Why a Black-Coffee Management Style Would Have Saved Starbucks

In a waiting room magazine I once read that Howard Schultz, the founder and CEO of Starbucks, ironically prefers black coffee to any of the outrageous hot or cold drinks offered by the morning/afternoon/evening "fix" giant. The pied piper of java himself sticks to the core of coffee, and I think that says a lot about him as a person. Black coffee is strong and bold; it is foundational and pure; it's as American as Lewis and Clark; and though it is so incredibly simple, it's almost against-the-grain. Now I understand that not everyone likes black coffee. Some think it's bitter and rather plain, which is why Starbucks' overhead menu is bigger than that of McDonalds. And just as their menu appears to be slightly cocky and over-the-top (a 13-shot venti soy hazelnut vanilla cinnamon white mocha with extra white mocha and caramel? You've got to be kidding me!), in recent years their business plan started to follow suit by adding dozens of stores to every corner of the globe. Today, with profits down an astounding 97%, the executives at Starbucks are starting to feel an awful lot like mortgage lenders, cleaning the gum off their faces from a freshly-popped bubble.

Now that the economy is looking like a typical season for the Pittsburgh Pirates (they suck, BTW), consumers are cutting back on spending like never before. And luxuries -- like Starbucks -- are hurting the most. We're through with our smoke-'em-if-you-got-'em (and-borrow-'em-if-you-don't-got-'em) spending habits and have moved to a more conservative way of living, as if we just discovered that we can actually brew coffee at home. We're starting to treat fru-fru coffee as a luxury now as opposed to an everyday entitlement. And guess what -- if Starbucks had stuck to a simple, black-coffee management style, they would've seen it coming.

Am I saying that we should never drink Starbucks because it's a luxury? Absolutely not. Actually, I almost always drink Starbucks when I'm at the mall watching my wife spend money on clothes that cost a hell of a lot more than my cup of coffee. I can probably count on two hands the amount of times that I visit a Starbucks each year. But when I think of coffee spending getting out of hand, a story comes to mind. While enjoying a hot drink with my in-laws at their local 'bux, I spotted a woman waiting in the 15-person line. She carried her own purple mug (going green -- nice), but it had a homemade sticker on it; I investigated. On the sticker was printed the exact specifications of her favorite [complicated] drink, the details of which I will not bore you with. I couldn't believe it! This seemingly frivolous experience (which we recognize with every $4 coffee joke we make) had become an obvious daily habit of this woman. After I watched her pass her mug across the counter, I noticed many of the other patrons in line ordering their drinks without even glancing at the menu. They were hooked, too.

A big reason that the economy is where it is today is that people spent outside of their means for several years. Today, the average amount of household credit card debt is over $8,000. And though the woman with the purple mug may have very well been wealthy and within her means while indulging in her $100/month habit, I've got to imagine that at least half of those people in line were part of the startling outside-of-our-means American spending statistic.

Did Starbucks know that consumer debt was spreading like a California wildfire? They must have. Did they know that their coffee was expensive? Umm, does a bear shit in the woods? Despite evidence that Americans were becoming poorer and the clear and present fact that their product was expensive and easily replaced by a much less expensive homemade substitute, Starbucks continued to build store after store after store. Now, with profits down for the count, they're closing hundreds of their locations to make up for their grossly overestimated forecasts that, frankly, were as ridiculous and pretentious as their holiday coffee selection.

I'm sorry to pick on Starbucks. What's happening to them is happening to a lot of businesses, which is why so many Americans are losing their jobs and, subsequently, their mortgages. When Americans as a whole strayed from a reasonable and symmetrical expense/income ratio, businesses like Starbucks saw the desert mirage of infinite exponential growth that, in reality, was merely dust. This is why I preach, day after day, the covenants of responsible spending.

Responsible spending helps individuals by allowing them to save for the future. It allows them to keep more of their own money and to live a sustainable and healthy financial life. Responsible spending helps the entire nation by eliminating these false forecasts of eternal growth and profits for businesses. It keeps the economy in check, managing inflation and stabilizing cash flow. Keep in mind that I am an absolute proponent of spending money. Spending is the be-all-end-all of a capitalist society. And if we as a people bought only the bare essentials, we'd eat nothing but rice and all live in caves. But by buying the things that we don't need day after day for years and years, we become a gluttonous society that cannot sustain itself, much like a balloon. Now, because of America's overspending -- much like overeating -- we must reduce our consumption to below normal levels to get back to the point of a healthy equilibrium.

So while irresponsible customer spending helps companies like Starbucks in the short term by giving astounding inflated profits for a few years, it can destroy them in the long term. If Howard Schultz had stuck to a black-coffee, back-to-the-basics management style, he would have recognized the looming bubble and directed the company proportionately. Like black coffee, it would have been simple, yet against the grain, to slow expansion -- but it would have saved his ass. Instead, for years he and his stockholders were swooning over the streams of cash and credit pouring through the doors and laughing all the way to the bank. But who's laughing now?

What the 1% Fed Funds Rate Means to You, Your Neighbors, and Your Neighborhood Bank

First let me say that I've got good news for you: If you're reading this blog, you're probably not going to be as affected by the troubles of today's economy as someone not reading my blog. Many of my readers are young 20 or 30-somethings that navigated here from Facebook or Twitter (yes, I keep track of my demographics!). Unfortunately for me (and them), I don't have a lot of older, fixed-income Americans reading my site. And they're the ones that are going to suffer the most in our troubled financial environment.

Yesterday the Fed cut its Funds Rate to 1% -- the lowest it's been since 2003. And the last time it was at 1% prior to 2003 was in about 1960. One might say that, historically, it's an uncommonly low rate. But what does it mean? Why is it so low? Should you be concerned? And who should really be concerned?

What it means:
You may be under the impression that when you go to the bank and ask for a mortgage, the amount the bank can give you is limited to the amount of deposits that it has from your neighbors. If you want to borrow $100,000 for a house, your rich old fogey neighbors down the street need to have at least that much sitting in their CD or savings account if you want the money...right? ...right?!?

Wrong.

Actually, if you want to borrow $100k from the bank, your rich old fogey neighbors only need to have $10,000 in their account. That's because banking regulations say that banks are only required to have 10% of their outstanding loans in reserves, a.k.a. "cash in the bank."

The Fed is the nation's central bank, and has kind of a big brother/little brother relationship with smaller, commercial banks. Commercial banks, eager to make bank (forgive the expression), lend out as much money as they possibly can every day because lending money is how they make money. But at the end of the day, when the little brother sees that he's lent out$150,000 and only has $10,000 in cash reserves, he knows that he's broken the rules (he only has 6.6% reserves, not the required 10%)...and he had better have that 10% before close-of-business (a.k.a "when dad gets home"). So what does he do? He goes to his big brother (the Fed) and asks, "Hey bro, can you spot me five grand before dad gets home? I promise I'll pay you back tomorrow...and with interest!" Big brother lends him the five grand, and the next day, as promised, little brother pays him back with interest equal to the Fed Funds Rate.

Because commercial banks are in the interest of maximizing their profits, they lend out as much as they can every day. But they never really know for sure how much cash they'll have at the end of a given day, so there's no way to know for sure how much they can loan out on a given day. If they lend too much (more than nine times their deposits), they'll need to borrow money from the Fed. But if little brother knows that he can borrow money from his big brother overnight at a mere 1%, he won't be as afraid to lending out more than he's allowed.

Why it's so low:
Big brother knows that loans are important to his little brother and all of the people that he lends to. And big brother helps out wherever he can. Well, the big problem as of late is this: the little brother lent lots of money to subprime borrowers, many of whom never paid him back. So all of the sudden, the cash reserves of his little brother diminished. Now, instead of using his cash in the bank as a reserve for making more loans, he is using that cash to cover his costs associated with foreclosures. And because more and more people aren't making their mortgage payments, he has less and less money that he can use as reserves for new loans.

Think of it this way: if a foreclosure costs a lender $70,000 (which is realistic), it means that lender will have to decline $700,000 in new loans. That means that one foreclosure might prevent three or four qualified people from getting a mortgage.

Many of the little brother's customers -- even those with good credit -- can't get new loans. It isn't anything personal -- he just can't afford to lend to them! These customers are both businesses and individuals. And when businesses can't get the loans they need, it sometimes leads to layoffs, which in turn leads to more individuals defaulting on their loans.

With all of this chaos in the air, big brother stepped in. "Hey little brother -- I see you're having tough times. Go ahead and loan to those people with good credit. If you need to borrow some money, I'll lend it to you for next to nothing." By lowering the Federal Funds Rate again and again -- eventually to 1% -- the Fed is attempting to give banks the wiggle room they need to be able to start lending again.

Should YOU be concerned?
With the Fed lowering rates, it will effectively drive up inflation, which has both upsides and downsides. Lower rates cause inflation because banks can more easily get money. And when money becomes easier to get, that means that it's worth less. As money becomes worth less, more and more money is required to buy the same things.

At first, this sounds bad. But in reality it can help some people. Those with long-term fixed-rate loans, like student loans or a mortgages benefit greatly from inflation. Essentially, they're repaying a loan over a long time with money that's becoming worth less and less. On the flip side, inflation is the key driver for increasing home values. So those that own homes are seeing inflation drive up the value of their property. Because of the fixed-rate nature of mortgages (though some are variable) and the general increase in property values over time, owning property is, for the most part, a good investment. Without inflation, this theory might be different.

Additionally, most working professionals get a raise every year that resembles the rate of inflation. This raise is often referred to as a cost of living increase. It is meant to offset the burden of inflation so that it has less of an effect on our wallet. So if the cost of goods goes up 3% each year, you're going to be just fine if you get a parallel raise of 3%.

So why should you care about the 1% Fed Funds Rate? If you're a working professional that has a fixed-rate mortgage, owns a home in a stabalizing market, and get a cost of living increase each year, you're going to benefit from slightly higher inflation. Your mortgage will become easier to pay, your home will increase in value, and your annual raises will cover most if not all of your increased cost for everyday goods.

Who should really be concerned?
The elderly that are living on fixed incomes for the rest of their lives should be the ones to worry. They're the ones that aren't borrowing money and the ones that won't get a cost of living increase every year. If they're living in the last home that they'll ever own, it will become increasingly difficult for them to keep the home in their family; unless they sell it or get a reverse mortgage, they won't benefit from inflation driving up its value.

Also negatively affected by lower rates and increased inflation are companies and individuals working on a long-term fixed price contract. As money becomes less and less valuable, the benefit that they'll receive as time goes on will decrease until their contracts are renegotiated.

Keep in mind that banks are included in the list of companies that work on long-term contracts (in the form of fixed-rate mortgages). With the Fed lowering rates, though their immediate costs of getting money may go down, they know that inflation will make the money that they'll receive in future payments worth less. Anticipating the decreasing value of the dollar, they'll need to increase the rates at which people borrow from them. Last week 30-year fixed mortgages were at 5.92%. Today, they've shot up to 6.35%. On a $200,000 mortgage, that rate increase would increase your monthly payment by $55.64.

Because of this significant mortgage rate increase, you should be concerned if you have yet to buy a house. A decrease in the Fed Funds Rate will increase mortgage rates and may therefore decrease homeownership. In 1980, inflation was at an astounding 13.58%. Interest rates for mortgages often exceeded 11%. Therefore, in the early 80s, my parents lived in a trailer.

Summary:
- The rate at which the Fed lends to commercial banks was reduced to 1%
- This gives banks wiggle room and makes it easier for them to make new loans to businesses and individuals
- Those that will benefit from the rate cut are homeowners with fixed-rate mortgages and those with jobs that offer annual cost of living pay increases
- Those that will be hurt are those living on fixed incomes and those committed to long-term fixed-rate contracts
- Increased inflation caused by the decreased cost of money will increase mortgage rates and therefore make it more difficult for first-time homebuyers to afford a home.

In case you were wondering: Yes, I was conceived in a trailer.

How Young Americans Can Profit From Today's Economy

Economy got you down? Well then chin up, young folks! You haven't got as much of a reason to worry as your older neighbors do. In fact, today's down market could have an incredible positive impact on your retirement if you play your cards right! I'm going to show you why you shouldn't beat yourself up about the nightmarish economy, but rather why (and how) you should invest. But be careful -- this is by no means a free pass to completely overhaul your personal financial plan (if you have one). My core values still stand: get out of debt, don't spend too much, and save your money. Let's get started.

Random optional side-notes:
First let me say that conspiracy theorists and skeptics and hard-core political enthusiasts are welcome to give me their comments about how the bailout and/or the election of a Republican/Democrat will doom us all. They may think that capitalism as we know it is over and before we know it, the government's interest in our financial institutions will create a socialist (or even communist) state and my words will be rendered irrelevant. Well, I hope that doesn't happen. But if it does, it's completely out of our control. The purpose of this post is to help average young Americans take advantage of this economy so they will benefit later in life. Future relevancy aside, this post assumes that the economy and government will function in the future as it has in the past.

On another side note, if everyone followed my advice and became completely debt free, the nation's economy would actually crumble. But don't worry -- it's impossible for an entire nation to become debt free. There is literally less money out there than there is debt. Sounds crazy, but it's true. :-)

Today's economy could actually help today's youth, and this theory is partially proven with the principle of dollar cost averaging. Essentially, the principle states that an investor's exposure to risk (risk of losing your money, that is) is reduced by buying investments incrementally instead of in one big lump sum. This works because in the short term, the stock market fluctuates frequently and unpredictably. So by buying stocks incrementally, you spread out your investment, buying in small batches for varying prices. On the other hand, the long term market is very predictable and its fluctuations are uncommon, minimal, and easily spotted. As you know, the idea of investing in stocks is to "buy low and sell high." In the short term, because it is difficult to know when you're at a peak and when you're in a valley, it's better to just keep buying a little bit at a time; sometimes you buy at the short term peaks and sometimes you buy at the short term valleys. In the end, you end up buying stocks for a dollar cost that is an average of its short term peaks and valleys.

Let's look at an example of short term fluctuation. You have $1,200 sitting around that you can invest in the stock market. Sure, you can take it all and invest it immediately, but it would be better for you to invest $100 it each month for the next year. Or even better, $50 every two weeks.

If you had invested that $1,200 in a mutual fund last October in one fell swoop, you probably would have lost quite a bit of your money (the Dow was at 14,000 last October and is at about 9,000 today). Let's say you bought the stock at 10 dollars per share -- 120 shares total. Let's also assume that because of the poor economy, the market has gone down 3% each month for a year (a realistic estimate given our recent history). So at the end of a year, your 120 shares would be worth about $912 -- about $7.60 apiece .

Now let's see what would have happened if you had invested $100 per month instead of putting it all in at once. In the first month, you would have bought 10 shares ($100 investment/$10 share price). But in month two, you would have been able to buy more shares with that money. Because the market had gone down, that stock was selling for $9.70. The next month, it would be selling for $9.41, and so on. By investing $100 per month for the full year, because of the discounted price, you would end up with 143 shares instead of 120 -- 19% more.

By investing incrementally, sure, you still lost money, but you also bought 90% of your stock for less than you paid for it when the Dow was at its peak a year ago. Because the market has gone down in the short term, the average price that you paid for that stock has also gone down. But because the market always goes up in the long term, you'll be better off when you eventually sell your stock because you will have a lower average cost per share and therefore, more shares. And the more shares, the better. When the stock eventually goes back up, you'll have 19% more money. When the stock pays a dividend, you'll get dividends for 19% more shares. More shares equals more money.

Of course, this theory goes both ways. Dollar cost averaging minimizes your short term gains as well. But if you want to guarantee your success in the stock market while maintaining your sanity, you need to give up on the notion of becoming a millionaire overnight or being the next Jim Cramer. Yes, dollar cost averaging will minimize both short term losses and gains, but it also ensures that your long term benefits aren't spoiled by the unpredictable daily/weekly/monthly peaks and valleys of the stock market.

Short term fluctuations are impossible to predict unless you've got the research budget of an investment bank. But in the long term, it's much easier to spot your "elevation" and buy when you're in a valley. Since 1978, there are only a few very obvious valleys. There was one in the late 80s, one in the late 90s, one just after September 11th, one in 2003, and one today. Today, stocks are cheap. This stinks for retirees that need to cash out to pay their mortgage, but it's wonderful for younger Americans that are just starting to save.

Just as it's true that short term ups and downs are unpredictable and should be handled with caution, it's also true that long term growth is quite predictable and its ups and downs can be more easily exploited. In the long term, when the market is growing quickly, it becomes proportionately more difficult to make a buck. But in days like these, when the market is down, it's the perfect storm for young folks to buy low and eventually sell high.

Those that understand the principle of dollar cost averaging and incrementally invest will minimize their short term losses (and unfortunately, short term gains, too). And those who, in the long run, slow their investing when the market is up and hasten their investing when the market is down (like today) will retire younger and more quickly enjoy a financially independent lifestyle than their get-rich-quick peers.

Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!