Understanding the basics of personal finance should not scare you. On the simplest level, it consists of three things: budgeting, saving, and investing.
Many get tripped up before they even begin. They think that they need to have or earn an arbitrary amount of money before they start or they think that investing is akin to gambling.
This couldn’t be further from the truth. Personal finance is for everyone and is even more important if you’re earning an average income. It affects your future and ability to retire with dignity.
Think of it like this. Budgeting is understanding your income and where it goes, savings is what is left over after you cover all of your living expenses, and investing is putting your money (savings) to work.
Personal Finance Basics: Budgeting
Starting a budget does not need to be complicated. All it is is understanding where your money goes.
I find that for budgeting, it is best to follow the KISS principle of design. It’s an acronym for “keep it simple, stupid”. The reason being is that the easier something is to follow, the easier it is to stay committed.
Step 1 – Define your budget’s goal
Do you want to save more, reduce your expenses or pay down debt? It should also align with your greater financial goals which you’ve defined in your financial plan.
My goal is simple. I set a certain goal for a percentage of income that I’d like to save and a certain percent that I’d like to use to pay down debt. I then allocate the remaining part of my income to my living expenses.
I put together a basic budget calculator that you can use to get an idea of what I am talking about.
Step 2 – Track your income
Tracking your income can be as simple as keeping all of your receipts for the month and recording them using pen and paper or as complex as setting up a spreadsheet. You can also use an app like Mint.
Mint is an expense and budget tracking app. It allows you to set a budget and track your expenses automatically. However, you still need to go into the app and categorize your expenses.
Step 3 – Review your spending habits
This sounds scarier than it is. All it means is that you should take a look at where you’re spending your money and look for expenses that you can reduce, or eliminate.
For example, maybe you have an unlimited cellphone plan but you only use 3GB per month. Cutting back your mobile plan so that you’re only paying for what you use is a great way to pick up a quick in the world of budgeting. There are services that you can use such as Ting or Google Fi.
It should be fairly easy to reduce your expenses by $50 / month, which over a year works out to $600. What could you do with an extra $600?
Step 4 – Revise as your goals change
Look, life isn’t a linear journey. Things change, we change. It’s important for your budget to also reflect this.
Maybe you’re planning to buy a house, want to get married, or had a kid (congrats!). Let your budget evolve with you.
Personal Finance Basics: Saving
Let’s define a few savings-related terms. The first is savings rate which is the total percentage of income that you save per month. Second is the “pay yourself first” method of saving. This entails treating your savings as you treat your other monthly bills.
If there is one thing that personal finance experts agree on, it is that the “pay yourself first” method grants the highest likelihood that you will be able to save consistently.
How much should you save? That all depends on the goals that you defined in your budget. If you are new to saving, then I suggest trying to automatically deposit 10% of your income into an account that you cannot easily access. This is the most basic implementation of the “pay yourself first” method.
If you get to the end of the month and you still have money left over, save it and increase the amount of money that you automatically deposit in your account. For example, if you save $200/mo and you get to the end of the month and still have $50 in your checking account, try automatically depositing $250 into your savings account.
Keep your saving process as simple as possible by automating everything. When something requires little to no willpower, the chance of success greatly increases.
Optimize your savings rate
The average millennial spends $478 per month on non-essential expenses. This alone gives plenty of room for optimizing your savings. This leaves a lot of room to boost your savings rate or pay down short-term high-interest debts like credit cards faster.
But please please please, don’t cut all of your non-essential expenses. You need to live a little too!
Let’s take a look at an example. Say you take two cups of coffee per day. One on your commute to work, and a second to relax in a coffee shop and read. Assume that each coffee costs $2.
Now, consider that you invest in what seems like an expensive $500 espresso machine to make your morning coffee at home. Considering that your coffee costs $2 at Starbucks, but only $0.25 to make yourself, you save $1.75 per day. That means it will take you 285 days to pay off your espresso machine ($500/$1.75). From then on it’s an extra $1.75 savings per day or $638 per year.
In an ideal situation, you should learn to treat each dollar as an investment. Every time you reach for your wallet, it is important to consider if it is the best investment you can make. You won’t put your wallet back every time, but it is important to think consciously about all of your financial decisions.
Personal Finance Basics: Investing
Before we get into investing, we need to briefly discuss a few important topics: compound interest, investing timeline, and the stock market.
This section will depend on your budgeting goals. Typically though, everyone should invest at least 10% of their income per year for retirement.
Compound interest
Warren Buffet, one of the greatest investors of all time coined the term that compound interest is the eighth wonder of the world. But what exactly is compound interest?
Compound interest is when you earn interest on an account balance, and then that interest earns interest.
Let’s look at a simple example. Let’s say you have $100 and put it into an account that earns 10% interest. After 1 year, you will have $110 — earning $10 of interest. In the second year, you will earn $11 of interest.
When you consistently invest over long periods, your account balance eventually reaches a point when compound interest grows your account more than you contribute.
Investing timeline
Investing timelines are used to determine what money you should invest and what money you should save in a low-risk account.
If you know that you will need the money within 5 years, save it in a low-risk cash account. If you know you will not need the money for 10+ years, invest it in the stock market. These are known as time horizons. The first is a short-term time horizon and the second is a long-term time horizon.
The reason you should pay attention to the time horizon is that the stock market goes through cycles known as bear markets and bull markets. In a bear market, stocks tend to decrease in value while in a bull market they tend to increase in value.
You might be thinking, why not invest in a bull market, and hold cash in a bear market? The answer to that is that it is impossible to predict when each will happen.
Some examples of things that you should always keep in low-risk accounts are savings for a down payment on a house or an emergency fund while retirement accounts should be kept in stocks and other investments that have higher growth potential.
The stock market
You may hear about the stock market on the news almost daily. Most commonly, the “stock market” is used to refer to indexes such as the S&P 500 or the Dow. These indexes contain only a small portion of available stocks. A stock also called a share, is a very small piece of a company that you can buy.
As a shareholder, you buy a stock in hopes that it will increase in value.
If you recall compound interest, this is where it comes into play. The S&P 500 has returned on average, 7% per year over its lifetime. However, this varies widely throughout bull and bear cycles.
For novice investors, it is advised to avoid individual stocks altogether and stick with funds known as ETFs that track indexes such as the S&P 500.
Some of the best to get started with are S&P 500 ETFs such as the Vanguard 500 Index Fund Investor Shares (VFINX), Fidelity 500 Index Fund(FXAIX), or Schwab S&P 500 Index Fund(SWPPX). These are provided by three of the major brokers — Vanguard, Fidelity, and Charles Schwab.
Basic investing strategy
Now that you understand the basics of the stock market, we will go through a basic strategy known as dollar-cost averaging.
Dollar-cost averaging is when you buy a stock consistently over time. This is a good thing because it reduces the odds that you invest all of your money at the peak.
To take advantage of this strategy, you need to decide how often you plan to buy. Assuming that you deposit 10% of your income every month into an investment account, you can invest once a month, or spread it out further by buying once per week.
Typically investing once per month in the indexes is enough and that is the practice that I follow.
Let’s review
That’s it, I hope you’ve enjoyed this brief introduction to the basics of personal finance. Just to review, the three most important things for building a stable financial future are having a plan and a budget to save and invest for your future.