Retirement planning isn’t the precise science you would like it to be…

Surprisingly, most people don’t “get” how the process works. Several myths have earned conventional wisdom status despite being wrong. These myths can be very expensive and undermine your financial security.

The truth about retirement planning is startlingly simple because the essential principles can be reduced to just 2 basic formulas.

In this article I’ll reveal several retirement planning myths while also diving deeper into these 2 critical wealth building formulas so that you have the tools necessary to secure your financial future – but first a quick story…

Missing The Forest For The Trees…

Let’s start with the basics…

Financial freedom (or retirement security – same thing) occurs when your passive income exceeds your expenses.

Notice how there are just two variables to this equation – passive income and expenses. That’s it – nothing complex!

The financial freedom game is about building passive income and controlling expenses. When income exceeds expenses you are financially free. Simple enough.

There are three broad asset classes to build passive income – business, real estate, and paper assets. None is better than the other although each offers distinctly different characteristics.

Amazingly, if you look at most retirement calculators you would never know there are three asset classes to build retirement with. They usually assume only one asset class – paper assets. They provide no mechanism for adding additional income streams from businesses or lump sum payments from selling real estate holdings. Instead, they just model the growth of paper assets.

Can you guess why? Look at the advertisers and services that support these free online calculators… brokerages, financial planners, and others in the business of selling paper assets. Not a coincidence.

Forgive me if this all seems painfully obvious, but the masses don’t get it! They’ve bought into the single asset class myth. Let me give you an example…

The other day my Ultimate Retirement Calculator was reviewed on a popular and respected blog and the readers came up with a variety of well-intentioned but petty criticisms. The site owner demonstrated his solid knowledge by noting how he used the calculator to develop retirement scenarios, but his readers couldn’t see the forest for the trees…

• “It doesn’t include separate inputs for each spouse.” (Answer: Who needs the complication? Just aggregate both spouses together. It’s called community property for a reason.)
• “It doesn’t provide separate tax rates before and after retirement.” (Who cares? Different tax rates would only be meaningful if your taxable income fell dramatically after retirement. Unless financial freedom equals poverty this added detail would only introduce meaningless complication.)
• The comments continued with little criticisms about minute details that had little practical bearing on the final calculation. They were focused entirely on the wrong thing!

More importantly, they completely missed the unique value of this calculator. Nobody provided positive comments about the important features that set this calculator apart from the competition…

• It is simplified down to only the essential numbers so that it is acceptably accurate without being excessively complicated.
• It allows you to change any input and hit “recalc” so you can test a variety of combinations efficiently and quickly.
• It allows you to include a future lump sum payment so you can model an inheritance, selling investment real estate, or selling a business at a future date.
• It allows you to set up three separate income streams so you can model income from real estate, Social Security, annuities, businesses or whatever unique plan you develop to make passive income exceed expenses.

The sad reality is these critics were stuck in the minute details of forecasting a mythical magic number for paper asset accumulation and never noticed the important points. They were distracted by detail issues and it led them in the wrong direction. Sure paper assets are important, but they are only one of three asset classes.

So that is the first mistake in retirement planning – undue focus on a single asset class… namely paper assets.

It is a myth perpetuated by a financial industry that has a vested interest in convincing you to spend your hard-earned retirement savings on the paper assets they sell (stocks, bonds, mutual funds, ETF’s).

The truth is there are three viable asset classes for retirement planning and your modeling should include all assets appropriate to your life situation.

With that said, most people’s retirement plans are dominated by paper assets so let’s go deeper into this subject by examining several other mistakes commonly made when planning retirement using this asset class…

Retirement Planning Done Right Is About Scenario Analysis – Not The Mythical Magic Number!

The next mistake is to believe in the mythical magic number – that amount of savings the retirement calculators’ claim you must accumulate to enjoy financial security.

The primary symptom of the magic number myth is a desire to apply increasingly detailed analysis in a futile effort to increase your retirement number accuracy.

Don’t waste your time! It doesn’t work that way…

Victims of this myth ask questions like the critics above because they believe every little number, tax rate, and detail is somehow marginally relevant to their goal of knowing how much money they need to retire.

It’s not!

The reason is because all those details are completely dwarfed in significance by one or two critically important numbers that will make-or-break the analysis. Get these big numbers right and all the other details are just that… details.

Conversely, if you get these important numbers wrong then you will fail completely no matter how detailed your analysis.

It’s as simple as that.

Let’s look at how these critical numbers monopolize the retirement planning process when using paper assets so that you don’t make the same mistake…

Savings Growth As A Percent of Spending

The first critically important number when planning retirement with paper assets is the percentage of income saved versus spent.

In my recent article – How Anyone Can Retire in 10 Years (or Less!) – I demonstrated how a super-aggressive savings rate would allow you to skip all the calculators by reducing retirement planning to one simple ratio that forecast with scientific precision how long it would take to become financially independent. The numbers were as follows…

• 10% savings rate = 42 years
• 20% savings rate = 32 years
• 40% savings rate = 21 years
• 50% savings rate = 17 years
• 60% savings rate = 14 years
• 70% savings rate = 10 years
• 80% savings rate = 7 years

(Ed. Note: These numbers are only scientifically valid for very high savings rates (i.e. 60%-80%) because longer time horizons introduce complication from compound returns and inflation as explained in the next section of this article. Lower savings rates (or longer time horizons) are shown for illustration only. See the full article for all the details…)

This is not some crazy math theory. It explains exactly how I retired at age 35. I saved roughly 70% of a substantial income and never allowed spending to rise with income. It didn’t take long for my assets to grow sufficiently large to support my lifestyle.

It is a brain-dead simple, scientifically accurate way to achieve the goal.

One of my favorite quotes is, “If you want to know how long it will take anyone to achieve anything just look at how much of their resources (time and money) they dedicate to the goal”.

This savings formula is saying the exact same thing. If you want to know how long it will take you to achieve financial freedom just look at the percentage financial resources you dedicate to the goal. Remarkably simple… and effective. It just plain works.

[FMCenterQuote]Principle: If you want to retire faster then reduce your spending and/or raise your income so that your savings as a percent of income grows. The higher the percentage, the faster and more reliably you’ll reach the goal.[/FMCenterQuote]

Again, don’t get hung up on distracting details. Keep it simple and focus on one thing – maximize your savings – in any form.

The goal is to direct income away from consumption and into the asset column. Once you have assets then the next critically important set of numbers enters the picture…

Return On Investment Minus Inflation Determines Amount Of Assets Required

The amount of savings you need to support any given level of spending is a function of your return on investment minus inflation.

This is the BIG ONE! Nothing else comes close when planning retirement with paper assets.

All the picky little details that arise when people seek to perfect their magic retirement number are dwarfed by this one ratio – ROI minus inflation.

The reason is simple – compound returns multiply little differences into HUGE differences over long periods of time. This isn’t about turning mole hills into mountains: this is about turning grains of sand into the Himalayas!

I’ve worked with these numbers all my adult life and it still amazes me when I work through the process with a financial coaching client and see the effect. Seriously, try it for yourself.

Go to my Ultimate Retirement Calculator right now and punch in your best guesstimates to figure how much money you need to retire. Seriously, do it right now before reading any further. Don’t worry about perfection. Your best estimates are good enough for this exercise.

When inputting expected lifespan use age 100 unless you have known health issues. Why age 100? Because research already shows high odds of a healthy couple at age 65 having one spouse live past 90. Additionally that number increases every decade so just use 100 as a round number.

You will get a lot more value from this if you do the exercise right now! Please, don’t trust me. Prove it for yourself. It will only take two minutes and could be the most eye-opening two minutes you spend all week.

Once you fill out the calculator with your base level numbers then write down the “magic retirement number” that it provides.

Next, try perfecting your magic number by “tweaking” a few variables like tax rate, retirement age, and other details similar to the critical comments cited earlier recommended. The only rule is you can’t touch the two key inputs highlighted in this article – return on investment and inflation. Everything else is fair game.

Notice that your magic number changes with each variation, but the changes are only fractional. Your estimates for how much money you need to retire remain in the same ballpark as your original number. The calculation is relatively stable.

Now, using the exact same inputs as before, raise your inflation rate by 2% while simultaneously reducing your return on investment by 2% (but make sure you’re sitting down first )

See what I mean? For most people this small change will literally multiply the amount you need to retire several fold. It should knock your original estimate right out of the ballpark, over the river, and into the next state.

That is why I call all the other variables “details” and label these two ratios “critical”. It’s just the way the math works.

[FMCenterQuote]Principle: Small changes in a few key numbers multiplied over long periods of time have HUGE impacts on your ability to retire with financial security. Therefore, focus on those key variables and don’t worry about the minute details.[/FMCenterQuote]

Focus On What Matters And Forget The Rest

Now let’s take this lesson a step further…

There is a little problem with this analysis that I disclosed in the previous section (showing how anyone can retire in 10 years). I explained that long periods of time introduced variables that could not be reliably estimated.

In other words, this key ratio (ROI – inflation) cannot be forecast with any accuracy. It is another myth of retirement planning because nobody knows what their inflation rate or return on investment will be (within 2%) over the next 15-30 years. It’s a complete guess – total fiction. Yet, every retirement calculator requires you to estimate what it will be. If you estimate wrong then your whole calculation is wrong.

Seriously, Ph.D. economists who study the subject extensively can’t reliably predict inflation one year into the future. It is an absurd joke that you are expected to bank your retirement plan on a layman’s guess for 30 years into the future when trained experts have no clue.

This problem should be intuitively obvious to anyone who can remember back to 1980 (interest rates were in the “teens” and stocks had gone essentially nowhere for 25 years). How many people back then forecast the beginning of the greatest stock market rise in history with long term interest rates declining to historic lows? I was working on the sales side of my hedge fund business meeting with CEO’s and retirement plan fiduciaries and I can tell you with certainty almost nobody saw it coming.

Still not clear that ROI and inflation can’t be predicted? Then remember back to the 2000 bull market top and recall how many soothsayers warned you about the coming decade of flat performance, record volatility, and artificially low interest rates? You could count them on one hand and still have fingers left over.

Similarly, at the top of the real estate bubble in 2007 how many forecasters correctly took defensive action and got out of the way before the bubble burst? I did and I can tell you it was a very lonely position. (If you need more evidence proving the fallacy of forecasting see a complete analysis here.)

Given these facts, what makes you think the next 15-30 years will be any different? The future is unknowable; yet, a retirement forecast built on the mythical magic number requires you to forecast all these variables accurately. If your forecasts are wrong by just a little bit then your entire retirement estimate isn’t worth the paper it’s printed on.

In plain language, the magic retirement number is a myth. That is why retirement planning done right requires scenario analysis – not creating a mythical magic number.

The truth is small errors in key estimates cause such large errors in the amount you need to retire that the whole idea of relying on the calculation is essentially foolish.

Shocking, but true!

Now you understand why I literally laughed when someone criticized my retirement calculator for not allowing individual input for each spouse. They missed the whole point. Detail like that is meaningless complication – totally irrelevant. It is equivalent to arguing whether a right or left turn is better for getting out of a railroad crossing when a freight train is heading toward you at 70 miles per hour.

Retirement calculators are useful but only for scenario analysis – not determining your magic number.

• Use retirement calculators to model a wide range of variables to produce a confidence interval.
• See what happens if you add 10 years of additional income – part-time work, consulting, or whatever might interest you to take the pressure off savings and allow your assets more time to grow.
• Try modeling real estate rental income that adjusts for inflation and rises when you pay off the mortgage.
• Try modeling what happens when you receive a lump sum inheritance, sell a home or business.
• Try modeling the difference between a conventional asset allocation and a dividend growth portfolio.
• Try modeling if it is better to delay Social Security or start payments early.
• Try modeling several factors together.

In other words, use the retirement calculator to put numbers behind different life plans for your financial future. Each example will teach another principle just as the examples in this article teach principles.

That is how you use retirement calculators properly, and that is why my Ultimate Retirement Calculator is designed specifically to facilitate a simple process for scenario analysis.

The Ultimate Retirement Calculator is designed with three specific objectives in mind…

1. It omits meaningless complication and non-essential detail thus reducing barriers to you completing the calculations. It is more important to plan retirement roughly than not do it at all. It is also important to not get so caught up in minute details that you deceive yourself into believing the output is scientifically accurate.
2. It provides a simplified platform so that you can model various real-life scenarios using all three asset classes (not just paper assets like competing calculators). No other calculator allows that flexibility which is essential for the way modern retirements are planned.
3. It allows you to quickly and easily build confidence intervals by varying single inputs and seeing how it affects overall output.

In short, this calculator is designed for scenario analysis – not mythical magic numbers.

[FMCenterQuote]BTW, if you appreciate this retirement calculator and this explanation about how to use it right then please “like”, link, and +1 both these pages. It helps get the word out about these important principles.[/FMCenterQuote]

Scenario analysis is how you blend life planning with retirement calculators to produce a realistic road-map to achieve financial security. It is a practical approach for retirement planning that avoids the myths and traps that have unfortunately become conventional wisdom.

In Summary

Building wealth for retirement is not complicated. The process is governed by strict mathematical principles that imply certain clear objectives.

Starting with the basics, the goal is financial freedom which is defined as passive income exceeding expenses. This focuses your financial plans on just two objectives – grow passive income and control expenses. Simple enough.

Second, most retirement calculators implicitly assume there is only one asset class (paper assets) and preach the magic number myth. Neither is true. That is why I designed the Ultimate Retirement Calculator so that you have a tool that works with the “New Retirement” reality – multiple asset classes, phased retirements, and much more.

Finally, when modeling paper assets as part of your retirement plan it is essential to focus on the two big ratios that account for the bulk of variation in the output…

• Your savings as a percent of your income.
• Return on investment minus inflation.

The key is to not fall prey to the magical number myth and don’t get caught up in excessive detail. The truth is retirement planning is essentially a bet on an unknowable future that requires assumptions about inflation and return on investment that cannot be accurately predicted. That is why excessive detail is a fool’s errand.

Even though the magic number myth taught by most other educators is wrong, you should not conclude that retirement calculators are a waste of time. They are not.

Studies by Employee Benefit Research Institute demonstrate that people who estimate how much money they need to retire take more effective actions toward saving for retirement and produce greater results.

Retirement calculators should be used for scenario analysis and to model different life plans for retirement. They provide a framework that is immensely valuable. They will teach you essential principles that will positively impact your financial decisions and have practical application for how you invest, manage your money, and design your life.

Just don’t mistake the map for the territory by believing the magic number produced is even remotely accurate.

Calculators are best used for mapping a path and putting numbers behind your life plan. They are indispensable for seeing the financial impact of “what if” scenarios so that you can make better informed decisions about the future.

With that said, always remember to treat the output with caution and never confuse mathematical science with art.

The future cannot be forecast with scientific precision… and neither can your retirement.

Finally, if you got value from this article please let me know by liking, linking and +1 this article and the retirement calculator resource page here. I appreciate your support and welcome your feedback in the comments below…

You Might Also Like…

• Retirement Calculator – 10 calculators to choose from to help you model every aspect of retirement planning.
• How Much Money Do I Need To Retire – A brief (46 page) ebook that teaches you the three valid approaches that actually work.
• Are Safe Withdrawal Rates Really Safe – A complete expose unmasking the controversy behind safe withdrawal rates and providing a step-by-step solution to estimating your personal safe withdrawal rate.
• 5 Reasons Why You Can’t Trust Retirement Calculators – Unmasks the magical number myth – warts, blemishes, and all.

Financial Mentor Around The Web…

My writing was featured in several blog carnivals over the past two weeks including…

• Canadian Finance Blog Carnival , Festival of Frugality, Carnival of Financial Camaraderie, Carnival of Personal Finance, Carnival of Wealth, Carnival of Retirement, Self Directed Investing For Retirement Carnival,  Carnival of Financial Camaraderie again, and Carnival of Financial Planning.
• Media mentions this month included SmartMoney.Com and Yahoo Finance. I also had several guest posts published on other quality financial web sites throughout the month.
• Please “like” my Facebook Page or follow me on Twitter here so you can stay up to date on all current developments. There is more going on than I can mention in this brief round-up and that is the best way to stay in touch.

Yet, it has become the biggest personal finance problem most people face.

How can something so simple create so much difficulty in people’s lives?

In this article I explain the deceptive nature of debt problems, the simple rules to keep you out of trouble, and the best way to solve any debt or credit problems you already have…

The Real Problem Isn’t Debt…

First off, debt is a symptom – not the problem.

Tracing the problem back to its root cause works like this…

• Your money problems result from excessive spending or insufficient income.
• Excessive spending and insufficient income problems are caused by life habits.

That is why debt and credit problems are so difficult to resolve for most people. It is a personal life problem masquerading as a financial problem. You look for financial solutions but they don’t exist because you’re looking in the wrong place.

Everybody knows the cure for debt and credit problems is to make more money or reduce spending. Duhh! So what? Getting it done is the surprisingly difficult part because the solution looks financial but is actually personal.

That is why extremely popular blogs exist on this topic. We want to believe there is a missing “secret” or “insider tip” that will solve our problems so we continue to search for more information. Unfortunately, more information won’t solve anything.

The real problem is inside you – money is just the symptom. There is no magic solution because you are a complex human being.

As a money coach I used to accept get-out-of-debt clients and it was a fascinating journey. With few exceptions the client’s financial problems were a mirror reflection of the underlying habitudes (habits and attitudes) that governed all of their behavior. Money problems were merely reflecting those habitudes financially just as other aspects of the client’s life (poor relationships, health, unhappiness) were reflecting the same habitudes.

In other words, people who ended up with credit card debt through overspending (as opposed to being caused by catastrophic events like medical bills, divorce, accident, etc.) shared some or all of the following common characteristics…

• Misplaced Priorities: They chose consumption and current lifestyle over investments and freedom. Their consumption decisions reflected the underlying belief that happiness was connected to more-better-different stuff. It’s not.
• View Credit As Money: They used credit to extend purchasing power. It doesn’t work that way (except in the short-term).
• Instant Gratification: They chose instant gratification over delayed gratification. They generally operated from the perspective of “today” and ‘this year” but failed to connect those actions to results 10-20 years later.
• Procrastination: Instant gratification leads to putting off the hard stuff until tomorrow. This multiplies short-term inconvenience into long-term disaster.
• Victim: They don’t own the source of their problems as caused by themselves. Someone else or some unfortunate event did it to them.
• Emotional Spending: They buy for ego and emotional satisfaction instead of utilitarian value. Self is emotionally connected to stuff.
• Entitlement: They are entitled to the good things in life. Why shouldn’t they have designer clothes, a big screen TV, and a nice car… everyone else does? (Answer: they can’t afford it – that’s why – but neither can most of the other people.)
• No Plan: Spending and earning are disconnected. There is no budget, no system for growing assets, no tracking of numbers, no plan for leverage, and no strategy for increasing earnings. In short, there is no discipline.

What’s amazing (and obvious in hindsight) is you can flip every one of these characteristics upside down and you have a short list of habitudes that produce wealth. In other words, my wealthy coaching clients had one set of habitudes and my debt clients had the mirror opposite.

I was amazed! But this was not a coincidence.

As I said earlier, debt is a symptom… not a cause. The cause of your financial problems is not financial (with the sole exception of unusual circumstances such as medical, catastrophe, etc.)

Now that we understand the root cause of debt and credit problems (your habits and attitudes), let’s look at some simple rules for habits and attitudes that cut through all the information clutter so you can avoid debt problems…

Proper Use Of Debt

Debt isn’t all bad.

Let’s start by looking at two acceptable forms of debt – financing large capital purchases and income property acquisitions.

For example, a perfectly viable wealth strategy using debt financing (a mortgage in this case) is to purchase a rental property that produces more income than expenses (positive cash flow).

Similarly, it can be a very smart wealth building strategy to leverage a business using debt as long as the income produced by what you purchase with the debt exceeds the cost of the debt.

These are both intuitively obvious examples of “good debt” because they put more money in your pocket than they take out while growing a valuable asset. The income produced by the asset exceeds the cost of servicing the debt. It is a straightforward application of financial leverage to multiply wealth.

The analysis gets confused when large non-consumption capital expenditures are purchased where no income is produced.

For example, debt is acceptable for buying your home. The reason is because you need housing so you either throw money away on rent in perpetuity or pay a mortgage and build equity. The key distinction is the asset has enduring value and isn’t “consumed”. It is not like a car that you use up and dispose of. It is a capital item that produces a utilitarian good (a place to live) without being used up (assuming you maintain it). It can even increase in value over time (except during a credit deflation).

These two situations (large capital expenditures that are not consumed and income producing property) are the two situations where debt can make good business sense.

These are both examples of good debt.

Now let’s look at bad debt…

3 Rules To Never Get In Debt

Bad debt is when you use credit to increase consumption beyond what you can afford to pay. The key point is the spending is for consumption – not an asset.

The rule is simple when spending on lifestyle: if you don’t have enough money in the bank then you can’t afford it.

That means the only acceptable function of credit cards is for transaction convenience. They should never by used to extend purchasing power.

In addition, you should pay your cards in full every month. Never roll a balance over from one month to the next.

Your objective is to be a credit card “deadbeat” by paying off your balance every month and incurring zero fees for the privilege of using the card.

Another advantage to credit cards are the various incentive programs that give free airline tickets, trips, hotels, and even cash back. Again, the rule is simple: only use these cards for spending you would already be doing anyway. Never increase your spending to get bonus awards.

You should never spend a dime more than you would if no credit was available and you should never carry a balance or incur monthly fees. Only then can the benefits of incentive credit cards exceed the costs (the annual fee).

I don’t promote credit cards on this site because my focus is building wealth, but if readers are interested in the latest offers here are a few links to several friends in the financial blogosphere who “eat their own cooking” by using the same cards they recommend…

• FreeMoneyFinance has researched the best cash back credit cards and uses the top choices from this list for his own purchases.
• PT Money keeps both the Chase Freedom card and the Chase Business card in his own wallet.
• Ben Edwards over at MoneySmartLife likes the American Express Blue Cash card for his personal use.

Finally, always look first at the fees charged so that you can determine if the incentive program will give your more benefit than the costs of owning the card.

In summary, the three rules to avoid getting in debt trouble are as follows…

• Debt should only be used to finance income producing property or large, non-consumption, asset purchases.
• Debt should never be used to extend purchasing power for consumption. Lifestyle should never be bought on credit.
• Credit cards should only be used as a transaction convenience and never to extend purchasing power.

That’s it! Those are the rules that will keep you out of trouble (if you follow them) – 3 simple rules that convert the complex world of debt and credit into straightforward, actionable guidelines.

Unfortunately, for many readers it is “too little, too late”. They are already in debt. If that is you then below is an equally simple, step-by-step guide on the best way to get out of debt and start building habitudes that will take you to wealth…

How To Get Out Of Debt

If you are in debt bondage then your starting point to freedom is you must create a positive spread between how much money comes in and how much goes out.

It is an inescapable fact. You must live on less than you make. There is no way around it. It is not negotiable because debt is paid off from the income leftover after expenses are paid. You can’t pay off your debt if you spend more than you make.

The way you start this process is by fully owning responsibility for your financial problems and developing a plan for solving them.

You must be proactive. Don’t bury your head in the sand because the problem won’t go away on its own. You must take serious action. The longer you wait the worse it will get.

There are two ways to achieve the goal of living on less than you earn – reduce spending and/or increase income. Seriously, I know this sounds obvious when written but this is literally all there is to it. It is not rocket science and there is no greater complication or missing secrets than what is described here.

Let’s start with a five step process for reducing spending…

5 Steps To Reduce Spending…

Step 1 – Stem the Bleeding:

Contact your creditors immediately and try to negotiate special terms. You may be surprised how helpful they can be if you just ask. It costs you nothing and the worst that can happen is they refuse.

If your existing lender won’t work with you then look into balance transfers and consolidate all loans onto the lowest interest card. Just be careful of balance transfer fees and other hidden costs. Examine the fine print first to make sure it’s really a benefit.

Your objective is to negotiate reduced rates and favorable terms to stem the bleeding. Eliminating fees and reducing interest on current debt can go a long way toward helping you ultimately payoff the debt.

Next, you must stop adding to the debt by cutting up the credit cards, locking them out of reach, or freezing them. You have already demonstrated a spending control issue so you must eliminate access to the vehicle that allows you to spend excessively – easy credit. The objective is to put obstacles between you and credit so that it is inconvenient.

Do it now before moving onto the next step. This will force you to live within your means – now!

Step 2 – Raise Awareness Through Tracking

Once credit is inaccessible and you’ve done everything possible to reduce the bleeding, the next step is to track your spending. This is not a budget. You are simply tracking where the money is going to raise your awareness…

• Is it to entertain yourself when you are bored?
• Is it on spontaneous purchases instead of planned needs?
• Is it on the latest gadgets?
• Is it on fees or interest because you are in debt?
• Do you spend for personal collections (curios, music, etc.) that you enjoy but aren’t necessary?
• How much goes to recurring expenses (rent, car payment, utilities, etc.) that can be reduced or eliminated?
• How much is wasted on fees for unnecessary convenience (ATM fees, advance ticket sales, etc.)
• Do you spend on expedient solutions that are little more than a convenience such as going out to dinner or expensive coffee instead of cooking at home (see our Latte Factor calculator for the true cost of these expenses)?
• For ego gratification (expensive clothes, latest trends, to show off to friends)?
• Name brands instead of generics?
• Processed food instead of whole food?
• Full price items instead of seasonal or sale discounts?
• New instead of used?

When you track your spending it raises your awareness about where your money goes and what your patterns are. This will point to a personalized solution that exactly fits your individual needs. Look at every aspect of your spending to figure out what is truly necessary and what isn’t.

And if you are looking for a budgeting spreadsheet to help with the process here is great list of free budget templates and spreadsheets so you can find just the right one to suit your needs.

Step 3 – Reduce Your Spending

Now that you are living within your means and tracking your spending, notice how every dollar you spend either takes you toward your goals or away from your goals.

You simply decide what priority you make certain goals – like financial freedom over current lifestyle. Remember, debt is caused by choosing the opposite. In fact, every day you are making literally 100s of these decisions that will make or break your financial future.

Your spending is a reflection of your values (once you become aware of your money). You want to align every dollar spent with your goals so that all spending moves you toward what you want most. You can’t have everything so you must decide what the highest priorities are.

The truth is you need far less than you think. The goal in this step is to get your spending down to your true “baseline” required spending so you can move away from lifestyle and toward financial security. The amount you save each month will determine how fast you can get out of debt so it is critically important.

Cut your spending ruthlessly. All excess and waste must be eliminated. Look at the big ticket items like housing and transportation first to make the biggest impact fast. Consider moving, getting rid of a car, using public transportation. Don’t assume any item is sacred no matter how entrenched, and at the same time don’t overlook any item no matter how inconsequential.

It all adds up.

Step 4 – Accountability To Supercharge Results:

Tell the world about your goal to be debt free. Pick a date, form a plan, and tell those closest to you.

Your objective in this step is to literally build a box around yourself that doesn’t allow squirm room so that you enforce your new spending patterns until they become habit. Enroll a parent, spouse, coach, or friend as an accountability partner so you have someone to report your results to. Create the tracking system.

Heck, go whole-hog and tell all your friends and enroll them to support you. This might mean they don’t invite you to eat out or go shopping but that’s okay. They shouldn’t tempt you with high cost adventures. You could even email them monthly on your results, blog about it, or report it on Facebook. Seriously! Why not? Do you want the goal or not?

Accountability is a magically, powerful force for shaping human behavior so use it to your advantage. The whole reason we resist accountability is because we intuitively recognize its power.

The question is – do you want to get out of debt or not? Accountability gets results. Use it!

Step 5 – Get The Right Attitude:

Don’t think in terms of sacrifice and all that you are giving up. Instead, think in terms of the peace-of-mind, freedom, and security you are heading toward. This is essential.

The cup is either half full or half empty. You choose the reality you live under. When you focus on where you are headed (peace of mind, security, and fulfillment) the reduced spending never feels like a sacrifice. In fact, it can be positively addicting because you are moving toward your financial goals – finally!

The Other Side Of The Coin – Increasing Income…

Now that you’ve reduced spending as far as possible the next strategy to getting out of debt is to look at all the ways you can increase income…

• Can you work overtime temporarily to get your financial situation under control?
• Is there seasonal, freelance, or part-time income you can add?
• What new job skills or education/certifications would increase your salary?
• Can you convert a hobby into income?

There are fundamentally two approaches to increasing income – short-term quick fixes and long-term permanent solutions.

The short-term quick fix is to increase the hours you work either through overtime, freelancing, or similar. This can be helpful to provide an immediate injection of cash but can lead to burnout over the long-term.

That’s why you also want to look into ways that permanently increase your income without having to work 24-7. This involves launching some type of business that begins as a sideline but can transition to full-time, or it involves gaining new job skills or certifications to increase salary in your current occupation (or possibly changing occupations).

A Few More Tips To Help Your Savings Grow Faster

Getting out of debt is a serious goal meriting serious action.

Below are a collection of additional tips in no particular order that can help you wage war on the debt monster…

• Debt results from a pattern of behavior (habitudes) so examine all patterns causing the problem and break them. This might involve changing friends or spending less time with the spendthrifts in your social circle. Any habit that results in unnecessary spending should be reconsidered.
• Don’t overlook radical measures that can make a huge difference. Rent is one of your biggest expenses. It may not be fun but moving in with friends or family, or living in your motorhome for a period of time can make a huge difference in your budget. Radical? Yes, but no more radical than putting up with the noose of debt strung around your neck.
• You absolutely must put a barrier between you and overspending. That means getting rid of your credit cards and other sources of easy credit. I said it before but I’m repeating it here because it is critically important. Cut them up or lock them away. You must live on less than you earn.
• Consider selling anything you don’t regularly use and apply the proceeds to your debt – fur coats, jewelry, a boat, motorhome, extra car. Craigslist, Ebay, and garage sales can convert an amazing amount of stuff into serious cash that can make a dent in your debt. Sure it is a short-term solution to a long-term problem, but it can also give you a jump-start while simplifying your life at the same time.

Putting it altogether, this gives you a four pronged attack for making forward progress on getting out of debt…

• Start by reducing spending to produce immediate results.
• Increase the spread between income and outflow by adding overtime or freelance work to provide a short-term income boost.
• Sell your stuff for a quick payoff.
• Add new job skills or start a business for long-term income growth.
• Rinse and repeat until you are out of debt.

While this sound simple on the surface (because it is), I also want to acknowledge how difficult many people find these action steps to implement even though they intellectually understand the process. After all, you already know what you should be doing. The problem isn’t knowing what to do: the problem is getting it done. Again, that’s because the problem appears financial when it is really personal, and there is no simple solution to personal issues like discipline, determination, and prioritization.

I encourage you to seek out support systems and apply all accountability tools at your disposal. Unfortunately, there is no royal road to the destination. Your success or failure will depend on your commitment and clarity to getting out of debt.

You wield the power to get yourself in debt; therefore, you also have the power to get back out of debt. You just have to complete the steps.

Once you create a positive spread between income and expenses the next step is applying the right debt payoff strategy to become debt free in the fastest way possible. There are two similar but distinct strategies that I will cover below…

Debt Snowball vs. Accelerated Debt Payoff

Start the debt payoff process by making a list of all your debts. You’ll find this information on the monthly statements your get in the mail.

Note the creditor’s name, interest rate, amount owed, and monthly payment. Enter all the information in this debt payoff calculator to help manage the process and estimate how long it will take you to get out of debt.

You can order your list of debts in two separate ways…

• Debt Snowball: Order the debts from smallest balance at the top to largest balance at the bottom. This gives you greater emotional satisfaction because you see results much faster. The small debts get eliminated quickly giving you immediate positive feedback and reinforcing discipline. This costs you a little more in interest than the alternative below but many consider it worth the price because the emotional satisfaction results in a higher probability of sticking with the process long enough to succeed.
• Accelerated Debt Payoff: The other alternative is to order your debts with highest interest rate at the top and lowest interest rate on the bottom. This is mathematically the best way resulting in the fastest, lowest cost payoff because it targets the highest interest rate debt first. The problem occurs if you have a large debt that is also high interest because it can feel like it takes forever to make any progress. This causes many people to give up.

There is no right/wrong answer to which debt ordering system is best. One is financially superior and the other is emotionally superior. The key is to decide what will work best for you so that you stick with the process long enough to succeed.

Next, enter the amount of income leftover each month that can be applied toward paying down debts in the box at the bottom of calculator. You get this number from the 5 step exercise above where you figured out how to spend less than you earn.

What this calculator will do for you is apply the minimum monthly payment on all debts except the top listed debt. That one gets the additional money from the step above to help pay it off as fast as possible.

Notice how the size of this additional payment determines how long it will take to get out of debt. I encourage you to play with different numbers and see how much difference it can make. It might be motivating to go back to the previous section and figure out how to increase your monthly savings so you get out of debt faster.

As the first debt is paid off you dedicate 100% of the money that went to that debt to the next one on the list. You repeat this process creating a snowball that concentrates an increasing amount of your total monthly payment to fewer and fewer debts until they are all paid off – in full. Yay!

Go ahead and punch your numbers into the calculator and give it a try. You might just be surprised how fast you can be debt free.

In Summary…

There are many ways to slip into debt. You might become underemployed, suffer a salary reduction, divorce, high medical bills, or simply lack good money management skills.

These life problems don’t necessarily translate into debt. Good money management skills combined with the following three rule system can save you from financial difficulty…

• Use debt only to purchase assets that increase in value or produce more income than expenses. Debt used this way leverages your balance sheet which can be a valuable wealth building strategy, but it can also increase your risk so be careful.
• Never use credit to increase consumption. If you don’t have the money in the bank to pay for lifestyle expenses then you can’t afford it.
• Credit cards should only be used for transaction convenience and should be paid in full each month.

These three simple rules will keep debt and credit problems from occurring regardless of life circumstances.

Credit is an expedient, short-term solution to life’s difficulties, but it is usually not the lowest cost or best solution in the long-term.

Once you have a problem the only way out is decisive action to solve the problem: it won’t solve itself. There is only way to get back out of debt. You have to do the work. There is – unfortunately – no magic fix to debt and credit problems.

From the moment you commit to taking action until the day you are debt free will likely require many months or possibly years… so plan accordingly. Set yourself up to win.

• First you must stem the financial bleeding by reducing expenses. This involves tracking all expenses and aligning your spending with your values so no money is wasted. It may also require cutting up credit cards or freezing them so you eliminate easy access to credit. (Did I say that before?)
• Second, you must increase income to widen the gap between how much you spend and how much you earn. This can include both short-term strategies such as overtime and long term strategies like adding career skills or starting a business.
• Next, take the amount saved each month and dedicate it toward paying down debt using either the debt snowball or the accelerated debt payoff method.

The key point is to realize that debt and credit issues are a personal problem masquerading as a financial problem. This deceit is the why so many people have trouble managing debt and credit. They look for financial solutions when the answer is personal – not financial.

Always remember the financial strategies for getting out of debt are simple to understand and implement. The personal obstacles that stand between you and debt freedom are far more complex and difficult to overcome.

This is the nature of the debt beast. That is why slaying the debt dragon is the greatest path of personal growth for anyone who has the problem.

So commit to your growth and freedom! Make this year a time where you finally break the bonds of consumerism and debt slavery.

Get out of debt and begin the journey to financial freedom.

It may not be easy… but it certainly beats the alternative.

You Might Also Like…

• Payoff Debt Or Build Wealth – Which Should I Do First? Explains the critical differences between the art and the science of paying off debt.
• 6 Steps To Recover From Financial Disaster: If you are suffering from a serious financial setback don’t worry – you’re not alone and there is a solution.
• The Minimalists Guide To Financial Planning: Financial planning is so simple it can be explained in two sentences. The principles and habitudes that lead to wealth are the mirror opposite that result in debt.
• Debt Snowball Calculator: A simple calculator that does all the heavy lifting. Just punch in your numbers and it will show you how fast you can be debt free!
• Faster, Better Results Now – A Boring Tool That Really Works! A step-by-step guide to using accountability to achieve any goal faster and with less effort.
• Are You Living In Financial Integrity? You can never be happy as long as you live out of integrity with your values. It’s a major cause of debt and financial mediocrity. Discover the solution…

Financial Mentor Around The Web…

I recently began entering my writing in financial blog Carnivals (think of  a carnival as a competition among financial bloggers where best posts are selected and celebrated.) I’ve only entered a few and you can see the results below so expect to see more of this in the future…

• Ken Faulkenberry runs the “Self-Directed Investing For Retirement Carnival” where my writing on investment strategy topics won placement in October, November, and December.
• The Best of Money Carnival elected my one and only submission, a guest post titled “The Complete Guide To Building Wealth In 2 Sentences” as the best financial article for all of 2011! Wow! Nice acknowledgement for a first effort.
• If you want to keep up with all my educational efforts that don’t appear on this site make sure to like my Facebook page here for future updates.

Oh yes, and please share you thoughts and ideas about this article in the comments below. BTW, it is a new comment system so try it out and tell me what you think!

Thanks!

It strikes me as the height of consumer insanity.

Truncating my holiday family gathering to rush out at a ridiculous hour in the morning so that I can join frenzied crowds of other insane people battling to spend money they don’t have on things they don’t need makes no sense to me.

But hey, maybe I just don’t “get it”.

I don’t believe that’s what the holidays are all about or what makes this a joyous season.

Below is my brief take on trying to keep sane during the holidays and find some happiness in the process.

First Off – What Do You Stand For?

I’ve taken a stand…

The holidays are first and foremost about family gathering and spending time together. They are about experiences – not stuff.

If you put Christmas and Thanksgiving in competition and asked me to pick which one brings more joy for the effort I’ll tip my hat to Thanksgiving all the way. Why?

• I love the spirit of giving thanks as the root of the holiday. I love a celebration that is based in gratitude.
• I love the turkey dinner with all the trimmings. Yum!
• I love gathering the family in celebration for all that is good.
• I love that there is no consumer oriented mental clutter – just giving thanks.

Christmas offers many of the same benefits but is encumbered by consumerism through gift giving. I have personally battled with this issue over the years trying to find a reasonable solution that balances all the conflicting needs while honoring my values. The following is as close as I’ve gotten to sorting it all out…

How To Shop Less And Enjoy More

My first rule for Christmas is to eliminate.

No, not the holiday, but anything that doesn’t add joy to the holiday.

For example, both sides of my family agree that Christmas is about family gathering and not consumerism so we have created a variety of gift giving guidelines:

• Gifts are for children only (through college graduation). Adults don’t exchange gifts. It just gets to be too much cost, work, and none of us really need anything anyway.
• My wife purchases gifts throughout the year based on inspiration in finding something that speaks to that person and their unique interests. She then stores it until Christmas eliminating the rush “to find something”.
• All remaining shopping is based on lists so there is no emotional buying “because it is an insane deal” or whatever.
• Any and all shopping that can be done online is done online (see my note about Amazon below). This reduces time wasted battling crowds, eliminates emotional buying, eliminates cost of gas and wear and tear on the cars. It is usually the lowest cost solution when everything is added in (even if the price isn’t the lowest).

Besides controlling the gift giving frenzy, we also eliminate wherever possible in other areas of the holiday celebration.

For example, we always decorate the house to create the festive mood in the household, but the tree is variable depending on where the holiday will be celebrated. Some years we get one and some years we eliminate this step. When we choose to have a Christmas tree we make it part of the holiday tradition by getting a cutting permit and hiking into the mountains nearby to cut the perfect tree (with hot chocolate in tow).

(Side Note – 2 years ago my daughter and I had a great time creating our own Charlie Brown Christmas. We found the scraggliest, most pathetic, little tree in the forest and built a Snoopy dog house out of boxes to place under the tree with our stuffed Snoopy Santa on top. We created an entire Peanuts Christmas scene out of the tree in one corner of our living room. It remains one of my favorite Christmas trees )

Online Shopping

One of my favorite retailers is Amazon. It is where much of my Christmas shopping will occur this year – all with the convenient click of a mouse and no crowd headaches.

I like Amazon because the search and ratings abilities make product selection a snap while giving me a no-brainer, low cost provider for nearly everything on my list. When I shop locally (computers, television, etc.) Costco provides the same no-brainer solution (best value for money without requiring tons of research).

Amazon is not actually a retailer because it acts as the middleman for an amazing number of retailers. That’s why the selection and availability of products is unparallelled. In fact, I will soon be one of those retailers as I move my ebooks to the Amazon Kindle marketplace early next year.

Another development for next year is I will be offering my first group coaching course (yes, I know it has been long anticipated and awaited). I haven’t named this new course yet (more on that in future emails) but it is all formatted and ready to go. What I will tell you now is the premise behind the course: It teaches the habits and attitudes that create wealth automatically as part of your daily living so that your financial success becomes a matter of “when” – not “if”.

The reason I tell you this now is because it ties into the Amazon shopping discussion above and the fact that readers have been pestering me for years to post a recommended reading list.

I’ve been putting off getting the recommended reading list done despite repeated requests because there always seemed to be some other priority. I’m finally making time for it now to coincide with the holiday shopping season.

What you can expect over the next several weeks is the addition of several reading lists organized by specific topics in investing and wealth building. Each will be announced in this newsletter throughout the holiday shopping season. This first list provides the recommended background reading for my upcoming course on the habitudes (habits and attitudes) that build wealth. Get a jump on 2012 and pick your favorite book today…

I’m trying to be a smart businessman by giving you value through the recommended books and giving you a chance to support this site through a shopping strategy I use myself. When you click through one of my book recommendations (which are all affiliate links) I get paid on every purchase you make at Amazon (whether it is the book or not) while you are there.

So anyway, these are wonderful books to give as gifts because you are giving the gift of financial knowledge. Books are your best value in financial education and every purchase made while shopping at Amazon (after checking out one of these books) supports this site so I can continue to bring you all the high quality financial education I provide at no cost.

It is a great way to give “thanks” and is a win for everyone.

So thank you for your support during this big shopping weekend and throughout the holidays. I hope you get value applying some of the same principles my family uses to keep the holidays sane, affordable, and most importantly – joyous.

Have a wonderful Thanksgiving (and a peaceful Black Friday with online shopping instead)!

In retirement planning the quintessential example is the safe withdrawal rate myth.

Everyone needs to know the answer at some point in their lives: How much can you safely spend from your retirement account without running out of money before you run out of life?

Excellent research exists on this subject yet it gets dumbed down by media and other bloggers into an oversimplified 4% Rule. It is a neat, clean, and tidy answer – well researched, simple to understand, and easily actionable.

It has great sales appeal… and it is also dangerously wrong.

Safe Withdrawal Rates Revealed

That is why I just spent the last two weeks researching and writing this article unraveling the truth behind safe withdrawal rates. Seriously – two weeks! That is how important I consider this subject to be for your financial future.

Why would I take that much time on a single article for a subject many of you don’t even know about? Let me explain…

• Critically Important: Because safe withdrawal rates are critically important to you – whether you know it or not. They define how much money you need for retirement and how much money you can spend from savings during retirement. This knowledge can make-or-break your financial security.
• Dangerously Wrong: Because there is a ton of misinformation and dangerous half-truths about this subject. I wanted to dig deep into it so that you had the knowledge you needed to make the right decisions.

Why Safe Withdrawal Rates Are Critically Important To Get Right

A lot of people don’t understand why this information is so critically important so let me explain…

Every new retiree needs an answer to the same question – what is the maximum retirement income I can withdraw from savings without going broke before I die?

It is the single most common question I get from retirees and near retirees.

The reason is because safe withdrawal rates impact every aspect of retirement planning – from the lifestyle you can afford to the amount of savings needed to fund it. Small errors in safe withdrawal rates multiply over many years causing huge financial impacts…

1. Lifestyle You Can Afford: Few people realize that a mere 1% safe withdrawal rate change makes a big difference in spending during retirement. It seems counter-intuitive because the number is so small. However, a 1% variation from the industry standard 4% assumption will increase (or decrease) your income in retirement by 25%. That can make the difference between a world traveler lifestyle or living at home on hot dogs. In other words, it pays to calculate your safe withdrawal rate as accurately as possible because small changes equal huge changes in the lifestyle you can afford.
2. Savings Required: The amount you can spend each month from savings and the amount of savings you must build to support your retirement are flip-sides of the same coin. One implicates the other mathematically. For example, the “4% safe withdrawal rate” is mathematically equal to the “Rule of 25” (you need 25 times your first year spending in savings). Similarly, a 3% safe withdrawal rate equals roughly 33 times your first year retirement spending in savings. Using the two examples above, a mere 1% change in safe withdrawal rate when spending $100,000 per year in retirement is the difference between building a nest egg equal to $2.5 million vs. $3.3 million – obviously a big deal. Conversely, knowing you can safely spend 6% would knock the savings requirement down to $1.7 million. That’s why it is so important to figure an accurate safe withdrawal rate: It can change the amount you need to save for retirement thus shortening the time it takes for you to reach your financial goals.
3. Risk To Financial Security: If you withdraw just 1% more than your actual safe withdrawal rate you will go broke before you die. It is a mathematical truth. A mere 1% less would have allowed your nest egg to last a lifetime. That’s why accuracy is critical – because the razor thin margin between 1% too much and getting it right is literally the difference between poverty and financial security.

Like Goldilocks, there is a sweet spot in retirement spending somewhere between “too much” and “too little” that is “just right”. In an ideal world you would exhaust your last penny from retirement savings as you exhaled your last breath. That is the theoretical objective of safe withdrawal rates.

It is a high-stakes game where the quality of your life during retirement is dependent on getting the answer right. For that reason, there is probably no question more important in retirement planning.

That’s why I spent two weeks writing this article for you explaining how it works.

How Conventional Wisdom Got Safe Withdrawal Rates Wrong

Common sense would dictate that a subject so important would have been well researched.

In fact, the truth is that it is well researched but mass media and casual bloggers have somehow dumbed the conversation down into a dangerous 4% Rule that is not consistent with quality research conclusions. It is dangerous and you need to separate the fact from fiction to make well-informed decisions.

What You Should Do About It

Simple. Read this article.

The only price you pay is time. I’m giving you this knowledge for free.

The price of admission is you just have to care enough to read it and leave a comment. Nothing for sale – no pitch.

The information in this article is critically important to your financial future. It can help you avoid falling prey to the over-simplified, conventional wisdom.

Please leave a comment at the end of the article and let me know how it affected your thinking. Did I achieve my objective? Did it make sense? Did you learn something of value?

I really want to know…

The link to the article is here – Are Safe Withdrawal Rates Really Safe?

Humans are motivated by many different things: money, prizes, power, praise, recognition, prestige, ego, time off, sex, and much more.

But on a more basic level our motivations can be broken into two categories – intrinsic and extrinsic – and this distinction is critical according to Dan Pink in his new book, Drive.

Extrinsic is the old carrot-and-stick approach – the hope of gain and the fear of loss. This includes payroll and bonuses.

Intrinsic motivators are more powerful and can be broken down into 3 categories:

1. Autonomy – Control over your own work and destiny.
2. Mastery – Continual improvement.
3. Purpose – Honor personal values and be part of something bigger than just yourself.

In a throwback to Maslow’s hierarchy of needs, Pink points out that when a worker feels fairly compensated then intrinsic motivators may have a more powerful influence than traditional extrinsic motivators (more money). When your basic needs are taken care of then self-actualization and esteem become a higher priority than additional financial compensation.

My own life experience and working with so many money coaching clients supports this theory. In addition, workplace research corroborates this finding with studies showing monetary rewards designed to increase performance may have the opposite effect. This is particularly true for autonomous workers in jobs requiring innovation and problem solving but less true for workers completing repetitive tasks.

Why “Drive” Is Essential Reading…

The “New Retirement” is a huge issue in today’s workforce.

The crux of the new retirement is that lifespans have increased 30 years in the last 100 making the old retirement financially difficult to obtain and not very fulfilling. Most people can’t save enough to support 30-40 years of leisure and even fewer define happiness as working like a dog for 40 years so you can do nothing of substance for the last 30 years while health declines.

Instead, the new retirement is following Pink’s prescription to perfection.

Once workers satisfy their basic need they become less motivated by money and more motivated by intrinsic factors. This causes early departure from traditional careers into part-time work and encore careers.

Employers would be wise to wake up. Employees are moving on when their basic needs are met and it is needlessly costing companies a fortune. Life is short and employees want fulfillment during their brief journey on this earth.

The Pursuit Of Fulfillment Above Maximum Wealth

The call for fulfillment usually occurs around the time a prospective client is marginally financially independent. They are typically a little short of obvious financial freedom but close enough to be driven by intrinsic motivation to make the call. They are restless and don’t understand why. They’ve worked a good career, built a solid nest egg, and now something is different but they don’t know how to put all the pieces together.

Sound familiar? Many of you can probably relate. I know that was my experience in my early 30′s.

It was a very confusing time because I “had it made” by everyone’s standard – except my own. I was making good money yet there was something missing… something more. I knew I wanted to change careers but couldn’t sort the issues out. If it was about maximum wealth I would have happily stayed in the investment management business. Blogging and coaching has always been driven more by fulfillment than making money.

Unfortunately, Pink’s book didn’t exist back when I sorted these issues out. It could have helped me understand what was going on and maybe saved me a lot of trial and error. It took me years to work through the issues because there was nobody to show me the ropes. I fumbled through by intuition alone.

I recommend the book. It is a smarter, more efficient path to the knowledge.

What This Means To You…

In a nutshell, if you are financially successful (which all my readers will eventually become, of course ) then you will transition from extrinsic motivation to intrinsic motivation. It is as inevitable as night and day.

You may not realize it now, but when your basic needs are met for the lifestyle you feel comfortable in then the issues discussed in this book will raise their heads and demand attention… whether you like it or not.

Get Pink’s new book, Drive, and it will help provide a basic understanding of the landscape.

I hope you get good value from this resource, and I welcome your thoughts in the comments below…

Good investments make a profit, of course.

But this glib answer avoids the real issue…

Today, everyone wants to know if precious metals are a “good investment”, 5 years ago it was real estate, and 15 years ago it was technology stocks. It’s the same mistake over and over again – everyone thinks in terms of product.

If you want to become a great investor forget about looking for a “good investment” and start focusing on risk management, timing, and strategy. Stop thinking in terms of “product” and start thinking in terms of “process”.

This distinction is critical to your long-term investment success.

Let’s see how it works…

What’s The Difference Between Product and Process?

Bob the broker calls up Johnny Customer with the latest hot tip from his research department.

“Johnny, stock XYZ is undervalued. Our research shows good things coming down the road for this company and we recommend buying it”,  says Bob.

Bob is selling a product – not a process.

Notice there is no discussion of the investment process involved (in this case – active stock selection). Instead, the focus is on the stock which means critical questions will be overlooked…

• Where is the long-term research showing a positive mathematical expectation for prior recommendations?
• How will you know if the recommendation is wrong and what criteria do you use to decide when to exit (risk management)?
• What percentage allocation is appropriate to any new position (risk management & strategy)?
• Assuming the research department is right and the stock rises then how do you decide when to sell? What do you replace the position with and why (strategy)?

In short, what is the investment process and how does it work? That is the relevant question.

Surprisingly, few people focus on that question.

Instead, everyone wants to find the next good investment. They want a magic pill. They want to find the next Microsoft or Google in it’s infancy.

Sorry, long-term investment success doesn’t work that way.

It is a process.

3 Ways To Profit By Getting Just One Thing Right

For example, at the height of the real estate debacle in 2008-2009 everyone agreed houses were a bad investment. Investors were going broke and prices were in record free-fall.

However, you could still make a great investment if you had a strategy that bought foreclosures and abandoned property at 20 cents on the dollar. At the right price any asset can be a tremendous investment – including an asset where the price is declining rapidly.

In this example, the product (real estate) was a terrible investment, but with the right process (a risk management strategy) it could be an excellent investment. How? Because you can convert a declining asset into a good investment without regard to market conditions when the margin of safety built into the intrinsic value of the price justifies the risk.

The key principle is the risk management process – not the investment product it is applied to. It is about process – not product.

Similarly, most people lose money trading options. The stats are abysmal. Few investment expert‘s would disagree that options are a lousy investment product for most people (except gurus selling options trading courses, naturally ).

However, a viable, low risk strategy is to sell out-of-the-money puts on new positions you seek to acquire so you can add current income to your portfolio while potentially acquiring new stocks for cheaper than they are selling today.

Again, a generally “bad” investment product for most investors can be turned into a low-risk source of income when the right strategy (process) is applied.

The truth is there are no bad investment products. They are neutral and have known characteristics. However, there are bad strategies applied to investment products.

Continuing with examples, gold has been in an 11 year bull market. Gold is not an inherently good investment product as anyone who owned it during the ’80s and ’90s can attest; yet, every now and then it has a day in the sun.

What is relevant is a valid timing process that can keep your capital out of the long-term bear markets and in the long-term bull markets. Again, it is about process – not product.

So, what can we learn from these three examples…

3 Things To Notice About Good Investing

From all the above examples there are three ideas you want to note…

1. If you get the timing right you can be wrong about valuation and strategy yet still come out with a profit.
2. If you get the valuation right you can be wrong about timing and strategy and still come out with a profit.
3. If you get strategy right (have a positive mathematical expectation with good risk management) your profit is assured over time even though any single investment can fail on timing and valuation.

The key is to realize there is no such thing as an inherently good or bad investment.

Successful investing is all about process – risk management, strategy, and timing. It takes work and effort.

Everyone want to know, “What is a good investment?”, but it’s a fundamentally flawed question that sends your thinking in the wrong direction. It is the myth of the magic pill – a one stop solution.

Good investing is all about risk management, strategy, and timing.

It is all about process.

So please share your thoughts on this subject. Did you gain new insights or am I missing something. I would love to hear what you think and thank you for joining the conversation…

You Might Also Like…

• Are You Gambling Or Investing? Learn how to invest with the house advantage so that you can put the odds of success on your side.
• Ten Commandments Of Investment Strategy: Find out how your investment strategy measures up to proven success principles and learn what you can do to increase your financial security.
• Top 26 Warning Signs of Investment Fraud: How to uncover even the best disguised investment fraud before it costs you money.
• Are You Making Any Of These Deadly Dozen Investment Mistakes? Reveals the twelve most common investment mistakes that can separate you from financial security.

Nowhere is this more true than with investment research. Every day another trading system or sure-fire way to riches gets published.

It always looks good on the surface – impressive statistics, testimonials, lots of social proof. You will find them in best-selling books, or published by an authority figure (like a professor), or endorsed by a trade journal.

None of that matters. It can’t be trusted.

There is still a good chance it can be total hogwash so you must do your own due diligence. You can’t blindly invest your savings based on third party research no matter how legitimate it appears on the surface… unless you are willing to lose your money.

How Investment Research Creates Fiction From Fact

Any time humans interact with data there is opportunity for error. Below are the 5 most common ways problems occur…

1. Data Errors: Investment research requires data sampling to keep the project from becoming unwieldy. Unfortunately, sampling introduce bias – by definition. Do you exclude or include companies that have gone out of business (survivorship bias)? What time periods do you test (cyclical bias)? Big cap, small cap, or micro-cap? End of day data, intra-day, weekly, or monthly? Every decision will affect the results – some quite dramatically. Just because an investment strategy appears to work on one time period does not imply it will work on another time period… or even in the future (which is the only time period that matters).
2. Undisclosed Assumptions: How are transaction costs accounted for? Did the system assume reasonable fills during the 2008-09 decline or the 1987 crash? What are the assumptions for the bid/ask spread? Commissions? Depending on trading frequency these small details can completely invalidate an otherwise stellar investment strategy.
3. Judgment vs. Mathematical Rigor: Beware of any “research” that allows room for interpretation, vagary, or judgment. The human mind can and will deceive (both in love and investment research). If the study isn’t mathematically rigorous then skip it. It’s either quantified or it’s fiction.
4. Interpretive Bias: Marketers use statistics like a drunkard uses a light pole – for support instead of illumination. You can’t understand a person’s opinion until you know the shoes they stand in. What are they selling? Did they build a business around this research? Who paid for the research? Do they have an axe to grind? All these things can pervert the science of statistics into supporting biased opinion and business expediency. Always analyze the source of the research and their financial motivations.
5. Algorithmic Errors: Some researchers simply screw up. They publish results that include blatant algorithmic errors or data errors. Seriously, it happens with surprising frequency. Worse yet, the flawed conclusions then get repeated throughout the blogosphere creating social proof and authority making the work appear indisputable.

The Devil Is In The Details

These concerns may sound like a bunch of financial geek details reserved for propeller-heads with thick glasses and pens in their pockets… but it’s not.

These concepts can make or break your financial future. They are critically important.

Think about it – you must base your investment decisions on something. If the logic and research behind those decisions is flawed then the outcome will likely be expensive. Knowing the difference between valid and fictitious investment strategy is critically important to your financial security.

The issues discussed above are not reserved for data freaks: they are relevant to every investor… including you.

The essence of investing is to only put your assets at risk for a positive mathematical expectation. Anything less is gambling. The only way you can know if your investment strategy provides a positive mathematical expectation is solid research. Period.

And if I’m sounding like a curmudgeon please understand this is based on decades of actual research myself and digesting other professional’s research. The process is far more tenuous than anyone who has not personally dug deep into this subject can be expected to understand.

I spent a decade of my life verifying and testing published trading systems for a hedge fund. Surprisingly, almost none of them worked as published. Seriously! The models were riddled with flawed assumptions and data issues that made them unusable for real-time investing.

Granted, I did this research a decade ago so you could argue the market is more sophisticated now… but I doubt it. See this post by the Empirical Finance Blog on  The Magic Formula for current evidence. If you think this is an isolated circumstance then remember the infamous “Beardstown Ladies” fraud and how their published track record was complete nonsense.

These are best-selling books by major publishing houses offering questionable research conclusions.

I know it shouldn’t be this way and you should be able to trust what you see in writing, but it’s not the way the game works. Sorry.

It all boils down to a simple equation – small errors in investment research compound into HUGE errors in results. It is the nature of compound returns. The equation is multiplicative – both for growing wealth and compounding errors in research.

The devil is in the details.

2 Ways To Solve The Problem

So what’s an investor to do? How can you determine what investment strategies are sufficiently trustworthy to justify putting capital at risk?

1. Verify the research yourself: Yes, it is a lot of work and probably not a viable solution for most, but it is an acceptable alternative if you have a passion for this subject.
2. Find independent, third-party verification: If you won’t verify it yourself then you will have to find someone else who did. Fortunately, with the growth of the internet this is frequently a viable alternative. Third party bloggers and competing authors often corroborate claims.

That’s it! Those are really the only two ways to resolve the issue. Either verify the research yourself or find someone else who did. Either way, it must be verified and deeply understood before putting capital at risk. Anything less is gambling.

In addition, I like to see two more pieces of evidence before putting capital at risk on investment research…

1. Real-time track record: I prefer the track record be independently audited and to include data periods that represent adverse conditions for the investment strategy. For example, if it is a trend-following strategy I like to see how the strategy managed risk during sideways markets. This is critically important.
2. Market logic: I avoid any investment approach that is rooted in data-mining instead of market logic. In other words, the math should quantify an exploitable inefficiency in market price behavior and not just be a statistical aberration of the data.

I understand this is all a painful inconvenience. Investing should be easier and you should be able to trust published research. Unfortunately, historical fact disagrees.

The reality is money is hard to save and easy to lose. It may take extra effort to complete proper due diligence, but I guarantee it will be far less effort than having to replace investment losses from earned income.

So what do you think? Maybe you can cite some more examples of bogus research in the comments below? What ideas did I miss and what thoughts would you like to add? Please tell me your thoughts in the comments below…

You Might Also Like…

• Due Diligence: Five “Must Ask” Questions Before Making Any Investment - Learn what due diligence questions to ask so that you can avoid losing investments before they cost you money.
• Top 26 Warning Signs of Investment Fraud: How to uncover even the best disguised investment fraud before it costs you money.
• Investment Fraud Prevention – A Due Diligence Checklist: Reveals the crucial questions to protect you from investment fraud and send the con-artist ducking for cover.
• Ten Commandments Of Investment Strategy: Find out how your investment strategy measures up to proven success principles and learn what you can do to increase your financial security.

“I am aching to be free of my student loan debt (roughly $60k), so I’ve been religiously following a debt-payoff plan thanks to your ADP calculator. At the same time, I’ve been struggling to put 10% of my monthly income towards savings, and another 10% towards my IRA (though, I know it’s not enough). I’m 26 years old. Years away from retirement. And aching to be debt-free….

What’s more important? Quick debt-payoff? Or maxing out IRA contributions and saving 10% of my income?

If I cut back on contributing to my savings and retirement even 50%, I could be free of debt 2 years sooner (saving $5,000 in interest) than if I continue to save/contribute the way I am. If I were debt-free, I could travel at will, put away more for retirement later on, save for a house… Oh, the possibilities! But, then I slow down my savings and retirement accounts. Any advice?”

Patty, first off, I want to acknowledge your clear focus and dedication to your financial goals. I’m confident you do well regardless of which choice you make with this decision.

Also, thank you for the kudos on the accelerated debt reduction calculator. I’ve put a lot of work into the free financial calculators and free retirement calculators on this web site, and I encourage every reader to make best use of these valuable resources. I use them personally and with financial coaching clients regularly.

To answer your question… the scientific, 100% accurate response is, “you should do what gives you the highest after tax return on your capital”. Unfortunately, this answer is useless for real world application.

The problem with the scientific answer is you have to know the future after tax, compound return for every investment alternative (which is impossible since the future cannot be predicted with any accuracy).

So much for science in the world of personal finance…

The practical answer is a blend of art and science. It combines the personal aspects of financial success (money habits, psychology, etc.) with proven financial principles. I point this out because the art-science principle is going to have broad applicability to most financial decisions you face over your lifetime. Science roots your financial plan in hard numbers while art incorporates the emotional/human aspects of building wealth. Both are important.

Putting the two together, there is a huge tax deferral value to retirement savings given your age that can never be recaptured if you don’t make use of it now. In addition, getting started early on retirement savings is one of the single smartest financial habits you can develop. I walked-the-talk on this one and it is a major reason I was able to “retire” at age 35.

My personal bias is to always max out tax-deferred and tax free retirement savings first unless there is a really compelling reason (higher after tax return elsewhere) not to. This is just a solid rule-of-thumb. The tax advantages provide great value over a lifetime, and the penalties provide a good fence around your fortune so you don’t raid your nest egg during life’s inevitable setbacks. Both are important to your lifetime wealth equation.

How you prioritize your remaining funds is a question of values. In other words, you clearly have a high emotional value on being debt free and will likely feel a great a sense of achievement and forward momentum when you reach this goal. The importance of this can’t be overstated. Since you are already playing offense (building wealth) with your retirement accounts it is perfectly reasonable to put on a good financial defense (pay down debt, reduce risk) with your remaining capital.

The counter-argument to the above logic would stress that student loan debt has a known cost in terms of interest rate. Post-tax, regular savings has an unknown benefit which is a function of your investment skill and market opportunity. Therefore, it is unknown which will provide the highest after-tax return (but it is relatively clear which will provide the highest emotional return).

After weighing all the various arguments, my suggested order of prioritization based on the limited information provided would be to…

1. Fully fund all tax-deferred retirement plans first.
2. Pay down debt second with remaining capital.
3. Build post-tax savings only to create a small nest egg for temporary hardship until debt is paid off and then go big after that.

I would add one more point to this equation… you should dedicate an equal focus to building your investment skill while your capital remains small and you are paying down debt. Learn the investment ropes now and make your mistakes early with smaller dollar amounts. The lifetime value of this early education compounded over a lifetime is literally worth a fortune to you.

Anyway, I believe this formula should strike a reasonable balance between the various conflicting needs for limited funds. It should come close to balancing both the art and science of building wealth.

What do you think? Do you agree or disagree? What principles discussed here can you apply in your own life? What did you like about this plan and what did I miss? Share your thoughts in the comments below…

That is exactly what I’m publishing, linking to, and providing over at my new Facebook fan page. I encourage you to check it out and “like” the page (if you haven’t already).

I tell you this because I’m now providing two distinct streams of financial education to help you build wealth. The way I’m organizing content now is as follows…

1. This web site serves as the permanent home for all my writings, courses of instruction, and educational material. All new articles get published here and you get them first as a subscriber. It’s all original stuff and it’s all mine.
2. My Facebook fan page is where I’m sharing links to all the other resources throughout the web that I find useful and valuable… but aren’t written by me. It is more conversational and casual plus you can access me directly.

Here is a sampling of the resources I introduced on FB last week…

• Interview/Podcast: Jaime Tardy over at Eventual Millionaire interviewed me last week and claimed it was one of her best interviews ever. That is no small statement considering the previous week her guest was none other than Guy Kawasaki. Wow! I feel honored. Many of you have never heard my voice so here’s the link to listen or download the interview. Tell me what you think in the comments below…
• Interview/Podcast: Zack Miller from Seeking Alpha infamy (at least, famous in the financial blogging space) interviewed me over at Tradestreaming.Com the prior week. If you didn’t get enough of me talking in the previous interview and want another round then grab your download link or listen here.
• http://econstories.tv/ : These guys put together a group of first-class videos that clearly demonstrate the differences in economic theories between Hayek and Keynes. This is essential education because Keynes theories determine economic policy throughout the world; however, it is just one theory. There are competing theories. If you don’t like the financial mess we are in right now then you may enjoy these videos. Pay really close attention, both to the graphics and the video footage. There are many important details that can easily be missed. These are beautifully and professionally prepared, entertaining, and yet very educational for the attentive listener. I loved them.
• http://www.gmo.com/websitecontent/JGLetterALL_1Q11.pdf : There is a lot of nonsense thrown around the web about resource depletion vs. conspiracy theories vs. monetary inflation to explain the rising prices we are all living with. Few are as qualified to sort the mess out as Jeremy Grantham. He is a voice of reason with a track record that lends credibility to his conclusions. This is authoritative, valuable education.

Why You Should “Like” My Fan Page…

If you liked these resources then you will love my Facebook fan page.

These links are just a small sampling of the content I will be publishing there. Much of it will not be found on this web site because I’m very careful to make sure this site doesn’t get cluttered. It already has over 1,000 printed pages of educational content and everything that gets added must carefully build out my unique message of “Financial Freedom For Smart People”.

My fan page, on the other hand, is a casual conversation with quick little thoughts, daily updates, and timely resources that I think are relevant and valuable for people on the path.

Come on over and join the conversation. Make sure you “like” the page so that you get the updates I showed you here (and much more…)  There will be many things over there that you don’t get here (and vice versa). Each venue will provide a distinctly different set of resources for growing your financial intelligence so you can build your wealth.

One Final Note…

If you decide to listen to either of the two interviews above then please tell me your thoughts below…

The reason I’m interested is many of you have requested audio so now is your chance to get your voice heard. I’m trying to gauge interest in launching a podcast series. What was your experience from hearing me talk? Do you want more audio material where I record educational content, conduct expert interviews, etc.? Let me know your impression from the interviews in the comments below. Your feedback will affect prioritization…

Yep, I’m finally moving forward with building a Facebook presence and this is your chance to participate.

I’ve put up a brand new fan page here with a really cool welcome graphic and wall header. I’m asking my loyal subscribers to be the first to “like” my page then tell me what you really want to see from my new Facebook presence.

What’s in it for you? Well, my plans are to…

• Take feedback for future articles so you can shape my publishing schedule to match your needs.
• Offer Facebook only Q & A sessions where you can ask me your most important questions about personal finance, building wealth, and investing… free financial tips for the price of a “like”.
• Introduce you to my favorite resources throughout the internet – stuff you won’t see on this web site.
• Offer a conversational, less formal place where I share ideas and interact with you.

It’s easy for you to get access. Just click here then click the “like” button at the top of the page.

Once you click the “like” button, go inside, and help me get started. Be the first to write on my wall by telling me what you want to see from this fan page.

I look forward to seeing you inside. I’m waiting…