Now that the global economy seems to have settled down a bit, most people are rubbing the financial slumber from their eyes and trying to figure out what happened and how to better prepare for the future.  As I’ve thought about the economy and personal finance in the past few months I’ve continually come back to the idea of becoming more financially resilient – basically, becoming better able to withstand and even thrive during future economic downturns.

It’s nearly impossible to become completely independent of the world markets, but the following are a few ways to help ensure that if things go south in a hurry (they will again, someday, sometime), you will survive and won’t be swept up in the wave of financial destruction:

1. Learn to track your spending – unless you can get a grasp on where you money is going each month, you have no basis for managing your finances.  With the availability of free online budgeting software like Mint and Wesabe, there is no excuse for not being able to track your spending.  Once you can categorize and measure the various financial transactions you make on a regular basis you can then develop a realistic spending and savings plan.

2. Be merciless with debt - during the past two years of financial wreckage, the first people to go under have often been those buried in debt.  An unexpected job loss, pay cut, or rise in interest rates can overwhelm anyone with a high debt-to-income ratio.  Whether you start with the smallest balance first, or the one with the highest interest rate, the important thing is to rid yourself of debt as quickly as possible and avoid accumulating more.

3. Cut costs/D-I-Y/Sustainability – to become better off financially there are only two options: spend less or make more money. Cutting costs is often a much easier short-term solution to increasing our wealth. Start by looking at your monthly expenses (see Step 1), identifying your biggest costs and whether or not they can be reduced. Do you have interest rates or fees that can be negotiated down? Subscriptions that you don’t really use? A simple phone call may save you hundreds, it costs nothing to ask.

Second, identify things that you could produce yourself. For example, my wife and I discovered that our monthly grocery bill was larger than we liked, but felt that much of it was due to our desire to eat healthy, fresh foods, specifically produce. Rather than cutting this out of our diet, we made the decision to plant a vegetable garden this coming spring. It won’t completely replace the grocery store, but growing our own tomatoes, lettuce, cucumbers, etc. will save us a significant amount of money over time, provide us with healthy, organic food, and insulate us from rising food prices.

4. Develop multiple streams of income – the second part of the wealth equation deals with making more money in the first place. Even if you have a full-time job, you can increase your financial resilience by developing multiple streams of income. For example, while it doesn’t earn much, blogging provides me with an additional source of income.

Focus on developing passive income, or income that comes from activities that don’t require your full-time engagement. Examples of this would be rental income, advertising revenue from websites/blogs or royalties from publishing a book or other intellectual property. Think “set it and forget it.” By increasing your streams of income you help ensure that if one stream dries up you are still able to survive.

5. Build an emergency fund – If you live paycheck to paycheck you are not alone, but you’re playing a dangerous game.  No matter how well you budget there are always going to be unforeseen costs and emergencies.  Car trouble, medical issues, last-minute travel, etc.  The way to make sure these events don’t crush you is to build an emergency fund.  Trent at the Simple Dollar explains,

“An emergency fund is cash that you’ve saved up for the sole purpose of helping you maintain your normal life through the emergencies that life hands you. “

Check out his awesome step-by-step guide to building an emergency fund here.  Various numbers on how much you should have in savings get thrown around by the experts, but 6 months of income is a good place to start.

6. Maximize contributions to Roth IRA – there is no better retirement vehicle available to young people today.  The Roth IRA allows the money in your account to grow tax-free and keeps you from having to pay taxes when you begin to withdraw payments come retirement time.

Do everything in your power to contribute the maximum ($5,000 for 2009) each year.  It may not seem like much at first, but if you start in your 20’s the magic of compounding interest can work for you and provide you with a good chunk of retirement income.

7. Diversify investments – “I believe that 98 or 99% – maybe more than 99% – of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs.” Warren Buffett.

The principle laid out by the Oracle of Omaha is sound advice for investors.  Since you don’t have enough knowledge (worry not, even the “experts” on CNBC don’t) to consistently and accurately predict which markets will provide the best returns and which will tank in years to come, invest in all of them.

How does the average 20-something do this?  By investing in low-cost index funds like the Vanguard S&P 500 Index Fund, which purchases shares of every company in the S&P 500.  By taking out the guess-work (excuse me, ehem, “technical analysis”) of fund managers the funds are able to charge the investor significantly less.  For more info check out Ramit Sethi’s in-depth post on mutual funds.

Of course, diversification extends beyond stocks.  Many have found real estate to be a profitable place to invest, as well as bonds, commodities, currencies etc.  However, for the average investor, index funds provide a great place to start.

8. Learn entrepreneurship – entrepreneur and author John Robb explains, “One of the best ways you can prepare for the future is to train yourself to become an entrepreneur — essentially a person that makes their own economic opportunities.”

Not everyone dreams of running their own business, but as more and more jobs are outsourced to countries who can do them for less money, the types of skills that may help you survive are those found in successful entrepreneurs.

Start small, test fast, fail fast and keep going.  Entrepreneurial opportunities are often much closer to home than you may think (sounds eerily like a piece of fortune cookie wisdom).

9. Nurture relationships – Very few people get through life without depending on the generosity, wisdom, or partnership of their friends and families in reaching their financial goals.  Besides the obvious benefits of having people to bail you out if you find yourself in trouble, relationships provide you with a network of people who can give you advice, mentorship and in some cases capital for a start-up or investment opportunity.

By nurturing close personal relationships you tap into a greater resource than any bank or investment firm could ever offer you – people who share in your vision and authentically want to help you succeed.  And in the end, no amount of money will fulfill if you don’t have people to share and enjoy it with.

10. Hold on loosely – Some of you might be asking, “Wait a minute Cameron, you just got done telling me how to make more money and keep it, now you’re saying to loosen my grip?”  Absolutely!  Money is a great tool, but it has an amazing ability to corrupt people who make it the chief end in itself.  When taking positive steps to better your personal finances it’s easy to become greedy as you witness just how much is possible with a few solid decisions and some daily fiscal discipline.

How do you fend off greed?  Simple, by giving money away.  Being rich isn’t about the bling, it’s about freedom.  For me this means the freedom to support my family and bless others at the same time.  Many of my friends are involved in some incredible non-profit organizations and missions – being able to support them is one of my favorite things in life.  Holding on tightly to your money may help you feel in control, but in the end it keeps you from receiving a much greater reward, the joy of helping others.

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When the economy is doing poorly, it is often the case that people start acting irrationally when it comes to their finances. The best evidence of this is the scores of people who have sold off their investments in the past months – the investments they worked so hard to shore up for years.

One of the biggest reasons for poor investment decisions as of late is due to unmet expectations. People expect their investments to go up, up and up.  When they don’t, lots of little doubts begin to creep in.

“Do I have too much invested in the market?”

“Am I just invested in the wrong companies?”

“Will the market ever come back…and if so will it be too late for me?”

Much of these unmet expectations come from a single source. The holy grail of stock market statistics that has been preached by advisers and professors for ages as the ultimate reason to invest in the stock market:

The average return of the stock market is 10%

The thing about this statistic is that many people zone in on the “10%” aspect and completely ignore or minimize the word “average”.
The word “average” should emphasize the long-term nature of investing, but to most it’s more like the warning sign for a roller coaster – “yeah, yeah, yeah, we get it, just let us on the ride!”

This is why I love following presentation by Carl Richards of Behavior Gap that I found on Ramit Sethi’s blog this afternoon. It shows the fundamental flaw in most of our thinking when it comes to associating average with normal. Here it is:

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I’m currently sitting on my couch listening to newscasters on television report the latest drop in the stock market with gloom face and menacing tone. Even those who don’t follow the market have not been able to escape the constant coverage of the current financial storm that has hit markets both at home and abroad.

Here are just a few of the headlines in the news recently:

“Wall St tumbles on economic anxiety”
“Recession to be ‘Worse than the 1990’s,’ experts warn”
“Markets latest lurch down raises new uncertainty”

In the midst of such volatility, misinformation and outright confusion, it has been hard to draw any logical conclusions. But, surveying the scene over the past month an age-old lesson in skilled investing has resurfaced:

When the market is going down in flames, seasoned investors see incredible buying opportunities where novices see only doom and gloom.

Warren Buffet, billionaire investor, recently wrote on Op-Ed piece in The New York Times where he said the following (emphasis mine):

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Everyone likes to say the key to investing is, “Buy Low, Sell High”, but how many people actually follow their own advice? Startlingly few, actually. Most people tend to follow the herd, buying stocks when the buzz of how well the market is doing finally reaches their ears and selling when they hear on the news that things are bad. Thus, they do the exact opposite, buying when stocks are inflated by market hype and selling when they have been beaten down.

So why is now such a great time to buy? Because what we essentially have is a HUGE STOCK SALE! Some great companies are selling for half, even 75% less than what they were a year ago. What this means is for every share you could have bought a year ago you can now buy 2 or even 3 for the exact same price.

Right now is an incredible time to buy.  This is the opportunity that seasoned investors recognize that others do not. And it’s why some people will get rich off the current situation while others will go broke.

There’s no doubt we’re in hard times, but part of skilled living is keeping your head in the midst of stressful and complicated situations. When others are scared and running for the hills there are some that come out swinging. Learn from those people and imitate them.

I leave you with some final words of wisdom from Buffett:

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

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Ever hear words like diversification and asset allocation dropped in conversations at the office or on CNBC and feel like you’re a stranger in a strange, strange land?  If so, I have news for you, you are not alone.  America is financially illiterate.

While the world of personal finance and investing can be quite intimidating, it’s not hard to learn a few of the basics AND in doing so, make better-informed financial decisions than the other 99% of the world.  Most of the terms used on Wall Street are fancy words for very simple concepts.

So, in an effort to make sure that readers of Schaefer’s Blog are well-equipped to “speak the language” of finance, I’ve surveyed a few of my friends and come up with the following terms and ideas that people should know.  This post will focus specifically on investing with an emphasis on the stock market.

The Basics

First things first.  When a company wants to raise money it basically has two options: sell stock or issue bonds.  By selling stock it’s essentially breaking up the company into a bunch of little chunks and selling them to investors.  By issuing bonds it is retaining ownership, but selling debt or, in other words, getting loans from investors.

Stock – Also known as “shares,” represents ownership in a company.  It usually entitles you to voting rights on company decisions and a claim on part of the companies earnings.

So when you hear someone say they bought 100 shares of Google, they are simply saying that they bought 100 units of ownership…they now own a fraction of the entire company.  How much ownership a share represents is dependent on how many shares of the company exist.  For example, Google currently has approx. 314 million total shares outstanding, so someone that bought 100 shares would only own .0000003% of the company.

Finally, when you’re looking in the newspaper in the finance section or you see a stock ticker online what you are seeing is the stock symbol (Google is GOOG, Coke is COKE), then the current price of one share of stock and how much it went up or down that day.  Looks something like this:  COKE   34.32   -0.56

Bond – an investment where the investor is purchasing a companies debt by loaning them money at a fixed interest rate for a defined period of time.  Different than stocks because instead of investors having to rely on company profits to make money, the company pays a fixed amount back to investors each year.

Another way of looking at it.  Just like you get a loan from the bank when you need to buy something, companies issue bonds to get lots of mini-loans from individual investors.  By buying a bond you are simply lending a company some money and trusting they will pay it back with interest.

Blue Chip – a stock of a well-respected company that is known to be consistent with paying dividends.  A blue chip is most likely a big company that you have heard of like Coke or Johnson&Johnson.

Mutual Fund – a pool of money managed by an investment company.  They all have different objectives, but the most common is a fund made up of many different stocks.  It is a great tool for the beginning investor because through buying one share of a mutual fund you are actually buying a fraction of several hundred or even thousands of different stocks.  Mutual funds are an easy way to diversify (to be discussed next) when you don’t have several thousand dollars to buy several different individual stocks.

A great explanation from Ramit Sethi, author of one of my favorite blogs, I Will Teach You to Be Rich:

Mutual funds work like this: You pick a fund you like (e.g., growth, value, technology, international…), buy shares of the fund, and let a money manager pick the stocks he thinks will yield the best return. In exchange for this diversification and his expertise, you pay an annual fee.

Diversification – This term is thrown around a lot and while it sounds complex it’s really just a fancy way of saying, “don’t put all your eggs in the same basket.”  If an investor puts all his money in American automotive stocks like GM, Chrysler and Ford he is NOT diversified and is at great risk if the auto industry or American economy in general hits a rough patch.  If, however, he buys GM, Nestle (Switzerland), Bank of America, Boeing and Petrobras (Brazil) he is much more diversified and as a result, taking on much less risk since it is less likely that all of these businesses and economies would hit a rough patch at the same time.

Asset Allocation – Instead of reinventing the wheel on this one I’ll defer to Ramit’s definition, “…asset allocation is a fancy way of describing where you put your money (e.g., 50% in stocks, 20% in index funds, etc). It’s like outlining a paper: You want to know where you’re going with your investments. Otherwise, you just get a hodgepodge of random investments with no central goal.”

A general rule is that when you are young most of your assets should be in stocks (less conservative, more potential for large growth) and as you get older you should transition more to bonds (more conservative).  The main reason is when you are young your investment horizon is much longer, you have several decades to let your investment grow so a few drops here and there won’t have a big impact in the end.

Bull/Bear Market – A prolonged period where the market is performing better than normal (Bull) or worse than normal (Bear).

Rally – when the majority of stocks in the market are going up for a given period of time, a sudden upturn.  Most investors love when the stock market rallies because prices are going up which means they are making a profit when they sell.

More to Come…

Obviously this is just the tip of the iceberg, but hopefully it has given you a few of the basics and shattered the idea that personal finance should be left to the “experts.”  I’m planning on continuing the Alphabet Soup series and including posts with emphasis on real estate, credit and banking.  So keep an eye out people!

***For a great resource in finding more definitions, check out Investopedia AND I Will Teach You to Be Rich AS WELL AS my other posts on Personal Finance

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Warren Buffett is to investing what Michael Jordan is to basketball with one twist, Buffett hasn’t retired. For those of you finding yourself confused and humming “Margaritaville,” here’s Buffett’s bio. I could write for hours on this blog about why I prefer certain investment strategies over others or why I’m a huge “Random Walk” fan, but at the end of the day it is much better to hear from someone who has mastered their craft.

Last month Buffett talked to a group of students from UT Austin and Emory about investing, life, leadership and other topics. What can I say, the man is incredible. I remember first being introduced to him in my Personal Finance class by my professor Lt Col Steve Fraser and his partner in crime Lt Col Jim Parco (at the time just lowly Majors). They would annually take the class to the Berkshire Hathaway shareholder’s meeting in Omaha, NE…or as they liked to refer to it, “Woodstock for Investors.”

Since that class I have always kept an eye and ear open to anything coming from Buffett so today I share some of my favorite pieces from his recent Q&A session, the full transcript is here:

On diversification:

I have 2 views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.

On happiness and love:

I won the ovarian lottery the day I was born and so did all of you. We’re all successful, intelligent, educated. To focus on what you don’t have is a terrible mistake. With the gifts all of us have, if you are unhappy, it’s your own fault.

I know a woman in her 80’s, a Polish Jew woman forced into a concentration camp with her family but not all of them came out. She says, “I am slow to make friends because when I look at people, I have one question in mind; would they hide me?”

The most powerful force in the world is unconditional love. To horde it is a terrible mistake in life. The more you try to give it away, the more you get it back. At an individual level, it’s important to make sure that for the people that count to you, you count to them.

On humility and personal influences:

I was lucky to have the right heroes. Tell me who your heroes are and I’ll tell you how you’ll turn out to be. One of your most important jobs in life will be raising your children. They will learn more from you than they will in graduate school. My father was a huge influence, and later on Graham came along. I was also never let down by my heroes.

On the current credit crisis and economy:

What we are seeing is a huge repricing and evaluation of risk, correcting for problems of the past. I don’t know of good credit propositions that are going unfulfilled. There’s lots of cheap credit for sensible deals, which I don’t define as anything that happened over the last 12, 18 months. A lot of things that didn’t make sense are being washed out of the system. It is painful for bad decisions. Comparatively, this is not a credit crunch. In 1982 the prime rate was 22% and money was very expensive. In the late 60’s, we made a sound deal there wasn’t any money to be had. That’s not the case now. The Fed has opened the window, and rates are down. It doesn’t mean there won’t be a major recession.

On individual investors finding opportunities in a market dominated by institutions and hedge funds:

Markets are efficient most of the time about most things. But for these opportunities, nobody will tell you about them. They won’t be on CNBC and they won’t be in brokerage reports. You have to go find them yourself. In 1951, after I graduated from school, I used Moody’s and S&P manuals as my sources of information. I went through them page by page. I was like a basketball coach looking for 7-footers. I still have to find out if he’s coordinated, and can stay in school. But if someone comes up to me that’s 5’6” and says, “Wait ‘til you see me handle the ball”, I say “No thanks”. On page 1443 of Moody’s, I found Western Insurance Securities. It had earned $21.66 per share 2 years ago, and earned $29.09 last year. Over the past year the stock was selling for between $3 and $13 per share. I still had to do the work to make sure the earnings were valid. The markets will get it right eventually. But they are there. You don’t have to find too many. Finding 10 of these opportunities in your lifetime will make you so rich. But you can’t be wrong. You can’t have any zeroes. A list of big numbers multiplied by zero will equal zero. You can’t go back to “Go”.

On picking the top contemporary investors:

I know guys who can make 50% a year with $5 million, but not with $1 billion. The problem with guys that do well is they attract so much money that it neutralizes their advantage. It’s hard to identify them, and even harder to make a deal to keep them from attracting other capital. It’s like betting on a 12 year old horse that won at 3 years old. It’s also important to avoid managers who use leverage. It’s the reason that investors with 160 IQs flame out.

On positioning yourself to deserve success:

Keeping score is terrible in marriage and terrible in business. I put myself in the seller’s shoes. With most humans there is a great desire to reciprocate. If you do something for them, they will do 2X for you. How rare is it to work during lunch hours and be the first one there in the morning. You’ll get noticed if you do something extra. It’s good to have a willingness to pitch in when you aren’t going to get credit for it.

On corporate tax rates and national debt:

Relative to GDP, government taxation is 18.5% and spending is 20%, so we borrow the balance. The national debt should not be a scary topic and the fact that it’s gone up is fine as long as it’s proportional to GDP. Where do we get that 18.5%? There’s 2.7 trillion in government revenues. 2.2 trillion comes from individuals, and less than 1% of that comes from the estate tax. 1.1 trillion comes from income taxes, with payroll taxes consisting of 900 billion, but it’s capped at the first $100,000 of salary. We want a tax system that encourages greater prosperity, but it needs to take care of the family.

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Here are the links to my latest guest posts: Why You Need Community to Reach Your Goals on Alex Blackwell’s blog, the Next 45 Years. AND “What an All-You-Can-Eat Buffet Can Teach You About Investing” on The Dividend Guy. Just happened to come out on the same day. Enjoy!

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Due to my love for finance and my ability to throw out the random buzzwords like “asset allocation” and “diversification” to sound really smart, many of my friends have begun to come to me for investment advice. “Cameron,” they ask, “this investing stuff is just too complicated, I am (insert an age) and still haven’t invested in anything, I don’t even know where to start.” The first question I always ask is whether or not they have a Roth IRA? Judging by some of the responses I have received I think it’s time to explain what a Roth IRA really is and why if you are young (college, twenty-something) and you don’t have one, you are throwing piles of cash down the toilet.

IRA stands for Individual Retirement Account, basically a simple way of saving money for retirement — remember though, it is just an account, not an investment itself. With an IRA you can choose where you want to invest your money. Think of an IRA as a basket in which you can throw various kinds of investments. Most people choose to throw a mutual fund in their IRA which is why you will hear the terms getting thrown around and mixed-up most of the time. As long as you remember that an IRA is simply an account to place investments in, you’ll avoid a lot of confusion.

Traditional Vs. Roth – These are the two main types of IRAs. I will save you the trouble right now and tell you that if you are under the age of 50 and you don’t make six figures then Roth is the way for you to go. The main difference between traditional and Roth IRAs are how you are taxed. With a traditional IRA you get a tax break when you deposit the money in your account each year. This means if you make $50,000 of taxable income in a year and place $3,000 in your IRA you will only pay taxes on $47,000 that year. Your money will then grow and when you take the money out after age 59-1/2 you will then pay taxes on the money in your IRA. A Roth IRA is different because while you get no tax break up front, your money grows tax-free in your account and when you take it out come retirement time, YOU PAY NO TAXES, not even on the earnings. Another way of saying it, traditional IRAs are “tax-deferred” and Roth IRAs are “tax-exempt” savings. American Funds has a great comparison chart comparing the two types.

Some Rules to Know – First, being that it is a retirement account you will be heavily penalized if you take the money out early, meaning before age 59-1/2 (there are a few exceptions like a first-time home purchase). This means put money in your IRA that you won’t need in the near term.

Second, for you overachievers, the maximum contribution has just changed from $4,000 per year in 2007 to $5,000 per year in 2008.

Finally, to be eligible for a Roth IRA you must make less than $101,000 as a single filer or $159,000 as a joint filer in 2008. So, if you’re raking in some good money already and you exceed these limits you will only be able to invest in a traditional IRA, still not a bad thing.

How to Set Up a Roth IRA – First, remember that banks and investment companies want your money, so they’re going to make it as easy as possible for you to give it to them and if they don’t, shop somewhere else. All you need to set up your account is your W-2 form showing you have earned income. There are a few different places you can go to set up your Roth IRA: bank/credit union, mutual fund companies, or discount broker. The bank route would be for the ultra-conservative investor that wants to use CD’s or money market accounts as their investments (if you’re under the age of 50 this is probably too conservative).

Next would be opening it through a mutual fund company. My favorites include: Vanguard, American Funds, USAA (All of these links will take you to the page dealing with opening an account with the company). By going through a mutual fund company you can then purchase shares in one or multiple funds from the company and put them in your Roth IRA. This method also helps ensure greater diversity being that with a mutual fund you are automatically investing in hundreds of companies rather than just one or two, spreading out your risk substantially. Plus, many times the minimum investment is lower when opening a retirement account than it would be with a normal brokerage account. The final avenue would be using a discount brokerage service, similar concept as above.

Once you have opened your account the next step is setting up an automatic investment plan (takes out money from your paycheck and automatically puts in your investments) so you can harness the power of dollar cost averaging (DCA), an investment principle I wrote on earlier (here).
Once you have this set up your goal then becomes to “max out” your IRA each year, or getting as close as possible.

With our country’s social security system looking more and more shaky all the time and many businesses moving away from traditional pensions, taking control of your own retirement is becoming more necessary than ever before. Probably the biggest reason people put off retirement planning and investing is simply lack of knowledge. The financial education given in the primary and secondary school systems is abysmal and unless you actively seek out investment classes in college, one can go through many years of school without learning even the most basic investment principles. So, if that is you, start now. Don’t be afraid to ask questions. Remember that your future is no one’s responsibility, but your own. As a young person time is on your side and by starting now you can quite easily amass a large amount of money so you can do the things you want to do when you want to do them.

Other good articles on Roth IRAs:
- The World’s Easiest Guide to Understanding Retirement Accounts – Ramit Sethi (the man)
- Why You Need a Roth IRA – Kiplinger.com
- Roth IRAs: A better IRA for almost everyone – AmericanFunds.com

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