I have been thinking about the importance of being smart about personal finances as many people are now struggling because of the COVID-19 pandemic. Many are losing their jobs and have not saved money to prepare for something like this. It is a rude wake-up call for many, very much in the same way as the 2008 financial crisis was. The lesson is clear: unexpected events will happen to the economy that we cannot control. We must focus on what we can control, which is our personal finances. In this train of thought, I wanted to write a basic guide for personal finance. Just some best practices and common sense information that I have learned over the years. Something a person can follow and know that they will end up being comfortable with money, even in times of economic turbulence.
A simplistic way to think about personal finances is to think of it as a game of Minimax, where the goal is to maximize your income and minimize your expenses. In practice it's not quite so simple, as there are many things to take into consideration in the complex world we live in. But it serves as a general principle against which we can evaluate if we are winning or losing with our personal finances.
But before we get to how, we must answer the why. Why should we bother and care about money? There are certainly no shortage of people who want to discourage this journey. We have all heard the sayings like "money does not make you happy". That is true, but what that saying misses is that the function and purpose of money is not to make a person happy. Money is not an end in itself, money is a means to an end. Money is like a car that you can drive, but you must be the driver and know where you want to go. You can buy happiness with money, but only if you know what to buy, which presupposes that you know what makes you happy.
I would propose there are two things that money does offer. First is security. Having money saved gives you confidence and peace of mind to know that you will be ok even in times of unexpected economic shocks. Second is freedom. Freedom is the degree to which one can make choices about his or her own life. Conversely, to the degree that you do not have freedom, some other person will make decisions about your life. It is a question of being self-sufficient rather than having to depend on others. This is the function that money provides.
The key to understanding money is to understand two key properties about it. The first is time-value of money which states that money now is more valuable than money later. Money loses value over time due to inflation but mainly due to the fact that if we receive money now, we can invest it and get a return on that investment. Lets say that we can get a 10% annual return from the stock market. Obviously we want to receive $100 now, rather than receiving the same amount a year from now, because then it would be worth $110 assuming we invested it.
This gives our first principle about how to manage our personal finances. If we have a choice, we want to bring forward our income, which is to say that we want to receive it sooner rather than later. Similarly, if we have a choice, we want to push out our expenses and pay them as late as possible. If there is a way to postpone your payments, and still pay the same amount, you can record it as a big win in your personal finances playbook.
This leads us to the second key property about money which is compound interest. This magic happens because we receive a percentage-based return on our investment, rather than a fixed amount. So our $100 became $110 during the first year, but what happens during the second year? Now we receive %10 on that $110 and it becomes $121. First year our profit was $10 but second year it was $11. That one extra dollar is the secret to understanding money. Compound interest is elusive to grasp because it starts off slow in the beginning, but really takes off in the end, given a lengthy time period like 20 years.
The purpose of saving and investing is to decrease our short-term consumption in order to increase our long-term consumption. We do not want to save money just for the sake of having the same amount of money at our disposal in the future. If you are considering buying a car either now or 5 years from now, certainly the assumption should be that the car you can afford today is not the same car you can afford 5 years from now.
You can use the Present Value and Future Value functions to calculate time-value of money and compound interest. They are found in all spreadsheet software such as Excel and LibreOffice. They should be your trusted companions in your decision making.
Reducing unnecessary expenses is one half of the equation for financial well-being. The first thing, and most important, is to go over all of your recurring payments. These are payments that you make every month such as subscriptions to a service. They are sort of automatic payments, where you don't make a conscious decision every time if you should buy or not. This is why they require special attention. They include essentials such as rent payments, utilities, insurance, internet as well as non-essentials like a Netflix subscription. Make a list of all of these on paper and consider each item. Some will be ones you are not really using and can just cancel. For others, like the essential items, consider if there is a cheaper alternative. Ask for competing offers from other companies that are providing the same service.
For one-time payments, you are making a conscious decision each time you buy something. Categorize everything that you wish to buy into needs and wants. Do you really need it, or is it just something that would be nice to have? The purpose of financial discipline is to postpone only those purchases that you want but don't really need. The purpose is not to save money on something you absolutely need.
The goal is also not to buy the cheapest items, but to get the most value for your money. Every time you spend money, learn to consider how much value you are getting in return. If you are eating for $10 at one restaurant and for $20 in another, it is very likely the food will be more delicious in the expensive one, but is it that much better? That is the relevant question to ask.
Always consider the quality of the items that you are buying. In many cases it actually ends up being cheaper to pay more for a better quality item that lasts longer. Clothes are a good example of this as cheap clothes generally don't last very long. Tools are another example of a category where it definitely pays off in the long run to invest a little more. Trying to cut something with a knife that is not sharp is not very productive.
Then there are other cases where it absolutely makes sense to go for the cheapest option. This is when the cheaper alternative performs the same functionality just as well. Sometimes if you buy the product of a well-known brand, you are actually paying premium not for actual quality but perceived quality, which means the value of the brand itself. The most extreme example of this are generic drugs compared to brand-name drugs. The generic alternative of the drug can cost a fraction of the price and is the same product for all intents and purposes.
Another aspect is to consider the longevity of the good or service in terms of cost and value. You should think about the cost over the expected lifetime of the item, not just what the initial price tag is. Similarly, you should consider whether the value derived from a purchase is a short-term or a long-term benefit. If something permanently enhances the quality of your life, then it's worth paying a very high price for it. For example I absolutely need glasses to see well. How much would I pay for glasses, in case they just happened to be an expensive item? Probably almost any price.
Budgeting and Accounting
Two tools that will assist in controlling your expenses are budgeting and accounting. There are plenty of personal finance software available for this, so I am not going to recommend any here. I will just say that do not pay for one. You are trying to control your expenses, the last thing you need is another paid subscription to some app. It is also perfectly fine to use a spreadsheet application like Excel for this. I have written my own software for this (a perk of being a software developer I guess).
To make a budget means that you allocate beforehand specific amounts for each category of expenses. For example next month you will use $600 for food, $200 for clothes and so on. I must confess that I have never made a budget because I have not seen the need for it. But in case you are having trouble with discipline, I would certainly recommend it as another tool in your arsenal.
However, what I have found very important for me personally is accounting. Accounting means writing down all your expenses in a software app of some kind. They must be categorized so that you can review how your expenses are distributed across different areas of your life. The categories must be small enough to be meaningful. For example, it is not enough to have food as a broad category, because you want to differentiate between eating out in a restaurant (a "luxury" activity) and cooking at home (a necessity). Each expense should include the date, category, amount and description as a minimum. This way you will start to accumulate historical data about your financial behavior and you can see how your finances change based on the decisions that you are making. If you don't know where your money is going it's going to be very difficult to make the right choices or to measure your progress.
Another benefit of accounting is that it keeps you accountable to yourself. If you waste money on something you should not have, you will have to face the issue again as you write the expense in your accounting app. And in fact, it will stay there as part of the permanent record. This is another way of building discipline.
Income is the other side of the coin to expenses in the pursuit of financial freedom. Initially it is important to focus on expenses to build discipline with money, but increasing your income is by far more important in the long run. This is because there is only so much you can save. If your salary after taxes is $2000, the most you can save is all of that. But you still need a place to sleep and food to eat, so of course that is not realistic. The point is that how much you can save is limited but how much you can earn is not.
Income is divided into active and passive income. Active income is where you are trading your time for money, such as receiving a monthly salary for being an employee. Passive income is when you receive money without actively working for it. Note that passive does not mean that there is no work involved, it just means that the income is not proportional to the amount of your time spent. When we are at the beginning of our journey into financial responsibility, we must focus on the active income so that we can receive passive income later from our investments.
Start by asking can you earn more at your current job? Perhaps by asking for a raise, or just doing more work, or taking on more responsibilities. Are you on a good career path where your income should increase in the coming years? Can you take on a second job, perhaps working with something else on evenings or weekends? How about just simply starting a blog or a YouTube channel which can eventually provide some extra income?
Of course this is not a very popular idea as most people are opposed to working more. Our society today is full of ideas that tell us we should in fact strive to work less such as something called downshifting. But it is important to remember that we are not trying to increase our total amount of work over our lifetime, in fact quite the opposite. We are trying to work more now so that we can work less in future. Of course each person has different priorities. Financial freedom is not for everyone.
Value Your Time
We learned earlier that money and time have an important relationship with each other. Another lesson to learn is to value your own time correctly. In order to make decisions about how to best use your time, you must assign some monetary value for it. It is not important to be exact, just some ballpark figure is enough to help you avoid clear errors in decision-making. For example, lets say your employer pays you $30 per hour, so you decide to use that figure. You will encounter daily situations in your life where you have a choice of doing something yourself to "save money", or to hire someone else to do it for you. Now you have some objective way to measure which choice is correct.
Given this example, lets say that you encounter a situation where you can save $10 by doing something yourself, but it takes one hour of your time. It is probably not a good idea to do it yourself, given that you could potentially work for one extra hour at your day job and earn $30 during that time. However, if you can save $50 by doing one hour of work yourself, you should probably not outsource it. This should be common sense, but I see many people really struggle with this. They will spend a lot of time and effort to save a tiny amount of money because of some discount or similar circumstance.
Assuming you are practicing discipline with your expenses and working to increase your income, you should have money left over each month. Figure out a percentage of your income that you can save comfortably without sacrificing your quality of life too much. Your goal should be at least 20%. If you cannot save 20% of your income, you need to go back and take a hard look at your expenses.
A good practice for saving is to pay yourself first. This means that when you receive your salary (or any income for that matter), the first thing you do is set aside this portion that you intend to save. You don't pay your rent and other expenses first, you pay yourself first. Most people do the opposite: pay everyone else first and only save money if they have something left over at the end of the month. This is one lesson I learned from Robert Kiyosaki from his book.
The first priority should be to build an emergency fund that makes you feel comfortable and sleep well without worrying about money for basic necessities. I would suggest a good initial goal is all your current expenses for 3 months. So if your expenses are $1600 per month, start with an emergency fund of $5000 or so. This should give some cushion in case of unemployment or other unexpected circumstances.
Debt is an interesting tool that is available to us in the financial world. It is a double-edged sword, capable of greatly boosting our success when used correctly, but also capable of leading us to financial ruin if used in excess. Debt is also called leverage because it allows us to take a larger stake in an investment than our own capital would permit. It enhances our profits as well as losses. For example, lets say we buy an asset and fund half of it with our own money and borrow the other half. If the price of the asset changes 10%, the profit or loss for our capital is 20%. This offers both great opportunities and great danger.
But debt is not free, there is always a cost to borrowing money. As a rule of thumb, the only acceptable use of debt is to purchase an investment with greater expected returns than the cost of that borrowed money. This is the only scenario where debt is working in your favor.
You should never borrow money for consumption or use credit cards. If you do, all the principles of money and finance are working against you, making the other person rich who is receiving your payments. Before I mentioned that saving and investing is a way to decrease your short-term consumption and increase your long-term consumption. Taking a loan for consumption is the opposite of that. You are increasing your near-term consumption but decreasing your long-term consumption because that loan has to be paid back with interest. It is probably not a coincidence that Visa and Mastercard are some of the largest and most profitable companies in the world.
The one exception to this is the mortgage on your house or apartment for two reasons. First, the interest rates on mortgages are generally pretty low because the real estate acts as collateral for the loan. Secondly, because it is not realistic for most people to have enough cash to purchase their residence without debt. And while spending all of your income to pay off your house as quickly as possible is a viable strategy financially, it's just not very exciting.
So, to recap, after you have saved enough for an emergency fund, pay off all of your debt except your mortgage.
After the painstaking journey of disciplined expenses, saving money and paying off debt, you have finally reached the point of investing on your financial journey. You have been able to accumulate excess capital, beyond your own immediate needs. You now have the means to become a capitalist, which means you can give your excess capital to others who need it and who will pay you for it. You are in a position to earn money merely by the fact that you have money. This is the honey pot at the end of the rainbow, but of course it required many sacrifices on your journey to get here. Are the sacrifices worth the reward? That is for every person to answer for themselves.
But what to invest in? As I have written about investing in other posts on my blog, I will keep it short here and offer just three recommendations. Index fund on a major stock market index like the S&P 500 or STOXX 600. Real estate like apartments that you can rent to others. Stock of individual blue-chip companies with strong balance sheets and brands. You can read about my investment philosophy and about owning companies that you use.
As I thought about investing, I thought about how poker players are categorized by their playing styles. They are classified as loose-passive, tight-passive, loose-aggressive and tight-aggressive. The last one, tight-aggressive, tends to be the winning strategy in poker, and the same is true for investing. That means you should be very careful and selective about which investments to take, but when a special opportunity presents itself, where the risk/reward is heavily skewed in your favor, you should be aggressive.
Investing and becoming a capitalist is not the end of the journey on the road of personal finance. There is one more step and that is donating money to charity. One of the best experiences in life is giving money to a good cause, something you really believe in. Perhaps this is the best reward of all, the reason what makes the journey worth taking. But it is not easy to get to this point. Most people would love to donate money to a charity but they don't have any money to give because they can barely take care of themselves. Start by setting a certain percentage of your income that goes to charity every year. It can be as small as 5% first and you can increase it as your wealth increases.
Personal finance is about common sense. It is about making small choices every day which add up over time. I could summarize this post in just a few sentences which is all that is required for success with money:
- Don't buy stuff you don't need
- Earn a good income
- Know where your money is going
- Save for a rainy day
- Avoid debt and credit cards
- Invest for profit