How do I tell about the Dow in 100 years?

In the year 1900 the Dow Jones Industrial Average was 65.29. One hundred years later it was 11,600. Using a Rate Calculator from Truth Concepts we can see that 65 (the calculator doesn’t round internally but it prints that way) growing to 11,600 over 100 years is 5.32%. So the Dow has averaged 5.32% over those 100 years.

What if we looked at the next 100 years?

Now we use a Future Value Calculator, put 11,600 in as the Present Value and the 5.32% for the Annual Interest Rate and we can see the Dow will have to be at 2,067,964 in the year 2100 to have averaged a 5.32% annual interest rate during the next 100 years.

Bold italics are the client’s answers

I’m glad we get some time together today.  We are going to be using software to numerically prove the truth about how money works as it grows and to discover the most efficient way to get your money to work as hard as it can.  Before we begin I have a few questions.

If we were meeting here 3 years from today, what has to have happened for you to feel pleased with your progress?

I’d like to have my money working harder for me, feel like I have financial options

Ok, what is the biggest danger for you now?

The loss of my 401k value, don’t know where to invest

I understand, what is your best opportunity right now?

My business is decent, and  I enjoy my work,

That is great and something to be grateful about for sure!  Are you conceptual or analytical?

Both actually…I know that’s an  unusual combo but its helpful

So, what do you think builds more wealth, increasing the rate of return

or decreasing the costs to build that wealth?

increasing the rate of return …that’s what I’ve always been told by the media and my other financial advisors

Response: well let’s take a look, I’ll pull up a Maximum Potential Calculator and we’ll figure it out.  This is from a suite of calculators known as Truth Concepts.  It enables us to be very transparent in our work with you by showing the gains as well as the costs.  You can actually buy the software yourself if you so choose at www.truthconcepts.com .

We use it to analyze all sorts of things about your finances as you can see here on this list of calculators, but for now lets look at the issue of returns versus costs.  

MAXIMUM POTENTIAL CALCULATOR:

We’ll look at a Period of 35 years and you said your Income as $100,000.  It should Increase at least 4% a year if not more and for starters we’ll set an after tax Earnings rate of 5%.  You can see on the right hand side that if you didn’t have to eat or pay taxes or spend money in any way, your Maximum Potential would be 16 million. 

Now, watch what happens as we add Truth to the situation.  Right here in the middle we have Total Taxes at 40%, that’s everything, fed/state/sale tax/property tax you name it.  Notice how 2.9 million of taxes dropped the savings down to 9.8 million.  That is opportunity cost in action which we’ll talk about in a few minutes.  For now lets stay focused on this issue of increasing returns or decreasing costs being the better way to build wealth. 

So, we’ll set Debt Service at 34% as statistics show the average American family spends about 34% of their income in debt service.  Now were down to 4.2 million.  And we’ll set Life Style at 23%.  Ouch, now we’re down to 494,000.  Lets change Other to Gifts at just 1% and here in the middle we have what most people are doing, which is saving 2% of their income.  Now I see you are saving more like 10 or 15% and I commend you for that! But if this picture were true, there would be 329,000 and you can see that is not even one years worth of income  (which is 379,000)  So, on the right we’ll stay focused on that 329,000 figure. 

 Again, lets stay focused on our question here:  Can we build wealth more effectively by changing the 5% net annual earnings rate on the left or by decreasing costs in the middle?

Again, right now I’m not including inflation to keep this simple.  On the left hand side, lets try changing our 5% to say 10%.  I know it might mean increasing risk, but lets try it.  Before I do, you watch the 329,000 on the far right.  Going from 5 to 10% did what?   Brought it up to only 885,000. That’s horrible! At least it’s two years of income, but that won’t cut it.

You are right, so lets go back to 5%.  What if we reduced costs.  Now when I say that, are you thinking I’m going to ask you to eat out less?

YES!   

Well, lets see if we can find ways to reduce costs that don’t reduce lifestyle.  What if we shifted our assets around a bit and were able to reduce taxes to 35%?  What did that do? 

It changed 329 to 1.1!

And what if we reduced debt down to 24%? 

IT MORE THAN DOUBLED! 

Yes and look how much we are saving? 17%.  So reducing costs which allowed us to save more, enabled us to build wealth much more effectively than increasing returns.

This is a good example of that first Prosperity Principle we spoke of last meeting.  We called it THINK and reminded you that prosperity thinking is often opposite of what most people do in the economic world.  Here most people think chasing high returns is the way to wealth.  Now you know that reducing costs is the way.  And you are clear that  its not lifestyle costs we are wanting to reduce, but taxes and debt costs.  Reducing taxes and debt costs which enables us to increase savings will build wealth more effectively.

Next question for you:  Do you remember the third Prosperity Principle of MEASURE as it is related to opportunity costs? 

Ahh, NO

 That’s not surprising, again, its because most people (including the media and most financial advisors) never take opportunity costs into consideration when making economic decisions.  Lets take a look at how people buy cars.  We’ll pull up this Automobile Calculator that shows the true cost of paying cash.  What do you think of the statement that you finance everything you buy?

I’m not sure I understand it.

I didn’t used to either.  So let’s figure out if it’s true.  If you finance everything you buy, then you either pay someone else interest or you give up interest you could have earned.

A good friend of mine says you pay up or you pass up.   Let’s take a look

AUTOMOBILE PURCHASES…THE TRUE COST OF PAYING CASH.

 I’m going to say you had an account with $200,000 in it that you designated your “car buying account” and it was earning a net 5%.  We’ll look at a 20 year time frame and say you bought a car every 4 years for $30,000.  No increases or sales tax yet, we’ll keep it simple.  Over on the right, your account of 250,000 would have grown to $530,000 if you hadn’t bought any cars.  And we know that 5 cars at 30,000 each would be $150,000.  Yet you can see on the right the account is not 530,000, its 250,000.  That is a $279,000 difference.  Why did $150,000 worth of cars cost you $279,000? 

  I’m not sure

Ok, lets work through it.  Going back to the statement “you pay up or you pass up interest”  in this case, didn’t you pass up interest, the 5% that the account was earning, on the $150,000 you took out of it to buy the cars.  Over that 20 year period of time, that $150,000 could have turned into $279,000.  That is opportunity cost.  We must measure it so we know what we are dealing with and then we can do something about it.

 ? So now, tell me what is your least favorite money spot right now? Your 401k,  your mortgage, your life insurance, your stock account, anything?  Lets take a look at what is really going on there.   What is working about that investment? What is not working about that investment?

 OR ? So now, tell me, is there an economic decision you are getting ready to make?  Let’s take it through a calculator so you have the whole truth about the matter.

How do I figure out if I can get ahead by earning 6% if I have an 8% loan? 

At first glance, the answer is obvious, you don’t get ahead.  However, sometimes we get confused and think that since an account (say at 6%) has an increasing balance while a loan (say at 8%) has a decreasing balance, we might be able to get ahead.  Let’s look at it to see the whole truth of the matter. 

Take a $100,000 account earning 6% over 20 years.  Future Value: $320,713.

We know it earned $220,714 worth of interest.  This is calculated by taking the  $320,714 total and subtracting the $100,000 initial investment.

Now let’s look at a loan for $100,000 at 6%.

We can see that our loan payment is $9430.76 and if we multiply that by 20 years, we get $188,615.20, so we know that we paid $88,615.20 in interest.  So an incorrect deduction would be that it would make financial sense to have 6% earnings while we are carrying 8% debt, but this is only because all of the facts are not presented.  Let’s take a closer look.  The only way to make valid financial conclusions is to have exactly the same cash flows and time periods in each of the comparisons we are trying to make.

Under those guidelines, if we take the $100,000 and pay off the loan at 8%, then take the payments of $9430.76 that we no longer have to make loan payments of and pay them instead to the 6% account, in 20 years, we have $367,731, instead of $320,714 in the earlier example. 

So while it is true that we pay less interest ($88,615.20) than we earn ($220,714), that is only part of the truth.  The whole truth is that cost of money does matter and in the above example, our costs are greater than our gains.  This is the whole truth, even though we earned more interest than we paid out in interest.  There is a $47,017 improvement by paying off the 8% loan with the 6% account and redirecting the freed up payments to the investment.

One critical issue left over is liquidity.  Obviously $100,000 in an account leaves us in a more liquid position initially than $9430.76 being contributed to an account every year.  But eventually the investment account with $9430.76 being added annually will over take the account with $100,000 being contributed up front and will exceed it by $47,017 in the 20^th year.

So if initial liquidity is a concern, then it may be worth giving up some of the $47,017 gain to be in a more liquid position.  However, it is not true that there is a mathematical advantage in having a higher rate of interest on your debt than on your earnings.

Let’s use a Cash Flow Calculator from www.truthconcepts.com to tell the whole truth about what happens to an account when it gets taxed. We’ll put in $20 in 1913, the year the tax system started. We’ll show the account earning 20% per year.

We can see below that the account has $798,784,476 (that’s $798 million) in it.

This assumes no taxes or management fees were taken out during this time. 

If we adjusted the account for inflation, assuming a 4% annual rate, it would have $18,502,442  ($18 million) in it assuming no taxes or management fees.

It’s interesting to note that this income tax was intended to be temporary when it started, was only at 8%, and affected only the upper income earners.  The person who owned this account was in a 50% average tax bracket over those 96 years, using the table below as a guide.

So, applying the 50% tax bracket to the $798 million account would cut it in half, right?  NO, it brings it down to $188,247.  Notice below in the government only gets $188,227.

How is that?  It’s due to the fact that taxes are predatory or confiscating in nature.  Every time taxes are taken out of the account, those tax dollars can no longer earn the 20% rate of return the account is earning.  This is also known as opportunity cost since the tax dollars lose the opportunity to earn interest.  Let’s see what dropping the tax to 40% would do.  Watch both the End of Year Account Value on the far right and the Tax  Payment in red next to it to see how to increase both the owner of the account’s estate and the government’s take as well.

Lowering taxes to 40% shows the owner at $1,061,598 and the government at $707,719.

Lowering taxes to 30% shows the owner at $5,806,250 and the government at $2,448,384.

Lowering taxes to 20% shows the owner at $30,831,664 and the government at $7,707,911.

Lowering taxes to 10% shows the owner at $159,111,913 and the government at $17,679,099.

Lowering taxes to 5% shows the owner at $357,715,937 and the government at $18,827,154  If we really want the government to get the most, we’ll try 6.65%.

So we could surmise that if one is talking about 20% rates of return, a 6.65% tax bracket is the most efficient.  According to our studies, if we are talking about a 9% rate of return, a 15% rate of taxation is the most efficient.

So now that you know the whole truth about the matter, what do you do with this information? Focus on accounts that do not get eroded by taxes and/or implement strategies that mitigate the taxation on these types of accounts such as taking dividends, interest and capital gains in cash instead of re-investing them.

How do you calculate the internal rate of return on an investment when the cash flows vary and you can’t use a typical financial calculator that only functions with the same stream of payments, not a varying stream? 

For example, you invest in an oil well where you contribute $100,000 the first year and the second year there is a $20,000 capital call (meaning you contribute $20,000 more).

Then in the third year, there wasn’t any income but starting in the fourth year, you received the following stream, $30,000, $25,000, $30,000, $28,000 and on down and then in the 14^th year you got your last payment of $4000. For this example we are ignoring any tax implications on the contribution and on the income. 

What is the annual internal rate of return? It is 8.57% as calculated below on the IRR calculator available at www.truthconcepts.com 
 
 
 

How is the calculator figuring out the 8.57% return?  It’s taking the investment of what you put up front, and getting the income stream back out as listed, and then figuring out that the account would have to earn the 8.57% every year in order to generate that stream of income and end up with zero at the end of the 14^th year.

Anyone is welcome to buy this software if this type of calculation is something that they would use in their own personal situation or for any type of work they may do.  Internal Rate of Return Calculations are helpful for figuring out IRR’s on oil and gas deals as above,  life insurance policies,  real estate deals and other investments where the money in and/or the money out is an uneven dollar figure every year.

How do you figure out if 12% annually is the same as 1% monthly?

First take a Future Value Calculator on “annual” and put in $100,000 at 12% for 1 year, and it shows the FV to be $112,000. 
 
 
 

Then take another Future Value Calculator set on “monthly” and put in $100,000 at 12% for 12 months, and it shows the FV to be $112,683. 
 
 
 

Most banks compound monthly, a few savings and loans compound quarterly, yet it is common to express interest rates in annual terms so it gets confusing.  There are hard money investments or bridge loans that express their payment in monthly terms, like 1% a month.

While the difference in this example is small, knowing that 12% annual and 1% monthly are not the same can help you understand the whole truth about your money.

How do you calculate the cost of paying a life insurance premium monthly instead of annually?  Get a Rate Calculator from www.truthconcepts.com.  Put the annual premium in the Present Value as a negative number (which changes it to Loan Balance) since the insurance company is loaning you the annual premium and you pay them back monthly.  Then make the mode “monthly” and “beg” for beginning of year since the insurance company loans you money at the beginning of the period.  Put the monthly premium payment in Monthly Payment box and the Months as 12.  In the following example, the interest charge the company assesses you for paying monthly is 6.5%. 
 

How do you know which is more important in building wealth, money saved or the rate of return?  From www.truthconcepts.com  in the calculator called Maximum Potential we can see that it is the money you save and the reduction of costs that matter, not the rate of return.

We’ll look at a Period of 35 years with a personal example where you said your income was $100,000.  It should increase at least 4% a year if not more and for starters we’ll set an after tax Earnings rate of 5%.  You can see on the right hand side that if you didn’t have to eat or pay taxes or spend money in any way, your Maximum Potential would be 16 million. 
 
 
 

Now, watch what happens as we add Truth to the situation.  Right here in the middle we have Total Taxes at 40%, that’s everything, fed/state/sale tax/property tax you name it.  Notice how 2.9 million of taxes dropped the savings down to 9.8 million.  That is opportunity cost in action.  For now let’s stay focused on this issue of increasing returns or decreasing costs being the better way to build wealth. 
 
 
 

So, we’ll set Debt Service at 34% as statistics show the average American family spends about 34% of their income in debt service.  Now were down to 4.2 million.  And we’ll set Life Style at 23%.  Ouch, now we’re down to$ 494,000.  Let’s change Other to Gifts at just 1% and here in the middle we have what most people are doing, which is saving 2% of their income.  So there would be 329,000 and you can see that is not even one years worth of income  (which is 379,000)  So, on the right we’ll stay focused on that 329,000 figure to see if we can improve it. 
 
 
 

Again, lets stay focused on our question here:  Can we build wealth more effectively by changing the 5% net annual earnings rate on the left or by decreasing costs in the middle?  If we decrease costs, then we can save more money.

Right now I’m not including inflation to keep this simple.  On the left hand side, let’s try changing our 5% to say 10%.  I know it might mean increasing risk, but let’s try it.  Before I do, you watch the 329,000 on the far right.  Going from 5 to 10% did what?   Brought it up to only 885,000. That’s horrible! At least that is  two years of income, but that won’t do. 
 
 
 

You are right, so let’s go back to 5%.  What if we reduced costs?  Now when I say that, are you thinking I’m going to ask you to eat out less? YES!   Well, let’s see if we can find ways to reduce costs that won’t reduce lifestyle.  What if we shifted our assets around a bit and were able to reduce taxes to 35%?  What did that do?  It changed 329 to 1.1! 
 
 
 

And what if we reduced debt down to 24%?  IT MORE THAN DOUBLED!  
 

Would you buy a $50,000 car yet only insure it for $30,000 because you only NEEDED a
$30,000 car? NO! and yet the life insurance industry does this all the time with people by completing a “needs analysis” to determine how much life insurance you “need”.  YOU don’t “need” any, but you family may.  However, trying to figure out how much THEY need is an exercise in futility.  Oh, and the thought that single people don’t NEED life insurance? It’s as correct as saying they aren’t worth anything.

So, how does one figure out their own Human Life Value?  Life Insurance Companies have rules of thumb they use, such as 15-30 times income or 1 x net worth.  Typically for someone between the ages of 20 and 30, Human Life Value is 30 X income.  Age 30-40 HLV is 20 or 25 X income.  Age 40-50 is 15 X income.  Age 50-60 and beyond is 10 X income.  Any age can use the 1 X net worth rule of thumb and this can be up to 2 X depending on business owned and asset base in existence.

We can use the www.truthconcepts.com software to figure it out more specifically.  There are 2 ways.  The quick way is to use the Maximum Potential calculator, the slow but potentially more accurate way is to use the Cash Flow calculator, the Present Value calculator and then the Cash Flow calculator again.

Looking at the Maximum Potential calculator, put in the number of years until 65 (that’s a retirement fallacy, addressed in another article) the income and NO other data.  So in the case below, we have a 30 year old with 35 years until 65 and currently earning $100,000 per year.  Obviously the income will increase over time, but for this snapshot, the information is accurate.  Human Life Value changes over time as income and net worth change. 
 
 
 

You’ll notice above on the right, the potential is 3.5 million for this person.  While that is slightly higher than the rule of thumb mentioned above, it is a guideline for Human Life Value.

A more specific way to determine HLV (and a way to tell the whole truth about what it would take a family to live in their current world if the main income generator dies) is spelled out below using 2 Cash Flow calculators and a Present Value calculator.

We’ll take a 35 year old earning $100,000 with 4% annual raises, and a 5% earnings on assets capacity.  The Future Value of that scenario is $16,484,000 in the bottom right. 
 
 
 

Then you take that $16,484,227 Future Value and using the Present Value calculator reduce it back to figure out that it would take $3 million of today’s dollars to replace that future earnings stream, assuming a net 5% rate. 
 
 
 

More importantly, that $2,998,430 goes to zero in 35 years, so the widow will have to save a portion of that $100,000 – just as the family did when everyone was alive – in order to have a continued income stream past the 35 year period.  Notice the account rises a bit first, and then shrinks to zero. 
 
 
 

Moral of this story?  Most people are insuring their $50,000 lives for $30,000 because some “needs analysis” calculator told them they only “needed” $30,000.  A person’s Human Live Value is the only way to figure out the insurance “need” and so for many, that means using a combination of whole life and term insurance since most can not buy their HLV in all whole life at the outset.  There is nothing wrong with term insurance when it is used for a term of time, is convertible to whole life, and the owner works to convert it slowly over the course of time so that by age 65 or so, it is all whole life.