Even When You Track Every Penny, You Still Have Uncertainty!

https://www.usmint.gov/downloads/pressroom/2014-Circulating/2014-Cent-Proof-O_2000.jpg

Source: US Mint. Do you know where all of your Lincolns are?

My friend and I were discussing, Your Money Or Your Life the other day.

There’s this cool graph where they extrapolate current earned income, current expenses, and investment income.  At some point, investment income surpasses (hopefully!) expenses.  At that instant, you’re financially free.  It’s a profound idea.

Now, don’t get me wrong.  I think tracking your expenses is a crucial start to to developing financial freedom.  But, I also don’t think it is a silver bullet.

As someone who has tracked expenses for almost 6 years, I’ve really struggled to apply the Your Money or Your Life view for myself. Maybe it’s because we’re 35 and have a new daughter.  I can tell you firsthand, she has injected more financial uncertainty into our lives than I thought possible.  Maybe it’s simply because financial freedom seems so far away.  Or, maybe it’s because there is lots of volatility in day to day, week to week, month to month, or even year to year financial ins and outs.  Let me show you what I mean.

Here’s our tracked expenses from Mint.com since 2010:

Mint's auto expense tracking is super convenient. Here's our chart of monthly expenses since 2010

Mint’s auto expense tracking is super convenient. Here’s our chart of monthly expenses since 2010

And here’s, my spreadsheet version…yes, I track things in 2 spots.  Ugh, and I’m admitting that publicly.

And because I'm a nerd, I also track spending within each pay period to ensure I don't go over budget.

And because I’m a nerd, I also track spending within each pay period to ensure I don’t go over budget.

First, they provide different results.  Mint.com automatically bucketizes things.  It’s super convenient, and I use it less for monthly tracking than for long term trends.  I also use a modified envelope method to keep savings funds for things like home improvement/repairs, rental property expenses, insurance premiums, etc.  My goal is to take big periodic cash outflows and bake small amounts of savings into my budget so that when the expense hits, I’ve already saved for it.  Unfortunately, Mint doesn’t do such a good job of managing these type of periodic expenses.

My Excel version is completely manual and is really used tactically.  How much do I have left in my budget for this pay period?  Can I go out to lunch with the work crew tomorrow, or am I brown-bagging it?  So, the bucket granularity is much different.

The first thing that jumps out at me is the upward slope of the trend-lines.  Yes, our real expenses are increasing.  That much is clear from both charts.  So, is it time to finally cut the cable TV cord!?  Should we start eating Ramen?  Probably not.  In this case, we’ve purchased our first rental property.  That’s the big set of spikes at the end of 2015.  And, our little girl is costs us way more than our two dogs do!  So, while the upward trend is disconcerting, it’s also understandable given everything that’s been going on in our lives.  To me, this is the power of tracking every penny you spend (twice!).

The real reason that I think tracking every penny still leaves you with uncertainty is the volatility.  I put trend-lines into each plot to also illustrate how far from “average” our expenses are in any given month.  Some months, they’re high.  Some months, they’re low.  This volatility also makes me pause when I try to extrapolate a trend-line 20 – 30 years from now.

I would like to explore this topic further in future posts.  I think there is great wisdom in tracking one’s spending.  I also think with thoughtful analysis, using income and expense trend-line extrapolation can reveal deep insight about one’s financial freedom trajectory.

Has anyone else tracked their expenses manually vs. using an automated tool like Mint.com?  Have you tried to forecast your financial freedom point? What did you learn?

I Have a Dollar. What Should I Do With It?

George Zoomed

It depends.

Of course.  Smart A$$.

No, really. It depends on a ton of different individual factors that are unique to your specific situation.  Funny enough, I’ve been taking about this very question with a bunch of folks. One friend has retirement savings that need a new purpose. Another is debating between adding debt to purchase a rental property vs. pay down their home mortgage.  And, we’re asking a similar question about how we could move closer to our work locations and acquire a second rental property.  My point is simple: everyone faces these kind of trade off decisions routinely.  I don’t think I could or should answer the question for anyone else, but I think there is a framework that folks can apply to their own situation.

At the heart of this topic is the concept of opportunity cost.  (Hold on to something solid; this gets heavy quickly.)  Opportunity cost is what you give up when you commit.  Just got married?  Congratulations; you just gave up your chance to date Claudia Schiffer (Or Justin Timberlake).

Bought a CD?  For the money you invest in CDs, you’re giving up on the chance to buy Amazon stock with those dollars.

Bought Amazon Stock?  Those dollars won’t be buying into the Uber IPO.

Bought Uber?  Those dollars won’t be buying a rental property for you.

To get more technical:

…opportunity costs are used to measure the differences in returns between a chosen investment and one that is forgone. For example, consider a person who invests in a stock that returns a paltry 2% over the year. By placing his money in the stock, the investor gives up the opportunity to invest in another investment, such as a risk-free government bond yielding 6%. In this situation, the opportunity cost is 4%, or 6% – 2%.

Read more: Opportunity Cost Definition | Investopedia http://www.investopedia.com/terms/o/opportunitycost.asp#ixzz4HBW1h1hG

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Sounds easy doesn’t it?  Let’s take a more personally  relevant example to understand some of the nuances of this kind of decision.  Say that I have an extra  $1000 sitting around.  As cash, it might as well be under Aunt Bertha’s mattress.  What should I do with it?  I see a couple of options.

  1. Pay down bad debt: one of our car loans
  2. Pay off our other car loan and start a “debt snowball
  3. Save/invest it for our next rental property

Option 1

This one is pretty straightforward.  Say our loan balance is about $5000.  The interest rate is 2.25%.  We’re a few months into this one due to the untimely demise of my beloved Scion xB.  Of course, our first car loan doesn’t change at all.  So, by paying down Loan #2,  we payoff the loan 14 months earlier, and avoid about $80 in interest over the life of the two loans. Our total interest paid for Option 1 would be $743.02.

Option 2

After almost 4 years, we have about $1000 left on our first car loan.  Let’s say our payments are $100/mo.  So, by paying the loan off now, we save a whopping $11 in remaining interest and free up $100/ mo to apply to the other car loan.  This is the start of the “debt snowball” popularized by folks like Dave Ramsey.  In short, it’s an emotionally satisfying way to pay down your debt.  Although, it’s not financially optimal(this is an awesome tool; check it out for your specific situation).  After paying off the first and applying the payments towards the second, we  find the total interest paid for Option 2 is $689.60.  Sounds a bit better.

Option 3 

This is the most complex of the three. We carry the existing two loans without avoiding any interest.  The rates are pretty low, so maybe it’s OK.  Now, a low cost bond fund has historically returned 3% (Vanguard’s has been a bit better with all the craziness going on over the past few years).  We’re looking to invest the money for three years.  If we assume past performance is indicative of future (possibly a BAD assumption), we’re looking at a potentially life changing $91.32 in distributions.  Our net interest paid for Option 3 would be $651.70.

So, how do these three options compare?  Someone play the “wah, wah” trumpets.  OK, I’m hoping that while our numbers aren’t terribly exciting, this concept is.

Opportunity Cost

Trade-off between paying down one loan, debt snowballing another, and investing funds instead.

It looks like Option 3 provides us with the best overall benefit.  What if we were willing to wait a few more years? What if we consolidated our car loans into a lower cost HELOC?  What if …?  And, that’s why I said, “it depends” way up front.  Your specific situation will vary.  Maybe you have higher rates or larger balances.  Maybe  you’re questioning weather or not you can afford to make extra payments each month.

The point is, you can use math to help make the best decisions possible with your limited dollars.  Those dollars can be the seeds of your future.

Let’s Go to the Casino!

We’re going to take a trip through the Monte Carlo.

https://i2.wp.com/upload.wikimedia.org/wikipedia/commons/5/53/Gambling_chips.jpg?resize=652%2C435&ssl=1

Photo Credit: Jamie Adams

What is Monte Carlo?

Nope, not the one in Monaco with the beautiful beaches, fast cars, and the roulette tables.

Not the one in Las Vegas either.

I’m taking about a statistical technique for simulating a process or phenomenon.  Remember that infernal “Bell curve” from school?  It looks kind of like this:

https://i0.wp.com/upload.wikimedia.org/wikipedia/commons/thumb/8/8c/Standard_deviation_diagram.svg/800px-Standard_deviation_diagram.svg.png?resize=652%2C326&ssl=1

Photo Credit: Jeremy Kemp

All the Bell or Gaussian distribution does is tell you how likely an event is to occur (think of the vertical axis as probability). When you have a known, stable distribution, you can use that distribution to quickly simulate a whole bunch of events.

For example, it takes me an average of 30 mins to get to work.  Some days, it’s shorter. Some days it’s longer.  Once, a car, 3 cars up from me got T-boned while going almost 60 miles per hour.  It took me almost 55 minutes to get to work that day (and no one was seriously injured).  Do here’s what my commute looks like as a distribution:

My commute duration averages 30 minutes. There’s variation. It’s rare for me to make it in 15 minutes or take more than an hour.

Once we know the distribution of historical values, we can use this information to make some educated guesses about what the future will be like.  Remember, when I looked at the long run returns for CDs, Bonds, and Stocks?  All I did was compare actual annual returns against a medium term average: 7%.

Let’s see what a simple Monte Carlo simulation can tell us about the range of future possibilities for our investment.  As always, this is just a thought experiment.  Any investment decisions you make are your own.

Here’s the histogram showing the past annual S&P returns since 1928:

Folks often tout an average S&P500 return of 7%.  Without understanding variation around the average, it’s easy to be mislead.

Here’s the scenario.  At 20 years of age, your Great Aunt Bessie passed away. She hated stocks, bonds, and even CDs.  “Too much risk for me!” She used to chortle from her rocker. “I keep my money cash and close at hand in case I need it.”  So she left you $1000 of cash out of her under-mattress stash. Let’s assume a 40 year investing horizon.  Let’s also assume that inflation and investing costs are zero!  Is Bessie right?  How much money might you have left if you invest it in the S & P 500?

I’m going to use Excel to do the Monte Carlo simulation.  I’m too cheap to spend money on a fancy software package.  And, this way you can do this on your own without needing fancy software.  Using the long run average return might be misleading, so we’ll stick with more conventional short run data 2006-2015.  The average return for the S &P 500 in this period was 9%.  The amount of variation around that average is described using the standard deviation.  In this case it is 0.187.

Don’t freak out if you’ve never loved statistics (most normal humans don’t).  All we’re doing is describing/summarizing the shape of the distribution. In Excel, we’re going to create a column called year.  Start at year 1 and count up to 40. In the next column, were going to enter a formula to calculate the new balance (warning for the faint of heart: there will be an equals sign coming up shortly). Here’s what the setup looks like thus far:

Excel monte carlo setup1

In cell B6, The formula is:

=$B$1*(1+NORM.INV(RAND(),$B$2,$B$3))

Plug this into Excel so it looks like this (if you’re really scared of doing this yourself in Excel, you can get to a Google docs version here):

In cell B7 copy the previous formula and make one change.  Switch $B$1 to B6.  It should look like this:

=B6*(1+NORM.INV(RAND(),$B$2,$B$3))

Now drag the formula down to year 40.  You just ran a single simulation of 40 years worth of S&P 500 returns.  That’s about all there is to it.  Keep in mind that your actual values will be different from mine, and they will recalculate every time you make a change to the sheet.  It should look something like this:

Excel monte carlo setup2

Now, are you ready to get really nuts!? Copy/drag the second column out 500 times.  You’ve created a (crude) 500 run simulation of the stock market.  Feel that mathematical prowess coursing through your veins?  This is one of the most useful tools you can get for doing some pretty powerful simulations…and it’s almost free!

Let’s look at the results. Copy the last row (year 40) for all runs and then paste values/transpose the data to a new worksheet.

Excel monte carlo setup 3

Once you have a column of final values, you can re-run the data analysis tool to create a histogram of your results.  Again, your specific results will vary, but from what I saw:

Excel monte carlo results

  • In 3 out of 500 runs, you did lose money.  That is roughly a 0.6 % chance.
  • In 151 out of 500 runs, you ended with between $100 and $1000. That is ~30% chance.
  • In 123 out of 500 runs, you ended with between $1001 and $2000.  That is ~25% chance.
  • In 223 out of 500 runs, you ended with between $2001 and %50,000.  That is a ~45% chance.

Tell Aunt Bessie, “Thank you for the gift of money, but you’ll use math to help make decisions about what to do with it.”  Your odds are better in the market than her 100% certainty of gaining nothing.  We’ll keep using tools like Monte Carlo to help make better decisions about a bunch of upcoming facets of our financial lives.  In the meantime, play around with this approach.  It’s a powerful tool for making better decisions.