Personal Finance Basics (and Achieving Your Goal In Life)

A friend recently had a few personal finance questions for me. I figured I’d just direct him to my outstanding library of foundational personal finance posts. Then I realized I didn’t have any. It was sad.

Let’s remedy that, shall we? Today I’ll lay down the basics of my approach to personal finance – consider it tenets I’d like to share with a very young me.

 

WHAT\’S THE GOAL?
(And be ready to answer “Why?”)

Personal finance discussions often start with no introduction, like you’ve walked into a movie 15 minutes late. “Pay off your credit cards!” Okay. “Get life/disability/umbrella/homeowner’s insurance!!” Sure thing. “Max out your 401K!” Roger that. What’s a 401K?

If you dive in and just start executing good rules of thumb, you can miss the most important part of the whole exercise.

You need to set a goal. Earning money, making investments, building a pile, and even retiring are all kinda fun, but what is it you’re really trying to do here?

Your personal finances should allow you to do something with your life. What are you trying to accomplish?

Your goal should:

• Stand up to the question, “Why?” – asked many times in succession, if needed
• Be defined in something other than financial terms
• Not sound ridiculously stupid
  (These all kinda say the same thing, but we’ll use a belt-and-braces approach ‘cause this is important.)

Here are some examples of goals that won’t cut it:

• “I want a net worth of $10 million.” Why? What will that money actually let you do?
• “I’d like to retire as soon as possible.” Why???
• “I want two houses and three cars and a country club membership and a pony.” Seriously? Why?
• “I want to make VP by 30 and SVP by 35 and do big deals and kick a$$!” OK! We’ll put that on your tombstone.

You have been blessed with the gift of life and almost limitless opportunities, so try to come up with something meaningful and important. If you keep asking “Why?”, you should end up with an ultimate goal that isn’t tied to money at all. Money is a means to an end, not the end in itself.

Without sharing too many details, my own goal centers around time with family and friends, raising two kids to be happy and successful, and realizing some of my creative potential. It has nothing to do with finance, but it has obvious financial implications. I need a nice pile to achieve my goal, but not a dragon-hoard-sized one. I also can’t devote my entire life to traditional work, and that’s an important restriction to know.

If you don’t set a goal for your life, there’s a good chance (roughly 100.0%) you won’t achieve it. You might have success – as defined by others – and maybe even a comfortable and happy life, but you’ll have fallen short of your potential and probably worked too much or too little or on the wrong things.

Prioritize what’s really important to you, and then work your finances so you can achieve it.

There is one more thing to keep in mind when setting your goal. Namely…

YOU ARE HUMAN

This has tons of implications. As a human:

• You’re mortal. You have a limited amount of time to meet your goal.
• You may die without warning. If you back-end load your goal, you may die before you get to achieve any of it. Structure your goal and your financial life so you can enjoy the present a little. Eat, drink, and be merry, for tomorrow we die.
• Your happiness is not linear with wealth. A guy with $100 million is not 100 times happier than a millionaire. Remember that.
• You are risk averse. Maybe a little, maybe a lot, but this test proves it.
• You are not a robot. Use your free will. Just because our default settings say you have to work to 65, or own a house, or enjoy shopping at Target, doesn’t mean you have to.

One last bit about being human – we’re social creatures, and we’ll often look to other people to guide what we should be doing. This can be helpful when we’re trying to figure out what roots and berries are safe to eat, but it’s incredibly dangerous when considering a lifelong financial goal, because…

THERE IS NO COMPETITION

You will not derive long-term happiness from financial competition with other people.

The only person you’re really competing against is yourself. You’re born with many opportunities and lots of potential, and your lifelong battle is to achieve that full potential.

If you’re trying to “win” a game of how much money or toys you can acquire in your life, I’ve got troubling news: on your deathbed, you are going to realize you were playing the wrong game altogether. You’ll have wasted your whole life in a stupid competition that doesn’t matter.

You aren’t competing with your high school classmates, or your co-workers, or your neighbors, or that dude who pulled up next to you at the stoplight. You just want to be happy. If you can break away from the herd and stop caring what strangers think, you’re halfway there.

Are you ready? Have you decided what goal will give you deep and lasting life happiness, and started to consider the finances required to meet it? Excellent!

Let’s pause for just a sec to consider what might go wrong. It’s always good to…

PLAN FOR THE WORST

Take a look at your goal and consider the worst that could happen. Be creative in anticipating trouble (this should be my motto…) and see what you can do to mitigate the risk.

• Consider term life insurance if you’re still short of any financial targets and would want to fix that from the grave.
• Consider disability insurance if you need to work to meet your goal.
• Secure property, liability, and umbrella insurance to help protect your assets.
• Make sure you have a will. And this other stuff.

Hopefully you’ll dodge all of the worst case scenarios and have time to achieve your goal. If it includes doing something other than working your whole life, you’re gonna need some assets.

You can produce financial assets when you….

SPEND LESS THAN YOU EARN

Spending less than you earn is a cornerstone of personal finance. Living on less than your income gives you a surplus you can invest.

If your earnings exceed your spending by a lot, you can rapidly build a pile and have the finances to race your way to whatever is your ultimate goal. You’re on your way to being asset-based.

If your earnings exceed your spending by very little, or not at all, you’ve got less options. I hope you like your job, ‘cause you’re going to be income-based for a long time.

If the size of your surplus is too small for your liking, you can remedy the situation by earning more, spending less, or (my favorite) both.

But we may be getting ahead of ourselves. In order to know that you’re spending less than you earn, you need to…

TRACK YOUR INCOME AND EXPENSES

Everyone should know how much they earn and spend. Managing your finances starts with measuring them.

A simple spreadsheet can suffice. I supplement that with using Mint to capture credit card transactions (and that’s all I use Mint for*). There are many fancy tools that can help, but this is arithmetic, not rocket science.

I have never known anyone who started tracking spending and income and then said, “Yep, this is precisely what I envisioned, down the the penny, and there are no surprises in these figures at all.” Math doesn’t lie, and seeing those cold, hard numbers for the first time can be incredibly edifying.

Tracking income and spending is just the first, passive step. Once you see what’s happening and want to change it, you need to enter the land of budgets.

You may not need a formal budget, but you need a budget function. Someone needs to be comparing what is happening to what should be happening. I’ve never had a formal budget, but I’m pretty vigilant with our finances.

If you need a little more structure, and especially if you’re working to get two people on the same page financially, a formal budget can be invaluable. The budget becomes the policeman, rather than one of the couple, and conversations can be based on data rather than raw emotion.

AVOID DEBT

Remember when we said to spend less than you earn? Debt takes you in the other direction – it’s an event where you spend more (perhaps way more) than you’re earning. You’re pledging future earnings to pay it off, plus interest.

There are times that debt can make sense. If you buy an income-producing asset with debt, that can be a good thing (assuming the income > debt cost…). A house purchase may only be possible with debt, and houses certainly can be lovely.

Debt is a good servant but a terrible master. Avoid it where possible.

INVEST

Once you have a surplus from earnings > spending, you can invest it. The more profitably you can invest the surplus, the faster you can grow your pile and (if this is part of your goal) stop needing to work.

However, it’s important to remember that in any investment, there should be a relationship between the risk of the investment and its expected return. This lesson is forgotten like clockwork, but fortunately there is always another reminder just ahead.

The stock market historically has been a good place to invest over the long-term and a good generator of wealth. It’s certainly been a friend to me. One appealing aspect of the stock market is that historically passive management (e.g., buying an index fund) has done well compared to active management (you or someone you hire buying and selling stocks to “beat the market”). That is rare among investments (try being a passive lemonade stand operator or landlord and see what happens). It’s good to remember, though, that every investment has risk, and past performance is not indicative of future results.

If you’re not skilled enough to choose asset classes and specific investments that match your risk tolerance and your overall financial goal, getting a fee-only professional to help may make sense.

DIVERSIFY

Don’t keep all of your eggs in one basket. This holds for your financial investments and your whole life.

Career – don’t become so specialized that you are at risk if the market for your skills changes.

Employer – don’t be so slavishly devoted that you’ve got lifelong regrets if they fire you (it does happen). Remember that sometimes the only way to get your market wage is to switch jobs.

Family and friends – build strong, rewarding relationships with as many people as you can. It will give you a richer life and make you a better person.

Investments – don’t risk your goal because you’re too concentrated in one _______ (fill in the blank – asset class, stock, entrepreneurial venture, financial institution, etc.).

OPTIMIZE MAJOR TRANSACTIONS

Avoid Taxes

Taxes will likely be one of your biggest lifetime expenses. You can either optimize them or work a lot longer. Use tax-advantaged accounts (e.g., 401K, IRA, Roth IRA, 529, HSA) whenever it makes sense. Even if you outsource your taxes, understand the best strategies to proactively minimize your obligation.

Don’t Buy Too Much House

Houses are technically investments, but they’re not always great ones. If you want to live in a house, treat it as an expense, and try to keep that expense low.

Buy Cheap Cars and Keep Them a Long Time

Buy a cheap one and drive it forever. You can even buy a new car as long as it’s cheap.

Minimize Fees and Expenses

Investment management fees can cost a fortune over a lifetime – minimize them.

House sales have really high transaction costs. If you’re a house-buying type, try not to move too often.

Periodically bid out major expenses (e.g., insurance) to make sure you’re not getting fleeced.

TAKE CARE OF YOUR ASSETS

You should definitely measure your financial net worth as your pile grows. But you also need to be aware of your full balance sheet – you have some big intangible assets there, and you ignore them at your peril.

If building a really strong marriage is worth a lot to you (at a minimum, you should value it at ½ your financial net worth…), then perhaps ignoring your spouse for years to chase modest promotions and raises at work may not be worth it.

I would pay a small fortune if you could guarantee my kids would have happy, successful, long, rewarding lives. That guarantee isn’t available, but we’ve made a number of decisions – at significant financial cost – to hopefully improve our odds. Be aware of trade-offs and optimize them with your overall goal.

If your health goes, you’d pay just about anything to have it back. Treat it as one of your most precious assets.

You can assign a hypothetical financial worth to anything – just ask how much you’d be willing to pay for that intangible, or how much you’d need to sell it. Once you have that figure, value it accordingly.

REMEMBER YOUR GOAL

Remember the goal you set back at the beginning? Continue to revisit it, because you’ll find yourself tempted from time to time. It’s just part of being human.

If you decided that a modest pile was everything you need to be happy, you may still feel a pang of envy when you find your high school classmate is a decamillionaire, or a former colleague becomes CEO, or you log into Facebook. Remember: there is no competition. Achieving your goal is what will maximize your happiness, so ignore everything else.

 

 

While many of these tenets are quite simple, they combine to give me a structure I can expand with more details and individual topic treatment. Consider this just the beginning of my dive into “personal finance basics”. More to come, and soon!

 

Is there anything you’d add to this list? Please let me know your best personal finance guidelines.

 

* As noted, I use Mint to help track my spending. Mint allows you to connect not only your credit cards but all your financial accounts for a total view of your entire financial position. I only connect my credit cards because that’s the only place I need help consolidating transactions, and I’m a deeply distrustful person. If my credit cards get hacked, it’s OK – credit cards have ample protections for fraudulent charges.

Many people will counter that I am so silly to fear linking my brokerage accounts to Mint because there’s, like, no way anything bad could ever happen. They’ll laugh and gladly connect every possible account (bank, brokerage, Ashley Madison, whatever) to Mint because there’s no way hackers could ever get that information.

Call me a pessimist, but I’m pretty sure ANY sentence that starts with “There’s no way hackers could…” is going to end up sounding really dumb someday soon.

And finally, for all of you personal finance bloggers, yes, I’m sure Personal Capital is the absolute best, but I haven’t gotten around to testing it because my Mint system ain’t broke. (Note to self – insert juicy Personal Capital affiliate link here and then change sentence to confirm it is indeed the BEST!!! Yeah!).