The Short Book
Wisdom from a fortune cookie. “Buy for $1.00, sell for $2.00, Happiness. Buy for $1,00 sell for $ 0.50, Misery.
The following was taken from a book titled, “Tales from the Vault by” Remmars Steven Dane. The book can be accessed at the Google site domain: StephenDaneDiary.com *
Two things to practice in managing your money.
Annualizing your expenses and maintaining your Purchasing Power.
Before you can generate wealth, you must have money to invest. Before you can invest you must have the ability to save. To save, your income must exceed your expenses. You can borrow money to invest, but your income, and earnings from investments, must now cover your expenses and your debt payments. The use of debt to maintain a lifestyle is a major contributor to financial stress. It has its most devastating impact on your life if incurred during Stage One, as discussed below.
Annualize the cost of your purchasing habits.
This is a simple idea to save money. If you graduated from the 3rd grade you can understand the concept. Calculate the difference between two numbers and multiply by 365.
One of my favorite ads on TV shows an elderly woman talking to a grocer about the price of melons.
She asks “What is the price for these melons?”
The grocer answers, “Two for 99 cents”
She then asks. “How much for this one”
He answers, “50 cents”
She responds, “I’ll take the other one”
If you understand this joke, you know what I am saying.
The woman calculated she would save half a penny by buying the “other one” for 49 cents.
In case you did not get it. Two melons would be 49 and ½ each.
This is the difference between two numbers. If the woman bought one melon each day for a year, she would save ½ penny times 365 which is $1.82. This amount was obtained by annualizing the difference between the 49.5 cent mellon and 50 cent mellon.
Nobody is going to worry about saving ½ penny a day. But suppose the numbers are bigger.
I compared the price of two different bags of Lay’s potato chips. The small bag, 2 and 5/8 ounces costs $2.50, or 95 cents an ounce. (.9523 rounded down) The family-size bag held 13 ounces and was priced at $5.99 or 46 cents an ounce. If I was in the habit of buying a small bag each day it would cost me $912.50 a year. $2.50 times 365 days. The big bag held 4.952 small bags, rounded up to 5 bags. So, each equivalent small bag from the big bag costs me $1.20 per bag ($5.99 divided by 5). Annualizing the big bag purchase would cost me $438 a year. The savings is $474,50 per year. ($912.50 minus $438.00)
Another way to calculate the savings is to Subtract $1. 20 from $2.50 to get $1.30 then multiply by 365.
$1.30 times 365 is $474.50. This is how the woman calculated her melon purchase.
Of course, there are other considerations like controlling you’re eating habits, or letting the chips go stale. Both can be controlled by putting the big bag of chips into 5 small baggies when you get home.
Although this whole discussion may seem ridiculous for a bag of chips, applying the concept to all your purchases could save you thousands of dollars each year. Some examples, eating out versus eating at home; the most efficient way to drive to work; coffee; toilet paper; Smart and Final versus Trader Joe's versus Whole Foods versus Bristol Farms; Costco gas versus Arco versus Shell; and generic drugs versus brands. The list is endless.
The idea only works if you annualize the cost. Because the marginal difference “I’ll take the other one” has no impact on the day you purchase if the amount seems small.
Maintaining your Purchasing Power. Three Stages
Purchasing Power is affected during all three stages of wealth creation. The variables, other than changes in income or expenses, that affect purchasing power are: interest rates, taxation rates and inflation/deflation rates.
Stage one Achieving BREAKEVEN
I repeat: You cannot generate wealth until your income exceeds your expenses. This is so obvious and simple to understand yet most cannot achieve it. It is like the formula to lose weight. Eat less and burn more calories than you consume. Those with a medical issue are exempt from this generalization.
Completing stage 1 is the most difficult step to achieve and is the subject of many books on how to budget. The following assumes you have control of your money and can save some money to invest. The purpose of the preceding discussion on annualizing was included to help you achieve stage one. However, it can apply to all three stages.
Stage 2 Cumulating cash to Invest The inflection point.
Upon achieving stage one you have a choice. Maintain current lifestyle, reduce current life style, or increase current life style. Unless you have an increase in income you cannot increase cash holdings or life style. So, upon achieving break even you can only accumulate cash to invest if you increase income, or you reduce expenses Creating debt to support life style just increases the breakeven point. However, debt can be incurred to support Stage 3 which is the investment stage addressed below.
Stage 3, Building wealth.
I am going to use one hour of work in the following discussion. The concepts apply whether you work one hour a year or 2,080 hours a year. If you earn $15 an hour, or $30,000 a year either you have something left over or you do not.
. You can multiply the numbers by 2,080 if you wish. Standard work is 8 hours a day, 5 days a week for 52 weeks. (8X5X52=2080)
Wealth here is measured in Purchasing Power. This is the ability to convert savings to the things you want to buy. Or to have in reserve of unexpected expenses.
If you save $1,000 and do not buy anything, it is worthless to you except as a hedge for the unexpected. You only save to have the ability to buy in the future. The ability to buy, either now or in the future is called Purchasing Power.
As noted above, the four variables that determine your purchasing power are Interest rates, taxes, Inflation, and Deflation. Inflation and deflation can be mutually exclusive or can occur together. This will be explained below.
I have created a simple formula that incorporates the four variables.
Interest, Taxes. Inflation, and/or Deflation
PP=(c+c*r)-r*tr-I(c+c*r)
A full discussion of this formula and an excel worksheet can be accessed here ( )
What is inflation?
Inflation is the marginal increase in the cost of trade between buyer and seller. It requires two separate trades. The first is to establish the base price and the second is to measure the change. The second trade can have three outcomes. No change in price, price increase (Inflation), or price decrease. (Deflation)
You can have inflation without the existence of a currency. Since the price is how the calculation is computed in a money society, inflation or deflation in a barter society would be as follows.
If one economy produces 1000 apples per week, and another economy produces 1000 oranges per week and each economy has 25 consumers. The trade value of apples and oranges is one-to-one. if all consumers consider apples and oranges to be equal in value.
Each consumer is paid in their economy’s fruit. So each consumer can eat, save, or trade. One consumer in the apple economy may only want to eat apples, while another may want 50% apples and 50% oranges.
Each consumer in the orange economy has the same options. If the ratio of apples and oranges stays at 1 to 1, there should be no inflation. However, if the production of apples or oranges is no longer one-to-one the difference causes inflation. How this difference affects everyone is unique to them. This is compounded by those who do not eat all their apple income but save apples for later to either eat or trade for oranges. I have not included this variable in my model because everyone is different. The behavior of saving creates a future apple-to-oranges inequality in the economy and is no different than a change in the production of either apples or oranges.
If apple production stays the same and wages for apples stay the same, those who only eat apples will not be affected. The same holds for orange production and consumption. However, if apple production exceeds consumption apples are less valuable than oranges. If apple production declines, apples become more valuable than oranges. The motivation and habits of each consumer will determine who and how apples and oranges are traded. The number of variables will cover an entire book on economics.
Now we migrate to a money economy. Instead of bartering apples and oranges, we have a government that creates money, and people are no longer paid in fruit. The apple producers still produce 1000 apples per week and the orange producers maintain 1000 per week.
Now we have a way of transferring wealth. I am not going to explain why this is true. Just read the biographies of those who have made fortunes and how they did it. Once the value of the orange and the value of the apple is given an arbitrary number, the ability to manipulate the market becomes possible.
To win the investment game you need to know how to predict
The three variables are: Interest rates; taxation rates and inflation rates* I know I said four variables above. Inflation and deflation on average can be netted so an increase in say gasoline can be offset by a decrease in bread. If you do not eat bread, but drive a non-electric car the increase in the price of gasoline is inflation to you and maynot be offset by a decline in bread prices. If you both drive a car and eat bread you must net the cost to you. If gas increases in and your gasoline demand is offset by a reduction in your bread consumption you have net inflation. This causes a decline in Purchasing Power. If the decline in bread prices exceeds your increase in gas costs, you have deflation. You have more purchasing power. Government statistics use averages to determine inflation or deflation.
In a barter society, you can not only have inflation but also interest rates and taxes. The only difference is interest will be paid in apples or oranges, and taxes can be levered by the king on both the production and consumption of apples and oranges.
In short, because of using averages, it is a generalized guesstimate that may or may not explain the actual change.
I will from here on just use inflation as the variable. However, if your crystal ball tells you a depression is on the horizon you can use a negative inflation rate. A negative inflation rate is the same as deflation. You have no control over inflation or interest rates. You can only guess. You have some control over your tax rate. But this subject is way beyond my purpose here. Just assume you have a good estimate of what your marginal tax rate is. Usually, your marginal tax rate is your tax bracket.
Assume you have some cash. Cash has no value if there is nothing to buy. Likewise, Cash has no value if no seller will exchange for it. So, we begin by assuming your cash can be exchanged for a good or a service you need or want, or, you can invest it. We invest our cash to gain more cash to exchange (spend) for more of what we want or need in the future. To invest some amount to get more in the future means you will not be able to spend it now.
During the time your investment is “locked up” is when the three variables, interest rates, taxation rate, and inflation rates come into play.
To be able to buy more in the future means your purchasing power has increased. If you can only buy less then your purchasing power has declined. To be able to only buy the same as you could before investing means you neither gained nor lost purchasing power
The following is the formula that determines the gain or loss of Purchasing Power.
Purchasing Power: PP = (Cash plus Cash times IR) minus IC* times TR, minus INFR times (Cash plus Cash times IC)
*IC is Income from invested cash.
1: Interest rates. IR in the formula. The movement of interest rates affects every investment opportunity.
2; Taxation. TR in the formula. There are many tax laws and they have both positive and negative consequences. Tax laws affect everyone differently. So the tax rate in your formula is probably unique to you.
3. Inflation. INFR in the formula one way to view inflation is an increase in prices. Another way is to view inflation as negative interest income.
C is the beginning value of your Purchasing Power.
Restating the formula gives.
Formula: PP= C + (C x IR)- ((TR x (C x IR))-INFR x (C +IRE)
Since (CxIR) =IE, (INVESTMENT Earnings we can simplify the formula to
PP=(C+IE)-TR x IE -INFR x rate.
What follows are 6 examples in which all or none of the variables are used to determine Purchasing Power.
Example one. You do not invest your cash. If at the beginning of some period you can buy 100 candy bars with your cash, and at the end of the period you can buy 100 candy bars with your cash, your purchasing power has not changed. In this example taxation and inflation have not affected your Purchasing Power with respect to candy bars.
In the formula above this would be PP= 100 +(100 x 0) -0 x 0 –(( 0x(0x0))
0r 100 =100
Example two. At the end of the period, candy bar prices have increased and you can only now buy 90 candy bars. Your purchasing power has declined by 10%. The decline in purchasing power is called inflation. You still have not invested so there is no investment income or taxes to be paid. In the formula, this would be
PP=100 +(100 x 0) – 0 x 0 – ((10% x100) + 0 x 0)
PP = 100 - (.10 x 100) = 90 an Inflation in price means a decline in purchasing power.
If you started the $100 with 5 twenty dollar bills, it is now the same as starting with four $20 bills and one $10 bill. You lost $10 in purchasing power even though each of the five notes still says $20.00
Example 3. You invest your cash with a current exchange rate of 100 candy bars. You are going to obtain a fixed interest return of 10%, So at the end of the period, if candy bar prices remain the same and there is no taxation on your 10% gain, you can now buy 110 candy bars. Your purchasing power has increased 10%.
Example 4; There is a 30% tax on your investment return, In this case, candy bar prices remain the same, but your 10% gain is taxed and you only get to keep 7%. Your purchasing power has still increased by 7%.
Example 5: We will assume the same numbers as in example 4 but we are going to have a 6% increase in candy bar prices. If there will be no taxes, like in 3, you would gain 10% from your investment and lose 6% from inflation.
In this example I will repeat using the starting price of $1.00 for a candy bar. You have $100 in cash. Invest $100 at 10%. At the end of the period, you have $110.00 Remember no taxes. But candy bar prices have gone up to 1.06. You have $110.00 to buy 103.77, almost 104
Example 6. For this final example we will add a 30% tax onto example 5. The variables are beginning Purchasing Power $100.00 investment rate 10%, Taxes 30%, inflation 6%,
$100.00 x10% = $110.0
Taxes: 30% x($110-$100) = $3
$107 before inflation affect.
Inflation =-6% x100 plus -6% x$7. = -$6 plus -$0.42
Total Purchasing power $110 Minus $3 taxes minus Inflation $ 6.42 equals $110- $9.42 or $100.58
So even at a good investment rate, you were only able to maintain your original purchasing power plus 58 cents,
The above examples using the purchase of candy bars may seem simplistic. However, the same three variables, interest rates, tax rates and inflation affect every decision you make. Like in example two above, the decision to do nothing with your cash causes you to lose. On the other hand, your decision to do nothing with your cash while the price of candy bars falls makes you a winner.
The most important application of this concept is the decision to invest in Real Estate. One additional element that enters the decision to buy Real Estate is the use of debt.
My last two examples will include the purchase of an item using debt. . The concept of leverage will be introduced Not only will the three variables affect your investment, they will also impact on your decision to use or not purchase using debt. This is where fortunes are made or lost.
Below are some terms used in the above along with some terms to begin to have cash to invest.
Purchasing Power, the ability to exchange cash for an asset. The asset can be consumed like food, gasoline, a haircut, rent. Something that is consumed over time like clothing, an automobile or a cell phone. Something purchased for pleasure, art work, a DVD or an antique. A complex purchase that is both a consumed asset and an investment. Your personal residence
Negative Purchasing Power. Caused by inflation or Debt. Why is debt negative purchasing power if you can purchase with it? It reduces your ability to purchase in the future. This will be discussed last as it is the main reason you have no money to invest.
Savings rate. The amount of cash left over to buy beyond your current purchases. Buy beyond means either an increase in things you now want, or money to invest.
Savings rate is a function of salary less expenses, Salary can be fixed or change. Expenses can be managed but are a function of price increases or decreases. No savings can be accumulated if expenses equal net salary
Net salary is after withholding and living expenses. However, inflation has a negative effect. If you are at break even and then prices rise, you must change expenditures or go into debt to maintain current expenditures. Most of us have or are currently experiencing this demoralizing situation. This is beyond the focus of this article. However, for those interested Go to StephenDaneDiary.com and scroll the chapter titled Managing Your EconoShell (a word I made up.)
Managing your finances to obtain savings is the first phase of the road to wealth and is the subject of hundreds of books on how to manage your money.
Net salary is assumed, Expenses are known and under control, the ability to invest savings at some rate of return is known. The current life style is maintained and you are not going to buy a Ferrari. The amount available to invest is also known. The actual return on your investment may be known or unknown.
Excel Program