bout de papier, Vol. 8, No. 1 (1990), pp. 31–32
This may sound like a contradiction in terms, given the abysmal salary levels of members of the Foreign Service (particularly at the FS-1 levels) vis-à-vis other professional groups in the Public Service. Nevertheless, it is possible to become financially comfortable on a government salary, and in spite of the costs associated with rotationality. The trick is relatively simple and painless, requiring only regularity, consistency, and to use Coleridge’s terminology, the “willing suspension of disbelief.”
One of the positive factors about working for the government is that you receive a regular paycheque for a known amount. This allows you to plan in advance. Another positive aspect is the ability to authorize payroll deductions or, alternatively, to write a series of post-dated cheques. This makes the necessary planning quite painless. The secret to financial success is to combine these welcome attributes with the magic of compound interest. This principle makes sense when considered in connection with rotationality, limited discretionary financial resources and few financial markets (at many posts).
I do not pretend to be a whiz at financial planning. In spite of this, and purely by accident, I found a most intriguing non-financial financial planning book, without charts or graphs, and which is straightforward, easy to read, and not boring!
The book is called, The Wealthy Barber: The Commonsense Guide to Financial Planning. It is written by David Chilton, and is published by The Stoddard Publishing Company (Toronto, 1989). It costs $14.95 in paperback and can be read in about two or three hours. It is a Canadian best seller, and has been featured regularly on “Canada AM,” “Lifetime,” “Basic Black,” and other national radio and television programs. Chilton writes in a narrative style, using as his medium a series of conversations amongst patrons at the local barbershop — a somewhat banal situation, but otherwise very identifiable and rather effective. This book illustrates the universal truth that if you want to get a point across, keep it simple; and that is what Chilton does extremely well.
Now to his theories. These are simple too, easy to apply, and full of infinite common sense. Point number one: Pay yourself FIRST ten per cent of every paycheque. will tell you what to do with the money in a moment.) The easiest way to pay yourself first is either to arrange for an automatic, but regular, payroll deduction or to have committed yourself in advance to a series of relatively irreversible post-dated cheques.
The reason for this is that most people do not miss what they do not see or do not already have in their hands. Generally, people tend to deal with their cheques the other way round. They pay everyone else first, and then look at whatever happens to be lett over as fodder for saving, or more often spending. Well, we all know what happens: There is never anything left over. When you get right down to it, ten per cent of a net (after tax and deductions) bimonthly cheque is not much money. In fact, I suggest that you round the figure up to the next $50.00 or $100.00 amount to make the numbers simpler for payroll deductions or post-dated cheques.
As the following discussion in the barbershop illustrates, compound interest really adds up.
“’Cathy, if you invested $2,400 a year, say $200 a month, for the next thirty years, and averaged a fifteen percent return a year, how much money do you think you’d end up with?’ challenged Roy.
’Well, $2,400 times thirty is $72,000.’ ’I’m impressed,’ (David Chilton) interrupted.
*…plus growth. I don’t know .. I’d say $200,000. Maybe not quite that much,’ Cathy concluded.
’Wrong. The answer is $1.4 million,’ Roy declared.”
Try another example. If you had started putting away $10 a month (the equivalent of $1 a day) at age eighteen, and continued until age sixty-five, averaging a fifteen percent annual return, how much would you end up with?
“I hate math, Roy, but I’ll give it a shot. Thirty dollars a month is $360 a year, times forty-seven years… Anybody have a calculator?’
’It’s just under $17,000,’ interjected Roy.
’Plus growth, I’ll say about $70,000.’
’Close,’ responded Roy. ’The answer is $2,679,000.’”
As Chilton demonstrates, this is not bull but magic. The magic of compound interest is that interest is paid on BOTH principal and interest, not just simple interest on principal. This makes it the eighth wonder of the world.
Well, now that you are paying yourself ten percent first out of every paycheque, what do you do with it? Point number two is that YOU do not invest the money in the stock market. Why not? Because you do not know anything about stock analysis and chances are that you do not know anyone who does either. Not only that, it takes time and discipline. This is because, to do well in the stock market, you have to buy when everyone is selling, and sell when everyone is buying. One top of all that, you have to spend time analyzing each company, its worth, its management style and then make buy/sell decisions on a daily basis, depending on the market and each individual stock which you may own. Brokers are in business to buy and sell, not to give advice. They make their commissions on transactions. Whether you are up or down, buying or selling, it is immaterial to them since they make a commission either way. The idea is to buy low and sell high, but the self-discipline comes in learning to let your profits run and cut your losses. Most people do just the opposite — they hold on to shares that are losing (waiting for them to go back to what they paid for them).
Chilton’s answer for the investment problem is point number three: invest in mutual funds. Chosen well, mutual funds generate a higher return than most individual stocks, and best of all from the perspective of the peripatetic foreign service life, you do not have to do anything, other than commit regular fixed amounts of money to acquiring more mutual funds. Someone else does the selection work. Therefore, you are not dependent on being in a city with a stock-market, you do not have to read the paper every day, and you do not have to spend time analyzing your portfolio and making buy/ sell decisions at the critical moment. The other advantage of a mutual fund is that instead of being limited by your available resources to a few stocks, you become part of a group of investors who have pooled their limited resources to acquire a wide range of stocks. You are thus able to reap the benefit of spreading the risk and it does not really matter what happens to an individual stock. As long as the mutual fund in which you have invested is a relatively respected one, you will do well. As Chilton says, there is a low PITA factor (ie. a low “pain in the ass” factor) in investing in a good mutual fund.
Unfortunately, even with mutual funds, there are drawbacks. One is risk. Obviously if the market goes down for a long period, so will the value of your mutual fund. Another is that you need to allow time for the compound interest factor to work. Therefore, you have to be prepared to stay in for the long run. Historically speaking, in spite of ups and downs, there has always been an upward trend in the market over a seven- to ten-year period. Thus, you must be able to leave your money in the mutual fund for at least that period of time. By leaving your funds invested while the market fluctuates, you are in fact “dollar cost averaging.” This is a concept by which your fixed regular payment will buy more units in the mutual fund during those months when the unit price is low. Conversely, when the price is high, your fixed payment will buy fewer units. The result over the course of the cycle is a lower average cost per unit. A disadvantage is that mutual funds, unlike money in the bank, are less accessible since there is a PITA factor involved in having them released. However, this may be an incentive to leaving them alone.
The next step is choosing a mutual fund. Here, admittedly, you do have to do a little work. Chilton provides a number of clues for determining a suitable candidate. He advises talking to the experts and reading a few investment publications. Then, when you have narrowed down the field somewhat, you should assess the following: ensure it has a good long-term track record; make sure that if a fund has a solid rate of return, the manager who created it is still there; buy an international fund which invests across many different industries, buy a fund whose manager is value-oriented, not fad-oriented; watch the commissions; and, remember that many financial product salespeople are confined to selling only their own products. Then, all you have to do when you have chosen the appropriate fund is fill out a fund purchase application form and arrange for pre-authorized chequing. Chilton advises you not to sign contractual plans because they limit your freedom to switch if, for instance, the fund manager were to move and you decided to change mutual funds.
Inevitably, people ask about taxes. According to Chilton, “That’s another beauty of mutual funds compared to plain old money in the bank. Not only do you reap the benefits of dollar cost averaging and the higher rates of return over the long run created through ownership, but you also pay a lower tax rate on your gains. “ This is because interest income is fully taxable, while capital gains (growth) are not. Each individual may now earn $100,000 of capital gains tax-free. After that, three-quarters of all capital gains are taxable at the individual’s marginal rate. (There are special exceptions for a principal residence, which is tax-free, and qualified farm properties and qualified small business corporations, where there is a $500,000 capital gains exemption.) In addition, with capital gains you do not pay tax until you sell, so ALL your money works for you full-time.
There are only two worthwhile ways for a Canadian to reduce income tax legally: proper income-splitting and becoming knowledgeable about all the deductions and credits available. Definitely strive to reduce your income tax, since a dollar saved is equal to two dollars earned. The point of wealth creation is that by having your financial house in order (le. no mortgage, a substantial RRSP, a growing “ten percent fund,” no consumer debt) you can enjoy life. This means you have to create a lot more wealth to be in this fortunate situation and that is what this book is all about.
By the way, this is only a taste of the broader strategy outlined in the book, which also covers RRSPs, insurance, wills, property, savings, investment, income tax and an individual’s responsibility in life and death. In many ways, this is a book which all in the foreign service should read, and periodically re-read. It looks realistically at the implications of whether you are married or single, childless or not, have aging parents or disabled dependents. It is straight-forward and banishes many myths on whether to buy life insurance or disability insurance, whether to buy real property or rent and other critical issues with which we have all grappled at one time or another.
This book concerns the creation of wealth: money above and beyond salary, pension or retirement savings. Wealth is the ability and independence to do what you want when you want, and to enjoy it without guilt or creating new debt. Chilton’s ideas for acquiring wealth appear to be both reasonable and attainable.
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Originally published in bout de papier, Vol. 8, No. 1 (1990), pp. 31–32. Read the rest of this issue →
