What Separates Success From Failure in Money Management?
Investing is important. We hear it time and time again. The great wonders of compound interest. The significance of saving and investing over a lifetime is paramount.
Yet despite all the so-called passion around saving and investing, I hear very little discussion about where to start investing.
For many, investing begins first by saving. Putting your dollars to work for you. Many of the self-proclaimed "guru investors" will be quick to point out that you can invest first without saving. This is called investing on margin. It's actually what most of us do when we purchase a home.
A mortgage is actually an investment on margin. We borrow money that we don't yet have to purchase an asset that we hope will appreciate in value over time. For those who want to learn more about mortgages, check out this article.
I am a strong advocate that the only thing to ever invest in through margin is a home. Do not borrow money for cars. Avoid borrowing for clothes. Couches. Appliances. Sure, if you want to have a credit card and pay it off in full at the end of every month, have at it Hoss. I highlighted the benefits of a paid-off-monthly credit card in this article.
Alright, I know by this point many of you want the answer. The answer to the highly controversial question: "What is the most important investment decision of my life?".
Technically, the answer to that question is not anything tangible or a commodity purchased with money. The best investment you can possibly make is in yourself. I am the furthest thing from a soft and sentimental man, but I truly believe this is the honest truth. Investing in yourself through acquiring wisdom, attaining improved health and fitness, and building foundational relationships is the single most important thing you can do in your life.
That aside, I do believe that their is a less-important monetary decision that dramatically affects the trajectory of most young individuals' and couples' financial journey.
The Purchase of Your Home
I previously wrote about why a house is an investment, not a liability like many experts would argue.
So why am I writing about it again? Truth be told, I do not believe that purchasing a home is directly what generates wealth and increases net worth. I do not believe that a home is a significant appreciating asset either.
Rather, my belief is that the purchase of a home has the power to indirectly make one wealthy. One might ask "How is that possible?".
Let me explain. The purchase of your home, particularly your first home, sets off a chain reaction. Many of the successes (or failures) of your future financial journey depend on the decisions you make when you are young.
If you overextend yourself on the purchase of your home, especially your first home, you dramatically reduce the power of your savings. Trust me when I tell you that nobody actually cares what house you are presently living in. Nobody cares how many square feet it is, how many bedrooms it has, or if it has a pool or exposed wood beams. Truth be told, the only person any of these things should ever have any meaning to (aside from yourself) is whoever buys it from you some day. That's it. So technically, you need two people ever to value your home: YOU and YOUR FUTURE BUYER.
With that out of the way, the single most repeated mistake in American society is over-mortgaging themselves on a home. This is commonly referred to as being "house-poor" or being "married to your mortgage".
Even worse, the buck doesn't even stop there. Aside from a larger mortgage payment per month, you also will suffer the following:
All of this because you bought too much house. You spent more than you should have. You sabotaged your own efforts at saving.
If there is one thing that I consistently see that dramatically alters the trajectory of a financial journey, it is the purchase of your first-home.
If nothing else, making the decision to be practical and still leave plenty of room for investing while your are young, purchase far less house than you can afford. Plain and simple.
What would I do next? Invest the remaining savings in low-cost index funds. But hey, that's just me. Do whatever you want. I am no investment professional nor did I stay in a Holiday Inn express last night.
Until next time.
Where It All Comes Together
Two major steps are out of the way at this point. To review, they are:
When you finally cross the threshold of owning more than you owe, you will have a positive net worth. This is where the long-term journey truly begins.
From my point of view, for anyone under a net worth of $10 million, all debt is bad debt. Focus hard on paying everything off. Some of you may want to keep your mortgage, but please realize that the interest on the loan (even if it is only 3%) can dramatically reduce the amount of money you are putting toward investing over the course of 30 years (average mortgage duration).
Remember, over the course of a 30 year mortgage, the average homeowner pays 2.5 times the original purchase price due to interest.
Once You Cross Over "Into the Black", the Fun Begins...
The first two steps of this journey were highlighted in Part 1 and Part 2. If necessary, go back and review those. The sole purpose of putting those two steps together is to get to the point of attaining a positive net worth, even if it's only $1.
Now you can begin to focus on savings, or what is commonly referred to as a "savings rate". I define this as the percentage of your take home pay you put towards savings.
A) To help start to figuring out your savings rate, consider the following:
B) After you have determined how much you are contributing to the above areas, find out how much you are adding to the following accounts on a weekly, biweekly, or monthly basis:
To calculate your savings rate, find out how much of your take-home pay goes to accounts listed in section B) from above. Section A) is still useful in adding up to determine "how much your job is truly worth" as many of these items listed in section A) are significantly cheaper for you as an employee compared to if you purchased them on your own.
Once You Know How Much Your Saving, Find Out How To Increase It!
Now that you have determined how much you are contributing to saving, look at this figure at least twice per year to see if you can increase it.
Never stop doing this step. Ever. You want to see throughout the "seasons of life" if you can be more and more aggressive with your savings efforts. Only you will be able to determine for how long and how much money needs to be accrued before you relax this plan.
Many have used The Shockingly Simple Math Behind Early Retirement article as a means for figuring out their "FI number". Perhaps this will be your next step as well.
To increase your savings rate, you can focus on income and expenses. Ideally, focus on both for the biggest impact.
The goal: Increase income and decrease expenses simultaneously
Ways to increase income:
Ways to decrease expenses:
The wider the gap between income and expenses, the greater potential your savings and thereby investments will have.
If you only have $100 saved, who the hell cares if you invest in something that generates a 25x return... you'd still only have $2,500 dollars---hardly enough to make you rich. This is a 2,500% return on your initial investment of $100. Guess what, "the market" typically returns 8-10% over time, not 2,500%.
Remember, your most powerful weapon at your disposal is compound interest. The way you make compound interest even more powerful is by saving, early and often!
Step 1 - Calculate Your Net Worth or Figure Out Your Lifetime Earnings vs. Savings
Step 2 - Attain a Positive Net Worth (most often by eliminating debt) and create some breathing room with a fund of at least 3 months worth of expenses
Step 3 - Determine your savings rate and find ways to increase it
Money Management Series "Part 1" Recap
In Part 1 of this series, I discussed the importance of getting a grip on how much money has flowed into and out of your life. You had two choices on getting started: 1) Calculate your net worth or 2) Calculating you lifetime after-tax income and compare it to your total present-day account values.
We start here to paint a very clear picture and teach you just how inaccurate your lifelong story about money truly is. You need to understand what your previous money management routine has yielded because it creates an excellent way to track where all your money has gone over your earnings lifetime.
The first step of this program was to find out how much your worth. Now what?
What To Do After You've Calculating Your Net Worth(less)
Perhaps in calculating your lifetime earnings, you realized you've saved none of it. Maybe you are even in debt. In that case, congratulations---you have managed to actually spend more money in your life than you have ever even earned. That ends today.
The focus is on getting back to neutral. Back to zero. For most people, a worthy place to start is actually eliminating a negative net worth.
Whether you have mortgage debt, couch payments, car payments, or whatever the hell else you can finance in this day and age, if you have a negative net worth the focus needs to be breaking even as quickly as possible.
I am not going to get into good debt vs. bad debt. That is a bullshit conversation for multi-millionaires to sip mixers and jeer about. If you are in debt, and have a negative net worth, there is no such fucking thing as good debt vs. bad debt.
It's all bad debt if you owe more than you have or make. If you are living beyond paycheck to paycheck, stay away from the bullshit advisement and arguments about how "houses are good debt" and "cars are bad debt". It's all complete and utter nonsense. Stay away from it and get back to even. Soapbox over.
Begin with the debt snowball or debt avalanche methods. They have been hashed out in great detail and people love Dave Ramsey's Total Money Makeover book for strategies on how to kill debt as quickly as possible. To that end, I will not repeat what others have already outlined better than I. Go read Dave's book or Google search 'debt snowball' or 'debt avalanche'.
Now Make a Plan For Saving
Whether you already have a positive net worth, or you followed the advisement outlined above, you need to develop a plan for where to direct your savings.
You certainly could direct it into a savings account. Perhaps increasing your retirement contribution percentage is now feasible. Maybe you want to open an IRA or a Roth IRA. You have options.
Age old wisdom advises 3-6 months worth of expenses in your savings account. Above and beyond that, your income or savings can be invested. There are many advanced strategies such as saving your 3-6 month emergency fund in your Roth IRA. For now, let's keep it simple and easy to follow.
I personally believe that if you previously held significant debt, teach yourself the discipline it requires to save a 12 month emergency fund. If you have had a positive net worth for years or decades, then you can be more aggressive with a 3 month emergency fund.
The amount you should save in the fund is based on total monthly expenses for a given time period. If you spend an average of $2,000 per month, and you wanted to have a 6 month emergency fund, you would need to save $12,000 ($2,000 a month x 6 months). Pretty simple stuff.
It may be boring as hell, but eliminating all debt in pursuit of attaining a positive net worth---even if it's only $1---is an essential second step after you have calculated your net worth or lifetime earnings and savings as outlined in Part 1 of this series.
Part 2 of this series is all about understanding your financial picture. It is about finding out what action steps you need to take after you discover your net worth or lifetime savings and earnings as outlined in Part 1 of the series.
Thus far in the series, we have covered these basic steps:
Step 1: Calculate your Net Worth or Lifetime Earnings relative to present-day savings
Step 2: Attain a Positive Net Worth and Start an Emergency Fund
In part 3, we will discuss what to do once you have established and completed Steps 1 and 2 above.
Dr. Jon is a physical therapist by day, and a dedicated frugalist by night, deeply enthralled in the thrill of "pinching pennies" and investing the margin.