An Investment Pyramid: A Solid Foundation

This week, I’m going to share my thoughts on creating an investment pyramid for the rest of the week. Because nothing makes investing fun like adding pyramids; if it works for nutrition, it should work for money-management!

All this week, we’re going to be building an investment pyramid. Building on a solid foundation, creating an appropriate set of investments, and working towards your hopes and dreams are good steps for anyone to take, and now, I’m going to share my thoughts on creating an investment pyramid of your very own. We’re going to start by creating a solid base on which to add our investments:

Building an investment pyramid is like building any large structure; if you don’t build on a solid foundation, it’s going to sink into the ground, leaving you with no pyramid and a great big hole. And nobody wants to spend their retirement in a huge hole in the ground.

There are many things you may need to do to get your financial foundation in order, enough to fill an entire week of posts (which is a nice thought for the next time I’m out of town for the week), but here are a few basics. If you can take care of all of the following, you should be in good shape to start investing. You’ll also be in pretty good shape for life:

1) Have a reliable source of income – If you don’t know whether there will be any money coming in next week, then your first priority has to be to SAVE, not to invest. Yes, you will miss out on some of the benefits of compounded earnings over time. But if you end up selling off your investments to pay the bills, you might end up taking a double hit: not only won’t that money be working for you, but you could lock in short-term losses, and have less money available for the expenses. If you don’t have a ready source of income, whether from a steady job, freelance work, or unemployment, your first task is to save until you acquire a regular money stream.

2) Spend less than you earn – Alright, so you’ve got money coming in on a regular basis. That’s a good start, but if you’re spending each paycheck as soon as you get it or have to stretch to make it from paycheck to paycheck, you still have some work to do. This sentiment goes double if you have to use credit cards because you’re spending MORE than you earn.

For the long stretch, you should try to increase your income, by making yourself more valuable at work, creating alternative income sources (like, say, a blog), or even working a second job, if needed. In the short term, it’s easier to trim your expenses and pocket the difference, by cutting out regular purchases such as lattes… But even when you have a little breathing room between your income and spending, you are not free yet.

3) Take care of your expensive debt – I touched upon the idea of cheap and expensive debt briefly when I talked about student loans, but the basic idea is this: paying off debt you owe to others at X% interest is the equivalent of getting an investment return of X%. If you put $1000 in an investment that grows by 10% annually, you’ll have $1100 in a year; if you pay off $1000 in debt at 10% interest, you’ll save $100 in interest over the next year. In either event, the effect on your net worth is the same: you’ll be $100 richer one year from now than you would be had you simply kept the $1000 in an envelope at your home.

In fact, paying off your debts is even better, because the return you get by paying down a debt is guaranteed, unlike most investments (especially now). Add in the high interest rates that you might be paying on credit cards (frequently in the 20-30% range), and cutting down on your consumer debt is a great investment, probably the best one you could make. If you have any debt that is charging more than you can reasonably expect to earn by investing (8% is a fairly conservative number), focus your energy and extra money paying it down first.

4) Set up an emergency fund – So, you’ve eliminated your (expensive) debt, have a regular income, and spend much less than you bring in; time to start investing, right? Not quite yet… If you run into financial trouble in the future, you need to be able to get past it without selling your investments. If you don’t have a stash of money set aside for unexpected expenses or a potential loss of income, you might have to sell when your investments have gone down or add expensive debt just to get by.

There are many different places to build and store extra money for your emergency fund; the key is that it be safe (you don’t want this money to disappear on you right when you really need it) and accessible (you should be able to get at the money if the need arises for a large, one-time expense, like car repairs). Two good options are high-yield, online savings accounts (I have accounts at ING, HSBC, and SmartyPig) and money-market mutual funds, as offered by mutual fund companies such as Vanguard.

How much to put in the emergency fund is the subject of endless conjecture from financial writers; I’ve heard suggestions ranging from two months worth of expenses (for someone with no dependents and a relatively secure job) to one year (for those with little tolerance for risk and multiple people who depend on their income). Enough money to cover six months of expenses is my goal, but if you want a more specific answer, you’ll have to ask yourself some hard hypothetical questions:

-If my car breaks down, how much would it cost to fix? How long could I get by without using my car? If I need to get another vehicle, do I have the money available to afford it?

-If there’s a problem with one of the appliances, can I afford to get it fixed? Are any of the appliances nearly the end of their lifespans? If so, can I afford to get new ones?

-Is there any part of the house that needs repair? If so, how important is the needed repair? Are there any known problems that might need to be fixed in the future? Are they structural or superficial; that is, can we still live in the house if we delay the repairs, without having to worry about our safety?

-If I lose my job, how much could I expect to get in unemployment? How much would I need on top of that to cover the monthly expenses (including COBRA or other medical, if my employer isn’t providing it anymore)? Is it reasonable to assume I’ll get another job before the unemployment benefits run out? If not, how much more should I have in the emergency fund to cover the period between running out of unemployment and getting another job?

These are all difficult questions, most going far beyond a simple matter of how many months of expenses to keep in your account. The main thrust is this: make sure you have enough money on hand to cover any costs you are likely to face, without having to float them on your credit cards. Your emergency fund is a buffer, keeping you from piling on debt or pulling money from your investments, allowing the money you’ve invested to keep working for you.

Once you’ve completed all four of these steps you should be ready to invest. You’ll have more money coming in than going out, no high-interest debt holding you down, and an emergency fund should some unexpected problem arise. The only question is, how to invest? Which, luckily for you, is the subject for tomorrow’s blog entry.

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