Chapter 4
How to think about money
Level I: It’s not just about spending
Get yourself a nice, crisp one of these:
Now prop it up on the table in front of you and give some thought as to what it means to you. For instance…
You might think about what you could buy with it right now. One hundred dollars buys a very nice dinner for two at a good restaurant. A fancy pair of sneakers. A tank of gas for your big- ass pick‘em up truck. A few bags of groceries. Maybe a nice sweater? I dunno. I don’t buy much stuff, so this is hard for me. I did just buy a $119 L.L. Bean bed for my dog. It’s going back.
He won’t sleep in it.
You might think, Mmmm…I could invest this money.
Historically the stock market returns somewhere between 8-12% a year on average. I could spend that each year and still always have my $100 earning more for me.
You might think, but inflation and market drops are a concern.
I’ll invest my $100 but only spend 4% a year. Any extra earnings I’ll re-invest so my $100 grows and the money it throws off keeps pace with inflation.
You might think, I’ll invest this money and I’ll re-invest what it earns and then re-invest what that earns, and years from now, after the power of compounding has worked its magic, I’ll think about spending it.
You can probably come up with other variations, but looking at these it’s easy to see that one view will keep you poor, one will get you into the middle class, one will take that a step further and the last will make you rich.
Consider Mike Tyson Mr. Tyson was one of the most intimidating and formidable boxers of all time. Few have mastered the “Sweet Science” (boxing) better. The “Dismal Science” (economics)—not so much. After earning some $300,000,000, he wound up bankrupt. A lifestyle reputed to cost $400,000 a month didn’t help. And as is always the case with the suddenly wealthy and financially unaware, I suspect sharks looking to bite off chunks of that fortune for themselves rapidly surrounded him. But the root of the problem is that at the time he understood money only in terms of buying stuff.
I don’t mean to pick on Mr. Tyson. (I’m not NUTS after all.) In this attitude towards money, he is not alone. The world is filled with athletes, performers, lawyers, doctors, business executives and the like who have been showered with money that all too often immediately flowed right off of them and into the pockets of others. In a sense, they never really had a chance. They never learned how to think about money.
It’s not hard. Stop thinking about what your money can buy. Start thinking about what your money can earn. And then think about what the money it earns can earn. Once you begin to do this, you’ll start to see that when you spend money, not only is that money gone forever, the money it might have earned is gone as well. And so on.
Clearly, none of this is to say we should never spend money. Rather, it is to fully understand the implications when we do. Consider buying a car for $20,000.
Even the least financially sophisticated person should see that once you buy the car you no longer have the twenty grand. I sure hope so, anyway.
However, distressingly it appears that most people don’t understand that in choosing to lease or borrow money to buy their car they are basically saying, “Geez. I don’t want to pay twenty thousand dollars for this car. I want to pay much, much more.”
Level II: Consider Opportunity Costs
What you might not have considered, and what I’d like you to look at now, is the concept that even if you pay in cash, that car is going to cost you far more than $20,000. There is an opportunity cost to no longer having that money available to work for you. “Opportunity cost” is simply what you give up when you commit your money to one thing (like a car) over another (like an investment), and it’s easy to quantify.
All you need to do is select a proxy for how the money could be invested and earning for you should you choose not to spend it. Since I’ll be constantly talking about (and explaining) VTSAX (Vanguard’s Total Stock Market Index Fund) later in the book, let’s use that.
For now, all you need to know is that VTSAX is a total stock market index fund and as such it mirrors the market’s average returns of 8-12% annually. As our proxy it gives us a tangible number to use as our opportunity cost. Let’s use the lower end of the range: 8%.
At 8%, $20,000 earns $1,600 per year. So your $20,000 car actually costs you $21,600. The original $20,000 plus the $1,600 it could have earned. But that’s just in the first year, and you are suffering this opportunity cost every year. Over the 10 years you might own the car, that’s 10 x $1,600: $16,000. Now your $20,000 car is up to $36,000.
That’s really still understating things, however. We haven’t even considered what those annual $1,600 chunks could have been earning themselves. And what those earnings could then have been earning. And so on.
Should you not already be depressed enough about all this, remember that the $20,000 is gone forever and so is the $1,600 in lost earnings year after year with no end. At the end of the day, it’s one expensive damn car.
You have probably heard of “the magic of compounding.” In short, the idea is that the money you save earns interest. That interest then earns interest itself. This causes a snowball effect as you earn interest on a bigger and bigger pool of money. Like the snowball it starts small, but as it rolls along it soon begins to grow in a rather spectacular fashion. It’s a beautiful thing.
Think of opportunity cost as its evil twin.
One of the beauties of being financially independent is that by definition, you have enough money such that the power of compounding is greater than the opportunity cost of what you spend. Once you have your F-You Money, all you need do is make sure you continue to reinvest to outpace inflation and keep your spending below the level your stash can replenish.
If you are not yet financially independent and you see this as an attractive goal, you’ll be well served to look at your spending through the prism of opportunity cost.
Level III: How to think about your investments
Warren Buffett is rather famously quoted as saying:
Rule #1: Never lose money.
Rule #2: Never forget rule #1.
Unfortunately, too many people take this at face value and leap to the conclusion that Mr. Buffett has found a magical way to dance in and out of the market, avoiding the inevitable drops. This is not true and in fact he is on record speaking to the folly of trying: “The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.”
The truth is that during the crash of 2008-9, Buffett “lost” about 25 billion dollars, cutting his fortune from 62 billion to 37 billion. (That left over 37 billion being the reason I was wandering around at the time irritating friends by saying, “Gee. I only wish I could have lost 25 billion!”) Like the rest of us, Buffett was unable to time the market and in fact, knowing market timing to be a fool’s errand, he didn’t even try.
But unlike many others, Buffett didn’t panic and sell. He knew that such events are to be expected. In fact, he continued to invest as the sharp decline offered new opportunities. When the market recovered, as it always does, so did his fortune. So did the fortunes of all who stayed the course.
That’s why I put “lost” in quotes.
Now there are likely many reasons Mr. Buffett didn’t panic as that 25 billion dollars and all the potential it represented slipped away. Having 37 billion left surely helped. Though another clue is in how he thinks about the money in his investments.
Mr. Buffett talks in terms of owning the businesses in which he invests.
Sometimes he owns them in part—as shares—and sometimes in their entirety. When the share price of one of his businesses drops, what he knows on a deep emotional level is that he still owns precisely the same amount of that company. As long as the company is sound, the fluctuations in its stock price are fairly inconsequential. They will rise and fall in the short term, but good companies earn real money along the way and in doing so their value rises relentlessly over time.
We can learn to think in this same way. Again, let’s use VTSAX in exploring this idea.
Suppose yesterday you said, “Mmm. This idea of owning VTSAX makes sense to me. I’m gonna get me some.” And having said that, you sent Vanguard a check for $10,000. At yesterday’s close the price of VTSAX was $53.67. Your $10,000 bought you 186.3238308 shares.
If VTSAX shares are trading at $56 per share a week from now, you might say, “Mmm. My $10,000 is now worth $10,434. Yippee. Mr. Collins sure is smart.”
If, however, the shares are trading at $52 per share a week from now, you might say, “Damn. My $10,000 is now only worth $9,689. That Collins guy is a bum.”
That’s the typical way average investors look at their holdings. As little slips of paper or, more accurately in this day and age, little bits of data that go up or down in value. If that’s all they are, drops in the price on any given day can be very, very scary.
But there is a better, more accurate and more profitable way. Take a few moments to understand what you really own.
At $56 per share or at $52 per share, you still own the same 186.3238308 shares of VTSAX. That in turns means you own a piece of virtually every publicly traded company in the U.S.—roughly 3,700 the last time I checked.
Once you truly understand this, you’ll begin to realize that in owning VTSAX you are tying your financial future to that same large, diverse group of companies based in the most powerful, wealthiest and most influential country on the planet. These companies are filled with hardworking people focused on prospering in the changing world around them and dealing with all the uncertainties it can create.
Some of these companies will fail, losing 100% of their value. Actually, they don’t even have to fail and lose all of their value to fall off the index.
Just dropping below a certain size or what’s called “market cap” will be enough.
As those fall away, they are replaced by other newer and more vital firms. Some will succeed in a spectacular fashion, growing 200%, 300%, 1,000%, 10,000% or more. There is no upside limit. As some stars fade, new ones are always on the rise. This is what makes the index—and by extension VTSAX—what I like to call “self-cleansing.”
If I were to seek absolute security (a very different thing than the smooth ride most mistake for safety), I’d hold 100% in VTSAX and spend only the ~2% dividend it throws off.
Nothing is ever completely certain, but I can’t think of a surer bet than this.
We live in a complex world and the most useful and powerful tool for navigating it is money. It is essential to learn to use it. And that starts with learning how to think about it. It is never too late.
Oh, and somebody please send Mr. Tyson a copy of this book. It’s not too late for him either.