What Do I Do With My Money?
Personal Finance and Investing: The Bottom Line
There is an uncanny dichotomy between the sheer volume of self-help personal finance materials on the internet and the amount of information that tells me what I should do with my money. I spent hours during my early 20s pouring over forums and articles to figure out how to optimize the money I was making in my first jobs. The good news is, it’s very simple to do. The bad news is, it’s incredibly convoluted to try and figure out. I did the convoluted part, and have compiled a no-BS version.
If you’re in a position where you have some extra money and you want to use it to build wealth, here’s the bottom line.
Personal Finance Hierarchy
Too often, folks get some extra money and just throw it all into the stock market immediately without having built any emergency savings, or without utilizing tax-advantaged savings accounts. The above visualization shows the hierarchy of what your priorities should be, moving from red to purple. I’ll summarize each box below if you need an explanation, otherwise continue onward:
1) Emergency Fund- You need 3-6 months of money in a savings account that you can live on before you start throwing any into investment accounts. This is because once money is invested, it’s both harder to pull out in a time of financial crisis and also can depreciate to $0 in the stock market. If you lose your job, get in a car accident, the market crashes, etc, you need cash that you can access while you come up for air. If you don’t know what 3-6 months savings looks like, google a budget template, pull up your bank account, and see how much you spend every month.
2) Company 401k- If your company has a 401k match, meaning they pay you a percentage of what you put in the account, then that is free money. If you pass that up, you’re a bonehead. No matter what, always try and invest the maximum percentage that your company will match (to figure this out you can read your company’s policy, ask coworkers, etc). A 401k is a tax advantaged retirement account that’s sponsored by your employer but is still run through a normal brokerage where you can make other investments, such as an IRA. If you don’t have a 401k option with your employer, read on.
3) Debt- If you have debt, paying it down is your first priority. You should view the longer that you have large amounts of debt as the more money that is evaporating from your account over time (because of interest). Credit cards should be paid off every month so that you don’t incur debt on them. That’s a no brainer. Student loans are tricky because of the sheer amount they can be, but you want to pay those off as fast as possible. In the sense that the 401k is free money, interest from debt like student loans is money being burned, eaten by rats, or name your preferred metaphor. Most investment professionals say that you should be paying debt off before you’re even dabbling in trading securities (stocks, ETFs, etc). That’s because the money you’re losing on debt interest is often higher than the gains you will make off of securities.
Should I Use a Roth IRA/401k Option or a Traditional?
BLUF- Roth takes taxes out now verses when you retire. If you think you’ll be making more money when you’re older than you do now, choose Roth. If you’re currently a computer scientist and will end your career working at a surf shop, go traditional.
4) IRAs- These are tax advantaged accounts similar to your 401k, and the only difference is they have nothing to do with your employer. You can usually contribute up to $6k a year to an IRA.
5) More 401k- Unless you have some disdain for the fund that your company uses for your 401k, you should max out the account (you can even do this before worrying about IRAs if your 401k is in a good fund such as Vanguard Index Funds). Up to 26% of your income per year can be put in your 401k. This limit is, notably, different from the limit of your company’s match. Your company may match 6% of your contributions, but you can still put in 20% more of your income to hit the 26% IRS maximum.
6) Other investments (the fun stuff) - After you’ve done all this, you now can start moving into index funds, ETFs, stocks, etc. This is an entirely separate discussion and will be something I will touch on in another posts.
Years ago, a guy named Harold Pollack distilled down all you need to know about financial literacy into an index card. It’s another good summary with some overlapping concepts, detailed below with my commentary in bold:
1. Max your 401(k) or equivalent employee contribution.
2. Buy inexpensive, well-diversified mutual funds such as Vanguard Target 20xx funds.
3. Never buy or sell an individual security. The person on the other side of the table knows more than you do about this stuff. -Bad news for your friends that love watching the green and red lines go up and down; individual stocks tend to lose out over time.
4. Save 20% of your money. -Making a budget will take you like a half hour. Not that hard to figure this out.
5. Pay your credit card balance in full every month.
6. Maximize tax-advantaged savings vehicles like Roth, SEP and 529 accounts.
7. Pay attention to fees. Avoid actively managed funds. -Index funds are mostly not actively managed, no fees.
8. Make financial advisors commit to the fiduciary standard.
9. Promote social insurance programs to help people when things go wrong. -Don’t be greedy, be a good neighbor.
We can debate nuances of this writeup forever, but the bottom line is you cannot go wrong with these above methods.