Building a Strong Foundation

Now that we have a good handle on the big picture we need to put together a plan to get us to where we want to go. Yes, we are going to talk about budgeting. I know a lot of people have a strong emotional diversion to the word budget. They equate it to a four letter word. If I go on a budget I won’t be able to do anything fun anymore. I won’t be able to go out for drinks, go shopping, or do anything except save for retirement.

A budget is not a tool for taking anything away. A proper functioning budget is a tool to help you get the things you really want in life now and in the future. The biggest thing a budget does is help you decide what you really want. Do you want to get out of debt faster, do you want to have money to go on vacations, do you want to save for retirement, do you want to renovate your home, do you want to save for a child’s education?

In order for a budget to work you have to look at your expenses ANNUALLY and then break them down into a monthly allotment. The regular every month expenses are not the things that usually mess with a budget. The things that mess up the household finances is the “surprise” expenditures. Things like school fees, vehicle expenses, holidays, and household repairs.

A simple way to put together a working, functioning is to use the three account method. The first account is simple. It is for your monthly fixed expenses. These are the expenditures that happen every month and the amount does not change. Things like mortgage or rent, loan payments, monthly investments, insurance payments, monthly property taxes and condo fee, even some utility payments. This is a flow through account. Money goes in, money goes out. Do not keep insta-broke access on this account.

The second account is for your every month expenses where the dollar amount fluctuates. Things like groceries, gas for your vehicles, toiletries and household items, eating out, pet expenses, entertainment, and the all encompassing miscellaneous category.

The third account is the “save your budget” fund. This is for all the expenses that creep up throughout the year, but are not monthly. Things like birthday, Christmas, and other holiday gifts, vehicle expenses such as oil changes, tires, repairs, and registration, clothing, school fees, home repairs, and vacations. Whatever comes up for you throughout the year.

I also suggest setting up separate savings accounts for the things we want to save for like a vacation, home renovation, or anything big we want to do. Seeing our money grow is a very positive and motivating thing. Personally I’m a big fan of ING Direct ISA accounts. No fees, they actually pay a little bit of interest, you can have and label up to five different accounts, and it separates the money just a teeny bit.

Creating a budget does not need to be complicated. But it does need to work. Keeping it simple, taking into consideration all the places your money needs to go, and making conscious decisions is where you need to start. This is the foundational piece to financial prosperity.

“The cold harsh reality is that we have to balance the budget.”
Michael Bloomberg

So Where Are We?

Okay, so far on our journey to financial health, wealth, and happiness we have made the decision to take control of our financial lives, we have picked our annual financial day, chosen to make financial education a part of our habits, and brought the whole family into the game. Now we need to figure out where exactly we stand in terms of our financial snap shot.

The first step is to figure out what our debt situation is. This includes everything we owe, every debt instrument we use, and what are the terms on our debts. If we have a mortgage and / or a secured line of credit on our home how much is owing? What are the details in regards to interest rate, maturity, amortization, property taxes, and creditor insurance? How much of our payment is going to principle and how much to interest? What is the realistic value of our home?

The next step is to look at our credit cards. How many cards do we have? How many do we actually use? Whose name are the cards in? What are the limits on the cards and how much do we owe? What is the interest rate on each card? Do we get any perks like cash back, travel points, AirMiles, or Aeroplan? Do our cards have annual fees? Are we paying for any creditor insurance?

What other debt do we have? Personal loans, student loans, vehicle loans or leases, private debt? How much do we owe? What are the terms on each debt? What are the payments? What interest is being paid? Is there any creditor insurance on the debts? What is the amortization for each debt?

Now that we have an accurate picture of our liabilities, now we need to look at the positive stuff, our assets. Do we have a pension plan, group RRSP, or personally held RRSP? What are they currently worth and how much are we putting into them on what frequency? Do we hold any other investments in a TFSA or non-registered account? What are they worth and how are we contributing to them?

Do we own any insurance with a cash value? If we do what is the value and are there surrender charges? Are we covered for life, disability, critical illness, or long term care issues? Who are we insured with, how much coverage do we have, what are the terms, and what are the payments?

Do we have any properties including our own home, vacation property, and any rental properties? What is the realistic value of them? If we have rental properties are they positive cashflowing?

Have we been putting money aside for our children’s education? If we have where is it, how much is it currently worth, what and when are we contributing, and are we collecting all available grant money?

Do we have any collectibles or other valuables? What are they, where are they, and what are they worth? Are they properly stored and properly insured?

Once we have gathered and compiled our information we can take an honest look at the facts and start to map out the best route to get us to where we want to be financially.

“To create a plan to get to where you want to be you first have to figure out where you are starting from.”
Tammy Johnston

The Mathematics Of Losses

Will a 30% advance after a 30% decline in a portfolio, return the account to the same market value?

The answer is no. It will actually take a gain of 42.9% to recover the lost capital.

As an investment loss increases in size, the gain that is required to restore the loss begins to increase at a faster rate. Individual investors have two distinct time horizons that occur over their investment lives:

– An accumulation phase: where the focus is on saving
– A withdrawal phase: where the focus is on spending

We all have a finite time horizon to build wealth that is determined by our own mortality. Even if we are diligent savers, we will likely only have 40 years as an accumulation phase before retiring from the work-force and starting some type of a withdrawal phase.

What happens if you experience a 30% portfolio loss and are then only able to receive 7.4% annual returns?

Loss                1 Year               2 Years            3 Years                   4 Years                     5 Years

30%                 42.9%                19.5%             12.6%                          9.3%                            7.4%

You would need five years of 7.4% annual gains to recover the loss, but those five years also represent 12% of the your wealth accumulation years. Those five years have been removed from your accumulation phase and will never return.

Recovery times for losses matter greatly. In fact, they matter even more when an accumulation phase is ending and a transition to a withdrawal phase is beginning.

What happens if an 8% withdrawal phase begins immediately after a 30% loss?

Loss                1 Year                 2 Years                3 Years                    4 Years                     5 Years

30%                 61.8%                  31.3%                    22.6%                       18.5%                       16.2%

You would now need five year annual gains of 16.2% to recover the lost value and cover the required withdrawals. If your portfolio fails to generate these required annual rates of return, then the capital value of the portfolio will erode further.

You should be concerned not only about the size of investment losses, but also about the amount of time required to recover a loss. The amount of time required to recover can be just as significant to your financial success as the size of the loss.

Ignoring the consequences of financial market uncertainty can be hazardous. Trying to reduce exposure to uncertainty in the midst of financial market turbulence is similar to trying to buy insurance once a house catches fire.

To truly evaluate financial market uncertainty, you must consider both the magnitude and the likelihood of all possible outcomes. This includes not just the good ones, but also the very bad

I Cannot Afford Anything That Cheap

By: Don Shaughnessy
Intuitively, price and cost are the same thing. Very wrong! Catastrophic mistake in the making! Truth is you get value by incurring cost and the money is just part of it.
Suppose you are flying over the prairies and the captain comes on the intercom and declares that the plane is going to crash. Fortunately, the airline has made provision for this and will rent parachutes to those who want them.
An attendant comes to you and says, “We have two kinds. One is $50, the other $100. Which do you want?”
You know that price is a poor way to judge value, so ask, “What’s the difference?”
“The $50 ones are factory seconds and work about half the time.”
The value, escape from a failed airplane, cannot be adequately achieved with the $50 parachute. Its cost to you is the money of $50 plus the acceptance of a 50% probability of death. The alternative of $100 and no concern for blood stains on the ground looks like a better deal.
Just like life insurance.
From the insurance company’s perspective, all life insurance “costs” the same. People die at the same rate regardless of who insures them or how, the cost to do business is about the same for all carriers and the investment returns they receive don’t vary much. If a carrier can offer a lower price, it is because they put something in that you don’t want, or took out something you do want.
An insurer could sell for half price if the contract included a clause that provided that in the event of a claim, the insurer will toss a coin. Heads they pay. Tails not. Some policies almost have this provision. It is the pre-existing condition clause. With it, you can’t be sure you have coverage.
An insurer would offer a very attractive price if you agree to take a medical every year and the policy ends if the company doesn’t like the result. How much is the access to coverage worth to you? You must pay more money to replace the cost of uncertainty.
Consider English philosopher, John Ruskin’s view.
“There is hardly anything that some man cannot make a little worse and sell a little cheaper, and people who consider price alone are this man’s lawful prey.”
If you don’t know how the price difference arises, you are blindly accepting a cost that is as real as money. Invisible is not the same as not there. I cannot afford anything that cheap is a thought to consider.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.  don.s@protectorsgroup.com