Wednesday, November 16, 2011

Economic Gauge Package

Engine gauges used to be prevalent in cars and are still common in boats.  Just as these gauges monitor several different aspects of engine health, your financial health requires monitoring of several different factors.

How are you doing, financially?  Are you in good shape, or going bust?  Most people have no idea - and that is one reason why, when they go broke, it comes as a rude surprise to them.  However, if you had been reading the gauges to look for changes in income, expenses, cash-flow, net worth, and the like, you would see problems coming up ahead and be able to take action accordingly, to limit financial damage.

With engine gauges, you can monitor a number of factors of your car's engine - and some of them are more important than others.  For example, if your oil pressure drops or the oil pressure light comes on, you have literally seconds to shut down the motor before you damage the main bearings or seize the engine.  On the other hand, if an engine gets hot, you may have minutes of time to shut off the engine before it seizes.  And yet other problems, like the alternator light (indicating a blown alternator) may allow you to drive for dozens of miles, before the battery drains to the point where it will no longer drive the ignition and engine computer.  Different gauges indicate different things - with different levels of urgency.

From a financial perspective, I think you need to monitor a number of "gauges" in your financial life, to determine your overall financial health.  And unfortunately, most of us, particularly in our youth, look only at one gauge - the speedometer - to see how fast we are spending.  We trade long-term engine damage for the short term "whee!" of smoky burnouts and drag racing.

The following are a number of "gauge factors" in no particular order of importance, that I think anyone needs to monitor, in order to maintain their personal financial health.

1.  Spending:  Most folks, including myself (at one time), tend to spend until they run out of money.  And then they borrow more, in the form of credit card debt.  And ironically, most folks monitor only spending, as if it were the most important gauge of their financial health, when in fact, it is just the speedometer.  And online programs like Mint and the like, do little more than gauge your spending.

While it is true you should track your spending, most folks gauge spending only in terms of how much they can spend (more, to them, being better) and how much they are "saving" by using coupons, discounts, and other ancillary deals that distract them from the fact that they are, well, spending.

The spending gauge should be monitored, to be sure, but not to see how fast you can go, but how to keep it at a steady speed over time - even if you end up with more gas in your tank.  The problem for most of us is that as our incomes rise and our wealth increases, most of us spend more, thinking we are "entitled" to it.  Accumulating wealth requires that you spend less and save more.  If you can live on X dollars a year, why increase that number merely because your boss gives you a raise?

Monitor spending and take action to reduce it if you see it creeping up.  And it always creeps up.  And even if it isn't creeping up, figure out ways to spend less, if you can, to increase your surpluses.  Dropping unnecessary services and toys is one big way to save big money.

2.  Income:  Monitoring income is also important, but again, most of us do this horribly wrong.  We look at income as something to be divvied up into little pie slices and spent - on things like smart phone service plans, cable TV, car lease payments, and house payments.  At the end of the month, if anything is "left over" (money is never "left over" just as there is no such thing as "spare change") we save it.  And guess what?  We end up not saving as a result.

Income is not a fuel gauge - an indicator of how much you can spend.  But you should monitor your income and take action to throttle back your economic engine if you see it dropping.

In the recent recession, you hear many a sob story from people being foreclosed upon.  They signed a toxic-ARM mortgage, which was bad enough.  But then their income dropped - sometimes voluntarily - and they wonder why they can't make their payments.  "I quit work because of disability" one says, while another pipes in, "My wife quit work to stay home with the kids".  Their incomes drop by half, but their lifestyle remains the same, and they sit in wonderment why they are on the side of the road, gas can in hand, hitchhiking.

If you have a drop in income, it is like the oil pressure light going on. You need to shut down NOW before it is too late.  But in many cases, I have seen people, out of pride, continue spending to "keep up their lifestyle" and tap into their 401(k) or borrow against their house, rather than cut back to live on their new, reduced income.

3.  Cash Flow:  Again, a lot of people live the cash-flow lifestyle, which is the wrong way to read this gauge.  Most folks look at money coming in and then think of ways to spend it going out.  Cash flow is basically the difference between Income and Spending (items #1 and #2 above) just as an ammeter in a car shows the positive of negative charge flow going to or from your battery.  You should be charging your battery, not discharging it.  Your cash flowing out should be less than the cash flowing in.   If it isn't, you are living beyond your means, plain and simple.  And while you can do this for years and years, eventually, the battery goes dead and the car comes grinding to a halt.

4.  Debt Load:  Many folks increase their debt load over time, from when they are in their 20's until they are in their 40's.  And today, many folks keep increasing their debt load well into their 50's and 60's, as they had children late in life and have to borrow to put them through college when they should be thinking about retirement.

Debt load can be scary.  At one time, I had over a million dollars in debts, in the form of a number of mortgages on my home and my investment properties, as well as credit card debt, car loans, and other consumer debt.  At the time, I felt, "Well, I am making all the payments, and the properties are going up in value, what's the big deal?   The bank thinks I am good for it!"

Wrong answer.

Many a night I would stay up and wonder, "What if the properties go down in value?  Suppose my income drops and I can't pay some of these debts?  What happens then?"  And worry like that is what made me "sell out" and cash in.  I own a lot less stuff now, but at least I own it - debt-free.

A lot of other folks were more blasé about debt load, and felt that since they were "successful in life" they could afford ever-increasing debt.

Yes, you will take on a lot of debt as a youth - your school loans, your first mortgage, etc.  But over time, if you want to get ahead, you need to work on reducing, not increasing debt.  Avoid "moving up" to that larger house, if it means more debt.  During my parent's era, increases in property values (and paying down mortgage balances) meant that you could "trade up" to a larger house and have the same mortgage payment - or less - than before.  Combined with increasing incomes over time, this meant you became wealthier as you became older.

Not so, today.  Most folks crank up their debt load with each raise in salary, so they remain "house poor" for their whole lives, just in a nicer house.

And note that debt load directly affects your cash flow requirements.  Just as each of the readings on gauges on your car affects the other, your "debt load" gauge reading directly affects your "cash flow" requirements.  The more debt you take on, the more money you have to earn to pay it off - with interest.   Getting rid of all debt should be everyone's goal, over time.  Once you are debt-free, your cash-flow needs drop precipitously.

5.  Savings:  Your savings should increase over time, and the amount you save, until a certain age, should increase as well.  When the cash-flow gauge goes negative, many folks try to limp along for a while by not putting money into savings.  This works for a while, but eventually they start taking money OUT of savings.  And eventually, they start taking on debt.

If your savings contributions are dropping, that is a sign that your financial health is dissipating and you need to take action.  It is, in effect, your fuel gauge, telling you how far you have left to go.  If the gauge is going down, you might be headed for trouble, unless you are an oldster in retirement.

On the other hand, if your overall savings is increasing, due to market value increases, this is no reason to celebrate.  In the 2000's, one reason so many people spent more than they made was that their savings increased in value with the stock market.  They felt "rich" because their 401(k) statements and their housing values were fat.  On paper, they were millionaires - so why not live like one?

Again, wrong answer.

It is great when your investments do well, but it is no cause for overconfidence.  Just because you are making money in the stock market is no reason to stop putting money aside.  And that is exactly what many of us did in the 2000's - convinced that market growth alone (or increased housing values) would make us rich, and we didn't have to put aside money anymore, but spend it instead.

6. Net Worth:  Arguably this might be the most important gauge of your overall financial health - but few people bother to read it.  Reviewing your overall net worth is a useful exercise and something you should do at least annually, if not monthly.  It is not hard to set up a simple chart using a spreadsheet program, or even a chart in MS-WORD that lists all your assets and their values, lists all your debts, and then calculates your net worth.  You can even use a pad and pencil, if you are not computer literate.

I keep these sheets in a binder, and over time, I look at the numbers and see where it is going.  Yes, it will jump up and down, over time, based on the market.  But you can see your debt load and your savings change over time, and figure out, for the long haul, whether or not your tired economic engine is going to "make it" to retirement age, or blow a valve beforehand.

But again, net worth alone is no indication of your overall health.  You can have a healthy net worth, but a declining income and negative cash-flow.  And in fact, a healthy net worth may mask the symptoms of major engine damage, until it is too late.  You may think, "Well, my income is down, but I have a lot in savings".  But if you don't cut spending to match income, that savings will evaporate like ice cream on a hot stove.

* * *

Monitoring your economic health and getting a real picture of where you stand requires that you keep track of more than just one factor.  And unfortunately, the media tends to hype on individual factors as indicia of your overall health.

For example, in the media, your salary is touted as the key to your financial situation.  If you make the fabled six-figure salary (and so many do these days) you are "rich" - right?  Well, not exactly.  As I have noted time and time again, if you are making $100,000 a year and spending $100,001 a year, you are basically broke.  Or even $250,000.  And even Congressmen do this - the ones who are supposed to be leading us out of this mess.

Income alone is indicia of nothing.

Similarly, the media, though advertisements, touts spending as an indicia of wealth.  If you spend money on a new car, new clothes, new cell phone, then you are "rich".  If you can afford a $10 cup of coffee, then you have made it, right?  But the reality is, you can't spend your way to wealth.  And you can't get ahead by chasing coupon deals and discounts.  Spending more is not wealth, but merely spending.

And that is where it gets tricky.  Monitoring all of these factors at the same time is hard to do - like flying a helicopter and trying to control the cyclic, the collective, the throttle, and the tail rotor, all at the same time.  Changing one control input alters the others immediately.  It is only until you get a visceral sense of control, that you can do it without thinking - and in fact, if you have to think about it, you can't do it.