How to manage your money (revisited)

July 30, 2016

Background
Been thinking about this topic recently and wanted to share my thoughts with you.

I’ve spent my whole adult life reading & learning about money. It’s an obsessive hobby of mine. Attribute it to a personality quirk, a deep desire for financial freedom, or to having mercury conjunct mars in my 2nd house of finances. If you want to go that route.

So these things are like second nature to me because I love the subject so much, but I still run into family, friends and strangers who do not follow the basic money principles. It drives me nuts!
 
 
 
The short answer:
Of all the things I’ve ever read, I like the Dave Ramsey system for personal finance.

His book The Total Money Makeover has the basic 7 Baby Steps that should be required reading for all humans.
 
 
 
The long answer:
First we need to answer the basic question…

Why should we invest at all?
Inflation.

If you do nothing, you will lose between 1-4% of your money every year to inflation. The way that affects us in reality is that things cost more every year. That’s guaranteed to happen.

So if your salary stays the same every year or even goes up 2%, but inflation is 4%, you’re on the losing end.

Thus it’s best to have our money do some work, rather that sit around.

Where should we invest?
There are a million places to invest.
Stocks, bonds, gold, real estate, your friend’s new restaurant.

The basic universally accepted idea is to invest in the stock market.
You can pick your own stocks (riskier) or invest in a mutual fund (safer).

An even more refined approach is to invest in index funds rather than normal mutual funds. That’s because in the long term, index funds (with super low fees) perform better than mutual funds (higher fees eat up returns).

The most common method is to invest in the Vanguard S&P 500 index fund. If you do only that, never touch that money, and resist the urge to look at it every day, you will be very happy in the end.

How much should we invest?
You need to pick a formula that works for you.

Dave Ramsey recommends living on 85% and investing 15%.
Once you’re wealthy, retired, kids’ education paid for, no outstanding debt, he recommends having fun giving your money away to worthy causes.

Jim Rohn recommends living on 70%, investing 20%, and giving away 10% to charity.

I have in the past invested 20-30% of my income and lived on 70-80%.
This was when I was making good money. When I had super low income, I simply put whatever I could into the market, even if that was $50 a month.

So even if your formula is 99% to live and 1% to invest, that’s a good start. Cultivating the habit is more important in the beginning that the quantity.

How to spread your investment risk?
This depends on many factors like age and risk tolerance.

The basic idea is to invest a majority of your money into the stock market, and a smaller portion into the bond market. You can accomplish both through index funds.

As a general rule, the older you are and closer to retirement, the safer you want your investments. This is because at this stage of your life, you don’t have enough time in the future to make up for any wild stock market swings. Older folks are recommended to increase their bond investments and decrease stocks, though not mandatory.

One variable I had never thought of until I heard John Bogle, the father of index funds, is the idea of social security. If you’re to assume $350,000 as the total value of your social security benefits, you can reduce your bonds even lower.

A young person, on the other hand, can take more risk because you have a longer time span. Time is your friend. You can invest 100% into an S&P 500 index fund and do fine.

For example, Warren Buffett, after his death, has advised his wife (age 70) to put 90% into S&P 500 index fund and 10% into a short term government bond index fund. So you can see that Warren doesn’t like to play it too safe by having too many bonds.

How about investing in the foreign market?

Should you invest in three index funds? One for S&P 500, one for bonds, and another in an international index fund?

I had thought so until I heard John Bogle.
He mentions that is a bad idea.

First of all, large US companies are already international. They make 50% of their money overseas. I had never thought of that! So if you invest in S&P500, that’s like having 50% risk overseas.

Secondly, international funds are heavy on Japan, UK, etc. All countries that haven’t had robust markets. And if you invest in smaller countries, too much risk due to politics and bureaucracy.

How long should we invest?
As long as possible.
Buffett says his favorite holding period is forever.

Realistically, at least 5 years. 10yrs is even better. 50yrs is infinitely better. The longer you hold, the longer the power of compounding takes effect. You will benefit from all the dividends being reinvested, causing a snowball effect.

Also, if you sell your stocks less than a year after buying, your taxes will be much higher, depending on your tax rate. Could be as high as 39%.

If you hold over a year, they’ll be taxed as 15%.

Full disclosure, I’ve killed the golden goose two times in my life. I’ve fully cashed out my stocks to fund a small few month retirement from a crappy job after college. And most recently, I killed a fatter goose to fuel my current four year retirement. Not recommended for the faint of heart but that’s the way I like to live and I understand the main money principles. I want to experiment and see if I can make big money using spiritual principles, like I’ve read about.

On the positive side, I’m glad to have diligently invested all those years and had a stock market cushion, without which I couldn’t take the breaks I needed and would’ve been miserable! And I have zero credit card debt, zero student loans, zero mortgage, no kids, no wife, no car debt.

What about credit card debt, car & student loans?
Like Warren Buffett says, “I’ve seen more people fail because of liquor and leverage (debt)”.

Avoid credit cards like the plague.
Student loans are harder to avoid.
Car loan is optional but likely.

I’m with Dave Ramsey on how to handle this debt.
Pay off this debt first, starting with the smallest one, before investing in stock market.

This is because credit card debt can have rates of 18% or higher, while the stock market may only be returning 7-10% (before tax). It’s like picking up one dollar off the street, while you’re losing two dollars because of holes in your pocket. Fix the holes first!

Student loans, by comparison, range from 5-8%.
Car loans are usually 4-5%.
Pay em off before investing.

Vanguard S&P500 index fund is returning 7.61% over the past 10yrs, estimated 5.90% after tax.

What about mortgage debt?
Dave Ramsey recommends paying off your house as the final step, before giving your wealth away.

Have an emergency $1000 saved up first. Pay off your other debts. Build up a 3-6 month cash cushion in the bank. Invest 15% in the market. Save up for your kids’ college funds (not applicable to people who don’t want kids of course). Then pay off your house.

I agree.
Though as a general rule, I think paying your house off is super overrated. (I also think owning a home is super duper overrated.)

I always shake my head in disbelief at people paying off their mortgage faster than they need to. It makes no sense to me because you will never see that money ever again. Most people sell the house only to turn around and upgrade to a bigger one. So that cash is gone into another house.

The other times people sell houses are due to emergencies (death, divorce, taxes) or retirement and downgrading.

Current mortgage rates are 3.88%. It’s better to use those extra payments and invest in the stock market for higher compounded returns.

So, like Dave suggests, pay this off as the last thing you do with your money.

Index investing is boring though
Remember what Warren Buffet said to Jeff Bezos, when Bezos asked why no one copies Buffett’s model of making money. “Because no one wants to get rich slow.”

I also understand that we’re not robots.
If we were, it would be much easier to put 15% of our income into an S&P500 index fund, never take money out, never even look at the account until many decades later.

Patience and self discipline are hard things.

This problem is simple to solve.
Just set aside 5-10% (or whatever you want) of your investment money and invest into whatever you wish, knowing full well in advance that you may lose it all.

Let’s say you earn $75,000 per year.
15% of that is 11,250 per year.
Comes out to 937.50 per month that you will invest in an S&P 500 index fund.

From that, set aside maybe 93.50 (10%) or round up to $100 and buy individual stocks that you want.

Am I investing pre or post payroll taxes?
Ok, I know what you’re thinking.

Are we talkin pre or post?
Because $75,000 may be your annual salary but your take home pay is more like $56,250.

Should we calculate 15% of $75,000 or 15% of $56,250?

Well, this one’s up to you! Depends on your lifestyle.

Resources:
The 7 Baby Steps – Dave Ramsey


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