One of the calculations that you’ll hear thrown around time and time again is the compound annual growth rate. It’s a more accurate measure of past investment performance than just a simple average of the different years investment returns. Knowing what the average return of some investment is doesn’t give you any insight into what you might actually expect to have as a result of some initial investment.

To illustrate this, consider the example of two consecutive years where you earn 50% the first year and then lose 33% the next. If you average these returns, you end up with a 8.5% return on your investment, which doesn’t sound that bad. But if you actually run the numbers on some initial investment, you can see that the actual two year return was 0%.

So here’s how you calculate the Compound Annual Growth Rate (CAGR):

CAGR = [Ending Balance/Beginning Balance]^(1/Time Period, i.e. number of years)

It’s a relatively simple calculation to make, and it’s important because you can then equally compare the returns from different investments. I will caution you though, that just because you know the CAGR of some investment in the past, it cannot accurately predict the future returns of the investment.

“How do you find the money to invest in the stock market and various other things?”

This question, or many variations of it, is something that I get asked every once and a while. It’s no secret that I love to invest, and it’s probably why I get the question. But as you can probably guess by the question, it’s usually asked by people who don’t think that they are able to invest or who think that you can only invest if you’ve already got a certain amount of money.

So let me shed some light on how I and anyone can find the money to invest in whatever they’d like to. Most people get paid on some sort of regular schedule, be it weekly, bi-weekly, or monthly. With this type of income it can be difficult to find a lump sum with which to invest, and many people will therefore just put it off, telling themselves that they’ll invest when they have the money.

If this is the attitude that you’re taking though, it’ll probably be a very long time before you start investing, if you ever do. If you want something to happen, you’re going to have to make it happen.

First of all, you need to realize that there are many types of investments that don’t require a large lump sum to get started. Many online brokerage accounts can be opened for less than a thousand dollars. I happen to use Scottrade for my Roth IRA and the account can be started for just $500. After that, you can make deposits of whatever amount you’d like.

Now, even though you can start investing in things that don’t take a lot of money to get started, it doesn’t mean that you should shy away from other types of investments that may take a larger amount to get into. In order to invest a lump sum, you’re going to need to accumulate a lump sum. It’s that simple. Just set up another savings account either with your bank or online, and begin adding to it with every paycheck or other income that you receive. At first it’s just a savings account, but it’s from this account that you’ll eventually be able to pull from to make those larger investments.

No matter what you’re financial situation is, it’s possible for you to invest. You obviously won’t be able to do everything at once, but as you begin to accumulate, more and more opportunities will begin to present themselves. So instead of wondering how other people are able to invest and you’re not, start making the small changes and taking the little steps forward that will allow you to invest as well.

It shouldn’t surprise anyone that I read a lot of financial websites and blogs. For some reason it seems that I’ve recently read multiple times about the comparison between stock market and real estate investments. More specifically, what I’ve read is usually something similar to the following statement:

Over long periods of time stock market returns outperform real estate returns.

The supporting data used to support such a claim is usually something like saying that the stock market averages around 8% while real estate only averages 3 or 4 percent (or pick your own numbers based on some past time period). On the surface, this seems like a pretty cut and dry conclusion, one that one person will say “it’s proven that a diversified portfolio generally beats real estate investments”. I can’t say that I agree with this statement, and wouldn’t say that it’s been “proven”, especially if it’s only “generally”.

This aside though, I don’t understand how one can think stock market investments will outperform real estate, especially diversified stock market investments, which usually means index funds or mutual funds. When these people think of real estate investments, they must only be concerned with the actual appreciation of the full value of the property. In this case, stock market returns may be higher. But I believe that most people would be and should be concerned with their actual returns.

When looking at real estate investments, the more important measure of your returns is better viewed as a percentage of the actual amount invested. For instance, if you put 20% down on a $100k property, then your actual cash outlay is $20k. If the property increases in value only 4%, it’s now worth $104k. This four thousand dollar increase is then a 20% return on your initial investment which is much better than what most people will attribute to real estate. You just can’t forget the effect of leverage on your investments.

And I haven’t even mentioned the benefits of the cash flow properties can produce and what’s known as Cash on Cash return. I’ll leave this for another post though. I just wanted to put my thoughts out there on this subject since I keep hearing that broad index funds and the like are supposedly so much better than real estate. Such a blanket statement just can’t be true.

Quite a while back I talked about the importance of having and being able to increase your free cash flow. As a reminder, your free cash flow is the portion of your income that is left over after you’ve paid all of your necessary living expenses. Many people also refer to it as their discretionary income, but instead of just spending it at your discretion on whatever you feel like, you need to start putting it to work for you.

Since it is your “free cash flow”, you can choose what you’d like to do with it, and there are a lot of different options available. You also need to realize that many of the available options can be considered good but not necessarily the best. Only you can decide for your situation how to best allocate your free cash flow, but it will require some thought on your part. So here are a few of my thoughts on the subject, and in my opinion, there are two main things that should be done with any free cash flow that you have:

1. Save up X number of months worth of living expenses as a security blanket, emergency fund, or whatever else you’d like to call it. I personally have the goal of a one year emergency fund, but again, you decide what’s right for you.

2. Buy investments that in turn produce more cash flow. By doing this, you’ll continually be increasing the amount of available income that you have with which to pay your living expenses and eventually become financially free. Investing for cash flow is in contrast to investing for capital appreciation which excludes most mutual funds and other traditional investments.

The reason for the focus on cash flow is because that’s what we live on. Even with a traditional retirement plan, people hope to accumulate enough over their working life which will produce enough income to live off in retirement. So it’s imperative to mind your free cash flow and find ways to increase it. And as always, I’d love to hear any comments that you have on the subject.

In the world of personal finance, investing is only one aspect. It is, however, an aspect that I talk about frequently and am very passionate about. There is a lot for one to learn about investing and it’s something that will be a life long pursuit as far as I’m concerned. There is one thing though that you should understand right from the beginning. What exactly is an investment?

I’m sure I’m not the only one who has heard the term thrown around quite a bit. I’ve also heard it used to describe a very large array of things. So, in order to figure things out, let’s take a look at some definitions.

A Few Definitions

Investopedia defines an investment as:

An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price

Wikipedia doesn’t really have a succinct definition, but it is very similar to the above definition from Investopedia. It also makes a distinction between the economic and the finance sense.

Many of you may also have heard the definition of an investment given by Robert Kiyosaki, the author of the book Rich Dad, Poor Dad. He basically says that an investment puts money in your pocket, and anything that takes money out of your pocket isn’t an investment.

What Do I Think About It?

I see valid points in both of these definitions. I’m not going to say that all investments “put money in your pocket” or at least not right away, but I do strongly agree that anything that takes money away from you without a promise/hope of a return is not an investment.

Many people will argue about whether certain things are investments, the most controversial probably being one’s own personal residence. I see valid points for both sides of the issue, but I tend to disagree that your home is an investment. I have, however, turned my own house later into a rental property officially making it an investment.

Mostly, I take issue with what I consider to be the improper use of the word investment to describe consumer goods. I’ve heard people repeatedly tell me that it’s alright to buy such and such because it’s “an investment.” When I bought my washer and dryer, I had a friend tell me that they were an investment. I don’t really see how this could be the case, but I wasn’t going to go off in a rant about it.

My point with all of this is that I see too many people justifying their consumer purchases by making themselves believe that they’re investments. I hate to rain on anyone’s parade, but furniture is not an investment. Neither is a new big screen TV or a fancy stand mixer. I don’t have a problem with people buying these things, as long as they understand that they’re buying a consumer item and not an investment.

I’m not going to give you a be all end all definition and description of what an investment is, but I do think that you should give it some serious consideration and thought for yourself. You’re going to want to understand for yourself what an investment really is so that you’ll know one when you see it. You don’t want to have to take someone else’s word for it, when determining if you’re going to invest.

I often hear people talk about their savings and investments almost interchangeably. I hear about people taking their savings and investing it as well as people who rely on their investments to be there if they need any savings. It may seem trivial to many of you, but I believe that there is or should be an important distinction between the two.

The Purpose of Savings

The primary reason for having some money readily available is in case of an emergency. This is why you’ll hear about emergency funds time and time again from many personal finance bloggers and other financial resources. There are many different opinions about what the size of such a fund should be and how it should be determined, but it’s usually agreed that we should have an emergency fund of some sort.

Savings also provide a sense of financial security and stability. Not only does it keep you from having to constantly worry about your finances, but it also allows you to invest with confidence. You’re able to make more rational decisions when you’re not worried about having to use any of your investments for near term emergencies.

The Purpose of Investments

Investments are a way for you to secure your future and have your money work for you eventually replacing your current forms of income. Investments are meant to provide alternative forms of income or are used to increase your income producing capacity. These are all different purposes than what standard savings are meant for.

A Practical Implementation

Both of these are important aspects of your finances, and one shouldn’t be done without the other. Fortunately, it’s all too simple to make progress in both areas while also keeping them separate. All you need to do is set up two different savings accounts or money market funds into which you can easily transfer funds. Each time you get paid or have some sort of income, just take a percentage of the income and transfer some into each account. The funds in the investment account can then be used for any investments that you want to make.

It’s important to keep these account separated from the beginning. I’ve talked to some people who keep putting money into a savings account and then raid it from time to time in order to invest in various things. Unfortunately, a lot of investments seem to be so good that more money is taken out of savings than what should be. Without an adequate savings buffer, it can then be difficult to weather any investment storms that can come.

Obviously there are many different ways to handle your finances including your savings and investments. This, however, is the best way that I have found so far to handle both savings and investments. It’s simple, straight-forward, and gets the job done. What are your thoughts on the subject? Do you handle things differently?

Now that 2007 is behind us and we’re a little ways into the new year, many people will be receiving year end bonuses and the like from their employers. Some of these bonuses could be considered enormous (if you look at some Wall Street firms) and others are a little more modest. Whatever the size of the bonus, there are smart things to do with it, and there are some not so smart things. I’ll explore both sides of the coin here.

Smart Bonus Moves

1. Start or enhance your emergency fund. I know, how boring. You just got a chunk of change and all you do is transfer it into an account where it’s going to just sit there. Well, sometimes boring is what’s best. And once you start to see the balance of your emergency fund continue to grow, it will get more exciting I promise.

2. Beef up your retirement accounts. This is a little more eventful since you’ll most likely be investing the balance in some sort of fund or possibly even stocks. Even if the bonus is paid out to you before being able to put it into your 401k, you can change your contribution amount that is deducted from your paycheck until the balance has been fully transferred. Keep in mind that you can contribute $15,500 to your 401k, $4k to an IRA for 2007, and $5k to an IRA in 2008. If you’re over 50 you can make catch-up contributions, but all that is for another post. Your Retirement accounts would be a great place to stash this extra windfall.

3. Pay down/off your debts. Here we go with another boring idea. It can also seem as if you never even got a bonus since it all went to pay off what you already have. So use this as the opportunity to rid yourself of the debt millstone and remember what it was like when you could keep your entire paycheck for yourself instead of handing a portion of it over to [insert favorite bank/lender here].

4. Invest in something. I’m not going to specify what sort of investment since we all have our preferences and different risk tolerances. I wouldn’t have a problem using it as a down payment or partial down payment on an investment property. Others may prefer to throw it in the stock market or try their hand at forex trading. Whatever your inclination is, give it a shot and put the money to work for you.

5. Start your own business. If you’ve ever thought about starting a business, there’s no better time than the present as they say. All you’ve got to do is check out Inc. Magazine to see how many businesses have been started with almost nothing. This isn’t the right thing for everyone, but I know there are some out there that have always wanted to and are just trigger shy. Give it a go.

Stupid Bonus Moves

1. Buying a new big screen TV. You could also substitute whatever gadget or toy you’d like, but the point is the same. Why would you go blow this extra money right out of the gate when you have the opportunity to greatly improve your financial situation? I see this one happen all the time and I always just have to shake my head.

2. Going for broke at the casino. I actually heard of someone that was going to take their bonus and head to Vegas for a weekend and just blow it all. There weren’t even any hopes of winning; he just wanted to blow it. I hope he takes a lot of pictures since the memory will be all he has after he loses the camera in a poker game. Unbelievable.

3. Splurging on some fancy restaurant. I wouldn’t mind if you wanted to treat yourself to something like the Big Deal from Jack in the Box, but going all out at some swanky place where you pay more and more for less and less food is something I don’t understand. There are much better ways to utilize your bonus money. If you just have to celebrate by going out to eat though, at least be savvy about it and use Restaurant.com to get a great discount.

4. Making a down payment on a new car. You might say that it’s good to put the money down on a car so that you don’t have to finance it 100%. But what’s wrong with your current car? If you actually need to get a new car (and I don’t actually mean new) there might be an exception here, but I would seriously evaluate the supposed inability of your current car to get you from point A to point B.

5. Doing anything that does give you actual value. This is kind of a catch all for thoughtless consumer spending. Does any of it add to your bottom line and increase your net worth? Will it help you reach your financial goals and ultimately allow you to spend more time with friends and family or doing what you love? These are just some of the questions you should ask yourself before hastily going out and spending that bonus.

So there you have it. 5 smart things and 5 stupid things to do with your bonus (or any lump sum payment for that matter). If you’ve got any other suggestions or something to add, let us hear about it in the comments.