3 Lessons from Being Self-Employed

44% of new businesses fail in their first three years, according to Statistic Brain.

In spite of knowing the odds, about two years ago I left the steady paycheck, benefits, and general comfort of a corporate job for the world of self-employment. I’ve replaced the predictable paycheck with the potential for big ones, the benefits with freedom and flexibility, and general comfort for sleepless nights worrying if I can provide for my family.

It is very exciting being fully in-charge of my own success, but the thrill is frequently tempered. First there is daily reinforcement that I often don’t know how to do something or even that I don't know there is something that I don't know. Then, once I figure it out, it will probably cost more money than I have budgeted for it. Then, finally, no matter how long I think that something will take, it always takes at least twice as much time.

Today’s update may not eliminate the ever present challenges mentioned above. But there have been some lessons I have learned along the way that may help those of you that are considering making your dreams of self-employment come true. At the very least, perhaps they will help prevent you from waking up to a financial nightmare.

Build a Big Emergency Fund

I had about 12 months of normal expenses in cash the day I left my job. I wish now that I had twice that amount. Things that once weren’t emergencies, such as new HVAC for my home, car repairs, and just the everyday costs of raising two teenagers quickly whittled down my rainy day fund. 

Nearly every successful entrepreneur I have met can tell a story about how short the runway is between starting the business, when they are spending their capital, and getting it off the ground when the enterprise actually turns a profit. No matter how flush you may feel at the beginning, the trees at the end of the runway will rapidly approach as you accelerate while struggling to gain lift.

Whatever you think you need in your emergency fund, double or triple it before taking off.

Take the credit before you need it

No matter how long you’ve been employed, how much money you used to make, or have saved up in your 401(k), the moment you walk away from the steady paycheck is the day the credit river will slow or even run dry. The time to refinance your mortgage, obtain a line of credit, or get your credit limit increased on a credit card or two is before you walk out the door to be the next Bill Gates.

Once you’re your own boss, creditors will want to see sustained success (typically two years) before considering you even a moderate risk. Even if you can find a willing lender, the rates will likely be higher than when you fit in a nice clean credit profile of a gainfully employed borrower.

Throw in the fact that underwriting standards are still pretty stringent following the mortgage meltdown in 2008, and you can almost forget about getting new credit unless you have assets to borrow against.

Don’t be shy about taking as much credit as possible before making the leap to self-employment. You’ll appreciate the flexibility of being able to pay off big expenses with the lowest monthly obligation as possible.

Record it!

“It’s ok, I can deduct it,” may be true, but make sure you can prove it. Being a business owner allows you to offset revenue with expenses for things like office supplies, equipment, mileage, etc. Being sloppy with record keeping, however, can be costly in the event of an audit. According to the IRS 2015 Data Book, returns filed with a Schedule C (Profit or Loss from Business) with income greater than $25,000 are 8 times more likely to be audited than someone with similar income that isn’t filing small business schedules or claiming certain tax credits.

While the chances of being audited are still relatively low (between 2%-3%), you can avoid the headache of having expenses disallowed or additional taxes owed (and penalties) by saving receipts, keeping your calendar records, and tracking your mileage with a phone application like MileIQ.

Create a system, whether it is technology based or just a folder, to keep and track all of those expenses. Your accountant will thank you.

TIP – Cats like to eat receipts left on your desk.

Be Accountable to Yourself

New business owners tend to focus on what they do for a living, and rightly so. There is no doubt that offering a great product or service is a key to success. Many businesses fail, however, in spite of offering a compelling value proposition. The failure isn’t always due to failing to meet the needs of their customers, it often comes from not being accountable to themselves as they focus on what they do best and neglecting the actual business.

Taking these lessons to heart may not guarantee your success as an entrepreneur, but they will go a long way towards helping you avoid becoming a bad statistic. 

Finance Question From the Campfire: Do Lifetime Hunting & Fishing Licenses Make Sense?

My little huntin' buddy.

As a kid growing up in Texas, I dreaded the evening sportscast in mid-July on the local news that announced that the Dallas Cowboys had started their training camp. Don’t get me wrong, I grew up idolizing players such as Roger Staubach, Tony Dorsett, Drew Pearson, Ed “Too Tall” Jones, Randy White, etc. One of the highlights of my youth were those Sundays that the Cowboys played at noon and the preacher would dismiss church 10 minutes early so no one would miss kickoff.

So, why the disdain for training camp? It was simple, it meant summer was almost over!

As I got older though, my contempt for Fall turned to affection. Baseball playoffs, football at all levels, and for most in the rural Piney Woods of East Texas, the three D’s of Dove, Duck, and Deer season were upon us.

I’ve even managed to marry some of these passions as the wonder of satellite technology now allows us to watch our favorite teams on TV while sitting around a fire at deer camp. Rarely, however, do I find the opportunity to apply my experience and knowledge from my day job to the campfire conversations. That was until a recent trip to the field when the mundane topic of hunting licenses came up.

For those of you that limit your hunting to aisle numbers at HEB, you should know that Texas requires you to purchase a license in order to hunt or fish. There are variety of choices when it comes to purchasing these government permission slips. As a citizen of the Great State, you can buy a Resident Hunting License and/or a Resident Fishing License. You can add stamps for archery, freshwater fishing, saltwater fishing with a red drum tag, upland game bird, and migratory game bird. If you want to have them all, you can purchase a “Super Combo”, which currently costs $68 annually. (Active duty military and disabled veterans are free, and for age 65+ it drops to $32.)

The conversation centered on the value of the Lifetime Resident Combination, which currently will set you back $1,800.  Some of us there had purchased the Lifetime License when they were less expensive, as little as $600. Most of those folks felt that the purchase was a great deal as they had long ago “broke even” on their investment. For those that were still considering making the annual purchase, opinions varied wildly.

Since I generally don’t include things like an HP 10bII Financial Calculator in my gear pack when headed to the field, all I could do is more or less agree that the simple arithmetic of the 26+ years it would take to “break even” ($1800/$68) wasn’t a great bargain. But I left wondering how good or bad of a deal it really was. When I got back in the office on Monday, I started crunching some numbers.

If you think of the Lifetime License as an income annuity, one that provides at tax-free inflation adjusted payments for life, you can then calculate the returns based on the number of years payments are made and compare to returns of other vehicles to understand how competitive of an “investment” one of these licenses may actually be.

My first calculation added in a modest inflation rate. Assuming license prices increase at 2% per year, at the current $1,800 Lifetime License fee, it will actually only take about 22 years to recoup your investment. The internal rate of return (IRR) in year 22 is a whopping .25% per year. That’s not exactly a score you’ll be bragging about at Christmas parties in a few months.

By year 32, the IRR has risen to 3.08%. That compares favorably to what you would earn by purchasing a 30-year AAA rated Texas municipal bond today. By year 40, the IRR rises to 4.12%.

Exhibit 1. Annual Texas Super Combo License cost at a 2% inflation rate versus the internal rate of return (IRR) of a Lifetime License.

What if you put the $1,800 in a diversified stock index fund and drew out what you need each year for the license? You definitely would come out ahead, right? Well….

I ran a simulation with the same assumptions as above using a method known as Monte Carlo analysis. My financial planning software, Money Guide Pro®, makes this much easier than using my calculator. Think of the Monte Carlo as using a deck of cards, each with a particular year’s historical return of the stock market written on its face (in this case, I used a global equity portfolio similar in construction to our “All Equity” Accountable Portfolio that is allocated 60% US Equity, 20% International Equity, 10% Emerging Market Equity, and 10% Global REITs).

We shuffle and deal out the 42 cards and then tally the results using those returns in the order they are dealt. A successful outcome leaves you with at least $1 at the end of the 42nd calculation while a failure ran out of money somewhere along the way. This is considered a better way to model portfolio withdrawal scenarios versus using average returns because averages don't show the risks of how sequences of various returns that equal the same average can result in much different outcomes.

If you shuffle and deal 1000 times you can eventually get a decent idea of the likelihood of success of a particular strategy. In this case, the percentage of outcomes that resulted in having money left over was 63%. That’s better than a coin flip but far from the "no-brainer" I thought it may be when I started this article. Considering I bought my Lifetime License when they were only $1000, I’m feeling pretty good about my decision.

I feel even better about buying one for my son, who was only 8 years old at the time. There is one other benefit that can be especially attractive when buying the Lifetime License for a youngster, and that is if they ever move out of state they won’t have to buy a Non-resident Hunting License (currently $315 + applicable stamps a year) when they come home to visit.

So even if faced with making the purchase today, I would still buy one for him at the current amount because the math ain’t bad. At age 48, however, my decision would be based more on optimism or a burning desire to live long enough to stick it to the government.

Of course, anything that makes it easier to spend quality time with my “little” hunting buddy in the great outdoors is priceless. Happy hunting!

Back to School

In addition to my day job as an investment advisor, I serve as Treasurer on a couple of non-profit boards, and coach a youth softball team. Those responsibilities, along with a couple of technical problems, resulted in this week's Accountable Update not being ready by press time.

Don't panic, though. My friends at DFA just came out with an Issue Brief about preparing for children's future college expenses. It has some similar themes to a couple of other recent Accountable Updates, Money For Nothing and College For Free and PSAT and an O$#!+ Moment, but it's a good read none the less. Next week, I hope to be back with all original content. For now, "Back to School".

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Back to School

September 2016

With school back in session in most of the country, many parents are likely thinking about how best to prepare for their children’s future college expenses.

Now is a good time to sharpen one’s pencil for a few important lessons before heading back into the investing classroom to tackle the issue.

THE CALCULUS OF PLANNING FOR FUTURE COLLEGE EXPENSES

According to recent data published by The College Board, the annual cost of attending college in 2015–2016 averaged $19,548 at public schools, plus an additional $14,483 if one is attending from out of state. At private schools, tuition and fees averaged $43,921.

It is important to note that these figures are averages, meaning actual costs will be higher at certain schools and lower at others. Additionally, these figures do not include the separate cost of books and supplies or the potential benefit of scholarships and other types of financial aid. As a result, actual education costs can vary considerably from family to family.

Exhibit 1.       Published Cost of Attending College

Source: The College Board, “Trends in College Pricing 2015.”

To complicate matters further, the amount of goods and services $1 can purchase tends to decline over time. This is called inflation. One measure of inflation looks at changes in the price level of a basket of goods and services purchased by households, known as the Consumer Price Index (CPI). Tuition, fees, books, food, and rent are among the goods and services included in the CPI basket. In the US over the past 50 years, inflation measured by this index has averaged 4.1% per year. With 4% inflation over 18 years, the purchasing power of $1 would decline by about 50%. If inflation were lower, say 3%, the purchasing power of $1 would decline by about 40%. If it were higher, say 5%, it would decline by around 60%.

While we do not know what inflation will be in the future, we should expect that the amount of goods and services $1 can purchase will decline over time. Going forward, we also do not know what the cost of attending college will be. But again, we should expect that education costs will likely be higher in the future than they are today. So what can parents do to prepare for the costs of a college education? How can they plan for and make progress toward affording those costs?

DOING YOUR HOMEWORK ON INVESTING

To help reduce the expected costs of funding future college expenses, parents can invest in assets that are expected to grow their savings at a rate of return that outpaces inflation. By doing this, college expenses may ultimately be funded with fewer dollars saved. Because these higher rates of return come with the risk of capital loss, this approach should make use of a robust risk management framework. Additionally, by using a tax-deferred savings vehicle, such as a 529 plan, parents may not pay taxes on the growth of their savings, which can help lower the cost of funding future college expenses.

While inflation has averaged about 4% annually over the past 50 years, stocks (as measured by the S&P 500) have returned over 9% annually during the same period. Therefore, the “real” (inflation-adjusted) growth rate for stocks has been around 5% per annum. Looked at another way, $10,000 of purchasing power invested at this rate for 18 years would result in around $24,000 of purchasing power later on. We can expect the real rate of return on stocks to grow the purchasing power of an investor’s savings over time. We can also expect that the longer the horizon, the greater the expected growth. By investing in stocks, and by starting to save many years before children are college age, parents can expect to afford more college expenses with fewer savings.

It is important to recognize, however, that investing in stocks also comes with investment risks. Like teenage students, investing can be volatile, full of surprises, and, if one is not careful, expensive. While sometimes easy to forget during periods of increased uncertainty in capital markets, volatility is a normal part of investing. Tuning out short-term noise is often difficult to do, but historically, investors who have maintained a disciplined approach over time have been rewarded for doing so.

RISK MANAGEMENT & DIVERSIFICATION: THE FRIENDS YOU SHOULD ALWAYS SIT WITH AT LUNCH

Working with a trusted advisor who has a transparent approach based on sound investment principles, consistency, and trust can help investors identify an appropriate risk management strategy. Such an approach can limit unpleasant (and often costly) surprises and ultimately contribute to better investment outcomes.

A key part of maintaining this discipline throughout the investing process is starting with a well-defined investment goal. This allows for investment instruments to be selected that can reduce uncertainty with respect to that goal. When saving for college, risk management assets (e.g., bonds) can help reduce the uncertainty of the level of college expenses a portfolio can support by enrollment time. These types of investments can help one tune out short‑term noise and bring more clarity to the overall investment process. As kids get closer to college age, the right balance of assets is likely to shift from high expected return growth assets to risk management assets.

Diversification is also a key part of an overall risk management strategy for education planning. Nobel laureate Merton Miller used to say, “Diversification is your buddy.” Combined with a long-term approach, broad diversification is essential for risk management. By diversifying an investment portfolio, investors can help reduce the impact of any one company or market segment negatively impacting their wealth. Additionally, diversification helps take the guesswork out of investing. Trying to pick the best performing investment every year is a guessing game. We believe that by holding a broadly diversified portfolio, investors are better positioned to capture returns wherever those returns occur.

CONCLUSION

Higher education may come with a high and increasing price tag, so it makes sense to plan well in advance. There are many unknowns involved in education planning, and there is no “one size fits all” approach to solving the problem. By having a disciplined approach toward saving and investing, however, parents can remove some of the uncertainty from the process. A trusted advisor can help parents craft a plan to address their family’s higher education goals.

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Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.