Not the B-Word!

Not the B-Word!

New Year, New You

Sometimes when I’m trying to find a blog topic, I try to get super creative. I envision questions that people may have in relation to what’s going on in the world and I try to give some form of analysis or opinion to further educate my readers.

My most recent point of inspiration came from an article title about how businesses (mainly gyms) were scrambling with the new restrictions in place. I could go into a macroeconomic spiral of small businesses and their impact on the economy, and maybe one day I will, but it made me think about how all those employees have been going back and forth from work to laid-off, and how the most pressing financial questions they have are about day-to-day finances.

Yes, today, we’re going to discuss the B-Word: Budget.

So first off, I have only met a small (and I mean small) hand full of clients who enjoy budgeting. For most, a budget is a set of handcuffs from which they want to break free. Because, as many have experienced, you typically build a budget when money is becoming an issue. With that perspective, the goal of a budget is to eventually ditch the budget altogether!

I like to tell my clients that a budget is much less important to financial success than one may think. If the goal of budgeting is to buy yourself time until you can catch up on bills or get a pay raise at work, you end up locking yourself in a vicious cycle of never feeling at peace with your finances.

So what’s the solution? Is there an alternative, or is it all doom and gloom?

Never fear, Garrett’s super-helpful-and-wildly-inspirational blog post is here!

Let’s talk about perspective and psychology for a moment.

If we look at our spending habits in the way described above, we are always looking for a change. Intrinsically, our financial plan relies on a constant swing from a financial freedom to financial restriction. In that case, budgeting is the consequence of either reckless spending (i.e. recovering from Christmas), or bad luck (an unexpectedly large repair to your car). The goal is to choke back spending to a point where you can ditch the budget and get on with life. The only problem is that Christmas is a yearly holiday and you never know when the transmission will fall out of your car.

What if we looked at budgeting as a behavior rather than a prison sentence? When you count each individual dollar, it’s hard to imagine, but if we look at your budget as a filter, we can avoid the repeat offenses.

Here’s how I see it. There are only three types of expenses:

  1. Necessary (needs)
  2. Unnecessary (wants)
  3. Waste

Obviously this is an oversimplification, but the process of creating a behaviour starts with making things simple.

So, first step: Define your needs. Traditionally, these only include the items that are required to take care of yourself and your family. Rent, groceries (not snacks), clothing (basic, not ‘extra’), etc. At the end of the day, when you look at your list of ‘needs’, you should not be able to remove anything from that list without the risk of mortal suffering.

Wants are a bit different, but may be extensions of needs. For example, I have 10GB of data with my phone plan. Do I need 10GB? Absolutely not. I don’t really need any data. For business, I need a phone, but the additions to my plan (and the phone itself) are all wants and not needs. This would extend to designer clothing, snacks, and other items that can be removed from your life without affecting your foundational well-being.

Waste is everything that falls through the cracks. When I sit down with clients and start the discussion around budgeting, we make a list of everything they expect for monthly expenses. We then compare that to how much money they bring in monthly. Quite often, we look at the difference and see that there should be a couple hundred dollars left over.

When I ask them if that feels right, they seldom agree. Even though their ‘budget’ says they should have $500 in unallocated income, they often feel like they live paycheck to paycheck. This is where ‘waste’ comes into play. We sometimes refer to this as the “latte factor”. No one budgets for coffee, because it’s typically such a small expense. But when you get a Starbucks coffee 4 days a week, at $5 a drink, the waste adds up. Inevitably, there will almost always be some degree of waste in a budget, but the behaviour change we want to build will allow us to not sacrifice the “Needs” and “Wants” for “Waste”.

That brings us to a few general rules of thumb:

First: Pay yourself first. This seems like an obvious strategy, but it is often disregarded in practice. When you get paid, do you start by paying off your rent, putting money onto the credit card, and making a grocery run? If there’s any money left over, you take yourself our for a nice lunch? What happens at the end of the month? Most often, unless your income far exceeds your expenses, you are waiting eagerly for the next paycheck. Paying yourself first means that you put money into savings before you do anything else. This requires knowing what your needs are, because you will have to pay for those, but get some money set aside for emergencies or long term savings before you get caught up in the extra stuff. Often, the ‘savings’ portion of someone’s budget is left for the end. They say to themselves, “If there is anything left after my expenses, my lunches, and my lattes, I’ll put something away for the future”.

The problem is that there is almost never money left, because there is always something that seems to take priority. For example, debt. Getting into the habit of paying yourself first can a) change your mindset around all your other expenses, and b) allow you to not rely on debt as much.

Think about it this way: most of my clients SHOULD have a few hundred dollars in unallocated income each month. If they put that money into a savings account first, then dealt with other needs, then wants, they may still have some money left for their lattes, but they know that they can spend that extra money without sacrificing their future savings goals.

Second: Budget your waste. If drinking expensive coffee is a common occurrence for you, don’t leave it in the waste category. If it isn’t something you want to give up entirely, start to track it. Sometimes the realization of how much it burdens your expenses can give the expense new perspective. This is true whether it’s weekly coffee, multiple streaming subscriptions, or other extra purchases.

Third: Think before you spend. The point of changing your behaviour around budgeting is that it should be treated as an exercise and not a punishment. Instead of looking at cutting expenses as a consequence, think about it as an opportunity to have more options in the future. The mental shift takes time and attention.

I have heard of multiple devices that have been used successfully to help with the shift. One of them is freezing your credit card in a block of ice or putting it in the fridge. The simple act of having to go to the freezer to get your credit card before making an online purchase gives you an opportunity to rethink your purchase decision. How easy has online shopping made it to buy something without thinking? They save your credit card information, have your address saved and ready to go. All you have to do is press “Continue” and it’s at your door a few days later. Their goal is to give you as little time as possible to change your mind.

Another tactic is to put all your coffee (or other activity) money in an envelope. This forces you to see the bills before you buy, rather than being able to ‘tap’ for $5 here or there. It takes effort, and it is awkward at first, but it gives you an opportunity to question whether or not you should be buying it.

The third tactic is a simple reward system. I’ve used this successfully in the past, especially when it comes to buying coffee. If I’m craving something sweet, I’ll tell myself that I have to accomplish something first. This could be as simple as cleaning the bathrooms, doing the dishes, or running an errand I’ve put off while I’m out. Sometimes, I still get a coffee, which is perfectly fine. Other times, I finish my task and the craving has subsided. All of a sudden, I’ve transitioned my mental space from needing that coffee to something else entirely. Not only have I crossed something off my to-do list, but I’ve also distracted myself long enough to let the craving pass. I’d say this has reduced my coffee expenditures by 50%.

Here’s what I’m not saying.

I’m NOT saying that budgets are bad, or that you shouldn’t use a complex budget system to track your expenses. I have seen clients use physical (or digital) budgets with great success and failure. The element that is often missing from people when they fail at budgeting is their mindset. They define financial freedom as being able to spend however much they want and indulge every craving without needing to consider consequences. That’s quite often not the case. Financial freedom is having a process that allows you to spend without sacrificing your future. Some people achieve this by finding a profession that pays such a high income that they don’t have to put on any restraints, but many people’s reality dictates that there is some form of discipline in place.

So where do I start?

It takes time and energy to make a change. Right now, if it weren’t for lockdowns, I’m sure we’d be witnessing the New Year’s rush at the gym. People head in with the idea of cutting out all their bad habits and creating a “New Me”. The problem is that, by February, they’ve dropped the 5 pounds, feel like they were successful, and revert to their old habits. The people who are at the gym year round have built dedicated processes and habits into their lifestyle to make their physical health a priority.

It is no different with budgeting. A new years diet simply restricts you until you’ve lost weight, but the habits that you built over the rest of the year are still there when you let your guard down.

So start with the simple things. Write down what falls into your needs, wants and waste categories. Look at the ways you spend your money and start with small and manageable changes. The gym enthusiasts didn’t start out by going to the gym 5 days a week and eating super healthy. They started by cutting McDonalds out of their diet and replacing it with a home cooked meal. Consistent small changes make a long lasting difference.

There’s a 1% rule that I like to reference. If you make a 1% change to your lifestyle each week, you are 52% better off by the end of the year.

All it takes are small consistent changes to be successful.

The Novice Investor: Piecing Together Your Investment Vehicle

The Novice Investor: Piecing Together Your Investment Vehicle

Investing… Stocks… Bonds… Mutual Funds… Markets… Internal Rates of Return… Value versus Growth Investing… ESG Investing… Portfolios… ETFs… Savings Rates… Risk Profiles…

There is so much out there when it comes to the parts and principles of investing that it can be hard to digest. On one hand, we are told to invest, and on the other, we are told to not do anything without knowing what we’re doing. That ideology can force a rift in people’s planning and cause them to be idle. I have had clients who sit on tens of thousands of dollars in their bank account, and most often the reason is that they don’t understand their options.

The richest men in the world have built their fortunes by having multiple streams of income. Jeff Bezos, the founder and owner of Amazon, is currently the richest man on earth. If we looked at his income strategy, you would see multiple inflows. First, he has his salary from Amazon. Secondly, he has his Amazon shares that increase in value as the company grows. Third, I imagine we would find that he has money tucked away into shares of other companies, which are also growing. All of these sources accumulate to roughly $2500 per second in income (from “The Registered Citizen”).

Especially with the current ongoing crisis, there are lots of headlines that say you should stay away from the world markets. Oddly enough, you can often find a link nearby that will tell you how to setup a ‘side-gig’ from home to earn more money. Each person has a unique situation, and in this post, I would like to explore how you can design your own secondary income streams. I will be using the analogy of a car, as it makes it easier to conceptualize investment components.

First, I would like to define the difference between ‘Active’ and ‘Passive’ income. It’s pretty self-explanatory, but active income (also known as “earned income”) refers to income you have to physically make. This would include going out to a job and getting paid a wage/salary. Passive income on the other hand is income gained for you by others. Investing falls into the category of passive income.

For the purpose of simplicity, I will speak in terms of mutual funds (which I will define later). Investing can be broken down into two parts: Equity and Fixed Income.

Equity:

Equities, also known as stocks, are the engine of our car. To have ‘equity’ in something is to own it. For example, Jeff Bezos has equity in Amazon because he owns shares (or stock) in the company. As the company increases in value, the market price of your shares increases. This means that every time you purchase something on Amazon, not only does Amazon’s revenue increase (which increases Jeff Bezos’s salary or bonus), it also increases the value of the company, therefore increasing the price of each share.

It doesn’t necessarily have to be companies. There are some investments that hold their equity in other areas, such as gold. In this case, the fund manager will buy gold, and sell ‘shares’ of the gold on the open market. As the value of gold increases, the value of each share also increases and people can sell their shares for a profit. 

Equities can define how fast and how long your car will run. Within equities, you can dive into asset qualities and other specifics that can be as different as the electric engine is to a V8 supercharged sports car’s engine. Equities give us the power and growth potential we need to earn our passive income.

Fixed Income:

Fixed income (also known as ‘bonds’) are the safety features of the car and this form of investment is far simpler than equities. In every sense of the phrase, it is an “IOU”. You, as the investor, are lending money to governments or companies for them to use in their operations. This is a lower risk and lower reward strategy for investing. The company or government gets a loan, and you receive a regular interest payment. For example, if you were to lend Amazon $10,000, they would pay you an interest payment (i.e. 1.5% or $150) either annually or divided monthly and return the $10,000 balance at the end of the term.

One common factor you’ll often hear about bonds is related to the interest rate.

If we paused time and looked at interest rates now, we would see a sharp decline in a new bond compared to 1 year ago. This is because the Bank of Canada (along with other country’s banks) have dropped interest rates in an attempt to stimulate the economy. Interest rates play a large role in the ‘risk’ associated with a bond, but that analysis is for another post.

Traditionally, bonds are a much safer way to invest, as there is little risk of a government or company not honouring and paying that debt back, but it also carries a lower reward. Your $10,000 does not participate in company growth in the same way equities do.

In regards to it’s relationship to our car analogy, with fixed income being the safety system, bonds protect the car as it moves. If there was an event that was cause for concern (for example, the markets dropped in value and you were unable to go to work), the fixed income component would preserve a portion of the investment to limit the damage.

The whole purpose and the relationship between equities and fixed income is to get you from Point A (where you are now financially) to Point B (retirement, first house, education, etc.). This is where mutual funds come into play.

Mutual Funds:

What are mutual funds?

Again, by their name, it is easy to guess that they are a funds designed to be invested by multiple people pooling their money toward a mutual goal. There are lots of different types of mutual funds. For example, there are funds designed for people who want to invest in certain parts of the world, different industries, or even subject to certain moral or ethical standards.

At it’s core, a mutual fund is a makeup of equities and/or bonds that provide growth opportunity while minimizing the downside potential. Since everyone’s risk tolerance and time horizon is different, finding the right mutual fund (or funds) to invest in takes more thought than most people would imagine. If you are considered ‘high-risk’ you may want a mutual fund that holds more equities than bonds. Vice versa, if you were closer to retirement and wanted to preserve your investment, you would lean toward a higher allocation of fixed income and safety.

Common Question: How is this better than buying individual stocks?

Quick answer: it depends. Do you have the time?

A long time advisor once shared an analogy with me that I thought was powerful. Unfortunately, it is highly visual, but I will do my best to paint the scene.

Diversification is one of the main strategies used by mutual funds. Imagine you have a pencil, and that pencil represents a stock. It can be any stock you’d like, but it is one single stock. You have heard that this company has a strong future and will grow in value for you, so you ‘get in at the ground floor’, and invest everything into that company. Now, fast forward in time. We have an event such as the recession of 2008, the tech bubble of 2000, or the current COVID-19 crisis. That company is put under financial stress, as this is an unforeseen position and the world is rapidly changing. Some companies are able to adapt and survive, and others can’t change fast enough and are forced to shut down. A real example of this may be the loss of mega-companies such as Sears. Sears couldn’t adapt to cater to the online shopper and subsequently ‘died out’. Any stock that Sears had is worthless today.

bunch of pencilsSo… take your imaginary pencil and bend it. Imagine that you bending the pencil is the company going through a stressful period. Does it snap? Maybe not, but you, as the share holder, are not protected from the companies failure. The money you invested could be gone.

Now imagine you have a box of 50 pencils, each pencil still representing a single stock. You take them out of the box, you strap an elastic band around them, and you try to bend them all together.

They don’t break so easily.

The difference between trying to buy individual stocks and buying a mutual fund, is that the mutual fund offers greater diversity and protection from market fluctuation. Theoretically, you could go out and buy 50 individual stocks and manually create your own diversification, but most people would find it takes a lot of work to purchase, research, value, sell, re-balance and execute a specific investment strategy while also earning income at their own career. The mutual fund offers a much simpler solution to investors and can create a stream of passive income.

Summary:

The value of not putting all of your eggs in one basket is that you are more protected from a depressed market. A crazy and unexpected event occurs and some of the companies feel the stress, but even if one company falls to the wayside, your portfolio is held together by the remaining mix of equities and fixed income.

Creating passive income can be more than working a 9-to-5 career and investing in mutual funds, but investments are a staple in most successful people’s financial structure.

I want to circle back to my original analogy.

A car has a single purpose. The kind of car, how fast you drive, and where you are going is up to you. But at the end of the day, the car’s role is to transport you from where you are now to where you want to be in the future. If you start your journey without enough gas in the tank or with worn out tires, you are putting yourself at risk of stalling or having problems down the road. Like an investment strategy, a car with proper care and maintenance will ensure you eventually reach your goal.

Proper investment strategies can provide peace of mind when traveling down life’s roads. You never know when there will be an unexpected twist or turn, and being prepared is a key to success.

What Lies Ahead…

What Lies Ahead…

As I prepare for each week, I like to do my own recap of the markets. I look at trends over the last week and scale it back to the month and quarter to see how the big picture evolves. Even though everyone is linking the market depression to COVID-19 (which is fair), I thought it would be an interesting opportunity to look at the previous market fluctuations and evaluate how this one compares.

I found a great article from Forbes that breaks down different recovery patterns, and I thought this would be a good place to summarize it and give my impressions.

There are four common shapes to describe market recoveries. The “V”, “W”, “U”, and “L”. The “V” and “W” are the most common, because the “U” is really a variation of the “V”, and the “L” is very uncommon. But let’s start in alphabetical order.

The “L”

The “L” is associated with a worst case scenario. As the shape implies, there is a sharp drop in the market which doesn’t recover, or at least takes a long time to transition to an upward trajectory. This shape hasn’t been seen in a long time, but most recently appeared in the 1990’s in Japan, known as the ‘lost decade’.

The “U”

If we look backwards in time, we’ll see that the “U” shape was a part of some of the bigger market events. It depicts a downward movement followed by a “bottoming out” period. This shape is seen through the Great Depression, as well as some of the market events in the late 1900’s. The “U” illustrates an economy that has declined without an individual stimulus of recovery. It leads to a slow incline in the valuations of the market rather than a stark climb.

V shape graph of market recoveryThe “V”

The “V” is a more common variation of recovery. It represents a sharp decline and a quick ascension back to original (and most often higher) values. It is more likely that the contraction and expansion are a result of an outside factor. For example, in 1952, when the market was still ‘booming’ after the Second World War, the US Federal Reserve raised interest rates in the anticipation of disproportionate inflation. This caused a “V” recovery from Q4 1952 to Q1 of 1955.

W Shape Market RecoveryThe “W”

Most people who are preparing for retirement remember the crash of 2008 vividly. The Lehman Brother’s went under and the economy fell in hot pursuit. Hindsight being 20/20, we can see the market crash of ’08 as a representation of a “W” recovery pattern. In the late stages of ’07, there was a relatively small and quickly resolved market depression followed by the major fall halfway through 2008. The minor correction combined with the major event form a “W” pattern.

So, what does this tell us?

Having knowledge about the ABC’s (or rather UVW’s) of market recovery is only helpful if we can apply it. Unfortunately, we can’t see a pattern until after it has appeared and it has joined the rest of the recoveries as part of our history. That being said, we can look at the behavioral patterns of people and how the COVID-19 pandemic varies or resembles patterns seen before/during previous market disruptions. Experts would agree that the market behavior would best point toward a “V” or “W”, but only time will tell. The rational for the “V” is that once we are allowed to mingle in public again, people will return to stadiums and restaurants, causing a quick surge of money flowing in and out of the economy. Specialists fear a “W” recovery if governments re-open the economy too soon. The news has mentioned the idea of a ‘second wave’ of Coronavirus stemming from healthy individuals returning to ‘normal’ and interacting with asymptomatic people. This would cause a second impact of new patients in hospitals, and see governments re-think their strategy, having potential economic consequences.

If we self-isolate and flatten the curve, a “U” shape could emerge. This would be caused by a slow and strategic introduction of economic stimuli. It could be even more pronounced if people were to be skeptical at first. Imagine the governments fully opening markets trying to create a “V” response. People are still fearful and decide to continue the limitations on their interactions. This means there is a slow and steady increase to economic activity rather than an ‘opening the floodgates’ response.

All that being said, we can’t predict what the market will do. People have been trying to time the markets for decades. And some have made careers out of it. It will be interesting to see how this plays out. I imagine that whichever way it pans out, this will become a unique lesson for us all to learn from.