Confusing Investment with Consumption: Emotional Attachment & Resale Value Transform Gold into Lead

"Practical Wealth V. Phantom Wealth" covered how to measure your financial wealth accurately by accounting for liquidity and stickiness (resistance to change). This article now covers how people reduce their liquidity without realizing it.

Consumerism Alchemy: Turning Assets into Consumption

Most people realize that some assets such as cars depreciate and the depreciation supposedly represents the consumption or usage of the asset in wear-and-tear. However, many people then assume that any retained or core value at any point in time is a positive asset (often for their supposed "net worth")--but people often behave in ways that turns an asset into additional ongoing consumption.

2 ways in which "retained" asset-value becomes consumption:

• The Resale Value Trap: Resale value is an "entry fee" surcharge and should be kept as low as possible. Resale value is a marketing trick to encourage overbuying. Never trading down (liquidating an expensive asset and buying a cheaper one) means that any core value is consumption, an expenditure never to be recouped. Some people fool themselves into thinking that they pay for car depreciation but “keep” the resale value, which is untrue, practically speaking. If you continually trade-in cars when they reach $10k value, that $10k (plus any interest) is forever lost as permanent consumption, an "entry fee" for "getting in the game."
• The Emotional Attachment Trap: Emotional attachment is a form of illiquid stickiness that turns an asset into ongoing consumption. Count your car only if you are willing to trade it for a junker. Otherwise, it is phantom wealth because you would never tap it. Instead of disaggregating the value of basic transportation from surplus conveniences (CD player, etc.), you are treating the whole, indivisible car as psychic consumption. Do not count your grandmother's wedding ring if you would never sell it despite defaulting on your mortgage.

Next: Best-Worst Financial Measures: How To Track Your Financial Independence and Security

Practical Wealth V. Phantom Wealth: Time Your Money

Time Is Money

Timing Is Everything

"Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?" covered how "net worth" and assets can trick you into the illusion of financial health (phantom wealth). Instead of net worth, use realistic measures of accessible wealth to rate your fiscal health. Too many people ask the "How much?" question but forget the crucial "When?" question.

Liquidity: WHEN you have money is as crucial as HOW MUCH.

Try calculating your wealth in the standard money measurements of liquidity to measure how much buying power you actually have at different time horizons, from immediately through the medium and long terms: Make your own personal M0 (“M zero”), M1, M2, and M3:

• M0 = Cash.
• M1 = M0 + checking or other “demand” accounts.
• M2 = M1 + savings accounts up to and including insured CDs (<$100,000).
• M3 = All money.

Compare cash with obligations at each time horizon (week, month, year, before age 59 1/2, etc.--including any withdrawal penalties). What if you lose your job, get sick, wreck your car, or have a house fire? You should have cash for small or likely or short-term events, scheduled liquidity for medium-term events, and use available credit or insurance only for the biggest, unexpected, unaffordable events.

Working Capital a.k.a. Operating Capital

Current Ratio = current assets divided by current liabilities

"Current" means liquid, liquidatable, or due within a time period. A potential pitfall is that, with a time period such as "this year," current assets include expectations of future income: Beware of relying on Accounts Receivable, including future wage paychecks, because they are not "a bird in the hand." If you have been opting for overtime pay recently, that precedent is no guarantee that you always will be able to choose your take-home dollar amount. Do not count your chickens before they are hatched.

Liquidity Ratio = liquid assets divided by expenses
Assume your income suddenly becomes $0. How long would you last? A typical recommendation is a 3-6 month buffer, and the self-employed or irregularly-employed are more likely to keep even bigger buffers for longer lean times.

Accurately Rate the Liquidity of Your Non-Money Assets

Rate the realistic time horizon for liquidating the asset (Week? Month? Year?) before you include it in your appropriate "time horizon" assessment of wealth.

Be very cautious in counting non-money assets because their ownership is "sticky" (resistant to change). The stickiness might be due to legalities such as a car title, or regulations such as car inspection (it is grandfathered but would fail a new inspection), or transfer costs such as a sales tax. Both time-to-sell and sales-price can change with events, such as a CNN expose on how your car model is a death trap.

Even more importantly, emotional attachment is another form of stickiness that confuses investment with consumption.

Savers Are from Mars. Debtors Are from Venus. Episode 2

Mind-Boggling True Story

Like Mother, Like Daughter

Deborah Beatty has no job but took a mortgage for a new New Jersey 3-story home with a view of the Manhattan skyline and Statue of Liberty and then did not pay the payments. Her daughter makes less than $20k/yr as a graduate student but took a $600k mortgage split into 8.75% and 12.5% interest rates and then did not pay the $5k/mo payments—maybe because the payments were more than 3 times (300%) her entire gross income.

“Beatty acknowledged the mortgage was probably too good to be true” (Union-Tribune of SD).

On what planet is $600k debt @ up to 12.5% and payments 3x gross income “good”?

(The quote might only refer to the mother’s unspecified loan but I suspect that she approved of her daughter’s loan and that the mother's loan was little better.)

Take the quiz: Do you find these loan offers attractive or repulsive? Answer in comments.

Dropout Pays Cash for Home

So many people imitate the most popular but unhealthy ways of finance that it is important to know the full range of possibilities in order to make an informed decision. Here is a parable of a hypothetical Jack and Jill.

How to drop out of high school and pay cash for a house at 21 years old (legally and honestly)

Jack drops out of school at 16 and gets a GED by taking the test. He gets entry-level jobs totaling a modest 60 hours per week (still time to take a community-college course) and $25k per year. Living at his parents' home with free room and board (as a normal teenager would do anyway), it is possible to save $15k per year and still keep some pocket money. An after-tax 5% interest rate compounds to about $100k while age 21, mostly before he is old enough to legally drink his paycheck at bars.

Jack can buy a $100k home in cash, or marry Jill who did the same plan so they can buy a $200k home with no mortgage, or the interest alone will pay for most of a studio rental while about $10-15k per person per year continues to go into the bank.

Jack and Jill might have risen to assistant manager by 21 years old and, with no home mortgage, it is affordable to finish the college degree in cash.

There are many ways to reach your goals, as long as you have a good plan.

Wealth through Garbage: Your Garbage Never Lies

Garbage men can spot a recession before some economists.

Landfills see shrinking deposits as the economy declines, because of a “double whammy” of people using things longer before throwing them away and postponing new purchases which means less product packaging in the trash.

Your garbage is your financial planner.

What is your garbage telling you? Is it filled with plastic “clamshells” and Styrofoam padding from all your new toys? Is it filled with single-serving food wrappings or, even worse, bulky prepared-food, disposable containers? How much waste does your garbage audit reveal?

Your mission, should you choose to accept it . . .

You will find that wiser spending correlates with less trash. Several curb-side trash barrels per week could indicate a problem. Aim for one barrel per month.

How To Save Money: Make Patterns Work for You, Not against You

Spot Patterns.

Track Patterns.

Make Better Patterns.

Spending Awareness

Everyone should know that trying to save the leftover scraps of a paycheck never works.

Reverse that recipe for failure by 180 degrees.

Plan to save most of your paycheck and leave the leftover scraps for discretionary amusements.

• Each transaction can risk a “leak”: In olden days before direct deposit of paychecks, you cashed out each weekly paycheck before depositing anything (sometimes minutes before, sometimes a week before), so there was a risk to hold on to your pay as cash and then fritter away the money. If you visit the ATM more than you visit your family, there is a temptation to round-up your spending “needs” at each ATM visit and then fritter away the overestimate (plus maybe pay fees each time).
• The invisible minus: Credit and debit cards are even more tempting to spend than cash because you do not do an actual tit-for-tat physical exchange at the purchase. Instead of having to leave cash behind in the store, you get your card back plus the new stuff.

The solutions are:

• Minimize the number of transactions/handling.
• Make debits highly visible at the time of purchase and after the spending euphoria fades.

Be creative in how you do these solutions:

• Pay cash or record your shrinking account balance at time of purchase.
• Post every receipt on the refrigerator (a cluttered refrigerator should tell you something—no, not to buy a bigger fridge).
• Get cash once a month for the entire month and seal your weekly gifts to yourself in an envelope.

What method works for you?

Please share by posting a comment.

Savers Are from Mars. Debtors Are from Venus. Episode 1

Mind-Boggling True Story

Debtor: “I’m going to buy a new car.”

Saver: “Why? Your Honda Civic might go another 100,000 miles. What’s wrong with it?"

Debtor: “It’s going to be paid off soon.”

Take the quiz: Would you buy a new car or not? Answer in comments.

Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Beware Phantom Wealth

Many people misuse "net worth" both on financial blogs and offline. Net worth is a simple snapshot for an immediate liquidation. Positive net worth is "solvent" and negative net worth is "insolvent" (unable to pay all your creditors even if you sold everything immediately). However, most people have no intention to liquidate and misapply the measure for long-term planning. Here are the 3 biggest mistakes that can fool people into false complacency:

1. Paper Profits: Investments have not made a penny until you cash out the profit ("realize" the gain). The housing bubble is bursting and middle-class people are waking up to find that their houses are worth $100,000 less than they thought. 401k profits are unguaranteed against market losses and uninsured against blatant theft. One 61-year-old woman found that her 401k lost nearly a half-million dollars before she knew it and a fraud victim found a 401k account cleaned out at $0. Social Security is no better, as those periodic statements of future payments include fine print that declares the estimates void of any guarantee, and the government rewrites your fictional “account” balance any time it wants by changing the retirement age or changing the calculation formula.
2. Real Costs (Present Value, Future Value, and Time Value of Money): Not only is $1 today worth more than $1 tommorrow in a typical inflationary environment, but people forget that different discounts apply to different assets/liabilities. $10,000 in a mutual fund does NOT cancel out $10,000 of credit card debt if the fund earns 11% but your debt costs 13%. Instead, you would lose about $5,000 over 40 years so, if you are trying to measure your long-term financial health, you should discount your mutual fund to $5k or increase the debt value to $15k (I will adress the misuse of tax-deduction modifiers in a future post). Another dangerous ommission is tax liability.
3. Illiquidity: It is not your money anymore, or not yet, as nowadays so many people sign away rights to their money by chasing tax deductions which restrict access. Whatever money people do not make inaccessible in retirement funds, they trip over themselves to bury in real estate (more on this in a future post).

Phantom Wealth and Broke Millionaires

These factors can result in an alleged paper “millionaire” who cannot make a mortgage or car payment. There are people who complacently carry tens of thousands of dollars of credit card debt because of an imaginary "wealth effect."

As for restricted nanny-state allowances (Social Security, IRA, etc.) and non-money assets (home equity), most people will not convert them into direct buying power until almost 70 years old (relocating home equity from one address to another does not change anything)--and maybe never before they die (when the heirs liquidate the house to pay off the legal, tax, and health-care bills).

Meanwhile, borrowing against assets is a sucker's game.

Resist the urge to borrow against your inaccessible wealth. Paying the interest penalty to borrow against asset value tells you that the asset itself is unavailable, which is why you have to pay someone else to use your own rumored "wealth."

That is quite a trick, being “wealthy” and still having to borrow money. If your "net worth" meant that you actually had money, you could lend to other people and make money by earning interest--instead of losing money by paying interest. Some people pay twice, since they paid an 8% mortgage to "build equity" and then paid another 8% for a home equity loan, which combined is not much different than a 16% credit-card rate. Try defining your wealth by the absence of borrowing.

Next: Learn how to measure wealth realistically in "Practical Wealth V. Phantom Wealth."

How To Avoid Debt: Stop the Debt Spiral before It Starts

The best way to avoid debt is to question why you are considering debt and reckon your happiness in both the debt and no-debt alternatives.

Let's say you want to buy a $200,000 house. The best method is to pay cash. Who has that kind of money? You do, and more, if you are willing to take a mortgage for it, because you pay the full price plus interest eventually. Right now, setting aside fees, etc. to simplify the example:

• Buying a $200,000 house with cash costs you $200,000.
• Buying a $200,000 house with a 15-year mortgage costs you $300,000 ($100,000 interest).
• Buying a $200,000 house with a 30-year mortgage costs you $440,000 ($240,000 interest; the interest exceeds the house price).

Why would you want to pay $10 for a $5 sandwich, $40,000 for a $20,000 car, or $440,000 for a house that is only worth $200,000?

Joe Consumer orders gadgets online or buys trinkets while traveling to save a few bucks of sales tax but then spends an extra quarter million dollar surcharge (mortgage interest) on the biggest purchase of his life.

Yes, inflation and tax deductions slash the pain but not the point.

How To Borrow Money Wisely: Do's and Don'ts

The best loan is the one not taken but if you must:

Do the Whole-Household Worst-Case Scenario

• Spot logical fallacies. Forget expert recommendations or the plan that "most people" choose. They are not you. Do the numbers make sense for you?
• Forget eligibility limits of maximum loans, which are enticements to "overbuy" the lender's product (overborrow). What you could borrow is irrelevant. Stick to what you need and nothing more.
• Demand the disclosure of all payments over the lifetime of a loan (avoid the trap of low installments that add up to far greater final cost, especially through negative amortization).
• Check the bottom line of total costs, including combined interest rates, fees, surcharges, taxes, or required insurance. A favorite trick is to say things such as "5% more" or "5% over" and people hear "5%" even though the total interest might be 10% or higher.
• Question all assumptions (e.g. adjustable rates "estimated" to rise very little). Forget what "probably" will happen according to the optimistic salesperson ("You can always refinance later."). What "could" happen on the downside? Spot oxymoronic, tricky weasel phrases such as, "At worst, it probably won't go higher than . . . ." Probable is not the same as possible.
• Consider not only "worst case scenario" with that isolated loan but consider a combined worst case for your entire household (all current liabilities plus possible future medical emergencies, employment interruptions, etc.).
• Review all final written terms at the moment of closing. Do not rely on what the proposal was yesterday and especially do not rely on verbal assurances.
• The first thing to do with final papers is to check the last few pages, because a favorite trick is to pack surprises at the end of a stack of papers for when you are tired, bored, running late, and deeply "invested" in a long process (surprisingly, even people who spot a problem will succumb to a "too late" feeling, which of course is the intent of the trick).
• Take as much time as necessary to understand the final terms. The rushed sell is one of the oldest tricks so do not be intimidated. A broker in a hurry should have gotten up earlier that day or can return tomorrow. The broker will warn of dire consequences but Rule #1 of business deals is, Be willing to walk away. Feel free to make people wait for your signature--because that quick scribble represents years of your life.

Avoid Debt “Anti-Scam” Scams

Everyone Wants To Believe in the Tooth Fairy and the Free Lunch

People who get themselves into debt problems often do so by wanting to see the best and ignoring red flags so they can sign on the dotted line and get instant stuff. When considering a contract or loan, there is a temptation to ask the right questions but accept dodgy answers that do not add up, so you rationalize that you “did your part” and any later problem will not be your fault. That is a self-deception because you are the one who will be left holding the bag.

Debt Relief: Out of the Frying Pan, into the Fire

People who get themselves in debt trouble are unfortunately likely to repeat the same mistake for the same reason by desperately wanting to believe that some debt-relief expert can provide a painless way out of a debt problem. Some companies charge up-front fees but offer no success guarantee. Some companies offer to take care of everything (sending the mortgage payments, negotiating with banks) but—as you discover too late—did not do so.

You are ultimately responsible and you suffer the consequences so the sooner that you accept responsibility and stop wishing for the too-good-to-be-true short-cut, the sooner you can establish a solid financial foundation.