Why Saving Does Not Work

Most people measure financial success in terms of having “money in the bank”.  As such, whenever most people try to accumulate wealth the entirety of their effort is comprised of hoarding cash.  Although the ability to save money and be frugal is crucial, I believe that saving money in and of itself does not work; rather, it is merely the first step in the process.  The strategy of simply putting cash in the closet cannot result in accumulation of wealth for two reasons: inflation and the velocity of money.

When President Richard Nixon decoupled the U.S. dollar from gold in 1971, our money became a currency deriving its’ value from a government fiat.  A fiat currency by definition does not possess intrinsic value and functions only as a medium of trade.  Unlike a gold coin which has value because of the metal it is made out of, the dollar’s value is due to nothing more than our government say-so.

Since the dollar has been decoupled from gold as the underlying collateral, our government can print as much paper currency as our politicians (in their infinite wisdom) deem necessary.  This is like allowing a prescription drug addict the run of the pharmacy.  As a result, not only are we facing a national debt which is mathematically impossible to repay, but every time they print more currency our wealth is being stolen from us due to the erosion of the buying power of our savings.

Here is an example of what I mean.  During a recent conversation, a gentleman happily told to me that his employer’s 401k money market fund returned 4% in 2011.  He was understandably excited having earned 4% on his money in this economy.  Unfortunately, the inflation rate in 2011 had also clocked in at around 4%, which means that all of the growth in his money market fund was eroded in terms of his money’s buying power.  In order to actually generate wealth, his return would have had to be grater than the inflation rate.  (Much greater if it was necessary to pay income taxes on the earnings.)  Thus, the U.S. monetary policy which results in chronic currency supply and price inflation has been placing people trying to save their way to wealth at a great disadvantage.

The other reason why it is disadvantageous to build wealth with currency is that currency, by design, has to move – it is a medium of exchange.  In fact, one of the ways the economists measure the health of our economy is by how fast currency flows from one person or company to the next.  Currency moving is an indication that people are confident with their financial circumstances to the point where they engage in spending money.  In a consumer-based economy like ours, if people stop buying then companies can’t make a profit selling goods, which leads to companies decreasing output, eventually resulting in lay-offs.  This, in turn, leads to even less consumer spending, since when people loose their jobs they become “entrenched”.  This is the vicious cycle which leads to the velocity of money slowing, and if it gets too slow, the entire economy crashes.  Thus, currency in a consumer-based economy is designed to move, which means that those of us trying to put money in the bank are hoarding something which is not meant to stay in one place – a losing battle!

Thus, the vehicle within which you store you wealth needs to accomplish two objectives.  First, it needs to be a hedge against inflation, while at the same time it needs to increase the velocity with which currency travels through your bank accounts.  The more currency comes in, the more settles with you.  Therefore, putting dollars into the bank and keeping them there is the opposite of what you need to be doing.  Instead, it is prudent to convert currency into assets which not only possess intrinsic value, but also produce cash flow.  In doing so, not only will those assets hedge your wealth against inflation, but they will increase the speed with which currency travels through you.  This is the key to understanding why the rich are getting richer while the middle class is taking it on the chin. The middle class is busy hoarding dollar bills, while the rich are hoarding cash flowing assets.  One of the best examples of such an asset is investment real estate!

For more in-depth discussion join Cash Flow Freedom Builders at www.justaskbenwhy.com<

© Copyright 2012 Ben Leybovich and Just Ask Ben Why. All Rights Reserved.

 

2 Comments

  • Milan Dukic Reply

    Well, it only takes a look at the following 3 charts to understand what Ben is talking about. Actually, before looking at them just now, I did not believe that the rise in CPI (Consumer Price Index) and therefore, inflation (from which it is derived) were this large in the USA. Look at the following three charts:

    http://inflationdata.com/Inflation/Consumer_Price_Index/CurrentCPI.asp
    http://inflationdata.com/Inflation/Consumer_Price_Index/HistoricalCPI.aspx
    http://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx

    What this tells me, simply, is that if the cost of a good in 1982 was $100, today it’s $225. And, this is an AVERAGE. Think what the things you use most cost in 1982? Gas, electricity, food and housing? The costs today are actually MORE than %125 from 1982!

    So in 30 years time the currency lost 125% of its value, in addition to actually things costing more even when adjusted for rise in CPI. So cash is clearly not a good vehicle to store value, I’d say. For you to just keep up with your current standard of living, you must get an annualized “return” on your currency (if you are just saving currency through IRA, 401K, Roth, Money Market, etc) of about 5% only to keep up, barring any unforeseen increases in costs due to unforeseen global developments which impact our costs of food, oil, etc. It becomes really scary really quickly…, so it’s better not to even think about it, right?

    If you are to grow and have more cash off of which to live (increase in cash flow), aside from getting a better paying job (which some people do, but most of us don’t), you have to figure out a way to get a better return on your investment of hard-earned currency you currently have. This only means you need to transfer the currency into some other asset, asset that will not only make you cash, but make it at a rate faster than currency’s loss of value do to rise in CPI and therefore, inflation (erosion of value of currency).

    In that sense, I also look at realestate investing as a vehicle for a better return for my $$, one that’s real (brick and mortar real), and one over which I have a greater control. As to ROI (return on the investment) I also look only at it as a cash-on-cash return. Here’s what I mean: How much cash it returns for the cash I personally put up from my own savings?

    So, let’s do some math.

    If you purchase a 4-unit building for, say $125K and put down about 25% as a down-payment (if you have so much saved in one of those above-mentioned funds), that brings it to about $31.5K for down-payment. At first it looks like a lot, but stay with me.

    With your current job, current liabilities, amount of savings and your credit score, the bank will, in fact lend, you the remaining $93.5k at about 5-6%. So your PITI will be about $800-850 (depending on RE taxes – which you can request from your County’s Board of Revision to be adjusted down, esp. if the property value was set higher than your purchase price. This is another topic and strategy for maximizing your cash-flow).

    If the 4 apartments are renting for $495 average each, that means that at full occupancy you get $1,980 per month in Gross Revenue. Deduct the cost of borrowing, taxes and insurance (PITI), then put aside $200 a month for vacancies and repairs (20% – which is aggressive, but you do want safety first – once you build this fund up, you can adjust it down depending on what you see is needed), and about $25 for common electricity (if utilities are separate), and about $150 for water/sewer, you are looking at total of $1,500 in estimated expenses. This leaves you, conservatively, with $480 per month of cash-flow,. That’s $5760 per year of return on your original $31.5K investment. That’s about 18.28% return.

    Now, come tax time, attach the paper loss of depreciation, as well as the real cost of INTEREST on your BANK LOAN, and your return numbers will be getting even better.

    And, if you manage the property properly, it will continue to create this kind of return in perpetuity. And this is just a beginning. Depending on your end-goal, you can use the cashflow to pay-down the bank-loan faster and own the property out right sooner, giving you greater cashflow, or use the equity as a spring-board for the next deal by refinancing. This is what means building some wealth.

    Is it sexy? Probably not, but that again depends on your point of view and on what gets you off. I’ll leave that to you and your partner to decide.

    In conclusion, all this takes time, takes patience, and takes educating yourself in relevant matters of real estate. Keep in mind that the above example is highly simplified, but it’s about right for where we are currently and more-less accurately. There are other things possible with the similar property, like making sure you do raise rents annually to adjust for inflation, or renting out garages separately, or building additional storage space in the basement that you can rent-out to non-residents, purchasing and owning coin-op washing machines in the building, etc. With a little ingenuity, you can further maximize returns on your investment.

    This is what I call “me being in control of my investment cash”.

    To juxtapose this example, in 2007, right at the height of the market, I placed $6,000 in a low-cost ROTH IRA account with Vanguard (Targeted Index Fund 2035 – roughly 30 years out), and did not touch it. It was a sort-of experiment for me, in real terms, to see what really happens to money invested in indexed fund that so-called analysts in the media so much recommend. In 2011 that fund had a cool $6,574. So in 4 years, without adding any other funds I received $574 in return. That’s 9% over 5 years. You may say, it did not lose any value, but you’d be wrong. That’s 9% over FIVE YEARS, not EACH YEAR. Adjusted for inflation, I actually lost value. Now, there were in fact times in there, from 2008 to 2010, that the balance in the fund was as high as $8,800 and as low as $3,400. If I knew to sell at $8,800, it would have been great, but I did not know. And who would? I also kept wondering what happened to people that were to retire in 2008-9 and were invested like this, only to see their “savings” go down to a half of what it was just a few short years earlier. For all I know, by 2035 I could be in the same boat. And then it hit me – do I really want to WORK for someone else until 2035, while HOPING my “savings” grow?

    So in my mind, it was clear I don’t have the stomach for this speculation. Yes, it IS a speculation – for you to derive “value” over someone’s willingness to purchase your holding at a price that is higher than what you purchased it at. And as we see what’s going on today with the Wall Street, the only people making money on the stock market are bankers and brokers whether or not the market is up or down. Thank you very much, but not over my back.

    In conclusion I can tell you, it feels much better with what I have now. The above example is what we did. Some 16 months later, even after vacancies, turn-over costs, maintenance costs, and even an eviction hassles (a tenant I inherited when the building was purchased, meaning it wasn’t me who vetted him), we are still up some $14,000 for the 16-month period. Now, that’s what I call a nice cash-on-cash return.

    Sayonara Wall Street!

    • Ben Reply

      Milan, you have a fantastic comprehension of how inflation works and how its effect on money translates into real estate! What can I say, it is a privilege to have you among the Cash Flow Freedom Builders. Keep your thoughts coming! More importantly, I’m looking forward to having an update on your latest deal. I’m sure the other members would be interested in following along – keep it in mind.

      The only thing I can add to your wisdom is this: Your calculations of ROI reflect a total cash investment of 25% (the down-payment). Imagine what you can do in this game when you learn how to buy property with no cash-down. What will your returns be then – infinity?

      Here is the deal: there are two centers of value to every real estate transaction. The property you are buying is one, while the financing is the other. If you focus less on the property and more on the financing, you will begin to see things that other people don’t see.

      P.S. Real, in real estate, stands for Royal. Translation – in the vast world of investing, only a few privileged people enjoy the “royal” benefits of real estate. This is because the art of real estate investing requires much knowledge, and only those few of us make the commitment to educate ourselves, and have the courage to actually follow through.

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