Personal Finance Advise

A number of my younger friends have asked for advice regarding personal finance. This is an attempt to summarize what I know. If you want more in-depth information I would suggest checking out my goodreads "money” shelf.

People are more Important than Things: Don't Make Money an Idol

In the eternal calculus of life people are much more important that money or anything else we can possess. It's best to love people and use things, not the other way around. Money and possessions are good, a blessing, but it's very easy for us to develop an unhealthy relationship with money and possessions which turns something good into something destructive. Some "bible" preachers become confused and assume that being rich is somehow an indication of God's specific blessing and might even suggest that if you have enough faith, you will become rich. This is a great distortion of the Bible which often correlates material wealth with people who are against God. In the Bible, I Timothy 6:10 says "the love of money is the root of all sorts of evil."  Jesus told numerous parables about how people were lost by getting tied up with riches. I have seen first hand how when people turn their focus on the accumulation of wealth that their personal lives became much poorer and their character started to corrode.  Proverbs 30:8 is maybe the best short summary of the appropriate perspective for us to have, to be "neither poor nor rich."  If you would like to understand what the Bible teaches about money, I would highly recommend the book Jesus and Money by Ben Witherington III.

Our modern consumer culture encourages us to be dissatisfied with what we have, and to desire more rather than to be grateful. Yet, study after study has found that there is no correlation between money and happiness once someone is over the poverty line: enough money to have a safe place to live - space/warmth/security, food, to eat, and clothing to wear. What's more, it turns out that numerous experiments have repeatedly discovered that spending money on others produces more happiness than spending money on self.  It would be easy for an entire post to be on this topic… maybe I will write more later. 

Action:

• Looking at the philosophy of minimalism advocated by people like Joshua Becker of Becoming Minimalist blog who advocates clearing material clutter out of our lives so we can focus on what's truly important.

Make more than you Spend: Don't be a Debtor

You should never spend more than you earn. In general debt should be avoid, but especially unsecured debt such as credit cards. There are several reasons to in general avoid debt. First, is that being in debt means that we lose freedom and have obligations which  control us. This is why the Bible encourage us to avoid debt.  Romans 13:8 says "Owe nothing to anyone except to love one another". Second, being in debt carries a huge psychological weight that most people under-estimate. One of the more stressful times in my life was when I wasn't sure if I could sell the house I owned for as much as I owed on the mortgage. The day I sold the house and paid off the mortgage felt like one of the most liberating days in my life.

Often times people will go into debt because they are unwilling to wait until they have been able to save enough money to make an outright purchase. While there are times I think going into debt is a reasonable thing to do, such as taking a mortgage out on a piece of property where the mortgage is for less than the value of the property, I think people should be very careful in taking on debt. Another place that might make sense to take on some debt is to fund investments in the future such as education or starting a business. But even when there is good long-term value in the investments, care should be taken to minimize long-term debt and be sure that they long term returns are worth the debt.

Action

• Use debit cards rather than credit cards, or if you using credit cards pay them off each month.
• If you are in debt, the make the minimal payment on all accounts which you owe except the one with the highest interest rate. Pay off that debt as quickly as you can, and then move on to the next highest interest rate debt until you have cleared all your debts. If the interest rates are about the same, pay off the smallest debt, and then move to the next biggest to feel like you are making progress.
• Make a budget so can direct your money to where you want it to go rather than wonder where it went.

Be Generous, Remember that It’s All God’s

The Bible teaching that everything is God's, and that we are to be good stewarts of what He entrusts into our care. We should enjoy God's provision and take care of our needs, but we need to remember that it's not ours to waste, but rather to invest for good. The Bible calls for a 10% tithe to be given to do God’s work. The tithe was to be from our first fruits. In other words, that we don’t figure out what we need and give the leftovers to God, but that we set aside at least 10% for God, and live on what remains. 

Our spending and our sense of what is a need tends to increase as we have more money. In surveys done in the US, the number one reason for not giving more is because people felt they can’t afford to give more, yet the percent of income given by the very poor is more than 3 times the very rich.

Growing up, my family insisted that if we received a gift of money, that a small portion of it was set aside to be given to a charitable endeavor and some put into savings.  Later in life I was exposed to a variety of Christian teachers who advocated 10% of income should be given away, 10% saved, and the remaining 80% is what to live on. I think the 10/10/80 is a good starting point, though I think the percent giving and saving should increase as income rises. Ronald Sider in Rich Christians in an Age of Hunger makes a very compelling case for a graduated tithe. Rathar than a giving a percent of income, he encourages a mindset of stewardship: everything is God's. Rather than our income being "ours" to spend on ourselves, it is God's to be used for what is important to Him. Sider suggests that as our income grows above the poverty line, that an increasing large percentage should be given away.

I would agree with Sider that as our income increases we should spend a decreasing percentage on daily consumption, but beside giving money away, saving/investing for the future are also appropriate options. The money saved and invested is not necessarily for ourselves. Having money in savings allows us to response not just to un-expected personal needs, but also help out others.

Action

• If you aren’t giving 10% of your income away, I would strongly encourage you to make a plan (e.g. cut expenses) so you have money to give away.
• If you are giving away 10% consider adopting a  graduated tithe
• Consider opening a donor directed charitable giving fund such as Fidelity’s Giving Fund (Schwab and several other companies offer similar programs) This allows you to donate money at the time you received it (getting the tax benefit) but give money to an appropriate charity as you decide what is a worthy cause.

Saving for the Future: Don’t be Foolish

Life is filled with surprises. A wise person saves money to smooth over the difficult times. The Bible is filled with stories of how wise men saved during prosperous times which enabled them and their community to thrive when the days were more difficult. One of the most striking stories was how God used Joseph to save an entire region during an extended drought. 

While droughts don’t usually effect us as directly as they did Joseph, we have our modern challenges. Our transportation breaks down, a surprising health issue, a good friend in need. Having savings can allow us to raise to these sorts of challenges without falling into debt.

I think it’s very important to remember that what you are saving isn’t yours, it’s God’s. The money in your savings may very well be for your needs in a time of trouble, but it might also be for someone you come in contact with. By remembering that God provided the abidance that allowed you to save, you will avoid to  temptation to put your trust in the saving rather than in God.

Action

• If you have no savings, identify what expenses you can cut so you can set aside 10% of your income
• Set a saving goal. I would recommend at least $1000. Conventional wisdom suggests that you should have several months of your essential living expenses in savings
• Once you have several months of living expenses saved, work on long term investments discussed below.

Long Term Investments

I encourage everyone to start saving for the long term as soon as they are able. The longer you save, the more time your money has the opportunity to grow due to market gains and compounding interest.  Generally people split their long term investments between cash, bonds, stocks, property, and in some cases a business. The general rule of thumb is that the best long term returns come from the stock market, but the stock market has volitility than other options. In some locations, real estate has out performed stocks in the long term with less volatility, though other locations it's done much worse.

Long term investments can be used in several ways. The first is to retire. Many people think they will work until 65-70, and then retire to a life of leisure. I think it's more productive to think of retirement as moving to a stage of life where what we do isn't constrained by the need to produce income. It's good to "retire" as early as we can. Not to have a life of idle leisure, but so you are free to invest your time in things that are truly worthwhile without being constrained by what salary you might make.

How much should you save for retirement?  Conventional wisdom is the "4% rule". The simple form of this is multiply your yearly spend by 25 and that's roughly your target. You can reach financial independence more quickly if your lower your spend because this lets you save more money now and lowers the total amount of money you need to save. For example, if you switch from a 2 person cell plan of $85/month to a $45/month "budget" plan, you are not only able to put $480 dollars into your saving account each year, but you are reducing the amount you need to save by $25,000. Drop a 1 starbucks / day habit would reduce your total saving target by almost $27,000!! For more thoughts check out  Financial Samurai’s How much should my net-worth be based on income and  Mr Money Mustache website.

Retirement isn’t the only reason to make long term investments. Long term investments can also be used to start a business, launch a non profit organization, or become an endowment for a foundation.

I recommend using a passive investment strategy.  Many people think a more active management will result in better return.  Some people do a ton of research in the attempt to pick the very best stock. Other people outsource this work to a financial advisor they trust or a well respected mutual fund that is actively managed.  I would recommend not doing these things.  First, active management results in fees which eat into any gains you might have made.  More important, while many people can beat the general market over the short term, the book A Random Walk Down Wall Street documents there are only two big named investors who have beat the general market over the long term:  Warren Buffet and Peter Lynch. You are much more likely to win a large lottery than you are to beat the market over the long term. It's very possible to beat the market for a modest period of time, but in the end, the market will do better than whatever strategy that you choose.  That's because no one can successfully time the market.  People have a tendency to believe that they are able to choose when to buy and sell to maximize profits. The truism "Past performance is no guarantee of future returns" is critical. No one can predict the future and so you only think (incorrectly) that you know the best time to take an action. The final bit of advise I would give is to "keep disciplined".  Humans natural fears of lose often drive people to buy high and sell low.  They buy high because they see huge gains made by everyone else and they fear losing out and so invest just as an issue peaks.  Then the bubble bursts, the stock falls, and it looks like they are losing all sorts of money.  Eventually panic sets in and the stock is sold after it has lost value.  Investing in the stock market needs to be done for the long term. The market goes up and down over time, but it continues to gain value over time. It's best to put your money in, and then do your very best not to track the changes except for the purpose to rebalancing your investment allocation.

One of the simplest passive investment strategies is called the three fund portfolio. Originally developed by John Bogle who started Vanguard Group. Money is split between very low overhead index funds which track over overall US stock market, international stocks, and bonds. Given today’s global market, some people use just two fund, a US total index and a bond index fund.  A general rule of thumb seems to be the percent in the stocks should be 120 - your age.  So if you are 30, 90% should be in stocks, with just 10% in bonds / cash. Once every six months determine if your percent allocation (stock, bond, cash) is what you want and if not, do exchanges to get the ratio where you want if to be.  If you don’t own your home, you might what to consider a forth fund for your portfolio which tracks real estate. If you own a home this might not be necessary since many people have a significant portion of their net worth tide up in their home.

Action

• Identify your "retirement" (financial independence) target
• If your employer offers 401K or 403B plan, take advantage of the plan so long as their plan allows the money to be invested in low overhead index funds. If you can afford it, make the maximum tax deductible contribution.
• If you can afford to save more money contribute to a Roth-IRA or traditional-IRA if you qualify.
• If you already have long term investments which aren’t following a passive investment strategy, consider selling them and reinvesting into a passive investment portfolio

Insurance

The number one reason for families to final for bankruptcy, to be homeless, etc are medical debts. No one can predict medical health. Someone can be apparently completely healthy one day, and find themselves in the hospital racking up tens of thousands of dollars of expense each day. I think it is fairly irresponsible not to carry medical insurance in our current society. Often times people look for plans which have low deducible. While low deductible is nice, I generally encourage people to pay much close to attention to the catastrophic coverage and the medicine benefits. Whenever possible I encourage people to select plans which cover 100% of the expensive once a deductible is reached. With serious conditions, it is very possible to have $1M work of medical expenses in a year. A plan which coverless 80% of expenses come means $200k that is owned by an individual. I also encourage paying close attention to the medicine coverage because for most people, they spend more money on the medicines than on the doctor visits. Beyond medical insurance is home and auto insurance. Like medical insurance it's most important to protect yourself against what you can't afford. So if you are driving an old car you can afford to replace, it might make sense just to carry liability insurance.

Buy a House?

Part of the classic "American Dream" is owning one's own home. In the past, home ownership has been one of the most powerful ways for family to build wealth, but it's not a guarantee. Part of what fueled the mortgage crisis was people purchasing homes they couldn't afford assuming that the value of the house would continue to rise and that in the future they could re-finance based on the increased value of their home. Like all purchases, I think no one should purchase a home whose cost is more than they can afford.

There is often the question buy or rent. The first exercise I think everyone should do before answering this question is compare the cost of a home to the cost of renting.  The total cost of the house should be calculated (mortgage, property taxes, upkeep, insurance, deductible from taxes) and compare that to the he cost of renting something of equal size. In several markets, renting ends up being cheaper.

There are several reasons to consider renting rather than buying. The first is freedom. If you want to move there isn't the hassle of having to sell your home. Switching residence can be done more easily, be it to change the size, quality, or location. There have been a number of studies which have suggested that people who rent have actually been more financially successful because they have been more willing to move to advance their career. People who own their own homes tend to be much more reluctant to move. Another advantage of renting is that you are often freed from having to deal with many of the hassles associated with home ownership: the maintanance to counter the inevitable decay and breakdown experience by all physical objects.

There are several reasons it can make sense to purchase a home, even if renting a place is less expensive at the present time. First is that home ownership can be a hedge against inflation. In many markets, it is reasonable to assume the price of rents will continue to raise. If a home is purchased with a fixed mortgage the cost of the mortgage stays the same, even though the price of everything else is rising. A second on reason to purchase a home is to have the ability to have / create a space than meets your specific needs. Third, the home can be a leveraged investment if the value of the home grows more quickly than the mortgage interest. There have been several long term studies which suggest that homes tend to increase in value around the same rate as the stock market (faster in places like the SF Bay Area) while having the stability / safety of a classic bond.

Automate Your System

Tim Ferriss has a good guest blog post by Ramit Sethi about building an automated personal finance system. The punch line is that a without an automated system we are facing more financial decisions that we are able to process in a wise manner. Rather than having to face those decisions one at a time, we should put our finances on "automatic" as much as possible. The classic example of this is rather than each month deciding if / how much money to save, set-up an automate transfer into a saving account for some reason, set amount. You don't have to think about it, it just happens.