- Track all of your expenses
- Live (significantly) below your income level
- Save a minimum of 20% of your after-tax income
- Minimize your fixed expenses
- Pay your credit card balance in full every period
- Never buy or sell an individual stock
- Invest in Exchange Traded Funds (ETFs), primarily through low-cost providers like Vanguard
All of personal finance can be broken down into just two categories:
- Spending money
- Investing money
Everyone knows how to spend money of course. The hard part is choosing what not to spend money on and figuring out what things are truly worth it to you personally. Here are four fundamental rules to manage your spending.
1. Track every single expense that you have - ignorance is not always bliss
Unless you have an endless supply of money, you should know exactly where your money is being spent. Without that knowledge, you will have a much more difficult time saving money and finding areas to reduce your expenses.
There are many ways you can track your expenses, I’ve listed a few of my favorite software based ones below:
2. Live (significantly) below your income level and save at least 20% of your income
If you follow this one rule, you won’t need to follow any others (although I don’t advise that!) to start growing your wealth. When most people think about what they can save, they subtract first subtract out their typical spending amount and come up with a number.
Lastly, and probably most importantly, is the idea of taking pride in being frugal. When most people make more money they feel that not only that they are entitled to a fancier car or luxury item but that these items will bring them more happiness. As a significant amount of research has already proven, this idea has been proven false after reaching a certain minimal level of spending and diminishing returns thereafter. In fact, the only way for a majority of people to become “millionaires” is to adopt a less materialistic lifestyle.
3. Minimize the percentage of your spending that falls under fixed expenses, (preferably under 50% of your after-tax income).
Now that you have a set upper boundary for your spending, let’s work on getting your expenses to fit inside that amount. And the first place to start is minimizing your fixed expenses to a max of 50% of your income - if it makes up a larger percentage you will find it incredibly hard to hit your savings goal.
For almost all people, their mortgage or rent is far and away their biggest fixed expense and it is the hardest one to lower. The typical rule that I use with housing expenses is to keep it under 30% of your after-tax income (and don’t forget to include the property taxes on your house). If you’re significantly above 30% I recommend you seriously reconsider your motives in having such an expensive place relative to your income (learn more about the true cost of houses).
For all other fixed expenses, you need to answer the following two questions:
- Do I really need this on a recurring basis?
- Am I positive I’m getting the best deal?
If you hesitated on either of these questions, make sure to read my post on lowering your fixed expenses.
4. Always pay your credit card in full every cycle, never (EVER!) let interest accrue
If you are ever in doubt about whether you will be able to pay for something, do not purchase it. There’s nothing more detrimental to wealth creation then high interest rates and bad credit. If you currently have credit card debt, there are a number of steps you can take to get on a path to financial security.
There are two common misconceptions people have when it comes to investing (and sadly both are kept alive by the financial services industry).
- Think they’re smart enough to beat “the market”
- Think they have to pay someone (a lot) to manage their money
Let’s start with the first one and the first rule of investing.
1. Never trade individual stocks – the person on the other side is more knowledgeable than you.
When most average people go about investing in the stock market they do so with this general mindset – “All I have to do is find the next trend and invest in that company and I’ll make a lot of money”. Although this mindset isn’t necessarily wrong, it’s just nearly impossible to do so on a repeatable basis. Literally tens of hundreds of academic research papers have been published that analyze the historical performance of all types of investors – from elite hedge fund and mutual fund managers to individual investors – and the reports consistently conclude that only a tiny (and I mean tiny) percentage are able to outperform the market on a risk adjusted basis.
To understand why this is the case, it’s helpful to go through an example. Let’s say you’ve recently been reading articles on how 3D printers are going to take over manufacturing and a few friends say they just bought stock in called 3D Systems (DDD). So you decide to invest as well.
Now let’s consider the opposite side of the equation, the person (or more than likely professional investment firm) you’re likely buying the stocks from, let’s call them Ultra-Capital. As with most professional investors, Ultra-Capital has a large staff of analysts whose sole job is to dig through DDD’s public filings, analyze its financial statements, compute its liquidity metrics, monitor its debt solvency, and memorize every little thing about the company. Additionally, Ultra-Capital’s analysts have made hundreds of calls and site visits to DDD’s suppliers, customers, and, employees, asking how their products compare to other companies in the industry. And to top it all off, Ultra-Capital has consulted with two Nobel Laureates in the field of mechanical engineering to explain where they think the 3D printing industry is heading.
Are you sure you want to be on the other side of the trade as Ultra-Capital?
2. Invest in low-cost Exchange traded funds, ones with expense ratios below 0.15%
There are two types of investors: active and passive. Active investors are trying to actively beat the market, which you can think of as the S&P 500 or Dow Jones indexes, and passive investors are purely tracking the market and matching its performance. As I mentioned above, there’s been hundreds of research papers that show that almost no one is able to actively beat the market on a repeatable basis. Additionally, when you take into account the fees these active investors charge, typically upwards of 1-2%, an even smaller number is able to outperform the market.
Given that fact, you should always invest passively and the best way to do so is with an Exchange Traded Fund (ETF). An ETF’s sole designed purpose is to track, and track very closely, indexes like the S&P 500 and almost any other index you want. The biggest benefit of ETFs over other investment vehicles, like mutual funds, is that they typically have very low expense ratios in the realm of 0.04% - 0.30%. As you can see in Figure X showing the returns of a $10,000 investment with a 6% return and two different expense ratios, a high expense ratio will significantly lower your returns over the long run.
If you don’t already have an investment account, I recommend signing up for a Vanguard account as it has some of the lowest expense ratio ETFs and you are allowed unlimited trades of Vanguard ETFs. Lastly, if you are looking for the best ETF to start with, I always recommend the Vanguard Total Stock market ETF (VTI) and the Vanguard FTSE All-World ex-US ETF (VEU), which are two broad based ETFs with very low expense ratios.