Personal Finance 101

Inspiration from Willian Bernstein's "If You Can".

See Bogleheads thread "Books for someone who is not that interested", started Tue, May 13, 2014 by "Weston".

Personal Finance 101

I've done a fair amount of reading on personal finance, but I have a natural inclination and interest in the topic. Unfortunately, it seems the average person does not share my enthusiasm about personal finance. Like so many things in life, people want an easy turnkey solution that doesn't require learning a lot of new terminology or, god forbid, math.

There's no shortage of "personal finance 101" articles out there on the Internet, but I haven't seen any that are truly simple. Trying to put myself in the mind of someone who wants a turnkey solution for their finances, the following is my attempt at a truly simplified solution for sucessful personal finance. First are the rules, in their simplest, most terse format. Then I repeat the rules with a little more detail.

  1. Maximize employer 401(k) benefits.
  2. Eliminate debt.
  3. Six+ month emergency fund.
  4. Maximize 401(k), Traditional IRA, and/or Roth IRA.

The fundamental rule here---and it's so important, we might as well call it the Golden Rule (of Finance)---is "spend significantly less than you earn". Following the above steps forces you into compliance with the Golden Rule. Some people like to say "live below your means", but to me, it doesn't drive home the point as well.

At this point, many articles might dive into the whole "needs versus wants" discussion, but I'll spare you that for now, and instead add some detail to the rules above:

  1. A 401(k) is but one of many "defined contribution" plans that an employer can offer. Not all employers offer them, and even if they do, not all employers offer a match.

    This rule is specifically about any kind of defined contribution matching your employer offers. If your employer doesn't offer a match, it might be time to re-evaluate your job. If it's simply not possible to work somewhere that offers both a definied contribution plan AND a match, you can skip this step. But, do work hard to be in a position where this step is relevant.

    If you don't take full advantage of your employer's matching, you are voluntarily taking a pay cut. It's that simple. Why would anyone work for less money? Chances are, your contribution plus employer match alone are insufficient to fund your retirement. We'll get to that later. This first step simply ensures you are fully realizing your wage.

  2. In personal finance circles, there is talk of "good debt" and "bad debt"... but for the person who wants a turnkey solution, we will simplify and say all debt is bad debt. Debt is a tool; in finance, it's the same as a hammer or saw in carpentry. It's a very powerful tool, and has its place in the hands of those willing to understand its nuances. If you are reading this, you don't want to know the "whys" or "hows" and simply want a recipe. So, we keep it simple: eliminate debt.

    What this means: you buy nothing outside of the following:
    • food: from the grocery store only, no eating out when you have debt
    • shelter: live at home if you can, otherwise, the cheapest apartment you can find in an area without regular shootings or stabbings
    • clothing: only the bare minimum you absolutely need to meet professional and legal requirements

    If this sounds hard, well, it is. Think of debt as a cancer, that slowly eats away your financial health, until it is gone.

    Some day, you may want to buy a house, and it seems that "everyone" buys their house with a mortgage. I will go so far as to say, you are not allowed to entertain the thought of buying a home on loan until you are willing to truly obtain a deeper understanding of personal finance in general, and debt in particular. (Generally speaking, from a historical perspective, home ownership is not to be thought of as an investment.)

  3. The emergency fund. Many "personal finance 101" articles will make the establishment of the emergency fund the first priority. I deliberately put debt elimination before emergency fund because debt is an emergency. Let's take a look at typical emergencies that someone might face: - hot water heater malfunction - furnace dies - hail damage to roof or car - major automotive repair - medical emergency With the exception of the medical emergency, all of those are mitigated by living the life of someone who is working aggressively to pay off debt. Most rental situations mitigate the risk of "homeowner emergencies" such as hail damage, major appliance failure, broken windows, roof repair, HVAC, etc. A car is a luxury if you're in debt, so you should be walking, biking or relying on public transit as your primary means of transportation.

    So what is a "six+ month emergency fund"? This is an amount of money sufficient to sustain you for at least six months in the event of a job loss.

    For the person who doesn't want to track their expenses, and/or hates math, or thinking in general: this is half a year's gross salary. Given that we've already established that you will spend much less than you make, half a year's gross salary will be well over six months of living expenses. But more is better, and hey, you avoided having to think about it.

    I'd recommend taking this a step further: put the money in a dedicated account at a separate financial institution (than you normally use). Best case is you generally forget about this money, except when you really need it. This money cannot be used to buy new toys, such as an iPad.

  4. Fixme...