Category Archives: Economics

Posted on

The Power of Opportunity Cost & Why You Should Use It

by

Writing this article has been on my task list for over three months. I chose to do many other things instead of writing it. I will come back to this at the end…

What on earth is opportunity cost?

Opportunity cost can be defined as:

The value of what you have to give up in order to get what you want.

Another way to say this is that opportunity cost represents the benefits you give up in choosing one option over another option.

It can be difficult to identify opportunity costs when the benefits of the alternative choices aren’t easily measurable. Fortunately, some alternative choices are easily measurable. Let me give you a couple of examples.

Smart Phone

I first encountered the concept of opportunity cost in economics. It is rather easy to see when you put it in terms of money. If I spend $1,000 today on a new smart phone, that is $1,000 that I cannot invest in a stock mutual fund (for example). Doing a quick financial calculation, if I take that $1,000 and invest it in a mutual fund earning a 6% annual return compounding monthly, in 20 years the value will be $3,326. So the opportunity cost of purchasing the new smart phone today is $3,326 in 20 years. Of course, there is value in me having that smart phone today, so I may still choose it. I will just be better informed about the actual opportunity cost of that choice.

It’s a New Car!

One more financial example.

As a young person, I felt it necessary to always drive a nice, new car. I never had the money set aside to be able to pay cash for a nice, new car, so I financed it (aka I went into debt). This means I had a fat monthly payment to make to the lender that funded the loan on the car. The financing was typically four years. I had to make 48 monthly payments before the car was really mine. This reminds me of the old saying “I owe, I owe, so off to work I go.”

As vehicles became more and more expensive, car dealers began working with their finance arms to offer increasingly long loan payoff terms. This was to keep the monthly payments “low.” That meant that to buy a new SUV, I might be making that monthly payment for six years or even seven years.

Let’s not get too crazy with this example. I am going to use the four year loan length. Let’s say I buy an SUV for $40,000. I finance all of the price at 6% interest for four years. My monthly payment is then a whopping $939 per month! On top of that, I still have to insure it, register it, maintain it with oil and tires, repair it when it breaks down, and keep it gassed up. That is quite a commitment.

The problem with a vehicle is that it is a depreciating asset. It goes down in value with each passing day. Eventually, it will be worth nothing. How do I know this? Most of the vehicles I have purchased are now rotting in a junkyard somewhere or have been crushed into large cubes. The same can be said of the smart phone. It will eventually be worth nothing.

Thinking in terms of opportunity cost, what would that $939 per month car payment be worth if invested in a mutual fund with a 6% return compounding monthly? In four years it would be worth $50,819.

When I was buying cars this way,  there was a related problem I faced. After about four years I was ready for a new car. After all, the new car smell had long since vanished. The paint had a scratch or two. So I repeated the process. I bought into the idea that “I will always have a car payment.“

So let’s go with that logic and assume that I will continue making that $939 car payment every month for 20 years. When we do that math, at the end of 20 years I will own a fourth “new” vehicle that is worth a lot less than when I bought it. That is what a depreciating asset is after all.

If instead of purchasing vehicles this way over the 20 years I instead invested that $939 per month into a stock mutual fund with a 6% annual return, my value in 20 years would be $434,000. Guess what? I could then remove $40,000 cash from my mutual fund and pay cash for a brand new vehicle.

“Wow!” you say. “Why doesn’t everyone do it  this way?”

For several powerful reasons:

  1. To actually do it this way you have to delay gratification and possibly drive (G A S P) an old car you pay cash for. Definitely no new car smell there.
  2. To do this you have to be able to withstand the constant marketing and advertising of some of the smartest people on earth whose job it is to get you to “need” that new car smell. Think white Lexus, huge red bow on top, and snow lightly falling on you and your golden retriever.
  3. Finally, you have to overcome the peer pressure that might come from those who could look down their noses at you for driving something they view as beneath your station in life. What would the neighbors say?

Once I really learned the lesson about opportunity cost with regard to cars, I became a little obnoxious about it. In an effort to  help my kids learn the lesson, I would sometimes look at a parking lot full of expensive cars and say something like: “Look at all those beautiful depreciating assets.” They were not that amused.

One reason few of us do the opportuntiy cost calculations above is that there is indeed value in doing or enjoying something today. Driving in that new car smell, getting the latest smart phone, or having that daily cup of joe brings a certain amount of pleasure.

The concept of opportunity cost is not limited to financial matters. The reason I am a guitar plunker with a very limited skillset is because 10 years ago I prioritized other things above playing guitar. Those things may have been more important, but I still chose them over guitar. I wonder how many things we could all learn and accomplish if we didn’t binge-watch streaming entertainment? It takes a certain amount of vision to see beyond the present moment and to see what this moment could lead to if I chose a different opportunity.

In chapter 11 of my book Forward Story I write about vision: “Your mind has an amazing ability to visualize a future that has not yet occurred.Some of the greatest inventors and entrepreneurs that have ever lived had the ability to visualize their invention and how others would use it. They could see how it would make peoples’ lives better before it ever became a product. That is vision.”

You and I likewise have the ability to develop the vision to see the opportunity cost in anything we buy or in any way we spend our time and talents. We must nurture that kind of vision.

Conclusion

Back to the point I began with. Writing this post has been on my list for over three months. The reason it was not written before now is that I took the opportunity to do other things with my time. The reason it is being written now is because I chose it over all of the other things I could have done with this time. Such are the decisions we make.

My encouragement to myself and to you is to be more intentional about the opportunities we take. Pay attention to opportunity cost. Ask “Is this the best and highest use of my time, money, and talents? Ask “What am I giving up or postponing by choosing this option?”

Posted on

What Retirement Means

by

Recently I wrote that it is time for me to re-write my Forward Story. That is because my wife and I recently achieved a major goal that we had been working on for well over a decade. With that accompished, it would be foolish to just meander without a new focus.

As I always do when I re-write my story, I start with the most distant timeframe I can envision. For me that is retirement.

The concept of retirement is a bit challenging. What does it mean to retire? We have all either known people or have heard stories of people that retired after a long employment and within a short time were either bored out of their minds or had actually passed away. Some people view retirement as a time to do nothing but relax and play.

Have you thought of what retirement means to you? I am fortunate to have many family members and friends that have already retired. By observing them I have a clear understanding of what retirement means to me. To me, retirement is simply that state of no longer needing to work for earned income. It is when passive income and/or retirement income supplies my needed standard of living. Let’s break this down:

  • Earned Income. Pretty self-explanatory, this is the most common form of income. I trade my time and talent for money. This could be hourly wages, salary, salary and commission, or contract. The biggest component of this that impacts my life is time.
  • Passive Income. This is income I receive from my investments. This can include equity appreciation through markets increasing, interest income, dividend income, etc. I get rewarded for putting my capital at risk. Very safe investments yield lower rates of return. Riskier investments typically have to pay higher rates to induce me into putting my money into them. Regardless of the actual investment vehicle and its returns, I get passive income from it. Instead of me working for my money, my money works for me.
  • Retirement Income. Increasingly rare, the company pension plan is an example of retirement income. Another example in the USA is Social Security.
  • Needed Standard of Living. Now we get a bit more complicated. I had to go and throw in the word “needed.” If I live in a tent on a friend’s property, my needed standard of living is very low relative to what it would be if I live in a four story house with a a gigantic mortgage. Of course, I get to determine my standard of living and whether I live in a tent, a four story house, or anything else. It is important to think through all of the implications of my needed standard of living vs my desired standard of living. I always need far less than I desire. You get to wrestle with all of that just like I do. As it pertains to retirement, the higher your standard of living, the more passive income you will need. This will likely delay your retirement.

Now that I have defined things, the main benefit for me once I retire will be more freedom over my time and talent. Without needing to use them for earned income, I now get to decide what is worthy of both.

Conclusion

Given this understanding of retirement, I have to calculate what that magic number is that combines both passive income and retirement income in such a way as to meet my needed standard of living. There is a lot of financial calculations and math involved in that. Nerds like me love this stuff. With all of the usual disclaimers about not knowing the future, we can then project a potential timeline for retirement.

Then I get to the more exciting part of writing the new story – envisioning the ways in which I will invest my time and talent in that new retired state. There may be some golf, tennis, and skiing in that for me, but that will be on the fringes. The retired people I know that are in their 80s and 90s are usually very active people that continue to serve and help their family, their friends, and their world. My plan will involve all of that.

What is your approach to retirement?

Posted on

Keeping Up Appearances

by

Keeping Up Appearances logo

My wife and I are fond of British entertainment. One of the older shows we used to watch is called Keeping Up Appearances. The main character is Hyacinth Bucket. Now, to you her surname may appear to be properly pronounced like a pail in which you carry water. Oh no…. Her name, she insists, is pronounced Bouquet, as in an arrangement of flowers. You see, a bouquet is much more elegant than a bucket. Hyacinth tries really hard to distance herself from her low-class family and to convince the upper crust of society that she is one of them. She wants to belong.

The comedic angle is that she is not, in fact, one of them. There is great fun in watching her try to keep up the appearance that she is something that she is not.

On December 1 of each year I begin the process of revising my Forward Story. As I argue in my book, my vision for the future changes with the years and with my own ambitions and values. It would be ineffective to stick with a Forward Story from a decade ago. I need a new, fresh, and relevant story for what comes next. With this annual ritual, I always look back at where I have been and wonder how things might have been different. I try not to wallow in regret. The past is gone, and there is nothing to be done with it other than learn from it.

In retrospect I can see that in some ways I fell prey to the modern Western myth that materialism brings happiness. There have been cars, lots of cars – mostly new and financed. There has been a lot of skiing, tennis, and general fun. Nothing wrong with that, but the idea that it is my right and that somehow I am owed these things regardless of my budget causes problems. There have been homes bought and then left behind for something bigger and better, with a much larger mortgage. Some of what drove that was a desire to keep up with (or exceed?) those people I knew and spent time with. There was some sort of personal dignity issue tied to our stuff. We were in some ways keeping up an appearance. What no one could see was all of the debt behind the scenes propping up the appearance.

We finally came to our senses around 10 years ago and got out of the appearances game. As a result we have a lot fewer of the trappings of success and a lot more actual substance. I give a lot of credit to Dave Ramsey for giving us the kick in the backside that we needed to realize where all that keeping up of appearances had gotten us.

As I was listening recently to a young couple on the Dave Ramsey show explaining how they got completely out of debt, one of them said she had learned how to be content. I think that is also a big key for us. It is a challenge to be content when you live in a materialistic society where some of the smartest and best educated people in that society get paid a lot of money to make you want the products they are selling. That old car just doesn’t look as good as that brand new luxury car on TV with the big red bow on top.

As we finish off another year and get ready for a new one, ask yourself if you are keeping up any appearances. I have found that it is expensive and burdensome. There is a lot of peace in setting all that aside in favor of contentment.

Let me know if you would like any help in getting started with your own personal Forward Story. I would love to hear from you.

Posted on

Tweets of the Week: Food, Health, Family, and More

Week ending July 11, 2015

by

twitter-bird-1We took last Saturday off to celebrate the 4th of July with our family, but we are back today with more great info. Because of the week off, today’s post is a little over twice as long as usual. We found some great stuff on a variety of topics.

Saturday is a good day to recap the activity from our Twitter feed from the past week. Not sure what Twitter is all about? That’s OK. Neither are we (or at least it remains somewhat mysterious to us). There is no denying, however, that there is some very valuable information shared on Twitter. That is what this weekly feature is all about. Click the links below to check out the good stuff. Here are my Top Tweets from this past week, great for retweeting (whatever that is). If you missed these, follow Forward Story on Twitter.

By the way, if you are wondering what the @ and # signs are all about, these are Twitter’s way to identify the Twitter handle (@) for the person who tweeted (for example, ours is @forward_story) and to allow for an indexing or categorization of the tweet by using one or more hashtags (#). Feel free to ignore these and just follow the link for the content we are sharing with you.

Here are a few recipes from people we trust:

Danielle Walker ‏@againstallgrain Jun 28
Homemade Gluten Free Chicken Nuggets #glutenfree #againstallgrain http://grainfree.ly/1JTHC2W

Danielle Walker ‏@againstallgrain Jun 28
Also- in need of pies and cakes for the weekend? These are all grain-free and dairy-free! … http://grainfree.ly/1IDx1VR

Danielle Walker ‏@againstallgrain Jun 28
Black Bottom Banana Cream Pie #paleo #glutenfree #againstallgrain http://grainfree.ly/1IYEu7A

Chris Kresser ‏@chriskresser Jul 7
Five delicious dairy-free ‘milk’ shakes. Cool off and indulge Paleo style. http://bit.ly/1LP1fKT

**********

Parenting

Great stuff for parents with adult children – 3 Tips for When Your Kids Move Back Home | Rachel Cruze: http://www.rachelcruze.com/topics/kids-and-money/3-tips-for-kicking-out-boomerang-kids#.VZRvRNmGxy_.twitter …

**********

Grandparenting

Susan Adcox ‏@grandparent Jun 28
10 mistakes to avoid when traveling with grandchildren: http://ow.ly/OT3Th @aboutdotcom

Susan Adcox ‏@grandparent Jul 3
Especially for grandparents: How to keep from going broke in the gift shop. My latest piece for @GRANDMMagazine: http://ow.ly/P9BDz

Susan Adcox ‏@grandparent Jul 5
Help for grandparents who have trouble saying no to adult children. http://ow.ly/PaLmC @aboutdotcom

Susan Adcox ‏@grandparent Jul 5
MT @grandmasbriefs: RT @NBCNews: A widow’s reverse mortgage ‘nightmare’ http://nbcnews.to/1RUhjux

Susan Adcox ‏@grandparent Jul 10
Grandparents have seen this change, and it’s not good! RT @aboutdotcom: Study finds little kids need to exercise more http://abt.cm/1IJtIkt

**********

 Medical, Health & Fitness

Chris Kresser ‏@chriskresser Jun 28
Chronic inflammation is believed to be a major risk factor for #osteoporosis. http://bit.ly/1R6S5c0

Chris Kresser ‏@chriskresser Jun 28
Virtually all skin disorders, including #acne, are inflammatory in nature. http://bit.ly/1LeMPV9

Mark_Sisson ‏@Mark_Sisson Jun 30
Why precommitment beats willpower. http://ow.ly/OZBMs

Amy Kubal ‏@AmykRd Jun 30
The benefits of going for a walk are about more than getting exercise http://www.theatlantic.com/health/archive/2015/06/how-walking-in-nature-prevents-depression/397172/ …

David Perlmutter, MD ‏@DavidPerlmutter Jun 30
Statins reduce libido. Read the science: http://www.drperlmutter.com/study/is-decreased-libido-associated-with-the-use-of-hmg-coa-reductase-inhibitors/ … #brainmaker #grainbrain

Digestible Tips for Staying Gluten-Free On-The-Go – Modern Wellness Guide http://www.modernwellnessguide.com/lifestyle/digestible-tips-for-staying-gluten-free-on-the-go

Forward Story ‏@forward_story Jul 1
This Is Your Body On Sleep Deprivation http://www.huffingtonpost.com/firas-kittaneh/this-is-your-body-on-slee_b_7663702.html …

Amy Kubal ‏@AmykRd Jul 1
Why Body Mass Index (BMI) Is Wrong for So Many People http://huff.to/1H035p0

Abel James ‏@fatburnman Jul 5
6 Easy Tips for Clean Eating on a Small Budget http://flip.it/l22jz

Amy Kubal ‏@AmykRd 7h7 hours ago
This is your body on alcohol: http://drugabuse.com/featured/the-effects-of-alcohol-on-the-body/ …

**********

Money

Experience Life ‏@ExperienceLife Jun 28
The Mirrors of Your Spending — How our most intimate sense of self & our use of #money reflect each other http://j.mp/1BH9LJw #values

**********

Wisdom / Productivity

Seth Godin ‏@ThisIsSethsBlog Jun 28
Seth’s Blog: Buzzer management http://bit.ly/1GIZTvB

Michael Hyatt ‏@MichaelHyatt Jun 30
Why You Should Flush 90% of Your To-Do List Down the Toilet http://mhyatt.us/1ol0bFb

Experience Life ‏@ExperienceLife Jul 7
New job jitters? How to settle in with minimal stress — http://j.mp/1KKe8Xh #worklife #balance #stressmanagement

Posted on

What I Learned from Margot’s Frozen Yogurt

by

When I was in my late twenties, I acted upon a desire to start my own business. The allure of being one’s own boss is very strong, and creating a business is one of the most exciting things a person can do. It was certainly exciting for my wife and me to start a frozen yogurt shop in Santa Fe, New Mexico.

The Author in Santa Fe – circa 1989

Rather than relate every detail of the start-up and operation, let me tell you about the challenges we faced and what I learned from them.

Under-Capitalized

We began Margot’s with virtually no capital of our own.  This meant that we had to borrow money to get started. At the time my desire to start the business was so strong that I was willing to borrow money to buy equipment and lease space. The idea was to invest a lot of our own sweat equity into the place and to buy the bare minimum of equipment required to get up and running. Then, we would upgrade from the profits of the business as time unfolded.

This was a problem on two fronts.

1. The strategy of buying just enough equipment to get started soon became a problem. The two soft-serve yogurt machines we could afford with our borrowed money were new machines, but they were air-cooled machines. We had selected a great location for the shop, so getting traffic into the place was no problem. In fact, the first day we were opened a line formed and stayed all day. This meant that the front door stayed open most of the day allowing the warm summer air to come into the shop.

As the ambient air warmed up, the air-cooled machines had to run more to keep the yogurt frozen. The more the machines ran, the more heat they threw off. We created a heat spiral. At one point it got so hot behind the counter that all of our chocolate toppings melted together in their respective containers. The machines could not keep up with the rising heat, and the product started coming out too soft. This heat problem remained until the day we sold the business.

What was the cause of the problem? We didn’t have enough money to buy the more expensive closed-loop (glycol) cooled machines or even water-cooled machines. If we had been able to afford those machines, we would have avoided this serious heat problem.

2. Given that we could not afford the proper machines, you might think that the solution to the problem would have been to have borrowed more money at the outset to buy the better machines.  That, however, would have just exacerbated problem number two. When you borrow money from a bank or any other creditor, that creditor has to be repaid with interest. This means that every month without fail, we had to write a  check to the bank for $800 to repay our business loan. That business loan, by the way, was personally guaranteed by my wife and me. Our home and vehicles were collateral for the loan. If we did not repay the loan as per its terms, really bad things would have happened to us.

So if we had borrowed more money up front, the monthly payment would have just been larger. When your new business is struggling to get off the ground, paying $800 per month to service debt doesn’t help matters.

What Would Have Worked?

My older wiser self would tell the young 20-something to save money toward the opening of the business. That requires patience. Patience is a four-letter word to people like my younger self. I had the idea, I had the location, and my mind was made up. I did not care that I had no money and no experience in the industry at all.  It was time to shoot now and ask questions later.

If I would have piled up cash first before starting my business, I would have begun Margot’s Frozen Yogurt without debt, with the proper equipment, and with much better prospects for long-term survival and expansion. Eventually we sold to a couple that was properly capitalized. The first thing they did was to replace the air-cooled machines with glycol-cooled machines. Because they had no debt, the operation of the business was a lot less stressful.

Conclusion

I realize that entrepreneurs as a class are risk-takers. I am one. However, I strongly recommend that anyone planning to start a business begin with their own personal finances first so that they can start setting aside capital to begin the new venture on solid footing. If you can live below your current means, you can stack up cash so that you can use your own money and avoid the business debt trap.

If you are an aspiring entrepreneur, don’t let this article discourage you. I believe in entrepreneurism. In fact, I love business. I just want you to be aware of some of the pitfalls of starting your own business so you don’t have to repeat my mistakes. Despite our challenges, Margot’s Frozen Yogurt was a tremendous blessing to us. It taught me many lessons that I took with me into the classroom as I finished my BBA. It continues to help me in all of my current business ventures. The people I met and worked with at Margot’s were tremendous. We got to employ a lot of excellent people in the Santa Fe community, including a lot of wonderful young people at Santa Fe Preparatory School. These were impressive people that blessed us. We got to know our customers well, and we loved serving locals as well as tourists and celebrities (like Brian Dennehy and Karen Grassle). All in all, we would not trade the experience.

If your Forward Story includes starting a business, I strongly recommend that you educate yourself as much as possible about not only your desired industry, but also about the wisest ways to finance, launch, and run your business. It is a lot easier to learn from those who have made mistakes than it is to repeat those mistakes on your own.

Posted on

Wisdom in Entrepreneurship

by

A friend recently told me about a young man who earned his MBA, worked for a year, lost his job, and got disillusioned about the corporate world. Instead of searching for a job he decided to start a new business.

Starting a new business is part of many Forward Stories. The thrill of entrepreneurship attracts many people, including me. However, the voice of experience has something to say to people like this young man. This voice of experience is my own. I have learned many things from the four businesses I have started.

This young man did not ask for my advice, but if he had here is what I would have told him:

1. Don’t Quit Your Day Job. Listen, the grocery store does not accept as payment your plans, hopes, and dreams. Neither does your landlord. They accept cold, hard cash or, in some cases, plastic. In that case, the credit card company accepts cold, hard cash. It is very possible in free societies to continue earning a living to pay the bills while starting your business on the side.

While I have not yet read it, I know enough about his thesis to recommend the new book by Jon Acuff entitled Quitter. The premise is that you do not have to accept the myth that the only way to achieve your dream and start your business is to go “all in” and roll the dice. There is a much wiser way to be a “quitter.”

If you have already quit your day job, find another one. Work at being great in everything you do. Start your business on the side and build it to greatness.

2. It Takes Money, but Don’t Borrow It. Starting any business takes some money. You may need to buy a computer, business cards, equipment, or any number of other “necessities.” The temptation is there to borrow the money either from a bank or on your credit cards. Don’t do it! Nothing is more discouraging than starting  a new business, earning revenue from your products or services, and then turning around and sending it all to your creditors.

So how do you do it without credit? Well, you could start with a pile of cash that you have saved up. That is the way the old-timers did it. You know, set aside money for a purpose and then use the money to achieve that purpose? That is called delayed gratification, and it is a very odd concept these days.

You could also choose to cash flow those items you need to start your business. How about using your old computer or finding one on eBay or at the local thrift shop? How about using that old computer and some free software to print your own business cards? How about renting your equipment for a specific job to generate profits from which you can buy your own used equipment?

This myth of necessary debt has sunk many a new business. If your business does fail, it is really discouraging to be obligated to continue paying credit card bills on a bunch of business stuff that you no longer have. When that happens each month’s credit card bill is a bitter reminder of your failure.

3. It Is Harder Than it Looks. To those who have never owned a business it appears easy. It is not. My goal is not to discourage you if you want to start a business. I am just saying that there is a reason to be conservative in your projections for revenue and be liberal in your projections for expenses. It is going to take longer than you think it is to achieve sustainable profitability.

Not only is it difficult to win new customers, it is also takes time and energy to take care of all of the required responsibilities in government reporting, bookkeeping and accounting, and taxes. If you hire employees, now you have the additional burden of making payroll, paying employment taxes, and handling employee problems. It is no walk in the park!

I have found that many people who leave the corporate world in frustration discover that owning their own business just shifts the burdens to them as the employer. Now they are wearing the boss hat. If they then decide that owning a business is not what they thought it was, they often return to the corporate world with a greater appreciation for being an employee and for how hard it is to be the employer. Often a paycheck never looked so good.

Conclusion

In future posts I will share some of the specifics of the businesses I have started and what I learned from them. A big part of wisdom is not only learning the hard way yourself, it is also learning from the experiences, mistakes, and successes of others.

Develop a Forward Story that includes your business, but do it with wisdom, patience, and realism. That is part of becoming an adult.