Ignore the fact that one can build surprising wealth by investing in ownership investments and earning just average returns
Ignore that one can get much, and maybe most, of the money from tax savings and employer matching
Don't tap your computer's and the Quicken program's power to develop powerful, wealth-building insights
Give up, because it's too late to start anyway
Get entangled in at least one get-rich-quick scheme
Fake it with false affluence
Give in to the first big temptation of wealth building
Give in to the second big temptation of wealth building
You read the chapter title right. But let me explain a couple of things. First, about ten years ago, I wrote a book about how to save a million dollars for one's retirement. That sounds a little money-grubbing, I'll agree, but my argument then (and now) is that most people need to accumulate a nice-sized nest egg for retirement because most of us can't or shouldn't really count on things like pensions and Social Security for all our retirement needs.
If Congress does nothing — absolutely nothing — to save Social Security in the United States, the best studies show that, about 30–40 years from now, the government will need to reduce benefits to around 70 percent of the amount it pays today. For example, someone who may receive $1,000 per month today may instead receive $700 in the future. Likewise, someone who receives $400 today may instead receive $280 in the future. Although that difference isn't quite the financial meltdown some people think, it does mean that you and I really must prepare to augment our retirement income by having our own savings.
So, anyway, as part of promoting this book, I spent several weeks on the road doing radio call-in shows, bookstore appearances, and television talk shows. I learned several things from that experience. First, I learned that after one appears on some television show, it is, apparently, customary to remove the strange makeup that's applied for the cameras. This step is especially important if you plan to appear later in public.
I also learned something else in my travels and talking with people. Although everyone is interested in becoming a millionaire or in preparing financially for retirement, it turns out that most people are really more interested in how not to become a millionaire. In other words, they wanted me to explain in financial terms why people don't accumulate wealth.
At first, I thought that this was a little strange. But then finally somebody explained, "We all know you need to save and invest to build wealth.... What we don't know are those things that prevent or sabotage our attempts to do this." People in the audience didn't want to make the same mistakes.
And so that is what I want to cover here. I want to share with you my observations and research results about why people who know they should save at least some money for retirement don't end up building wealth. I've observed that eight really common problems or traps foul up most people.
Tip
Before I begin, note that one thing that happens when you start talking about compound interest and future values is that inflation makes comparing apples to apples difficult. In other words, I can say something like, "... and then you'll have $3,000,000." But you then have to wonder what that amount will be worth factoring in inflation. To deal with this annoying complexity, I adjust for inflation all the numbers I use in the following paragraphs. I subtract the inflation amount and give you only the adjusted-for-inflation numbers in current-day dollars. Note that the Quicken financial planners also let you adjust for inflation by checking the Adjust For Inflation check box, which appears in most of the calculator dialog boxes.
You can build surprising wealth just by investing in ownership investments that produce average returns. By ownership investments, I mean basically stocks and maybe real estate. Here are three examples:
Just by earning the stock market's average inflated adjusted return of around 6 percent, a 25-year-old saving $150 per month can build as much as $300,000 by age 65.
Just by earning the stock market's average inflated adjusted return of around 6 percent, a 35-year-old saving $300 per month can build as much as $300,000 by age 65.
Just by earning the stock market's average inflated adjusted return of around 6 percent, a 50-year-old saving $850 per month can build as much as $300,000 by age 65.
I want to stop here. An important truth here is that, sadly, most people miss this information. Consider what this means: You don't have to get fancy. You don't have to spend a bunch of time worrying. You don't need to spend a bunch of money on advisors, newsletters, or commissions — or even on books about using Quicken.
Compound interest is a powerful engine, and it creates wealth. And that means that you can build surprising wealth by investing in ownership investments and earning just average returns.
Note, too, that you can lock in average returns by choosing a low-cost index fund, such as The Vanguard Group's Index 500 or Total Stock Market Portfolio mutual fund.
Warning
If you choose an actively managed mutual fund or a mutual fund that charges average fees for managing your money, you basically don't have a snowball's chance in you-know-where of actually earning an average return over time. Over the long investment horizon required to prepare for retirement, if you go this route, chances are you'll actually earn a return that's equal to the market's return less the expense ratio that the mutual fund manager charges and the trading costs the manager incurs. Expense ratios for actively managed funds run about 2 percent annually. So, rather than a 6 or 7 percent annual adjusted-for-inflation return, you'll actually earn a 4 or 5 percent annual adjusted-for-inflation return on actively managed mutual funds.
One final point: People see way more risk in this investing than really exists — particularly after the last few years. But over decades, which is how long you'll invest, the risk drops. If you had begun investing in the stock market in the mid-1920s and then continued systematically investing for 25 years through the crash of 1929, the global depression of the '30s, World War II, and the start of the Cold War, you would have earned about an 8 percent return on your money. Given that the inflation rate was just 2 percent over this same period of time, you still could have built wealth by investing in ownership investments producing average returns. I honestly expect similar real returns over the remaining decades (I hope) of my life.
Okay. I'm moving on to another really important point. It's fine to say that you need to invest just $300 per month, and that produces the wealth you need. The big question is this: Where do you get that money?
You've got bills to pay and a rent or mortgage check to write. You want to enjoy at least a few of the material pleasures — like food and drink — that life offers up. Where in the world does someone come up with this kind of money?
Well, the answer is mostly from the tax man and your employer. No kidding. Because of the way that employer-matching provisions work in things like 401(k) and Simple-IRA plans and because of the way our progressive income tax system works, you can get a lot of money from your employer and from the government in the form of tax-deduction savings. You may even be able to get most of the money you need for your retirement savings from these sources.
Table 18-1 shows how someone who wants to save $300 a month might come up with the money. And, in fact, the first line of Table 18-1 shows how much you want to save: $300.
The second line of the table shows how much you might get from your employer in a 401(k) or Simple-IRA plan. Note that an IRA obviously doesn't include employer matching. (This line shows up, therefore, as zero in Table 18-1.) But 401(k) plans commonly provide a 50 percent match on at least the first portion of your contribution. (This shows up as $100 in the table.) And basically by law, Simple-IRAs provide a 100 percent match on the first portion of your contribution (which shows up as $150 in the table).
Table 18-1. Ways to Come Up with $300 Monthly
IRA | 401(k) | Simple-IRA | |
|---|---|---|---|
What you want to save | $300 | $300 | $300 |
What you can get from employer | $0 | $100 | $150 |
What you can get from tax man | $90 | $60 | $45 |
What you come up with yourself | $210 | $140 | $105 |
The third line of the table shows how much you might get in the way of tax savings. For example, if you're contributing $300 per month to an IRA, you might actually enjoy $90 per month in federal and state income tax savings if the tax rate you pay on your last dollars of income equals 30 percent. (This rate would be the case for many readers.)
The fourth line of the table shows what you need to come up with yourself. The IRA is the worst case shown in the table. With an IRA and $300 per month of savings, you would need to come up with $210 yourself. The 401(k) plan looks better; with it, you need to come up with $140 yourself. The Simple-IRA is the best case in the table. With it, you need to come up with only $105.
I don't want to overload you with data. But please note that this is an incredibly powerful insight. Much, and maybe most, of the money you need to build wealth can come from other people — specifically the tax man and your employer, if you work someplace that offers a 401(k) or Simple-IRA plan.
This is hard to describe in general terms because by definition, what the computer lets you do is get very specific. Consider this: Personal financial planning is essentially applied mathematics. What that means is that to make a decision, you often need to tally up the costs and benefits of Option A versus Option B, and then you need to make time/value of money calculations. (Practically speaking, this just means that you also need to figure in things like interest expense and investment income.) These sorts of tasks are the perfect applications for the personal computer.
When you use your computer to make better personal financial decisions, you develop powerful, wealth-building insights that often supply the rest of the money you need for your investing. More specifically, if you need to save $300 per month and you can get $150 of this from your employer and through tax savings, you still need to come up with that last $150 per month. But what I'm saying is that your computer can, and should, help you find this money.
Here's one example: Have you heard about early mortgage repayment? It sounds like a good idea, at least on the surface. If you add an extra $25 per month to the regular mortgage payment on a typical mortgage, you often save about $25,000 in interest. (Maybe more. How much you save depends on the interest rate, the mortgage balance, and the remaining number of payments.)
Based on that bit of financial data, early mortgage repayment sounds like a pretty good idea. Lots of people — encouraged by financial writers — have started doing this. But is it a good idea? It depends.
To determine whether this is truly a good idea, however, you need to weigh your options. If you can instead put an extra $25 a month into a 401(k), you end up with about $100,000.
So there you have it: Option A, which is early mortgage repayment, sounds pretty good because $25,000 of interest savings is a lot of money. But Option B, the 401(k) option, is clearly better because, for no extra pain or hassle, you end up with $100,000.
But other important financial decisions and personal financial planning issues often provide you with similar opportunities for free money or extra wealth because you use your computer:
ARMs: Sometimes, adjustable-rate mortgages (ARMs) actually make you bear less risk and work better.
Buying a home: Sometimes this isn't a good investment — even when it seems like it is.
Car leases: They can be great deals or terrible deals. It all depends on the implicit interest rate that the lease charges.
In Chapter 10, I talk about how you use the Quicken financial planners to make better financial decisions. The Internet also provides a ton of tools, many helpful, for doing personal financial planning. I don't want to sound like your mother or some cranky uncle, but I urge you to use these sorts of computer-based financial tools to make wiser decisions. A little extra money here, a little there — and pretty soon, you've found that last bit of money you need to save for a comfortable retirement. No kidding.
Another common trap that prevents people from saving money for retirement is they give up, thinking that it's too late to start. I have to tell you that, mathematically speaking, that's just dead wrong.
You may think that wealth-building schemes that rely on compound interest work only for young people. It's true that wealth building can be very easy for someone who's young. Often, young people need to make only a single, clever decision in order to build wealth. For example, if a 25-year-old, pack-per-day smoker quits smoking and puts the money he saves into savings, he can rather easily build $1,000,000 by retirement. All he needs to do is save his money in an IRA and select a small-company, stock mutual index fund. (Remember, I adjust for inflation; so really, this person will probably have between $3,000,000 and $4,000,000 of inflated dollars.)
You can't do that if you're 50 years old. I mean, you can't make one decision and expect that single good decision to grow to $1,000,000.
But there's another angle in all this: You aren't limited to making a single good decision. Oh, sure. That's easiest. But I really believe that if you make five or six or seven — maybe even ten — good decisions, you can still build substantial wealth by the time you stop working.
I don't think that surprises you if you're a mature investor. And I don't think it should discourage you. You possess more life experience and, I daresay, more wisdom, than someone who's 25. You can use your experience and wisdom to make a greater number of good decisions, and that can produce the wealth you need.
Get-rich-quick schemes don't work except for the person selling the scheme. And, in fact, they drain off energy and money you really should be using to build your investments. You know all this, of course. We all do. But I think that all of us have a tendency to assume that this one particular great investment or business we're presented with is different. Oh, sure, we know that other dummies get suckered, but "fill in the blank" is different.
I actually don't think trying the occasional flier is a bad idea. If you have some small percentage of your investment money chasing speculative returns, that's okay, but only as long as this iffy investing doesn't foul up your other, more important, boring-but-predictable wealth building for retirement. That's fair, right? If you or I want to try chasing down the hottest new mutual fund or try online day-trading or invest in some friend's start-up business, that seems okay. But you can't allow these get-rich-quick schemes to foul up your meat-and-potatoes investing.
Unfortunately, I see that most of the people who get involved in get-rich-quick schemes try to use this speculation as a replacement for true, disciplined investing. And I have never seen a get-rich-quick scheme that consistently works.
I offer one other comment: Many, and perhaps even most, of the best-selling books about money and investment techniques amount to just new get-rich-quick schemes. I'm not going to name names here. Neither my attorney nor the publisher will let me. But any book that promises you some way to magically and consistently double or triple the returns that other investors earn is a get-rich-quick scheme.
However, some wonderful books out there show you how to better manage your money. For example, Eric Tyson's book, Personal Finance For Dummies, 5th edition, is a really good book about the basics. And I'm not just saying this to schmooze the publisher. (Both Eric's book and this book are published by Wiley.) I also love basically everything that Andrew Tobias writes plus John Bogle's books about mutual fund investing — Bogle on Mutual Funds (Irwin) and Common Sense on Mutual Funds (Wiley) — and Burton Malkiel's The Random Walk Guide to Investing (Norton). All these books provide good, fact-based advice that leads you in the right direction.
I talk about this a bit in Chapter 3, but it's an important point and worth repeating. When people spend all their money trying to look rich, they don't have any money left over to save and invest. That means that most people have to decide — either explicitly or implicitly — whether they want to be rich or look rich. Weird, right?
Yet, most millionaires live average lives. They live in average houses located in middle-class neighborhoods. They drive average cars.
Ironically, most of the people who live in big houses or drive expensive cars aren't rich. They may have high incomes, but they aren't rich. And yet that makes sense. You can't become rich if you're spending all your money trying to look rich.
Faking affluence is a trap that goofs up more people than you'd guess.
I think that when you boil everything down to its very essence, the big problem is that most people lack the commitment. We all must be culturally programmed this way or something. But most of us — I'm the same way — stumble over a couple of big temptations. So I mention these temptations here and in the next section.
Temptation #1: I can tell you, and so can any good financial planner, how to come up with an extra $100 or even $500 per month. Also, if you really do use Quicken in a disciplined way to manage your financial affairs, you'll find yourself freeing up money. You'll save a little bit of money here, waste a little less over there; pretty soon, you'll find yourself with a bit of extra cash. But you must have the commitment to save and invest that money. You and I have to decide to dedicate the next $100 or $500 to investments. If we do, we don't have to worry about financial security in retirement. And if we don't, we should worry. But anyway, that's the first temptation. When you find some extra money, you need to have the discipline to save and invest those funds. And if you do start to do this, you'll rather quickly amass thousands of dollars.
Ironically, resisting Temptation #1 leads rather quickly to...
Temptation #2: After you collect an extra $5,000 or $25,000 or $50,000 in your portfolio, you need to have the commitment necessary to let that money grow. That seems obvious, of course. But I've also noticed that a lot of people don't do this. A lot of people, after they amass a nice little pot of money, decide it's time to abandon a strategy that has worked wonderfully. They decide to buy a bigger house or a boat. Or they change investment strategies, maybe by investing in some friend's or family member's new business. Or they turn their money into a hobby — perhaps deciding that they're going to use their retirement money to try out this online investing thing or leveraged real estate investing.
It's your money, of course. You get to do with it whatever you want. But I am going to be honest with you and say that if you really want to build up a nice nest egg for retirement, you need to be committed enough to resist these two big temptations.