Advanced Personal Finance

It’s always been a source of amazement for me that our family has always made money ‘work’ regardless of how much of it there was. Just like any young family, we’ve had our share of changes through the years. We’ve gone from one income and one of us in college, to two incomes, and back to one when our daughter was born. The interesting thing to me is how we never wanted for anything in any of those situations.

Different lifestyles

I’ve read the posts of several other bloggers about how lifestyle inflation can happen and how to avoid it. I’m not necessarily talking about lifestyle inflation. People’s lifestyles adjust, and not always just up. When we lost my wife’s income, we made do. And it wasn’t a hardship.

The point I’m trying to make is that we lived just fine regardless of how much money we had. We can all see the same phenomenon by looking up and down our street. People of widely different incomes live side by side.

Putting it to work for you

We will find a way to ‘consume’ all the money earned by us. I use the term consume purposely. That consumption can mean saving, spending, or retiring debt. But in the end, all of the money will be accounted for.

You can make that fact work for you.

A great technique I’ve found (and it’s not original) both for getting out of debt or saving is doing it automatically. In blunt terms, hide the money from yourself. Don’t even give yourself the chance to spend it. Have an EFT come out of your checking account into your IRA, set up your paycheck so a portion goes to a separate savings account, whatever. Anyone with a 401(k) knows this technique works, because they make their budget work without the money that’s deducted from their paycheck for the 401(k) being available to spend.

I think knowing this can provide encouragement to people trying to get out of debt. It’s hard walking that path and it can be discouraging. I know. We did it. But you can have a great life living on less than you make (and putting the rest toward debt or savings or whatever).

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There is now a great deal of speculation about whether, and to what degree, the government will bail out the sub-prime mortgage market. Well, it has already happened. The Fed did it last week when it flooded the market with money and cut the discount rate.

This wasn’t quite the bailout some people argued against, but it was a bailout nonetheless.

Once again, the Fed bailed out Wall Street.

It seems like a routine event now. Wall Street will shill anything they can come up with. In this case, it was packaging risky mortgages into bonds, tranching the bonds so they’d get excellent bond ratings, and laughing all the way to the bank.

Next, the inevitable happens and it eventually collapses. Wall Street then implies that grave damage to the entire U.S. (no, world) economy will result if ’something isn’t done to restore confidence.’ The Fed, a supposedly apolitical body, knuckles under and begins the bailout.

Fed chairman Bernanke can’t do the right thing and let the situation play out, because the U.S. economy is so drunk on credit there’s a risk a recession will result. So he does what any good politician would do - takes the easy answer for today that comes with a more painful tomorrow (inflation).

I see inflation as a real threat to the U.S. economy now. I thought that before, but I think the risk is even higher now. Here’s to hoping I’m wrong.

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One of the most awesome employment benefits you can have is an Employee Stock Purchase Plan. Most of the time, contributing to them is the equivalent of getting free money. Most of these plans give you a discount on the price and many have a look-back provision that makes them even sweeter. Buy one day. Sell the next. Make 15%.

ESPP Basics

Employee Stock Purchase Plans are programs that allow employees to buy stock in the company they work for, usually at a discount. They all have their own rules set by the company, but there are usually commonalities among them:

• Provide for a discount on the price. The discount will vary, but 15% is not uncommon.
• Have a look-back provision. A look-back sets the your purchase price at either the day the purchase cycle ends or the day it began, whichever is lower. In other words, if your plan runs every six months, you’ll buy at the lower of the January 2nd price or the June 30th price.
• No restrictions on how long shares must be held. This one is key. Ideally, you can sell the next day. Sometimes the transaction takes a few days. Worst case, you have to wait for several months.

Take the money and run

Here’s how the free money works. It’s too simple. As soon after your program buys shares for you as you’re permitted to, sell them. At minimum, you make an immediate 15% (or whatever your discount is) profit. It could be even better using a look-back provision. In that case, it’s possible your discount (and hence, profit) would be even higher.

What I’m advocating is derisively called ‘flipping.’ Some people say it’s an abuse of the system. To which I have two things to say.

1. They set up the rules. I’m just playing by them.
2. Do you really expect me to keep an inordinate amount of a single stock, in the company I work for no less, in my investment portfolio? That breaks, like, rule number one of investing.

Our experience

My wife worked for a company that had an ESPP. The discount was 15% and it had a look-back provision. We took a slightly different tack than what I’m advocating here, simply for tax reasons. We waited until we’d held the stock for a year to take advantage of long-term capital gains tax. Though in retrospect, it probably didn’t make any difference because of our taxable income.

The beauty part is that, because the money for the ESPP came directly out of her paycheck, we never even missed the money. So every six months was another windfall. If I remember right, we used the bulk of it to pay for her MBA program.

Bottom line, if you have an ESPP available to you and you don’t participate, I think you’re a turning down free money. And turning down free money is dumb.

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I’ve finally gotten around to writing up my favorites from the Carnival of Personal Finance at the Simple Dollar.

So here they are, in no particular order, my favorite posts from the Carnival:

• Teaspoon Finance wrote a post about using credit lines as an emergency fund backstop.  I personally agree and wrote about how we have a small emergency fund and use credit as a supplement.

• Dough Roller explains how to avoid being conned.

• Family Finance Blog helps keep me centered with this post about wealth and happiness.

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We prepay our mortgage. I’ve written about before about my thinking on the matter. Basically, for me the psychological benefit of having the mortgage paid off outweighs the potential financial cost. But, as Lazy Man commented on that post, there is a possible cost.

I figured out our cost in real dollars for paying off our mortgage early. Assuming a $200,000 mortgage at 6% and $200 extra per month going either to investments paying 8% or the mortgage balance, it costs $77,671 to prepay(tax consequences have been neglected, mostly because I’m too lazy to include them). I pay off the mortgage nine years early, but at the end of 30 years, I’m poorer by $78,000.

Or am I?

The assumptions in this example are important. The key one is the rate of return. Just recently, I figured out and wrote about the effect of volatility on return.

Basically, it’s not completely realistic to assume a steady 8% return from investments in things like stocks. You can do that with fixed-rate instruments like CDs and savings accounts or retiring debt (like a mortgage or credit card). But you really can’t just assume a smooth 8% (or any other percent) return on equities.

This is something Suze Orman and I actually agree on. The return on investment from prepaying your mortgage is a sure thing. Not so with stocks. ‘Long term,’ yes, stocks average better than my 6% mortgage. It just depends on how long you have to wait for that average.

So thanks go to Lazy Man for making me consciously think about and calculate the effect of our prepaying our mortgage.

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