How much should I spend on rent? On food? What the #$% is a 401(k)?
Money doesn’t buy happiness, but it does buy an eccentric imagination and a great legal team to significantly improve your odds of not getting arrested for pursuing it. Read on as I demystify the ridiculously complicated world of personal finance and get you on a path to stockpiling cash.
Disclaimer: I am not a financial advisor, and my lawyers don’t have my forwarding address in Argentina, anyways. Also, I wrote this post on my iPhone while traveling on a 35 hour bus ride to see the glaciers in Patagonia – please excuse any rambling.
For most of my life, I’ve based my investment strategy on a time-tested, ancient wisdom: “a bird in the hand is worth two in the bush.” What the hell did I want to save money for? I figured that I would make more money each year, so saving money at a young age seemed silly – even $50-100 a month as a teenager amounts to a significant portion of your income. The impact on my buying power (measured in video games, pizza, and bee…uh, soda) would have been intolerable.
I had a girlfriend who – from age 16 – put every spare cent into her retirement account. She had to budget her spending in order to put that money away. Budgeting, to me,
was is an insane concept – a sort of self-limiting/self-loathing behavior practiced by people who hate fun (she’s probably retired and sipping champagne in Monaco by now – and having plenty of fun).
I decided that I would start saving when I was older. I could invest a smaller percentage of my income because I would be earning a lot more. Of course, when I got older, I reasoned that – as an entrepreneur – I could realize a greater return on my investment by investing in my own company vs. investing in stocks or bonds for companies managed by some idiot cubicle slave on Wall Street.
At age 25 – with no savings whatsoever – I came to three important realizations:
1. I will inevitably spend any easily-accessible (i.e. “liquid”) asset that I have within reach. Because I am very confident that I will continue to be successful, I will never plan for a rainy day. Each year, I plan to make more money than I did the previous – I’m an optimist to a fault, and, as a result, I spent every cent I had.
2. If money gets siphoned off automatically, I’ll never miss it. I didn’t budget myself – I just spent everything that was in my account. If I invested $100 per week automatically, I wouldn’t go hungry or stop having fun – I’d never notice at all.
There are thousands of books on personal finance – how to cut spending, budget yourself, where to invest, how to pick stocks, etc. It’s overwhelming – a phenomenon called “analysis paralysis” – there are so many choices, you end up doing nothing at all.
I’ve laid out below the step-by-step plan I’ve implemented to start saving cash. I devised the plan by listening to some very smart people, including a book called I Will Teach You To Be Rich (which, despite the infomercial/get-rich-quick-scheme name, provides some practical financial advice to people who can’t be bothered to spend a lifetime picking the perfect strategy).
Before we start building up your coffers, one quick order of business: statistically, most of you won’t finish reading this post. At least help your Facebook friends get out of debt by sharing this post now.
Condensed Plan to Get Rich
1. Figure out how much you’re making per month after taxes. If you get a paycheck, that’s the total amount your company deposits into your bank account per month. Be sure to add back anything that is optionally deducted from your paycheck (401(k), medical insurance, etc).
2. Make sure you are spending no more than 60% of that amount on “fixed expenses” – rent, utilities, student loan payments, credit card minimum payments (if you’re paying more than the minimum, just write down the minimum towards the 60% for now), cell phone, medical insurance, car payment, internet, groceries, gym membership – anything recurring. If you’re spending more than 60%, get a cheaper apartment, cheaper car, etc. This is really important – more than 60% is unsustainable.
For flexible, “guilt-free spending,” allocate 25% of your take-home income as an allowance. This includes going out for dinner, drinking, etc.
How To Pay Bills
If you have no credit card debt, autopay all “fixed/recurring” bills possible with your credit card. Pay all “guilt-free” spending possible with a credit card. This helps build credit and reward points.
If you have credit card debt, set up your “fixed” bills on autopay with a debit card or checking account. Withdraw your 25% allowance in cash each week to control spending.
3. If your employer offers a matching 401(k) program, contribute just enough to get 100% of your employer’s match. For example, some companies offer a 100% match up to 5% of your salary. This means that they will match your contribution up to a certain point – if you make $100k per year and you contribute $5,000 to your 401(k), your employer will kick in an extra $5,000.
Investment Guidelines for 401(k) Plans
Companies that offer 401(k) plans give you a few choices, ranging from aggressive to conservative. Aggressive means it’s mostly made up of stocks, conservative is mostly bonds. If you’re young, go aggressive. This may sound scary/risky, but the risk is that stocks are more volatile – you are hedged against this risk because you have a lot of time before you take your money out. Temporary stock plunges won’t affect you, and stocks historically offer the best returns.
4. Sign up for a Schwab High Yield Investor Checking Account (free). Don’t let the word “investor” scare you. There are no fees, plus they reimburse you for any out of network ATM fees (awesome). I recommend depositing your paycheck directly in here. While you’re at it, sign up for their High Yield Investor Savings Account and a Roth IRA account. All of them are free.
Note: if you have no debt, skip to step 7, and ps – you’re awesome
5. If you have credit card or student loan debts (higher than 4-5% interest), schedule automatic minimum payments for all of them from your Schwab checking account. For the card or loan with the highest interest rate (APR), pay every cent you can. So, you’re spending 60% of your take home money on fixed costs, 25% on guilt-free spending – that means 15% of your income should be going towards paying off your debt.
6. If you pay a card off completely, schedule a small, recurring charge on the account – like Netflix – to make sure the credit card company doesn’t close your account. You want the account to stay open because it helps your credit score to have available credit.
For low-interest student loans – say, 2-3% – pay just the minimum payment for now.
7. Schedule an automatic transfer from your Schwab checking account to your Schwab Savings account – it should be for 10% of your Step 1 income. This is your short-term savings fund for stuff like a car, new TV, wedding, or presents for me.
8. If you still have money left over, schedule automatic monthly transfers from your Schwab checking to your Schwab IRA – as much as you can afford, or up to the maximum.
Investment Guidelines for Your Roth IRA
Very simple: buy a Vanguard Lifecycle Fund. You choose it by your target retirement date. If I’m planning on retiring at 65, I’ll choose the 2050 fund – symbol VFIFX. This fund automatically adjusts investments based on your age, and they only charge a 0.19% fee – the fund is managed by a computer (free labor) whereas a typical mutual fund manager earns millions of dollars (and typically doesn’t beat the market!). This fund requires a $3,000 investment.
9. If you still have extra income, contribute as much as possible to your employer 401(k). The current limit is $17,000.
10. If you STILL have money left over, pay off your low-interest student loans or open a regular investment account and put it in there. Or, give some money to charity, Scrooge.
Until the next time – un abrazo fuerte, my friends.
One trick here as an employer and employee is to max out the 401k offerings on both sides to get the maximum tax breaks.
Thanks for this! It has been a great help for me as I prepare for a new job. I was wondering what part of the allocation the 10% for savings comes from (step 7)? You have 60% fixed expenses, 25% allowance, and 15% debt…that’s 100%. Should you take the 10% out after calculating taxes but before calculating monthly expenses?
You should only start a savings fund after you pay off your debt. Paying off high-interest debt is the #1 priority.
You know, i think you might enjoy Daniel Kahneman’s Thinking, Fast and Slow. The man received a Nobel prize in Economics, but this book is more psychological than economic. It’s about all the systematic errors our minds are prone to make (and there’s quite a lot of them). I’m reading it right now and some of your posts make me feel like it’s the kind of book that would fit your interests.
Thanks – I’ll definitely check that out!