Sunday, May 11, 2008

Personal Fiance 101 - How to Save and Invest

As most of you know, I’m an engineer at Boeing. What few of you probably know is that I am a wannabe financial planner. Tiffany is a member of a mommy blog, and the theme for May was “money-saving May.” Since I have a strong opinion on personal finance, I created a long post on the subject. I thought that some of you might be able to learn something from it. Here’s a little disclaimer: I’m frugal. Even though you might not care to be as frugal as me, you will probably be able to glean something from this post.
During my senior year of school I grew disinterested with engineering, so I decided to read as much as I could on investing. I figured that if I learned to invest wisely at a young age, the knowledge learned about investments would pay dividends (literally) over the course of my lifetime. Due to the power of compound interest, I realized that it is especially important to master the concepts of investing and personal finance at a young age.
I’ve divided this post into three parts:
  1. How to Increase Your Savings
  2. Understanding the Value of a Dollar
  3. How to Invest Wisely
  4. Why I Save
PART 1 – How To Save
Most people think that they acquire savings when they earn more than they spend. Though this is true, I would encourage you to think of savings another way: You save by spending less than you earn.
In this section, I’ve tried to illustrate some practical ways to spend less than you make. I’ve tried to arrange my thoughts in order of importance.
Live under your means.
If you want to increase your savings significantly, you will have to learn to live well under your means. The following principles have helped me considerably in my life:
  • Understand needs vs wants
    • Whenever I make a purchase, I ask myself if it is a need or a want. If it’s a need, I buy it without remorse. If it’s a want, then I have to do some more thinking. If you want to increase your net worth, this is the single most important principal that I could impart to you. There have been countless times that I have wanted to buy a new toy, but I’ve refrained because I didn’t need the thing. I use this skill daily.
    • A budget can help you distribute your spending to satisfy your needs and wants. I’ve heard that they are very useful for a lot of people, but I don’t use them.
  • Spend less than you make
    • When you get a raise/bonus/tax rebate, pretend like you didn’t. You’ll magically increase your savings. Tiffany and I pretend like we are college students even though we’re making a hundred times what we were in school. It pains me when I hear of people blowing off their tax rebates on plasma TV’s which they really can’t afford. I am not going to alter my spending habits at all when my $1200 gift from the IRS arrives. It will go straight to savings.
    • Watch out for recurring fees. They’ll kill you because you don’t even thin when you pay them. I’m talking about cell phones, tv, internet, car insurance, etc.
      • Tiff and I pay $13/month for Comcast local TV. It was tough saying goodbye to ESPN (more so for Tiff than for me), but we hardly miss it at all.
      • Tiff and I pay $100/year for BOTH of our cellphones. We have T-mobile prepaid phones which we use sparingly. We use less than 1000 minutes a year total. Tiff and I are able to get a hold of each other 99% of the time when we’re apart through normal phones at home/work. I don’t miss having my normal 1000 minute/month plan one bit.
      • Tiff and I pay $13/month for voice over IP (VOIP) phone service, with unlimited long distance. Since we can’t live without broadband, I figured that we ought to get the most use out of it. VOIP quality is fine. It’s better than cell phones but worse than land lines. We use viatalk ( and like them fine. I believe they have a promotion right now for 2 years of service for $200. That’s better than the promotion that I locked in to.
      • We take advantage of internet promotions, which give away internet for free for the first 6 months. Once the rates go up, you can switch services to qualify for the new internet promo. We switch between Comcast cable internet and Earthlink broadband every 6 months or so. The great thing about this strategy is that Earthlink uses Comcast cable, so you don’t need some installation guy coming to your house every time you want to switch. It’s as easy as a phone call. We save TONS of money each year by doing this. If you are too lazy to do what I just mentioned, simply call up your current provider and ask them to match a competitor’s promotion. 99% of the time they will give you a cheaper rate so that they don’t lose your business. Info here:
      • Car insurance. Tiffany and I have gotten some pretty sweet discounts at Geico by following the counsel provided here: We save about 15% a year on car insurance by simply by opening up a checking account at PENFED. I believe we put $5 in there to open the account an haven’t used it since. This discount is the same as Berkshire-Hathaway shareholders enjoy. Fortunately, $5 is a lot cheaper than the $4179 that a Class B Berkshire stock is going for now. If you don’t have family in the military, you can pay the $20 fee as explained in the link.
    • Develop cheap hobbies. Some of our favorite cheap hobbies are playing board games, hiking, biking, going on walks, and reading.
      • I could go on forever and ever and ever about board games. I’m not talking monopoly or sorry. I’m talking about German strategy board games like Settlers of Catan, Alhambra, Ticket to Ride, etc.
    • Eat out less frequently. It pains me to the core every time I go out because I realize how much cheaper I could eat at home. It’s so bad that when it’s my birthday, I request to eat at home instead of going out. If you do go out to eat, don’t order drinks, sides, or desserts. I realize that I’m pretty unique one this one… I simply don’t care about food that much.
  • Never, ever, ever pay bad interest. I would categorize education loans and mortgages as good interest. Anything else would fall under the bad interest category, including cars.
Part 2 – Understanding the Value of a Dollar
At this point in the post, you’re probably asking yourself if I could be any stingier. Let me try to explain why in the heck I care about minimizing expenses. I like to save money because I understand the significance of saving a dollar. In order to spend a dollar, I have to make over a dollar because of taxes and tithing. If I assume a 25% marginal tax rate, I would have to make $1.33 to spend a dollar ($1/0.75). If I pay tithing, I would have to make $1.54 to spend a dollar ($1/0.65). When you save $1, it’s the equivalent to earning $1.54. This is an incredibly empowering topic which a lot of people don’t understand. For us members of the church, I believe it to be especially important, since we pay tithing and usually live off of one income.
One of my coworkers is a single guy with a lot less financial obligations than me. He doesn’t pay tithing or support a family. He shares rent costs with a roommate. I would think that our salaries are almost identical, but he cannot manage to stay out of credit card debt. We, on the other hand, manage to save about 35% of our pre-tax income. It just goes to show you that it’s not how much you make; it’s how much you spend.
Ultimately, if you learn to minimize your expenses, you can work less to support your lifestyle. This will allow you to spend more time with things that you enjoy doing, like spending time with the family or developing hobbies.
Now that we’ve learned how to maximize savings, we should have some extra change lying around. In this next section I’ll try to explain what to do with it.
PART 3 – Invest Your Wisely
  • Own a home if you can. Unfortunately, after being out of school for 1.5 years and living in an overheated Seattle real estate market, we have been unable to cough up the 20% required for a house. Fortunately, through living the principals mentioned in the first section, we’re getting close. There are countless benefits to owning a home. I’m looking forward to building equity in a house, never having shared walls again, and having a juicy tax write-off some day.
  • If your employer matches any retirement contributions, you must take advantage of that. When you fail to take advantage of your employer’s matching, you are throwing money away. This is a tough principal for a lot of us young folks to grasp. When I was an intern at my company, I didn’t take advantage of the company matching because I was a dumb kid. I didn’t understand what a 401(k) was or why I should take advantage of employer matching. I’ve wised up over the past several years, and I’m kicking myself for my wasted opportunity.
    • Invest in low-cost mutual funds. The most significant costs associated with mutual funds are sales loads and expense ratios. Just like the principles described in the first section, cutting costs is one of the best ways of guaranteeing superior performance on stocks. I invest exclusively in index funds, which are like mutual funds in that they hold a variety of stocks, but they are passively managed. What this means is that a person isn’t actively trying to guess what the best stocks are going to be. Rather, the index simply tries to follow a pre-determined mix of companies. The S&P 500 and DOW are the most common US indices out there. There are countless PhDs out there who swear by passive investing. I’m not as smart as them, but I’m smart enough to read their books and believe them. If you care to learn more about investing, I have some recommended reading at the end of the post.
  • If you have money left over, put it in a Roth IRA. Capitalism is great. Business are out there doing hard work to make money. They create amazing innovative technology and perform great services. Through the miracle of stocks and bonds, you and I can share in the profits of these companies!!! All of this while sitting in our underwear at home!!! Stocks and bonds are profitable investments when companies make profits. Since most companies usually make profits over the long run, stocks and bonds remain to be pretty profitable investments.
    • Each year, you are allowed to put $5000 per person in this tax-sheltered account. The Roth differs from the traditional IRA or 401(k) in that you pay the taxes now, but you never pay taxes again. That means that when I withdraw from my Roth IRA in 40 years, I won’t pay a penny of taxes to the government. One of the greatest advantages of the Roth IRA is that you can touch the principal (money that you have contributed) without penalty at any time. When you do this, you don’t have to pay taxes, since the money has already been taxed. Traditional IRAs or 401(k)s impose a 10% penalty upon withdrawal of funds in the event that you withdraw before retirement.
    • Open up a Roth IRA at Vanguard. It is hands down the best brokerage out there. Vanguard has the lowest fees out there, and they have a wide variety of index funds to choose from. Investing in a target retirement fund is the easiest way to go because it automatically adjusts your portfolio's risk profile as you age. If you are planning to retire in 2040, invest 100% of your money in the Vanguard Retirement 2040 fund. You will be incredibly diversified with this one fund.
    • One word on realistic expectations on returns: The 12% return in the markets that we’ve seen over the past 25 years is unsustainable. Businesses simply aren’t that profitable. What has driven up stock market prices so much is speculation. Warren Buffet, the richest man in the world, has indicated that future returns should be no more than 7%. Call me crazy, but I listen to the guy when he talks. He knows a thing or two about investing.
  • Invest in yourself. The leaders of the church have told us on many occasions to “get all of the education that you can.” It’s a powerful statement that has inspired me to go back to school for a graduate degree. Investing in your education is simply the best investment that you can make. As the world becomes flatter and flatter, it is getting more and more competitive. Having an education will be paramount in remaining marketable through these times. Thirty years ago, all it took was a high school diploma to be marketable.
  • Open up a money market savings account. These vary from traditional savings accounts in that their interest rates don't suck. Current money market rates are around 3%, though they were as high as 5.5% before the federal reserve started slashing interest rates over the past 6 months. WAMU has one of the best rates in the country right now, at 3.25%. Sign up here:
    • At any point in time, Tiffany and I only have $50 which is rotting away in a checking account. Everything else is invested in the stock market or making interest.
    • Since money market accounts have a limit of 6 withdrawals a month, we simply buy everything ever on a rewards credit card and pay it off in full every month. This way, we have far less than the 6 transactions a month. If we owe a friend $5 bucks or something, it comes from our checking account.
Part 4 – Why I Care About Saving
I don’t hoard money so that it can go unused in some savings account somewhere. My philosophy is that I deny many small things which I don't care about in order to buy big things which I do care about. The things that I don't care about are eating out, having a big TV, having nice cars, wearing the latest clothes, having 1000 HD channels, etc, etc. Here are a few of the big things that I am planning on using my money for:
  • Safety net. I have a HUGE piece of mind when I realize that I could be laid off tomorrow, and still be able to provide for my family for over 2 years without income. This freedom will enable me to take my time to find my next job instead of committing to the first job offer that comes my way.
  • A house. I realize that I could spend frivolously and eventually get into a house in 20 years, but I'm not that patient; I want to get into a house sooner. Living frugally will enable me to do so.
  • Retirement. I don't want to work at the age of 65-70 like some of my coworkers. I want to retire at a reasonable age. I would rather be serving a mission or traveling the country to visit my grandchildren when I’m retired than working at Walmart at 65 because I didn't save enough.
  • Vacations. I love vacations. Some of my best memories as a kid were of being on vacations with my family.
  • Paying for kids. Kids are going to get a lot more expensive once they get older and start going to college, wrecking cars, and going on missions. Savings will definitely help here.
I fully intend to use my money for good causes. In my mind, it just clicks for me. I deny myself simple pleasures (which I don't really really enjoy) like eating out so that I can realize my long-term goals more quickly. I don't deny myself anything that I need or that I really want. The long-term goals are very important to me. For some people, they prefer eating out and having nice cars to having a safety net in case of job loss or buying a house. I don't.
When I served my mission in Chile, I met families living in poverty who were happier than any family that I've ever met in the US.
I've never met a person who has claimed to have too much in savings. I have met countless people who have spent too much money on frivolous items which have prevented them from reaching their long-term goals. Money can't create happiness, but the mismanagement of it can create misery.
The last point I want to bring home is that living frugally has not negatively affected my happiness one bit. In fact, it has done quite the opposite. Knowing that I'm working towards my long-term goals is incredibly liberating to me. Was anyone else frugal in college? Those were some of the best times of my life.
I am a firm believer in financial freedom/independence. Living frugally is a very important part of that goal. Sorry about the length of this post. This is a subject that I’m incredibly passionate about.
Recommended Reading:
The Richest Man in Babylon. This is the best book which I’ve ever seen on the topic of personal finance.
A Random Walk down Wall Street. This is hands down the best book which I’ve read on investing (and I’ve read a lot). It’s pretty technical, so you may want to read my next recommendation.
The Little Book of Common Sense Investing. This book is a quick read and gives a convincing argument for index funds.
- Brian