The Finance of Self-Employment

I have been self-employed as a consultant since 2008. I opted to go independent for a variety of reasons, primarily to afford myself more freedom in choosing  what work I do, and how I do it. I felt too restricted by corporate policies at my previous job. I worked for 11 years at a tech company on their Online Marketing department.

There were a number of financial things I had to learn after deciding to become an independent consultant. Going independent was initially daunting – this was my first venture into working independently. Thankfully I had some friends who were also working as independent consultants, who were able to share some of their experience with me. The first thing I did was to obtain an LLC in order to separate my business and personal finances. By “doing business as” my LLC instead of as myself, I reduce the likelihood of a client being able to sue me for all my personal assets; limiting the liability to just business assets.

Another financial consideration taxes – not only did I now have to think about the so-called “self-employment tax” (having to pay the full amount of the FICA / payroll tax, which previously my employer paid half of), but I also had to plan to pay quarterly estimated tax payments. Previously all my taxes were withheld from my paychecks by my employer. As an independent consultant, I now work as a 1099-contractor and my clients do not withhold taxes from what they pay me. I have to set that money aside each quarter or worry about paying a penalty during my annual tax return.

Between the federal income tax, state income tax, and FICA/payroll tax, I generally have to set aside 40% of my income to cover my quarterly estimated income tax payments.

Now after having to consider all that, the next thing I had to figure out was how much was I actually going to charge for my services, how I was going to invoice my clients and how quickly was I going to expect to receive payments. I have had to refine all these over the years  and finally have a good pricing model that all my clients seem comfortable with, along with a consistent payment model. For shorter one-time projects, I send an invoice upon completion of the project, with a net-30 payment expectation (which I’ve built into my consulting agreements with my clients). For longer-term / ongoing projects, I invoice on a regular basis – either weekly or monthly, depending on the client’s preference, with the same net-30 expectation. I prefer to have a relatively flexible invoicing model and not stick to a single, rigid model.

Finally, as I grow my business, I need to take into account how I am going to pay other people for their services. I have opted for a subcontractor model over an employee model for my business. My work and income is still too volatile to even consider hiring employees, and working with subcontractors on a per-project basis works far better with the current way my business works. I have also opted for a revenue sharing model, instead of a set hourly rate with my subcontractors. Since my current rates are still considered somewhat low for my industry, I am paying a higher revenue share (80/20) in order to get better quality subcontractors. Over time I plan to increase my rates and decrease my revenue share until I reach a revenue share that’s 60/40, but still guarantees a fair income to my subcontractors.

So as you can see, there are a lot of financial considerations with becoming self-employed. My recommendation is to find a good CPA (accountant) to help, especially with the tax side of things. If you can afford to also hire a bookkeeper (or find good software to help you keep your accounts receivable and accounts payable in order), do so. These can be critical to your success.

High-Tech Portfolios

When I think about the phrase “high-tech portfolio”, I don’t think tech stocks.  Instead I think about using technology to build a smarter portfolio.   Most actively-managed portfolios are constructed, in full or part, using 50-year-old “modern portfolio theory” methods.  I’m working to change this by bringing superior portfolio technology to market.

So, while writing for this financial blog remains a passion of mine, I will likely be spending much more time refining software and building a financial software business.  Much of that effort will be off-line at first.  Occasionally, however, I will provide business and software updates on the Sigma1 Financial Software Blog.

Developing portfolio-optimization software combines two of my long-term passions:  software development and finance.

Rest assured, that I will keep this blog up and going.  I think it contains some hidden gems that are worth discovering.  I will also continue to blog here when inspiration strikes.

5 Ways to “Show Me the Money”

Ask whether these people are showing you the money. Hold them accountable for your money.

1. Your boss/company. Ask yourself first if you had a good year. If so, do some research on at you should expect to be earning.  Try starting with Glassdoor.  If you are not making what you want and are not moving in the right direction, consider moving to another company.  But, be sure to do through research and then line up a job (in writing) before giving your notice.

2. Politicians.  Are you getting reasonable benefit for your taxes?  Grade by region.  Here’s my grading:  City C, County B, State B+, Federal D.   If your grade is C or less, consider voting the bums out!

3. Social Security.  Ever work out the rate of return on your projected Social Security payments versus the amount you have and will put in.  Mine is about 0% return.  And that is *if* I ever get *any*.  Not much you can do about it, but something to consider when planning your own retirement…. What if I get nothing from Social Security when I retire?

4.  Investment Adviser.  How does my return stack up to A) The S&P500 total return (including dividends)?  B) A 100% bond profile such as Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)?  If, overall, it is under-performing both, fire your adviser.  If it beats one… ask questions like why it didn’t do better.   If it beats both, ask “what risks are you taking with my money!”?  If you are your own investment adviser ask yourself the same questions.  And, if you decide to fire yourself, consider getting advice from someone reputable and sane like Vanguard.

5.  Your credit score.  Know your credit score (FICO score).  Guess what?  If it’s below 711, it’s below average! [Technically below “median”, but let’s not split hairs.]  720 used to be golden, but today 750 is the new golden score.  In some cases 770.  If your score is below where you’d like it to be, start getting financially fit.  And remember, success doesn’t happen overnight.  Success takes time.

What Baseball and Finance Share

A Litte Baseball

Baseball before Moneyball

In a word: stats.  Baseball has statics for almost anything of relevance that happens on the field.  Finance has statics like expense ratio, yield, price-to-earnings ratio, total return, alpha, beta, R-squared, Sharpe ratios, and the Greeks (delta, vega, theta, rho)… just to name a few.  I  suspect most of my readers are more familiar with baseball stats like batting average, on-base percentage, slugging percentage, OPS, ERA, K%, BB%, GB, and the like.

Today’s blog will start with the simple concept of batting average.  In baseball batting average is the number of hits divided by the number of official at bats.  Since a typical baseball player can have 400 at bats per baseball season, there is a lot of statistical significance to his batting average for one year.

In contrast, a fund manager could be said to have about 4 at bats per season — one per quarter.  It would take a 100-year career to have as many “at bats” as baseball player has in one.  Even if you decided to count fund performance on a monthly basis, it would take 25 years to match a baseball season’s worth of data.

The most common financial definition of batting average counts a hit as outperforming the market (say the S&P 500) over a given time period, say 3 months.   An out is under-performing the market.  Generally a .500 batting average is analogous to the the Mendoza line in baseball.  Sadly, many fund managers and financial planners bat below .500.   And often those that do exceed .500 get there by early luck… luck which generally fades (back below .500) with time.

Just like in baseball batting average is not the most useful static in finance.  OPS (on base plus slugging percentage) is probably a better financial stat… if it existed.  Instead financial stats like Sharpe Ratio and alpha fulfill a similar role of financial performance measurement.  The problem with all these financial stats for measuring fund managers is there are simply not enough “plate appearances” to reliably measure a fund manager’s performance until his or her career is almost over!   It is only after a long financial career that the difference between skill and luck can be accurately sorted out… a bit late I’d say for investors looking to pick fund or fund managers.

There is a factor other than stats that financial and baseball matter share.  In a recent conversation someone mentioned that baseball is the only major sport where the player scores [directly].  In other words the runner himself (herself) scores by getting safely to home plate.   Basketball, football, and hockey require an object (ball or puck) to cross a threshold.  Football requires a ball + a player to score a touchdown, but a field goal does not directly require a player to fly through the uprights!  Only in baseball does the player himself score a run.

This analogy can be extended to the idea that the investor herself can be the only thing that matters (that scores).  At the end of the day it the investor who determines how successful she is at meeting her financial goals.  The Sabermetrics of finance may help her get there, but ultimately it is the investor herself who has a winning, losing, or World-Series-Championship financial season.

Financial Toolkit: The Rule of 72

The rule of 72 is an easy way to make fast financial calculations in your head (or on a sheet of paper)… no calculator is necessary.  The idea is that you can determine how fast money will double based on an interest rate or rate of return.  Divide 72 by the interest rate and that is the number of years it will take for the investment to double.

For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.

The rule of 72 can be used for decreases in value, such as inflation.  If inflation is 4%, money under a mattress loses 4% per year in value.  Because 72/4 = 18, that money’s value will be cut in half in 18 years.   So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.

The rule of 72 provides convenient illustration of how fees can effect an investment.  Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam.  Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index  but managed by the Sam’s company with a 2% expense ratio.  Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years.  If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money!  Tell Sam to find some other sucker to win his stupid boat.

Rule of 72

Cost of 2% based on the Rule of 72

Finally you can use the rule of 72 together with inflation and expected return to plan your financial future.  If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years.  Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer.  Possibly 6 more years until you retire.  Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years.  Yes, even a 1% fee can cost you 12 more years until you retire!

The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal.  For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay.  For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.

The rule of 72 is a powerful tool for financial estimation.  The rule of 72 is not perfectly accurate, but it is generally pretty close to the target.  It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”.  It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.

Is Investment Real Estate Right for you? (So you want to be a landlord?)

Rental House Income

Investing in Rental Property

I have been a rental property manager (landlord) for just over two years now.   I’ve learned many things; two stand out:

  1. Residential real estate can be a great investment.  Rental real estate can provide steady cash flow, excellent asset diversification, favorable tax treatment… all with modest capital gains potential.
  2. Rental real estate can be a real pain to manage at times.  Both tenants and repairs cause headaches.

I currently own one rental property through my LLC.  Because of item #2 above, I’ve recently turned over the property management to property management company.  This choice will probably reduce net revenue about 10-12%, but will help take much of the stress out of finding and screening new tenants and dealing with repairs and tenant issues.  If things work out well, I will consider purchasing a second rental property.

In my local real-estate market it is reasonable to expect about 5-6% net income on a fully-owned rental property.  And over a 30-year period I conservatively estimate 1.5% appreciation.  Further since real-estate prices are a large competent of cost-of-living and inflation, real estate makes a good hedge against real inflation.  Finally, just as property values tend to go up, so do rental rates.  Simply put, residential real estate is the best long-term inflation hedge I’ve found.

The flip side of rental property is the eventual likelihood of landlord/tenant issues ranging from breaking the lease, to late or unpaid rent, to property damage, to eviction — just to name a few. Vacancies without rent can really take a bite out of your cash flow.  Properties can drop in value, and marketable rental rates can fall dramatically.

Somewhat of a wild card is the tax treatment of rental properties.  In the “pro” side are depreciation of the structure which can be deducted, and the fact that “passive income” like other investment income is not subject to Social Security tax.  On the “con” side is that fact that nothing can offset “passive income” except passive losses (and vise versa).  Owner’s of rental real estate (or at least their accountants) will become very familiar with IRS Schedule E of their income taxes.

Rental real estate is not for every investor.  Personally I wouldn’t recommend buying rental real estate until you have a minimum of $250,000 net worth.  Managing a rental property can be time-consuming and challenging.  Alternately, finding a good property management company is also a real challenge.  And unlike infomercials and “Rich Dad Poor Dad” author Robert Kiyosaki suggest, real estate is not a financial panacea.  However, for some higher net-worth individuals, rental residential real estate is worth considering as part of their investment portfolio.

Financial Blog Year in Review

I’m starting to look back on 2011 numbers for the Balhiser Investing Blog.  The first thing that caught my attention is this investing blog has been visited by all 50 states except Wyoming.  Thanks all other 49 states for taking a browse.

I’ve been reviewing which topics and blogs have been the most popular.  Computing beta was the most popular topic, followed by my CBOE visit, then financial baseball.  Popular searches were what CPI stands for, bitcoin inflation, entrepreneur jobs, possible investments and living below your means.

Some analytics stats are better than last year, some are worse.  The most improved stat was time per visit which is up 70% to 2 minutes and 6 seconds per visit.

Finally, the financial blog has passed 150 blog posts.  This blog post will be #156.

CPI Stands for Nothing Real; Wall Street Understands This

I do a lot of reading about financial matters.  Recently I was in Barnes & Noble and picked up the December 2011 copy of “Futures” magazine.  Browsing through it an article on investing and inflation caught my eye.  I bought “Futures”, took it home, and afterwards felt very happy about my $6.95 investment.

There were several interesting articles, and a few that did not strike my fancy… involving MACD and other technical analysis methods.  Overall I found it a worthwhile read.

First and foremost I found the reference to CPI-U and shadowstats.com to be the most exciting aspect of “Futures”.  I have long been a casual follower of ShadowStats (SGS) and I was pleased to see in print what I have seen online.  What Wall Street and many economic statisticians understand is that the government-reported CPI (specifically the CPI-U) has become a bogus indication of inflation.  CPI-U  remains relevant because of it is tied (directly or tangentially) into many things such as Social Security benefit changes, COLA and TIPS.  CPI-U is a “headline number”, but many on Wall Street use their own inflation models.  These Wall Street models routinely show CPI-U to understate actual inflation.

Here’s the deal.  U.S. Bonds today, while “safe”, simply do not keep up with inflation.  Their performance in taxable accounts is even worse.  The same holds for money markets and savings accounts.  This knowledge is part of the inside baseball of finance, that I like to call financial baseball.  For the investor that wants to keep up with inflation, this “inside knowledge” pushes them towards riskier investments including stocks (and stock ETFs), junk bonds, and international stock and bond investments.  The bottoms line is that investing is either more risk-prone or inflation-ravaged… or a combination thereof.

Dumb Phone, Smart Money

My two-year contract expired, and I traded in my smart (HTC Android) phone for a “dumb” phone.  The main reason was to save money: I will save $25/month by being able to drop the data plan.  That’s a savings of about $340/year including tax.  I enjoyed my Android phone, but I also have an Android Tablet with wifi only (and a 10.1″ screen) so that satisfies my Android needs.  Of course my laptop has wifi which allows me to write this very blog in a coffee shop.   I just don’t need a smart phone, and $340/year in savings is not insignificant.

I will divulge that I have been much less vigilant with my spending habits this year.  Since my girlfriend and I have stable, high-quality jobs and our financial strategies have been reasonably successful, it has been easy to indulge a bit.  One indulgence has been adopting two wonderful rescue dogs.  We spoil them, and they eat a lot.  I figure they collectively cost $4000/year.  We enjoy their company greatly so the price, while steep, is worth it to us.

I used to be a master of savings.  Now I am merely pretty good living below my means.  I still have the extreme saver know-how, but I am no longer living the extreme-saver lifestyle.  I am living the disciplined saver lifestyle.  I say this because I am sensative to the fact that my finance blog readers are in a wide variety of financial positions.  I am a strong believer in living below your means, especially in your accumulation (savings) years.

Jobs, Jobs, Jobs: an Entrepreneur’s Perspective

It’s hard, but I believe that if you can’t find a job then make a job.  I have been working or in school (or both) since age 11 or 12.  I had a shared a paper route with another paperboy (delivering alternate weeks) for a couple years.  I worked odd jobs while in junior high and high school including painting fences, mowing lawns and babysitting.  In late high school I had summer jobs doing things like HVAC maintenance (as an assistant/gopher), a surveying assistant, and installing Ethernet cable.  I even did freelance work for a small/medium-sized publishing company, producing graphics and slides and sent in over a 2400-baud modem.

I always found a job, because a) I needed the money for college, b) I was willing to take what I could find.

Now that I am a professional I have steady work.   I’ve also continued to be an entrepreneur as I worked.  If I was laid off and couldn’t find work I’d like to believe that I would continue to pursue my entrepreneurial effort.  I’d take part-time work (like I did during my school years) to pay for the basics.

I write this after having returned from an internet entrepreneurial group meetup.  I get to meet and reacquaint with other entrepreneurs at varies levels in the entrepreneurial process, from “haven’t a clue, just getting started” to “been self-employed for 20+ years”.

If your are unemployed, I’d encourage you to consider what job you would like to create for yourself.  Sure, keep applying for “regular” jobs to, and if a good-enough one comes around, take it.  In the mean time apply yourself to developing your own small business.  I recommend something with low start-up costs, and something that you have a passion for.  You may find yourself developing new and valuable skills in the processes…  Discover talents you didn’t know you had.

You may, just may succeed in creating a wonderful business.  Even if you don’t, you will learn more about yourself, your talents and what you really like (and don’t like).  So when you do land that cushy corporate job, you will have a better idea of how to shape your career.  Even after landing that job, you might find yourself dabbling in entrepreneurial enterprises.