I sat down to talk with a young couple with three kids about personal finance. This taxes me, because I’m not a financial planner. I can remember most but not all of the rules on the taxation of various investments.
But this is the way that I handled it:
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Do you have your risks covered?
- Life insurance on the husband, because the wife stays at home with the kids. Bright lady, highly employable, but she wants to raise the kids. Not enough insurance for this family.
- Disability insurance — covered by his employer.
- Health insurance — ditto.
- P&C insurance for cars and house — difficult to avoid, but wise to check.
Do you have a buffer built of 3-6 months of expenses?
Remember my stoplight rule:
- Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.
- 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
- More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.
When my friends asked me how to define a month of expenses, I said take half of your discretionary expenses over a year, add it to your non-discretionary expenses, and divide by 12. In this case, it revealed that they weren’t tracking their income and expenses, and so I suggested getting Quicken.
They need to build the buffer.
After the buffer comes expenditures that improve life, or reduce long-term costs. Use cash payment to get discounts.
After that, invest the excess. 50-50 stocks and bonds in index funds is an excellent start, with annual rebalancing. Or 25-25-25-25 cash-gold-stocks-bonds works really well across a wide number of economic environments.
The most important thing is to spend less than you earn, build the buffer, and then invest, or reduce debt, whichever is more promising. How you invest is secondary. The first priority is to be wise with your spending money, and then, save. Especially in a low interest rate environment, the biggest benefit of saving is saving, and not what you earn.
One more note: there are two ways to make sure you spend less than you earn. The first way is to budget strictly. The second is to make sure your cash balance grows over every six months. The latter has been my way. It is more flexible, but it requires that people have limited desires, viewing spending as a necessary evil at best.
By David Merkel, CFA of Aleph Blog