returns between right around 9-11% over long periods of time (30+ years). However, we will assume that because of the drag of dividend taxes (undoubtedly at 20% for someone in this player's income tax bracket) this fund returns 8% annually over the next 43 years. When you run these numbers, it would not be crazy if this player would find approximately $250 million dollars sitting in his account at age 65. Not to mention, it would be likely that these investments would be producing approximated $5 million dollars of dividend income each year (and growing). All of this in the year 2059, because of a one-time investment in the summer of 2016. Quite remarkable.

As a side note, if you are the last player drafted this year, pick #253 which is owned by the reigning Super Bowl Champion Denver Broncos, and chose to do the same thing (albeit a little more challenging with a "slightly" reduced salary to the #1 overall pick, you would still have nearly $800,000 from your one-time decision with a growing dividend income starting at $16,000 a year.