Financial Security and Prosperity

Warren Buffet publishes a letter to the shareholders of Berkshire Hathaway every year. Bloomberg Businessweek published it last week.

Warren Buffet gives some simple but great ideas.

• Buy a house, but buy the one you can afford, not the one of your dreams.


• Don't use credit to operate your business or personal budget.


• Leverage is risky

Excellent!

Amy Hoy has a great article at unicornfree.com. Her core assertion is that you don't need to possess wealth to be wealthy. You only need the ability to make money quickly to be wealthy. She doesn't worry about wealth because she knows that if she loses it all tomorrow, she can make it all back in a straightforward way.

Ayn Rand wrote an interesting piece on root of money, quoted here which describes money and its less pleasant alternatives.

It's a good read because it describes other perspectives on money.

A wise old Newfoundlander once told me, "If your outgo exceeds your income, your upkeep will be your downfall". Wise words indeed, and related to prosperity and financial security. Let's examine a little closer.

Outgo - This is just what you spend. You have to eat. You need warmth. You probably need to travel. You probably have a place to live. This costs money...your outgo. Most of us also have outgo that we could do without. For some, that may be the upgraded hotel, the expensive car, the extra mock-chock-non-fat-double-foam-soy-extra-hot venti latte, "retail therapy", or whatever. A part of prosperity and financial security is to control the outgo so that a lack of money does not threaten financial security and prosperity.

Income - This is the cash flowing in. It comes through wages, dividends, capital gains, interest income, etc. For most people worried about financial security and prosperity, it comes in the form of wages. Income can be controlled somewhat by working harder, working more, and by upgrading marketable skills and then selling services or goods based on those skills.

I checked a couple of dictionaries for definitions:

Definitions of "prosperity":

1. a successful, flourishing, or thriving condition, esp. in financial respects; good fortune.


2. an economic state of growth with rising profits and full employment


3. the condition of prospering; having good fortune

Definitions of "security"

1. the state of being free from danger or injury; "we support the armed services in the name of national security"


2. defense against financial failure; financial independence; "his pension gave him security in his old age"; "insurance provided protection against loss of wages due to illness"


3. freedom from anxiety or fear; "the watch dog gave her a feeling of security"

I'll go one step further:

Prosperity is having what you want and having the ability to acquire what you want.
Financial Security is the hope of having enough finances in the future so that you are not left wanting.

These are fairly abstract operational definitions, but are useful to broaden your understanding of this topic.

An old song goes, "Neither a borrower, nor a lender be. Do not forget, stay out of debt....". Yet most of us have some form of debt. Home mortgages, student loans, car loans, tabs at the bar, credit card balances, etc. Many people tell us that these debts are a part of the reason for the current recession. (They say that in every recession). But are they?

In sticking with the theme of this lens, remember that financial prosperity and security is the having what you need today and the hope of having what you want and need in the future. How does debt affect this? First of all, when you have a debt, you are usually obliged to pay it back with regular payments. These payments are supposed to be small enough that you can make them until you pay back the debt. When you have to make a payment on a debt, that money is not available for you to have what you want today. For example, if you have $300 left in the bank, and would like to buy $250 of groceries, but also have a $200 car payment due, your debt may be jeopardizing your prosperity because you will only be left with $100 for groceries. (I say "may be" because you may be OK with the reduced quality and quantity of food you can buy with $100 instead of $250). The debt also jeopardizes your financial security because you have nothing left after the car payment and the groceries, and may not be able to get what you need tomorrow. In this case, that $200 car payment is bad.

Suppose though, that you drove that car to a good secure job that pays well. You wouldn't be able to get to work without that car. In that case, the $200 car payment is the price of getting to a job that pays much more. In this case, $200 and your time is the price to pay to earn much more money, which can then be used to buy what you need today and give you better hope that your needs will be covered tomorrow. In this case, that same $200 car payment is good.

Debt is tempting because it allows you to acquire something now on the promise that you will work to pay it off. That temptation is bad if the debt causes you to reduce your financial prosperity and security, and the temptation is good if the debt enables you to increase your financial prosperity and security. i.e. Not all debt is bad. Some of it is good.

When taking on debt, ask yourself if servicing the debt will cause you more financial loss than the gain induced by buying something you cannot afford now. If it is the case, the debt is usually bad and you are better off saving for what you want. Luxury items usually fall into this category. On the other hand, if the debt enables you to improve your financial prosperity and security then the debt is good. Student loans, some business loans, and home mortgages often fall into this category.

Most folks and conventional wisdom believe that saving is good. After all, if you save now, you'll be able to enjoy things later. Also, if an unexpected large expense comes along, you won't have to go into debt to meet it...."saving for a rainy day", if you will.

Most folks say the usual...top up your tax-sheltered savings plans (RRSP in Canada or 401k in USA), put money into an education savings plan for kids, and save about 6 months of expenses in the bank or a liquid money market account.

But is it all good? I know people years ago who put off paying down their mortgages so that they could put money into an education savings plan for the kids. Is that good savings? Perhaps. It means that when the kids need the money for education, you may still be paying off the mortgage. However, if you had paid off the mortgage, you would be able to help the kids with their education bills. The answer is not clear-cut.

I know other folks who contributed to tax-sheltered retirement savings plans, but who kept a few thousand dollars of balance on their credit cards. This saving was definitely not good. The sheltered investment was making them 6%, but the debt was costing them 25%. Not good.

I know other people who put of paying down their mortgages so that they could top up their tax-sheltered savings plans. Was that good? Most conventional advice said yes. After all, you could get 6% tax-sheltered gains (after inflation). However, it is not always true. In Canada, mortgages are paid with after-tax income. If you pay money down on your mortgage, you save 6% of that after tax every year until the end of the mortgage, typically 15 years. 6% after tax is closer to 10% before tax. All of a sudden, that 6% tax-sheltered investment doesn't look so good, especially when you know you're going to have to pay tax on it when you withdraw it. Again, the answer is not clear-cut.

The last 3 cases suggest that saving is good if you have paid off your short-term debt and if the benefit of the saving exceeds the cost of servicing your long-term debt.

Many folks know people who are compulsive savers. Are these savers prudent? Many of these compulsive savers deny themselves and their families joy that could come from spending on a few extras. Others deny themselves future income by not spending on education, and saving it instead.

Many folks worked hard and put their money into the stock market and other equity investments. Many of those investments were severely reduced during the stock market crashes of 1987, 2001, and 2008. That was money that could have been spent. Was that saving good? Hard to say. They lost it on the stock market. They could have invested it elsewhere, or put it into education, their health, or charity. It would have done them all more good. With 20/20 hindsight, this saving might not have been good.

If you are going to save, ask yourself why. Is there an opportunity cost to the saving? i.e. Could you have invested the money elsewhere, flushed debt, or increased your capacity to earn money by spending the money instead? The answers to these questions could temper your desire to save too much.

When you find a savings vehicle, ask yourself if you are in it for safety, growth, or liquidity. (These are the same questions that a good financial planner will ask you as well). If you know your goals and your investments match it, you are doing well, and it will keep you closer to your view of financial security and prosperity.

Suppose there were two men who worked downtown.

• Both men earn the same amount of after-tax income every year.
• Both men are "middle-aged", say 46.
• Both have equal amounts of debt and equity, and their debts and equities are changing at the same rate. i.e., Their financial picture is exactly the same.
• The first man works as an insurance claims adjuster at a large insurance company.
• The second man works running his street-side hot-dog cart.

Now suppose calamity strikes.

• Both men have half of their equities wiped out by falling stock prices and failing banks.
• The insurance company goes bankrupt, casting the insurance adjuster out without a job or severance.
• The hot-dog vendor's cart is hit by a bus and was insured by the same insurance company, so he gets nothing.

Which man now has better financial security? I am going to argue that the hot dog vendor has much better financial security. Why is the hot dog vendor more secure?

1) He has many direct sources of income. Each paying customer is a source of income. If a few of them stop, he still has other customers. On the other hand, the insurance adjuster just has his pay cheque from the insurance company. When they stop, he is broke

2) The hot-dog vendor has portable skills. Chances are that he'll make the same money on another street corner doing the same job. Part of that is because he has many sources of income. The insurance person will be relegated to working for a small handful of companies where his skills would pay the same. If they're not hiring, he gets nothing, or probably gets another job paying much less.

3) The hot-dog vendor has to sell every day. Because he has to hustle and sell, he is very aware of the relationship between sales and his income. The insurance adjuster is sheltered by his company. When cast out, he doesn't know how to sell, which makes it harder to make money.

4)A small loan will get his cart back and his income on its way. A hot dog cart stands between the hot-dog vendor and income. Not so for the insurance adjuster. He has a job hunt, or retraining, or relocating before he gets income.

Does this mean that being a hot-dog vendor is the best thing you can do? Probably not for most people. However, income security is more likely if you know how to sell, have portable skills, and have multiple sources of income.

Every few years, our country goes through times when farmers are hurting. Crops fail, commodity prices are low, operations costs are high, etc. There's an old joke:

(A farmer wins $1 million in a lottery)
News Reporter: So...what are you going to do with your winnings?
Farmer: We'll keep on farming until the winnings are gone.

In all of this, I met a farmer from Pakenham, Ontario a few years ago. He seemed to be contentedly well off. His main product was organic pasture-fed beef, and he also raised a few chickens, sheep, and pigs for meat as well. He also had an unusually large family. I was puzzled. I asked him why other farmers were going under and he seemed to be prospering. His comments were telling.

First of all, he stayed very focused on his core product, which was the beef. He branched out into other things such as pigs and sheep only because one of his kids stepped up to do the work. As soon as the kids stepped back, he got out of pigs and sheep.

Secondly, he stayed well-capitalized and took on as little debt as possible. He pointed out to me that he had only his family vehicle and a couple of all-terrain vehicles (ATV). He compared that to other farmers who often bought big tractors, haying machines, etc that were too big for their farms, and they took on debt to pay for them. This meant that other farmers often had to focus excessively on short-term revenue to pay their debts. He pointed out to me that many farmers value the status of having a big or new tractor more than servicing the debt needed to own them, and all of that idle machinery was causing them to be poorer than they needed to be.

Thirdly, he measured the return on investment (ROI) for his farm investments. He needed the ATVs so that he would not need as much labour to move the herds around the pastures. The ATVs easily replaced manual labour. He didn't buy any tractors for his hay. He instead subcontracted the haying to a neighbour with the tractors etc, and paid the neighbour with a share of the hay. In all of that, he was able to get his haying done without having to take out a loan for the machinery. The cost of the haying machinery was not worth the benefit of making his hay. The neighbour was happy to use their idle machine and idle time to make some more money or hay for themselves.

Fourthly, he did his own direct sales and marketing, and he did it very efficiently. I met him at a farmer's market myself, where he had a booth to sell his product. He pointed out that a lot of farmers are uncomfortable marketing and selling their product, and they often prefer to sell to distributors. He said that distributors take a lot of the markup, and that is where the profit is for him. He made his sales and marketing very efficient by offering a free newsletter and selling a lot of his product in bulk (such as a side of beef). That greatly reduced his sales costs, leaving behind a prosperous farm.

His farm was prosperous because it met his need to keep him and his family on the farm, and his income was made more secure because he owned the land, and had a large list of customers eager to buy every year.