Why I rent (even though I could buy) – Price-to-rent ratios

One rule of thumb in determining whether it’s better to buy or rent a home is the ratio of the price of the home to the cost of renting the home (actual or estimated.)  15 times annual rent  is one starting point.  (I’ve also read 150 – 200 times monthly rent, which equates to 12.5 – 16.7 times annual rent.)  For example, if a house was selling at $300,000 and it (or a very similar place) could be rented for $15,000 per year ($1250 per month), that house’s ratio would be 20, meaning it would be better to rent it than buy it.

I read an article on CNN Money that looked at 10 cities to either buy or rent in depending on the ’15 times annual rent’ rule for average home prices.  Seattle, my hometown, came in at 25 times rent, meaning it’s generally better to rent rather than buy (from a financial perspective.)  As the article shows, the general trend is that desirable coastal cities (Manhattan, San Francisco, Portland [Oregon]) tend to be overpriced using this metric, meaning it may be better to rent than buy in these cities.  Midwestern and Southern cities (Minneapolis, San Antonio) tend to be undervalued, meaning it may be better to buy than rent.  (There are other reasons why you might do one thing or the other, but I won’t get into them here.)

While useful, one problem with this simple ratio is that it doesn’t account for growth rates in real estate in these various markets.*  Presumably, home prices in markets with higher price-to-rent ratios like the coastal cities are likely to grow faster than sleepier midwestern cities.  Thus, some adjustment for growth should be made for a better evaluation.

Lastly, while knowing this average ratio for a whole city is a good starting point, one should always do the calculation for each property.  Even in a city where property is cheap relative to rents, it’s possible to overpay on an individual property.  Similarly, in a city where real estate is expensive compared to rents, you can still end up paying too much rent given the worth of the property.

Remember to account for homeowner’s dues if the property you’re considering is a condo or townhouse where such fees apply.  (As an arbitrary way to compare apples to apples, take the monthly dues and multiply by 60 and add that result to the purchase price of the condo.  Use that adjusted value as the ‘true’ cost of buying for the purposes of the above calculation.)

The graph below shows some housing data for various cities (circa April 2010.)  The skinnier bar at the bottom for each city corresponds to the price-to-annual rent scale at the bottom of the graph.  The fatter bar at the top for each city corresponds to the foreclosure rate scale at the top of the graph.

* For investing geeks, the Price-to-Rent ratio for homes is similar to Price-to-Earnings ratio for stocks.  The PE ratio also doesn’t account for the future growth of companies.  Hence, fairly valued high-growth technology stocks tend to have higher PE ratios than fairly valued, mature consumer goods companies.  Even so, the PE ratio is a useful starting place since the market often overvalues high-growth stocks under the false assumption that the steller growth rates will continue indefinitely, which they never can.  (Think of the tech boom when we saw PE ratios at astronomical levels of 100 – 200, suggesting that investors expected such companies to maintain absurd growth rates well into the future.)

The PE ratio can be adjusted to account for growth by dividing by historical/expected growth rates to get the PEG ratio.  Like all ratios, the PEG is fraught with its own problems as well.

Automating your finances (Ramit Sethi-style)

I’m a big fan of automation, especially for personal finance & investing (think automatic 401k withdrawals.)  A ‘classic’ video from Ramit Sethi is at the bottom of this post, outlining his approach to automating your money.  I recommend watching it (12 minutes) and trying to automate your own money to the extent possible.  It takes a little up-front effort (which you never have to leave your computer chair for), but it pays off big time in making life simpler & helping you effortlessly hit your financial goals.

Using INGDirect for online banking is a big step in the right direction on the automation front.  I use them to automatically mail out my monthly rent checks, and to automatically put pieces of my direct deposited-paycheck into various high-interest savings sub-accounts.  Here’s how I do it.

How I automate my money

I generally have a ‘cycle’ of automatic things that happen per each paycheck.  A certain percent goes to my 401k at Vanguard (and invested according to the index funds I picked.)  The remainder (minus taxes and insurance premiums) is direct-deposited into my ING checking account online.  Of that, a fixed dollar amount goes into a vacation sub-savings account, an account for money that I spend on myself to make more money, and to my no-ATM-fee Charles Schwab checking account that I use for miscellaneous cash needs.

Once a month, my rent check is automatically mailed out to my landlord from my ING checking.  All my other bills (including utilities, cell phone, internet, etc) have been set up to be automatically paid by my credit card.  Thus, I just have one automatic credit card payment out of my ING checking that occurs monthly.  (Some bills can be set up to automatically come out of your bank account if paying by credit card is not an option; but I prefer the latter for the simplicity.)

Anything left over is available for me to either spend (without feeling guilty since I’ve hit all my savings goals), or add to my savings.  If you know me, you can guess that I generally choose the latter, but every once and a while I loosen the purse strings and splurge on myself in the form of good beer or relatively-inexpensive travel.  (I know, I know, I’m a wild man when it comes to my spending sprees.)

Below is a picture from Ramit’s post (linked below) that illustrates how this works:

Having my money automatically going to various savings places BEFORE I get to spend it on discretionary items is part of the idea.  I’m ‘paying myself first’ as the mantra goes.  Of course, you’ll want to have a rough idea of your more ‘mandatory’ spending like rent/mortgage, utilities, gas, groceries, plus a little spending money so that you can estimate how much you can sock away.  If you want to have more money to save, scroll down to the 30 excellent tips in this post.

Ramit’s more detailed explanation

Ramit outlined the approach he discusses in the below video in a blog post here as well.

On happiness and choice: mindful ways to feel better about life

I watched a ‘TED Talk’ by author & psychologist Barry Schwartz on the ‘paradox of choice‘.  He explained why too much choice can make us less happy than we would be if we had fewer choices.  This is because with many choices we 1) have more regrets about our choices, 2) feel the loss of the ‘opportunity cost’ of the options we don’t choose, 3) expect more from the choice we make, and thus are more frequently disappointed, and 4) blame ourselves when we’re disappointed, since, with so much choice, we have no one to blame but ourselves if we make a bad decision.

Check out the video for more on this reasoning.  Schwartz’s arguments are a stark departure from the usual line of reasoning in Western thought which argues that more personal liberty and freedom equals more choices (and vice versa), and hence greater societal welfare.

As Schwartz argues, and as empiricalhappinessstudies have shown, this appears to be false for prosperous societies like ours.  While choice is wonderful up to a point, too much of it can be bad for us.  (Unlike poorer or dictatorial societies, whose problem is not enough choice.)  Studies suggest that, despite the proliferation in material & social gains, human happiness has not increased in the United States since 1950.

I wanted to share my own thoughts (warning: this is an ‘opinion’ piece!) on this, and provide some personal recommendations on how to minimize the harmful effects of too much choice.

Simplify, simplify

Take a page out of Thoreau’s book (it’s called ‘Walden’) and voluntarily cut down on choice by simplifying your life.  By reducing the things that absorb your time and energy without producing commensurate benefit, you can focus on what really matters to you.  Consider limiting your exposure to television advertising and shopping malls.  They increase your material options for things that probably won’t make you much happier after owning them for a couple months.

Experiences, on the other hand, increase in value over time.  Spend money & time acquiring good memories instead.  Or, provide more choices for those who WILL benefit from them by contributing charitably to poor nations.

The secret to happiness

Simplification notwithstanding, there are obviously many benefits to choice.  Being able to decide whom to marry, how many children to have, what job to work at, where to live, etc allow people to pick and choose the things that they believe will make them the happiest (within the range of their ability to attain these things.)  One of the problems with all of the great choices we have (think food, electronics, cars), is that people’s expectations have increased along with their improved options.  There’s much truth to Schwartz’s statement that ‘the secret to happiness is low expectations.’

To me, I think of this as a difference between absolute and relative value.  The standard economic model of human behavior is that humans care about absolute value, or how much stuff/money/time/pleasure we have on a zero to infinity scale.  Thus, if you can choose between 25 different digital music players, and can select the one with the most valuable features, you’re better off than only being able to pick from 2 players with less gadgets.

However, what humans also care about is how things match up to their expectations.  If you already expect your digital music players to do 10 things, and the new player does 11 things, you may only feel ‘1 thing’ better, but not 11 things better.  This may be easier to see in how people feel about their jobs.

Folks in the western world have more purchasing power, work less hours in more comfortable surroundings, and have more free time than any generation before us.  Despite this, many of us still hate our jobs, even though, on an absolute scale, we’re way better off than even our parents’ generation.  (Read ‘The Progress Paradox‘ if you don’t believe the last part of that sentence.)  A big reason for this is because we’ve come to expect certain characteristics in our jobs.  We measure our happiness by how much our job meets, exceeds or fails to exceed the things we take for granted.  (Like leisure time, health benefits, wages that allow us to live in large houses, own multiple cars, and never go hungry.)  If this is true, how do we learn to appreciate the ‘absolute’ value in the objectively luxurious (by historical standards) lifestyle we live?

Be appreciative at every opportunity

One way is to be actively conscious of how fortunate we are, and to remind ourselves of the good things in our lives (rather than constantly grouse about the negatives, something humans are particularly skilled at.)  For example, the next time you’re at the grocery store complaining about the unripe bananas in January, remind yourself of how amazing it is that we have access to cheap, out-of-season produce every day of the year.

Being appreciative is also important when confronted with even better versions of the stuff we already have.  Some of the happiness literature (cited above) suggests that envy is responsible for part of our failure to enjoy the immense material wealth that’s been created over the last 60 years.  When your neighbor gets a new BMW, your own Toyota Corolla doesn’t look so great in comparison.   (Never mind that your car has excellent comfort, performance and safety features, especially when compared to cars of just a few decades ago, or the fact that you were perfectly happy before your neighbor’s purchase.)

Be appreciative of people as well.  Complimenting those around you for what they do increases your happiness as well as theirs.  (Psychologists have shown this empirically; people who are more appreciative are happier than those who aren’t.)  It’s easy to take the nice things a spouse or friend does for you for granted.  Be mindful of when someone is doing something beneficial for you, and praise/reciprocate accordingly.

Be appreciative of random chance (or Providence, depending on your viewpoint) and remember all the good luck you receive, and try not to dwell on the bad.  Everyone can bring to mind the last time they were stuck in grinding traffic, but what about the last time your commute was a breeze for some inexplicable reason?  Did you remind yourself how fortunate you were at that moment?

Don’t be too hard on yourself

While I believe that people should hold themselves to high ethical and behavioral standards, I also think people beat themselves up over things that, when put in perspective, are actually quite trivial.  Even if you make a big mistake, it doesn’t make anything better to simply feel guilty about it.  Focus on the future instead: repair the damage if you can, cope with it if you can’t, and consider if you need to take preventative action going forward.

I know someone who has been agonizing about leaving a job they don’t like, mostly because they’ve invested a lot of time and effort into this career path.  They spent a lot on school to receive a specialized degree to go into this field.  They spent several years gaining experience on the job.  This person dislikes the job, but feels guilty about quitting because they’ve put so much into it.

The bottom line is, they can’t get back the time and money they spent for their current profession, so there’s no point in feeling bad about it.  Instead, they should focus on answering questions that matter like: will it make me happier to leave this career for a new one?  (Yes!)  How can I find a new career and avoid making similar mistakes in my next job?  Note that these questions deal with the controllable future, not the uncontrollable past.

Worry about what you can control, steel yourself against for the rest

This last suggestion is particularly apt to investing and my point about letting bad luck go.  In investing, the best you can do is make smart choices in the present with respect to your goals and needs.  For most people, low-fee stock index funds are the way to invest for distant goals, like retirement.  If you have $100,000 in such a fund for a retirement that’s 20 years away, and the fund drops by 25% the next day, should you feel remorse for your decision?  No!  When uncertainty is involved, rationally expected results should determine how you evaluate your decision-making, not actual results.  To see why this is true, imagine the following gambling scenario:

Multi-billionaire Bill Gates offers you the following proposition: You’ll flip a quarter, and if it comes up heads, you get $2 from Gates.  If it’s tails, you pay him $1.  Do you accept this flip?  (Make the decision in your head for the purposes of this thought experiment.)

Now ask yourself: if the coin comes down tails (you lose $1), does that mean you made a bad decision (before the flip occurred)?

Assuming your goal in this scenario is to make money, the answer to the first question is ‘yes, take the flip’ and the answer to the second question is ‘no, you made a good decision even though you lost.’  Let’s see why: 50% of the time, you win $2, the other 50% loses you $1, for a net average gain of $1 (= 2 – 1) for every two flips.  This is a positive ‘expectation’ (average result) of 50 cents per single flip.  With each flip you ‘expect’ to win 50 cents on average, so ‘yes’ you want to flip.

If the coin comes down tails, losing you a buck, did that change your expectation before the flip?  Of course not, you still had a 50 cent expectation.  Thus, even though you lost, you made the right decision in terms of maximizing your expected profit.  Similarly, your expectation for future flips is still a positive 50 cents, so you should offer to keep playing with Bill no matter how many times you lose (or win.)  (If you can flip fast enough and/or get Bill to raise the stakes, you’ll eventually bust one of the richest men in the world.)

This example can be applied to life, albeit with less clarity.  If you made a decision that seemed like a good one based on your rational evaluation of the information you could get, that’s the best you can do.  In the investing example, since market movements are impossible to predict with any accuracy (run from, or punch, anyone who tells you otherwise), there’s no point in kicking yourself if the market dives unexpectedly.  (The same goes for congratulating yourself on your wise intelligence if the market soars.)

Instead, be emotionally prepared to cope with the misfortune that is sure to come to everyone in greater or smaller amounts in life.  Counting the positive things in your life will help.  (I remind myself of my wonderful wife, friends, family, ridiculously good looks, and the existence of microbrewed beer whenever I’m feeling down.)

If your decisions repeatedly turn out badly, you should reexamine your thought process to make sure you’re really making rational decisions based on good information.  (This is because similar repeated outcomes suggest that luck is not the reason for them.)   Ask your friends or family to check your logic.  They should be quick to tell you if, say, you’ve dated obvious jerks in your last three relationships and need to stop kidding yourself about your ‘bad luck’ with love.

I’d love to hear comments from folks on how they’ve dealt with choice, and their thoughts on what I’ve written above.  Good luck implementing the above in your own life!

Working for yourself: how to get started as an entrepreneur

As a financial advisor who launched his own business, I have a strong interest in entrepreneurship.  Contrary to what you might think, no huge life-changing leap is required to start your own business.  I still kept my ‘day job’ while doing what I’m really passionate about during the other waking hours of my life.  In this post, I’ll discuss why you might want to work for yourself, the typical barriers that keep people from doing this, and how to discover what you can make money at.

Motivation

As a physics student in college, I had a kindly old professor that would start every lecture with what he called, in a funny Russian accent, ‘moh-teee-vaaaayyy-shun’, or why what we were about to learn was going to be valuable to us.  To me, the two key reasons for starting your own business are 1) freedom to do what you want, when/how/where you want and 2) money.

The first reason, freedom, is multi-faceted.  If you work for yourself, you get to set your own hours, write your own job description, pick your office space, and work in a way that makes the most sense to you.  The second reason, money, means that a side job can allow you to do things financially (retire sooner, pay off debt, plate yourself in gold) that you might not have been able to do otherwise.  Your own business can even eventually replace or surpass your current income, if that’s your goal.  Some schlub toiling away at a box factory isn’t likely to get rich, but many (though few per capita) hardworking entrepreneurs have.

Overcoming barriers to starting your own business

Many reasons, also known as ‘excuses’, are cited as making entrepreneurship difficult.  Some are valid, but others are just rationalized laziness (mental and physical.)  Because it’s fun to blame people, let’s start with the nonsense:

“I don’t have enough time to start a side business!”

I have a general premise that if you really want to do something, you can make time for it, regardless of how ‘busy’ you are.  The trick to good time management is to eliminate activities to make room for more important ones, and to focus on getting one important thing done at a time.  There are a number of good books and blogs on ‘personal productivity’. One book that I highly recommend everybody read (not just the entrepreneurs) is ‘The Power of Less‘ by Leo Babauta (he also has a blog.)  Tim Ferris also has some great posts on controlling your time and getting important things done.  His book, ‘The Four Hour Workweek‘, is already a classic treatise on how to live an accomplished life (however you define it.)

Let’s say you spend 50 hours per week at your full-time job (including lunch.)  Let’s also assume it takes you 45 minutes to commute each way, 5 days a week.  That’s 7.5 hours per week + 50 = 57.5 hrs for work.  Add in 8 hours of sleep per night (56/week), and that brings the total to 113.5.

There are 168 hours in a week, leaving you with 54.5 hours to do what you please.  Of these, maybe 3/day go to personal stuff like eating, bathing and getting ready for the day.  That leaves 33.5 hours.  Spending 2 hours per day with family & friends leaves 19.5 hours.  Even if you give yourself an hour of free time each day to read, watch TV, surf the internet, etc, that leaves you 12.5 hours.

So, even if you work more than 40 hours, have a long commute, spend lots of time with family & friends, sleep a full 8 hours, take time for meals, and sit on the couch an hour each night, you have at least 12.5 hours per week to spare, and nearly 20 if you cut out free time spent alone (be honest; you’re getting some of that web-surfing time in at work anyways.)

This is more than enough time to get a part-time freelance project going.  I started my business while working full-time and pursuing a graduate degree in business in the evenings.  Did I do this by cutting contact with family & friends while simultaneously stressing myself out?  No!  I still saw family & friends for a few hours at least once per week, got plenty of sleep, read, cooked, and got all my homework done.  I even took an awesome 11 day trip to the Czech Republic while on break from my MBA classes.

I DID make a conscious effort to set and complete small (written) goals each day that would get me closer to where I wanted to be.  These might have been designing a page of my website, filing my sole proprietorship business license online, or contacting & meeting with potential clients.

What I DID NOT do is just as important:  I didn’t spend much free time browsing the internet (when I was on the internet, it was to get something specific done), watching TV, playing video games or just lounging around.  I stopped going to the monthly meetings of an organization I had joined (and let everybody in the group know that I had to be firm on that.)  In a nutshell, I prioritized getting important things done at the expense of letting small things slip (I use this strategy at my ‘day job’ too; see the above-linked Tim Ferris articles for more on this idea.)

Even though I made sure to see friends & family, especially on weekend nights, I hung out with them less than I would if I had all the time in the world.  If you have something important you need to finish, you have to learn to say ‘no’ to requests for your time.

“I don’t have any money”

While it’s true that certain types of businesses require large upfront capital expenditures (like manufacturing), many can be started with no more than a phone, computer and some office supplies.  I have a friend who started a bakery in Seattle without investing much upfront by renting kitchen space by the hour (including the expensive equipment) and selling wholesale.  If, like me and many other people, you’re going to supply a service, you really don’t need much to get started.  If you do need cash, finance your venture out of your (non-retirement) savings or income, hit up relatives or friends for loans, or start saving a bit each month to get what you need.  Avoid buying anything you don’t absolutely need for the business.

Focus instead on generating cash from customers.  Ramit Sethi, my favorite personal finance blogger, recommends getting paid by at least 3 customers (1 could be a fluke) as a sign that your venture is viable.  Start marketing your services to friends, family, co-workers and the acquaintances of these folks, build a simple website, and stay focused on taking action towards your goals.

“But I don’t know what to do?”

After setting aside time and money (or lack thereof), many would-be entrepreneurs are stymied by not knowing what services or products to offer.  Sethi has posted a great video about this discovery process.  In general, you want to come up with a business venture that combines three things: 1) Interest – what you’re passionate about, 2) Skill – what you’re good at (you don’t have to be an expert), 3) Marketability – what people will actually pay for.

Digest Ramit’s video and start setting your entrepreneurial goals today:  ‘How to figure out what to do’ video

Here’s another video from Ramit on entrepreneurial goal-setting.

%d bloggers like this: