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Sunday, January 28, 2007

Increasing Your Income

"Give me six hours to chop down a tree and I will spend the first four sharpening the axe."
- Abraham Lincoln
In order to retire, you must accumulate wealth to draw upon when you are not working.

The most obvious way to accumulate wealth is to save money by spending less money than you earn. This is not the only way to accumulate wealth (and perhaps not even the best way), but it's the most straightforward option and it's the one I've chosen. Given that as a starting point, it's clear why there has to be a focus on income.

The single biggest thing you can do to increase your chances of higher income and wealth accumulation is to acquire more education. Income is strongly correlated with level of education. Perhaps less well known is the fact that employment rates are also strongly correlated with level of education. More education means a higher chance that you will be employed and that you will make more money while you are employed. This is illustrated in dramatic fashion by the following table:

Education Level
2005 Yearly Earnings
2005 Unemployment Rate
Some high-school, no diploma
$21,268
7.6%
High-school graduate
$30,316
4.7%
Some college, no degree
$33,956
4.2%
Associate degree
$36,348
3.3%
Bachelor's degree
$48,724
2.6%
Master's degree
$58,708
2.1%
Professional degree
$71,240
1.1%
Doctoral degree
$73,892
1.6%


Source: U.S. Bureau of Labor Statistics


All of these facts are consistent with my personal experience. Back in 1990, I had a Bachelor's degree and I was making about 24K per year. I quit my job and went back to school. 18 months later I had a Master's degree and landed a new job making 38K per year.

Of course there was hard work involved. But frankly, it was probably no harder than 18 months of employment and a lot more enjoyable. Amazingly enough, my entire tuition bill was less than $3,000! That is an unbelievable return on investment! Even when you factor in the opportunity cost of 36K (24K/year x 1.5 years), the payback was fairly quick.

I subsequently went to school for 5 years at night while I worked during the day. I eventually dropped out of a PhD program after completing all my coursework and comprehensive exams - in other words, another All But Dissertation dropout. Still, the mere fact that I was in a PhD program opened up other doors and my salary increased substantially. I really don't want to discuss my salary in any remotely recent year, but there is no doubt that the extra education increased my income significantly.

Notice that a small increase in your income can have a dramatic increase in your savings because of the leverage involved. For example, suppose you are making 50K per year and your expenses are 45K per year. Your savings are 5K per year. Now if your income increases 10% to 55K and your expenses stay the same, your savings have now doubled to 10K per year - a 100% increase in your savings rate. This is intuitive and obvious to most people, but I think we generally still fail to grasp the big picture of what that means.

So let me put it another way. According to a U.S. Census Bureau report, a person with a high school degree only is on average expected to earn about $1.23 million over the course of an entire working career, while a person with a Bachelor's degree is on average expected to earn about $2.14 million. Now what if $1.23 million in living expenses are necessary throughout life? Think about it! The high school graduate is able to save zero. The college graduate is able to save $910,000! And if the college graduate's savings are invested each year, they will grow to several million dollars. Unfortunately, regardless of the potential investment returns, if the high school graduate was unable to save any money, the end result will still be zero.

In addition to the highly probable financial gains, there are also a lot of intangible benefits to education, including social networking, a sense of accomplishment, and exposure to new people and new ideas. That is why you won't find a lot of people who say, "I wish I had never gone to college and completed my degree."

Caution is always in order when applying averages to your own life. Nothing is guaranteed. It's obviously possible to make a lot of money with little or no education, and it's possible for a PhD to be out of work. For most people, however, more education will lift income. Often when people start crunching their retirement numbers, they find that things are not working out fast enough, and they begin searching for investments with higher and higher rates of return. If you find yourself doing that, remember to consider what will probably be your best investment: more education.

Tuesday, January 23, 2007

Welcome To The Real World

"Those who wish to succeed must ask the right preliminary questions."
- Aristotle, Metaphysics

Like many people, I dreamed and schemed for years about early retirement. While there were definitely many times that I did enjoy working, I never did feel like I quite fit into Corporate America. Partly I didn't like the lack of control, and partly I didn't like the games that were played, and partly I didn't like the daily repetition of tasks. But mostly, the problem was that work interfered too much with the other things I wanted to do in life. Imagine that!

Over the years, I attempted to reconcile the situation by experimenting with different work schedule options: self-employment work; part-time work; contract work; etc. None of these options worked very well for me. I also thought about whether I could somehow make enough money to live on by doing the things I really wanted to be doing. This seemed unlikely. Like a lot of people, I felt trapped in the corporate rat race.

As I continued working, one of my hobbies was learning about investments and how they worked. At first, there was just the allure of learning something new and of making some money. But the investing field turned out to be quite interesting to me, and I even considered a career change. After a while, however, I wondered if investing held something more: a chance to escape the corporate hamster wheel early. But by this time, I realized that most serious financial professionals never see it that way. Prudent investing is viewed as a good way to ensure that a normal retirement at age 65 will probably go smoothly, but early retirement is generally considered unattainable and perhaps even a bit reckless.

Eventually I learned enough about finance to realize that most of the investment and retirement advice that is repeated ad nauseam by the media is based on assumptions and averages about the population at large. I attentively read the endless stream of articles reminding me to eliminate morning lattes, pay off credit cards, and invest in a 401(k) plan. And of course, the articles all explained to me to accumulate enough savings to replace 80% of my preretirement income, and to withdraw 4% of it each year in retirement.

To be sure, a small portion of such advice was simply wrong. But more often than not, the advice was not so much wrong as it was oversimplified. I suppose this is how things have to work with the mass media. Writers cannot customize the information for each individual situation and often don't (or can't) explain the rationale and the assumptions behind the rules of thumb. This is really too bad, because this turned out to be the key to making the whole thing work for me. Once I understood the assumptions in many of the generic formulas and rules, I was able to customize a real world financial plan that worked for my specific situation.
If you stumbled onto this site and are hoping to find some sort of magic formula or silver bullet for making your investments work, you have come to the wrong place. In fact, an overarching theme to all that I have learned is that there is rarely a magic formula for anything in life. Why should it somehow be any different for investment and retirement planning? In spite of all the magazine and newsletter covers, we all know there are not "7 easy steps" to retirement or "5 sure things" for your investment portfolio. We get sucked into reading these articles because we wish it were so, even though we know full well it is not.

The real world is complex. It rarely fits neatly into formulas and rules. The achievement of anything difficult usually requires a lot of study and work and discipline. Nevertheless, difficult does not mean unattainable, and eventually through perseverance, a workable strategy for early retirement fell into place for me.

Note that my retirement plan is no "get rich quick" scheme. First of all, it is not quick. It took about 10 years of hard work and disciplined saving to get to this point, and I've still got at least another five years to go. Secondly, I won't be rich by the standards of many people. Lastly, it is no "scheme" in the negative sense of the word suggestive of a scam or a contrived trick. There is nothing novel about what I am doing, and I have no dispute with 95% of the standard body of knowledge in finance. Rather, I use this knowledge in a practical manner by applying it to my specific situation in order to achieve specific goals.

The key is critical thinking. Ask the preliminary questions. Challenge assumptions. Make sure to understand your world, your self, and what your investments can and can't do. Be certain your plan is based on the real world - your life situation - not on rules of thumb that capture a statistically good outcome for the average person in the world.

As I advance toward my goals, I have come to realize that there are many people who are curious about personal finance. I decided to set up this blog to organize my thoughts and offer it as a resource to others. But please understand that my plan cannot be your plan. My life is not your life, and my goals are not your goals. Still, I hope that understanding the process of how I put together my retirement plan will perhaps enable you to gain insight into your own state of affairs. Whether your interest is early retirement, or "normal" retirement, or simply curiosity of how someone else approached it, I hope this will be of some help to you.

I intend to update this blog once a week with more details about early retirement and my progress towards it. Unlike many self-professed investment and retirement gurus, I don't have all the answers. I am learning new things all the time and many times I make mistakes. But on the whole, things are working out pretty well so far.

It's been quite a financial journey thus far, and I hope you'll join me to see how the rest unfolds. Maybe along the way, you'll begin your own journey as well.