By BOB CUNNINGHAM
Have you heard the phrase, “conventional wisdom?” It’s typically used when information is thought to be so common-sense correct and accepted, that numerous alleged authorities echo the same sentiment, thought, or advice.
When preparing to cross the street, it’s conventional wisdom to look both ways. Okay, no argument here.
But in the personal finance niche, I have learned over my 30+ years enrolled in TSOHK (The School of Hard Knocks) that conventional wisdom isn’t always the savviest take, nor can it be assumed to be applicable, or even helpful.
Sometimes, it can be downright detrimental.
In this week’s BWE post, I want to talk about some examples of when conventional wisdom simply isn’t the best way to go about your money life. Now, to be fair, not all of these are blatantly false. It’s just that in some cases they over-simplify a topic, and while I’m usually in favor of keeping things straightforward, I’ll never support the notion of bypassing applicable specifics.
So, without additional adieu, here are some money misconceptions:
1) All debt is bad. As noted author Robert Kiyosaki of the pioneering finance and investing book, ‘Rich Poor Dad,’ has often said, there is most definitely such a thing as “good debt” as well as bad debt. Kiyosaki correctly postulates that good debt is used to buy assets, such as stocks and bonds or investment real estate, and bad debt is associated with credit card debt and other methods of purchasing liabilities – things that depreciate over time.
But I’ll take it a step further in noting that a debt doesn’t have to directly purchase an asset in order to be good debt, even if a liability is being bought. If the debt, in itself, creates the opportunity to profit, I believe it should be considered good debt. This scenario is most common when discussing home mortgages – low interest rates, the interest being tax deductible. Mortgages, when utilized correctly, can be truly valuable. But there are other ways to reap these types of benefits.
For example, say you need a new car – not brand new, necessarily, but an updated vehicle because your current wheels are costing you too much in repair and maintenance. Because of your stellar credit, you qualify for 1.9% financing through your bank. You’re looking at spending about $20,000 on a certified pre-owned car.
Should you pass on financing the purchase because you’re acquiring additional debt? Maybe… if you can’t afford the monthly payment in your current circumstances, none of the forthcoming pointers will truly be applicable. Still, go with the point I’m making here and let’s assume your budget allows for the payment.
Being that this is for buying a car, are we to assume automatically that this is bad debt? After all, the car will most certainly depreciate in the coming years, right?
Most people would read the above and suggest, “sure the terms are great, but you’re still better off paying cash if you have it available.” I disagree, because what is being overlooked – and this happens frequently – is the opportunity cost.
Instead of forking over $20K on the car up front, what if I can put that money to work earning, say, 4-5% with tax-free access to this money if I ever need it, and still acquire the car? Wouldn’t that be a 2-3% positive Rate of Return over what the auto loan is costing me? Sure is. And if you’re thinking perhaps that the small profit I’ve illustrated would be devoured by the car’s depreciation, that really isn’t so because the car will go down in value over time regardless of how I buy it. In other words, if I pay $20,000 cash now, the car will still be worth only $15,000 (or less) in two years. How I went about buying the car isn’t really relevant.
In short, it actually makes (arguably) more sense to take advantage of the ultra low-cost financing, put the cash to work earning more than that, and still drive my nearly-new ride.
2) Live below your means. I really hate this expression, which virtually EVERY financial guru insists you must do, because it is so vague. If the key is to avoid unnecessary spending, just say that. But even then, more specificity is needed. If you go out to the movies once a month as your sole entertainment, you’re certainly spending money unnecessarily – you don’t HAVE to go see the flick. But obviously, if that is your only fun all month long, you’re most certainly living below your means.
I’m also opposed to the concept that you have to set a living standards guideline. Determine your fixed expenses, and your necessary discretionary expenses, then decide how much of what’s left from your paychecks you’re comfortable with saving and investing, and otherwise live normally. Make a reasonable, thought-out plan, pay yourself first before you do the rest, and have a life. Progress doesn’t have to be excruciatingly painful.
3) Tax-deferred is better. There are some pretty savvy financial minds out there who harp on the idea that if you can defer paying income tax until later, you’re going to be better off because more of your money is working for you. Sounds logical, but I will prove it’s balderdash.
The most obvious example is a Traditional IRA (or an employer-sponsored 401K), which uses before-tax income to be funded, with taxes not due until you take the money out down the line. This is opposed by the Roth IRA, which uses after-tax money now, and allows you tax-free withdrawals later.
A quick look at the numbers through an example: Teresa opens a traditional IRA and commits to putting $200 per month into it, for 20 years. For this exercise, we’ll assume a 25% income tax bracket and a 7.2% rate of return on the invested money. Richard goes the Roth route, and so his after-tax monthly contribution (based on the same 25% tax rate) is $150 per month, again with the same 7.2% ROR. Where will each be in 20 years?
TERESA: $200 per month for 20 years = $48,000 invested. At 7.2% ROR, her account balance after 20 years, according to a financial calculator at www.bankrate.com, is $103,844.78.
RICHARD: $150 per month for 20 years = $36,000 invested. At 7.2% ROR, his account balance after 20 years is $77,884.34.
Now of course, Richard has already paid his income taxes, so he keeps the whole $77K+ should he choose to take it out. Teresa, however, still owes the 25% income tax. Her balance after paying the tax? $77,884.34.
Well, how ’bout that! In the end, with both getting the same ROR and owing the same percentage of income tax, they come out exactly the same. Except for one thing… Teresa paid $25,960.44 in tax, while Richard paid just $12,000.00 ($50 per month times 12 months times 20 years). Which do you suspect hurts more – $50 each month on the front end, or more than $25K straight to Uncle Sam in exchange for simple account access?
This example demonstrates why the government loves deferred taxes – because it makes more money that way. Those who insist that tax-deferred is the better method fail to understand that the extra compounding in the account benefits only the government, NOT the account owner. Why? Because unlike you, the government doesn’t pay taxes (to itself) on the gains.
One last point: Is it feasible to conclude, based on the current national financial state of affairs (i.e. the national debt nearing $20 trillion!) that tax rates might very well be higher down the road than they are now? I believe so. Sure, they might go down… but who’s willing to bet on that? Pay now-pay nothing later is a much safer and prudent way to go. As many before me have pointed out, would you prefer to pay taxes on the seed, or the harvest?
4) Average Rate of Return is important. Another fallacy I enjoy debunking. It sounds innocent enough – “the average rate of return for the ABC Fund over the last three years is a sparkling 15%!” Really? Okay, well’s let’s consider the following scenario and see if a 15% average annual ROR is truly beneficial.
ABC FUND: Year 1 ROR = +30%, Year 2 ROR = -55%, Year 3 ROR = +70%. Average ROR annually over the three years = +15% (30 – 55 + 70 = +45 divided by 3 years = +15 per year). Total opening balance in the account at the beginning of the three-year period: $10,000. Total after the three-year period at 15% annual average ROR = . . . $9,945.
Whaaaaat?? We actually fell by 55 bucks? What the fudge?
Yep, it’s true. And this is just the investment itself. It doesn’t take fees into account.
How can this be? Run the math, my friends. After Year 1, with a 30% gain, you would have $13,000. After Year 2, down 55%, you would have $5,850. After Year 3, even with the monstrous 70% gain, you end up with $9,945.
The above is an example of Wall Street ‘gotcha’ at its finest. Losses matter much more than gains. If you have $1,000, and lose half (50%) the first year but gain half in the second, are you now back to even? Nope… you’re still down 25%. When you drop 50%, you need a doubling (100%) gain the next year just to get back where you started. Crazy, but true.
The big banks and investment companies don’t want you to understand this, which is why keeping full control of your assets, through sometimes unconventional strategies like whole life insurance (see last week’s post) is the only way to really know what you have and, better still, what you can expect to have at any point in the future. Steady gains every year, even small ones, are much better for you in the long run.
Once again, thanks for reading.
DISCLAIMER: This post represents the author’s opinions only. In no way should any part of the content of this post be interpreted as official financial advice, nor does it represent an intention to solicit readers into a specific company or investment. Results are never guaranteed. Utilize the information as you see fit, make all money decisions at your own risk.