1) Take advantage of any employer matching and any tax shelters. These are the only places in all of finance where you will ever find a sure source of free money.
2) Build a reserve fund of liquid and stable assets, sufficient for 3-6 months unavoidable expenses. Nothing exotic here—bank accounts, money market funds, or conservative mutual funds. This is for covering you if you lose your job, if your furnace breaks and needs replacing in January, or the like.
3) Invest a substantial proportion of your income, like 10-15%, unless you’re truly destitute. If you’re not, there are people who are living just fine on 85-90% of your current income, so live like them. You can count a proper pension against that number, but I mean this should be over and above government pension taxes. Most national pension schemes are primed for detonation not long after the Boomers retire, and for the same reason I expect significant reductions in growth rates over the long term. You’re not going to be able to do what someone who retired in 1997 could do of just saving a big chunk after their kids graduated school and wind up with a giant nest egg from 20%+ growth every year, we’re going to have to work for our retirement. It’s much easier to get used to living on 90% of your income now than it is to have to live on 40% of it when you’re too old to work. And this should go without saying, but you actually need to live within your means on the other 85-90% - don’t go earning $50k, spending $50k, and saving $7k on top of that, or you’ll wind up in Consumer Debt Hell.
4) Get disability insurance unless either your income is so low that it could be replaced by government benefits if you were unable to work, or you have good coverage from work(If you have mediocre coverage, top-up plans are fairly cheap). If you have dependants(including a partner), get term life insurance to replace your contributions to the household as well, plus a proper will and power of attorney. Other forms of insurance(critical illness, long-term care, whole life, child life, etc.) are luxuries, but those two are both very important.
5) Match your assets to your liabilities. If you’re saving for a house next year, keep it in low-risk investments, and try to minimize up-front costs(or back-end costs) while worrying less about ongoing costs. If you’re saving for retirement in 2057, invest riskier, and worry less about short-term fees but more about higher ongoing costs.
6) Try to diversify your portfolio as much as you reasonably can—index funds are a classic choice for doing so cheaply, but they’re not perfect. Remember that “your portfolio” doesn’t just include things where you get a quarterly report in the mail, it also includes things like your house and your career—don’t be one of those Enron employees who lost both their job and their pension when the company tanked. Likewise, if you rent an apartment then a real estate investment may be much more suitable for you than it would be for a homeowner who already has the bulk of his net worth tied up in a real estate investment. Remember also that one stock index is not full diversification—the world is bigger than the S+P 500. Get some of your money overseas, and don’t be afraid to put a bit into things like small-cap, emerging markets, commercial real estate, and commodities.
7) Know your risk tolerance, and invest accordingly. If you’re the sort of person who will pull their money out when its value tanks, you shouldn’t be in anything volatile—people like that lost their shirts in 2008-09, while the more placid investors made their money back pretty easily. If you can’t handle a 30% drop, find an investment that won’t lose 30%. Fortunately, this is pretty easy right now, because we have a very nice stress test of investment performance that’s recent enough that it still shows up on performance charts. If you’re a conservative investor, take a look at your investment’s performance in 2008, and make sure you could handle seeing that on your next quarterly statement without panicking.
8) Don’t be afraid to find an expert to help you. Some people treat finance as a hobby and do just fine, but if you’re not one of those you can sometimes be stunned by how much money you’ve left on the table. As an example, a guy at my office spoke to a business owner the other day with two teenage kids. Told him to bring the kids on as employees for $10k/year, to get money out of the corporation virtually tax-free instead of taking it as personal salary and paying taxes at his(very high) rate. Saved him $9k per year that he didn’t even know could be on the table with a sentence. I may be biased here, but I think I’m worth what I get paid, and most of my clients agree.
Obviously, these rules are not absolutes. For example, both employer matching and tax shelters often come with restrictions that may make them undesirable. But if you follow those rules, you’ll be doing personal finance better than 90% of people.
Follow-up questions. If one uses a spreadsheet and basic math, one concludes that one should pay off debt before starting to save, because debt is usually at a higher interest rate than savings. However, one frequently hears that one should not in fact do this; rather, that one should always be saving. It’s frustrating, because I can show you exactly how much money I’m burning in interest payments by following this advice. Can you justify or possibly refute this oft repeated wisdom?
There’s a couple circumstances where having both loans and savings makes sense. One, emergency fund—if you have a $3000 problem with your car, you can’t pay your mechanic with your lack of a mortgage, you need cash. Having to go get a loan at that point isn’t really practical. If you have revolving credit(credit card/line of credit) then you can use that, but a traditional loan that goes away when it’s paid off is no good.
The second case is leverage loans. When you borrow for business purposes, the interest can be used as a tax deduction(in most countries, consult local tax advice before trying to do this). Depending how you invest, you can get tax-advantaged returns in the form of dividends and/or capital gains, whereas the loan is a tax deduction at ordinary income tax rates. In Canada, capital gains are taxed at half the normal rates, so if you borrow at 4% and earn 6% of capital gains, you’re getting a deduction of 4% of the loan but only paying tax on 3%, so you pocket a net tax deduction of 1% of the loan size, on top of earning a spread of 2%. All this without putting any of your own money in. That said, this is a higher-risk strategy, because if you lose money you still need to pay back the loan, so it’s not for everyone.
The third reason is psychological. Some people believe that you should make a habit of savings. Depending on who you are personally, it may be a decent tactic.
How should I, a normal person, invest my earnings?
My rules, in rough order of priority:
1) Take advantage of any employer matching and any tax shelters. These are the only places in all of finance where you will ever find a sure source of free money.
2) Build a reserve fund of liquid and stable assets, sufficient for 3-6 months unavoidable expenses. Nothing exotic here—bank accounts, money market funds, or conservative mutual funds. This is for covering you if you lose your job, if your furnace breaks and needs replacing in January, or the like.
3) Invest a substantial proportion of your income, like 10-15%, unless you’re truly destitute. If you’re not, there are people who are living just fine on 85-90% of your current income, so live like them. You can count a proper pension against that number, but I mean this should be over and above government pension taxes. Most national pension schemes are primed for detonation not long after the Boomers retire, and for the same reason I expect significant reductions in growth rates over the long term. You’re not going to be able to do what someone who retired in 1997 could do of just saving a big chunk after their kids graduated school and wind up with a giant nest egg from 20%+ growth every year, we’re going to have to work for our retirement. It’s much easier to get used to living on 90% of your income now than it is to have to live on 40% of it when you’re too old to work. And this should go without saying, but you actually need to live within your means on the other 85-90% - don’t go earning $50k, spending $50k, and saving $7k on top of that, or you’ll wind up in Consumer Debt Hell.
4) Get disability insurance unless either your income is so low that it could be replaced by government benefits if you were unable to work, or you have good coverage from work(If you have mediocre coverage, top-up plans are fairly cheap). If you have dependants(including a partner), get term life insurance to replace your contributions to the household as well, plus a proper will and power of attorney. Other forms of insurance(critical illness, long-term care, whole life, child life, etc.) are luxuries, but those two are both very important.
5) Match your assets to your liabilities. If you’re saving for a house next year, keep it in low-risk investments, and try to minimize up-front costs(or back-end costs) while worrying less about ongoing costs. If you’re saving for retirement in 2057, invest riskier, and worry less about short-term fees but more about higher ongoing costs.
6) Try to diversify your portfolio as much as you reasonably can—index funds are a classic choice for doing so cheaply, but they’re not perfect. Remember that “your portfolio” doesn’t just include things where you get a quarterly report in the mail, it also includes things like your house and your career—don’t be one of those Enron employees who lost both their job and their pension when the company tanked. Likewise, if you rent an apartment then a real estate investment may be much more suitable for you than it would be for a homeowner who already has the bulk of his net worth tied up in a real estate investment. Remember also that one stock index is not full diversification—the world is bigger than the S+P 500. Get some of your money overseas, and don’t be afraid to put a bit into things like small-cap, emerging markets, commercial real estate, and commodities.
7) Know your risk tolerance, and invest accordingly. If you’re the sort of person who will pull their money out when its value tanks, you shouldn’t be in anything volatile—people like that lost their shirts in 2008-09, while the more placid investors made their money back pretty easily. If you can’t handle a 30% drop, find an investment that won’t lose 30%. Fortunately, this is pretty easy right now, because we have a very nice stress test of investment performance that’s recent enough that it still shows up on performance charts. If you’re a conservative investor, take a look at your investment’s performance in 2008, and make sure you could handle seeing that on your next quarterly statement without panicking.
8) Don’t be afraid to find an expert to help you. Some people treat finance as a hobby and do just fine, but if you’re not one of those you can sometimes be stunned by how much money you’ve left on the table. As an example, a guy at my office spoke to a business owner the other day with two teenage kids. Told him to bring the kids on as employees for $10k/year, to get money out of the corporation virtually tax-free instead of taking it as personal salary and paying taxes at his(very high) rate. Saved him $9k per year that he didn’t even know could be on the table with a sentence. I may be biased here, but I think I’m worth what I get paid, and most of my clients agree.
Obviously, these rules are not absolutes. For example, both employer matching and tax shelters often come with restrictions that may make them undesirable. But if you follow those rules, you’ll be doing personal finance better than 90% of people.
Follow-up questions. If one uses a spreadsheet and basic math, one concludes that one should pay off debt before starting to save, because debt is usually at a higher interest rate than savings. However, one frequently hears that one should not in fact do this; rather, that one should always be saving. It’s frustrating, because I can show you exactly how much money I’m burning in interest payments by following this advice. Can you justify or possibly refute this oft repeated wisdom?
There’s a couple circumstances where having both loans and savings makes sense. One, emergency fund—if you have a $3000 problem with your car, you can’t pay your mechanic with your lack of a mortgage, you need cash. Having to go get a loan at that point isn’t really practical. If you have revolving credit(credit card/line of credit) then you can use that, but a traditional loan that goes away when it’s paid off is no good.
The second case is leverage loans. When you borrow for business purposes, the interest can be used as a tax deduction(in most countries, consult local tax advice before trying to do this). Depending how you invest, you can get tax-advantaged returns in the form of dividends and/or capital gains, whereas the loan is a tax deduction at ordinary income tax rates. In Canada, capital gains are taxed at half the normal rates, so if you borrow at 4% and earn 6% of capital gains, you’re getting a deduction of 4% of the loan but only paying tax on 3%, so you pocket a net tax deduction of 1% of the loan size, on top of earning a spread of 2%. All this without putting any of your own money in. That said, this is a higher-risk strategy, because if you lose money you still need to pay back the loan, so it’s not for everyone.
The third reason is psychological. Some people believe that you should make a habit of savings. Depending on who you are personally, it may be a decent tactic.