One podcast I frequently listen to is Tim Ferris. He always has interesting guests and he is a fantastic interviewer. One question that he often asks his guests is: if you could teach any class to eighth or ninth grade, what would it be and why. A lot of the highly successful, intelligent folks on the podcast suggest some self-actualizing topic like how to love yourself, or how to think abstractly. My answer to that questions is so much more practical, and so much more needed. I would teach personal finance.
Currently, I teach finance to adult learners in evening classes. The age range of these students is 25 to 60, and I am always surprised at how some of them have had no exposure to basic finance concepts like compound interest and risk vs. return. If I had my way, I would make personal finance a mandatory course for high school freshmen. You could squeeze it in between algebra and geometry.
Until such a time as my dream becomes reality, here are some simple rules of thumb that will do most of the heavy lifting in terms of your personal finances. Some of these are easier said than done, but you can use these as benchmarks to aim for.
1) Save 10% of your gross income for retirement.
Money for your child’s college education is not included in this amount. Neither is saving for a down payment on a house. This is strictly money that will be for lifestyle expenses in retirement. The personal savings rate average is currently around 5%, (which would include all forms of saving, including deferred spending) so most Americans are short of the target. Unfortunately, your ability to adhere to this strategy will go much farther toward you being able to retire than whether you invest in Coca-Cola or Pepsi. (Read this post for more information.)
2) Eliminate credit card debt
Having a car note or a mortgage is not a terrible thing. As long as you can easily make the payments, these forms of debt are usually low cost and can help build credit. Credit card debt is expensive and can be destructive. I personally use a credit card for most purchases (for two reasons, first to collect travel points and second, to guard against fraudulent charges…it’s not that a credit card will deter fraud, but I would rather be in a position to say I will not pay for a charge instead of fighting to get money back into my bank account), but it is imperative that you pay off the balance every month.
3) Keep 3 – 6 months’ worth of necessary expenses in your savings account. No more, no less.
This is your emergency fund. You should have this available in case you suddenly lose a source of income or have an emergency cash need. These days, with cash earning close to 0% in the bank, I recommend to keep the target amount closer to 3 months, with more of your after-tax savings going to short-term bonds which can at least earn some income.
4) Own a home instead of rent – RETRACTED!
It used to be common knowledge that in order to be financially responsible you had to own a home as opposed to renting. After the financial crisis, it was acknowledged that you do not have to own a home to be fiscally responsible. Renting can be a perfectly reasonable choice for many people out there. Purchasing a home gives you control and the potential (not the guarantee) of accruing equity, while renting gives you relief from maintenance responsibilities and offers flexibility (to pick up and move without having to unload a piece of real estate.) So this point needs to be updated to read, that you should rent or own depending on your personal specific preferences.
5) Insure against catastrophic risks.
There are three ways to deal with risk in your financial life. You can either avoid it, assume it, or insure against it. For instance, I avoid the risk of getting hurt on a motorcycle by not riding one (mostly just because my wife tells me no). I assume the risk of going to the doctor for common colds, flus, and injuries (due to my high deductible medical insurance) because it’s cheaper overall than trying to insure it. I insure against the risk of having to pay for a major surgery because I could not afford to pay that out of pocket. I have considered more comprehensive disability insurance than what is offered through my work policy, but have so far decided that the current cost is too high. If I were disabled in an accident I would just have to make do with less cash. That is a risk I am assuming at the moment.
Insurance is a tricky thing. Start with making sure you have enough life insurance to give any dependents a good head start if they have to deal with life without your contributions. You will have to work the rest out with a financial planner and/or an insurance agent. The rule of thumb is that you insure risks that are low probability, but potentially devastating in impact. Home insurance is a good example. The hope is that you never have to use it, but you will be very thankful indeed if your house burnt to the ground.
Conclusion
Good financial planning starts with common sense and prudent risk management. Spend less than you make, avoid high interest debt, and plan for worst case scenarios. The power of compound interest and understanding that you cannot get more return on your money without taking additional risk is something that people should be taught in high school. Even those people that do have a good grasp of personal finance could always do well with a refresher.
Until next time….
“Money can’t buy love, but it can improve your bargaining position” – Christopher Marlowe