We are bombarded with a plethora of information on how to asses and value companies. I wanted to chime in and actually talk about analyzing and valuing companies in the context of practicality.

We have all read books on value investing and many of those books are the 101 foundations of how to approach markets and how to think about Mr. Market and it’s participants. As an avid reader of many of these books who holds them in high regard, I do feel that a lot of new investors get lost in trying to find the next steps.

I believe that books have their place but a bigger focus on reading financial statements ++ (10K, 10Q, 8K, proxy statements, investor relations resources, wall street publications etc.) should take up more of your time as your investing philosophy evolves.

First, all analyzing and valuation begins with numbers. You need a good, reliable source of datasets that provide you with numbers that you can work with. You have to think of yourself as a data analyst initially; sifting through and compartmentalizing data to make sense of the broader picture. I believe that numbers speak louder than words (albeit, the story has it’s place and is also very important).

I should add that this is only meant for those that think with a 3-5 year timeframe minimum (with a bottom-up approach), anything less is too fractal and random for me to work with. If you have the IQ to constantly crunch numbers in your heads and work out probability trees with certainty and act on it, then this is definitely not the right guide – you belong at a hedge fund btw.

The most important information is contained in the 3 financial statements and the notes that accompany it (to help make sense of the 3 statements for adjustments and quality of earnings).

Income Statement is the name of the game for anyone breathing on wall street or Omaha. Here are the numbers to focus on when it comes to the income statement:

1. Revenue: First, you want to analyze the trends and growth; Qualitative Tip (QT): you want to know how they’ve been growing. Is it organic, if organic is the marketshare growing or the price/mix changing or the volume increasing in the static marketshare or is it acquisitions that are accretive.

• Once you understand the revenue sources, segments, and where it’s coming from you will be able to anticipate the lateral and vertical moves of the future.

1. You want to home in on the Operating Income. I believe, OI is an extremely important element of assessing the moat, the competitive advantage, and the management capability of exploiting it (synergistic with Revenue) – understanding the OI will allow you to basically understand the ‘economics’ of the company. COGS/SG&A are the most impacted items when business cycle change and we have +/- inflation, interest rate changes, valuation movements, and dark clouds on the horizon. Between Sales and OI (before D&A), you can have a very good idea of what you are looking at and how it’s being run; interspersed with Revenue study, it can help you stand out from the crowd.

• Historical study at this point makes for highly lucrative edge in the markets.
• I would also like to add that I consider EBITDA as the Operating income of the company because of it’s clarity. Rightfully so, some Wall St’s consider this the Cash Flow which I disagree with.

Further down Income statement needs to peppered in with a historical understanding of taxes, interest and any ‘extraordinary’ and or ‘non-operating’ expenses of the company under study. Once you start to become better at breaking apart the financial statements, you will be able to find the true Net Income which is often very different than the reported earnings. Most of these items require switching over to the Balance sheet so you can understand the Capital Structure and other tax assets/liabilities being generated (often the reported tax on Income statement is different than cash tax).

• Majority of your time on breaking down the numbers should be spend on these items below the Operating Income as this is where accrual vs cash accounting muddies the water most.
• Referring to the Cash Flow Statement at this point would make your work very efficient in understanding and adding back non-cash expenses to derive the true Net Income.

Now I am going to take a big leap and say that you have the EBITDA and the true Net Income calculated, understood, and internalized at this point.

• If you can go back 10-15 years and record the reported Net Income, true Net Income, and EBITDA, you edge will become emphatically more pronounced.
• Warren Buffet is notorious for never creating models and making decisions from historical information. The reason why he has so much clarity with his investments is due to the reliability of what has been reported. That’s not to say that models (3 statement models + DCF) are useless, it’s just that that they are more meant for ‘selling’ investments and less ideal for making long-term decisions.

Cash Flow Statements should be mixed in orange juice and served at breakfast for any true investors. Understanding Cash flow statements is extremely important because a business may ‘document’ earnings and EPS on an accrual basis but collects actual cash to pay off expenses and liabilities. Your owner’s earnings are also derived from cash flow statements. Your ability to predictably calculate true Net Income will require a back and forth reference to the Cash Flow Statement.

Here are the key items to focus on: Reported Net Income, D&A, restructuring and or other extraordinary and non-recurring charges, other income (not part of the operating business), deferred taxes, stock compensation… this is where you will have to make judgement calls on what to include and exclude from non-cash/non-operating expenses and earnings to get to a historically accurate true net income.

• Also, true Net Income + D&A and few other non-cash/non-operating expenses and earnings based on my personal judgements as a business analyst = Cash Flow generated in a year as far as I am concerned.
• Change in working capital is important if it’s deviating from the historical norms, a growing company will have to invest more in WC to keep up with the demand. Also, during business cycle troughs, WC will likely become capital intensive as inventories and AP/AR build up and stagnate, respectively.

So: “owner earnings = true Net Income + depreciation, amortization +/- other non-cash charges – average annual maintenance capex +/- changes in working capital,” becomes our basis of actual earnings to the owner.

Further down the Cash Flow statement, Capex will be listed. Some companies will break apart the Capex from maintenance and growth. We always use maintenance for the purposes of Owner’s earnings and EBIT. Some also list software expenses, and while other investors capitalize R&D as part of growth capex which can be/is classified as reinvestments for deriving sustainable growth.

• Cash Flow after Capex will allow a company to pay dividends, buyback shares, pay down debts, square away retirement obligations, and retain leftover for continue reinvestments in high margin projects that generate a durable moat (ROIC:moat, competitive advantage).

Balance Sheet is also extremely important and is a snapshot in time. Balance sheet speaks to the ability of the company to survive, thrive, and keep up with the changing dynamics of the business cycle. Credit companies utilize ST and LT Debt ratios against OE/EBITDA/EBIT/Interest Expenses to derive their ratings and move the lever of covenant controls on companies. Liquidity and Solvency ratios are of paramount importance for any investor and should be calculated for each company under study.

• A/R to Sales is also a very important metric to gauge the quality of sales and often presages revenue and earning troubles in the quarters and years ahead.
• Operating cycle & other popular ratios are important, but I have yet to find how they can help me make decisions as a majority of my investments are at times when the numbers tell me not to buy (and historical and future industry analysis (story) does).
• Your ability to understand the riskiness of the company will stem from your understanding of the capital structure and how it has evolved and where the management thinks it’s going. Studying shareholder equity along with St/Lt Debt will help you fine-tune your valuation as well.
• Finally Return on Total Capital (ST+LT+EQUITY ((few adjustments), my definition), along with ROC (Return on Capital) – Greenblatt way which is very close to how Buffet talks about the ROUNTA (Return on Unlevered Net Tangible Assets) are all different names of the same concept which help us investors understand Capital Employed to returns generated ratio. This is a very important concept to become grounded in as this derives your future organic growth assumptions. ROIC (whether NOPAT based or OE based) along with reinvestments will help you value companies and create a band within which your company’s stock price will fluctuate. You can backtest your derived valuations EBIT/EV or P/E ratios against the last 10-15 years to feel confident in your valuation process.

Further growth, going back to studying the Revenues and OI, will come from product/price mix up, gaining more marketshare, acquiring competitors, evolving business models, targeting different niches, and rolling up small innovations which almost start to argue for a 3 financial statement models + DCF. I would highly recommend that you stay away from it because the amount of work that goes into it and the level of return (other than psychological) is not worth it as your scenario analysis is not more accurate than thinking through how the economics of the company will evolve based on a historical/industry understanding. Uncertainty creates opportunity, models breed overconfidence. Bull makes money, bears make money, pigs get slaughtered.

Now Returns: Returns are not the discount rate that you use.

• Returns are the buybacks, dividends and growth of the OE that will be reflected in the value (stock price).
• Again: Returns are not the discount rate that you use.
  • i.e. 1000 OE at 10% is 10,000, 5000 OE at 10% is 50,000, and 250 at 10% is 2500. It’s a change in price based on a discount rate, not a return to you. It can serve as a return if the P/E expands or a loss if it shrinks. If you buy at a P/E that doesn’t include growth that your thesis believes is possible, then discount rate can be a source of return, but I argue, you should value it with the growth assumption included as it will be more accurate and help you buy at the low-end of the valuation band.

Valuation (brief discussion): Discount rates can be any discount rate that you want. If the entire market is using WACC and you are using 10%, very likely the stock will correspond to the wisdom of the market as everyone votes on how it should be valued. I think of discount rate as a starting point – shiller is 16 P/E, very likely that’s the mid-point of all Large/Mid-caps – you can gain more clarity by studying the P/OE of companies and use a mid-point of the company under study. If you do want to use WACC because you feel more comfortable moving in tandem with the masses then you will have to re-calculate a FCFF value as WACC includes the debt weightage and will throw your valuation askew with the OE number. This is a longer topic on it’s own so I will leave it until my next valuation post.

• I do not use a DCF model to value companies, I use basic discount rates to calculate PV of the future cash flow. I buy when my 3 scenarios, gleaned from an intense historical/industry study, allow me to enter at the low-end of the valuation and I hold and study quarterly and annual results until the investment return materializes as per my thesis.

QT: Industry analysis and competitor analysis is also extremely important. You want to understand the make up of the industry. You want to understand the players in the industry and what kind of marketshare they have. You want to briefly understand what they are good at (vertically integrated vs diversified sourcing etc.), and you want to understand what drives that industry (KPIs). With the historical context of the company and the key drivers of the industry painting a picture of the near future, you want to step back and take a 30,000 foot view (forest from the trees) and play the company forward, specifically Revenues, EBITDA (OI), Capital Structure, ROIC, and returns to the shareholders in the form of buyback/dividends/growth over the next five to ten years. By this time, you will have done everything that you possibly can without getting granular on next quarter/year minutia and with qualitative insights backed by quantitative valuation to make a YES/NO decision. That is your edge – long-term arbitrage.

Five additional thoughts:

-Volatility is a gift.

-Debt/Liabilities/Obligations/Covenants/other dilutions are the risk that should be factored into your valuation even if the market doesn’t, your goal is total in-hand cash just like a small business that you own.

-Just like the beauty contest, average of the average is the place to be.

-Positive expectancy will mean that even if your thesis is wrong, your long-term results will be positive (law of large numbers).

-Market may not look insane for a long time, but markets get really insane for the patient.

Final prose, I am not an expert (if that’s a thing), so I am always open to learning more, do share where you differ.

As much as I am a fan of the FIRE community and the focus on paying down debts and increasing your net worth, I am also always looking for ways to supercharge my portfolio.

You’d find numerous examples of people who have a different way of approaching investing from dividends, to day trading, to ETFs & index, and to simply dollar cost averaging. I believe all of have a place in the world as the equity are a positive sum game.

Circle-K (ATDB.TO) caught my attention as I was researching for ways to expose some of my savings to the oncoming paradigm shift towards EV from fossil fuels. The current valuation of the company, in accordance with the Cash flow and Earning Per Share, makes this an ideal time to invest in this company.

Circle-K has a portfolio of over 9,000+ convenience stores and gas station across North America, South America, Europe, and East Asia. The company is being neglected at the moment due to soft sales from the “Road-side” segment stemming from the Covid-19 reduction in total km/miles driven in the national average.

The tendency of traders and often short-term investors is to neglect any company that is facing medium-term headwinds is uncanny. Often this irrationality makes buying great companies a worthwhile exercise as long at the hold position is 3-5 years out.

As a majority of our investments are invested for the 10+ year period, adding some great companies in the portfolio and holding them for the long-term makes perfect sense as well. However, we should avoid the internet and the paid services on the internet guiding our investment philosophy. For that reason, I have spent the better part of the last decade researching and studying the process of finding really good companies to hold them for the long-term to add to the index returns.

The goal of any investors with the long-term mindset should be to meet the index returns first, and exceed the index returns second – given that the investor understands that the excess returns require far more work than is necessary to be a successful long-term investor and often entails it’s own risks.

I am a great believer in the bogglehead approach of indexing. I am also a human, a businessman, and a capitalist. To each their own.

It’s a time of celebration for many, for some, it’s a time of anguish and sadness. While others, despite careful planning and a big nest egg, they feel that they don’t have it in them to hang it all and walk away. Retirement, now more-so than ever, is becoming a ‘personal’ decision, rather than one which was dictated to us by the finance professors. In the context of Human Capital, retirement comes when you primary years of working based on your profession has allowed you to unlock all of your financial capital. Sometimes that could happen earlier, given the pace of change in technology and irrelevancy of skills, and sometimes it happens later for the growth-oriented evergreen individuals. Really though, Retirement in this context, starts when you begin to draw on your financial capital, instead of your human capital. When that shift happens, whether earlier or later in life, you have officially initiated a phase in life that will be very different than when you planned for all of your financial milestones.

This time of your life requires a need to create an income stream without relying on your human capital. During the Golden Years of the past few decades, many organizations worked with the employees to help them smooth out their retirement if they dedicated their life to it. What they offered was something called the “Defined Benefit Plan.” As per the defined benefit plan, you are entitled to receive a pension that will help you transition into retirement without worrying about investments or withdrawal rates.

The way a Defined Benefit Plan works, for example, is taking the years of service, let’s say 30 years, and taking your annual earnings towards the end of your career, let’s say $100,000, and then multiplying the years with the earnings and then multiplying it again with 2%. So $100,000x30x2% = $60,000 annual pension for the rest of your life. Wow! those were the days (are for some that are still on a defined benefit plan).

In those golden days, the greater the number of years of service, the greater your salary towards the end of your career, the greater your pension! Also, this pension is guaranteed never to decline and may even increase if there’s a cost-of-living inflation adjustment built into the plan. This type of a plan created the employee that your father and grandfather were. They loved their job, they got to work on time, they gave it their all, and they never though about job hopping or a $10,000 pay raise elsewhere. These organizations had really found a way to keep their retention low and build the skill levels of their internal talent to grow companies! They also allowed the transfer to a survivor in case of an untimely death or a longevity risk of living till 95-100! Good lord!

Sadly, many employers have been cutting down on this kind of a plan and replacing with something that is completely different. In order to save money and increase the shareholder’s value, organizations and municipal governments have been replacing the Defined Benefit plan with the Defined Contribution Plan. A Defined Contribution Plan is no different than a 401k or an RRSP, a tax-sheltered saving plan that an employee contributes too and the employers matches up to a certain number, usually 5% of the contribution. Pocket change, in my opinion!

More than likely if you work in the private sector in the United States, there’s only a 15% chance that you are covered by a Defined Benefit Plan. More than likely, if you do have a plan, for the 40% of other employers, it is a Defined Contribution Plan. In the Government sector, there’s a 74% chance that you have a Defined Benefit Plan. In Canada, there’s a higher percentage of Defined Benefit Plans out there because the Public sector accounts for 19.3% versus 6.3%, in the United States. This is the main factor that, on average, more Canadian are covered by a Defined Benefit Plan. The pension plans are dying faster in the United States than in Canada, but they are dying, nonetheless!

All of this means that the liability of your old age is falling from your employer or corporate balance sheet to your personal balance sheet. This could’ve been predicted with the rise of the shareholder’s value maximization that came into effect in the 80’s.

Behavioral financial research indicates that income from a defined plan with a stable, guaranteed, lifetime source of funding, creates happier retirees. As people age, the increasing mental decline and diseases like Alzheimer’s create a need for an autopilot of retirement income fund. Whereas, those with a tax-sheltered account, experience a decreasing rate of happiness and satisfaction.

Another interesting study showed that happiness was the highest among retirees with a Defined Benefit Pension plan, moderate if you had no pension plan, and the lowest, if you had a defined contribution plan. I feel that this is due to the increasing age and need for management of the funds and how it will play out in your much older years. Again, it shows that instead of it being a corporate liability, it has become a personal balance sheet liability with yet another financial decision to manage into your retirement. It’s very sad to see the rise of Defined Contribution Plan, in place of, a defined pension.

Initially though, the Defined Contribution Plans were created due to the demand from some employees who wanted more mobility in their careers and a need to manage their own finances. The savings for corporations from this changed, essentially, changed the paradigm for everyone where the responsibility became the employees altogether.

Once you enter retirement, those who have been following the Human Capital Value series, you transition from withdrawal from your Human Capital to your Financial Capital. If you made rational forward-looking decision, you should see a smooth transition without a drop in your living standard. If, however, you have not been following the smooth consumption throughout your life, you will see a drop or a gap in your standard of living. Often, these retires wake up to realize that they have to tighten their belt to survive.

One good news for the retirees, whether in smooth consumption model or superfluous lifestyle model that they followed while working, is that they can use some of their time as currency to reduce their costs of living. As they say time is money, in retirement, you can spend your time looking for cheaper deals, go to multiple stores to purchase an item for the cheapest price, you can walk to the superstore and other life hacks to replace using monetary currency for time currency. This finding was researched by the University of Chicago and the Federal Reserve Bank to explain the 30% drop that retirees tend to experience in their spending as they transition.

The other arguments by people is the inheritance that they expect to receive as the Baby Boomer retire across North America. According to BMO Retirement Institute, Canadian’s averaged $56,000 in inheritance, while Americans averaged $64,000 from inheritance. This is pocket change and definitely not worth celebrating.

If all of this has you down and your company doesn’t offer a Defined Benefit Plan, you can still shop in the market for plans that make sense. Instead of trying to figure out everything on your own, you have a choice of buying an Annuity Plan that helps with longevity, need for planning till a very old age, protects against longevity, and offers Spousal transfer in case of an untimely death. Also, if you plan rationally, keep Human Capital Value as the framework to make all lifelong financial decisions, saving and invest money, you can create your own personal pension plan that pays out a withdrawal of 3.5-4% that can easily sustain you against all risks. We will cover retirement strategies in another article, but know that despite the corporate belt tightening, you should still continue to invest and save in a smoothed consumption pattern.

People dont’ usually make financial decision, they tend to fall into them. People sometimes think that the siociety either expects them to buy something, or they have reached a point in thier life where they have to it, or they just listen to other people and buy something that they’re not ready to use. By not following a framework, any framework, they set themselves up for regret.

The stock markets are volatile, your company doesnt offer pensions, you have too many kids, you bought a house bigger than you needed becuase you could afford it before the recesssion, your neigbour bought a new car so you bought one too. There are multitude of reason fo why we make purchases, we are not always rational and this has created quite a stur in the financial community and especially among the financial researchers. The ever increasing need to figure out human consumptin patterns has given us a lot to learn from. After having read the last few articles in the series, you are better than 99% of those that have never factored in any other scenario other than if they have the money to buy something, or credit.

Some want to start saving and investing, yet the 50% drop in the markets, the complexities of investing, the high fees charged by banks, the unwillingness to follow and create a budget, are all valid human reactions. Despite all of those things, you still have to make decision. Now you can either fall into those decisions as the majority of people do, or you can adopt a framework to make those decisions.

In that spirit, I want to invite you to start at the begining of this series and start learning about the simple framwork that can you make rational decision all thoughout your life.

Principal 1. Identify what your total Human Capital Value is.

Your biggest and most important asset is your human capital of your working life. it represents the discounted value of your future wages. We often undervalue and underappareciate this asset, especially earlier on in life. As you progress, you convert your human capital value into financial value. This financial capital you increase through saving and investing. It’s not just your capital assets, but also your Human Capital value that belongs on yoru persnal balance sheet. To truly understand your life values in a financial sense, you have add up financial and human capital value to find the true position in life.

Principal 2. Recognize and Budget for all hidden liabilities in your futre.

A truly healhty and realistic holistic balance sheet will account for the hidden labilities on your personal balance sheet. Many of the money minelstones you might pass through in life can add to the hidden liabilities side of your perosnal balance sheet – notably – marraige and children, although both might strengthen and add o your assets over time. Your capacity to generate income from your human capital also can create hidden liabilities, in that its loss creates a gap that you need to fill. A clear-eyed view at your life circumstances through the lens of human capital can help you identify, hedge, and bridge all the liabilities you encounter in life. Don’t add assets without subtracting any corresponding liabilities.

Principle 3. Division – Plan to spend your total resources evenly and smoothly over time.

WHen you recorgnize and account for the value of all assets on your personal balance sheet, devise a long0term consumption (or spending) plan that spreads your total (human and financial) resouces over your entire life cycle. It makes little sense to starve yourself for decades so that you enjoy life in middle age, or when you are old and frail. LIkewise, if you “live it up” today wihtout any consideration for tomrrow, you ight regret this as well. THink long term and avoid foreseable disruptions by budgeting for all predicatbale liabilities.

Princple 4: Multiplication – Perpare for many alternative and unexpected universes.

Recognize that there are many different future patths of your evolving human life cycle. At each instant in time there are infinite number of money paths and states of nature over hich your future develop. You owe it to yourself to consider all of them, today. Make sure that you make decision tha help smooth your ocnsumtion over all posisble paths and not just the expected or hooped-for path. So, insure against all catastrophic and unforeseeable disruptions. Be a smooth oepartor over time and space.

Money decision are universal. These principles should help connect the dots for many disperesed financial decisions in your ife. For exmaple, investing in what appears to be coslty education actually maximizes the value of your human capital; whereas borrowing money and living beyond you means is not necessarily inappropriate privided it smooths the ups and downs. Childeren initially may cause a reduction in disposible income and notieable longeterm reduction in your financial capital but might also defuse some long term retirement liabilities, other than the other nonfinancial pleasures they bring. A fraction of your lifetime HUman capital belongs to your business partner, the tax man so you have to be vigilant not to give him more than his fair share. Buying a house seems like the most disruptive of all financial transations, but in fact it hedges against future liabilities sometimes but it’s not prudent for everyone. Insurance smoothes out your consumption across alternative universeses. Retirement planning is about smoothing out consumtpion over your lifetime to stay protexted against the surprising risk of a long life.

The biggest reason for that is because the “hard” limit is really just an arbitrary number that makes sense from looking at the financials from far away. Often the purchase of a house is confused with a Home. This consequences of this mistake are huge. A home is any place that you live in with your family and you can comfortably live in it fulfilling your shelter needs. A house is an asset that you buy, at a reasonable price that will allow you to make it into a Home. So just by separating the house from the home emotion, you get ahead of crowd. Essentially, any decision made with emotions rather than logic, in the context of financial well-being, could have devastating consequences. Sometimes, you get lucky but this only makes you more prone to making more decisions with emotions eventually causing you to make a mistake.

The purchase of a house, being that it’s the biggest financial purchase, should be made with a logical framework, first and foremost. Within that framework, you have to figure out how you can turn that house into a home. Think of it as a step 1 and step 2 approach, which you cannot reverse. It is exactly what we do when we are purchasing a house.

In fact, as of 2007, 85% of the financial Net Worth of individuals is derived from their personal residence. For population under the age of 35, it represented over 220% of their net worth. For those 65 and over, it represented between 35% to 40%. Since 2007, according to the Survey of Consumer Finances, the primary residence of the whole population, increased initially to 65% or the holding, only to be reduced to 63%.

Ownership of primary residences also fell, from 65.2 percent of families owning a primary residence in 2013 to 63.7 percent in 2016.27 This decrease represents a continued decline since the 2004 SCF, when the home ownership rate was 69.1 percent. The conditional median and mean value of primary residences rose, however, by 6 percent and 11 percent, respectively. Among families who are homeowners, the median family’s home was worth $185,000 in 2016, up from $175,300 in 2013. This increase reflects widespread increases in home prices between the two surveys, although the drop in home-ownership rates indicates fewer families are sharing in those house price gains. Ownership rates and median and mean values of other residential property, which includes residences such as second homes and time shares, rose between 2013 and 2016.

Survey of Consumer Finances

Despite the decrease in the primary residence holding, reflecting the fear of the recent Great recession and Availability bias, the personal net worth is still strongly biased to a house ownership.

One of the biggest implication of this increasing allocation to housing on our personal balance sheet, is that our net worth fluctuates in lockstep with the value of housing. There is a trend of slowing home-ownership on the rise in the United States, but the debt on personal balance sheets for home-ownership is still the highest of all other debts. Education and vehicle debt seems to be increasing faster from 2013 to 2016, but it still pails in comparison to home-secured debt.

Paralleling the drop in home-ownership, rates of holding of home-secured debt fell between 2013 and 2016. The fraction of families with mortgages and other home-secured debt fell from 42.9 percent in 2013 to 41.9 percent in 2016. Home-secured debt, however, continued to be one of the most common types of debt held by families.

Survey of Consumer Finances

One way to explain the Availability bias in play is to look at what happened after the sub-prime mortgage crisis in 2008. According to Economy.com, a quarter of homeowners, 10 millions Americans, had debt that exceeded that value of their homes by mid-2009. This is known as as being upside down or being underwater on your mortgage loan. The gravity of this situation can cause anyone to shun home ownership for something safer. All of this is pointed out, despite what your mom said about home-ownership being the best investment to own, is not the risk-free investment it’s touted to be.

To really understand how the prices of homes have moved, the volatility of household net worth, in the past few decades, look at the chart below.

Ignoring the lack of historical perspective on home prices, and using the stratospheric increase from the early 90’s to early 2005, it explains why parents of millennials advocate home ownership. If you purchased a house in late 1990’s or in 2010, you would have definitely seen a great return, but only the foolish believe that they can time the market. Much like a retirement portfolio, a house is a lifelong asset, that you want to outlive you. Given the fluctuation, and removing any biases from the picture, in the last two decades, the home prices have only increased by about 3.5%, only keeping pace with inflation. Your capital in a portfolio would’ve earned you double of that with a lot more liquidity.

There is also another school of thought that says leverage increases returns on a house purchase that you cannot replicate in a retirement portfolio. First of all, I am not a huge advocate of leverage in an investment portfolio. Secondly, leveraged real estate has and can provide a much better return than any other unleveraged investments. It’s basic math.

If you have been following this series from the beginning, then you know how to create your own personal balance sheet. Most people finance the purchase of their house with a mortgage. Most buyers aim to put down 20% equity to purchase a home, although, some credit unions and bank allow for a much smaller equity deposit – which is a mistake. Let’s say that the purchase of your house cost you $500,000, which increases the asset side of your balance sheet by the same amount. If you put down $50,000 as a down payment towards the purchase, the $50,000 reduced your capital from the asset side, and the $450,000 increased the liability side of your personal balance sheet. Essentially, nothing changed in your personal balance sheet as the debt offset the increase in the asset.

To give you a benefit of the doubt, let’s say that you stayed in that house for five years and paid down another $50,000 towards the equity. Increasing your asset side and reducing your liability side. Still the both sides stayed the same and it hasn’t increased your net worth. Now if you purchased a home in 2005, and the home prices dropped by 20%, exactly what happened in the regions of United States due to the subprime mortgage crisis, this leaves you with a home value of $400,000. Essentially, wiping out your initial down payment and also five years of equity that you paid towards it. Yes, leverage can be good if it works in your favor but most people forget that leverage can wipe out years of gains, leaving you no further ahead financially in one stroke. It’s a double-edged sword that should be analyzed carefully and not when you are emotionally-charged and hope for a good outcome. If that’s what you consider an investment, you can do it a lot cheaper in Las Vegas and it’s a lot more fun.

First and foremost, a house should only be bought for consumption because it fulfills a needs. Only secondly, if it increases in value, should you think of it as a fortunate happy accident. In order to become financially independent, one of the tenants of that independence is having a place that you call home and doesn’t cost you more than you make. In fact, ideally it should be paid off by the time you initiate your early retirement. So think of a house purchase in context of how to expedite paying it off as quickly as possible and reducing the interest costs. If it increases in value, then it either doesn’t affect you or you can use the excess to downgrade and add the lump sum to your retirement portfolio. Speculating and hoping is a bad strategy and one that should be avoided at all costs. This is true whether you are thinking about investing, or purchasing a house.

Under the microscopic lens of Human Capital, an idea that we have used to discuss all financial milestones of our lives in the past articles, purchasing a home before the age of 40 doesn’t make sense. Think about it, your Human Capital is locked up and it’s only released slowly as we age and we move up the career ladder. By buying a house, you buy an asset that is illiquid and fixed in a geographic area. Your total wealth and earnings are sensitive to a bad economy, along with your primary house. In order words, it is very likely that if your job takes a hit, your real estate will take a hit too. If both of these take a hit, more than likely, you might have to either travel much farther away for a new job or to move to a new location altogether to replace the previous income. Renting, in that scenario, makes sense as it gives you geographic flexibility and reduces your sensitivity to a recession, all the while allowing you to invest the difference in an investment portfolio. If, however, you are in a recession-proof industry, go ahead and purchase a house earlier than 40 and work on paying it off.

It seems that most people underestimate the implicit and explicit costs of home ownership, and they overestimate the appreciation of home prices. Given your circumstances, home ownership could make sense if you live close to your family that could save you other family-raising costs, or increase the social capital around the neighborhood by investing in your neighborhood, and or if renting comes out more expensive than owning a property.

We have been looking at major financial milestones of our lives in the context of Human Capital in this series, to go back to the basics and see other article, start here:

Part 1: Human Capital

Part 2: Education

Part 3: Saving

Part 4: Debt

Part 5: Marriage & Kids

Part 6: Taxes

Part 7: Home Ownership

Want to buy an extended warranty on that?

Insurance is one of those requirements of life that don’t make sense at all. You cannot objectively define whether the said insurance will come in handy or not. At the same time, not having insurance causes extreme anxiety as the legal ramifications of not having it could literally bankrupt you, overnight. So the question is whether that extended warranty on a $20 computer mouse or the flood and structural insurance on your house is worth the premium.

What’s even worse with this whole insurance buying phenomenon is that you can buy an insurance for anything that you desire. I have heard that Jennifer Lopez insured her behind because it was a money maker for her, I am not sure if it is true but it sure is interesting. Often singers insure against their vocal cords going bad on them as well. If I was a metal genre musician, I would totally go for that kind of insurance – just given the probability of my vocal cords prematurely quitting on me!

As hilarious as some insurance stories maybe from your past – insurance is one of the major milestone’s of your financial journey. Knowing about what and how to buy insurance is crucial within the context of Human Capital.

The history of insurance is a long one and it goes as far back as the second or third millennia. It was really the Chinese and the Babylonian traders that practiced the early forms of it to transfer and distribute risk. If you are familiar with the ancient code of Hammurabi (you should look it up, if you are not familiar), it included a basic form of insurance to debtors against any act of God. It wasn’t until the monarchs of Persia introduced an evolution in insurance that we had the first record of insurance against human life in 550 to 330 BC.

Really though, the revolution of modern insurance didn’t start until 1654 when two renowned mathematicians and polymaths of the 16th century, Blaise Pascal and Pierre de Fermat, discovered and formalized a way to express probabilities. This invention and discovery allowed human kind to use probabilities to understand the level of underlying risk and calculate charts, same ones used now to calculate insurance premiums. These tables and charts are now used in the formalized practice of underwriting.

Anytime you take out a policy, the insurer uses the expertise of an underwriter to understand the risk of the insured-item and quotes a premium that justifies taking on that risk. Underwriting has become the backbone of today’s insurance business and actuarial sciences have become a formal field of study to become an underwriter.

In 1693, using Pascal’s table, the first form of life insurance was created in response to the Great Fire of London in 1666 that destroyed 14,000 building and left the survivors homeless. We cannot be more grateful to Pascal as his work is used by Casinos, Lottery Associations, Engineers, Scientists, and in investing.

In the context of Human Capital, what we have learned so far is that we have to take our lifetime earnings and divide them over our lifetime to create a Smooth Consumption model for many of our milestones. In this way, insurance plays a huge role as a chance of 0.1% that could cause you a loss of $1,000,000 and can dramatically wipe you out and decrease your standard of living. This will also have a lifetime impact on everything that you have planned up to that point. In that scenario, you are better off insuring against anything that could potentially have a devastating impact on your well being and on your Human Capital Value.

What if you could buy an insurance policy that you pay into on a monthly basis, one which could protect you from such a disruption? I wouldn’t be against that idea and not only that, I would fully support anyone taking out a policy that protects them against a disaster. So it seems that insurance is not only compulsory, if you want to practice living with the Human Capital mindset, but necessary to achieve your financial independence goals!

Basically, the necessity of insurance is so that you can plan the Smooth Consumption model and protect yourself against all catastrophic potential outcomes.

Let’s talk about how and when to purchase insurance to protect against potential catastrophe in an alternative universe. I believe that insurance should be used for anything where the potential loss could have a devastating affect on your smooth consumption lifestyle. If a $500 phone purchase is being done, I wouldn’t insurance against it as the original manufacturer’s warranty will protect you in most cases. If, however, given your stage in life that $500 is a large sum of money that will take you months to replace, I would go ahead if the cost of insurance makes sense to obtain it.

Another way to think about it is within the same context as insurance companies think about insurance premiums. First, the probability of the event occurring and second, magnitude of the catastrophe to your lifestyle and Human Capital’s Smooth Consumption. The lower the probability and the higher the damage, the more you should look into it.

Did you know that as of 2007, the total sum of life insurance in coverage was approximately $20 trillion dollar in the United States. In Canada, it was $3.1 trillion. This is the amount of money that would be paid out if all insured individuals died at the same time.

As bad as that sounds, in your life – your own death alone is a catastrophe big enough.

When you are making a decision to get life insurance, you are really hedging against loss of your Human Capital. As you buy life insurance, you have to keep in mind as to whom will benefit from it. If you are leaving behind a spouse or kids, you want to make sure that you carry enough life insurance that the Human Capital that you created up til that point, and of the future, is covered by a life insurance policy to take care of the beneficiaries. In case of an untimely death, your Human Capital is insured with a life policy that will go to those that were dependent on you – to at least, keep their Smoothed Consumption on track.

Going back to the lifetime Human Capital Value, it makes more sense to have life insurance when you are younger than when you are older. As you age, you unlock your Human Capital so with the passing of time, the need for life insurance should be reduced and you should have ample financial assets in place with the unlocked Human Capital. At an older age, instead of spending money on life insurance to reward your wife or husband for putting up with you, you are better off depositing that in a savings account.

In fact, Professor Solomon Huebner of Wharton School of Business at the University of Pennsylvania, was the first to describe life insurance as a hedge to protect “human life value.” Professor Gary Becker and Professor Theodore Schultz actually used Professor Huebner’s work to initially formulate the idea of Human Capital Value that you are reading here in this series.

In an interesting research in the Journal of Financial Intermediation, it was noted that those that are in the low-income households tend to carry no life insurance, or a very small amount that would materially reduce the standard of living of the spouse in case of an untimely death. On the other hand, it was noted that those in the higher-income household tend to carry more life insurance than is required to sustain the spouse’s lifestyle. Moreover, Florida State University researchers reported that an unusual spike is often reported in region purchases of life insurance that wasn’t, at first, explainable. After some analysis they found out that any time there was a threat of a disaster, or an important figure had suddenly died, or there was an act of god in another region, it would cause a spike in a close by region. When people consumed news of destruction or loss, close to home, they opted to sign up for life insurance more often. This was driven out of fear and the recency bias, as per the researchers.

These findings are important to discuss because it often explains how people think about insurance and why that’s not in accordance with the Human Capital thinking that we are discussing here. The idea is that you should protect against anything that is catastrophic and unlikely to occur.

Here’s a good way to think about insurance decisions:

• 1. There’s an 11.4% chance that you will live to 95, you should invest in a pension and possibly a life annuity.
• There’s a 0.62% chance that you will die within the next 5 years, if you have dependents, get a life insurance.
• If you need your toe for your job, and you lose it in an accident, a 0.012% probability, insure your toe!
• A 0.002% chance that an asteroid will hit the earth, don’t worry about insurance.
• What if a lightning struck you? a 5-20% chance or higher if you stand atop a hill with your umbrella pointing upwards, life insurance is enough. Also, invest in an education.
• Your iPhone screen will break, a 100% chance, it’s cheap to replace so don’t buy insurance.
• If it’s catastrophic to your financial well-being, and it’s unlikely – you should insure. The catastrophic event will be covered, and the unlikely will reduce your premiums!

For more of a practical approach, get credit cards that cover you against trip cancellation, car insurance, and extended warranties. Don’t purchase any extra insurance, or extended electronic warranties at all. Save your money!

I also suggest that you opt for the highest deductible that you can afford on all your insurance policies. First, it will reduce your insurance premiums, and second, it will create a habit for you to take care of your things. When getting house insurance, choose the highest deductible of $5000, then place that $5000 in a high-interest saving account. For car insurance, choose $2500, then place that $2500 in a high-interest account. This account should be separate from your “rainy day fund” account so it’s only used and replenished when needed. Your “rainy day fund” is also your deductible for your life insurance, it should also be invested in a high-interest savings account. These gambits can allow you buy the best insurance possible, but also save you thousands in premiums. Practice discipline when it comes to insurance, invest the difference and deductibles in a high-interest savings account, and only use it when an emergency comes up. I really like this practical advice and I think if you can put this in practice, it will save you a fortune that you can invest in the market to compound!

Another reason I like this gambit is because when it comes to paying out, insurance companies become notoriously difficult to deal with. They bring up any clause, or legality into play that they can use to avoid paying any premium. That “deductible” part of the policy is where the highest probability of events occur, if you can cover that from your own pocket, then all big claims are much clearer and more straightforward to deal with.

So in conclusion, don’t treat insurance as a luxury or magic. It should help you achieve your goals, allow you to unlock your human capital, smooth out the consumption over your lifetime, and protect you in case of a catastrophe. The insurance companies are the “house,” and on average, the house always comes out ahead.

So insure fully, and insure wisely!

Taxes are bane of my existence!

If you have ever been audited, you would know the anxiety that it causes. Taxes are a serious pain in the behind and they are very time consuming. Interestingly, they are also very time consuming for the IRA and the CRA. Unless you are red flagged, known offender, or have a fluctuating record of reporting income, more than likely you will not be picked on. However, if you are picked on then the Big Brother will do whatever it takes to make sure that you not only pay up from your previous erroneous fillings, along with a hefty penalty, but also keep you in line for the future. Taxes are a bane of my existence because I view them within the context of Human Capital, and they are the biggest wealth killer. I could have my budget blow up for a few months but I can find a way to subdue it eventually, taxes are a constant outflow of my wealth that I cannot stop.

State of Minnesota actually carried out an experiment on the behaviors of individuals when they are notified in advance that they will be audited. The state divided the group in three segments, low-income, medium-income, and high-income. The fascinating finding from that experiment was that if you give people an advance warning, most people will over-report and pay more taxes and disclose more income. Who wouldn’t want to just get the big monkey off of the back?

But, oddly enough, the most surprising part of the whole experiment was that the high-income earner’s actually disclosed less income and paid less taxes. Furthermore, once warned that they would be audited, they approached the tax specialists more often than low to medium-income earners. They utilized more tax avoidance resources than the other two groups.

For those that follow, it means that generally those that are considered high-income are more prone to exercise their rights to employ tax avoidance techniques, in a much more assertive way to the authorities. If this doesn’t blow you mind, then go back to your middle-to-low income earnings.

High income earners, who often possess higher education, get involved in the tax process with a sense of confidence that you would find in a negotiation at a shop. They view the tax date/audit with the authorities as a negotiation rather than imposition. They are capitalism in their thinking of when it comes to taxes, as they try to find the right equilibrium between when and what to pay and how and what is expected. They are in a sense, negotiating with the authorities to pay as little as possible, while the authorities are asking for as much as possible, unlike the other two groups, they don’t back away and stay persistent. They understand that the cost of doing audits, having specialists assigned to the case, and going through all the details is a tedious process that has high costs on both ends. However, given their affinity towards financial well-being, they don’t like to back away and give in.

One of the best ways to really come to terms with taxes is to understand them in a context that creates harmony. If you view the tax collector as a lifetime partner in all endeavors of life as you unlock your Human Capital, you will create a mindset required to deal with them as such. Everything that you earn has a tax implication, so if we change our mindset to ask what those implication are before we begin, that can help us carry our goals further. Internal Revenue Agency states on their website that most middle-to-low income earners understand their tax obligations, yet 16% continue to overstate their tax liability. If that statistic doesn’t make you cringe, we are not at the same wave length here.

When it comes to Taxes, don’t be Passive – Be Proactive!

What comes as a surprise to a lot of outsiders to North America is that everything here is quoted in excluding taxes and VAT, as known in the UK. For the most part, Americans and Canadians quote income, earnings, and everything that we buy in a before-tax basis. When we don’t even know what we will earn and how much we will pay for an item, our entire mindset becomes disillusioned to before-tax numbers. This is a grave mistake as one of the first tenants to understand and pay attention to is how much we are taking home, and what we are paying at the store for any items that we buy. South Americans, generally, don’t have this problem as everything in Uruguay is quoted in after-tax basis. In order to become more efficient in dealing with your lifetime business partner, that is the tax man, you have to learn to work backwards with everything. A $100,000 salary is not a $100,000 when looked at after taxes are taken away, rather it’s just enough where you fall in the average earning according to the Income Statistics in the US and Canada. We often tell ourselves that we are richer than we are, when in fact, we are much poorer if the numbers under consideration are always before-tax.

Now, would you allow me to hold onto your earnings and save it for you at no interest-bearing advantage, and return it to you at the end of every year?

To me that doesn’t sound like a great proposition as I can take my earnings and deposit it in a savings account and earn interest, rather than have someone hold it for nothing. That’s exactly what we find puzzling when it comes to individuals getting a tax refund at the end of the tax year. According to the IRA, 75% of the Americans receive a tax refund at the end of the year with an average balance of $2,500, while Canadians receive on average $1,400. Do you find the irony in the statement above and statistics after?

If I didn’t know any better, I would opt for a tax refund as it’s forced savings and it is a nice surprise to have. However, over-withholding and giving the government an interest-free loan for a whole years goes against everything that we have learned so far. Capital should be invested to increase our assets, not given to our rich business partner for free to do as they may for a whole year.

In the US and Canada, you can do something about it. By filling the advanced Earned Income Tax Credit (EITC), and in Canada TD1 and T12131, you can take your tax credit and deductions to be taken into account throughout the year, as opposed to waiting till the end of the year.

According to two economists at the University of Chicago and the Federal Reserve Board, most people opt to have more withheld for a bigger refund at the end of the year, which has a a much lower discounted value. And less than 20% realize the financial advantage and have less withheld for a much smaller refund. Moreover, those that have more withheld are paying the government in earned-interest to help them save money. Whereas, those that understand the financial advantage, invest the capital now and earn much higher returns as the compounding plays out.

What revealing about this research is that consumer, more than ever, are inclined to become spender if they are not forced to save in a way that is outside their control. First, it goes to show how effective Sales and Marketing teams have become at convincing consumers to part with any money that they have. Secondly, it shows how weak the consumers have become to the social pressures of the society that if they have the capital, they feel it necessary to spend it on something for an instant reward. This is classic Capitalism at play, and who we are in the this matrix of an ecosystem. No wonder, financial literacy is so important if you want to become the owner of Capital production versus a seller of your time for a wage.

If the tax refunds are too small a figure to worry about it at all or you have that figured out already. Then more than likely, you fall in the high income category and a tend to be an investor in stocks, bonds, and other investments. There is a something to be aware of as well when it comes to investments. Although, you don’t have to pay any capital tax until you sell your investments (except interest and dividends), you do have to keep in mind the before-tax statistics of what the mutual funds and indexes claim as final returns. Often a 10% return of a mutual fund is so useless a statistics that it should never be advertised, but that is not how they roll. 10% return could be from a high turnover within the index or the fund as managers buy and sell to “beat the market”, or it could be from dividends or interests, or simply from growth. Unless you know where that return is coming from, you cannot know if that 10% is really what you will receive and you often don’t ever get what is advertised with the funds and indexes.

I don’t want to get into the whole science of investment in this article, but what you should remember is that the best you can do to take advantage of investments is to first max out your 401k or the Roth IRA/IRA, and then open an unregistered once they are maxed. This will allow you to maximize your tax advantages to the fullest with your earnings. Secondly, if you are past that, then remember all statistics of returns quoted by funds are pre-tax and pre-expense basis.

A very early study on this topic was done by two economists at Stanford University, and published by the National Bureau of Economic Research in 1993. Another study in Canada was also conducted to confirm the finding across the border. According to both of these studies, ranking of funds on a pre-tax basis is significantly different and worse in the post-tax basis. Over time, it was observed that due to the inefficiency of the tax management with these funds, any gains are wiped out except low-turnover index funds. There isn’t a very straightforward answer to making your investments more tax efficient if you are a tinkerer. You’d have to invest considerable time and energy into not only learn how to do it, but also how to make those investments tax efficient. The simplest and the best advice, as given by Warren Buffet, is to invest in low-cost, low-turnover, highly-diversified, index funds and continue to Dollar Cost Average. We will tackle how all of this is done in later articles.

So within the context of Human Capital, you shouldn’t forget to reduce your holding by taking out the tax liabilities and obligations of the future to understand your explicit Human Capital Value. That is what you owe to the tax man and there is no way to evade it, possibly just avoid it to an extent which is legal.

The tax man is your lifetime business partner, a portion of everything that you will earn will go to your business partner. By becoming more educated on the tax issues, you can create tax-efficient decisions and investments. Also, by doing little things like withholding less taxes on a monthly basis, will allow you to get ahead with compounding your returns in the long-term. Finally, understanding every financial decision from a context of after-tax basis will allow you to make better financial decisions that will keep your business partner’s share to a minimum.

Within the context of Human Capital and Smoothed Lifetime Consumption models, you need to understand your true tax obligations from the start. This will give you a realistic, explicit picture of where you stand on financial milestones in life.

Next we will talk about buying a House and if it’s a good decision? Stay tuned!

If you’d like to understand human capital and all of the financial milestones – start at:

Part 1: Human Capital

Part 2: Education

Part 3: Saving

Part 4: Debt

Part 5: Marriage & Kids

Part 6: Taxes

Do you think that children are an asset or a liability? and did your parents have you for consumption (in an economic way, off course) or as an investment?

According to the Survey of Consumer Finances, in the year 2007 couples without children had an average Net Worth of over $206,000 over their children-dwelling households. This pattern was observed in the year 1998, 2001, and 2004 surveys as well. The study available until 2007 indicates a 25% premium added to the Net Worth of those without children, median being $191k without children and $141k with children. These findings from 2007 and the historical consistency of the the survey results indicate that having kids creates an impediment to your Financial Independence goals.

Fortunately for me, my parents were Humans and not Economists!

Oh, and Canada doesn’t really have an official number as to what the costs of raising a child is. However, various estimates exist which put the total either at $166,872 or at $243,000 approximately. This is the total cost from Birth to Young-adulthood, until the age of 18. Mind you, if you want to be strict with this number, you have to kick them out when they are 18! Yes, kids are terribly expensive.

Phew! Now that we have that out of the way, let’s talk about Kids and Marriage in the context of your future-self in either early or timely retirement.

Let’s go back in time to 1815-1898 when Otto von Bismarck, German Chancellor, introduced the concept of state-funded pension plans. When the plan was adopted in 1889, it was decided that a basic income would be provided to all retirees, funded by the taxed workers, in other words, funded by the state. You know where I am going with this, right?

Under the refinement of Britain’s Sir William Beveridge in the early 1940’s, the pension plan underwent changes and since then has been known by it acronym, PAYGO. Under that Pay As You Go, retirees receive their pension, indirectly, from younger worked in the labor force. This has become in our modern day, Social Security and CPP in North America. This brings me to another point, immigration.

If the fertility rates, at historic low levels in Canada and the United Sates, keep their pace – only immigration can solve our future-retirement Social Security problems. With a low fertility rate and an increasing number of retirees, the young workers are not able to support the shift in balance of Young-to-Old. As much as we think that the state is able to support the Pension plans of the future, by having a low fertility rate, we are putting a humongous pressure on the system. In fact, if we are to get another recession in North America, one half of what we had in 2008, we are bound to see an ugly explosion of the pension system.

If you are under the assumption that companies, and large Fortune 500 companies and the government so to speak, have a plan to protect the “promise” of life-long pensions for workers of the past few decades, then you are embarrassingly wrong.

I don’t want to go down this rabbit hole as I digress, but those that are interested should look at Chrysler and GM and what happened to the pension plans during the Great Recession.

So kids are terribly expensive, yet they are needed in the society and the nova capitalism to help offset future old age pensions. Many, almost everyone, agrees that immigration is the solution to this problem and I don’t disagree. However, with immigration, we are not really curing the heart of the problem. Within this Digital Age, what people are forgetting is that it takes ten years to learn what it took decades for the generation before. This is a true fact. What it implies is that these new economic immigrants will wisen up quickly to the system in place and they will eventually also prioritize mercantilism-to-capitalism as they evolve in the new land.

Furthermore, North American policies and laws and even the constitution is based on Judeo-Christian values. These values are often at a stark contrast to where the current generation of immigrants are coming from. Indians, Asians, and South Asians to be specific are highly educated, can communicate in English, and understand the corporate culture. Yet despite all of these advantages, Populism is rising rapidly in the Western Countries. So where do you stand on the issue, what your understanding of immigration is, and how effectively immigrants are assimilating, will all be key issues to tackle in the future. What I am saying is that Old Stock privilege will have to give way to the rising need of immigrants in the North American societies.

So Kids are expensive if have them, and given your stand, expensive even if you don’t have them.

Having a child is a truly a milestone in your human cycle, as evolution has designed it to be. You can choose not to have a child, given your priorities, and that in itself is a defining milestone in your life. There is not right answer, only a moral and financial equation that you have to decide between. Given the research, it seems that we should have two kids, as part of our civic duty. It may further postpone your early retirement, by about 4 years, but it will bring my social benefits.

Marriage is another sensitive topic and the recent statistics do not support the union as it was idealized in the “divine” wordings. Marriage, often seen through the lens of culture and religion, is in an economic sense creates too many legal challenges. In one way, Marriage diversifies the household’s income which is great as it helps expedite Financial Independence. On the other hand, Marriage is an obstacle, given the legal obligations, as it can definitely erase years of progress. I like to think of it as a major recession in one own financial journey of life. It can be a “soft landing” as the FED likes to point out when they lower interest rates, but often our emotions are over-charged and we are humans.

Marriages creates diversification in income, they allow more than one human capital to contribute to the finances of the household, they create an effective team environment where two heads are working to achieve one goals. Marriages are also great because they often involve two separate industries of where the cash flow is coming from and they can offset some of the blows of the recession in our highly exuberant capitalistic society. Within the context of Human Capital, Marriage or Common-Law can be wonderful, if the partnership can last the test of times.

One of the most fascinating finding over the last decade on marriage was a study done by Wharton School of Business and Northwestern University, which resulted in the finding that the correlation between tightwad and spendthrift spouses was negative and statistically significant. This finding has a huge implication of how we view ourselves in the society, how we perceive who we are versus how we view others, and how wrong we are at thinking about what we want in life. The study pointed out flatly that despite our own personal goals and views on life, we view the others’ perceived goals and values as more important and fascinating to ours. This is off-course an explanation due to the statistical significance of the findings, and not meant to be written in stone. However, it is very fitting given how the society has become about the “Self” due to the “individual contribution” that American-capitalism promotes.

A topic of this magnitude is beyond my capabilities to answer for you. I merely want to point out that Kids and Marriage play an important in the society and the culture. They can also help us explicitly and implicitly diversify our present and our futures. They can create a explosion of opportunities, or they can diminish any flame of hope of future financial independence. They are a tricky, they are expensive, they are a blessing, and can help you achieve an early retirement or complicate it to a timely one.

Within the context of Human Capital, you want to find a life partner who shares your beliefs and values in how you view life. You want to practice what you preach, and you want to be mature enough to know that when you make such a decision, it is the right decision as it will have a persistent and long-term impact on your life.

Let’s discuss how to use Taxes to our advantage in the next article and strike back at the biggest killer of wealth! Stay tuned!

Part 1: Human Capital

Part 2: Education

Part 3: Saving

Part 4: Debt

When you are young spending more than you earn is, in fact, quite rational!

Debt is a fact of life whether we like it or not. Debt follows us around and every financial decision, especially life’s milestones, require that we take into account debt and the costs associated with it.

You need to borrow money to buy a house, finance a car, or invest in an Education.

Really then, instead of running away from debt, we should learn to harness the power of debt.

Americans and Canadians are notorious for having high debt to equity ratios on their personal balance sheets. Even more troubling is that due to our natural chunking heuristic, we diversify debt to make the impact even worse.

Simply stating, we tend to have different buckets for our debts. For example, we carry a mortgage debt at a rate much lower than our car loan, education debt at a much higher interest rate with some gimmicky financing provisions, and credit cards at an insanely high rate of almost 20%.

This diversification of debt makes it really hard to manage. Due to this negative diversification and our chunking heuristic, we human tend to put money in different categories in our mind and feel satisfied. If you look at the bigger picture though, you would realize that the debt is spread out unevenly with varying interest rates that can be bundled into one or two chunks. These one or two chunks can then make even bad debt be managed by a Good Debt Management Strategy.

According to the Survey of Consumer Finances, 77% of Americans had some type of a debt. Canadians on average, according to Statistics Canada: The Wealth of Canadians, have increased their debt holding by about 37.5% from 1999 to 2007. The trend is obvious in North America, it’s moving significantly higher whether we examine it relative to income or assets. The study further states that between 2007 and 2010, “the the overall level of debt owed by families was basically unchanged, debt as a percentage of assets rose because the value of the underlying assets (especially housing) decreased faster.”

According to U.S. Commerce Department News Release: The Savings Rates of Americans, as of 2005 was -0.4 percent, that changed to 6% after the Great Recession. Now in 2019, the saving rates have started dwindling again in the opposite direction. As of early 2019, the personal saving rates of Americans where between 6% to 7.5%. The employment, stock market, portfolio net worth, and the news hysteria has a considerable impact on the saving rate fluctuations on a monthly basis. Canadians also, according to Statistics Canada: Economics Indicators by province and territory, share the same characteristic with the American neighbors, where the saving rate was 1.2 percent up until 2005, and only after the Recession did it climb higher to 4.7 percent.

Another interesting finding in the study pointed out that Canadian households’ debt-to-disposable income have steadily edged higher against the US households. The reason for this has been the rather soft landing during the last Great Recession in Canada versus the United States. This is a great time to point out that the principle of antifragility by Nassem Taleb has a sound basis.

With such a high borrowing-to-savings ratio, a debt management strategy becomes paramount. However, majority of the debtors holding varying interest rates, cannot find a way to consolidate or optimize their debts. Moreover, often the debtors are forced to borrow from various financial institutions for different assets that they hold. One example would be the interest rates for Educational loans cannot be combined at the rate that is offered for mortgages.

Nonetheless, there is evidence that most people still have the ability to optimize their debts but choose not to do so.

To further complicate the matters, due to a lack of understanding on the long term effects of interest rates and the cost implications, Americans tend to deposit cash in non-interest bearing accounts instead of paying down liability obligations. Another example of chunking heuristic in play where we often think that we have more money than we actually do.

By consolidating the debts into one chunk, it not only frees up capital sooner but also decreases the amount required to pay down the liabilities. A debt accruing at 15% interest rate for a credit card versus an open line of credit at 3.25%, should allow individuals to transfer the credit card balance to the lower interest rate debt right away. This exercise and use of debt management will inevitably increase the saving rate, lower the months required to pay down the debt, and free you up sooner than if you kept making payments without paying any attention.

Another study, had some interesting finding on the consumer behavior on not only debt but foregone saving opportunities. According the study, people allow interest to accrue on the credit cards, while cash stays idle in banks that could be used to pay down the debt. While others carry more than one credit card with different interest rates, all with balances. Some people even make use of the overdraft feature of the checking account while cheaper source of credit are easily available.

Within the context of Human Capital, it advocates spending earlier in life and saving later when more capital is available. However, the lack of financial literacy in people makes it a dangerous proposition, to say the least.

According to the Noble Prize-winning economist Daniel Kahneman and Richard Thaler, we make mental accounts for how we spread our investment and especially debt, without taking into account the interaction between them. Often people in their quest to build a nest egg, forgo common sense and incur other debts and liabilities that offset the gains. This is also noticed with people with a financial goal of paying off their mortgages in 10 to 15 years sooner. The occurrence of this habit is more pronounced when we approach the debt repayment goal with a tunnel vision.

Interestingly, some that do try to become clever with credit card transfers to no-interest credit cards make even bigger blunders. They often transfer balance and start to use the new credit card right away. Usually the no-interest transfers only apply to the transferred balance and the payment each month goes towards paying that transfer balance down. Without realizing, people start to use the new credit card which accrues interest on the new monthly balance at the going high rate. This costs them more than if they just transferred the balance and stuck to using their old credit cards in the meantime.

If managed and consolidated properly, Debt is an amazing tool to take advantage of the lifetime Human Capital Value.

So then the questions becomes whether borrowing is good at all. I don’t suggest a no-debt lifestyle, at least earlier in life, as that’s when majority of life’s financial milestones happen but I do suggest good debt management strategies along with debt that is used to build assets. Keeping Smoothed Consumption in mind, borrowing at the best available rates, consolidating whenever necessary and optimizing credit is the best approach.

So before your go out and borrow to buy a house,a car, or get an education – things we need as part of Maslows Hierarchy of Needs, ask yourself this:

Will this purchase, financed by high-cost long term debt, reduce my future lifestyle by more than it will increase my present lifestyle?

Division of Dough on Debt

Now we understand the role of Debt, third pillar within the context of Human Capital. We have already discussed Saving, second pillar, and Education, first and primary pillar, that will create a lasting long-term impact on increasing your Human Capital Value towards Financial Independence!

Next we will tackle Kids and Marriage and it’s implications on our goal of Financial Freedom. So, stay tuned!

Saving 10 percent of my income will allow me to retire happily

A lot of people are under the assumption that saving a small portion of their earning is ample to allow them to retire, whenever that time comes. The flaw in that thinking can be easily deduced if you really think hard about it. (Who wants to think hard about retirement?)

Retirement is not the only reason for saving money. Often, if you tell people that they should save more money, their first response is “what’s the point of saving money?”

This is where the first flaw is revealed in their thinking because they lack a framework for having a saving plan and what those savings can do for you. If you ask a group of young people the same question, the response are often funny but also insightful and revealing.

Young people tend to think either that saving allows one to retire as young as possible, while others say that savings help with retirement later in life, and some after having read my previous posts often state that it allows us to retain some of our Human Capital.

Astonishingly, none of these answers are wrong but they lack depth, as in a clear plan for what to save for.

If you understand the process of discounted cash flow, you can run the numbers and find out the worth of money saved today vs invested for the future – which one of these scenarios give you the best bang for the buck. Don’t fret if you don’t understand the discounted cash flow as I will cover it in my later articles. The very first fundamental to understand when it comes to money is whether you think of it as something that’s a tool or something that you’re being rewarded for you efforts. The mindset shift that’s required to differentiate this equation is simple, yet very hard to comprehend. It’s simple when we talk about it and say that money is a tool that we can use for the future US Inc. It’s hard when we put it in practice as we don’t really know how to separate the use of it as a tool versus consumption (from the mindset of reward).

This article follows the series of financial acumen building articles that I have written previously. If you’d like to become the master of your coin, then start here.

Now, we have previously talked about building your Human Capital and Education as the first pillar on that path. This article is another crucial pillar to building your Human Capital. As we previously discussed, your Human Capital is unlocked a little at a time as you work in your chosen profession. Saving has a lot to do with the Human Capital, since saving is the left over after your needs are met.

Nobel Laureate and economics professor Franco Modigliani, was the first with co-authors who researched a paper in the 1950s and 1960s on the idea of lifetime consumption pattern among individuals. He won the Nobel Prize due to this study of savings of individuals. He said that the consumption of your Human Capital should be divided across your lifetime and used up in a rational manner. To understand this concept, let’s say that your total Human Capital over your lifetime is $1 million. Now, earlier in life you’d have to borrow more because you haven’t unlocked your entire Human Capital, and later in life you are financially stronger and the need to borrow is less as you have the capital required for purchases. The research states that you should borrow, typically earlier in life, and save when necessary, typically later in life. He called this concept the Smooth Consumption, saying that your consumption should be spread out evenly throughout your life.

Now I know some of you are saying that this is impractical as the Human Capital cash flow is dynamic and it can go up and down, the volatility of the earnings are never guaranteed, and only a Nobel Laureate can make decisions like that. Believe me, I also think that this concept is nice on paper but in practice, this will die a quick death.

The reason I mention this is because thinking of your Human Capital cash flow in the Smoothing Consumption framework can allow you to make the best financial decision with the limited amount of knowledge at hand. This is a very handy and a practical tool, if used properly in the right hands.

Look at the above table and try to figure out what is going on. You’d quickly realize that that your savings play a huge role for the latter part of your life. In the early stages, as you can see in the table, the consumption pulls you into the negative net worth. However, as you start to unlock your Human Capital, you can bring your lifestyle to a balance and bring your net worth in the black again. The whole idea of saving comes into play when you start to plan for the long haul. This is obviously a simplification, as the discounted rate and compounding rates of saving will have a dramatic effect on how the consumption and saving is laid out. If you don’t know these two principal, then don’t worry for now as the future articles will cover these topics in detail.

This simplification void of death, taxes, inflation, interest rates, and pensions is only to delineate that saving money should and does have a purpose.

From the chart above, this individual starts of her life at -$25,000 debt due to education, then over the next 42 years, goes on to earn $1,000,000 unlocking her full human capital. Now subtract the debt from the earning, and take the $975,000 and smooth it out over the entire lifetime. From 23 to 85, she will have $15,725.81 available, as an example, smoothed out for each year. Her target, if retirement lifestyle is comparable to working lifestyle, would require a saving of $15,725.81 for those 20 years.

So, in nutshell, your arbitrary percentage of saving that you have been taught in magazines or on CNBC is completely wrong. The right framework to think about savings is within the context of your lifetime earning potential. Once you have a plan and you can distinguish between your Maslow’s Hierarchy of Needs and the need for future savings, you can easily derive the right number.

Investing and compounding can help you achieve a retirement lifestyle even sooner.

Those that have gotten ahead of me at this point know that compounding and interest rates play a huge rule. In the next article of the series we will look at taking on or paying off Debt within the context of Human Capital, so stay tuned!

Part 1: Human Capital

Part 2: Education

Part 3: Savings