Thursday, June 9, 2011

How do you tell if the shit is hitting the fan?

Many folks don't take action until it is too late.  Why?  Because oftentimes things appear to be normal, when in fact, they are seriously wrong.

Pffft!  Pffft!   Pffft!   The gentle sound of fecal matter hitting rotating fan blades and splattering all over the room.  What?  You can't hear it?  Listen more closely.

Most people are not very skilled at understanding when bad things are about to go down.  People on the Titanic didn't think the boat was going to sink, until the bow was under water.  How could the boat be sinking?  The lights are still on, and the bar is open, right?  But people who qualitatively analyzed the rising water levels realized the boat was going down, in a matter of hours.

In your personal life, things can go horribly wrong and you may not realize it.   You sit down to pay your bills and at the end of the evening, you've made at least the minimum payments on all your bills, and have money left over in the bank!  You must be a financial genius!  The bar is still open and the lights are still on.  Everything must be OK.  Right?

Wrong.  Making your current bills is not an indicia of your financial health.   And you could be sinking, financially, and not realize it, if you are not monitoring your real financial stats.

Your Net Worth is one of these - but it can be just as misleading as being able to pay your bills.  Monitoring your Net Worth is not just an exercise in narcissism, but rather a means of telling whether you are getting ahead in life, or sinking to the bottom.  Checking this on a monthly or at last bi-annual basis is important.

But as I noted, it can be deceiving, and in the Real Estate meltdown, many folks were fooled by rising Net Worths into thinking they were getting ahead, when they were actually falling behind.  The problem was, of course, the staggering rise in Real Estate values - or phantom values.  In 2007, sitting on six properties, I could argue that my net worth was over two million dollars.  But of course, most of that was phantom equity - not real money.

And moreover, what most people did was take out that equity, in the form of loans, rather than sell off the properties.  As a result, their debt load increased as well as their asset values.  Since houses (and stocks) were rising more than the amount of debt they took out, they could kid themselves they were "richer" - when in fact they were getting poorer.

Similarly, if you use things like cars, boats, and other depreciating assets in your net worth calculation, you can fool yourself into believing that buying a brand new Lexus doesn't affect your net worth.   On one side of the balance sheet, maybe you take  $40,000 out of savings or borrow that amount - which is a negative.  And yet on the other side of the balance sheet, you pencil in "2011 Lexus, value $40,000" which of course is a bit optimistic (it was worth $36,000 the day you bought it, as it depreciated 10% the moment you drove it off the lot).

Worse yet, the car will continue to depreciate, while the loan payments or dent to your savings remains.  At the end of five years, you are $20,000 poorer, no matter what.  But initially, it may appear that the change to your net worth is zero, or near zero.

Similarly, your Net Worth can decline, and your real wealth actually increase.  For example, recently the stock market dropped several percentage points.  If you have a lot invested in stocks, this might drop your net worth by several thousand dollars - or tens of thousands of dollars.  But usually, these stock market dips are just a transitory thing.  Your finances are not shaky as a result of these market mood swings.  If you take this as a sign of trouble and sell all your stocks (as many did, in February 2009) then you lock in your losses and then you really are in trouble.

Phantom (paper) losses in stocks and phantom (paper) gains in Real Estate have one thing in common - they mean nothing, until you cash out and realize those losses or gains.

Your Debt Load is probably a much better "miner's canary" of personal financial trouble, and in the 2000's we all took on more and more debt (I know I did).  For most people, when you start out in life, you may need to borrow money for school or for a house.  But as you get older, you should be paying down debts, not taking on bigger and bigger ones.  Most people of our generation did just that - approaching retirement with staggering debts, instead of making the last payments on their mortgages.

If your overall debt load increases every month, then you are falling behind, plain and simple.  Credit card debt and home equity loans (often tied together, as one is paid off by the other) are insidious as they can creep up over time, and you don't notice the trouble as you are "making the minimum payments" on the cards or other debt.

But like the rising water in the hold of the Titanic, eventually it reaches a point where the ship will sink.  And then you realize that your minimum payments were only forestalling the inevitable, not preventing it from happening.

Many people kid themselves that debt load doesn't matter - and often happy bankers will helpfully suggest this.  "I'll always have a mortgage" one baby-boomer says, not realizing that the $3000 a month they make in retirement will barely cover their mortgage payment, much less pay for food or even the light bill.

You should calculate your debt load every month - like clockwork - if not more often.  Add up the total amount of your debts - car payments, credit cards, mortgage(s), student loans, and the like.  If the number is greater than last month, then you are robbing Peter to pay Paul, and likely are falling behind.

Of course, some may argue (and have a point) that if you buy an investment property, your debt load will go up - but that since your net worth is increasing by the value of the property, AND you have a positive cash flow, your financial situation is actually better.  And yes, this is probably true - and such a one-time increase is not a sign of financial difficulty - in that situation.  However, if you have miscalculated your operating expenses on the rental property and your debt load continues to increase, because you have a negative cash flow on that property, well, the shit has hit the fan, my friend.

Some others will argue that "moving up" to a larger house doesn't count either.  Yes, you have more debt, but you have this honking big house to show for it.  Here, the problem is, a personal residence doesn't make money for you, so borrowing more to have more house is sort of like buying the car - it doesn't really add to your bottom line.  And oftentimes, the expenses of larger homes can cause your credit card debt to skyrocket, as you spend all your time in Lowes and Home Depot fitting out your new digs.

Income of course, is one economic indicator that might indicate trouble.  But like expenses it can be deceiving.  For example, my income has dropped in recent years.  But, my debt load has gone to zero, and my expenses are far lower as well.   My actual disposable income is higher, my savings rate is higher, and my net worth is going up - which illustrates that making more money doesn't always mean you are richer - only making more money.  And you can actually be richer while making less money - depending how you spend it or save it.

Nevertheless, if your income drops precipitously, you should anticipate that the shit is going to hit the fan and take action to ameliorate the consequences.  Business as usual is not the answer!  See my previous posting on this.

For me personally, I sensed the shit could hit the fan, if I did not take action soon.  We sold out of the Real Estate market in 2007, which was a good move.  But we did buy a lot of house - or two houses - for our personal use, which in retrospect was an expensive luxury.  We didn't rent them part-time when they were not in use, either, which was stupid.

With the recession, business has dropped off, and increased competition in our business has meant that fees remain flat.  I have enough business, it just doesn't pay as well as the "good old days".

While I was making my bills on time and my net worth was doing OK, my debt load was increasing, or at the very least, not decreasing fast enough to suit me.  It would have taken years to pay down that debt - perhaps decades, and it would have been a long, hard slog.  Moreover, any illness or disruption to my business would have been catastrophic - we didn't have enough in reserve to cover all the bills.

But for five years, things seemed to go on as before - from a Qualitative standpoint.   The light bill was paid, and there was always food on the table, and good wine.  And the BMWs were always waxed and polished and full of gas.  And I probably could have continued that way for another five years, if I chose to.  But it was a lot of work, and with Real Estate values being flat, the net payback for "holding on" was going to be slim.

So we sold it all, and paid off all our debts - BEFORE the shit hit the fan.  And it was a smart move, in retrospect, as for one thing, I don't have to worry so much anymore about work or making money.  A client calls me and says he wants me to work on a project.  I can afford, now, to say, "I don't want to work for you, I'm afraid."  Before, they would have me over a barrel, and that is never, ever a place you want to be.

And of course, this means that I can personally weather any further financial storms in a much better fashion - since our monthly overhead is lower.  Loss of income today is not as big a deal as it would have been a year ago.  And the same after-tax savings will now last years, not months, as before.

If you can figure out, years in advance, where things are trending, you can do far better for yourself.  And oftentimes, the telltale signs are there for you to see, if you choose to see them.  But most of us rely on Qualitative versus Quantitative data.  Everything "seems" to be going well and the bills are all paid, so we must be doing all right.

But eventually, you will hit retirement age, and by then, you should be debt-free.  From age 40 onward, the goal should be to reduce debt, not increase it.  And if you find your debt load creeping up and up, well, Pfft!  Pfft!  Pfft!  I think I hear something!

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