Friday, March 9, 2018

Case study: Analyzing an average person’s budget and investments

Here’s a new thing for me: Yesterday, I met with a friend to give her financial advice. Believe it or not, in the twelve years since I started Get Rich Slowly, nobody has ever asked me to sit down with them and review their budget and investments. Pamela is the first. (And because I forgot to ask her permission to share this info, for this article I am totally changing anything that might identify Pamela.)

I’ve known Pamela for almost six years. She cuts Kim’s hair, and sometimes she cuts mine. She knows I write about money, but I don’t think she’s ever read anything I’ve written.

Pamela is 41. She’s single. She owns her own business. She loves her work and she’s happy with her life, but she’s starting to think about the future. Is she saving enough? Will she have enough for retirement? What if she wants to buy a home? Is there anything about her budget that seems out of line? When she cut my hair last month, she asked if I’d be willing to sit down with her over coffee to look at her numbers.

“Sure,” I said. Yesterday, we spent ninety minutes going through her budget and her investment accounts. Because I feel like Pamela’s situation is very typical of the GRS audience, I want to talk about

Pamela’s Budget

Pamela doesn’t keep detailed records of her earning and spending. “Once a year, I take a month to log everything. I want to make sure I’m not out of control,” she told me. “I’m tracking my money this month, for instance. The numbers I have here are rough estimates.”

Pamela earns about $3940 per month cutting hair, or about $47,280 per year. Her business expenses — including taxes — run about $1100 per month. These are fixed, and nothing about them seems out of the ordinary to me. The remaining $2840 per month represents her “take-home pay”.

Of that, $650 goes toward rent. This is a really good number for Portland, and she knows it. She’s not happy with her roommate situation right now, but she finds it tough to move because her rent is so low. Anyplace else would probably cost at least $950 per month, and $1200 per month is probably more realistic. For now, she’s willing to put up with roommate issues in order to save $300 to $500 per month.

Pamela’s second-largest expense is food, which costs her $600 per month. “I could cut that if I had to,” she told me. “I like to eat well, and I know that costs me.”

Her other expenses — clothing, utilities, therapy, and so on — total about $900 per month. (I didn’t think to take detailed notes on Pamela’s situation because I didn’t realize I’d be writing about her.) So, her monthly expenses average $2150, which means she has a surplus of roughly $690. That’s awesome!

The bottom line: Pamela earns $3940 per month, or about $47,280 per year. Her expenses (including business expenses) total $3250 per month, or about $39,000 per year. Her saving rate is roughly 17.5% if you include the business expenses in the calculation, or roughly 24.3% if you don’t.

I think Pamela’s budget is entirely reasonable, but she could always choose to cut spending a little more.

Note: I want to tie this back to my criticism of the Frugalwoods book earlier this week. In my review, I noted that the author was able to achieve financial independence quickly not because her family’s spending was $37,000 per year, but because she and her husband have high incomes. Pamela’s spending is roughly the same as that of the Frugalwoods, but because her income is in the average-normal range, her saving rate is much lower. This is an example of why income is such a vital piece of the puzzle.

Pamela’s Investments

Of the $690 that Pamela sets aside each month, she routes $200 to an Edward Jones brokerage account. This account currently has a balance of just over $42,000 spread across nine different mutual funds. (Pamela really likes her Edward Jones financial advisor.) She also has $11,000 in a credit-union checking account, and another $3000 in miscellaneous investments.

Pamela’s advisor has invested her money in the following funds. (I didn’t write down fund balances. Sorry.)

  • American Funds AMCAP Inc. (AMCPX) – 5.75% load, 0.69% expense ratio
  • American Funds High-Income Trust (AHITX) – 3.75% load, 0.69% expense ratio
  • American Funds Capital Income Builder (CAIBX) – 5.75% load, 0.59% expense ratio
  • American Funds Capital World Bond (CWBFX) – 3.75% load, 0.97% expense ratio
  • American Funds Fundamental Investors (ANCFX) – 5.75% load, 0.62% expense ratio
  • American Funds Income Fund of America (AMECX) – 5.75% load, 0.56% expense ratio
  • American Funds New Economy (ANEFX) – 5.75% load, 0.78% expense ratio
  • American Funds New World (NEWFX) – 5.75% load, 1.04% expense ratio
  • American Funds SMALLCAP World (SMCWX) – 5.75% load, 1.07% expense ratio

Pamela also owns roughly twenty shares of Square Inc. (SQ), which she purchased because she uses and loves their technology in her business. Her $200 initial investment is now worth $800. Plus, she has about $1000 in the T. Rowe Price Science and Technology Fund (PRSCX), which has no load and an expense ratio of 0.83%. (This fund is in a Roth IRA.) These are investments she’s made on her own and they have nothing to do with her Edward Jones portfolio.

My initial thoughts on seeing Pamela’s portfolio? HOLY SHIT! I’m not joking. I can’t help but curse at this asset allocation. I cannot believe that in 2018 a financial advisor would have their client invested like this. It’s baffling.

What’s the issue? On average, Pamela’s $42,000 portfolio carries a staggering 5.31% front-end load and a 0.78% expense ratio. When she sends her $200 to invest each month, roughly $10.62 of that is going to initial fees, leaving her with $189.38 invested. Then, she’s losing at least another 0.50% (or $210) per year to expense ratios (when compared to index funds).

All told, Pamela is investing $2400 per year, but paying $337.44 to expenses. That’s 13.64% of what she’s putting in — not to mention any future earnings that money could have produced. That’s great for Edward Jones, but not for her.

Here’s another way to look at it (using a new metaphor I’m inventing for this article). It’s like Pamela and I are going to race one mile around a track. We know in advance that both of us average the same speed: about 6.8 miles per hour (or about 8:49 per mile). The race should be a close one. Or it would be, except that each of us is handicapped.

  • I’m required to carry an extra nine pounds of weight (representing the the 0.09% expense ratio for my Fidelity S&P 500 index fund).
  • Pamela has to carry an extra 78 pounds (representing her average 0.78% expense ratio) and she has to start 280 feet behind me (about 5.31% of a mile).

Assuming we’re otherwise physically equal, who do you think is going to win this race? It doesn’t take a rocket surgeon to see that Pamela would have to expend Herculean effort to catch me. And the longer we run, the more the difference in the weights we’re carrying will begin to tell.

The bottom line: Pamela’s budget is great. Her investment portfolio is not. She’s losing a ton of money to “drag” each year — and each time she makes a monthly contribution to her portfolio.

My Evaluation

“I’ll be honest,” I told Pamela after reviewing her numbers. “I feel like you’re doing fine. You don’t have debt. You spend on the things that are important to you, but you’re not materialistic. You like your work. You don’t have a driving desire to retire early.”

“So, you wouldn’t change anything?” Pamela asked.

“Well, you could always spend less, right? You don’t need a smartphone. You don’t need to spend $600 on food every month. Plus, if you took on more clients, you could boost your income.”

“Right,” Pamela said.

“But again, based on what I know of you and your goals, you’re doing a great job of balancing tomorrow and today. If there were one change I’d make to how you’re handling money, it’d probably be to save more — and to change how you’re investing.”

“What do you mean?” she asked.

“You don’t want to make things too complicated,” I said, “but if I were you, I’d consider four buckets for savings. First, set aside an emergency fund. You already have $11,000 in a checking account. That’s perfect. But I’d also have a savings buckets for short-term goals like your new cell phone and for long-term goals like buying a house.”

“That makes sense,” she said. (I didn’t tell Pamela during our meeting, but if I were her, I’d use an online savings account to get better interest rates.)

“Your fourth bucket is for retirement. You’re off to a good start there, but you might consider saving even more. And really, I don’t like how your money is invested.” I spent five minutes explaining my philosophy of how to invest and describing why I prefer index funds to standard mutual funds.

It didn’t occur to me during our conversation, but in retrospect I think Pamela needs to be using tax-advantaged accounts to save for retirement, such as a Roth IRA and/or a 401(k). (The Roth IRA is probably the simplest thing to set up, so I’d recommend that.) Right now, she’s putting her money into a regular taxable account. When I next see her, I’m going to recommend that Pamela set a goal of maxing out her Roth IRA. That’d bump her retirement savings from $2400 to $5500 every year. I think that’s both smart and doable (even if it might seem like a bit of a stretch).

Overall, I think Pamela makes wise decisions, both with her business finances and with her personal finances. She’s smart and level-headed. And again, I feel like she typifies the average Get Rich Slowly reader — or at least where the average Get Rich Slowly is starting from. My hope is that with just a few tweaks, she can give her retirement savings a turbo boost!

The post Case study: Analyzing an average person’s budget and investments appeared first on Get Rich Slowly.

Via Finance http://www.rssmix.com/

No comments:

Post a Comment