No matter how much money we make, we always want more. If you ask someone who makes $50,000 a year how much is “enough”, they’ll say $75,000 per year. If you ask someone who makes $75,000 per year how much is “enough”, they’ll say $100,000 per year. What about a person who makes $1 million per year? “Well, $2 million per year seems just enough to live on.”
The goal of personal finance is to get our money to work for us so we don’t have to work for it. If you make more money from your investments than you spend on your lifestyle, you’re financially free.
Financial advice is confusing and contradictory. One person says invest in index funds, another says buy real estate. One person says don’t buy “fads”, another says invest in Bitcoin now because it’s the future and you don’t want to get left behind.
Then, our minds go haywire when we hear about someone making a ton of money speculating, also knowns as getting lucky. I heard once, I believe from author and hedge fund manager, Joel Greenblatt, the saying, “If you light a match and run through a dynamite factory, you might survive, but you’re still an idiot.”
What we don’t hear about are all the people who lost money with similar speculations. Our hard-wired availability bias results in us thinking about only the person we heard who made a bunch of money. Maybe I should try putting money in that too?
Most people who give financial advice want something from you. Some want to charge you fees for advice or fees for investing your money. Some want you to give them some of your hard-earned money so they try to make money off it without risking their own money. The more money you make, the more attractive you are to these “professional” financiers.
Because of the confusing nature of financial advice and the extreme, potentially harmful incentives offered by money managers, I’ve developed a list of financial rules. My goals are to build wealth over the long-term, make more from my investments than I spend on my lifestyle, and sleep well at night. These rules work whether you earn $20,000 per year, $200,000 per year, or $2 million per year. I believe the sooner you apply these rules, the better off you’ll be.
Rule #1: Save 25% of your pre-tax income, or better.
If your lifestyle costs you 100% of what you make, you will have to work forever. If your lifestyle costs you 0% of what you make, you can retire right now because your lifestyle is free. The right amount of savings lies somewhere between these two extremes.
The most important rule of personal finance is to spend less than you make. Let your lifestyle scale with your income. Don’t try to force your income to scale with your lifestyle.
If you make $50,000 per year, live like a person who makes $50,000 per year. If you make $100,000 per year, don’t try to live like someone who makes $1 million per year. No matter how much money you make, you’ll always want more. Save at least 25% now and only increase the amount you spend when you make more money.
Rule #2: Avoid debt.
MIT determined people are willing to pay up to 100% more for the same product when paying with credit (debt) instead of cash. I prefer zero debt. No mortgage, no car loan, no business loans. I even prefer no personal credit cards and went ten years without one. Paying cash makes you more careful with your money.
If you can’t comfortably afford to pay cash for something, wait until you can.
Rule #3: Don’t buy something you can’t handle selling at a 50% loss.
Optimism and excitement hijack rational thinking when we’re excited about buying something. Is the real estate market up 50% in the last two years (like in my hometown of Austin) and you’re excitedly bidding against 50 other people for the same house at the top of your budget? Don’t think, “Ah, but it will keep going up, right?” Maybe. But, what happens if it doesn’t?
If you can’t stomach or financially survive a 50% loss on anything you buy, don’t buy it. Wait. Or, get something cheaper. The way to accumulate wealth reliably over the long term is through survival, not swinging for the fences. If you get wiped out financially trying to make an extra $100,000 on a house, or any investment, you may never recover financially because you may never recover psychologically from the loss. Stay in the game. Invest safely and carefully.
I once lost $50,000 on a sports car in six months. I bought it and quickly decided I didn’t like how much attention it brought to me. I went to sell it and learned an important lesson: It’s easy to buy expensive things (they literally let me drive away with this $190,000 car with a personal check in my twenties); it’s much harder to sell expensive things back if you don’t want them. I took a $50,000 hit getting rid of it. Had I thought about that potential loss beforehand, I might have rented a similar car for a few months instead. Forcing ourselves to think about the thing we want to buy declining in value by 50% or more, which is possible for almost anything, makes us more cautious with our spending.
Now, imagine that house you want to buy for $750,000 declining in value by 50% to $375,000 in two years. Are you willing to stay in that house, paying the mortgage (if you have one – see rule #2), for ten years or more until the property appreciates back to its original value? If not, rent or buy a cheaper place.
Rule #4: Keep six months of living expenses in cash.
If you’re 100% invested in your business, stocks, or your house, what happens if you need $10,000 or $100,000 in a pinch for an emergency? You’ll be forced to sell assets, potentially at a terrible time. We need a buffer.
By building a financial cushion, we give ourselves room to let our investments appreciate. We also create space between our biological impulses wired for survival and our rational thinking. Good financial decisions require rational thinking. If you’re down to your last dollar, you’ll do almost anything to survive financially. Those decisions might cost you for the rest of your life.
Rule #5: Start investing immediately, mostly in a S&P 500 index fund.
The best time to start investing is now. Even if you only have $10, get that $10 working for you immediately. I don’t claim to be a personal finance expert, but almost no matter what your situation is, I’d start putting money to work today. Pay down debt (rule #2) and build your cash reserve (rule #4). At the same time, start investing a portion of your money. The easiest way is to set up an online brokerage account and put money into a basic S&P 500 index fund such as Vanguard’s VFIAX.
I like to treat my index fund investments as a one-way street. Once money goes in, it doesn’t come out. It’s not available to spend. It’s not available for other investments. It’s there to accumulate and work for me. Your invested money is your ticket to freedom.
I’ve not followed my own advice at times and it was always a bad idea. I took a chunk of my money out of index funds toward the end of 2019 because I thought the market was overvalued. The market tanked after the start of the COVID-19 pandemic (a house of cards falls fast with the slightest breeze). Then the market rallied for two years straight. In hindsight, I likely should have just kept my money invested in the one way street and never touched it.
Saving for retirement always seemed boring and impossibly slow to me. “You’re telling me I have to save 10% of my income for 40 years and then MAYBE I get to retire and enjoy life for another 30 years until I die?” Not super exciting to me. However, there’s a different formula for you to consider that makes the proposition of saving and investing a significant portion of your income a lot more exciting. It’s called the 4% rule.
Some people debate the rule. Some say it’s too conservative. Others say it’s not conservative enough. Regardless, the premise is if you save enough money and put that money to work in reasonably safe investments such as an S&P 500 index fund, and maybe a portion in government bonds, you’ll be able to pay yourself a portion of that money for the rest of your life. One study determined you can live off 4% of your invested money safely.
This is possible due to the dividends paid via ownership of an index fund and the long-term appreciation expectation. Historically, the S&P 500 has delivered about 7.5% after tax per year.
If you save and invest one million dollars, you can pay yourself $40,000 (4%) per year for likely the rest of your life. Save and invest two million dollars, you get an $80,000 per year lifestyle. Now we’re talking!
Make more income? Achieve financial freedom faster. Save more money? Get there even faster. Live a less expensive lifestyle? Freedom is just around the corner!
The sooner you start investing, the sooner you get to your goal of financial freedom. Don’t wait for a “better time” to invest. That money will burn a hole in your pocket and might get wasted on lifestyle expenses or bad “investments” such as speculating on Bitcoin or overvalued stocks. Instead, get it working for you so one day you don’t have to work for it.
Rule #6: Don’t try to time the stock market. Keep your money invested no matter what.
If you make a wild, public stock market prediction and you’re right, you’re a genius. You get a book deal. You get featured on all the news publications. People want to know your prediction secrets.
If you make a wild, public stock market prediction and you’re wrong, nobody remembers. You sit low for a few months, then come back out with an even crazier prediction. Eventually, you’ll be right. With a million monkeys typing at computers for infinity, eventually one will produce the writing of Shakespeare. The price of being wrong is almost zero. Asymmetric risk at it’s finest.
This article reports a few of the many bad previous economic predictions. Jim Cramer, one of the most popular financial “experts” on TV, said to keep your money in Bear Stearns five days before it was sold at a 93% discount. One of the economic advisers to presidential candidate Mitt Romney, a long-time financial expert himself, thought the stock market would skyrocket to an extraordinary level right before it crashed in the early 2000s. The book, The 5 Mistakes Every Investor Makes, spends about two hundred pages mostly going through the incorrect predictions of so-called “experts” to drive one point home: nobody knows where the stock market is headed.
Prices will go up and down. That’s OK. Short-term volatility is not risk, permanent loss of capital is. All we should care about is long-term appreciation. Focus on the general direction over decades, not months or years.
Be boring with your investments (rule #5). Focus on following the six rules and bringing in more income. You’ll be wealthy and financially free before you know it.
I have nothing to sell you related to personal finance. I don’t want to be a personal finance guru. Yet, I’ve seen a lot of bad personal finance advice and want to try to steer you in the right direction.
My goal is to build a lifetime of low-stress wealth so I can remain financially free. I don’t want to have to make money. I imagine you don’t either. These six rules are what I follow. Use them as inspiration to create your own rules. Treat them as hypotheses to test and validate them for yourself. If you come up with something better, let me know.