How to Think About Money

A Chinese coin from the early Han Dynasty of China (74–49 BCE)

A Chinese coin from the early Han Dynasty of China (74–49 BCE)

By Ryan Allis

Summary: This post provides a roadmap to becoming a millionaire during your lifetime either by building a business of your own or by consistently saving and investing $1,000 each month for 30 years.

Starting From the Middle Class

I was born in 1984 in Pittsburgh, Pennsylvania, the son of an Episcopalian minister and a social worker. My mom stopped working full-time when I turned five, and so our family’s income was about $32,000 per year while I was growing up in Woonsocket, Rhode Island and Bradenton, Florida.

My mom taught me to dream big, be confident, and to understand personal finance. When I was 16, in the year 2000, after reading Rich Dad Poor Dad and Think and Grow Rich, I wrote down an ambitious goal: to build a company to $1 million in sales by the age of 21.

On July 3, 2003, my co-founder Aaron Houghton and I incorporated iContact. We worked out of a small office in downtown Chapel Hill. I had two years left until my 21st birthday, on August 14th, 2005. I missed the goal of building iContact to one million dollars in sales before my 21st birthday, but only by 18 days. iContact reached $1 million in annual sales on September 1, 2005.

After we sold iContact in 2012, I worked with financial advisors to ensure I could make angel investments in companies I felt were making a difference in the world, invest in building a new company called Connect, and have enough for my family to always be taken care of.

What Money Means to Me

To me, money simply meant the ability to make investments in other entrepreneurs, engineers, and technologists who were working on making the world better. I also saw a responsibility to be a steward of the funds and to work hard to build another company that will hopefully someday make a big difference in the world.

But it doesn’t take building a business to become a millionaire. The reality is that anyone can become a millionaire over time by saving $1,000 per month every month for 30 years and then investing it at a rate of return of 7% per year (see chart below for how to do this).

Why should you even care about setting yourself up for a solid financial footing? Because it’s easier to make a huge positive impact in the world when your and your family’s financial needs are taken care of and you have funds to focus on building a business that makes a difference and investing in the causes and companies you’re passionate about.

Below is what I’ve learned over the last 28 years about money and how to set your family up for a lifetime of financial prosperity. The basics are: pay off your debt as quickly as possibly, save money each month, and invest it so that it grows predictably (perhaps in a place like LendingClub or Prosper), and eventually build a business of your own. More detailed thoughts follow.

Feel free to ask any questions you have in the comments at the bottom and I’ll reply to them.

The Five Steps to Building Wealth

When I received Rich Dad, Poor Dad by Robert Kiyosaki, I read it avidly, and was inspired to buy a second book by Kiyosaki called Rich Dad’s Guide to Investing. In both books, Mr. Kiyosaki talks about his real dad, a professor, who didn’t know too much about money, and his mentor (who he calls his rich dad), who invested, saved, got out of debt, built his own businesses, and over the course of a few decades, accumulated millions of dollars. Kiyosaki’s mentor enabled him to do so much more than he could otherwise have done, and to invest in the causes and people that he really believed in.

I learned a lot about personal finance and investing from my mom, from books, by studying fundamentals-based value investing in public companies, by being an angel investor in 15 companies now through Connect Ventures, and by working with a personal financial advisor since 2007.

Here are the first five key steps to setting yourself up for long-term financial success.

1. Pay off your debt.

Many people in the United States are in tens of thousands dollars of debt. According to data from the US Federal Reserve, US credit card debt totaled $793.1 billion, with the average household owing around $16,000 on credit cards. For many, this is added to student loans, mortgages, and other forms of debt, each of which is demanding monthly interest payments. Debt is not always a bad thing, but the key is to not be getting into more debt every month. Pay down that debt as quickly as you can and pay off your debts in the order of the highest interest rates first. If you have a credit card that’s at 22% and you have an education loan that’s at 4%, pay off the 22% credit card first.

Paying off debt is like a guaranteed return on your investment. While in the stock market, you might get, on average, 10%, 7%, 20% or -30% in any particular year, paying off debt offers a guaranteed return on your money equivalent to the interest rate that the debt carries.

2. Build up your savings.

If you’re lucky, you might already be out of debt. Or it could take you a year, or several years, to get to debt freedom. If you have large debts, it could take a decade or two. That’s okay. Just work at it every year. As you pay off your debt, you’re going to start having a surplus, and when you have a surplus of net assets, those, of course, are called savings. Once you have savings, you can do things with your savings.

The key is to have at least 10-20 years prior to retirement where you can actually build up savings—build up positive net assets and be able to invest those so you can retire and eventually have your money work for you and make more money for you, rather than having to use your time and energy to get more money. The secret to true financial wealth is to eventually accumulate enough money so that you can just make money from your money.

You can invest your savings in a money market savings account at your bank that might pull back a half a percent or one percent in return a year. But once you factor in the effective inflation, which has recently been averaging about 2.8% per year, you realize that by keeping your money in a savings account, you’re actually losing money every year. Anything that produces less than 2.8 or 3% per year in return is in fact losing money, and your principal (the core amount of money you have) is getting depleted over time. I recommend considering investing in LendingClub where investors over the past few years have been earning 7-14% annual returns.

Here are some creative ways to make some extra money on the side to ensure that you make more than you spend each month:

  1. Drive passengers around in your car a few hours per week via Lyft, UberX, or Sidecar.
  2. Rent out your apartment or house when you’re not there via AirBnB.
  3. Find side-projects to work on via and
  4. If you’re the nerdy type like me, you can use your computer’s spare processing power to mine Bitcoins which can be used to purchase a number of online goods.
  5. Rent out your car by the hour using GetAround.

3. Invest in cash-producing assets.

Getting out of the middle class—in other words, succeeding to the point where you don’t have to work and you can make money from your investments—requires having cash-producing assets. A cash-producing asset is simply something that, over a period of time, whether it be a month or a year, ends up being worth more than it was worth previously. It could be ownership in a business, a certificate of deposit, or a treasury bond. Here is a list of some of the most common cash-producing assets out there. You can see that they range in both return and risk type from savings accounts at the low end to hedge funds or venture funds at the high end—the most volatile and potentially highest-reward.

  • Savings accounts
  • Certificates of deposit
  • Treasury bonds
  • Municipal bonds
  • Corporate bonds
  • Real estate with a positive monthly cashflow (through tenants paying rent)
  • LendingClub notes / Prosper notes
  • Private company stock
  • Public company stock
  • Venture funds
  • Hedge funds

4. Use the cash flow that your cash-producing assets or investments are producing to make more investments.

This is a really important step that too few people take. If you can invest the returns from your investment, rather than just spending them, they will accumulate much, much more quickly.

Once you have a few stocks, bonds, and so on that generate cash for you, take the annual returns, which are hopefully above the rate of inflation, and keep re-plowing them in to invest.

5. Earn equity in companies you work for or start.

As you work, make sure that you’re not only working for companies whose mission you believe in, but you’re working for companies who will give you a share of the upside—who give you ownership (or options to purchase ownership) in the firm that you’re working for. In fact, if your current firm won’t give you the opportunity to have stock options, I’d have a conversation with your executive team, because they are losing out on an immense source of power. They may not realize that if a company can align what they love with what their employees love, and align the economic incentives for the company with the economic incentives for their employees, they are likely to experience a dramatic increase in productivity.

And Continue the Cycle…

Pay off your debt, build up your savings, have net positive savings (or net assets), invest these positive savings in cash-producing assets that create cash flow, and then use this cash flow to invest in more cash-producing assets while earning equity and ownership in the companies you work for or the companies you start as an entrepreneur. Then continue the cycle over and over.

This is the simple formula for building wealth. But while it may be simple, very few people actually follow it. If you follow this formula, not for one year, not for five years, but for 20, 25, 30 years, you’ll most likely be much better off.

The Difference Between the Rich & the Middle Class

In Rich Dad Poor Dad, Robert Kiyosaki makes an interesting observation that struck me the first time I read it and has continued to strike me ever since:

“Individuals in the middle class accumulate more debt as they become more successful. A pay raise qualifies them to borrow more money from the bank so they can buy personal items like bigger cars, vacation homes, boats, and motor homes. Their wage income comes in and is spent on current expenses and only then on paying off their personal debt. So as their income increases, so does their personal debt. This is what we call the rat race.”

Later, Kiyosaki contrasts this with the approach of the rich:

“The rich have their assets work for them. They have gained control over their expenses (by saving and investing money each month) and focus on acquiring or building assets. Their businesses pay more of their expenses, and they have few, if any, personal liabilities.”

One of the most simple but critical lessons about money is that if you save up and invest today, you can expect to have more in the future. Here’s a table of what you might have in the future if you start investing today:

saving&investing slide

So, if you save $1000 for 20 years and invest that with a 7% after-inflation return, you’ll have $520,000. If you save $1000 for 30 years and invest it, you’ll have over a million dollars. If you want to make a million dollars in 20 years and have that in your bank account in today’s dollar value, you need to save $2000 for 20 years and invest it in investments that produce an after-inflation return of about 7%.

I’m not denying that it can be hard to save these kinds of sums. With the cost of living going up every year, if not every month, and unexpected expenses like health care, saving money can seem, at best, counter-intuitive and at worst, impossible. But, if you can find a way, particularly earlier in life, to save $1000 a month and keep that habit for 30 years and invest wisely, you’re quite likely to end up with over a million dollars.

If you take a very safe or even a generally safe investment (let’s say a tax-free municipal bond that might pull in 4.5-5% a year), you can save, over the course of 30-40 years during your career, $3 million (which is achievable by saving $1000 a month and investing it for 45 years, $2000 a month for 35 years, $3000 a month for 30 years). 5% on $3 million is $150,000 per year. Depending on your current living expenses and your family’s needs, you’ll be able to live entirely off the returns from your investments.

Is it easy to get there? No. Is it possible to get there for nearly anyone over the course of 35, 40, 45 years? Absolutely.

How to Invest Wisely

Let’s talk more about investing wisely. There are really two types of investments: debt and equity. Debt investments are loans. You earn a fixed interest rate every period (say, every year). You might be able to give a loan to a neighbor and get a 10% annual return. You might be able to invest in something like a lending club and distribute your loans across hundreds of people and get a diversified return. Whether it be a treasury bond, a savings account, a loan to a friend, or a loan through Lending Club or Prosper, debt investments are loans with a fixed principle and a fixed interest rate return.

Equity is different than debt, because equity involves the investment of money in exchange for partial ownership in a venture, a company. Equity investing is simply purchasing equity, which is another name for stock or ownership in a for-profit business.

With equity, you don’t get a payment except when the company distributes profits, which are called dividends. You get most of your return when the value of the company goes up—in other words, when the market values the company more—because the level of that company’s profits or expected future profits has risen.

There are many things in the market that can make the value of a company go up, but generally it happens when the present value of its future expected cash flow is higher. Present value just means the expectation of the future, discounted to today.

There are dozens of different types of debt and dozens of different types of equity. Savings accounts, treasury bonds, muni bonds, corporate bonds, and peer-to-peer lending are all forms of debt. Mutual funds, index funds, exchange traded funds, emerging market investments, private companies, venture funds, hedge funds, options (rights to buy in the future or ways to sell in the future with put options) are all types of equity.

As we talk more about debt and equity—particularly equity, where the return is often variable—it’s important to know that there’s a correlation between return (the amount of money you make back during a period of time; for example, if I have $1000 on January 1st and I have $1100 on December 31st, then I’ve earned a 10% return on my money that year) and volatility (the fluctuation in price).

A lot of people choose not to invest in the stock market because they think it’s a gambling game of speculation. The reality is that the stock market is simply a place that enables people to buy and sell ownership interest in companies. One of the greatest wealth-producing vehicles of all time is ownership interest in businesses. The average return of the Dow Jones Industrial Index from 1932 until the end of 2011 was 10.6%. That’s pretty darn good. Even when you take out inflation, that’s still above the 7% after-inflation returns that you will need to achieve the goals stated in the table we discussed above.

Let’s take a closer look at the average annual returns by type of investment, including both common debt instruments and common equity investments.

average returns slide

You can see, for example, that the Dow Jones Industrial Index Average over the course of 50 or 60 years generally falls between 9-11%. Whereas savings accounts are often less than 0.5%. Even the best banks will only give you 1% on your money back each year. After inflation, many of the debt instruments have a negative return. With savings accounts, certificates of deposit, and treasury bonds, you might think you’re making money on your money, but you’re actually losing it. That’s not worth the risk. As I said before, the riskiest thing you can do is have a guaranteed negative return every year.

What’s less risky is investing in things that have a positive after-inflation return. Muni bonds, corporate bonds, and lending club notes, for example, enable you to take some risk, but on average have a positive after-inflation return, which, over the long-term, may give you a better return overall.

Equities, which are the S&P 500 Index and the Dow Jones Index Fund, often have some of the best rates of annual return over the long-term, but are the most volatile, which means they fluctuate the most year to year. Many of us have not-so-fond memories of 2008, when the stock market dropped quite significantly. Fewer of us alive today remember 1929, the other time when the stock market dropped dramatically.

Whether it was 1932, 2001, 1987 or 2008, there are many times when the stock market has dropped more than 25% in a year. But on average, even including all of those metrics, we still see double-digit returns before adjusting for inflation.

How to Use Peer-to-Peer Lending

One of the investment areas I’ve found to be most exciting recently is peer-to-peer lending. Lending Club and Prosper are the two leaders in this market. Peer-to-peer lending means that you as an investor (someone with savings) can invest in a number of loans that are given to other people who are seeking loans in order to pay off and consolidate debt, go to school, travel, or have a wedding.

Often, the interest rate on these loans will range from 6% at the low end to 24% at the high end. Even after default, organizations like Lending Club are able to provide (at least for the time being) a very attractive return. I started investing with Lending Club in 2012 and I’m seeing interestingly positive results so far. One of the ways that they enable you to have lower risk yet get a pretty good return even with a debt or loan type investment is by diversifying the money you’re lending, $25 at a time, into hundreds of different loans.

For example, if you make a $2500 investment in Lending Club, you can select 100 loans for it to be divided between, so if one loan defaults, you’ll only be losing 1% of your principal. Lending Club enables you to select loans to be provided from you to the recipient based on many risk factors—demographics, states, credit score, history, how much credit they have outstanding already. It enables you to very clearly narrow down options as you choose. They also give letter grades to each of the recipients of loans ranging from A to F. What I found personally is the A, B, and C loans are the safest, but they also have the lowest return. So what you want to look at is the combination of safety and return averaged out across multiple loans. At least according to the data that Lending Club publishes, investors that invest across hundreds of loans ($25 per loan), are able to get higher after-default returns from the D, E, and F lending notes that they provide.

Of course past performance is by no means a perfect predictor of future performance. However, I would encourage you to consider peer-to-peer lending organizations like Lending Club and Prosper as part of your investment mix. These investments can still be risky, but if you look at the data, at least for the time being, they is providing one of the lowest risk ways (on a risk-adjusted return basis) to generate double-digit returns on your money.

Understanding Basic Financial Ratios

One of the keys to successful investing is to understand some basic ratios. I won’t spend too much time on this topic, because that’s probably better saved for more advanced courses on investing. But I will say that I have found the most important ratio in investing is the price-to-earnings ratio. What that means is the total value of the company currently divided by the total annual earnings of the company.

If a company is worth $1 billion and has annual earnings of $100 million, then the price-to-earnings ratio (or PE ratio) is 10 ($1 billion divided by $100 million). PE ratios can be calculated quarterly or can be averaged over the course of a prior few years. Pretty much every major stock index has an average PE that is reported. If you go to Google Finance, Yahoo Finance, or any brokerage, you can get the price-to-earnings ratio for any stock.

Higher gross stocks often have higher price-to-earnings ratios, because again, the value of a company is whatever the market thinks is the equilibrium between buy and sell, but it’s also the present value of future cash flows, future profits, future net income of the company.

If the future profits are expected to go up because of a higher growth rate, you’ll have a higher current price-to-earnings ratio. Conversely, if growth revenue and growth of profit is slower, you’ll often have a lower price-to-earnings ratio.

One way to think about this is if profits did not increase at all, how many years would it take you, (assuming the company provided all of their profits back to their shareholders in the form of dividends) to make the money back on your investment? If you’re putting in $100 and you’re getting $10 in profits for your share of the company per year, it would take you ten years to get that money back.

The average price-to-earnings ratio on the stock market, going way back to the early 20th century, is about 16 or 17. We’re currently in a time where PE ratios are inflated higher than their historical averages.

However, when you’re looking at individual companies to invest in, a PE ratio can be very valuable, even if it’s 20, 10, or 30.

One of the reasons Facebook stock declined so rapidly over the summer of 2012 is because it went out at a price-to-earnings ratio above 200. What that means is it would take 200 years for Facebook shareholders to recoup the money from their investment if Facebook’s profit were to stay in equilibrium (in other words, didn’t grow).

Of course, Facebook’s profit is potentially going to grow in the future—at least, that’s what they believe—so people are willing to take that risk. Potentially, in a market with high demand and low supply, you’re going to see higher prices. What happened, though, in the three months after their IPO, is that Facebook stock declined in price from over $40 a share to less than $20 a share. Even now, Facebook’s price-to-earnings ratio in Spring 2013 is still around 70.

When you compare that with a company like Google, which has a price-to-earnings ratio of about 20 and is many times the size of Facebook, you can see why some people are shifting their money from Facebook (which is a high risk, probably high volatile, very high PE investment) into lower risk, slightly less volatile, lower PE investments like Google or Apple. Even Apple, which is the most valuable company in the world by market capitalization today, has a PE ratio under 20—less than 1/5 that of Facebook at the moment.

Understanding these basic principles about investments and ratios will be critical to your ability to choose wise businesses and operational teams to invest in as you pursue your financial future. Picking stocks is not about throwing darts at a newspaper, and it’s not about getting lucky. It’s about understanding companies, management teams, products, and societal trends and investing in companies that have a margin of safety in which the price-to-earnings ratio, the rate of growth, and the team will enable you to, more often than the average investor, pick winners.

Angel Investing

Angel investing is purchasing ownership in an early stage private company. Angel investing has become all the rage in San Francisco and Silicon Valley. Today, for companies that not only have no profits but no revenue (in other words, they have an infinite price-to-earnings ratio and an infinite revenue multiple), we’re seeing valuations starting at $5 million for a company that might only be a couple months old. Illustrating this phenomenon was the $700 million 2012 acquisition by Facebook of Instagram—a company with 13 employees, no revenue, and no profits.

Now, that’s a rare example, an edge case. Oftentimes it could take decades to build a company to be worth $700 million. But the people who invested early in Instagram and other companies that have done very well in the innovation capital of the world have enabled an ecosystem that creates more and more demand for early stage high technology and deep scientific companies that are working hard to make a positive impact on the world through science and technology.

Warren Buffet Doesn’t Believe in Diversification

One of the more complex theories in investing is something called portfolio theory. Portfolio theory is a complex topic, particularly mathematically, but it’s actually quite easy to understand the concept. To put it simply, for an average investor, who doesn’t really know the difference between stocks and bonds and price-to-earnings ratios and current ratios, returns are maximized by having a large basket of investments, including some non-correlating or low-correlating asset classes.

In other words, if gold, for example, has a low correlation (in other words, it moves not in the same direction as stocks or equity markets), then you might include some gold or you might include some bonds in with your balance of investments.

Portfolio optimization theory over the last 30 years has created many Nobel Prize winners, but the reality is that portfolio theory is only true if you don’t know what you’re doing in investing. If you take time to do your due diligence and do your research—to understand price-to-earnings ratios and societal and geopolitical trends—often you can select companies that in the future will be worth more than they are worth today based on an increase in their present value of future cash flows. Portfolio theory can easily be beaten if you take some time to invest in learning how to invest.

In practice, when you look at the highest returning individuals—people like Warren Buffet who achieved over a 20% compound annual growth rate, going back to 1956, over the course of nearly 55 years—the highest returns are seen when you invest in just a few eggs in your basket and you watch that basket very closely. You understand which eggs you’re buying and why.

Warren Buffet’s investing method is pretty complex, but at the basic level, besides having a rather good knowledge of how to read a financial statement, the core thing he learned back in the 1950s at Columbia University from the father of security analysis, Benjamin Graham, was to always have a margin of safety with your investing.

If you understand a firm well, you can calculate, with the information you have, the expected future profits of the company. Then you can look at what the market thinks the company is worth versus what you think the company is worth, and then picking those companies that you think the market has underpriced when you believe a sufficient margin of safety exists. So you are not simply looking for good companies with good management teams with good product; you’re looking for good companies with good management teams with good products that the market has mispriced for lack of understanding that asset, that security, that investment, and that company.

If you have fewer things to understand well, you can gain an information advantage, or information arbitrage, against the other people who are investing in that same company. That’s not insider information. It’s just doing your research and only having a few assets to understand at once.

The History of Money

Money is one of the most important topics to understand on your journey to being able to change your own life and change the world.

What is money? In the simplest definition, money is just a store of value—an object of value that is generally accepted within a given society as payment for goods and services.

Money replaced the barter system, where people would exchange goods or services they could provide for goods and services they needed. Barter works well—until you don’t have the thing the other person wants, or you don’t want what they have to offer. The invention of money allowed for two individuals to exchange value, without both of them having to, by happenstance, have the exact thing that the other person wanted. Money stores value, which you can use to buy something that you want later.

Some people consider cattle to be the earliest form of money. Between 9000 and 6000 BC, many cultures used livestock as a standardized form of barter, making them effectively the first currency. Starting around 1200 BC, cowrie shells became common currency—in fact, they are historically the most widely used and the longest used currency in the world. Metal coins were invented around five or six hundred BC, and in 806 AD the first paper money appeared in China. Today there are almost two hundred different currencies in use around the world.

Understanding how money works is key to your ability to make a big impact in the world.

What My Mom Taught Me About Personal Finance

To end this section, here are three key lessons I’ve learned about money growing up from my mom, Pauline.

1. Spend less than you earn every month.

Spending less than you earn is not always possible, particularly when you’re taking out a loan to going to school or when a medical emergency strikes you or your family. But as often as you can, on a monthly basis, make sure that what’s coming in (minus taxes) is greater than your expenses. If you’re making $5000 per month and paying 35% in taxes, you’ve got about $3300 or $3400 you can spend on other things. If you’re spending $4000, you’re actually going into debt every month. There are two situations people can be in. There are those who pay interest on loans every month and there are those who earn interest on loans every month. If you can get into that latter category, where you can earn interest on the loans that you’re giving to others—whether they be through savings accounts, CDs, a lending club, or earn returns from other forms of investments—you can grow your assets through the power of compounding returns on your assets over time.

2. Never go into debt for something that you don’t need.

If it’s an investment in education, health, or the future (yours or your family’s), that’s one thing. But if it’s that new boat that you don’t really need (you could simply rent a boat two or three times a year when you really want to go boating), or that big-screen TV that’s 60 inches instead of 50, don’t do it. If you can delay gratification for a few years and invest that couple thousand dollars that you would have spent, over time that can turn into tens of thousands of dollars that will enable you to do so much more in your life.

3. Save up early in life.

Start young. And if you have kids, start your kids young on saving and investing. The law of compound interest helps a lot over time. I’ll demonstrate this in the pages that follow.

To Sum It All Up

To summarize, you can become wealthy over time by paying off your debt, by saving, by using the results from your savings to invest, by using the proceeds from that investing to invest more, and by not going into debt for things that you really don’t need.

There are two different types of people in this world:  people who pay interest on loans and work for companies, and people who receive interest on loans and own parts of companies.

The really important question is: which segment are you in? If you’re in the first right now, think about how you can shift in the next five or ten years. How can you go from paying interest on your debt and working for companies to receiving interest on loans that you make and owning parts of companies that produce cash flow for you and your family?