Personal Money Management 101 Blog

Time flies. Another year is just about to bite the dust, and a new one is almost upon us.

Do you still make New Year Resolutions? Or have you long since given up with a history of pledges that never made it through January? Either way, New Year really is an excellent time to make some financial resolutions. Most of us get a decent break from work over the Holiday season, and in-between festivities we can take the time to review our finances.

1 Check your asset allocation

One of the most important aspects of financial planning is asset allocation, how we balance our funds between different types of investment. We need to review this periodically for two reasons. First, the relative proportions may have changed as different classes perform differently over time. Second, our own personal goals and circumstances may have changed, meaning some adjustments are needed. Your review may just confirm that you’re on the right track. If so, great, you’ll sleep easier at night. Otherwise you may need to do some re-arranging. But avoid minor switches; the fees involved will probably outweigh any benefits.

2 Lose less in fees

One of the biggest drags on the growth of your wealth is fees and commissions. And one of the worst leakages is in the form of mutual fund management fees. Time and again research has shown that managed funds on average underperform the market as a whole after management fees. And the few that do perform better (whether by luck or skill) can’t be predicted in advance. Ditch the managed funds for lower cost index funds or ETFs and keep the difference in fees in YOUR pocket. However, don’t begrudge commissions to TRUSTED advisors who actually make/save you money, eg real estate agents, lawyers, accountants etc. Choose these carefully, but when you find good ones it’s worth paying a little extra to keep them – they will earn you back their fees and more.

3 Develop financial thinking

Many of us want to be rich, but we don’t do anything about it (other than maybe buying a weekly lottery ticket). Wealth begins with the financial thinking. Think before entering into any financial transaction. Is it good for you? Are you getting the best deal? Maybe you can forgo a few inches bigger TV screen today to build your income-producing assets for tomorrow and beyond. Or when an over-eager salesperson offers you insurance with your latest purchase ask yourself if you really need it?

4 Watch your debts

Unsecured consumer debt is a killer. It’s the most expensive form of borrowing and pushes countless folk into bankruptcy every year, leaving the still solvent borrowers to pay for their recklessness. Credit cards are fine as long as you settle each month and don’t carry a balance. If you do have debts on your credit card look at moving it to lower rate borrowing, eg by extending your mortgage.

5 Do a stock take

Check through your bank statements for regular payments that may no longer be appropriate, eg insurance policies no longer needed, subscriptions for magazines you hardly look at, membership of clubs you never visit… And for those things you do need, check you’re getting the best deal. Price comparison sites make it easy to check.

6 Make time for money

We all lead busy lives. But just an hour or two a week balancing the family accounts, reading the financial pages, or catching a money show on TV can pay rich dividends. Be informed, but maintain a healthy skepticism too by not rushing out to buy every single tip you come across.

7 Watch the pennies

Maybe you could walk all or part-way to work rather than taking the bus or subway (better for your health too). Taking a few minutes to make a sandwich and/or brew a flask of coffee rather than buying out might seem like cents a day, but over weeks or months those cents become a significant number of dollars.

Creating wealth begins with learning to adopt the right thoughts and habits. Before you can create wealth you have to start thinking wealthy, and that begins with day-to-day money management.

Spending

What dictates your spending? Do you spend what you earn, what you need?

We all need food, shelter and clothing. We might want the latest wall-sized flat-screen TV, but we certainly don’t need it, and if we want to become wealthy we’d do better to wait until we can really afford it.

An all-too-common model is to treat all income as available for expenditure (or worse still to borrow more if it isn’t enough to meet all the wants); ie cash in, cash out. This model is guaranteed to keep you poor.

A better model is to spend what you need, leaving some left over for investment. Over time your investments will increase and start generating an income of their own. This too can be invested, allowing you to benefit from the effects of compounding.

Income

There are two kinds of income. If you want to become wealthy you need to begin shifting from one to the other.

Earned income is income you work for. The most common form is wages. It also includes profits that you personally earn(rather than your employees).

Passive income takes the form of interest on savings, dividends on investments and rent from land. Profit from business also counts if you don’t actually have to do anything to get it.

One problem with earned income is that it stops if you stop earning it, eg if you fall sick or get old, or if your employer utters the R-word (redundancy). Another problem is that it often requires you spend a large amount of time doing something you’d rather not be doing. I’m frequently amazed when big lottery winners say they’re not going to quit their jobs, they must be a rare breed.

The aim in wealth creation is to grow your passive income. Once it reaches the level of your needs you have the option to quit working, or rather to spend your time doing what’s important to you rather than what you have to.

Creating wealth is a possibility for everyone – including YOU. It’s not rocket science, but it does demand discipline; the discipline to forgo a little pleasure today for much greater potential tomorrow. And once you get started and watch your wealth growing the satisfaction will be far greater than that provided by short-term consumption.

This post was inspired by Gary Keller’s The Millionaire Real Estate Investor. Though specifically focused on real estate investing this book contains a clear and detailed explanation of how to change your thinking about money.

Two known facts about financial markets are 1) They’re unpredictable – the movements of markets has been likened to a drunkard’s attempts to find his way home (random walk theory), and 2) They’re volatile – in The (Mis)Behavior of Markets Benoit Mandelbrot suggests markets are much more volatile than generally acknowledged by standard financial theories.

The corollary of all this is that 1) Mutual funds generally don’t beat the market (in fact they generally underperform it after fees), and 2) The best safeguard against volatility is diversification, with the ultimate diversification being the purchase of index funds or ETFs.

See Why Managed Funds are Bad for your Wealth

Therefore the most important decision faced by investors is how to allocate their funds across the available categories / sub-categories of investment, the main ones being:

• Cash
• Stocks
  • domestic
  • international
  • blue chip
  • smaller companies
  • tech stocks
  • value stocks
  • income stocks
  • growth stocks…
• Bonds
  •   government issued
  •   corporate
  •   high yield (high risk, junk bonds)
• Index-linked funds
• Real estate
  •   direct – buy/flip, rental units
  •   indirect – REITs
• Commodities
• Derivatives
  •   options, futures…
• Specialist investments
  •   antiques, art, wines…

It’s important to keep some easily accessible rainy-day money in the form of cash. But while your capital sum is (generally) safe its value is being eroded by inflation, ie $100 10 years ago would buy more than it does today.

Stocks have traditionally been the engine of growth returning in the region of 7%pa long term [Bogle, Yahoo! Finance]. But even within the broad realm of stocks there are numerous varieties as indicated above.

Bonds, especially government issues, are safer than stocks but unless they are help until maturity still carry some risk as their value rises and falls in the opposite direction to interest rates and expectations.

For the risk-averse the “safest” of the above is the index-linked fund, which guarantees your funds will keep their absolute purchasing power. However, you still run the risk that other investments will far outperform tame inflation trackers.

Index investing is the safest way to take advantage of market growth, but it can seem a little bland. You can spice up your portfolio by some direct investment in some personal choices, eg investing in your favorite store. You can do easily this through cheap execution-only online brokers. But don’t place too much money in too few stocks.

So how do you determine the best allocation of your assets. There is no single right answer for all folks. The right balance for YOU depends on 1) YOUR personality, and 2) YOUR goals (and their timeframes).

Your personality determines the amount of risk you’re comfortable with. The higher the risk, the higher the (expected long-term) returns. But if you can’t sleep at night go for a safer, lower-yielding option. Your personality may also suggest some preferences that are close to your heart, eg you may have a love of Asia, or railroads, or… and want to feel you on a piece of the action. Just don’t let your emotions overrule logic.

We all have financial goals – usually several of them – and each with its own timeframe and priority. Examples are a holiday, car, house deposit, kids’ college fees, a passive income, a comfortable retirement…

Each goal contributes to how you distribute your assets in proportion to its importance and the size of sum required. Generally, the longer term the goal, the more you can afford to take risks. If you’re 20 and building a retirement plan you can be quite aggressive. If you’re saving for a holiday in 6 months time you’re probably better off in cash. As retirement is one of the biggest goals for most people so portfolios tend to get less risky as the holder ages.

As well as the risk/reward profile of each portfolio element you should also consider how closely they are correlated with one another, ie how much they move together. The textbook example of negative correlation is the ice cream maker and the umbrella factory. If one’s doing badly, chances are the other is doing well. EG Stocks and real estate often move independently of each other so together form a good mix.

Matching your investments to your goal can also provide a degree of hedging. If you’re saving for a house deposit, REITs should move with overall real estate prices. If you’re hoping to move to, say, Mexico, having some Mexican holdings will help your money maintain its value in your intended destination.

Over time your goals will change, some will be fulfilled or dropped, others will emerge. Also some assets will do better than others. Therefore you should re-assess your asset allocation every so often. Once or twice a year makes sense. However, avoid making lots of minor changes, you’ll just spend a fortune in fees.

Further reading

All About Asset Allocation by Richard A. Ferri
The Intelligent Asset Allocator by William Bernstein
Asset Allocation by Roger C. Gibson
The Art of Asset Allocation by David M. Darst

For more about the index-investing, asset-allocation approach see Smarter Investing by Tim Hale

Fact 1 – around 40% of marriages in the US end in divorce. Fact 2 – The biggest cause of divorce is… money!

We all have different preferences to how we manage money. These differences can take the form of amount to spend vs. amount to save, differences in spending/saving priorities, and different approaches to investment risk. All of these can cause be causes of conflict unless discussed and resolved in a mature fashion.

Another major bone of contention is where one partner is a(n unpaid) homemaker while the other earns an income. Traditionally the female has adopted the homemaker’s role but with greater career opportunities for the fairer sex the roles are being reversed in more and more households where she can earn more than he. This can be an added cause of frustration when the male feels unable to fulfill his customary function.

It is imperative that the homemaker’s job be valued by both partners. Running a home and family is a 24/7 responsibility. Doing a good job in raising kids is infinitely more worthwhile and satisfying than closing any amount of deals.

Another crucial question is whether to have joint or individual accounts. A joint account giving both partners full and equal access to funds can be convenient; it also requires a demonstration of great trust. On the other hand the joint account can diminish the sense of autonomy of both partners to spend as they wish. A joint account as well as individual accounts can provide a happy medium.

One financial advantage of marriage is the possibility of tax minimization. By appropriate distribution of your assets and income you can cut your tax bill. For example, in England if one partner does not work the couple’s entire savings should be held in that person’s name to receive tax-free interest.

It’s not very romantic, but given the marriage failure rate these days it might be worth at least considering a prenuptial agreement detailing what financial arrangements should apply in the event of going your separate ways.

The key to a happy financial relationship is openness, willingness to compromise, agreement on a set of ground rules, and flexibility to change the rules in response to changing circumstances.