My Dear Reader,
I recently interviewed my P&C agent for an upcoming project that I am working on. We covered many topics, from online insurance purchasing to opportunity cost to shifting markets. As enlightening as this conversation was, I couldn’t help but feel that the American public is seen as uneducated by the top professionals in the market. For today’s article, I thought we would take the time to review some of the most important terms that are often forgotten by distractions of everyday life.
Opportunity cost is seldom explained by the financial community. If your financial adviser has already explained this to you, or you know what it means, thank him or yourself; not understanding it can cost you hundreds of thousands of dollars over your lifetime. The basic premise is that every dollar you spend today could have been invested to yield increasingly more money over time. This is a sobering fact: every dollar spent today will never again be able to work in your favor. For instance, $100 invested today at the market average rate of return of 7.91 percent will be worth about $1,000 in thirty years. So, every payment made today with your own dollars hurts you in the future. This is why excessive taxation, especially personal income tax, is so harmful to all levels of society. USA Today estimates that the average American pays roughly $10,000 in personal taxes per year.1 If we use this number and apply the current market average rate of return of 7.91 percent, that one year’s payment of $10,000 costs $96,463 thirty years later. Now that we understand why opportunity cost is such a threat to the prosperity of the average American, it’s imperative to understand why compound interest is so important.
Albert Einstein once called compound interest the 8th wonder of the world. Yet it is surprising how few people are able to take advantage of it. The idea of compound interest is that over time, starting slow, the interest gained from an investment will compound exponentially if left untouched. But an investment that is interrupted will reset the compounding effect, and will forever damage the earning potential of that investment. Remember the $10,000 in taxes that you paid? The ones that would cost you $96,463 over 30 years? Keep in mind that the greater the loss, the greater the amount lost over time. This is part of the reason why the financial meltdown of 2008 was so destructive, people lost great amounts of wealth that they will never fully recover from. Plus many then owed back taxes, the government doesn’t care that you lost your job or house, they want their money. This is why this next concept is so important, it’s bluntly called OPM, or other people’s money. here’s the simplified version: you never spend your own money on investments. See, the big banks in this world don’t avoid debt; they use it. What bothers me is not that banks conduct their business in this way, it’s that we are taught to avoid debt like the plague. But by using the power of a loan, which we just touched on with liquidity, we can, as private citizens, operate like a bank. By using other people’s money, our original investment never loses its earning potential, and thus it avoids the pitfall of opportunity cost. This also allows the original investment to take full advantage of compound interest, because we never touch the principal, and the interest keeps growing in our favor. Before we move on, there is one demon that is seldom spoken about, and its name is inflation. Let’s suppose someone wants to retire at age sixty-five, and they are forty-five now. They currently make an average of $50,000 and can comfortably live on this amount. In retirement, they will want to make the same amount from their retirement accounts. Let’s also assume that they will live no longer than their life expectancy of age eighty-four. If we use the current inflation rate of 3 percent, that $50,000 will need to be $90,000 in twenty years. By the last year of their life, at age eighty-four, that income will need to be $158,351. This frightens me. As a young man, I’m going to have to figure out how to make six figures soon or be lost in a tidal wave of useless currency. To solve this problem, I think we need to understand how the wealthy think. If we adopt their mindsets, and their principles, we’ll be much better off.
To your Creation and Potential,