DISCLAIMER: I am not a financial advisor and this should not be taken to be financial advice. You should consult a financial professional for advice. I am a financial amateur. These are my thoughts and opinions on money that I have recorded here for my children, with the hope that my thoughts might help them. They are responsible for the results of the advice they choose to follow. Always worth keeping in mind: Past performance is no guarantee of future results. Your mileage may vary. The map is not the territory. Keep your eyes open. Smell it before you take a bite.
To my children:
Everyone wants to find a cash cow. A cow that you can milk for money instead of milk. People think they don’t exist. I think they are all over the place. It just depends how long you’re willing to sit there and milk the cow. I think what they really want is a money cloud, a cloud that rains money, and those don’t exist, unless someone happens to leave you a big inheritance. Let’s not count on that. There are many money machines. Here are some.
Jobs (Infinitely Positive % return, but you must give your time) – For most people, their money machine is their job. They put in 40 hours and get $X in return for their time. These are okay but if your job isn’t the type of thing that you would do for free on a Saturday, then you’re probably interested in looking into other options. It’s also hard to put more into this machine. You might be able to put in 80 hours and get paid twice as much but there is a limit to how much time and energy you have and are able to put into it. Jobs are deceptive because you don’t need any money to make money but you have to commit time and time is what you probably value most. The return on investment seems almost infinite, because you put in $0 and get back $1,000 a week or whatever you get. Whatever you get, it’s more than $0, so it seems like a good return on investment. No one ever goes to work and comes back with less money than they started out with. But remember that you have to invest something very valuable: Time. Your time will never come back to you.
Credit Card Debt (-15%) – If you don’t pay off all of your credit card balance every month, then you have credit card debt. The interest on this debt is about 15% annually, if not more. This is a bad money machine for you. You receive $100 from this machine when you borrow $100 to buy something, but a year later, you have to put $115 back into the machine, not just the $100 you borrowed. You are the money machine for the credit card companies—they put $100 in and get $115 back a year later. That’s a 15% annual return on their money. Credit card debt is a good money machine for credit card companies, not for you.
Casinos (-1%) – You can go to a casino and put $1 into a slot machine and watch $100 come out of it sometimes, but not every time. That’s the exception. That’s lucky. I saw a billboard advertise a casino that paid out 99% of the money they collected, meaning that, on average, when $100 goes into their money machines, $99 comes back out. Maybe that’s good for a casino but that’s not the type of money machine that’s going to help you save or make money. The expected return on an investment there is negative 1%. They buy their tables, chairs, and chandeliers with your money. I’ve had fun at casinos, but I’ve never entered one thinking that I would come back out with more money than I started with.
Lottery (-3 to -22%) – Buying a lottery ticket is a bad money machine. The California Lottery scratch off odds are listed here and the return on investments ranging from -3% to -22%. So depending on which lottery game you play, on average, if you put in $100, it will give you back $97 or $78. That’s no game to play if you’re trying to make money.
Checking Accounts and Your Mattress (0%) – Doing nothing with your money and putting it under your mattress or in a checking account that gives you 0% interest in return for holding onto your money is no way to make money. It might feel nice because at least you know you’re not losing any money but actually you are, because prices slowly inflate and over time the buying power of your money diminishes.
Savings Accounts (0.25%) – If you put your money in a savings account at a bank, it might grow at 0.25% annually. Not a great growth rate. Your money might be saved there but it’s not growing there. It’s good for the banks, because your money isn’t actually just sitting there in a savings account—they are loaning it out to people who have small businesses or who want to buy homes. Banks need to make money too, so if they can loan your money out to someone else at 4% annually for a home loan to some else and then pay you back at 0.25% annually, they’re making a profit. Savings accounts are not a good place to grow your money. They are good money machines for the banks, not you. The interest you earn there probably won’t keep up with the rate of inflation (which long term has been 3% historically in the USA) and so just like the checking account and your mattress, money in a savings account will lose its buying power over time due to inflation.
Bonds (5%) – A bond is a loan from you to an organization like a company or a government. Loans to the US government are generally considered to be very safe. There is not much danger that they won’t pay back your loan with interest. The return rates for long term US Treasury bonds have historically been 5%-6%. That’s a pretty good money machine, but there are ones with even higher rates of return on your investment.
Stocks – Individual Companies (% return varies widely) – When you buy stocks, you buy a percentage of the company. If you owned all the shares, you would own the whole company. Stock prices go up and down. You can lose all of your money if the company goes bankrupt and you can double or triple your money if the company does well. In the first half of 2020, Apple’s stock price went up by 24%, Tesla’s went up by 167%, and Hertz’s went down by 91%. So if you invested $100 in Apple or Tesla or Hertz on Jan 1, 2020, then on June 30, 2020, your $100 would be worth $124 (Apple) or $267 (Tesla) or $9 (Hertz). Buying individual stocks can be a wonderful or terrible money machine, depending on how the stock does.
Stocks – Groups of Companies (10%) – Jack Bogle, founder of The Vanguard Group, invented the index fund, which is a way of reducing the risk of investing in stocks. Instead of having to pick which individual companies to invest in and not knowing whether their stock price will go up or down, and by how much, and when, you just invest in all of them and receive the average return of all of the stocks in the index. There are many different indexes in the world. The most well known US stock markets are the Dow Jones (30 companies), the S&P 500 (500 companies), and the Nasdaq (over 3,000 companies).
Warren Buffett, widely considered to be the best investor of all time, has said that the average investor should invest 90% of their savings in an index fund (He has recommended Vanuguard’s low fee S&P 500 fund, VOO) and 10% of their savings in short-term government bonds. Most professional investors do not perform as well as the S&P 500. After 10 years, over 80% of the actively managed funds perform worse than the S&P 500. (source) The average investor managing their own money also earns less than the S&P 500. (source) The average annual return of the S&P 500 since it started in 1926 through 2018 is 10%-11%. (source)
Index funds like VOO are good money machines. Over the long run, they will outpace inflation and will provide higher returns than bonds.
Real Estate (3%) – If you buy a house, that can be a money machine. Real estate increases about 3%-4% each year. But you can only cash in on the profits by selling the house. With stocks, you could sell a little bit at a time and sell them much more easily than you can sell a house.
Invest in Yourself (% return varies widely) – One of the best investments you can make is in yourself. Buy a book. Take a class. Pay to learn a skill. Or try to learn it for free. A medical, dental, or law degree will pay for itself. Anything where you expect more money to come back to you than what you put in—that’s a good investment.
Start a Business (% return varies widely) – Starting a business can be daunting and it can fail but it can also be an incredible money machine in terms of the return on your investment. For example, I sold greeting cards that cost me about 50 cents to make and I sold them for about $5, so that’s a 900% return on my investment. That’s incredible but the problem was that the business required effort to build and maintain. It’s not as if there were a line of people waiting outside my door who would buy every greeting card I made as fast as I could make it. I had to find the customers. There was competition. Stores would prefer to deal with a distributor from whom they can buy all of their cards, not just individuals like me for every different type of card they sell. There are a lot of hurdles in starting and running a business. And they may fail despite your best efforts. But it might be worth a try. Especially if you can limit your risk. And have the grit and agility to climb the mountains and waves that will come your way.
Taxes – Income Tax (-10% to -37%) – Everyone pays taxes on their income but there are different rates. The first $0 to $9,875 is taxed at 10%, so if you earned $9.000 in annual income, then you would owe $900 in taxes. There are various tax brackets and the tax rates can change from year to year. In 2019, the highest bracket was $510,301 or more, which was taxed at 37%, which means that any dollars you made over that threshold of $510,301 were taxed at 37%.
Taxes – Long-Term Capital Gains Tax (0%, -15%, -20%) – When Uncle Sam taxes your hard earned dollars from your job at 10%-37%, you might start to look around to see if there are any other options. Good news! There are! A great way to pay less in taxes on the dollars that come your way is long-term capital gains tax. A long-term capital gain is when you sell a stock that you bought over one year ago for a profit. The first $40,000 of gains are taxed at 0%. That’s right, they are not taxed at all. Let that sink in for a moment. You could go to work every day for a year and make $40,000 a year and owe $4,658.16 in taxes (effective tax rate is 11.65% on $40,000 of income) OR you could let your money work for you, not have to go into an office or wherever you work, grow your investment until there is $40,000 of gains, sell it, make $40,000, and pay $0 in taxes. I know which deal I want.
Keep in mind that it has to be long-term capital gains, meaning that you have to hold the stock (or mutual fund or index fund) for at least one year. If you buy and sell it in less than one year, then any gains you have are treated like regular income and are taxed at the normal income tax rate. The next bracket of long-term capital gains, $40,001 to $441,450, is taxed at 15%, which is still great compared to the regular income tax rate. See the chart and explanation below.
Compare the tax rates of normal earned income (left) and long-term capital gains (right). (Numbers are the 2019 US Federal Income Tax Rates and the 2019 US Long-Term Capital Gains Tax.)
For $0 – $40,000, it’s:
- 10% – 12% for normal income
- 0% for long-term capital gains
For $40,001 – $400,000, it’s:
- 22% – 35% for normal income
- 15% for long-term capital gains
The tax rates are WAY better for long-term capital gains. AND you could buy an index fund and take a hands off approach to it and the money you earn on long-term capital gains will cost you almost none of your time, versus the 40 hours a week, many weeks a year, that your job may require.
Margin Loans (% return varies widely) – This is an advanced financial instrument that carries more risk with it and it’s not appropriate for everyone but I think it’s worth mentioning. A margin loan is a loan from your brokerage that’s secured by the value of your account (cash, stocks, index funds, etc.) at that brokerage. You have to pay interest on the loan but if you invest the loaned money and make a return rate that covers the cost (interest rate) of the loan, then you can make some extra money.
Here’s an example. Let’s say you have $1,000 to invest in an index fund and grow it 10% annually. Margin loans give you a chance to increase your returns by loaning you more money to invest with. So if you have $1,000 to invest, then your brokerage can loan you up to $1,000. You can invest it or do whatever you want with it. If you invest the $2,000 you now have at your disposal in an index fund and it returns you 10% after a year, then you have earned $200 (which is 10% of $2,000) instead of $100 (which is 10% of $1,000). The return on your $1,000 investment is now 20% instead of 10%, but you also have to account for the interest on the loan that you must pay as you go. If the interest that you pay on the loan is less than 10%, then you’ve made money. Interest rates among brokerages vary quite a bit and it’s worth shopping around. At the time of this writing (Sept 2020), the interest rate for a $1,000 loan is 8.325% at Schwab and Fidelity and 1.59% at Interactive Brokers. The low interest rate that Interactive Brokers offers is attractive because if you invested the loaned money in an index fund, then you would likely make money over the long run because the returns of the S&P 500 are generally over 1.59% over the long run.
Margin loans are a double-edged sword, though. They amplify your gains and amplify your losses. If you have $1,000 to invest, and you borrow $1,000 and invest $2,000 in an index fund and it loses you 10% after a year, then you have lost $200 (which is 10% of $2,000) instead of only $100 (which is 10% of $1,000), and you still have to pay the interest on the loan. It doesn’t matter if your investment makes money or not, you always have to pay the interest. There are also further risks that I haven’t discussed in detail here, which are mostly due to the fact that stocks and index funds can be very volatile. You can be forced to sell at a low price when you don’t want to, and you can lose more money than you originally invested. So it’s definitely not for everyone.
But the basic scenarios are as follows.
- Scenario 1: No margin loan, and your investment goes up. You have a cash account, don’t take out a loan, invest your $1,000 in an index fund, it grows 10% after a year and then you have $1,100. You made $100.
- Scenario 2: You take out a margin loan, and your investment goes up. You have $1,000 and take out a margin loan for $1,000 and invest the $2,000 in an index fund that grows 10% after a year to $2,200 and then you have made more than 10%. Your balance of $2,200 minus the loaned money of $1,000 is $1,200, minus the interest on the $1,000 loan—let’s say it’s 2%, which is $20, so now you have $1,200 minus $20, so $1,180. You made $180.
- Scenario 3: No margin loan, and your investment goes down. You have a cash account, don’t take out a loan, invest your $1,000 in an index fund, it falls 10% after a year and then you have $900. You lost $100.
- Scenario 4: You take out a margin loan, and your investment goes down. You have $1,000 and take out a margin loan for $1,000 and invest the $2,000 in an index fund that falls 10% after a year to $1,800 and then you have lost more than 10%. Your balance of $1,800 minus the loaned money of $1,000 is $800, minus the interest on the $1,000 loan—let’s say it’s 2%, which is $20, so now you have $800 minus $20, so $780. You lost $220.
The last thing I’ll say about margin loans is that if you use them, you don’t need to borrow the maximum that they allow. If you have $1,000, then you can borrow any amount up to $1,000. You could borrow $100, which would limit the downside risk (and also limit the upside reward). If any of this makes you uncomfortable, then don’t use margin loans. You should always be as comfortable as possible with your money.
Bottom Line: Everyone is looking for a cash cow but money machines are actually everywhere. Choose the ones with good returns on your investment. Stay away from the ones that give you less money back than what you put in.