The Infinite Compounding Fallacy

The financial planning profession has a long history of demonstrating the power of compounded growth to clients.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically compounded at a high rate.  This is supposed to enable you to enjoy a happy and comfortable retirement from your compounded returns.

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Losses Loom Larger Than Gains

Everybody hates to lose.  One of the trends that many people experience in the world of investing is a noted tendency to become ‘gun shy’ when they experience volatility in their investments.  The reason for this is because our psychological makeup is much more afraid to lose than joyful over gains.  This leads many people to either become irrationally risk-averse or to take risks that they are not aware of in a desire to achieve safety.  The problem this creates is that fear of loss can make people blind to the opportunity for gain.

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Buying Low and Selling High

The cliche “buy low and sell high” has been around seemingly since the beginning of time.  However, there is quite a bit of depth behind this simple piece of wisdom.  In order to discover this depth, we need to ask ourselves what kind of person will buy low and what kind of person sells high.  We also need to ask what situations result in low prices for you to buy, and what situations result in high prices for you to sell.

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Re-Thinking Wealth Building

Wealth building has become a key topic of conversation in the financial media.  Traditional financial advisors frequently talk about equity and debt.  (aka ‘stocks and bonds’)  This is certainly a part of wealth building, but the current world has become highly complex.  In order for people to achieve their financial goals, they need to think about wealth building differently.  Many people go through booms and busts but never manage to get ahead.  This is especially important for people who over-invest in buying a home and under-invest in other financial assets.

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Wealth and Income

During business and economic discussions, it seems that distinctions are rarely made between income and wealth.  Income represents the resources that are accumulated annually.  Wealth represents the total amount of resources that have been accumulated throughout the tenure of your life.  Income must be earned by you year after year.  Wealth can be used to generate income year after year, without any direct input from you.  (Now we’re talking …)

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What is Wealth?

Every time that an asset class rises or falls, the media begins to challenge the notion of wealth, productivity, and output that many people hold in their minds.  The typical situation for most people is that they think of wealth as being measured in money.  For people like Ben Bernanke, money means currency.  For people like Bill Bonner, money means gold.  However, in both cases, I see wealth as something much deeper.

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The Financial Overweight Smoker

Many overweight smokers know what they need to do in order to become healthy, but do not do it.  Most people that are smokers don’t suffer from a lack of knowledge that smoking is bad for them.  Most people that are overweight already know that there are health risks associated with being overweight.  In both of these cases, a lack of knowledge is not the issue.  Similarly, beating overweight smokers over the head with information about the health risks of their lifestyle isn’t very likely to make them change.  This phenomenon applies to our financial life also.

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A Dollar Saved is Two Dollars Earned

Benjamin Franklin is famous for saying that a penny saved is a penny earned.  With all due respect to Mr. Franklin, it is possible that he has under-estimated the return when yous save.  The reason for this miscalculation is the fact that you must pay taxes on every dollar that you earn before you have the opportunity to spend it.  (Remember the parable of death and taxes)

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Good Debt, Bad Debt, No Debt?

Throughout the lexicon of financial advice in the marketplace, there are many different views regarding the role of debt in our lives.  The traditional view is that debt causes us to make interest payments that deplete our wealth and erode our ability to build wealth.  In the case of the mortgage crisis, many lending institutions and government agencies encouraged excessive lending to borrowers that were at very high risk of default.  This even prompted some financial authors to proclaim that all debt is bad, regardless of what it is used to finance, and regardless of how it is structured.

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3 Steps to Plan for Financial Emergencies

Financial emergencies are an unfortunate part of life.  No matter how hard we try, it is inevitable that something will blindside us at some juncture in our life.  Chances are that it will be many things blindsiding us at many points throughout the tenure of our life.  The thing that is important for people to understand is that the way we address these emergencies will determine whether they become catastrophes.

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