Photo by action datsun

“Where have all the dollars gone?
Long time passing
Where have all the dollars gone?
Long time ago
Where have all the dollars gone?
Gone to Starbucks, every one
When will I ever learn?
When will I ever learn?”

- Pete Seeger, “Where Have All The Flowers Gone?” (paraphrased)

To balance your household budget, you have to be able to accurately track your expenses. So you might make a spreadsheet listing your taxes, 401(k) and IRA contributions, mortgage, insurance, food, utilities, etc., and add them up to find your total expenses. When you see that your expenses are less than your income, you breathe a sigh of relief. You’re in the black! Or are you?

There’s an invisible force wreaking havoc on many household budgets, turning black ink to red ink and vanishing with hardly a trace. They call it The Latte Factor. David Bach, author of The Automatic Millionaire, coined this term to refer to our many small expenses that add up to large amounts over time. A coffee here, a magazine there, and before you know it, you’ve spent a staggering amount of money without realizing it.

When I finished school and landed my first job, I whipped up a spreadsheet to track my expenses. I entered every expense I could think of, and they all added up to less than my salary, so I thought I was running a profit. And yet, that didn’t seem to be the case when I saw my bank account balance dropping every month. On closer inspection, I found that I had missed $600 of monthly expenses in my spreadsheet.

I decided that I needed a better system to see where the dollars were really going. I needed two spreadsheets, one to track my budget (a high level view of where my money was going), and one to track my expenses (the amount I was actually spending). Open up the sample worksheets Budget.xls and Expenses.xls, or follow along with the HTML versions at the bottom of this post.

These are hypothetical numbers for a single person. I have no idea if they’re reasonable, but they’ll get the point across. Of course, you’ll need to replace them with your own numbers.

First let’s look at Budget.xls. At the top we have our monthly salary of $5,000. Then the monthly expenses are split into two parts. The first part consists of our fixed expenses. These are things that are fixed in the short term, like taxes, mortgage, and insurance. (I also put 401(k) and Roth IRA contributions here. While technically not fixed, everyone should strive to max out on these). Everything is expressed as a monthly value regardless of how frequently the bill is actually paid.

The second part of the expenses consists of our variable expenses. These are the discretionary expenses that vary according to our spending habits each month: electricity, food, gas, etc. I like to separate these from the fixed expenses because we have control over them in the present moment; every day we make choices that determine our variable expenses. To estimate them, just take your best guess based on your most recent bills.

Now you see the problem. The expenses we’ve entered here are not everything we’re spending. We’ve forgotten all the lattes, scones, movie tickets, etc., and maybe a few big expenses such as car maintenance.

That’s why we have a line item called “Miscellaneous.” This is a magical fudge factor, defined as all variable expenses not already listed, which is $346.16 in this case. Let’s come back to this later. For now, just assume that $346.16 is correct.

Now we can calculate our total expenses, and by subtracting expenses from income we see that we have $85.51 left at the end of the month. Had we not accounted for The Latte Factor we would have come up with $431.67. Our $85.51 may be less encouraging, but it’s much more accurate.

In addition to seeing how much money is left at the end of the month, we might like to see what percent of our income we’re saving. Our investments here consist of a 401(k) and a Roth IRA, and I assumed a 401(k) match of 5% of our salary (if you want to get technical, the 5% 401(k) match should be counted in the Income section at the top, but we won’t do that here). This works out to us investing 39.2% of our income. (At this point I’m seeing that these numbers aren’t realistic, but like I said, they’re just hypothetical numbers to make a point.) Considering our investments plus the $85.51 we have left at the end of the month, we’re saving 40.9% of our income.

Now, back to that magical fudge factor, the $364.16 in miscellaneous expenses. Where did we get that number from? That’s what the expenses spreadsheet is for.

Open up Expenses.xls. This is a list of our monthly variable expenses over the last 12 months. We want to look at the average over the last 12 months to smooth out any anomalies such as holiday spending. To find your expenses for a given month, just look at your checkbook. Add up every check you wrote and every electronic debit you made during that month, but don’t count fixed expenses like your mortgage payment.

Expenses.xls tells us that our average monthly variable expenses are $836.16. Now look at Budget.xls. If we did our budget perfectly, the variable expenses we listed would add up to exactly $836.16. But of course, there’s no way we accounted for everything. Surely we missed some things, and that’s why we need to set the miscellaneous expenses to [$836.16 - the variable expenses we've accounted for = $364.16]. It’s set up as a formula in Excel, so it will automatically update to reflect any changes we make to our expenses, and the total expenses will come out exactly right. That’s why I called it magical.

Now Budget.xls accurately reflects how much money we’re spending, only we don’t know exactly where the $364.16 in miscellaneous expenses is going. But if we think about it and realize that we spend $150 a month on lattes, we can add a new line item for lattes, and then the miscellaneous expenses amount will automatically drop to $214.16. The closer we get the miscellaneous expenses to $0, the better we can see exactly what we’re spending money on, but the “remaining income” value is accurate no matter what.

After I got my budget under control, I eventually stopped tracking my expenses so carefully, and I haven’t used these spreadsheets in years. However, back when I was bleeding red ink and not knowing why, I found this system to be very helpful in answering the question: Where have all the dollars gone?

Budget.xls

Important: the “miscellaneous” line item is determined by setting up an Excel formula to calculate [average monthly variable expenses - those variable expenses already listed]. The value for the average monthly variable expenses comes from the expenses spreadsheet.

Income
Salary	$5,000.00
Expenses
Taxes	($1,400.00)
401(k)	($1,291.67)
Roth IRA	($416.67)
Mortgage	($900.00)
Car Insurance	($50.00)
Homeowner’s Insurance	($20.00)
Natural Gas	($42.00)
Cable	($100.00)
Electricity	($25.00)
Cell Phone	($25.00)
Food	($200.00)
Gasoline	($80.00)
Miscellaneous	($364.16)
Total Expenses	($4,914.49)
Remaining Income	$85.51
Investments
401(k)	$1,541.67
Roth IRA	$416.67
Total Invested	$1,958.33
Percent Invested	39.2%
Percent Saved	40.9%

Expenses.xls

(Excluding fixed expenses)

February 2007	$772.77
March 2007	$803.45
April 2007	$759.53
May 2007	$1,007.12
June 2007	$830.99
July 2007	$705.42
August 2007	$756.74
September 2007	$525.39
October 2007	$1,142.95
November 2007	$922.97
December 2007	$604.42
January 2008	$1,202.13
12 Month Average	$836.16

(This post appeared in Carnival of Personal Finance #142 – The Homeless Edition, hosted by The Bag Lady.)

This is the first addition to the Resources page: The Science of Getting Rich by Wallace D. Wattles. Published in 1910, one year before the author’s death, this book went on to inspire Rhonda Byrne’s The Secret nearly a century later. Not much is known about Wallace Wattles, but we know that he was prosperous in his later years after living most of his life in poverty.

This book is about the law of attraction, although it doesn’t call it by that name. It’s very similar to The Secret, but of course it focuses purely on the financial aspects. One notable way in which it differs from The Secret is by placing much greater emphasis on taking action instead of just waiting for the universe to deliver. To quote Wattles:

“A person must not only think, but his personal action must supplement his thought. By thought you can cause the gold in the hearts of the mountains to be impelled toward you, but it will not mine itself, refine itself, coin itself into double eagles, and come rolling along the roads, seeking its way into your pocket…Your pocketbook is not going to be transformed into a Fortunata’s purse, which shall be always full of money without effort on your part. This is the crucial point in the science of getting rich — right here, where thought and personal action must be combined.”

One of the biggest complaints about The Secret is that it completely glosses over the importance of hard work, saying only that “action will sometimes be required.” This was my only major complaint about The Secret, so I was glad to see the need for action being stressed in The Science of Getting Rich.

I’ve heard several people complain that Robert Kiyosaki refers to people who don’t want to be rich as “hamsters.” Those people would probably not like to hear Wattles say this:

“It is perfectly right that you should give your best attention to the science of getting rich, for it is the noblest and most necessary of all studies. If you neglect this study, you are derelict in your duty to yourself, to God and humanity, for you can render to God and humanity no greater service than to make the most of yourself.”

It’s really not surprising that Wattles was ejected from his position in the Methodist Church for heresy.

This is definitely a recommended book, especially for the bargain price of free. The copyright has expired, and the book is now in the public domain. The other books in this series are The Science of Being Well and The Science of Being Great.

Note that this particular copy of the ebook contains an advertising link at the top of each page, and then several more at the end. I’m not affiliated with any of these links, I haven’t researched them, and I have no recommendation either for or against them.

Please share your thoughts on The Science of Getting Rich in the comments.

Photo by Tracy O

Admit it, you think that headline is complete hype, don’t you? I can’t blame you. People who think they’re financial experts go on and on about how creating a six figure residual income is impossible, and anyone who says otherwise must be promoting a scam. When you see enough of this, you might start to believe it.

It’s a shame, though. Creating a six figure residual income is actually quite easy, if you have enough time to wait. So easy, in fact, that I decided to make the challenge a little tougher. I’m going to show you how to realistically create a seven figure residual income, without any smoke and mirrors.

If you have Microsoft Excel on your computer, you can open the spreadsheet stocks.xls. Otherwise, you can see the HTML version at the bottom of this post. Yes, we’re going to create our seven figure income with common stocks.

From 1928 to 2002, large cap stocks averaged a 10.8% annual return, and small cap stocks averaged a 12.5% annual return (source). We’re going to assume a 10% annual return for this example. You can think of our hypothetical portfolio as a mix of large caps and small caps, with taxes paid on distributions.

We’re going to assume that we’re starting at age 22, right out of college. I know you’re probably older, but you can change the age and other parameters later. We’re also going to assume that we have a job with an above average salary (like an engineer), and we’re willing to forgo some consumption today in order to invest for the future. This will let us invest $1,000 a month (for simplicity, we’ll assume a single investment of $12,000 is made each year, with the distributions reinvested). Now realistically, this is more than a 22 year old engineer can invest, but I think it’s a fair assumption because it won’t be too many years before they can invest much more than $1,000 a month.

Let’s take a look at our spreadsheet. We have one column showing our age. I’ve entered 22 for the age in the first row, and it automatically increments from there. Off to the right, we have two other parameters: our annual investment ($12,000), and our rate of return (10%).

The two other columns are Portfolio Value and Est. Annual “Income.” Portfolio Value refers to the amount we’ve accumulated over the years by investing $12,000 a year at a 10% rate of return. Est. Annual “Income” refers to the amount of residual income that’s generated annually from our portfolio. Our money gives us a 10% return just by sitting there.

The reason I put “Income” in quotes is because some people would argue that it’s not income. I agree that it’s not realized income, meaning money that is actually paid to us as cash in the form of dividends and capital gains distributions. Most of the gains are unrealized, meaning they’re sitting in our investment account instead of in our hands. It’s still real money though, and I think making a distinction is splitting hairs for the purpose of this example.

Returning to the spreadsheet, we see that by age 46 we have a portfolio of $1.06 million, generating an income of $106,000 a year. By age 69 we have a portfolio of $10.5 million, generating an income of $1.05 million a year. Well lookie here—we’ve got a seven figure residual income at age 69! If we want to keep going, by age 80 (which really isn’t that old anymore) we have a portfolio of $30 million, generating an income of $3 million a year.

If you download the spreadsheet, you can change the parameters to fit your current situation. In the first row, set the age to your current age, and set the portfolio value to what you actually have invested in stocks. Change the rate of return if you wish, and play with the amount invested annually to see what it does to the numbers.

This really does work, but the obvious problem is that it takes a long time (47 years to get a seven figure income in our example). Older people won’t have enough time to create a seven figure income this way, but even younger people can’t spend their whole lives just sitting there waiting for the money to add up. That’s why this is just one strategy at our disposal, and not the be-all, end-all of personal finance.

But at least now we can put behind us all this bunk about a six or even seven figure residual income being impossible. It’s actually quite easy, given enough time and some ability to save.

Age Portfolio Value Est. Annual “Income” 22 $0 $0 23 $12,000 $1,200 24 $25,200 $2,520 25 $39,720 $3,972 26 $55,692 $5,569 27 $73,261 $7,326 28 $92,587 $9,259 29 $113,846 $11,385 30 $137,231 $13,723 31 $162,954 $16,295 32 $191,249 $19,125 33 $222,374 $22,237 34 $256,611 $25,661 35 $294,273 $29,427 36 $335,700 $33,570 37 $381,270 $38,127 38 $431,397 $43,140 39 $486,536 $48,654 40 $547,190 $54,719 41 $613,909 $61,391 42 $687,300 $68,730 43 $768,030 $76,803 44 $856,833 $85,683 45 $954,516 $95,452 46 $1,061,968 $106,197 47 $1,180,165 $118,016 48 $1,310,181 $131,018 49 $1,453,199 $145,320 50 $1,610,519 $161,052 51 $1,783,571 $178,357 52 $1,973,928 $197,393 53 $2,183,321 $218,332 54 $2,413,653 $241,365 55 $2,667,019 $266,702 56 $2,945,720 $294,572 57 $3,252,292 $325,229 58 $3,589,522 $358,952 59 $3,960,474 $396,047 60 $4,368,521 $436,852 61 $4,817,373 $481,737 62 $5,311,111 $531,111 63 $5,854,222 $585,422 64 $6,451,644 $645,164 65 $7,108,808 $710,881 66 $7,831,689 $783,169 67 $8,626,858 $862,686 68 $9,501,544 $950,154 69 $10,463,698 $1,046,370 70 $11,522,068 $1,152,207 71 $12,686,275 $1,268,627 72 $13,966,902 $1,396,690 73 $15,375,593 $1,537,559 74 $16,925,152 $1,692,515 75 $18,629,667 $1,862,967 76 $20,504,634 $2,050,463 77 $22,567,097 $2,256,710 78 $24,835,807 $2,483,581 79 $27,331,387 $2,733,139 80 $30,076,526 $3,007,653

Amount Invested Annually $12,000 Rate Of Return 10%

(This post appeared in Carnival of Personal Finance 134: Building on the Basics, hosted by Mrs. Micah.)

How can we quantify wealth in a meaningful way?

When people think about their financial situation, they often focus heavily on the numbers. But while an income of $100,000 a year might psychologically feel a lot better than $90,000, it’s really arbitrary and doesn’t make much difference in the here and now. What matters a lot more for your outlook on life is what the numbers actually do for your lifestyle.

I use the 6 levels of wealth to compartmentalize the many possible financial situations into 6 meaningful categories that we can work with.

Poor Level 1

At this level, you’re either homeless or a stone’s throw from being there. Your life basically can’t be made any worse by taking away money. Most people reading this have probably never experienced this situation.

Poor Level 2

You earn an income, keep a roof over your head, and pay the bills. You’re getting by, but not getting ahead. The money’s all gone at the end of the month, so you don’t seem to be gaining any ground. This is where people usually find themselves right out of school, and often for a very long time afterwards.

Poor Level 3

To others, you appear to be living the good life, and might be considered rich. However, you can only sustain the illusion by prostituting yourself (by which I mean having a job). Your lifestyle is completely dependent on your salary, and you live in fear of losing your job, knowing that the house of cards will come tumbling down.

Rich Level 1

Now we transition from financial dependence to financial independence. At this level, you may not have any fancy things, but you can maintain your lifestyle indefinitely without having a job. Your income from your business activities and your investments is enough to pay the bills, so you enjoy tremendous freedom from “the man.”

Rich Level 2

More than just getting by without a job, now you’re able to afford nice things as well. You might have a swanky house, exotic car, and so forth, or maybe you don’t need material things so you just save your money or give a lot to charity.

Rich Level 3

This is where professional athletes and Hollywood celebrities are, the level where you don’t even consider money to be a limited resource.

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Of course, these levels are not set in stone, and someone else could come up with an entirely different system that also made sense. But I think it’s important to think about where you want to be with your financial situation, and not just in terms of dollar amounts, but in terms of what your life would be like. I’m shooting for no less than rich level 1, with an ultimate goal of rich level 2. What about you?