Tuesday, March 20, 2007

Your Total Measure of Wealth: Income, Personal Savings Rate, and Rate of Return

Author: Nick
Category: Money
Topics: , ,

your total measure of wallet

If you joined us last week, then you know that we’re well on our way to redefining the way people think about wealth. No longer is net worth alone a worthy sign of one’s wealth. Instead, we’re working on a new, more complete calculation for determining one’s wealth status: your Total Measure of Wealth™.

We’ve already reviewed the two easiest parts of your Total Measure of Wealth: age and net worth. Today we’ll cover three more simple components that belong in your wealth measurements.

Income

wish my paycheck were in there

Description

As its name suggests, income is all of the money “incoming” to you before it’s “outgoing” to someone else. Income can come from a variety of sources: your job, investments which increase in value, interest on your savings account, gifts, etc.

We could put together an exhaustive list of every single place from which you earn money, but we’re really only interested in income you can expect to earn for work you perform. Why are we only interested in earned income? Because just about every other source of income is better accounted for by calculations we’ll perform later (like housing status and rate of return).

Your earned income–your salary–is what you make for committing a large chunk of your day to some form of work. Assuming you continue in your same line of work for the foreseeable future, this amount represents the value of your effort. Unlike passive income from things like real estate or investments, you must work continuously in order to maintain your level of earned income.

How to Calculate It

The most common method of comparing earned incomes is by annualizing it, and that’ll work fine for us. Every tax assessment agency in the world probably has a different way of determining your annual earned income, so we’ll need to come up with a standard formula for our purposes. Fortunately that formula will be very simple.

total annual earned income = sum of all annual earned incomes

Before you scream “duh” at your computer screen, we still haven’t done the hard part of this calculation: determining what qualifies as an “earned income.” In order to put together an accurate depiction of your financial status, we’re only going to be interested in income for work you perform which you reasonably expect will continue into the future. You might have made an extra $20,000 last year working weekends as a stripper, but if you’re only pulling in $100 a night these days, you can’t expect to earn another $20,000 this year. And if your salary is $150,000 and you’re expecting a pink slip any day now, your expected salary is now zero until you find another job. But if you’ve been filling out online surveys diligently for a few years now and bring in an extra $50 a month, don’t hesitate to include that as earned income if you plan to continue filling out surveys in coming years.

How to Use This Number

You probably spend a boatload of your time earning this income, so it should have a big influence on how you perceive your wealth. If you compare it to your instantaneous net worth (or, more simply, the amount of money you have in liquid savings), it’ll tell you how important your continued ability to work is to your future livelihood. And if you compare it to the earned incomes of others in your line of work, it’ll also indicate if you’re receiving compensation commensurate with your efforts.

Personal Savings Rate

no, that is an ATM, not a personal savings rate calculator

Description

Your personal savings rate is a measure of how much money you save out of the money you make. A positive personal savings rate means that you get by on the money you make, and you have at least a little bit left over. If you spend every penny you make, then your personal savings rate is zero.

It is also possible to have a negative savings rate. In fact, not only is it possible, but it’s true for the average American. In 2006, the average personal savings rate was negative one percent. That means for every dollar the typical American made, they somehow spent $1.01! How is that possible?

Credit. Loans. Debt. Dipping into existing savings. People are spending money that they’ve already saved without saving new money, and sometimes they’re even spending money they don’t have.

Don’t confuse your personal savings rate with your bank’s savings account interest rate. These are two very different figures, the second of which we’ll take into account later when we examine your rate of return (ROR).

How to Calculate It

Your personal savings rate is easy to calculate. You’ll need two numbers first: your income (see the section above) and your annual savings amount. You can use last year’s figures for both if you like.

How do you determine your annual savings amount? Savings is simply how much of your income you don’t spend. If you have deductions into a retirement fund, this is savings. If you automatically transfer $100 out of every paycheck into a savings account and you don’t spend it, this is savings. The interest you earn on your savings or investments is not savings; these are returns on your investments which we’ll cover later.

You must also factor in negative savings into your savings figure. The biggest sources of negative savings are credit cards you don’t pay off and withdrawals from savings. Subtract any such items from your annual savings amount.

Once you have your income and savings amount figures, just drop them into this equation:

personal savings rate = savings / income

So if you made $100,000 last year and saved $8,000 of it, then your personal savings rate is:

personal savings rate = $8,000 / $100,000 = 0.08 = 8 percent

But say you made $100,000 last year, saved none of it, put $3,000 of purchases on credit cards you didn’t pay off last year, and took $2,000 out of your savings account that you didn’t replace. Your savings rate is:

personal savings rate = ( -$3,000 + -$2,000 ) / $100,000 = -0.05 = -5 percent

How to Use This Number

If your personal savings rate is above zero, congratulations! You’re already well ahead of most Americans. But how far above zero are you? Are you saving 5% of your income every year? How about 10%? The reason I mention 10% is that this is a figure popularly tossed around for how much you should save each year toward retirement. In reality, the percentage you should be saving depends on other factors: your age, your expected life span, your current savings, and many other factors. It might be much higher than 10%, and it probably won’t be much lower.

Visit ChoosetoSave.org for a handy calculator to help you determine your suggested personal savings rate based on your specific situation. Compare your suggested figure to your actual figure in order to panic because you are probably not saving enough.

Suffice it to say that your savings rate should be as high as you can make it. Otherwise, you might have to work every day for the rest of your life. Even Bob Barker doesn’t want to do that, and he’s 83!

Rate of Return (ROR)

invest in barrels

Description

In order to have a rate of return (ROR), you must first have savings or investments. Some examples of these include savings accounts, certificates of deposit (CDs), stocks, retirement funds, and real estate. If you do not have savings or investments, your rate of return is zero; please go sit in the corner for the remainder of this article.

For you cool people with savings or investments, your ROR is simply a measure of how much money your savings and investments are making you. You put money into a CD or a retirement plan and you expect that money to magically grow. There’s nothing magical to the growth–it’s just banks lending your money to other people and giving you a cut of the interest they charge the borrower. But that growth is the basis for your ROR, so let’s compute it now.

How to Calculate It

Your ROR is just another rate of change. It can be positive, negative, or zero. Hopefully it is positive or else you’re picking really bad places to stash your cash.

You may have multiple savings accounts and investments. You can compute your rate of return individually for each one, or you can combine them all and come up with an across-the-board ROR.

To determine your annual ROR for any one investment, use this formula:

annual rate of return = interest earned / amount invested

You might vaguely recognize this formula from grade school. It’s just the familiar simple interest equation solved for the interest rate with a time of one year.

The formula above is only useful for a single year and doesn’t take into account one very powerful factor–compounding interest, or the amount of interest earned on the interest itself. So you may instead wish to use this formula:

annualized rate of return = [(ending value of investment / beginning value) ^ (1 / # of years) ] - 1

For example, let’s say you invested $10,000 in the stock market on January 1, 2005 and rang in New Year 2007 with your investment valued at $14,000. Your annualized rate of return would be:

annualized rate of return = [ ($14,000 / $10,000) ^ (1/2) ] - 1 = 18.3%

You’ll sometimes see the above formula referred to as a compound annual growth rate (CAGR) formula. I think some people just like saying CAGR. Kagger. Kagger. Heh.

Once you apply the formula to all of your investments and savings accounts, you’ll probably notice that they vary. You might have a savings account earning 3%, investments earning 12%, and money in a piggy bank earning 0%. To calculate your overall rate of return across all investments, use this formula:

overall annualized rate of return = [(sum of investment values at end / sum of investment values at start)  ^ (1 / # of years)] - 1

So if you start with $3,000 in savings, $10,000 in stocks, and $200 in a bottle on the nightstand, and you finish with $3,100 in savings, $12,000 in stocks, and $200 in a bottle on the nightstand, your overall rate of return is:

overall annualized rate of return = [ ($3,100 + $12,000 + $200) / ($3,000 + $10,000 + $200) ^ (1/1)] - 1 = 15.9%

How to Use This Number

Your ROR is one of the best health indicators for your savings and investment portfolio. Looking at your ROR by itself isn’t that useful; you need to compare it to other RORs since a “healthy” ROR can change from year to year.

I, like many people, prefer to compare my annual personal rate of return to the S&P 500 index–a listing of 500 large company stocks used to gauge the performance of the stock market in general. Many folks set a goal of “beating the S&P” each year, and they are satisfied with the health of their investments if they do so, even if it’s just by a little.

The final example in How to Calculate It above which showed an overall ROR of 15.9% just squeaked by the 2006 S&P 500 ROR of 15.8%.

There are some years in recent history where you might not want to use the S&P 500 for your comparisons. You may recall the S&P breaking 1500 points in 2000. Thanks to the bursting of the dot-com bubble, it was back below 800 two years later. Lots of people lost a ton of money, but there were plenty of safer investment avenues available to the smart investor (like a savings account earning zero interest, for example!). “Beating the S&P” was not such a hot achievement during these two years, that’s for sure.


With the easy keys to your Total Measure of Wealth out of the way, it’s time to start exploring the new frontier of wealth calculations. Next time, we’ll talk about your job status and how to determine its influence on your financial health.

Wednesday, March 14, 2007

Your Total Measure of Wealth: Age and Net Worth

Author: Nick
Category: Money
Topics: , ,

ben franklin - highly sought after old guy

Now that we’ve established that net worth is inadequate for wealth determination and have come up with a suitable list of alternative wealth measures, it’s time to start looking at each of the criteria and put together a new formula for deriving one’s Total Measure of Wealth™. (Seriously, where’s that book deal??? Don’t make me trademark more stuff.)

Today we’ll start covering the easy stuff–the keys to your Total Measure of Wealth that already have established, standard metrics associated with them.

Age

Description

time is ticking, er, shadow... uh, moving

For those who haven’t touched a calculator since grade school, we’ll start off easy. Your age is how old you are. It’s the number of years between today and the day you were born. I could say more about this, but a long paragraph here might confuse you into thinking this is more complicated than it really is. Oops, too late.

How to Calculate It

If you don’t know your age, ask somebody who does. Or just assume that you’re 37.

How to Use This Number

Despite its extreme simplicity, age is perhaps the most important factor in determining your Total Measure of Worth. That’s because age is the factor over which you have the least control. In fact, you have no control over your age until you build a time machine, and I just don’t see you doing that anytime soon.

Age can mean the difference between a bright financial future and a hopeless financial meltdown. $100,000 does a lot more for a 20-year-old who has a lifetime to invest it than a 65-year-old retiree who must spend it to survive. Age won’t tell you too much about your wealth picture alone, but you’ll see shortly that it can have a big impact on the other measures of wealth.

Net Worth

Description

line up all your assets

Net worth has long been the de facto standard of wealth determination. If my net worth is higher than yours, then I am richer and you are poorer. But how can we say that a starving orphan with a net worth of zero is richer than a person with a home, a job, and a promising outlook but who currently has a negative net worth due to a few thousand dollars in student loan debt?

While net worth can’t demonstrate wealth on its own, it is still suitable as a snapshot of your current financial status. It is even more useful when compared to your historical net worth calculations; a rising net worth may suggest smart financial decisions, while a plummeting net worth could indicate out-of-control debt or rapidly depreciating assets.

How to Calculate It

There are really two parts to any net worth calculation: instantaneous net worth and historical net worth growth. Computing your instantaneous net worth is simply a matter of tallying up all of your assets and subtracting all of your liabilities:

instantaneous net worth = sum of assets - sum of liabilities

Historical net worth growth is a little trickier to compute because you must decide over what span of time you would like to calculate your net worth’s change. On the one hand, we’d like to look at data over a long period to see how your finances have progressed over the years (and maybe decades). On the other hand, long-term data might not place enough emphasis on more recent smart (or stupid) financial transactions.

Let’s start with a look at your long-term net worth change. How far back should we look? That depends on how old you are. Older people have more financial history and should look back further than younger people. For now, we’ll set up a rule of thumb stating that long-term net worth is over the course of the last one-third of your life. So simply take your age, divide it by three, and compare your net worth from that many years ago to your net worth today. (If you don’t have exact figures from that long ago, just estimate.)

beginning date = today - age/3

For example, since I’m 24, my beginning date would be:

beginning date = 2007 - 24/3 = 1999

Once we have our dates set, we determine our rate of change:

long-term net worth growth = net worth today - net worth beginning / net worth beginning

Now we need a short-term net worth change formula. Let’s say that the short term is fixed for everyone and just looks at your net worth growth over the last year.

short-term net worth growth = net worth today - net worth 1 yr ago / net worth 1 yr ago

How to Use These Numbers

You should view your instantaneous net worth merely as an indicator of where you are financially today. Without the change rates, there is no way to tell based on this number what you should start doing differently, if anything, with your money. Then again, if your net worth is a few million dollars or more, you could try writing me a check.

The long-term and short-term net worth growth figures are much more useful to us. The long-term change provides a summary of how you have handled your finances over the years and indicates what sort of net worth goals you should set for yourself in the next stages of your life. The short-term change lets you know if you’ve made any dumb mistakes lately.

You can also annualize your long-term change rate and use it as a starting point for setting future net worth goals. Simply divide your long-term net worth growth by that age-divided-by-three number to get your annualized long-term net worth growth rate.

annualized long-term net worth growth rate = long-term net worth growth / age/3

So if you’re 24 and your net worth tripled (i.e. increased by 200%) over the last 8 years, your annualized long-term net worth growth rate is a healthy 25%.

While some may argue that maintaining a steady long-term growth rate is a smart goal, I’d like to see my rate increase every year. Comparing your short-term net worth growth to your annualized long-term growth rate will tell you if you’re hitting your target of meeting or beating your growth rate each year.


Tomorrow we’ll look at the other three “easy” wealth indicators: income, savings rate, and rate of return.

Wednesday, January 3, 2007

This Make$ Me Laugh: InvestorGeek Jason’s Year In Review

Author: Nick
Category: Money
Topics: ,

investorgeeks make$ me laugh

Lest this little gem of humor be lost in all the Year in Review articles that have appeared in recent weeks, the first edition of This Make$ Me Laugh highlights the sobering year-end review by Jason at InvestorGeeks.

The line that gave me the most giggles:

My trading strategy for that first half of the year can be summed up as “find great company stocks, buy them when they are overpriced, then sell like a pussy when the stock loses money…”

While I’m sure my amusement would see no end if you all decided to adopt this tactic, you’ll want to actually read the article for some much better investment advice that Jason picked up during his tribulations.

Wednesday, September 20, 2006

Great Investing Tip: Put Your Money Into BARRELS

Author: Nick
Category: Money
Topics:

BARLS 30.21 UP 1.75

You, my friend, are about to become a very rich man. And if you’re not a man but always wanted to be one, you’ll soon be able to afford it thanks to the fabulous investment tip I’m about to give you.

lookit all the colored paper

Come closer.

A little closer.

Yeah, right there.

Ready? Okay. Here I go.

You’re going to get in your car, drive to your bank, go up to your bank teller, take out all of your money, and invest in… BARRELS!!!

spinach and barrels--cornerstones of democracy

Yes, that’s right. I said barrels. They come in all shapes (well, barrel-shaped) and sizes (um, big… and I guess really big), and they’re made from things like wood, metal, or some eerie combination of metallic wood. No matter what they look like, barrels are just as vital to our economy as oil, gold, and uninfected bags of spinach.

Barrels: Nature’s Gift to Mankind

Think about all the different things we need barrels for in our lives. If you think hard enough, you’ll discover that we use barrels for exactly 719 different purposes, five of which are:

why are monkeys in barrels of monkeys red

  • Wine barrels
  • Rain barrels
  • Barrels of monkeys
  • “Roll out the barrel”
  • Lock, stock, and barrel

But there’s one thing barrels are most commonly associated with–oil. Did you know that the world uses 30 billion barrels of oil each year? If you stacked 30 billion barrels on top of each other, you would form a chain of barrels that extends all the way to Barreltonia, the mythical home planet of the barrels. You don’t need a calculator to tell you that there’s an awful lot of that “B” word floating around.

boobies spelled out on an upside-down calculator

No, not that “B” word. Barrels!

Why Your Portfolio Needs More Barrels

I know what you’re thinking: barrels haven’t been used to transport oil in decades. Instead, it all gets shipped around in oil tankers and trucks. But consider this: are not tanker ships simply giant barrels of the sea? And correct me if I’m wrong, but oil trucks sure do look like big barrels with wheels (which may also be barrels themselves).

Consider the recent surge in oil prices that sent a barrel of oil skyrocketing to nearly $80. Was it the cost of oil that sent it that high? Surely not; there’s tons of the stuff all over the world! No, my fellow investkateers, I submit to you that the price of a barrel of oil climbed so high because of the cost of barrels.

And if you don’t believe me, consider this graph from the National Barrelogical Institute which shows historic barrel prices:

historic barrel prices, 1200 BC - 2006 AD

And if that’s not enough to motivate you to turn your barrels of cash into barrels of barrels, then check out this lovely footage taken at this year’s International Barrel Traders Conference:

OMG BARRELS INVEST INVEST INVEST

(Note that this article is meant to relay financial information, not provide financial advice. Should you invest in barrels and lose tons and tons of money, don’t go blaming me. And don’t expect to sue me and get any money back because all of my cash is tied up in barrels, too.)

Saturday, July 29, 2006

And the Winner of the Super Stock Pick Tournament Is…

Author: Nick
Category: Money
Topics:

and the super stock pick tournament winner is... meeeeee

ME! How much do I rock? Totally much!

In case you’re new here, I’ve been running a little bit of a fake tournament made up of teams of five stock picks as an experiment in investing. Some team rosters were selected intelligently, others randomly. We’ve gone from 32 teams five weeks ago to just two this week. The two remaining teams were Nick’s Picks, a group of five stocks selected semi-intelligently by yours truly, and Internet Slang, a sorta-random group of stocks chosen solely because their ticker symbols were internet slang terms like LOL or BRB.

And even though Internet Slang has been kicking butt the last few weeks and rose 8.5%, they were no match for Nick’s Picks this week which finished up 22.69%.

I’ll post a more detailed analysis of the tournament next week, but here’s how the final brackets look for those who are interested…

honest, i did not fix this

Oh, and stay tuned to Punny Money in coming weeks for another round of the Super Stock Pick Tournament where you’ll have your own chance to go up against other teams for the tournament crown… and prizes!