Fear of failure, or looking stupid, holds us back from learning new skills. Whether you are learning to swim, or figuring out the risks with borrowing a certain amount of money, it pays to develop your beginner’s mind.

If you had trouble following this series then get a copy of The Richest Man in Babylon. The book uses stories, rather than case studies, to teach about money. 

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When I ask people to define financial independence, most back into their answer based on current spending. Other people have no idea about their spending so they toss out a huge number that they think would enable them to stop working. Both of these methods fall short because the answers they imply are unrealistic.

I started this series by asking you to consider if a million dollars was as much as you thought. To balance that idea, I showed the power of saving $20 per day.

While it seems attractive to have our financial needs covered via passive income (see Four Hour Work Week), the idle rich are poor role models and the active rich are often held in bondage by their spending.

Constantly saving money to have the ability to spend whatever we want at some future date is a lousy goal. First, we might never achieve our goal. Second, it overlooks a much easier, and more valuable, target. Financial independence is about having the ability to choose your location and occupation.

Additionally, financial reserves give you the ability to say yes to what you want to do and, most importantly, make it easier to define what you are unwilling to do. Many wealthy people end up in prison, or dishonored, because they forget that financial wealth makes it easier to say NO to bad ideas. 

For example:

• Do I work in a team that shares my personal values?
• Should I keep my mouth shut when senior management break the law?
• Should I lie and cheat the bank, tax man, shareholders or government?
• Should I invest in companies that sell products that hurt my fellow citizens?
• Should I sell a product that I know is not in the customer’s best interest?

I’ve had to make decisions on all of the above. These choices cost me (a lot of) money in the short term. However, my choices helped maintain my freedom, and honor, over the long term.

When I think back, a few of my ethical decisions appear irrational based on the economics that I learned in school. Perhaps we undervalue self-respect, or fail to capture the rapidly diminishing returns beyond our basic needs. Perhaps there is a value, of freedom, that we’re not capturing in traditional economic analysis.

A reserve fund, and a mantra of being willing to make less, changed my ability to stand for what I believe in. Optimizing for self-respect is easier with the reserves to sustain unemployment! I’ve chosen unemployment more than once. 

If you haven’t created financial freedom for yourself then set a small daily goal and get started. Make time for the financial education of your kids and spouse. In teaching others, you will remind yourself of the basics:

• Spend less than you earn
• Protect core capital
• Be wary of leverage
• You only need to achieve financial security once
• Wealth is about freedom, not money

These topics are poorly understood and largely ignored.

Start small and stick with it.

If you’re under 40 years old, and live in the West, then the only world you’ve ever known is one of declining interest rates and reducing inflation expectations. In this world, inflation happens in textbooks and far away places. Last week, I tried to show that it wasn’t always so.

I want to share a case study about how you can use mortgage debt to provide inflation insurance. While I am very cautious with using leverage, mortgage rates are at a level where it made tremendous financial sense for my family to take advantage of the opportunity I’ll outline.

The numbers that follow are based on a deal that I did last month. You can find my workings in my Financial Education spreadsheet.

What I’ve done for this example is adjust the numbers from a December house purchase to reflect actual values per $100,000. These numbers are for Boulder, Colorado so you’d need to crosscheck for your own geography.

I assume a conservative debt:equity ratio of 50%. You might be able to borrow more but the interest rate that you’ll pay might increase.

Our loan provider gives us a single payment for the mortgage, taxes and insurance. 2/3rds of that amount relates directly to the mortgage and is fixed for 30 years. 1/3rd of that amount, as well as 100% of the other ownership costs, are subject to inflation. You’ll find a checklist for the costs of ownership on Page 55 of my book.

Using the scenario from last week, I imagine a decade of mild inflation (2.5% per annum) followed by five years of historically high inflation (7.5% per annum). This increases prices by 84% over 15 years.

Currently, for the type of property that we bought, the cost to rent is similar to the cost to own – about $300 per month per $100,000 of capital value.

What happens if prices rise by 84%?

• My cost to rent is likely to increase by inflation and rises to $544 per month.
• My mortgage payment is fixed so inflation only applies to half of my cost of ownership, which we assume rises by 84%. This means that my future cost to own is $424 per month.

In an inflationary environment, borrowers of low-cost fixed rate debt benefit relative to: (a) people that don’t own assets (the poor); and (b) people that aren’t leveraged (debt-free prudent citizens). What concerns me is the largest borrower of low-cost fixed rate debt is my government.

In an environment where public and private debt levels are high, inflation is a politically painless way to reduce the real value of debt. It is an “easy way out” for elected officials (and overleveraged companies/individuals) to deal with high levels of debt.

I have no idea if we’re going to have high inflation. However, if we experience high inflation, then it is valuable to my family to have a strategy where we can stay put with a payment that is lower than our cost to rent.

Additionally, even with moderate borrowing (50:50), the case study projects that the value of our home equity grows at 7.7% versus inflation at 4.1% per annum.

30 years from now, when I’m 74 years old, we will have a debt-free asset. The family will have the option to use this asset to take care of mom/dad in their senior years. If my wife and I pay down this loan over our working life then we remove end-of-life financial pressure on our family. 

The house we bought was the smallest that met our requirements in the one of the best neighborhoods in our city. You will be tempted to size up in a secondary location – this is a mistake. Choose location first then get the smallest place that meets your needs.

Convenience is my #1 criteria for “best.”

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Other Considerations

This house is well located – I suspect that real economic growth in Boulder will be higher than the national average – real economic growth is a key driver for local property values.

Make sure that you get your cost of ownership calculations correct – there are many hidden costs of ownership that I cover in my book.

Inflation might not happen – make sure you are comfortable with low, and no, inflation scenarios (prices could even fall).

Make sure you understand what it would take for you to be unable to service your loan. I’ve been unemployed once per decade in my adult life.

Variable debt, especially loans that reset or are linked to the Prime Rate, can bite you in the butt. The 30-year fixed rate loan, effectively offered by the US Government, is an essential part of this case study. The inflation insurance comes from the fixed-rate loan.

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Final Notes

The only thing I know for sure is the future will turn out differently than this projection. It will be fun to revisit this post in 15 years!

Prediction is not the purpose of running scenarios. The purpose of looking at alternative outcomes is to provide information so you can ensure that you are comfortable with any outcome.

One of the best decisions I made in my 20s was focusing on my career and maintaining complete geographical flexibility by renting. This allowed rapid career progression. Even in a rapidly rising market, I “made” much more money by excelling at work, than I would have done with real estate ownership.

I’ll kick off this piece with some charts. The first one is historical inflation in the US, UK, Japan, Germany and France (1950-1994).

The exact numbers aren’t important – what catches my eye is two periods (early 50s & mid-70s) where inflation was at, or over, 7.5% per annum for a few years. To see why this matters, let’s do a case study.

You have $1,000 stashed in your mattress (or yielding close to 0% in a bank account). Across the year, prices go up by 2.5%. With the gradual increase in prices, how does the effective value of your money change over time?

I view inflation like a negative interest rate. Instead of earning money across the year, you “lose” money because your purchasing power goes down.

In our example, $1,000 on January 1st would buy the equivalent of $975.61 on December 31st.

$1,000 divided by (1 + inflation rate)

You can’t buy as much a year later because prices went up, and you didn’t earn anything on your money.

To be able to buy the same amount of stuff, you would need an after tax return of 2.5%. When your investment return is equal to the inflation rate, you stay neutral. In our example, $1,000 times (1+0.25) = $1,025 is required to stay neutral on December 31st.

Real Return = After Tax Return minus Inflation Rate

Most people will feel happy when $1,000 goes to $1,025 over a year. However, in our example, you haven’t moved forward. Your return has let you stay in the same place.

Right now, the return on low-risk assets is small and the inflation rate is small. So parking your money in low-risk / low-return assets has little cost to your purchasing power. However, doing this for many years can be a poor investment strategy. Inflation hurts consumers slowly and, aside from the price of gas, is largely hidden from our collective consciousness.

Consider the chart that follows – it assumes a baseline inflation rate of 2.5% per annum and a five-year block where inflation jumps to 7.5%.

The chart shows the purchasing power of $100,000 over time. I used $100,000 because that’s the target that I’m going encourage my kids to achieve by the time they’re 30. It’s do-able if they save $20 per day from the time they are 18.

When my balance sheet was largely low-risk, low-return cash equivalent assets, the chart (above) was on my mind. The steep drop in purchasing power due to a five-year period of higher than average inflation would hurt my family’s purchasing power. With extremely low interest rates and rapid Central Bank money creation, I thought (incorrectly) that significant inflation was right around the corner.

How low are today’s rates? The chart below (posted yesterday by Ritholtz’s blog) gives an idea. Note that the chart goes back to 1790.

In 2009/2010, I made a decision to shift into real estate. The market was falling and debt finance wasn’t available. For me, it was the perfect time to buy and I expected Boulder real estate to hold its real purchasing power. In other words, I expected the long-term value of my investment to link closely to the inflation rate. I wasn’t trying to get rich, in a very uncertain time, I wanted an investment that was likely to hold purchasing power. We hear this argument about gold but gold lacks many of the benefits of residential real estate. For an explanation of long-term real estate valuation see Shiller – Irrational Exuberance.

For what it’s worth, an alternative investment that I considered was buying two large-cap stocks (GE/WMT) with attractive dividend yields. I wasn’t able to achieve my target entry price on the stocks so missed that window.

In addition to an expectation that real estate would hold its real purchasing power, the net yield on real estate is attractive if interest rates fall to very low levels. Real estate offers some income protection against prolonged very low inflation and even lower interest rates. I didn’t expect rates to fall as far as they did but considered “what if.”

Here’s a chart that plots US rates against the post-bubble history in Japan:

The precise numbers aren’t important. What’s useful is to consider a scenario where low-risk assets have yields under 1% for five, or more, years. What type of investments make sense in that environment? For me, high-quality real estate makes sense. There’s a substantial section in my latest book about real estate.

Other investments that make sense are my kids 529 college accounts and low-cost index funds. The 529 program that we use is has a 0.46% expense ratio and is tax-free, or tax-deferred, depending on use of funds. In 2012, I started small, weekly investments in Vanguard funds for my kids. With Vanguard, the index products (VTSAX/VTIAX) have expense ratios of 0.06% and 0.18% respectively. I’ve only used the US fund so far but am considering adding international.

The index funds have yields that are lower than what I earn on real estate but they are far easier (and less costly) to sell. 

My point: inflation can be a risk, or a benefit, to your family finances. When thinking about portfolio strategy, consider how changes in inflation, and interest rates, will impact your life. Be comfortable with every scenario and remember that we are in a highly unusual situation.

Next week I’ll share a case study of using a mortgage to protect your family from unexpected inflation. I think it’s a much more practical strategy than speculating in commodities, like gold.