3 Basic Steps to Mastering your Personal Finances

In my upcoming book, What should I do with my Money?, I offer a simple three step process to taking control of your personal finances.  This post is essentially the 1 page summary of my book.

If there are certain parts of this summary you do not understand then you should check out the corresponding chapter in my book for more context.  Please do not be discouraged if the summary is a bit over your head or confusing to understand, this is meant to be used as a reference for the book and not a replacement.

 

3 Basic Steps to Mastering your Personal Finances

  1. Live below your means (get cash-flow positive)
    • Live on 80% of your income, save and invest the remaining 20%.
    • Pay yourself first – start with a goal of 5% of each paycheck, work up to 20%.
    • The 20% you pay yourself is your “net income” – if more than 20% already, great!
    • Prioritize your spending, cut expenses (even the small things can add up quickly).
  2. Save Cash – 10% of your income or half of your net income
    • Open a savings account, online banks can offer about 1% interest
    • Build your Emergency Fund – a cash reserve in case of unexpected costs or loss of income that will help you sleep at night
      • First, save $1000 – use all your net income until you save $1000
      • Next, save 3 months of living expenses – can start investing some of your income and/or saving for other goals if you have secure job
      • Finally, decide on a long-term goal (6-12 months of living expense).  Consider your income stability and financial responsibilities.  As you save for other goals and invest for retirement continue to put 25-50% of your cash savings towards building your emergency fund.
    • Save for your goals – once you have at least $1000 or 3 months of living expenses in your emergency fund (whichever you deem appropriate for yourself) you can begin putting half of your cash savings towards a goal you have.  For example save for a vacation, a new car, a house down payment, etc.
  3. Invest for Retirement  – 10% of your income or half of your monthly net income into low-cost index funds
    • Accounts – 401k and IRA offer tax benefits but have specific limits and rules
      • 401k – from your employer, see if they match your contributions.  If they do, then contribute up to the match they offer, this is free money.
      • IRA – open at a broker, limit of $5,500 per year.
        • Roth IRA – if you are young and expect to earn more later in life
        • Traditional IRA – if you want the tax write off now
      • General Investment Account – for your investments after you maxed out your 401k and IRA accounts for the year.
    • Portfolio – Low cost index funds (expense ratio 0.25% or less)
      • We control the volatility of our portfolio with the allocation of bonds versus stock.  Have your age as the % of bonds in your portfolio.  You want to hold more bonds as you get older because bonds fluctuate less than stocks
      • Stock index funds – Low cost, tax efficient, passive
        • Stock Index Fund – US stocks and international stocks
        • Bond Index fund for your bond allocation
      • Even easier just buy a Target Retirement fund (offered by some brokers) – they change allocation for you as you get closer to retirement, fee slightly higher than doing it yourself but can be worth it.
    • Stay the course – Goal is Slow & Steady
      • Market averages a 7% return per year but only over long-term (10+ years)