The Chestnut and Cedar Stock Report - An Investment Guide for Young Adults

My first introduction to savings and investing was watching my parents manage the envelope system. The process was simple. They divided their take home pay into three parts: savings, room and board, and spending. Each expenditure would be put into a separate envelope and deposited into a passbook savings account, a checking account, or left in the envelope to be used for specific expenses. Many families managed their personal finances by using the envelope system. If you tried spending beyond the amount in the envelope, the items just went back at the cash register. If you did overspend, you had to redistribute the cash in the remaining envelopes. It was a zero sum game. Using your savings was discouraged, since that was rainy day money, for college funds, and for keeping you out of the poor house when you became old. The system worked well; it was a disciplined approach to savings and spending.

Prior to the past one or two generations, the majority of seniors who lived beyond their working careers found that old age meant living in substandard conditions. Life was not fun for them and living in poverty was miserable. No one wants to go back to those days! That is why social security was started. Currently, the newscasters and lawyers are preaching that the social security system is broken and benefits will not be available to you when it’s your time to collect. That is not true! If you paid into social security, you will receive your benefits! At the end of the day, the government controls the treasury’s printing presses, and they will just print more money if necessary. We are the wealthiest country in the world, and the government will honor its obligations! Social Security, however, was only created to be a safety net to prevent seniors from living on the streets and dying of starvation; it was not created to make you wealthy.

While this book discusses many concepts, the principles behind the envelope system hold true today. High school and college graduates need to establish a pattern of regular savings. Taking a portion of every paycheck and saving it is the key for financial wellness. People are motivated to save for a variety of reasons: A car, engagement ring, wedding, vacation, house, furniture, college, and retirement, whatever. There are a few financial concepts that are critical to understand.

First, as mentioned above, it’s imperative to establish a program of regular savings when you’re young.

Second, time is on your side. For young adults, the time value of money works in your favor. You probably have seen the banking advertisements: if you save $2,000 per year for 50 years, at 8.0%, you can retire with $1.1 million.

Third, you also need to understand the differences in investing in a pretax or after-tax mode. There are substantial penalties for withdrawing savings from tax deferred accounts. If you have a short-term need, for instance, to buy an engagement ring, savings in after-tax dollars is preferred. If you’re saving long-term for retirement, then a pretax account is recommended. Some planning is involved. Young adults should start saving now, and get into the habit of paying themselves first. It’s imperative that you develop an additional cash flow that will supplement social security when retiring. The envelope system was so popular because its underlying financial principles worked. The savings, living, and spending model is still sound financial management. Enjoy the remaining chapters of this book, but remember, finance is a life long study.

The Time Value of Money

I am purposely discussing the Time Value of Money concept in the opening sections of this book. I want to emphasize that being young has a big financial advantage: the accumulation of money grows exponentially if you start saving in the early adult years. The dollar amounts need not be large; time will grow it for you.

Examples are all around you. The person who bought a house in the 1940’s now worth 20 times its cost. A friend who purchased a McDonald’s franchise for $30,000 in the early 1960’s now worth millions. The engagement ring that cost $2,000 twenty five years ago is now worth $12,000. These are all examples of asset appreciation and wealth building driven, in part, by the Time Value of Money.

The Time Value of Money concept can also be effectively applied to wealth distribution. The teacher who retires and is given a pension option of $140,000 today; or $1,300 a month for the rest of her life. The lottery winner, who has to choose between a lump sum payment, or installment payments over 20 years. Your car payment, mortgage, and investments all use time value of money concepts.

Normally, when the Time Value of Money is discussed, most people think of the old adage: “A dollar today is worth more then a dollar tomorrow.” While most investors also believe this, it may or may not be true, because the adage implies the investor has a “risk free” asset. Do you know that in the late 1990’s, some of the Japanese banks were “paying” a negative return on their savings accounts? Depositors would receive back slightly less then their original deposits. The economy was so bad in Japan, that a very small guaranteed loss was a lot better then the market place alternatives. For approximately 20 years, from 1985 to 2005, the Japanese real estate and stock market took severe hits (losses). My point is that making rate of return assumptions using computer spread sheets is easy. What the Japanese learned was that it’s difficult to achieve these assumptions. In the early 1980’s, investors did notice that Japan’s economy was “hot.” Few people, however, imagined the 20-year economic downturn that followed. Today, many U.S. investors are solely interested in making their “return”, and are jeopardizing their principal savings, while trying to get a little extra cash flow. Some retirees are now buying “junk bonds” (i.e. high risk debt securities with high interest rates) to generate higher current income levels. In effect, they are emphasizing current cash flow needs over principal protection, which is usually a mistake.

Recently, some hedge fund investors lost significant money in Bayou Management, when the founder absconded with their money. The founder promised to turn $100 million into $7.1 billion. Promising a 71 “bagger” should have raised concerns. These investors lost sight of appropriate risk / reward levels. Understanding interest compounding should have alerted these investors to the fact that there was a problem. Some of the best investments for the past 25 years were Berkshire Hathaway, General Electric, and AIG. These companies grew their businesses 15% to 20% per year; their shareholders became very wealthy with these returns. What possessed intelligent money managers to believe that a relatively small and undistinguished hedge fund could duplicate and surpass the results that only a few achieved over the past quarter century? Be careful and skeptical when relying on overly optimistic promises and time value of money projections.

Calculations don’t make money; it’s the people and infrastructure behind the calculations that make money.