The Amateur Financier

Ah, now we’re getting to the good stuff; now that you’re not spending all your money, have a decent emergency fund and have debt under control, it’s time to start having your money make money.  If you want to retire (who doesn’t?) and aren’t earning several times the amount of money you spend each year (who does?), you need to put some portion of your money aside in investments that will grow your money at a rate faster than inflation, fast enough to let the magic of compound interest take hold and leave you with a sizable retirement fund (or college fund, or whatever you are attempting to save up to achieve).  In other words, you need to

Invest Early and Often

Getting your investments started as early as possible is one of the best ways to increase your net worth that exist.  Thanks to the power of compound interest, where the interest you earn in turn earns more interest, which in turn earns even more interest, you can turn a relatively small initial investment into a sizable fortune.  Each dollar you invest at age 20 will turn into thirty two dollars by age 65 (assuming you earn a fairly modest 8% return on your money).  If you wait until age 30, each dollar will grow to only about fifteen dollars by age 65, less than half of what you’d earn by starting a decade earlier.  It only gets worse from there: start at age 40 and your dollar becomes seven dollars; start at age 50, and your dollar will only grow to three dollars when it’s retirement time.

Starting your investment career early has some other advantages, as well; you have more options for what investments you can use when you have more time available to recover from your mis-steps.  If you want to choose highly speculative investments, the types that could either greatly grow your initial investment amounts to huge sums or leave you completely penniless, it’s much, much, much better to do so when you’re 20 than when you’re 40.  While I certainly hope that you have good luck and end up with a sizable amount of money, if you do end up losing your shirt, it’s much easier to pick up the pieces of your financial life at 30 compared to 50 (just look at the difference in the grow of your money starting at those two ages).

Conversely, if you want to invest more conservatively, starting earlier gives your investments more time to grow, allowing you to stick with investments that allow you to sleep at night while still growing your money to meet your goals.  If you’re earning only five percent return on your money (perhaps by investing in bonds, or even keeping your money in a savings account when interest rates start to go back up again), it’s important to get an early start to allow time for compound interest to work its magic.  Starting at age 20 and earning a 5% return will yield nine dollars when you’re 65; wait until age 40, and you’ll have less than $3.50.

Of course, most people don’t put a lump sum into their investments and then just stop, only taking the money out at retirement.  No, most people follow the second part of our advice and invest often, putting aside a bit of money monthly or whenever they get a paycheck.  The advantages of investing regularly really add up over time.  Remember how each dollar invested at age 20 grew to thirty-two dollars by age 65?  If our twenty year old added an extra dollar each year, by sixty five he or she would have a total of $418.  If we use more realistic numbers (after all, who invests only a dollar each year?), say $5000 each year, investing each year yields a total of over $2 million, compared to $159,000 for a single five thousand dollar investment at 20.

Investing often also allows you to dollar cost average your investments.  By putting in the same amount of money on a regular basis, you’ll buy more shares of your investment when the price is low and fewer when the price is high.  If you invest a single lump sum right before a big decline (say, back in 2008), you can end up losing years worth of compounded interest (at eight percent return, it’ll take nine years to get back to even with a fifty percent drop in value).  If you invest year after year, though, a sizable drop in value offers you the chance to greatly increase the amount of your holdings, leaving you with a much more valuable investment.

Where to Invest

You’ll notice we haven’t discussed where to invest your money yet.  There’s a reason for that: there’s a lot of investment options.  From stocks and bonds to options, futures, and forex, a complete list would fill a pretty sizable blog entry by itself.  As a result there’s no real way for me to give you a simple rule on what to invest in.  You’ll have more options if you start investing earlier (as there’s more time to catch up if you run into trouble and more time to grow your money), but what exactly to invest in is up to you.

If you want a simple, set it and forget it type of investment that will automatically adjust your holdings to something appropriate for your investment goals, you could do much worse than a target date fund.  Target date funds hold a mix of other mutual funds that is designed to slowly decrease in risk as you approach the target date (which is generally retirement or the start of college, or another major life event for which you’re setting money aside), making it less likely you’re lose all your money right when you need it.  If you choose an appropriate fund from a quality company, a good target date fund (or one for each goal) could be all you need, investment wise, though they’re still far from the only option.  Otherwise, reading and learning more about the other types of investments available is your best option.  Good luck with your investments!

We are now at one of the most tricky spot in personal-finance, debt management, something that gives a great number of people quite a bit of trouble. But if you do it right, you will save yourself a great deal of time and aggravation.

Manage Your Debt

There are many different theories as to how much debt is acceptable. Some people, like Dave Ramsey, believe that you should do everything in your power to remain debt-free. Others, such as Robert Kiyosaki, consider debt, even substantial debt, to be necessary part of building your financial future, something you can’t do without if you hope to retire rich. And of course, there are many opinions that fall in between these two extremes.

Regardless of which tactic you prefer, it’s important to know how to manage your debt in a way that will keep it from overwhelming you. If your amount of debt continues to rise beyond what you have the capability to manage, it can overwhelm you, wrecking your financial goals and your life.  (That’s one reason I came forward with my current debt issues before they got to be too overwhelming.). So we’re going to go over a few tips to help you keep your debt under control.

Controlling your debt

The first step in managing your debt is knowing where you stand. You need to take an honest inventory of your current debts and obligations. It might be painful, but it’s important that you know what you owe, whom you owe it to, and how much interest you’re being charged in order to know how to get out of debt.

Once you know where you stand, it’s time to work out your plan. There’s a variety of techniques you could use in order for you to get out of debt. I’ve covered several of them previously, even comparing their effectiveness, but it’s worth a quick review.

The most effective technique is to pay down the highest interest debt first and then go to the next highest interest debt, pay that debt down, and so on. This has the advantage of being the most efficient means of paying down your debt. Dave Ramsey, on the other hand, favors paying down the lowest balance debt first. While not as financially efficient, unless of course your lowest balance debt also happens to be the debt with the highest interest rate, it does have the advantage of a quicker repayment of the first debt, giving you a psychological boost as you attempt to pay down your other debts.

Rather than spending too much time worrying about which is the most effective or “best” method, it will be much better for you to simply begin paying down your debts in whatever fashion you prefer. Put extra money (beyond the minimum payments, which you should be making for all your debts) toward one of your debts, and you’ll slowly wear down the debt and eventually eliminate it.  Keep doing that for all the other debts, and you’ll soon be debt-free (or at least, free of non-productive debts like credit card debt).

I realize that all of this is easier said than done, as there will be no one in uncontrollable debt if repayment was as simple as I make it sound. Obviously, the psychological element is very important as well. In order to have the willpower to eliminate your debt, you need to have as much encouragement as possible. If you are married or in a committed relationship, your spouse or significant other should be able to provide you with support. Other members of your family or your friends can also serve to help support and encourage you in your debt elimination goals. And of course, there’s any number of personal finance writers and bloggers whom you can read to gain encouragement. (Many of them, myself included, will gladly accept e-mail describing your challenges and attempt to provide you with whatever help and encouragement will enable you to succeed.)

Good debt versus bad debt

There is much discussion about the concept of good debt and debt. While there is general agreement that the worst debt is debt taken on to buy goods that decline in value, such as taking on credit card debt to buy consumer goods, there is more disagreement on whether there is such a thing as good debt. Mortgages and college loans, for example, are used to acquire goods that grow in value over the years. Some commentators, such as the aforementioned Kiyosaki, considered it perfectly acceptable take on such debt; others, like Ramsey, believe that debt should be avoided at all costs.

Which position you take is going to depend on your personal beliefs and values. I can’t tell you which will be the best position for you, but regardless, any debt you do have needs to be treated with caution and kept under control. If you find your debt increasing, or it’s getting harder and harder to make the needed payments, you should take a step back, reconsider you need for that particular debt, and if needed, stop adding to it and start trying to eliminate it.

That’s all very really is to know about debt. It’s not really that hard a concept, although fully getting a handle on it does take time and effort. Here’s to both you and I getting out of debt as soon as possible. Cheers!

We’re continuing today with our list of five simple rules to help you make your financial life easier.  After yesterday’s advice to earn more than you spend, you should have a bit of extra money left at the end of each month.  One of the first things you should try to do with that money is

Keep An Emergency Fund

Actually, if you do much personal finance reading, you’ll discover that there’s actually two types of emergency funds that you need.  The first is designed to protect you (and your wallet) from sudden, unexpectedly high short term expenses.  For example, if your car breaks down or you need to go to the hospital, you should be able to cover the expense without having to put it on your credit card or sell off some of your investments.  This is a buffer fund, designed to keep your income flow buffered from the sudden expenses that life throws your way.

The sort of emergency a buffer fund is perfect for

For longer term situations where your cash flow is decreased (or nonexistent), you need something more substantial.  The second type of emergency fund is really an unemployment fund, a sizable chunk of money that is easily accessed, safe from any (major) losses in value, and substantial enough to supply with living expenses for several months, at least.  This is what most people tend to think of when you mention the term ‘emergency fund.’

In practice, these two types of funds can (and should) be used in conjunction with each other.  What you want is a step like arrangement of emergency funds, where each step contains more money, earning a little bit more interest, in a little bit harder to reach location.  As you use up the money in the preceding step, you move onto the next step, slowly drawing down the money you have available there to provide living expenses.  I like to think about the number six as I try to organize my emergency fund, as follows:

Emergency Fund Levels

Six Days of Expenses: Cash – Keeping nearly a week’s worth of your average spending in cash on hand.  You don’t have carry the full amount on your person at all times; a locked safe at home with a few hundred dollars in it would be an excellent idea.  That way, you’ll have a little money available for those sudden unexpected expenses, or if (knock on wood) you find yourself in a disaster a la the aftermath of Katrina, unable to reach a bank and unable to use credit cards to get needed supplies.

Six Weeks of Expenses: Bank Account - Once you’ve got a nice cash supply, the next step is put some money away into a regular, brick and mortar bank account.  This will form the basis of much of your financial life, and will also provide a ‘hub’ to which you can link other accounts (like an online bank or investment firm).  Most importantly for our purposes, a bank gives you a safe place to put some extra money, enough to cover your regularly monthly bills (and then some, hopefully).  This will form the bulk of your buffer fund, keeping you from living pay check to pay check and having to hope you can cash your latest check in time to cover the monthly expenses.

Six Months of Expenses: Online Savings Account or CD Ladder – The disadvantage of accounts with traditional brick and mortar banks is that they tend to have very low yields, regardless of whether you have a checking or savings account.  The cost of being able to run to the ATM or write a check against the balance in your account is a low interest yield.  Once you have enough money stored away to cover your monthly expenses, you can start trying to seek a higher yield for your money (while still keeping it safe).   Online savings accounts, like those for ING, HSBC, or Smartypig, make it harder to get your money (you’ll usually have to a wait a few days to transfer the funds), but offer a much higher yield than most traditional banks in exchange.

Once you have a sizable amount of savings, if you want to boost your return even more, you can opt for a CD ladder.  Essentially, you’ll buy CDs of varying maturities, attempting to arrange your money so that each month, a CD with one month’s worth of expenses will mature.  You’ll be able to (usually) get a higher interest rate than with a straight bank account, without much added risk.  Be careful though; if you need to get the money in a CD before if matures, you’ll usually pay a stiff fee.  Be sure that you have enough money in other, more accessible accounts to cover any foreseeable (and some unforeseeable) expenses you may incur.

(Up To) Six Years of Expenses: Other Cash Equivalents – Once you’ve gotten the previous steps complete, you might be ready to call your emergency fund finished.  Six months is a pretty sizable emergency fund, and if you’ve been high-balling your expected expenses, six months should cover you pretty well.  But perhaps you want even more money set aside in your emergency fund because you have a large family to support, or you’re approaching retirement and will soon be using your ‘emergency’ fund to provide your regular living expenses for decades to come.

In those cases, you’ll be best served by looking into some the higher yielding but still fairly safe investments, allowing your cash a chance to grow at a faster clip than any of the previously mentioned locations without too much risk of it dropping in value.  One possibility is money market funds, mutual funds that invest in highly safe and steady short term investments.  They frequently yield more than regular bank accounts (although, as of this writing most money market funds have essentially zero yield) with only a tiny chance of losing money.  If you’re in a retirement account, you can also consider a stable value fund, which has as its goal keeping the value of your investment safe while still earning a yield (however low that might be).

For those willing to take a little bit more risk to get a higher yield, there are other reasonably safe options.  Short term bond funds, for example, have much higher yields than money market funds.  In the event that interest rates start to rise, though, short term bond funds will decline in value, at least temporarily, while money market funds almost certainly won’t.  If you have a substantial amount of money in the other parts of your emergency fund, though, you might be willing to take that chance in exchange for the higher rates of return offered.

There you have it, how to build a sizable and complete emergency fund.  It’s a bit trickier than you might have guessed (at least, if you want to be ready for any emergency), but still fairly easy to do.  The piece of mind it can bring is hard to understate, though.

This week, I thought I would go back to basics, and provide five simple rules to help make money management that much easier.  It’s not possible to cover everything about money in five rules; it’s probably not possible to cover it all in five hundred rules.  But these five rules should help you to get a better handle on your money, and if you truly understand them, you’ll be a much better position financially.  That brings us to our first rule:

Earn More Than You Spend

If you do nothing else to improve your personal finance situation, if you take no other personal finance advice from this site (or the thousands upon thousands of other blogs, books, magazines and other personal finance media), let it be this: keep your spending below the money you earn.  If you spend more than you earn, or even the same amount of money that you earn, you won’t have the extra money you need to save, pay down debt, invest, or accomplish any other personal finance goals.

Charles Dickens knew the score: 'Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.'

If you want to accomplish this goal, there’s two different ways you could do it.  You can…

Increase Your Earnings

-Work Longer Hours: If you work for an hourly wage, the easiest way to bump up your income is simply to increase the number of hours you work.  Besides helping to show your dedication to the job, working longer increases the money in your paycheck (unless you’re a salaried worker, in which case you have to hope that the dedication you show to the job leads to a larger raise).  Admittedly, this may not be an option; most employers limit the number of hours you can work (and for which they’ll pay you) in order to limit their expenses.  If you find yourself in this group, you might need to…

-Get Another Job: We’re not talking about leaving your current job (although, if you can find another position that pays higher than your current one, it’d definitely be worth considering), but rather getting a second (or third, potentially) job to supplement your income.  It’s not for everyone (particularly those whose family or other commitments limit the amount of time they have available), but it does offer one major avenue for increased income.

-Develop Alternate Streams of Income: Easier said than done in many cases, there are ways to earn money other than working for an hourly wage.  Owning rental property, creating a blog, starting your own business, or writing and selling an eBook are all options (among many) to create income that can continue and grow without your continued effort.  (Of course, often forgotten in discussions of alternate streams of income is that they do take time, effort and frequently money to develop, and many times are far from guaranteed.)

If earning more money is not an option, or it’s not enough to close the gap, there’s always the second option:

Decrease Your Spending

-Cut Down Small, Regular Expenses: David Bach calls it your ‘Latte Factor‘; the tiny, daily or weekly expenses (like your morning latte) that add up over time to big amounts.  If you can identify the small areas were you spend almost without thinking, plug up the leaks, and save the money, you can make a large difference in your actual cost of living (and help to spend less than you earn).

-Save on the Big Expenses: On the other end of the scale, it’s important to try to save on the large expenses, from appliances to automobiles.  Comparison shopping, buying used whenever possible, and trying to delay the need to replace these big ticket items as long as possible are all ways to ensure that you don’t overspend on big expenses.  You might only have one or two of these savings opportunities each year, but any method of savings on these costs is will help to decrease the amount you outlay.

-Just Cut Your Impulse Spending: Probably the best way to keep your spending below your earnings, developing the ability to keep your wallet in your pocket (or purse) when you go out to the mall (to say nothing of not going to the mall as often to begin with) is your best ally in keeping your spending under control.  Just say no to the urge of spending and you’ll be able to keep more of your money.  (And of course, if you cut down on recurring expenses, like monthly television and phone bills, you’ll help to save even more.)

Which is Better: Earning More or Spending Less?

While not quite a big enough discussion to be called a Great Debate, there is some discussion of whether it is better to focus on earning more or cutting your spending.  Each method of closing your budget has its advantages and disadvantages.  Cutting your spending is fairly quick, for example; cut the amount you pay on your cell phone bill and you’ll see the savings within a month, while resisting the urge to spend the remnants of your paycheck at the mall every other week will leave more money in your pocket almost instantly.  The disadvantage is that there is a limit to how much more money you can generate by saving; you’ll never have more money than what you are getting paid (after taxes and other deductions).  Add in the fact that because of the need to spend some of that money on food, water, heat and other necessities, you’ll never get down to zero spending, and there’s an even greater limit to how much spending you can really cut.

Earning more money, on the other hand, is practically limitless.  Building a good blog or investing in real estate can generate as much (or even more) income as working a job (or two), meaning that the sky is the limit for your income.  While there’s a limit to how much more available funds cutting spending can generate, that’s not the case with earning extra money.  Of course, attempting to earn more money isn’t without its own flaws.  Trying to build alternate income streams is tricky and often leads to failure; while working more hours or an extra job requires time and a willingness to work that many people lack.  Either method requires a lot of time, effort, and much less certainty of how much you’ll be able to gain on top of your current earnings.

My view is that both methods are important; cutting your spending allows you to quickly boost your earnings above your spending, and lowers the bar for how much you need to earn in order to have the money for other personal finance goals.  Earning more money through whatever method you choose then yields even greater rewards and helps to boost your earning above your spending.  Taking advantage of every method possible to make sure that you earn more than you spend will help you to get your personal finance house in order, improving your monetary situation.