Personal Finance Philosophy
Saturday, May 30, 2020
Since becoming an adult, I’ve become more and more interested with the world of personal finance. I started browsing /r/personalfinance wiki to learn about the basics of managing your finances as an adult. In particular, this flowchart made it very clear how I should be directing money to set myself up well financially. The mantra is pretty simple: reduce expenses, pay off (high interest) debts, and save+invest your unspent money.
The ‘mantra’ is pretty easy to understand but isn’t easily implemented. I, like many others, do spend money on things I enjoy: eating out, purchasing material goods I like, doing activities (bars, concerts) with friends and family, and going on vacations. In order to have a clear picture of where you’re at financially and to be able to set realistic/achievable financial goals, I think any individual should know:
- How much are you actually spending and on what? If you want to reduce expenses, you need to establish a baseline. It isn’t enough to just say “Well, my credit card bill is $750 this month so I spend $750 on stuff plus rent.” Where does that money go? You need a budget.
- Per the ‘save+invest’ point, what are and where are your assets? Building an emergency fund (3-6 months of expenses depending on your job stability) is step (1) but after that, you want to invest your money so that it grows. A High-Yield savings account is a start, but a portion should also be invested in stocks/bonds. That may be in your 401k, an IRA, or a personal (taxable) brokerage account.
I’ve gone deep enough into the personal finanace rabbit hole to also become deeply fascinated with the idea of Financial Independence (called FI, FI/RE, FIRE); it’s the idea that once you are generating enough passive income through investments (enough to cover all your expenses), you are no longer required to maintain a job for primary income. Achieving FI is not easy though - you need to do a lot of saving and reduce your expenses to make the numbers work. The topic is faily complicated (though this is a good starter) but a simplified way of looking at it is that you need about 25 times your yearly expenses invested to consider FI. That means if you spend $50,000 per year (on everything), you need 50k x 25 = $1,250,000 invested!
Setting a budget is an important step in personal finance but an honest and thoughtful budget must allow you to know where your money is going. You need to be tracking your expenses in categories. Below is an example budget (very similar to the one I use) where you would fill a value in each of the cells in the “Amount Spent” column on a monthly basis:
Trying to keep track of a budget with this many categories is difficult and without any type of automation also quite time consuming. To make this easier on myself, I’ve automated many parts of it - I’ve developed spreadsheets with pivot tables to automatically sum categories by month and written scripts to convert CSV files downloaded from credit card companies and banks to their expense categories. This allows me to rigorously keep track of every single dollar in every account and know whether the budgeting goals are met.
Investing can seem like a pretty scary topic for people who haven’t done very much research. However, there are a few simple rules to follow if you want to do yourself a lot of good with minimal effort. They are:
- If your job has a 401k (or similar e.g. 403b) investment account with a company match, always invest enough to get the full match. The match is free money; why lose out on it?
- Diversify your money in low-cost index funds. Do not pick individual stocks (e.g. AMZN, TSLA) to invest in. Put simply, this means looking through the fund options your plan/brokerage has and trying to find funds with the lowest Expense Ratio (ER). Don’t be fooled into pretty graphs that claim a “higher return” – they often have much higher ERs that will eat away at your money over time. Do not pay for a financial manager, they’re expensive at best and lose to index investing at worst.
- Set up automatic investments to keep your account growing, preferably via paycheck deductions. It’s much easier to save when you never have to think about it.
- Don’t ever panic and sell your investments if the markets are down – selling means you’re realizing a loss! Let the markets recover.
Speaking with a little more detail, the easiest way to invest is to build a simple three-fund portfolio consisting of domestic stocks, international stocks, and bonds. Better yet, consider investing in a ‘target date’ fund if your brokerage offers one (just as long as the expense ratio is not really high). If you’re young (20s or 30s), you should consider allocating the majority of your investments (as much as 90-100% if you’re under 30) in stocks and keep a 60/40 or 70/30 ratio off domestic/international stock. Stocks have more risk but more reward - since you’re young, you can take on much more risk since generally speaking you would never sell and realize a loss if the markets were down. Rather, you’ve got 10s of years to let the markets recover and your investments compound.
If you have investments in different kinds of accounts (401k, Roth IRA, IRA, taxable brokerage), you should also begin considering tax efficient fund placement which essentially boils down to: (1) keep income-generating investments in tax-deferred accounts (e.g. bonds and REIFs in 401k) and growth investments (stocks) in taxable accounts. You should always pick an allocation and stick with it (summing all assets across all accounts). That might mean you have 100% stocks in your taxable account and more than your overall allocation of bonds in your 401k.
To be concrete, here’s the allocation I target at 27 years old:
|Holding||Goal Allocation||Actual Allocation|
|US (domestic) stock||55%||63.8%|
These are some personal finance pitfalls that I think a lot of people fall in to:
- Carrying a credit card balance. Don’t do this ever. It does not improve your credit score, it only costs you money. Simple possesing the credit card and making on-time payments is what improves your credit score.
- Financing (or leasing!) a new car with a high interest rate. Cars always lose value and salesman usually sell you a car based off the question “What payment can you afford?” That question is designed to completely hide the details of the transaction and make your payment look attractive by making the loan term really long (84 months!) with a high interest rate. If you want to finance a car, you always need to negotiate the lowest interest rate first then determine if you can afford the payment at a specific loan term (e.g. 48 months).
- Holding too much cash in a savings account. Yes, you do need to save enough money to have an emergency fund but at some point, holding a ton of cash in your savings account makes you lose in the long run - that money would give you a much greater return if it was invested.
- Not switching banks to get a better interest rate in your savings account. You should check to see what the interest rate of your savings account is. Many big banks like Chase and Wells Fargo have horrendous interest rates (like 0.01%). Find a HYSA (just Google ‘best HYSA’) at some other bank and move your money there. I’ve been banking with Ally Bank for the last ~4 years and loved them.
- (controversial) Paying off low-interest debt as quickly as possible. For example, a loan that has a rate in the 2% or low 3%. While I agree there can be tangible benefit to your mental health by not having debt, you should not be paying off this low-interest debt before getting the full match on your 401k or 403b from your employer. In my opinion, it’s unnecessary to pay this off early at all - just invest the extra money. It’ll do better in the long run if it’s in the market.